Corporate Governance In Development: The Experiences Of Brazil, Chile, India, And South Africa (Oecd Development Centre)

CORPORATE GOVERNANCE IN DEVELOPMENT THE EXPERIENCES OF BRAZIL, CHILE, INDIA, AND SOUTH AFRICA edited by Charles P. Oman...

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CORPORATE GOVERNANCE IN DEVELOPMENT THE EXPERIENCES OF BRAZIL, CHILE, INDIA, AND SOUTH AFRICA

edited by Charles P. Oman

Center for International Private Enterprise OECD Development Centre

OECD Development Centre Center for International Private Enterprise

CORPORATE GOVERNANCE IN DEVELOPMENT THE EXPERIENCES OF BRAZIL, CHILE, INDIA, AND SOUTH AFRICA

Edited by CHARLES P. OMAN

2003

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2003 © CIPE and OECD

Table of Contents

Preface....................................................................................................v Acknowledgements.................................................................................vii Chapter 1: Governance - The Underlying Issues..................................1 Chapter 2: Brazil - Keeping It In the Family.........................................35 Chapter 3: Chile - Enter the Pension Funds........................................77 Chapter 4: India - The Tide Rises, Slowly..........................................105 Chapter 5: South Africa - After Apartheid..........................................161 Appendix...............................................................................................223 Bibliography...........................................................................................233 About the Authors..................................................................................241


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Preface Major corporate failures at Enron, Vivendi, Arthur Andersen, Marconi and others have put “corporate governance” in the headlines. They remind us that poor corporate governance can seriously affect the lives of thousands of people – investors, savers, creditors, retirees, employees, suppliers, consumers – even in the most highly developed countries. But is corporate governance important for developing countries? Is it, or should it be, a matter of concern for policy-makers in those countries? Until recently, at least, few thought so. Corporate governance is generally perceived as important mainly for companies whose shares trade on the stock market. In developing countries, the preponderance of small firms that do not have listed shares, on the one hand, and of large state-owned, foreign-owned and/or private family-owned companies whose shares are also not widely traded locally, on the other, helps explain why many people still doubt the significance of corporate governance for developing countries. Only in 1997-1998 did the “emerging markets” financial crises in Asia, Russia and Brazil attract serious attention to the quality of corporate governance in a few developing countries. Still today, few policymakers see it as a matter of concern for most developing countries. The OECD broke important ground by establishing the OECD Principles of Corporate Governance in 1999. The Development Centre has sought to build on and extend this work, and to clarify the importance of corporate governance from a long-term development perspective, by analyzing the institutional conditions and actual functioning, and malfunctioning, of corporate governance “on the ground” in developing countries in Africa, Asia and Latin America. Four country studies from that research, each written by recognized local experts in their country, are included in this volume. Another, on Malaysia, will be published separately. Initial versions of these studies served as the basis for an informal highlevel policy dialogue on Corporate Governance in Developing and Transition Economies, organized by the Development Centre and the European Bank for Reconstruction and Development and sponsored by the Center for International Private Enterprise. Participants in that meeting, held at the OECD in April of 2001, are listed in the Appendix at the end of this volume, along with participants in a prior workshop to discuss drafts of the studies. A follow-up dialogue was held with investors in London in 2002. The main message from these meetings, which the evidence and analyses presented in this volume confirm, is that the quality of corporate governance matters greatly for developing countries. More than is widely perceived, 2003 © CIPE and OECD

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improved corporate governance can contribute to a country’s ability to achieve sustained productivity growth and lasting democratic political institutions, both of which are crucial for long-term national development. While there can be no “one size fits all” approach to enhancing corporate governance in developing countries, the message is clear: reaping the full benefits of globalization, for all countries and for all segments of the population, including the poor, requires good corporate and good political governance combined. Neither can stand today without the other.

Louka T. Katseli Director OECD Development Centre

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John D. Sullivan Executive Director Center for International Private Enterprise


Acknowledgements The Development Centre gratefully acknowledges a grant from the Alfred P. Sloan Foundation that made possible the country studies and the Paris workshop to discuss their initial drafts. The Development Centre and the Center for International Private Enterprise thank the European Bank for Reconstruction and Development for its efforts as joint organizer of the Policy Dialogue meetings in 2001 and 2002, which led also to the joint EBRDDevelopment Centre Policy Brief, on Corporate Governance in Developing, Transition and Emerging-Market Economies. They thank the participants in those meeting for contributing to what was unanimously recognized as highly fruitful exchanges of views, and The Asia Foundation, the OECD Centre for Co-operation with Non-Members, and the Private Sector Support Program of the OECD’s West Africa and Sahel Club for their support for the 2001 meeting. The editor thanks Nicolas Meisel for his very able assistance, and Bill Crist, formerly of CalPERS, Grant Kirkpatrick, of the OECD’s Corporate Affairs Division, and John Sullivan for their encouragement and their feedback on Chapter 1- for whose final contents he nevertheless remains responsible.


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Chapter 1

CORPORATE GOVERNANCE IN DEVELOPMENT: THE CONCEPT, THE ISSUES, THE POLICY CHALLENGES Charles P. Oman

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orporate governance matters for national development. Studies of Brazil, Chile, India, and South Africa show that corporate governance has a role of growing importance to play in helping both to increase the flow of financial capital to firms in developing countries and to enhance those countries’ financial development as a whole. They further show that corporate governance matters for development, more than is widely perceived, because it can contribute greatly to achieving sustained productivity growth in developing countries’ real economies. The value of improved corporate governance for development cannot, however, be considered in isolation. In the financial sector attention must also be given to measures to strengthen the banking sector and a country’s financial institutions as a whole. To gain most from improved corporate governance in the real economy, close attention must also be given to competition policy and to reforms of sector-specific regulatory practices. Forces working in favour of improved corporate governance include those operating both on the demand and on the supply side of domestic and international equity flows to corporations in developing countries. Forces resisting such improvement, on the other hand, include dominant shareholders and other corporate insiders who widely operate – in the private and public sectors – within entrenched distributional cartels. Resistance to 2003 © CIPE and OECD

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CORPORATE GOVERNANCE IN DEVELOPMENT

many of the changes needed significantly to enhance corporate governance often exerts itself most strongly through clientelistic relationship-based systems of corporate and political governance. The weakening or collapse of such relationship-based systems in recent years, widely visible in the greatly reduced capacity of state-controlled providers of investment finance (such as national development banks), can thus be seen as a window of opportunity for countries to achieve change that is needed as much in the institutions of political governance as in those of corporate governance. Introduction Corporate governance was long ignored as a matter of importance for developing countries. It remained virtually invisible in those countries until the East Asian financial crisis of 1997-1998 drew attention to the problems of “crony capitalism,” and their perceived relationship to poor local corporategovernance practices, in several major emerging-market economies. Yet, as the threat to global financial markets raised by that crisis has receded, efforts significantly to improve corporate governance in the developing world have flagged. Indeed, even at the height of international concern for corporate governance in the emerging-market economies (called “emerging” because of the rapid growth of portfolio equity flows thereto in the early 1990s by large institutional investors based mainly in United States and Great Britain), little attention was given to corporate governance in other developing countries, especially the smaller and poorer ones. This tendency to ignore the quality of corporate governance in the developing world is a mistake. It is wrong because the institutions of corporate governance play an essential role in the long-term process of development of a country. True already in the post-war period as corporate capitalism spread in the developing world (in the form of domestic and foreign-owned private and state-owned corporate enterprise), the importance of corporate governance for developing countries further increased from the 1980s as globalisation accelerated change and intensified competition within as well as across national boundaries worldwide. The four countries covered in this volume could not be more diverse in their institutional infrastructure, national history (including legal heritage), business and political culture, size and geographic location. Our focus in this introductory chapter will not be on their diversity, however, but on lessons to be drawn from the significant relative commonalities among their diverse experiences. Our focus will be on the common corporate-governance challenges these countries – and many other developing countries – now face in their struggle for long-term development.

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CHAPTER 1 | CORPORATE GOVERNANCE IN DEVELOPMENT: THE CONCEPT, THE ISSUES, THE POLICY CHALLENGES

The remainder of this chapter is organized into five sections, plus a conclusion. The first defines corporate governance; the second explains why corporate governance is important for development. The third clarifies the key factors or forces that tend today both to work for improved corporate governance in the developing world (or that can be mobilized to do so) and to work against that improvement. The fourth section clarifies the policy implications, especially the concrete steps that should be taken both in the financial sector and in the real sector to improve corporate governance. Section five provides a brief discussion of the importance of the quality of the institutions of public, or political, governance. I. The Concept “Corporate governance” comprises the private and public institutions – both formal and informal – which together govern the relationship between those who manage corporations (“corporate insiders”) and those who invest resources in them. These institutions typically include a country’s corporate laws, securities regulations, stock-market listing requirements, accepted business practices and prevailing business ethics; an illustrative list is provided in the Annex to this chapter on pages 27-29. Corporate “insiders” can include dominant stockholders (i.e., owner-managers, or shareholders with the power directly to control management) as well as managers per se. Investors can include suppliers of equity finance (shareholders), suppliers of debt finance (creditors), suppliers of relatively firm-specific human capital (employees) and suppliers of other tangible and intangible assets that corporations may use to operate and grow. Perhaps more fundamental to understanding the meaning of corporate governance than any list of institutions, however, is to grasp the purpose of corporate governance. In all countries, the institutions of corporate governance serve two indispensable and ultimately indissociable objectives: enhance the performance and ensure the conformance of corporations in the country. •

The institutions of corporate governance facilitate and stimulate the performance of corporations – the principal forces behind economic wealth and growth in society – by creating and maintaining a business environment that motivates managers and entrepreneurs to maximize firms’ operational efficiency, returns on investment, and long-term productivity growth.

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The institutions of corporate governance ensure corporate conformance with investors’ and society’s interests and expectations by limiting the abuse of power, the stealing or siphoning-off of corporate assets, the moral hazard, and the significant wastage of corporate-controlled resources (so-called “agency problems”). These are the losses and distortions that the self-serving behaviour of managers and other


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corporate insiders can be expected to impose on investors and society in the absence of sound corporate governance. •

Simultaneously, the institutions of corporate governance establish the means to monitor managers’ behaviour to ensure corporate accountability and provide for the cost-effective protection of investors’ and society’s interests vis-à-vis corporate insiders.

Corporate governance can be understood, in sum, as serving both to determine what society considers to be acceptable standards of corporate behaviour, and to ensure that corporations comply with those standards. II. Why does Corporate Governance Matter for Development? A good illustration of the importance of this question, and of its challenging nature, is the fact that for 30 years or more, until mid-1997, developing East and South East Asia achieved very impressive, sustained, high rates of economic growth – growth that significantly raised the populations’ standards of living – in a context that most corporate-governance experts would now qualify as one of poor corporate governance. If corporate governance is important for development, then how was that possible? The importance of productivity growth Part of the explanation was suggested, albeit in highly provocative and caricaturised fashion, by Paul Krugman in his notorious 1994 Foreign Affairs article (three years before the onset of the crisis) when he compared the growth “miracle” in East and Southeast Asia to the Soviet model, and predicted a similar outcome.1 Krugman’s point was that experience (in this case Soviet experience) shows that while not easy, it is possible for a country to achieve high rates of output and income growth for long periods of time – many decades even – by engaging in a process of massive mobilization of factors of production in the country. Such factor mobilization can be achieved through various kinds of forced saving, significant and sustained investment in the education of the country’s population, high rates of rural-urban migration, mobilization of the female population into the modern manufacturing as well as the agricultural and services sectors, and so on. And – it should perhaps be emphasized more clearly than Krugman did – there is nothing illegitimate about the income growth that stems from such factor mobilization; on the contrary, such growth in production, and in people’s standards of living, is very real. The further point, however, is that because decreasing returns to continued factor mobilization must ultimately set in, growth based on factor mobilization alone cannot be sustained indefinitely. Such mobilization can last for years and should not be seen as anything less than a vitally important source of 4



economic growth. But the key to achieving sustainable development in the long run is to achieve reasonably self-sustaining factor productivity growth. Relationship-based versus rules-based regimes Beyond the distinction between input growth and productivity growth, and the importance for long-term development of a nation’s achieving the latter, a further distinction is crucial: that between systems of governance that are relatively personalized, clientelistic and often patronage-oriented, which we can call heavily relationship-based governance systems, and governance systems that are predominantly rules-based. Experience shows that predominantly relationship-based systems of corporate and political governance (and poor corporate governance) – which are ubiquitous in the developing world (including East and South East Asia at the time of the crisis) – are not incompatible with national development strategies based on massive factor mobilization. However, the same cannot be said for development based on long-term productivity growth: predominantly relationship-based governance systems tend not to be conducive to sustained long-term productivity growth.2 Nor, it turns out, are clientelistic relationship-based governance systems (and poor corporate governance) very amenable to a country’s movement, or transition, from a strategy based mainly on factor mobilization to one based more on long-term productivity growth. The country studies in this volume illustrate well these assertions. All four countries are in the midst of a dual, often difficult, transition – as is much of the developing world – from predominantly relationship-based to more rules-based systems in both their economic and political spheres of governance. In the economic sphere the movement is from relatively closed or inward–oriented and market-unfriendly systems to much more open and market-friendly systems. In the political sphere the transition is from relatively undemocratic to more democratic systems. Some countries, of course, are more advanced in their transition processes than others. Chile is more advanced than many in its move to rules-based governance in both the economic and political spheres, though its move in the political sphere is recent. Brazil has made very significant moves in both spheres since the debt crisis of the 1980s, which marked the end both of the country’s import-substituting-industrialization development strategy and of its military dictatorship. India has long been a political democracy but in most respects effectively began its move to a more open and market-friendly economy in 1991. South Africa began its challenging move from inwardoriented economic and undemocratic political governance to more open and democratic economic and political governance with the abolition of apartheid in the early 1990s. 2003 © CIPE and OECD

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Under the previous, heavily relationship-based, systems of governance, longterm investment finance was widely provided to corporations by state-directed, sometimes state-owned, sources, such as a national development bank. Countries could achieve significant growth of output, for periods of varying duration, through sustained factor mobilization (including forced saving). But sustained productivity growth in the corporate sector – and therefore in the economy as a whole – remained out of reach. The weakening or relative collapse of clientelistic relationship-based systems and the moves underway to more rules-based systems may or may not be irreversible. They constitute an important opportunity for needed change in governance structures. Agency and expropriation costs Much of the literature on corporate governance focuses on the “principalagent” relationship between shareholders (the principals) and managers (the agents) that stems from the separation of ownership and management in the “publicly” owned corporation of the kind that prevails in the United States and the United Kingdom, in which no single shareholder owns more than a small fraction of a corporation’s stock. Many authors argue, or assume, that the raison d’être of corporate governance in any country is to protect the interests of shareholders because the interests of other investors can adequately be protected through contractual relations with the company, leaving shareholders as the “residual” claimants whose interests can adequately be protected only through the institutions of corporate governance.3 They thus tend to see the role of corporate governance in development as one of helping to ensure the supply, and lower the cost, of the financial resources that corporations there require from sources outside their own enterprises (i.e., beyond retained earnings) to finance their investment activity. However, in countries where poor contract enforcement due to pervasive clientelism and/or a weak judicial system renders the very distinction between “residual” and “non-residual” claimants questionable – as is the case in many developing and emerging-market economies – the applicability of this reasoning is doubtful. Equally crucial is the fact that, outside the United States and the United Kingdom, the corporation with widely dispersed ownership is not the rule but the exception. Such is the case in the four countries covered in this volume, and apparently in much of the rest of the world as well.4 What prevails, throughout the developing world, is the corporation with concentrated ownership, i.e., dominant stockholders (“blockholders”) who directly control managers. Also widespread in the developing countries is the use by dominant shareholders of means to control corporate assets considerably greater, 6



even, than those to which their stock ownership rights would directly entitle them.5 The most important of these means are (a) corporate insiders’ use of cross-shareholdings among companies, (b) the issuance of multiple classes of shares with different voting rights and, especially, (c) pyramidal corporate ownership structures.6 The key potential conflict of interest in the four countries covered in this volume, and in the developing world as a whole, therefore tends not to be between managers and shareholders per se but between dominant owner-managers on one hand and minority shareholders and other investors (domestic and foreign) on the other. This conflict of interest is commonly referred to as the “expropriation problem,” as opposed to the “agency problem” that applies to the principal-agent relationship between shareholders and managers. Vested interests Many developing and emerging-market economies suffer from the destructive behaviour of powerful local vested interests. These are often entrenched in highly concentrated oligopolistic structures of local economic and political power. Their behaviour can greatly weaken or undermine healthy price competition and the proper functioning of markets, which are indispensable for an economy’s move to sustained productivity growth. Their behaviour can also greatly weaken or prevent the development and consolidation of democratic political institutions. The significant moves in many developing and emerging-market economies since the 1980s to privatise formerly state-owned corporations, to reduce anticompetitive market regulations, to liberalize trade and investment policies, and to attract foreign investors are having, overall, a major positive impact. Not clear, however, is whether those moves will prove sufficient to sustain the kind of dynamic and interactive processes of productivity growth and political as well as economic-policy reforms that are needed to carry forward the fights, both against poverty and corruption, and for the strengthening of political democracy and modernization of the state, that virtually all those countries require. For developing and emerging-market economies, even more than for OECD countries, institutions of corporate governance that work effectively to complement and reinforce the (still weak) competitive market mechanisms and (fledgling) democratic political institutions are becoming increasingly necessary to address the behaviour of entrenched vested interests. That behaviour, discussed further below, can constitute a major obstacle to achieving longterm productivity growth. Indeed, in all market-based economies – developed or developing – the firm is, and over the last century the corporation has become, society’s principal agent of economic activity and development. The institutions of corporate governance – combined with those of market competition (Adam Smith’s famous invisible 2003 © CIPE and OECD

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hand) and, where necessary, of government regulation – are society’s principal means of motivating corporations collectively to behave in ways that are good for society as a whole. A principal-agent relationship between society (the principal) and corporations as a group (the agents) can be seen as embodied in a country’s institutions of corporate governance: Society provides corporations with the incentive to act (in particular the right to earn profits) and the means to do so (notably the rights to act as a “legal person” and to benefit from limited liability) and seeks, in return, through the institutions of corporate governance – along with those of market competition and government regulation – to ensure that corporations collectively serve its best interests. As globalisation enhances the strength of market forces relative to that of regulation by national and sub-national governments, corporate governance thus becomes still more important. In the developing world, moreover, this importance is further amplified by two additional phenomena, beyond the effects of globalisation per se. One, a positive phenomenon, is the sea change in many of those countries to more market-friendly policy regimes. The other, a negative phenomenon, is the pervasiveness in those countries of concentrated oligopolistic local power structures. Those structures tend to be highly conducive to self-dealing7 by corporate insiders, in the private and public sector alike, that is deleterious to sustained long-term national productivity growth. As past experience in all four of the countries in this volume – and in the developing world as a whole – demonstrates, the consequence of such behaviour can be huge wastage of corporate-controlled resources and a highly inefficient economy-wide use of capital. The result is major dynamic inefficiencies, including foregone innovation and investment in new capabilities, on top of static misallocation, and often the perpetuation or exacerbation of local inequalities as well. A further consequence is to exacerbate resistance to needed change, reflected in excessive rigidity, and simultaneously (paradoxical though it may seem) excessive volatility, in both the political and economic spheres of power and decision-making. The behaviour of vested interests, in sum, widely constitutes a very serious hindrance to long-term development in both low- and middle-income countries throughout the developing world today. While the potential contribution of corporate governance to increasing the flow and lowering the cost of domestic and foreign financial resources to corporations is significant, equally if not more important, therefore, is its potential contribution to reducing the considerable wastage and misallocation of real investment resources – human and physical – and to overcoming the often highly negative-sum games of strategic rivalry among locally entrenched vested interests. Such wastage and misallocation, and perpetuation of the status quo, can constitute a major constraint on sustained productivity growth, and thus on a country’s long-term development.

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III. Forces working for and against better corporate governance in developing countries Factors and forces working for improved corporate governance In OECD countries, interest in corporate governance has grown rapidly in conjunction with the current wave of globalisation. In the United States, the interest mushroomed in the early 1980s when major US corporations suffered a number of widely publicized losses of home-market shares to foreign competitors, followed by the advent of “junk bonds” which led to the first big wave of hostile takeovers. More recent in Europe, the interest has been fuelled by deepening regional integration and the growth of cross-border mergers and acquisitions. Recent scandals associated with such names as Enron, Arthur Andersen, WorldCom, Tyco, Marconi and Vivendi have of course given further impulse to this interest. Institutional Investors, foreign and domestic Also important in OECD countries has been the spectacular growth of portfolio investments in corporate equities both at home and abroad by rapidly growing pension funds and other major institutional investors, along with concerns by corporate investors about establishing a “level playing field” for their international investment activity. The rapid growth of international portfolio investments by OECD-based (particularly US and UK) institutional investors is in turn reflected in, and largely responsible for, the significant growth of foreign portfolio investment in emerging-market economies in the 1990s. Portfolio equity investment flows going to developing countries rose from insignificant levels prior to the late 1980s to an annual average of $2.7 billion in 1989-1990 and then surged in 1993-1996 to an annual average of some $43 billion. Dropping to about $16 billion in 1998 in conjunction with the East Asian crisis, they are estimated to have risen again to about $48 billion in 2000 before declining again due mainly to the sharp decline in OECD stock markets and a general flight from equities by OECD-based investors.8 Anxious to ensure returns on these investments, OECD-based portfolio investors, in particular the major institutional investors, thus became a force working in favour of improved corporate governance worldwide, including in emerging markets, in the 1990s. Also important, though less widely perceived, has been the establishment and rapid growth of domestic pension finds in many developing countries. Chile’s 1981 creation of a fully funded, privately managed, pension system with individualized mandatory savings accounts was followed in the 1990s by the creation or significant development of such “funded” (as opposed to “pay as you go”) pension systems in 26 developing countries – including 2003 © CIPE and OECD

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Brazil, India, and South Africa.9 While these funds remain small compared to the largest OECD-based institutional investors, many have been important purchasers (along with foreign investors in some cases) of domestic corporate equity issues, notably in conjunction with local moves to privatise state-owned corporations. These domestic private pension funds constitute a significant current or potential force – arguably the single most important one in the long run – for improved corporate governance in the developing world. That said, even in Chile where the pension fund structure is relatively well developed, as Chapter 3 explains, regulatory restrictions on the amount and type of their investment – designed to protect the pensioners who are the funds’ ultimate beneficiaries – mean that the local funds are unable to play a more active role to enhance the governance of the corporations in which they invest. Demand for funds If foreign and, in some countries, domestic institutional investors (pension funds in particular) have become an important force for improved corporate governance as potential suppliers of funds through their purchases of corporate shares in developing countries, equally important is the fact that many domestic corporations have increased their demand for such funds in recent years. One reason for this demand growth is the considerable increase in the needs of corporations, in all countries, for extra-firm sources of finance to be able adequately to respond to the growing competitive pressures engendered by globalisation. The acceleration of change (in technology, but also in the dominant business model10) has required most firms to undertake major investments – and often continues to require large investments – in tangible and intangible assets (including human capital and technology), for which finance must be found, in order to remain or become competitive. The significant moves to liberalize international trade and inward-investment policies and to deregulate domestic markets have added greatly to these competitive pressures. So too has the significant privatisation of state-owned enterprises in many countries (just as the acceleration of change in technology and in the most competitive business model has been an important factor behind the drive to privatise poorly performing state-owned enterprises). A further, crucial, reason why the extra-firm financial needs of corporations in developing countries have increased is that in many the bulk of those needs used to be supplied (especially for large private companies, as well as for state-owned firms) by national development banks and other largely state-controlled sources of investment finance (often through various forms of forced saving). As the experiences of all four countries included in this volume illustrate well, many developing countries have witnessed the relative collapse 10



or even the disappearance of the relationship-based and politically directed financial systems that once prevailed. The consequence has been greatly to reduce their ability to supply long-term finance to local corporations (often in the name of “industrial policy”) as they did until a few years ago. The combined result, in the 1990s, was thus a marked decrease in the supply of extra-firm investment finance from traditional domestic sources precisely at a time when corporate extra-firm financial needs in those countries, as elsewhere, rose substantially. The result has thus also been to increase domestic pressures, within governments as well as among corporate insiders, in favour of improved corporate governance in order to facilitate the flow of investment finance to local corporations. Obstacles to Improved Corporate Governance Significant resistance to the changes required in order markedly to improve corporate governance is nevertheless widespread. Vested-interest groups that benefit from corporate-control rents11 – at the expense of minority shareholders and other corporate stakeholders both local and foreign – are often a major source of resistance to needed change. They tend to operate simultaneously, as noted earlier, both in the economy, notably as corporate insiders, and in domestic politics, in a context of concentrated oligopolistic local power structures. Part of the problem are the widespread monopoly powers of such groups, which tend to be reflected in foregone investment and innovation compared to what one would find in a more price-competitive context. Yet even more harmful are often the actions of these groups in their strategic rivalry with one another. In seeking to maintain or increase their share of a country’s wealth, vis-à-vis one another, these oligopolists – “distributional cartels” as Mancur Olson called them12 – tend to invest significant corporate-controlled and/or governmentcontrolled resources, not in the creation of new wealth, but in their actions of strategic rivalry per se. Those actions – both to manipulate the role of the state to their private economic advantage, and to use corporate resources to increase their share of political and economic power – tend not only to stifle healthy inter-firm price competition, as one would expect in the case of a monopoly, and to siphon-off significant resources for the rivals’ private benefit. They tend also to consume significant resources in their actions of rivalry. The result can be huge wastage and misallocation of a country’s resources, which of course reduces aggregate wealth and constitutes, for society as a whole, a highly negative-sum-game set of dynamics that is deleterious to long-term productivity growth in the national economy. Certain “paradoxes” found in many countries today that are struggling to develop illustrate well the possible effects of the behaviour of such distributional cartels. One is the extent to which corporations are prone to undertake large investments in highly capital-intensive production facilities 2003 © CIPE and OECD

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that remain unused or significantly under-used (i.e., costly investments in over-capacity) in countries that, virtually by definition, suffer from capital scarcity. Another is the tendency of oligopolists both to resist needed change (as when firms need to adapt to new conditions created by, say, the availability of a new technology, changing consumer preferences, or the advent of a more competitive business model) and, simultaneously, to create excessive volatility in markets, and often in politics as well – volatility that can even lead, in more extreme cases, to armed violence. The reason for this behaviour, put simply, is that, in their games of strategic oligopolistic rivalry, distributional cartels tend, on the one hand, to resist interfirm price competition and any (needed) change that might upset the balance of power within their oligopoly. Yet, on the other hand, they are simultaneously prone to provoke (unneeded) change whenever a member of the cartel or coalition of members within the cartel believes it can increase its share of power (e.g., product-market share, share of corporate-control rents, etc.) visà-vis other members of the cartel. The result is a significant wastage of capital resources, both material and human, combined with foregone investment in capabilities needed to compete in global markets, on one hand, along with a building-up over time of bureaucracy and resistance to change in corporations and government alike, combined with relative instability or volatility and thus fragility in both the economy and local political institutions, on the other. The result is also a tendency to reproduce clientelistic relationship-based forms of both corporate and political governance that are insufficiently transparent and accountable. The consequence is thus also to constitute a tremendous drag on growth and development, as well of course as on the changes needed to improve corporate governance. Clientelistic relationship-based systems of governance are also, in turn, particularly fertile breeding grounds for distributional cartels. Indeed, while such oligopolies operate in all countries, it is arguably the greater pervasiveness of their rent-seeking behaviour and negative-sum-game actions of strategic rivalry – to a point where their effects tend to overwhelm the benefits of healthy price competition – that constitutes the greatest obstacle to sustained productivity growth in many developing countries. That pervasiveness not only constitutes an important obstacle to improved corporate governance in many developing and emerging-market economies. It means, by the same token, that corporate governance has an importance that goes far beyond the question – very important in it own right – of how to increase the flow of investment finance to corporations in those countries. It points to a crucial role for corporate governance in helping to overcome the major obstacle to sustained national productivity growth in the real economy that the behaviour of distributional cartels widely constitutes today in the developing world. 12



IV. Policy Implications Corporate governance thus has a potentially key role to play today both in the financial and in the real (non-financial) sector in developing countries. In the financial sector Because of accelerated global change and significant domestic policy liberalization, as noted earlier, many firms in developing countries have a more pressing need for outside funding than they did in the past. This need comes moreover precisely at a time when the availability of long-term investment funds from traditional sources (e.g. the national development bank) has shrunk markedly. The institutions of corporate governance thus have a significant potential role to play today in helping to channel more investment finance to firms – a role understood by many as the very raison d’être of corporate governance in developing countries as elsewhere. Stock Markets The increased importance of improved corporate governance in the developing world is reflected in the spectacular growth in the size of the stock market – i.e., in the value of shares listed, referred to as “market capitalization” – particularly in the emerging-market economies during the 1990s. The data in the tables and figures at the end of this chapter (pp. 30 - 32) show this growth, in total value and in proportion to GDP, for each of the countries covered in this volume. Recently, however, many developing countries have also witnessed a serious weakening or shrinking of activity on their local stock markets – as also visible in those tables and figures13. Four phenomena, whose relative importance varies from country to country, have been largely responsible for this shrinkage: i. Many major local firms have seen their shares de-listed after they were bought by foreign corporations (i.e. taken over through foreign direct investment). ii. Many others have turned to, or increased their use of, American or Global Depository Receipts (ADRs/GDRs) as a means to sell shares in New York or London.14 iii. A few large firms, most notably in South Africa, have simply moved their primary listing from the local market to the London or New York Stock Exchange. iv. Since 2000, the collapse in share prices in OECD stock markets has led to a fall in share prices in emerging markets, in part because of 2003 © CIPE and OECD

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a retrenchment and withdrawal of OECD-based investors both from emerging markets and from investment in equities as a whole. While the decline of a country’s stock market is not necessarily evidence of weak corporate governance in that country, these contrasting stock-exchange experiences do raise questions for policy-makers. In particular: •

How important are stock markets as a source of investment finance for corporations in developing countries? (In South Africa they seem important, but is South Africa representative, perhaps even a model, or should it rather be understood as an exception?)

•

What is the importance of a country’s having a vibrant local stock market for the country’s long-term development? (In Brazil, for example, concerns have arisen that the country’s stock exchange might wither away. Suppose it did: Would that have much impact on the real economy’s longterm development?)

•

Are local stock markets significant potential suppliers of funds for small and medium-size local enterprises? (In many low- and middle-income countries these firms account for the bulk of local employment, and are also a key source of local dynamism and flexibility. Yet, in contrast to some large local corporations, these firms are unlikely ever to be able to sell their shares on the New York, London, or other OECD-based stock exchange.)

The question of how important stock markets are as suppliers of investment finance for corporations in developing countries can usefully be broken down into two separate components. One question concerns the relative importance of different sources of funds: What is the importance for firms of the finance they derive from new equity issues, compared to that they derive both from internal sources (mainly retained earnings) and from external debt (be the latter bank loans or via the sale of corporate bonds or other debt securities)? Closely related is the question: do corporate insiders desire to sell more equity but find it difficult to do so, perhaps because of poor corporate governance, or rather do they choose not to sell more equity – as would also be consistent with the well-known “pecking-order” theory of corporate finance?15 A separate question is how funds raised on the stock market are used by those who issue the stocks. In particular, are new equity issues used mainly to finance the creation of new production capabilities, thereby also perhaps adding to healthy price competition in the real local economy? Or do stock issues tend rather to be used by corporate insiders to absorb competitors without creating new production capabilities, perhaps serving to reduce local competition as well?

14



The evidence suggests, overall, that the issuing of new equity in not a major source of funding for the creation of new production capabilities – a pattern also seen in the historical development of corporate capitalism in the United states (to which we return shortly) and other OECD countries. Equally if not more important for our purposes is also the considerable evidence that dominant shareholders widely use non-voting shares, cross-shareholding and especially pyramidal corporate-ownership structures as means to gain access to significant external finance. An important consequence of this use is that corporate insiders gain access to considerable external finance without having to dilute their effective control over corporate resources, as they would if they sold more equity (with full voting rights) to gain access to that finance. Corporate insiders operating in a context of concentrated ownership structures, which are ubiquitous in the developing world, may thus widely be choosing to retain strong ownership positions in part, at least, because they can obtain significant external finance by means other than the sale of shares. Those means – notably the use of pyramids, whose benefits for the insiders are only amplified by combining their use with non-voting shares and/or cross-shareholdings – may constitute a functional alternative to improved corporate governance (and thus in particular to better protection for minority shareholders’ rights). Those means often allow insiders to gain access to external finance while retaining a degree of effective control over real corporate resources which can be considerably greater, even, than the insiders’ level of equity ownership. The greater problem from a development policy perspective may thus not be a shortage of corporate finance per se. It may rather be the extent to which the ubiquitous use of devices to separate corporate ownership rights from the control of corporate resources serves to facilitate and camouflage self-dealing and related rent-seeking behaviour – and the negative-sum-game dynamics that widely accompany that behaviour – by corporate insiders. The costs to society and the economy as a whole in terms of wasted resources, excessive rigidity combined with volatility, lost growth opportunities, and foregone development undoubtedly go well beyond the cost incurred by expropriated minority shareholders, because of the extent to which powerful distributional cartels use these devices. Measures to reduce or eliminate the use of shares with different voting rights, cross-shareholding and, especially, pyramidal corporate ownership structures are therefore widely advisable. Equally if not more important are measures to combat self-dealing by corporate insiders, notably through greatly enhanced disclosure and transparency requirements. The United States as a developing country The role played historically by Wall Street and the New York Stock Exchange in the development of the U.S. economy provides a useful perspective on 2003 © CIPE and OECD

15


the role of equity issues as a source of investment finance for corporations.16 Clearly Wall Street and the NYSE played a central role after the U.S. Civil War (1861-1865) in financing the construction of the nation’s railroads, whose development was in turn largely responsible for the emergence of a viable nationwide market towards the end of the 19th century. The creation of a large and rapidly growing national market in turn drove the remarkably sudden emergence, in the 1880s and 1890s, of large industrial corporations that were able significantly to cut costs and establish dominant competitive positions in their respective industries by taking advantage of large economies of scale and scope in production and marketing.17 While many of these corporations went on to dominate their industries for years to come (in the United States and sometimes globally), their phenomenal growth, from the time of their inception through much of the 20th century, was very largely selffinanced, i.e., financed through investment of retained earnings. The stock market’s meager direct contribution to financing the emergence of new industrial firms and the creation of new production capabilities cannot, therefore, be said to have played a major role in U.S. development. Starting before the First World War, and until the NASDAQ bubble of the 1990s, the key developmental roles played by the U.S. stock market appear rather to have been: a)

to make it possible for the founder-owners of the large industrial corporations, or their heirs, to sell or significantly reduce their equity in the company, and

b)

to facilitate major corporate merger waves in the 1900s, 1920s, and 1960s (as again in the 1980s and 1990s) by allowing firms to acquire other firms through the issuance of equity.

A direct consequence was also therefore to promote or facilitate the separation of ownership from management in corporate America. This separation in turn had two further important effects. Professionalisation of management One set of consequences was the professionalisation of corporate management, the emergence of a professional managerial class, and the development of a competitive market for managers. These trends and the emergence of a class of people imbued with a managerial culture (also reflected in the establishment of many leading U.S. business schools at the time) stand in marked contrast to the situation widely prevalent in the developing world today. In heavily relationship-based systems, too often a top corporate manager’s main “job qualification” (in the private as well as the public sector) is his close personal ties to top politicians – with all this can imply in terms of self-dealing, the expropriation of minority shareholders, 16



and the destructive dynamics of strategic rivalry within and between powerful distributional cartels. Liquidity: a key to economic development Second, the separation of ownership from management in the United States made it possible for shareholders, often led by corporate founder-owners or their direct heirs in the early part of the 20th century, to diversify their corporate equity holdings. In the process they were able to spread their investment risk, and thus reduce their overall level of exposure to commercial risk. A further result was to create a self-reinforcing process, a virtuous circle, which greatly increased the liquidity of the nation’s stock market. Probably more than the increased size of the stock market per se, the market’s greatly enhanced liquidity in turn made it possible for the stock market to play an important role in strengthening the entire U.S. financial system, and the process of development of the U.S. economy as a whole. Recent studies have indeed shown that it is much more the degree of liquidity than the size per se of equity markets (turnover rather than market capitalization) that strongly correlates, positively, with the strength of a country’s subsequent economic growth.18 Whatever the potential long-term development benefits for a country of its having a vibrant stock market – vibrancy to which improved corporate governance could in turn be expected significantly to contribute – those benefits appear likely to be more a consequence of the market’s contribution to enhancing the liquidity of the country’s overall financial system, than of its contribution to corporate finance per se. More important for a country’s long-term development than the primary market for shares, in other words, may well be the secondary market, because of the importance for national development of enhanced liquidity in the economy as a whole. The data and trends on “value traded” in the national stock markets of Brazil, Chile, India and South Africa, presented in the tables and figures at the end of this chapter, are thus perhaps of greater relevance from a long-term development perspective than are the “market cap” data. Banks and Stock Markets: Compliments A further key implication for policy-makers is thus that measures to strengthen a country’s system of corporate governance should be understood as a potentially important complement to, but not as a possible substitute for, measures needed to strengthen its banking sector.19 A country cannot have a strong and vibrant stock market without a strong, healthy, commercial banking sector. Indeed, for small and medium-size local firms in particular, and for assuring liquidity in a country’s financial system – including in low-income countries – a healthy banking system is sine qua non for development.20


17


An important implication for policy-makers and regulators – as Chile’s experience points up most clearly, and the chapters on Brazil and India also emphasize – is thus the need for careful attention to the quality of bank supervision and prudential requirements, as well as to bankruptcy rules and procedures. Often equally important is the need to enhance the corporate governance of local financial institutions, notably including that of banks. The latter implies a need for policy-makers to focus not only on disclosure requirements, the quality of auditing, etc., for financial as well as for nonfinancial companies. Policy-makers must also address such questions as whether business groups should be prohibited from having a bank as one of their group firms (as Chile’s experience would seem clearly to recommend) and whether a developing country should require a separation between commercial and investment banking activities. Enforcement The local stock market’s likely contribution to a developing country’s long-term development process may thus be greater through its potential contribution to the liquidity of the local financial sector as a whole, and less through the primary sale of corporate shares to finance the creation of new production capabilities, than is sometimes believed. Yet, from a policy perspective, it is still relevant to address the question of how to strengthen a local stock market – including its potential relevance for small and medium-size local firms – and, more broadly, of how to enhance a country’s system of corporate governance as a whole. On both counts, two broad policy challenges stand out: the need better to protect minority shareholders’ rights, and better enforcement of the rules and institutions of corporate governance as a whole. There can indeed be no doubt of the need greatly to strengthen the effective protection of minority shareholders’ rights throughout much of the developing world. To achieve that protection in a given country will usually require the enhancement or modification of several, perhaps many, of the institutions listed in the Annex. Exactly which ones, and how best to achieve the required modification or strengthening of each, will of course vary from country to country. Increasingly, however, the problem is not primarily one of putting the right laws and regulations on the books. Many countries – not all of course – now have a reasonably complete and well-written set of corporate-governance rules and institutions. The proliferation of national corporate-governance codes and the development of international benchmarks – to which the OECD Principles of Corporate Governance and the OECD-World Bank Corporate Governance Forum’s Regional Roundtables have contributed significantly21 – have been important in this regard. The principle weakness now, most experts would agree, and therefore the main policy challenge for developing countries today, tends much more to be one of achieving adequate enforcement of existing rules. 18



The need for effective enforcement in turn comprises two related sets of issues that require policy-makers’ careful attention: •

how best to combine – and where to draw the line between – voluntary and mandatory mechanisms of corporate governance, and

•

how best to combine judicial and regulatory means of enforcement.

On the question of voluntary versus mandatory governance mechanisms, some OECD countries (notably Great Britain) have found that a good general approach is one that emphasizes disclosure. Put simply, the approach involves using clearly-defined and relatively extensive mandatory disclosure requirements – notably including the disclosure of a firm’s degree of compliance with key, specified, voluntary codes or standards, and of the firm’s reasons for any non-compliance (the so-called comply-or-explain principle) – combined with an otherwise heavy reliance on voluntary governance mechanisms. An important advantage of this approach is that it promotes managerial transparency, which is necessary for corporate accountability, while simultaneously allowing maximum leeway for managerial flexibility. With globalisation, such flexibility has become all the more important for firms to be able quickly to respond to change in their competitive environment and maintain or enhance their competitiveness in global markets. It remains unclear, however, whether such an approach is appropriate for countries whose institutions are relatively weak. Nor is the distinction between mandatory and voluntary mechanisms as clear-cut as it might seem, because “mandatory” mechanisms may depend to a considerable degree on private enforcement mechanisms. An obvious example is the potential importance of stock-market listing requirements: Many stock exchanges were created by groups of stock brokers or traders and remain privately owned and operated; while few would deny the importance for a country of having a public securities-market regulator (often called a “securities commission”) as a separate monitoring and enforcement body, the threat of de-listing by the stock exchange can serve as a powerful enforcement mechanism in its own right. Another important example is that of collective self-enforcement of professional standards, and perhaps a code of professional ethics, by members of a particular profession, such as accountants, whose enforcement depends mainly on the importance of reputational effects within the profession. Yet, given the information asymmetries from which corporate insiders inevitably benefit especially in countries with concentrated corporateownership structures and poor protection of minority shareholders’ rights, and the considerable difficulties and inherent costs of monitoring their behaviour that arise therefrom, enforcement remains the key corporate-governance challenge for policy-makers in the developing world today. The question of enforcement also lies of course at the heart of the very distinction between 2003 © CIPE and OECD

19


relationship- and rules-based systems of governance. It is, indeed, within the context of promoting their country’s transition from the former to the latter that policy-makers must address the question of the proper role for public means of corporate-governance enforcement. Particularly important with respect to public enforcement is, in turn, the distinction between judicial and regulatory means of enforcement. Of course, because the judiciary is indispensable in any rules-based system for the enforcement of private contracts, as well as of public laws, the judiciary will always have a central role to play in corporate governance. Yet, in countries where the judiciary is weak – whether due to insufficient political independence, to insufficient resources, motivation or experience, and/or, conceivably, to legal heritage22 – recent experience in the transition economies shows that a regulatory enforcement can be more effective than judicial enforcement of a country’s securities laws.23 Recent experience thus highlights the potential value for developing countries of having a centralized, independent, accountable, well-funded and motivated securities commission endowed with adequate regulatory powers. True for all countries, this is especially true for counties with weak judiciaries, not least because of the considerable amount of time it can take effectively to strengthen a country’s judicial system. Policy-makers should not, however, perceive the choice between regulatory and judicial means of enforcement as an either-or choice. Each set of institutions (regulatory and judicial) has its potential strengths and inherent weaknesses; they should be seen – and developed – as complements. Indeed, from a long-term development perspective, few institutions are more important for sound rules-based governance than a sound judiciary. Part of the reason is that a country’s institutions of corporate governance comprise considerably more than its securities laws and their enforcement. Another, crucial, reason is the danger of regulatory “capture,” which occurs when those (e.g., the securities commission) with responsibility to regulate a given market are corrupted or otherwise unduly influenced by one or more participants in that market. The risk of such capture tends to be especially great in countries with strong distributional cartels, often reflected in those countries’ having weak judiciary systems as well. As the chapters on Brazil and India highlight, strengthening a country’s judicial system can be one of the most important corporate-governance challenges a developing country today faces. In the “real” sector Equally if not more important than the potential contribution of improved corporate governance to a developing country’s financial development is its potential contribution to the country’s long-term “real” economic development. Significant wastage and misallocation of human and physical capital in 20



countries that suffer critical shortages of both, and volatility often combined with resistance to needed change, widely constitute serious constraints on long-term productivity growth and development in the developing world. These are problems towards the solution of which improved corporate governance can also make a significant contribution. It can do so by helping to discipline corporate insiders — in private business groups and state-owned corporations alike — in the way they allocate and especially in the way they use, or waste, the sizable real resources they control. In the “real,” as in the financial, sector the institutions of corporate governance cannot operate alone. In the financial sector policy-makers must give careful attention to ensuring a sound banking system (including bankruptcy procedures, etc.) along with measures to enhance protection of minority shareholders’ rights and others to strengthen corporate governance per se. In the real economy, policy-makers must simultaneously give attention to three sets of institutions: •

the institutions of corporate governance per se (see the Annex);

•

the institutions of market competition;

•

the institutions of regulation that are generally required in certain non-financial sectors (notably such infrastructure network industries as telecommunications, electricity, gas, water and rail, land and air transportation) including many where major state-owned corporations have recently been privatized.

The significance of the institutions of market competition is of course that vigorous inter-firm price competition can serve as a major tool to compel corporate insiders to allocate and use resources efficiently. The problem in many developing countries is precisely the extent to which such price competition is overwhelmed or displaced by the actions of distributional cartels. Significant recent moves to liberalize trade and investment policies and reduce anti-competitive market regulations should help. But many countries may need to establish or strengthen a pro-active domestic competition agency – one with sufficient political autonomy and resources to be able to monitor compliance with and enforce the rules of healthy price competition. Similarly, it is difficult to overstate the importance for policy-makers to give adequate attention to the need for regulatory reform and the establishment of competent regulatory bodies in those specific sectors (in addition to financial services) that require regulation. This importance is considerably amplified, moreover, by the risk of regulatory “capture” especially in countries where there are strong distributional cartels.


21


For a country’s competition authority and for its sector-specific regulatory bodies alike, a crucial challenge is to achieve the appropriate balance between the operational independence each needs (notably from short-term but often intense political pressures from the government, but also from producers, consumers, financial institutions, employees and other potentially powerful market actors), on one hand, and the high degree of institutional accountability which each must accept, on the other. Parties to whom accountability is due may include the public executive authority that established the agency, members of the legislature that makes the agency’s relevant governing legislation, and the judiciary that applies (and in common-law countries may also help make) that legislation. They may also include consumers, industry, and other taxpayers or interested citizens – since they are among those who collectively constitute the polity in which all public regulatory authority ultimately resides. A high degree of operational transparency is key to achieving this balance between independence and accountability. Such transparency contributes as well both to a country’s ability to attract investors (especially “patient” investors, who generally need to be assured of a long-term commitment to relative regulatory stability) and to facilitate a necessary degree of regulatory flexibility (needed for adapting to significantly changed technological conditions for example) in the real economy.24 Both are crucial for sustainable real productivity growth. V. Political Governance Effective resistance to the changes needed significantly to improve a country’s system of corporate governance (including adequate protection of minority shareholders’ rights) often asserts itself most strongly in clientelistic relationship-based systems of political governance. Even where corporate insiders give lip service to a country’s need for better corporate governance, old cosy arrangements between politicians and businessmen die-hard. The relative weakening or collapse in recent years of such relationship-based systems, widely visible in the greatly reduced capacity of state-controlled providers of investment finance (such as national development banks) to supply such finance, can thus be seen as a window of opportunity for countries to achieve change that is needed as much in the institutions of political governance as in those of corporate governance. Indeed, the close interaction between the institutions of political governance and those of corporate governance is reflected in at least three ways: •

22

in the central roles played in corporate governance by the legislative, regulatory and judicial institutions of political governance (as shown in the list of corporate-governance institutions and actors cited in the Annex);



•

in the extent to which distributional cartels exert their power in both the economic and political spheres of activity in much of the developing world; and

•

in the importance of the enforcement problem in practical attempts actually to enhance corporate governance in developing countries.

It is in fact virtually impossible to move to an essentially rules-based system of governance in the sphere of corporate governance without doing likewise in the sphere of political governance. And vice-versa! Though conceptually distinct, ultimately, in practice, the two sets of institutions are two sides of the same coin. Indeed, the arguments on good political governance put forward some three centuries ago by John Locke, in England, and Montesquieu, in France – when those countries were in the midst of their own, difficult, transition from heavily relationship-based to predominantly rules-based forms of political and economic governance – could hardly be more relevant to the developing world today. The gist of those views was to assert the importance of establishing a clear and effective separation of powers and responsibilities – including effective checks and balances among them – of three branches of government: •

a legislature that effectively assumes legislative but also oversight powers and responsibilities, and is representative of all relevant segments of society;

•

a competent and administration); and

•

a fair and independent judiciary

accountable

executive

(including

its

public

These views constitute the principal conceptual foundation, still today, for effective rules-based political governance. To those views one can usefully add an observation that is now widely accepted as part of the conceptual foundation for effective rules-based economic – and therefore also corporate – governance. It is the importance, for achieving long-term national productivity growth, of ensuring an effective separation of powers and responsibilities between those actions and organizations that are designed to serve individuals’ private interests, on one hand, and those whose purpose is to serve their collective or public interests on the other. The importance of institutionally separating private and public interests in turn points up the need for well-defined property rights, in order to protect individuals from the predatory actions both of other individuals and of the state. In providing such protection, property rights are indispensable to encourage 2003 © CIPE and OECD

23


the sustained private investment of human efforts and “patient” capital in the productive, as opposed to “redistributive” (i.e., predatory), activities that all countries require to achieve long-term national growth and development.25 The importance of institutionally separating private and public interests also points up the importance of ensuring an effective separation of powers and responsibilities between a strong corporate sector (both privately and stateowned corporations) which is capable of and responsible for producing goods and services and driving productivity growth, on one hand, and strong rulesbased institutions of political governance, on the other.26 The importance of effectively separating the powers and responsibilities of corporate and public interests, one might add, is considerably greater today, in the age of corporate capitalism, than when England, France or for that matter the United States were undertaking their transformation from relationship- to rules-based governance systems. The implication, in sum, is not only that good corporate governance requires good political governance, but also that the reverse is now equally true. Countries cannot achieve sustained corporate-driven productivity growth without both. Political leaders and policy-makers thus need to give careful attention to the incentives and means that can be mobilized – internationally and above all within developing countries – to ensure sound political governance. In their absence, efforts significantly to improve corporate governance, no matter how sincere, or costly, will often prove ineffective. Conclusion Sound corporate governance matters greatly today for national development. It matters more now than in the post-war period – and much more than when most of today’s developed countries accomplished their transitions from heavily relationship-based to predominantly rules-based systems of economic and political governance, before the advent of corporate capitalism. Corporate governance has a central role to play in helping to increase the flow and lower the cost of the financial capital, from international and especially from domestic savers, that firms in the developing world need to finance their investments and growth. The importance of this role has recently grown considerably, and is likely to continue to grow, as the needs of corporations for extra-firm finance have increased precisely at a time when the capacity of their traditional sources of such finance has diminished. The significant growth of portfolio equity flows from OECD to emerging markets, especially by institutional investors, points also to the potential for improved corporate governance in those markets to contribute to the stability 24



and growth of international financial markets. The potential benefits for the developing world as a whole of such stability and growth are not insignificant. Much less widely perceived yet equally if not more important are the potential benefits of improved corporate governance for achieving long-term productivity growth in the real economy of many developing countries. Volatility combined with excessive rigidities and huge wastage of real investment resources, both human and material, reflect the actions of distributional cartels in many developing countries. Characterized by ubiquitous self-dealing and rent-seeking behaviour by corporate insiders in a context of clientelistic relationship-based systems of local governance, such actions widely constitute a serious obstacle to sustained productivity growth in much of the developing world today. Improved corporate governance has an important potential role to play in helping to limit that behaviour, and thus promote development, in many countries. Improved corporate governance is not, however, a development panacea. In the financial sector, close attention must also be given to measures to strengthen the banking sector, and a country’s financial institutions as a whole. In the real sector, close attention must also be given to competition policy and to sector-specific regulatory reform. Forces working in favour of improved corporate governance include those operating both on the demand and on the supply side of portfolio equity flows to corporations in developing countries. Those on the demand side include corporations whose extra-firm financial needs have grown as their traditional sources of supply have shrunk; they can include governments responsible for those traditional sources (mainly national development banks), where they still exist, as well. Forces on the supply side include major institutional investors, especially pension funds and other long-term investors, both in OECD countries and, increasingly, in developing countries themselves. Forces that resist significantly improved corporate governance (which may nevertheless give lip service to the need for such improvement) include many dominant shareholders and other corporate insiders, who widely operate in the private and public sectors alike. They often benefit from corporate-control rents and therefore have significant means as well as the motivation to resist the changes needed for truly enhanced corporate governance. Sadly, many are also part of locally entrenched distributional cartels whose behaviour tends to impose costs on society and to damage the process of national development in ways that largely surpass those, such as foregone investment and growth opportunities, which one would expect under conditions of monopoly alone. The importance of distributional cartels as obstacles to development as well as to sound corporate governance in the developing world today, combined 2003 © CIPE and OECD

25


with the heightened risk of regulatory capture in countries characterized by predominantly relationship-based systems of governance, strongly reinforce the conclusion that good corporate governance requires good political governance, and vice-versa. Development requires moving from the rule of individuals to the rule of law, in the institutions of corporate and political governance together.

26



Annex to Chapter 1 Institutions of Corporate Governance - An indicative list A country’s institutions of corporate governance can usefully be thought of as comprising key formal and informal rules, including generally accepted practices, that are established among private actors as well by the state or other public authorities. An indicative list of typical corporate-governance institutions and actors includes: •

Corporate law, in particular legislation that (i) gives corporations juridical personality, i.e., recognizes their existence as legal “persons” independent of their shareholders, (ii) determines corporate chartering requirements, and (iii) limits the liability of shareholders to the value of their equity.

•

Securities laws, particularly legislation that allows and regulates the issuing and trading of corporate equity and debt securities (including laws on the responsibilities and liabilities of both securities issuers and market intermediaries such as brokers and brokerage firms, accounting firms and investment advisers).

•

A government body (“securities commission”) that has the legal authority and the material and human resources to regulate the issuing and trading of corporate securities, including the means needed to monitor and enforce compliance with securities laws;

•

Stock–exchange listing requirements (i.e., the conditions that corporations must meet to be allowed to list and trade their shares on the exchange), whose monitoring and enforcement may be the sole responsibility of the stock exchange (notably via the threat of de-listing) or may be shared with the securities commission.

•

A judiciary system with sufficient political independence and the investigative as well as judicial powers and the resources required to make and enforce, without excessive delay, informed and impartial judgements.

•

Professional associations or “guilds” (such as those of accountants, stock brokers, institutes of directors) that contribute – e.g., through membershiplicensing, information-sharing, peer pressure – to the definition and maintenance of standards of professional conduct in their field.

•

Business associations and chambers of commerce that, in a similar fashion, use formal and informal means to influence members’ thinking on and behavior with respect to acceptable business practices;


27


•

Other private and public monitors of corporate and securities–market participants’ behavior (notably pension funds and other institutional investors, ratings agencies, financial media).

In addition to these corporate-governance institutions and actors (including the body or bodies that enact relevant legislation), two broad categories of laws, regulations, other formal and informal rules and generally accepted practices are important: those that concern corporate oversight and control, and those that concern information disclosure and corporate transparency. Oversight and Control: •

Shareholder voting rights and procedures (including those that are especially important for the protection of minority shareholder rights visà-vis dominant shareholders as well as vis-à-vis management, such as cumulative voting rights and other so-called anti-director rights1);

•

The duties, powers and liabilities of corporate directors (boards and individual directors, including definition of what constitutes an “independent” director and requirements on board composition and on the constitution of board committees on audit, the nomination of directors and the remuneration of directors and top executives);

•

Proscription of self-dealing by corporate insiders (whether self-dealing occurs via related-party transactions2 or “tunneling”3 or takes the form of insider trading4);

•

Stock-tendering requirements (notably to protect small shareholders in the context of a corporate merger, acquisition or privatization)5;

•

Judicial recourse for shareholders vis-à-vis managers and directors (derivative suits, class-action suits6);

•

The functioning of markets for corporate control (take-over markets)7;

•

The functioning of markets for professional managers, and of labor markets.

Disclosure and Transparency •

Financial accounting standards, and how those standards are set;

•

Public disclosure, in a clear and timely manner, of such information as financial accounts (including both segment and consolidated accounts, the level and means of remuneration of directors and top executives); related-party transactions undertaken by corporate insiders; compliance, or the reasons for non-compliance, with specific provisions in corporate-

28



governance codes, other relevant codes, laws, regulations and selfdeclared corporate values or objectives; •

External audit (including how the auditor is chosen);

•

Independent or “third-party” analysis and assessment of corporate prospects (e.g. by stock-brokers, risk-assessment specialists).

Notes to Annex 1. “Anti–director rights” is the expression used by La Porta et al. to refer to six key shareholders’ rights: the right to mail their proxy vote to the firm; to participate in the General Shareholders’ Meeting without having previously deposited their shares with the company; to benefit from cumulative voting or proportional representation of minorities in the board of directors; to benefit from the existence of an oppressed minorities mechanism; to hold an Extraordinary Shareholders’ Meeting if it is called for by a minimum of no more than 10 per cent of share capital; and to pre-emptive rights to new issues that can only be waved by a shareholders’ vote (cf. La Porta, et al., 1998). 2. “Related-party transactions” are business transactions between a corporation and one or more other firms, or one or more individuals outside the corporation, with which (whom) one or more corporate insiders has a personal (often family) relationship. Related-party transactions are widely used as a vehicle for self-dealing (see note 7 in the text above) although not all related-party transactions involve self-dealing. 3. “Tunneling” is self-dealing that occurs within pyramidal ownership structures when controlling shareholders transfer resources from companies in which they have smaller cash-flow rights (cf. note 6 above) to companies in which they have larger cash-flow rights; it is analogous to asset-stripping. See Johnson, et al. (2000). 4. Insider trading occurs when corporate insiders or others with privileged access to information likely significantly to affect the market value of a company’s shares use that information to make profits through trading in the company’s shares before the information is released to other market participants. 5. Particularly important are pre–emptive rights to new issues – sometimes referred to in Brazil as “tag along” rights – included among the “anti–director rights” cited here in note 1 to this annex. 6. Derivative suits allow shareholders to sue corporate directors on behalf of the corporation itself; class-action suits allow individuals to sue on behalf of an entire class of individuals (e.g. shareholders in a given company). 7.

See also Leechor (1999).


29


Tables: National Stock Markets – Listed Firms, Market Capitalization, and Turnover Brazil* Number of listed firms

Market capitalisation ($m-end year)

Market cap. to GDP (%)

Value traded ($m)

Value traded to GDP (%)

1990

579

11,201

2.4

3,967

0.9

1991

570

32,152

7.9

6,941

1.7

1992

565

45,416

11.6

14,782

3.8

1993

551

96,779

22.1

27,081

6.2

1994

549

189,303

34.6

66,360

12.1

1995

544

147,636

21.0

57,025

8.1

1996

551

216,906

28.0

97,510

12.6

1997

545

255,478

31.1

190,658

23.2

1998

535

160,887

20.4

139,583

17.7

1999

487

227,962

28.8

83,772

10.6

2000

467

226,152

38.1

101,537

17.1

2001

429

186,238

37.1

64,606

12.9

2002

399

126,761

25.0

48,153

9.5

* Sao Paulo Stock Exchange Sources : World Federation of Exchanges ; WDI 2002 ; EIU database

Chile* Number of listed firms



Value traded ($m)


1990

216

13,636

1991

223

27,990

45.0

759

2.5

80.8

1,880

1992

244

29,595

5.4

70.7

2,055

4.9

1993

263

1994

277

44,887

98.8

2,809

6.2

68,195

137.2

5,371

10.8

1995 1996

282

72,928

122.9

11,412

19.2

290

65,971

96.2

8,488

12.4

1997

294

72,046

97.2

7,444

10.0

1998

287

51,866

71.2

4,412

6.1

1999

282

68,228

101.1

6,859

10.2

2000

261

60,401

85.7

6,083

8.6

2001

250

56,310

88.6

4,282

6.7

2002

246

48,045

73.4

3,018

4.6

* Santiago Stock Exchange Sources : World Federation of Exchanges ; WDI 2002 ; EIU database

30



India* Number of listed firms



Value traded ($m)


1990

2,435

1991

2,556

38,567

11.9

21,918

6.8

47,730

17.5

24,295

1992

2,781

8.9

65,119

24.7

20,597

7.8

1993 1994

3,263

97,976

35.1

21,879

7.8

4,413

127,515

38.6

27,290

8.3

1995

6,734

226,428

62.2

21,648

5.9

1996

7,627

225,011

56.7

95,252

24.0

1997

7,307

241,066

57.3

151,008

35.9

1998

7,142

197,944

47.2

146,115

34.9

1999

7,106

380,615

85.1

277,553

62.1

2000

6,960

310,958

68.0

493,735

108.0

2001

6,836

229,968

48.2

242,759

50.8

2002

6,459

270,300

53.9

213,360

42.6

* Mumbai Stock Exchange alone for 1990-1994 ; MSE + National SE for 1995-2002 Sources : World Federation of Exchanges ; Mumbai SE ; WDI 2002 ; EIU database

South Africa* Number of listed firms



Value traded ($m)


1990

769

136,869

122.2

10,469

9.3

1991

728

167,958

139.7

8,703

7.2

1992

671

148,675

113.9

7,754

5.9

1993

631

215,883

165.5

10,363

7.9

1994

624

240,026

176.7

17,631

13.0

1995

638

277,109

183.4

17,426

11.5

1996

626

239,579

167.5

26,998

18.9

1997

642

211,599

143.3

44,696

30.3

1998

669

150,670

112.5

61,837

46.2

1999

658

180,463

137.7

86,838

66.2

2000

606

131,321

102.7

77,446

60.6

2001

519

147,472

130.2

70,056

61.8

2002

451

181,998

156.0

79,000

67.7

* Johannesburg Stock Exchange Sources : World Federation of Exchanges ; WDI 2002 ; EIU database


31


Figures: National Stock Markets – Trends in Market Cap and Turnover

32



(Endnotes) Krugman (1994) The New Institutional Economics points clearly to this conclusion as well. See for example North (1990). 3 See for example, Shleifer and Vishny (1997) and Hart (1995). 4 See La Porta, et al. (1999). 5 This phenomenon is known in the literature as effective “control rights” that exceed nominal “cash–flow rights”. 6 A “pyramid” exists when one corporation (at the “top” of the pyramid) holds a dominant equity share (say, 51 per cent, though less may suffice) in and thereby controls one or more other companies (the second “layer” in the pyramid) each of which may in turn have a dominant equity share in one or more additional companies (the third “layer”), and so on. Corporate insiders who effectively control the corporation at the top of the pyramid – often a holding company – can thus control entire groups of corporations, and massive corporate assets, with very little direct equity ownership in corporations lower down in the pyramid. 7 “Self-dealing” is the expropriation or diversion by corporate insiders of a corporation’s assets (sometimes also called “asset stripping”) and/or of its income or income–earning possibilities. Common forms, or means, of self–dealing include having the corporation purchase inputs from one or more other firms (presumably also controlled by the corporation’s insiders or their close friends or relatives) at excessively high prices, or sell output at excessively low prices; having the corporation borrow money at excessively high interest rates, or lend at excessively low rates; having it lease assets at similarly non-market rates; having it guarantee other companies’ (or individuals’) borrowing; or even outright appropriation of the corporation’s tangible and/or intangible property without compensation. 8 See H. Reisen (2003). 9 Malherbe (2003) provides a useful typology of corporate-governance capabilities of domestic pension systems in 29 developing countries: Argentina, Bolivia, Brazil, Brunei, Chile, Columbia, El Salvador, Hong Kong, India, Indonesia, Kenya, Malaysia, Mexico, Nepal, Papua New Guinea, Peru, Singapore, South Africa, Sri Lanka, Swaziland, Tanzania, Uganda, Uruguay, Zambia and Zimbabwe. 10 On the central role of a new business model in driving both globalization and regionalization over the last two decades, see Oman (2000). 11 See also Dyck and Zingales (2002). 12 Olson (1982) provides a detailed analysis of the behavior of “distributional cartels,” albeit in OECD countries. Olson explains why such a group will tend to undertake actions (to gain, say, 2 billion dollars in increased income or wealth for the group) that often cost society as a whole much more than the group itself stands to gain (cost society the equivalent of, say, $10 billion in wasted resources, reduced income and lost growth opportunities). 13 By way of comparison, market cap on the NYSE grew from $2.7 trillion at end-1990 (equivalent to 47 per cent of United States GDP) to $11.4 trillion at end-1999 (124 per cent of GDP) and then fell to $9 trillion at end-2002 (86 per cent of GDP). Similarly, market cap in France, Belgium, the Netherlands, and Portugal – whose main stock exchanges merged in 2000 to create the “Euronext” exchange – rose from $0.5 trillion (28 per cent of the countries’ combined GDP) at end-1990 to $2.4 trillion (111 per cent of GDP) at end-1999 before falling to $1.5 trillion (76 per cent of GDP) at end-2002. Comparable figures for Japan are $2.9 trillion (96 per cent of GDP) at end-1990, $4.5 trillion (99 per cent of GDP) at end-1999 and $2.1 trillion (52 per cent of GDP) at end2002. For Germany they are $0.4 trillion (21 per cent), $1.4 trillion (68 per cent) and $0.7 trillion (37 per cent). 1 2


33


American Depository Receipts are securities backed by shares of non-U.S.incorporated companies that voluntarily comply with U.S. securities laws, thereby making it possible for the securities to be sold on a U.S. stock exchange. Global Depositary Receipts can also, for example, be used to sell a firm’s securities on the London Stock Exchange. 15 Cf. Myers and Majluf (1984). 16 See also Geisst (1997). 17 See Chandler (1977, 1990). 18 See Levine and Zervos (1998) and Rajan and Zingales (1998). 19 The considerable recent debate on whether countries should follow the route of the so-called bank-led system of corporate governance or rather that of the so-called Anglo-Saxon equities-based system may thus be addressing something of a false dichotomy (see e.g., Carlin and Mayer, 1999). 20 See for example Berthélemy and Varoudakis (1996) and Blommestein and Spencer (1996). 21 See in particular Fremond and Capaul (2002). The issue of enforcement has also been highlighted in the White Papers on Corporate Governance published by the OECD for Russia, Asia, South Eastern Europe and Latin America, which are summarized in OECD (forthcoming). 22 The role of legal heritage is much debated. La Porta, et al. (1998) launched the debate with their finding that minority shareholders’ rights are significantly better protected in countries with common law legal systems (of Anglo-Saxon origin) than in countries with civil law systems – of the French, German or Scandinavian variety – and, moreover, that among the latter, minority shareholders’ rights are least protected in civillaw countries with systems of French origin – countries which notably include much of Latin America. Using more extensive, and more recent, data Rajan and Zingales (2001) find however that civil-law systems tend to fluctuate more over time than common-law countries in the degree of protection they may provide to shareholders, and that one cannot “attribute cross-country differences in financial development to time-invariant factors, such as a country’s legal origin or culture.” 23 See also Glaeser, et al. (2000). 24 See Córdova-Novion and Hanlon (2002). 25 See for example North (1990). See also De Soto (2002). 26 To take such inspiration from Locke, Montesquieu and North – and, while their names are not mentioned in the text, from Ronald Coase and Hernando de Soto as well – on the importance of well-defined property rights may expose these views to criticism – say, from advocates of the concept of “Asian values” – that they are too “western,” thus biased, and not necessarily applicable in today’s developing countries. Yet, in response to such hypothetical criticism, I would highlight the remarkable parallel between these views’ emphasis on the importance for society of eliminating ambiguity and establishing clear social norms on who should yield to whom under what circumstances (through well-defined rules to which all individuals and governments are subject) and the teachings of no less a figure than Confucius, with their equally strong emphasis on the importance of eliminating ambiguity and establishing clear social norms on who should yield to whom under what circumstances. (Indeed, given that Confucius preceded Locke and Montesquieu – not to mention North, Coase and de Soto – by about 2000 years, one might even conclude that much of Asia long understood what the West only “recently” discovered about the fundamental wisdom of establishing such governance norms as clear and socially accepted property rights. Plus ça change, plus c’est la même chose!) 14

34


Chapter 2

BRAZIL: KEEPING IT IN THE FAMILY Luciano Coutinho and Flavio Marcilio Rabelo

A

lthough recent changes in the legal and institutional framework governing relations between controlling and minority shareholders may help local capital markets develop, major problems persist and serious obstacles to reform remain. Long-term finance is hard to find, existing governance procedures offer shareholders inadequate protection, and the fact that many Brazilian corporations are still often family-owned can militate against efficient management. The legal system is unsatisfactory, supervision inadequate. The best hope may lie in the emergence of pension funds which by their sheer size could fulfil a monitoring role. Problems of corporate governance have repercussions beyond the financial and economic sectors because they reflect deeper problems within Brazilian society. Brazil is a country with strong authoritarian traditions, and inadequate corporate governance laws make it possible to perpetuate authoritarian and concentrated influence over governance structures. There are signs of change but there are also real problems relating to regulation and the risk that the agencies responsible for policing large companies – notably privatised utilities – may come under the influence of the bodies they are supposed to be supervising.


35


Introduction A major concern for emerging economies like Brazil is the availability of long-term finance, at competitive rates, for private-sector development. The scarcity of such finance became particularly acute in Brazil in the 1980s, when the state could longer provide much funding. The crisis of Brazilian public finance, which remains severe, increased the need for private sources of longterm finance. Still today, insufficient finance is widely considered an important handicap for the competitiveness of Brazilian industry, especially in those sectors dominated by locally owned enterprises. The Brazilian banking sector, long accustomed to very high interest rates, has never been able to provide long-term credit for industrial development; nor is a lowering of interest rates likely to lead banks to show interest for this kind of risk. Local capital markets are also quite underdeveloped, particularly in the area of equity finance. Since the early 1980s, local business groups have thus been relying practically entirely on retained earnings and (when macroeconomic conditions allow) on foreign capital markets to finance growth. Governance and development Finance is the main link between corporate governance and economic development. It is often posited that improved corporate governance should foster local capital-market development and thus provide the private sector greater access to long-term funding. While we subscribe to the logic of this hypothesis, the cause-effect relationship does not appear to be as clear or direct as one would wish. In particular, the considerable scope for the expropriation of shareholders in Brazil’s system of corporate governance means that investors may be less willing to provide equity finance to corporations. It is therefore to be hoped that the improvement of the legal and institutional framework that regulates the relationships of shareholders and lenders with controlling shareholders of corporations will foster the development of local capital markets. The recent approval by the Brazilian Congress of a new Corporate Law, granting somewhat more protection to shareholders, is evidence that this issue has gained importance in the business and political communities. Unfortunately, however, the final version of this new law embodies substantial shortcomings, and therefore protection of shareholders is still lagging behind desirable standards. The São Paulo Stock Exchange (BOVESPA), on the other hand, introduced a structure very similar to that of the German Neue Markt in the hope of stimulating Brazilian firms to adopt better government practices. Another benefit of an adequate corporate-governance system may be greater efficiency in the allocation of resources in the economy. If governance 36


CHAPTER 2 | BRAZIL: KEEPING IT IN THE FAMILY

mechanisms allow effective monitoring of management this will tend to reduce the scope for inappropriate use of scarce capital resources. Yet high corporate ownership concentration in Brazil and the fact that most large Brazilian-owned corporations are under family control hinders the effect of market discipline on managerial turnover (particularly in the case of corporations that are owner-managed), thereby allowing sub-optimal managerial practices to persist longer than would occur in a system where capital markets exert stronger signals. The recent histories of many large Brazilian family-owned and -managed business groups illustrate well the difficulty of removing owner-managers that are clearly destroying value. Indeed, another deleterious practice common in such groups is to allocate resources in a manner that favours the private interests of controlling ownermanagers at the expense of the corporation.1 The privatisation process initiated in the early 1990s, the growing role and activism of domestic institutional investors (pension funds), and the flow of foreign capital into the stock exchange, were all expected to produce important salutary effects in Brazilian corporate governance. These effects have remained limited. One reason is that the new ownership structures that emerged from privatisation continue to be characterized by a high degree of ownership concentration. Control in some privatised firms is shared among a small group of shareholders (family-controlled business groups, pension funds and local and foreign investment funds) and in others it is now held by a single dominant shareholder or group of shareholders. But privatisation did not lead to widely dispersed shareholding even in those firms acquired by Brazilians. Moreover, in many cases the privatised firm was acquired by a multinational company, which often then proceeded to buy many or all of the remaining shares from shareholders, thus also further reducing or eliminating the liquidity of the firm’s shares in the market. For their part, foreign portfolio equity investors (as distinct from foreign direct investors, who control management) have generally avoided adopting a more activist stance as shareholders, probably because they afraid of the complicated and inefficient Brazilian legal system. Obstacles to change The single greatest obstacle to major improvement in Brazil’s corporate governance system is the relatively high degree of shareholder expropriation. That expropriation means that the private benefits of corporate control are sizeable, as revealed by the large premia carried by the selling of control blocks of shares in Brazilian corporations. It is not clear, therefore, if the promise of greater access to long-term funding sources will entice controlling shareholders to grant more rights to shareholders. The long period of time and the important concessions required for the approval of Brazil’s new corporate law clearly attest to the importance of resistance to change in the structure of corporate governance in Brazil. 2003 © CIPE and OECD

37


Another important obstacle is the nature of Brazil’s legal system. All administrative processes judged by the local securities exchange commission (CVM) may be brought to court, where a final resolution is always long and frequently costly. Moreover, the ability of the CVM effectively to monitor capital markets is hampered by its lack of adequate funding and staff. The new corporate law seeks to correct these matters, and also grants the CVM greater autonomy. The stabilization of the Brazilian economy following the 1994 Real Plan has been crucial in the development of better corporate governance. However, the high vulnerability of Brazil’s balance of payments does not yet allow for solid long-term macroeconomic perspectives, with much lower and stable interest rates, which would provide conditions necessary for the growth of capital markets. Such a scenario, if it emerged, would stimulate the development of long-term savings vehicles, particularly the private pensions industry (a positive sign was the large issue of corporate bonds in 2001 and in 2002 in spite of high macroeconomic uncertainty). As in many other countries, pension funds have come in recent years to play an important role in local capital markets and, given their sheer size, hold the promise of being better able than small investors to develop a monitoring capability with respect to corporate-sector performance. I. Evolution of the Corporate Sector in the 1980s and 1990s Before the 1990s Governmental promotion of capital accumulation has been strong in Brazil since the 1930s under the “developmentalist” strategy persistently pursued by the Brazilian state up to the 1990s. Many business groups have been created and supported over the years with state assistance.2 The major instrument used by the state in the 1940s and 1950s financially to assist local business groups was the Banco do Brasil; since then it has been the National Bank for Economic and Social Development (BNDES). Created in 1952, the BNDES has been funded through forced savings and by tapping international loans. The bank uses the relatively cheap funds it derives therefrom to finance local corporations. Brazil’s corporate sector was largely formed by the rapid process of importsubstituting industrialization (ISI) during the 1950s, 1960s, and 1970s, characterized by high tariff protection and the above-mentioned state-directed credit promotion of industry. At the end of the 1970s, however, the thenoptimistic view that Brazilian corporations had good prospects of becoming international players was frustrated by the country’s building debt-crisis. That crisis, which visibly exploded in 1982 but which was mounting already in the late 1970s, hit the entire private sector along with state enterprises that held large dollar-denominated debts to the offshore euromarket accumulated during the 1970s. 38



The state then absorbed most of the impact of the crisis by taking over those dollar-denominated debts from the private sector, through various mechanisms. The consequence, in Brazil and elsewhere in Latin America, was to weaken the state’s ability to continue promoting the development process. Fiscal fragility and severe foreign-currency shortage, coupled with the socialization of the debt, led to rampant inflation. In Brazil, the threat of hyperinflation was thwarted by the implementation of a pervasive system of indexation of all financial instruments, which created various forms of quasi-money. Inflation-proof bonds (especially self-indexed treasuries) provided safe liquidity harbours for the circulation of capital, thus preventing an overall rejection of the monetary system. High inflation uncertainty nevertheless required very high interest rates to reassure investors, which made borrowing virtually suicidal for firms. Financial managers throughout the private sector had to escape from debt as fast as possible. This led to massive de-leveraging in the corporate sector. According to Central Bank data the amount of bank loans to the private sector contracted from around 50 per cent of GDP in the first half of the 1980s to approximately 25 per cent of GDP in the second half of the 1990s. The accumulation of a portfolio of liquid financial assets became a major objective for all firms during this period, since it could offer juicy interest and capital gains. Firms with fluid cash flows and market power could extract extra gains, particularly if they had sufficient pricing power to raise their prices faster than the rate of inflation. Corporations in oligopolistic markets thus became leaders of and profiteers from the inflationary process. This anomalous inflationary regime, steeped in uncertainty, strongly favoured rent-seeking forms of financial accumulation. It reinforced the backward character of Brazilian corporations, insofar as the accumulation of wealth by the controlling families became a dominant objective per se. Thus, during the 1980s there was no progress in corporate governance. The 1990s In the first half of the 1990s this scenario changed little and was aggravated by more uncertainty and a progressive adhesion of the Brazilian elite to the then-dominant neo-liberal consensus. The discretionary freezing of all financial assets by the “first Collor Plan” in early 1990 further weakened confidence in the quasi-money financial assets, leading to higher interest rates and instantaneous indexation clauses. At the same time, the beginning of trade liberalisation put increasing competitive pressure on corporations and heightened uncertainty about the future, exacerbating their defensive strategies. A noteworthy turn-around of international capital flows to Brazil nevertheless took place in 1992. The recession that began in the United States spread to 2003 © CIPE and OECD

39


the G-7 countries during 1990-1992. Attempts to resume economic growth in a context of blatant financial fragility of the developed world’s banking systems prompted OECD countries’ central banks, led by the U.S. Federal Reserve, substantially to reduce interest rates in a stepwise manner. This significant reduction in interest rates led investors in OECD countries to look for alternative placement possibilities with more attractive returns, with the consequence that “emerging markets” received growing volumes of foreign capital in 1991-1993. A number of developing, “newly industrializing” or “emerging market” economies, starting with several that had adopted the liberalizing reforms proposed by the IMF and the World Bank, were thus flooded with foreign capital. Some Asian countries were major recipients in the early years of the decade, but as investors came to see the capital markets of those countries as relatively saturated, they started looking for new alternatives. In Latin America, this process began in Mexico, Chile and Argentina. Brazil, despite recurring threats of hyperinflation, started receiving massive amounts of foreign capital towards the end of 1992. Direct investment by foreign firms and other private financial flows from foreign sources were sizeable in Brazil during the 1990s. Foreign direct investment increased steeply (although showing a cyclical decline in 1995) and reached US$ 30 billion in 1999. An important reason for this formidable performance of foreign direct investment was the privatisation program, which attracted major European investment into the telecommunications, electric-energy and banking sectors. Foreign sources of financial-capital inflows, such as bank loans and the issuing of bonds both by affiliates of foreign firms and by Brazilian corporations, were also very important throughout the period. Latin America’s successful macroeconomic stabilization programs, which began in the early 1990s, would not have been possible without this massive inflow of foreign capital. It permitted the freezing or at least the stabilization of nominal exchange rates. What at first seemed only to be a blessing – the return of Latin America’s indebted countries to the international financial markets – nevertheless gradually led to an accumulation of major distortions. True, after more than a decade of crises and the persistent threat of hyperinflation, the price for stabilization did not seem high at the time. Overvalued exchange rate and weakened corporate competitiveness The stabilization brought on by the 1994 Real Plan in Brazil resulted in a seriously overvalued exchange rate right from the start. As also occurred in Mexico and Argentina, it undermined the trade balance and led to the emergence of a large deficit in the country’s foreign current-account transactions. Such stabilization, based on a substantially overvalued exchange rate, thus came with a high and not easily reversible price tag: a structural increase in imports and a deceleration in the growth of exports. 40



The current account deficit climbed quickly from a negligible amount in 1993 to US$18.6 billion in the first year of stabilization under the Real (1995) and reached US$33.6 billion (4.3 per cent of GDP) by 1998. The rapid erosion of the trade surplus underscored the structural fragility of Brazil’s competitiveness, which was based on commodities sectors with large production scales and low added value – raw materials (agricultural, natural resources and energy intensive sectors) with relatively low levels of industrial transformation. Reduced tariff protection together with an overvalued exchange rate and high domestic interest rates overburdened companies’ profits and made it more difficult for them to carry out restructuring in order to be competitive in world markets. In addition, capital costs were persistently higher for Brazilian corporations that sought to issue bonds in the American and Euro markets throughout the 1990s.3 Brazilian corporations were forced into purely defensive or survival strategies. Family ownership and management continued to be well entrenched. Family wealth-protection prevailed over the risks associated with corporate accumulation of capital. In sum, the situation of the Brazilian-owned corporate sector at the end of the 1990s was one of evident fragility, characterized by: •

persistent financial vulnerability resulting from very high capital costs;

•

significant regression of the long-term domestic financing base and of the capital market, which delayed corporate restructuring and perpetuated the concentrated structure of family ownership;

•

weak competitive performance with marked trade fragility in all sectors of high added value and high technological content; competitiveness is strong only in commodities sectors with large production scales and low added value – sectors that use raw materials and agricultural inputs and are energy intensive; and

•

widespread loss of national ownership in many sectors, and weakness and reduced size of the remaining Brazilian business groups which make it very difficult for them to become active world players.

Thus, although Brazil benefited from an abundant inflow of capital to stabilize inflation, the government opted for an onerous economic policy marked by five years of currency over-valuation and extremely high interest rates. The high price paid for this policy included much lower economic growth; a burgeoning public debt; the erosion of several industrial sectors; the persistence of backward corporate governance; and the widespread loss of national control of industrial and service enterprises. Foreign investors have increased their presence in all the dynamic sectors of high value-added activity. Foreign direct investment has come to dominate 2003 © CIPE and OECD

41


important services and infrastructure sectors that produce non-tradables and therefore cannot export – and because they are quite profitable those sectors will tend to generate a continuous outflow of profits, royalties and other income remittances, overburdening the country’s balance of payments. Brazilianowned corporations remain dominant almost only in industrial sectors of low value-added activity (commodities) and in other sectors of lower profitability. This serious weakening of national business groups switched the control of more than 300 major firms to foreign corporations. At least 50 of those were publicly held corporations that became fully foreign-owned and closed subsidiaries. Corporate governance in those firms was thus reduced to an internal matter for multinational corporations. Given the country-risk and the “ceilings” set on sovereign debt issues, Brazilian corporations’ issues of bonds in the international capital markets paid very high risk spreads (an average of 445 basis-points between mid-1996 and mid1998 and approximately 600 basis-points between mid-1998 and mid- 2000). Those high-risk yields meant a higher cost of debt for Brazilian firms even in sectors, such as pulp and paper, where Brazilian firms are highly competitive, since they were always classified by the rating agencies as belonging to the “speculative grade” category. The fact that Brazilian corporations had to pay higher capital costs undoubtedly put them at a competitive disadvantage visà-vis their competitors, which was an important factor driving both the poor performance of large Brazilian firms and the process of denationalisation in the 1990s. The second half of the 1990s also witnessed the speeding-up of the privatisation program, which created a number of opportunities to enhance corporate governance structures. While the Brazilian State historically played a major role in the development of basic infrastructure (electricity, telecommunications, transportation) and of basic capital-intensive industries (steel, mining, petrochemicals) through state enterprises, the debt crisis of the 1980s overburdened these state-owned firms and rendered them dysfunctional in terms of capital accumulation. Inefficiencies and management shortcomings then developed, given their narrow investment capability, and, abiding by the liberal wave of the 1990s, the Brazilian government initiated a privatisation program that went through various phases. II. Corporate Governance under Concentrated Ownership Corporate ownership is very concentrated in Brazil. The main owners are local family-controlled business groups and the families behind them, the state, and the affiliates of multinational corporations. An important part of the Brazilian economy is not directly affected by Brazil’s existing governance structures, since foreign affiliates are seldom established as public companies in the country and are not dependent on the local market for finance. The privatisation process initiated in the early 1990s is probably the most significant 42



event for corporate governance in Brazil since the end of the country’s industrialization phase. Resistance comes from existing power structures, which argue that protection of shareholders is not a major concern for the development of capital markets. But the effect of the present situation is that local business groups cannot amass enough capital to fight off foreign buyers. State intervention engenders inefficiencies; and Brazilian corporations punch significantly below their weight on the international scene. Widely held firms are the exception in Brazil – as they are in most countries, other than the United States and Great Britain, as was shown by La Porta, et al. (1999). Following the method used by La Porta, et al. (who did not include Brazil among the 27 countries covered in their study of corporate ownership structures around the world) we analysed the ownership structure of Brazil’s 20 largest firms (whose size is measured by their market capitalisation4) and also of Brazil’s 10 “medium firms” defined as the smallest listed companies with market capitalisation of at least US$500 million.5 We excluded majorityforeign-owned affiliates of foreign firms6; banks and utilities were also excluded from the sample of medium firms. Two groups of firms are distinguished: (i) widely-held firms, and (ii) those with controlling ultimate owners. A firm is considered to have an ultimate owner (controlling shareholder) if a single shareholder’s combined direct and indirect voting rights exceed 20 per cent of total voting rights in the firm. Among the firms with controlling owners, five categories of ultimate owners were then identified: (a) (b) (c) (d) (e)

a family or individual the state a widely-held financial institution a widely-held corporation miscellaneous (such as a co-operative, a voting trust, or a group with no single controlling investor).

Our main findings are: •

Only one large firm out of 20 qualified as “widely held” using the 20 per cent minimum-ownership threshold (and none would have qualified if we had used a 10 per cent instead of a 20 per cent threshold).

•

The State is the most prevalent ultimate owner, followed by families.

•

Three “medium” Brazilian firms out of 10 qualified as “widely held” according to the 20 per cent criterion (none under the 10 per cent criterion).


43


•

Families are the prevalent ultimate owners of “medium” firms.

•

“Widely held” firms in Brazil are not only rare; they tend to be quite different from the widely-held “public” company so common in the United States and the United Kingdom, because all firms classified as such in our sample still had clear control blocks – formed by a small group of shareholders (as opposed to a single shareholder).

The issue of separation of ownership and management is therefore not important in the realm of corporate governance in Brazil. Concentrated ownership also means that the relevant “agency conflict” in Brazil is that between controlling and minority shareholders, i.e., the “expropriation problem,” a subject to which we return below. It is also evident that while the privatisation process began in the early 1990s, the State, though shrinking, is still an important shareholder in large Brazilian corporations. It still controls very large firms like Petrobrás, Banco do Brasil, Caixa Econômica Federal, and the large part of the electricity sector that is not yet privatised. Pyramids and dual class shares In many countries pyramidal ownership structures, which dominant shareholders and business groups use to enforce their control over firms within the group, are common. Pyramid ownership structures make it possible to control some firms even with a very small share of their total capital. Controlling shareholders may use pyramidal ownership structures more than they do shares with differential voting rights as a means to separate cash flow from control rights and gain power disproportionate to their cash flow rights. More than half of the firms in Brazil that have families as their ultimate owner use pyramids in their ownership structures. (In some countries cross shareholdings are used as another instrument to enhance the control rights of dominant shareholders; but in Brazil cross shareholdings are illegal.) Dual-class shares and pyramid structures also interact to further reinforce the control of large shareholders. If only dual class shares were used, and given that in Brazil companies are legally permitted to issue up to two-thirds of their shares as non-voting shares, a shareholder could control a Brazilian company (hold over 50 per cent of votes) with 17 per cent of the firm’s total capital. Unfortunately, in response to heavy pressures by controlling shareholders, the new Brazilian Corporate law fails to terminate the existence of the “preferredstocks” (non-voting shares) and therefore to restrict the utilization of pyramid structures. In fact pyramid structures make it possible to gain effective control with even smaller percentages of ownership of a firm’s total capital. For example, the Setubal and Villela families control Itau bank with only 8.5 per cent of its total capital; the Moreira Salles family does the same in Unibanco bank with 10.9 per cent of total capital.7 The Odebrecht family uses pyramids 44



and dual-class shares to obtain control of the petrochemical firm Trikem with 10.7 per cent of its total capital. In the case of Gerdau S.A. (a major steel company) the controlling family (Gerdau) exerts control with 8.3 per cent of the total capital. It would be difficult to say which of these instruments – dual-class shares and pyramid structures – is more important for corporate control in Brazil. What can be said is that combined they provide an efficient method for a large shareholder to ensure control over a group of firms with a small percentage of total capital. Complicated ownership structures were also created in some cases for purposes of tax planning. A second issue, in the case of family-controlled firms, is the separation of ownership and management. (The controlling family is considered to manage if a member of the family is the CEO, the Chairman, the Honorary Chairman, or the Vice-Chairman.) In all the family-controlled firms in our sample there is no separation of ownership and management.8 A third issue is the role of banks in the ownership of non-financial firms. In Brazil, government regulations limit banks’ shareholdings in non-financial firms, and ownership of equity by banks is uncommon. Only one bank (Bradesco S.A.) has important shareholdings in non-financial companies.9 Rather, what we have in Brazil are families that own banks and are also dominant shareholders in important non-banking ventures, e.g., the Setubal and Villela families – controller’s of Brazil second largest private bank – and the Safra family. A further important issue is the question of who monitors large shareholders. In our sample of large and medium Brazilian firms, about 55 per cent of the firms with ultimate owners (at the 20 per cent threshold) did not have any other important monitoring shareholder.10 Most of the few exceptions, where controlling shareholders are not hegemonic, are products of the recent privatisation process, in which local business groups have established partnerships – with other groups, financial institutions, pension funds and foreign firms – in taking control of privatised companies. A further key issue is the growing importance of institutional ownership, notably by pension funds. We return to it shortly, when we discuss Brazil’s privatisation process. Business groups Corporate ownership, as we have shown, is very concentrated in Brazil. The main owners are the State, local family-controlled business groups and the families behind them, and the affiliates of multinational corporations. The presence of affiliates of multinational corporations has been very important since the beginning of the country’s industrialization process, 2003 © CIPE and OECD

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and they almost entirely control such key sectors as the auto industry, food and pharmaceuticals. With the rapid liberalisation of the economy in the 1990s, coupled with the privatisation process, their importance has grown substantially, especially in telecommunications, banking and energy. There has been a very high concentration of recent foreign direct investment inflows in public utilities and services, which are non-tradables in the case of Brazil. An important part of the Brazilian economy is thus not directly affected by Brazil’s existing governance structures, since these foreign affiliates are seldom established as public companies in the country and are not dependent on the local market for finance. Local Brazilian capital is mainly represented by family-owned business groups.11 These business groups are similar to the hierarchical groups found in Continental Europe.12 The dominant shareholders or coalitions of shareholders, which dominate the boards of all group companies and exercise control of these groups, are families. And, it is worth repeating, the combination of dual-class shares and pyramids allows the families to control many firms with a small percentage of total capital. Prior to the privatisation process, all large privately and locally owned Brazilian firms had a similar ownership structure. (The only notable exceptions were the petrochemical firms, characterized by trilateral control arrangements comprising local business groups, affiliates of multinational petrochemical companies and the State through Petroquisa, a subsidiary of Petrobrás13.) However important these groups were, and still are, in the Brazilian economy, none has succeeded – given the adverse macroeconomic environment, particularly high uncertainty, high interest rates and high country-risk ratings – in developing a consistent multinational strategy. Compared to the experience of their Korean counterparts (the chaebols), the experience of these groups makes it evident that Brazil’s state policy to aid and concentrate local capital was not able to generate competitive global firms. When the State was no longer able to provide funding to these groups under privileged conditions, their growth strategies faltered. While privatisation and economic liberalisation opened up potential new opportunities for these groups, those opportunities arose under the very unfavourable macroeconomic conditions (very high domestic interest rates, high external cost of debt and a markedly overvalued exchange-rate) noted earlier. The impact of privatisation The privatisation process initiated in the early 1990s is probably the most significant event for corporate governance in Brazil since the end of the country’s industrialization phase. State-owned companies in steel, mining, petrochemicals, telecommunications and energy – some of them among the largest and most valuable firms in the country – have been transferred to the private sector. The government has sold controlling blocks of shares in these companies rather than proceeding through a dispersed sale of 46



shares in the stock market. This approach was more apt to foster pro-active governance structures, and added significant premiums to the sale price of the control blocks of shares in the companies being privatised. Of course, a pulverised sale of shares could hardly give birth to genuinely widely held companies in the country. Given the very high level of income inequality in Brazil, a concentration process would certainly have followed in the secondary market, and the State would have transferred the control premium to private interests. The first two sectors to be privatised – steel and petrochemicals – did not attract the interest of foreign investors. In the case of the petrochemical firms, privatisation was an opportunity for local groups to assert their control rights over certain companies that they considered strategic to their growth. Privatisation then led to a concentration of ownership in most firms, something that was feasible given that the amount of capital required was not too large. Shared ownership was preserved only in the basic petrochemical “crackers” since none of the local groups had a capital base large enough to assume sole control, and also because none of them wished to give up its stake in these units that were seen as strategic within the value-adding chain. Privatisation did not really lead to new forms of corporate control in the petrochemicals sector. A different picture emerged in the steel sector, where the amount of capital required to purchase control blocks in some major firms sold by the State (CSN, Usimininas, Cia. Siderúrgica de Tubarão and Acesita ) was too large for any local investor alone. Local business groups thus had to build partnerships with other groups, pension funds, investment funds, banks and foreign investors in order to be viable participants in the process – and the experience of shared control, without State intervention as in the petrochemical industry, effectively started in Brazil. These partnerships also materialised in the privatisation of the largest Brazilian mining firm (CVRD) and in the privatisation of the aeronautics firm Embraer. Foreign investment The presence of foreign investors leapt forward with the privatisation of the energy and telecommunication firms. This took place in 1997-1998, when Brazil’s current account deficit rose to record levels (above US$30 billion per year - more than 4 per cent of GDP) under difficult financial-market conditions made more difficult by the effects of the Asian crisis and the subsequent Russian foreign-exchange crisis. The priorities of Brazil’s authorities changed, and the privatisation process was geared to facilitate the entry of foreign investors. In most cases the control of privatised firms in these two industries was acquired by foreign firms, without the presence of local investors in the control block. This outcome was particularly clear in the telecommunications industry. Although state banks were acquired mostly by locally owned banks, with the notable exception of the São Paulo State Bank (BANESPA) which 2003 © CIPE and OECD

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was bought by the large Spanish Banco Santander Central Hispano with a very significant control premium, there is a growing presence of foreign capital in Brazil’s banking sector basically explained by foreign acquisition of private local banks that have either been on the verge of failure or sold by an ageing owner lacking a family member qualified to manage the business. The efficiency of the governance structures ruling these shared-control firms is now being tested. The agency problem facing them is still not the classical one involving relations between owners and managers. Two agency conflicts may emerge in these new structures: (a) one between controlling and minority shareholders (already present in the country), and (b) one among controlling shareholders (the new type of conflict). These latter conflicts are particularly interesting given the diverse nature and investment-horizons among the controllers. The private benefits of control Large premia paid for the control of Brazilian corporations constitute clear evidence of the private benefits of control, i.e., control rents. An important study recently found those corporate-control premia to average 65 per cent in Brazil over the period from 1990 to 2000 – the highest average level of control rents found in the 39 countries covered by the study.14 Three concrete examples that we have investigated illustrate well this phenomenon. The electricity company CEMIG, whose controlling shareholder (the State of Minas Gerais) opted for a partial privatisation, sold a control block of its voting shares in a public auction in 1997. The sale agreement included a clause that granted veto power to the purchasers over certain operations of the firm and also assured board representation. A week after the announcement of the intended sale, a group of local and foreign investors bought 32.96 per cent of Cemig’s voting shares for R$1.13 billion. In the closing session of the day of the formal announcement, Cemig’s voting shares were priced at R$27.40. At market prices, the block of 32.96 per cent of voting shares was thus valued at R$512 million, which means that a control premium of 120.7 per cent was paid by the acquiring investors. Another illustration is provided by the well known aeronautics firm Embraer, whose controlling shareholders (pension funds and a local investment bank) established an agreement with a group of French firms for the latter to purchase 20 per cent of the voting shares, outside the shareholders’ agreement. This operation, announced on October 25 1999, had the following structure: 15 per cent of voting shares were purchased through a public offering to shareholders and 5 per cent were acquired through a private deal with an investment bank. On October 26 Embraer’s voting shares were traded at R$6.90 and the group 48



of French firms paid R$8.47 in the public offer, representing a premium of 22.75 per cent. There is no information available on the price negotiated with the investment bank. The relatively low premium may be explained by the fact that this block was not included in the shareholders’ agreement, diminishing its control value. The privatised energy company Light provides a further illustration. The State kept (through BNDES) a block of voting shares in the company which it put up for sale in a public auction on March 16 2000. The block (9.23 per cent of voting shares) was purchased by the French firm EDF, already a controlling shareholder of Light. The acquisition meant that EDF is now the de facto controller of Light. The block acquisition was concluded with a price of R$391 per thousand shares, while the exchange price at the end of the day of the auction was R$235 per thousand shares, implying a premium of 66.38 per cent. Resistance to change The concentrated ownership structure of Brazilian family-owned business groups and the warding-off of strategies that involve a dilution of control are clear indicators of the significant private benefits of corporate control. It might therefore be expected that controlling shareholders would oppose any measures that meant a reduction of their control rents. This opposition was in fact very effective in the debates in Congress in 2001 about the new corporate law. The public position of these shareholders towards governance matters, usually voiced by the Brazilian Association of Public Companies (ABRASCA), a traditional representative of the business élite, does in fact reveal their tendency to oppose some measures that might improve governance in the country. According to ABRASCA’s evaluation, the protection granted to shareholders is not a major concern for the development of capital markets in Brazil. The problem, they argue, lies elsewhere: high interest rates, the tax structure and high costs of issuing bonds and equity. Their solution would probably call for more, and less expensive, government lending through BNDES and for fiscal reforms. ABRASCA’s point of view is certainly based on the fact that it represents the traditional wealthy families that control most Brazilian-owned corporations. While tax distortions and high interest rates do indeed exert negative effects on the capital market, lack of protection for shareholders is also a major stumbling block to the development of a dynamic capital market. Business groups do, nevertheless, face an important dilemma. It is becoming increasingly difficult for them to grow without sacrificing their high existing levels of control. Maintaining their strategies for control was possible when the State was still able to provide finance under privileged conditions and to grant fiscal incentives. While, as noted before, none of these groups developed a successful international growth strategy under unstable macroeconomic 2003 © CIPE and OECD

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conditions, since the mid 1990s the challenge has become even greater because of the very high cost of capital. As Brazilian business groups could not amass sufficient funds to acquire the more promising firms that were privatised in the telecommunications and energy sectors, many began to lobby for better financing conditions from BNDES in order to place competitive bets in the auctions for privatisations. A good illustration is the privatisation of Banespa bank (total assets in September 1999 of US$12.8 billion), formerly owned by the State of São Paulo. Four Brazilian banks (Bradesco, Itau, Unibanco, Safra) had announced their intention to acquire Banespa, which they saw as strategic since the acquisition could determine market leadership. Foreign banks (HSBC, Santander Central Hispano, Bilbao Vizcaya, Citibank, etc.) showed interest as well. Even though at least three of the local banks were satisfactorily capitalised, the unfavourable capital cost they face, related to Brazil’s country risk, placed them at a disadvantage vis-à-vis their foreign competitors. This disadvantage prompted some of them to initiate a lobbying campaign, even before the auction took place, to pressure for cheaper government financing (through BNDES) and/or for a prohibition on foreign banks taking part in the auction. The intense lobbying by the local bidders shows there are still active forces in the country trying to re-establish practices of development based on State protection – especially since alternative arrangements, such as a merger between two of these Brazilian banks (through a swap of shares) that could enhance their competitiveness in face of foreign bidders, were not considered. Family ownership structures and resistance to a dilution of corporate control thus seem to constitute a barrier to the development of novel corporate growth strategies that would not depend for their success on aid from the State15. III. Financing the Private Sector Government intervention in capital markets, which stimulated the creation of the stock market, came to end with the financial crisis in the 1980s. The country has never had a developed equity culture, preferring bonds and internal financing, and present conditions act as a disincentive to prospective investors. Trading is thin and, on a regular basis, confined to a limited number of companies. The law offers only limited protection for minority shareholders, given its long delays; they may be the object of discrimination, not to say active obstruction by controlling blocks. There is some question as to whether the Brazilian stock market has a long-term future. When analysing the state of the Brazilian capital market it is useful to distinguish the debt securities market (relatively successful) from the stock market (quite underdeveloped). Looking at the history of the stock market helps us understand the grounds for this fragility.

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Strong government intervention is behind the creation of the Brazilian stock market. During the first military government, which came to power in 1964, policy makers awoke to the need to foster a local stock market. The initial measure adopted to this end was to grant fiscal incentives both for firms that went public and for those who purchased their shares. Further incentives, of a regional- and industry-specific nature, were afterwards offered to public local firms. A second instrument used to stimulate the capital market was the creation in 1974 of BNDESPar (the investment arm of BNDES) whose mission was to acquire shares issued by Brazilian firms and help place them in the market, offering credit to buyers. This financing was undertaken with subsidised interest rates. Until today those credit operations have mostly been granted to individual capitalists or to groups of majority controllers of ongoing businesses that were selected by the state in the late 1970s (under the 2nd National Development Plan) to develop new projects particularly in the capital-goods sector. BNDESPar remains an important shareholder in the country.16 A third instrument used by Brazilian authorities was the creation of a compulsory demand for shares, when a minimum percentage of investments in shares was established for the portfolios of pension funds and insurance companies.17 The government of Gen. Ernesto Geisel (1974-1979), which had a strong developmental impetus, appointed a very clear mission for the local capital market: provide funding for private locally owned firms. According to this rationale, state-owned firms should continue to rely on the State for funding, while multinational firms should seek capital from their headquarters. It was under this government that Brazilian corporate law was reformulated in order to invigorate the growth of the stock market. This new law allowed a higher limit for the proportion of non-voting shares in the total capital of the firm: from the previous 50 per cent this limit increased to 67 per cent (two-thirds). Family-owned firms could then issue new shares without endangering their dominant shareholders’ positions of control. The entire government orchestration in this field came to a halt with the virtual bankruptcy of the Brazilian State in the 1980s as a result of the international debt crisis. Under great pressure from the growing public debt (resulting from two maxi-devaluations of the exchange-rate and from the absorption of private dollar-denominated debt by state-owned enterprises and banks) and aggravated by the protracted absence of foreign credit to Latin American countries, the Brazilian government lost its ability to sustain its generous scheme of fiscal incentives and of privileged financing to local business groups. It is reasonable to say that Brazil lacks an equity culture; real shareholders (in the Anglo-Saxon understanding of the concept) have been rare and controlling 2003 © CIPE and OECD

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shareholders do not see minority shareholders as partners. Quite to the contrary, shareholder attitudes and behaviour that are considered natural in the United States, like showing up in a shareholders’ meeting, may cause managers (controlling shareholders) virtually to panic. Capital markets as a source of finance for the private sector Sources of funds The role of the domestic capital market as a source of finance for the private sector, particularly that of the stock market, is a minor one. A study of financing patterns of Brazilian firms found that the stock market provides only 6.5 per cent of firms’ financing needs.18 The major sources of corporate finance are internal funds (63.9 per cent) followed by the issuing of bonds. Data for 1995 through 1999, as presented in Tables 1 to 3, confirm this picture. They show that new issues of bonds and shares by Brazilian public companies are insignificant, both in terms of the percentage of companies that issue securities and the value of these issues relative to GDP. They also show that the stock market lags behind the bond market. To a large extent both are due to poor corporate governance practices that imply a lack of respect for minority shareholders. Also worth noting is a considerable growth in the use of short-term finance instruments (commercial notes of 180 to 360 days) in recent years. Another thorough study of the Brazilian financial system concluded that the State’s fiscal problems, and the State’s consequent enormous need for finance, have seriously compromised the functioning of the domestic financial system and the development of capital markets.19 Pressured by a substantial, inflation-indexed, and short-term debt structure, the State’s large demand for funds is a key determinant of the very high interest rates that have prevailed in Brazil for many years. Liquid, high-yield, low-risk public-debt instruments thus help explain the inhibition of an internal development of long-term finance to the private sector. A further result is a growing dependence on foreign funds for the financing of the Brazilian private sector. This dependence is visible in the evolution of the private sector’s foreign debt in comparison with that of the public sector, as shown in Table 4 (see also Table 6). The problem with this dependence is that foreign funds are a very volatile source, whose cost and terms depend on perceived country risks, the behaviour of international interest rates and international capital flows over which individual Brazilian firms have little or no control. The 1997-1998 Asian crisis and Brazil’s internal currency problems, for example, increased spreads paid by Brazilian issuers of private debt and shortened the term of their securities.

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Finally, the State plays an important role through the National Bank for Social and Economic Development (BNDES). This State development bank remains the only domestic source of long-term finance for Brazilian firms, even though the interest rates it charges are no longer as inviting as they were in the 1970s. Market size and liquidity Table 5 provides market capitalization data for Brazil’s principal stock exchange, Bovespa, during the 1990s; however, very few shares have real liquidity: for example, between July 1997 and July 1998, only 19 firms (our of 463 listed) had their shares traded every day, and only 60 firms (13 per cent of the total) were traded at least 261 days in this period. Moreover, some of these companies became public through the issue of bonds, without ever having made a public offering of shares. Table 6 divides trading volume according to the type of investor. It shows that foreign investors are an important force. Their share in the total yearly traded volume was about 16 per cent in 1993, 29 per cent in 1996, and 26 per cent in 1997.20 A key factor stimulating the growth of the stock market from the early 1990s, in addition to the privatisation process, was the liberalisation foreign investors’ access to Brazil’s stock exchanges provided by reforms undertaken in 1992.21 An important characteristic of Brazil’s stock market is its high degree of concentration. Data from Bovespa for January 2000 show that the 10 largest firms represent 50 per cent of total market capitalisation (474 firms). This figure may be somewhat distorted since the 12 telecommunication holding companies resulting from the privatisation process are traded as a block (a legacy from the former state holding company), which alone accounts for 17 per cent of Bovespa’s capitalisation. However, if we exclude this block of shares from the analysis, we still find the 10 largest companies accounting for 41 per cent of total capitalisation.22 Market concentration is more evident if we look at trading volume at the stock exchange. In the last four years, the 10 most-traded shares in Bovespa accounted for 60 to 80 per cent of total trading volume. The stock market was also traditionally dominated by state-owned firms. According to data from Economática (a consulting firm specialised in capital markets research) and the Gazeta Mercantil newspaper, in June 1997, stateowned firms represented around 80 per cent of daily trading, considering the 20 most traded shares in the stock exchange. After the privatisation of the telecommunications network in 1998, private firms accounted, in mid-1999, for 64 per cent of total trading volume Since 1992 Brazilian firms are issuing American Depository Receipts (ADRs) as a source of finance. These programs have reportedly brought benefits to 2003 © CIPE and OECD

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participating firms in terms of higher liquidity and lower capital costs.23 The volume traded with Brazilian ADRs reportedly reached US$100 billion in 1998, then fell to US$ 50.5 billion in 1999, largely due to the fall of the dollar price of Brazilian shares.24 The market value of the 71 ADR programs listed in November 1999 was reportedly US$20.78 billion.25 Regulation of the capital market and protection of minority shareholders The Law and Regulatory Authorities There is widespread agreement among market analysts and investors that Brazilian legislation is inefficient in terms of investor protection and regulation of the capital market. The distortions in the Brazilian stock market certainly begin with the existence of dual class shares and the proportion allowed between the two classes (as noted earlier, up to two-thirds of equity can be non-voting shares). Legislation is particularly weak in two related matters: the degree of disclosure required from public companies, and protection of the rights of minority shareholders. Market analysts complain that public companies are not obliged to provide quarterly cash flow data, which makes valuation a more difficult task. Audits are also not fully reliable, since audit firms usually take responsibility only for the balance sheets of the controlling company, but not that of its controlled companies (subsidiaries); i.e., there is no mandatory consolidation of accounts. This loophole is sometimes used by firms to hide undesirable information, which is not a difficult task given the ownership structure of Brazilian firms already discussed. The problem of disclosure is being eased by the growing tendency of Brazilian firms to issue ADRs in the U.S. market. In order to do this they have to comply with U.S. accounting and disclosure rules, providing information that many have long denied in the local market. A proposal is also under discussion in Congress for the adoption of a specific corporate accounting law. Such a law would correct most of the distortions and loopholes pointed out above. Market analysts point to the fact that better disclosure would certainly help the valuation of Brazilian shares, since the present monitoring risk is high and works as a discount factor in the prices of shares. Confirming this argument is the rise in the share prices of firms that issue ADRs. The protection of minority shareholders’ rights is a more delicate matter. Part of the current problem of minority shareholders is due to a change in the old Brazilian Corporate Law introduced by the government in order to promote the privatisation process. Prior to this change, minority shareholders with voting shares had the right to sell their shares for the same price paid to the controlling shareholder in the event of the sale of a company. The acquiring 54



party was obliged to make a tender offer to minority shareholders with voting shares under conditions similar to the deal with the party selling the controlling shares. This change in the law has allowed controlling shareholders to expand their ability legally to expropriate minority shareholders. The new controlling shareholder, after acquiring the company by paying the market premium for the controlling block of shares, could make a public offer to purchase the remaining shares left in the market for a much lower price, and minority shareholders were forced either to accept the offer or risk being left with shares no longer liquid in the market. The new corporate law approved in late 2001 has partially corrected this flaw. Now the new controlling investor has to make a tender offer to purchase ordinary shares from minority shareholders at 80 per cent of the price paid per share of the controlling block. However preferred stocks (which have no voting rights) were left out of this obligation. During our interviews with local investors we heard many cases of abuses perpetrated against minority shareholders. Beyond stories of the havoc caused when a minority shareholder shows up in a shareholders’ meeting, suggestive tales included those of a firm that denied access to its premises to minority shareholders and others that do not provide office space for the meetings of minority shareholders. Firms also usually do not provide, on request, lists of their shareholders. The recurrence of such practices has stimulated the still embryonic organisation of shareholders to evolve into a civil association geared to protect their rights. This association, the National Association of Capital Markets Investors (ANIMEC), was created in the final quarter of 1999 thanks to the initiative of capital-market professionals and a few small investment bankers interested in uniting and managing -shareholders’ positions in special funds dedicated to improving corporate governance. Another clear piece of evidence that expropriation of shareholders (“assetstripping”) is considered to be a significant obstacle to the development of the Brazilian stock market is the recent attempt by the Bovespa to create a new structure similar to the German Neue Market. This New Market, which was officially opened in December 2000, establishes stricter rules and sound corporate governance practices for firms that wish to be listed. Some of the most important rules are that firms may only issue voting shares and must give “tag along” rights to shareholders which re-establish the latter’s right to sell their shares for the same price paid to the controlling shareholder in the event of the sale of a company. It also allows for shareholders’ participation in the audit committees. Besides creating the New Market, which is voluntary, Bovespa has also introduced other voluntary corporate governance certificates (levels 1 and 2, according to how close firms abide by a set of governance practices). This initiative was designed to signal to the market how modern firms should treat their shareholders and holders of non-voting shares, with the hope that such a “demonstration–effect” would enhance corporate credibility and accountability and therefore induce a larger supply of savings into the capital market.


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Enforcement The problems in the Brazilian capital market are not restricted to current legislation and regulations, but include insufficient monitoring capacity by the local securities exchange commission (CVM) and the inefficiency of the Brazilian judicial system in matters related to corporate law. In the case of the CVM, the main problem is the lack of resources to conduct an efficient monitoring function. In theory, the CVM is financed through a fee paid by public companies. The amount collected goes to a common government fund and only a fraction actually goes to the securities exchange commission. With insufficient funds the CVM cannot adequately monitor capital markets. Moreover, since it is a state agency, salaries are tied by federal legislation. The CVM has then great difficulty attracting qualified personnel, given the relatively low salaries it can offer and the high-skilled nature of the employees needed. Regarding the Brazilian judicial system, the basic problem is not one of poorly trained judges in matters of corporate governance, nor one of an insufficient number of judges, nor one of endemic corruption or political dependence. The problem lies with the system of justice distribution itself, which is excessively bureaucratic, slow and expensive. These features reportedly plague many civil-law countries. The procedure to reach a final conclusion regarding who has a right is very complex. The emphasis is on procedure and process with too little regard for substantive right. Many cases are “resolved,” i.e., terminated, after a long period of litigation, due to a procedural mishap or mistake by one of the parties – such as missing a deadline, forgetting to attach a required document, etc. The result is to make judgements very slow, uncertain, and costly. An investor is frequently overwhelmed by the legal costs incurred in such a contest, which he has to pay out of his own pocket, while the firm can simply include legal costs in operating expenses. Protection of Creditors As for creditors’ rights, the problems are related both to the existing law and, again, to its enforcement. The argument put forward by bankers is the extreme difficulty of seizing through the courts the collateral used to guarantee loans. Given the normal procedures of the Brazilian judicial system, a case may go on for a very long period of time before the lender can have access to the guarantees. In addition the existing Brazilian Bankruptcy Law enables controlling shareholders to overprotect themselves at the expense of creditors in cases of insolvency. This law provides to controlling owners a form of protection (“concordata”) that goes far beyond the well know “chapter 11” 56



of the US law. The initiative to call for a “concordata” is a privilege of the owner-shareholder and is usually granted by judges under the influence of specialized law firms. Creditors cannot influence the management of the company under “concordata.” Recourse to this mechanism usually leads to a complete collapse of new credits by both banks and suppliers. Once initiated a “concordata” inevitably leads to a liquidation process in which the owners have the absurd lawful privilege to practice different forms of asset stripping in order to protect their family wealth at the expense of other investors and creditors. Hence, after the recent approval by Congress of the new Corporate Law the attentions of the investment community are now geared towards the reform of the bankruptcy law. Banks are the main driving force behind the lobby for such reform – reform which has been promised under the current agreement with the IMF, made by the former Brazilian Administration, as a positive step in the agenda of institutional reforms. In our view the focus of the new bankruptcy law should not aim only to protect creditors but must also create built-in incentives to foster corporate restructuring. Such incentives should combine the interests of creditors, shareholders and other stakeholders (labour) in order to push for a successful turn-around of firms when possible. Thus, in addition to curbing asset-stripping and ameliorating the protection of bank creditors, suppliers and investors, the new law should create a steering management-committee representative of all stakeholders, empowered to present a business restructuring plan produced by renowned professionals. Liquidation would only be allowed if such a business plan were to be unviable. Although the issue of creditors’ protection is not the main focus of this chapter, we believe that the approval of an improved bankruptcy law will help to develop better financing conditions for Brazil’s corporate sector. It would also signal the further weakening of the unsound privileges of controlling shareholders that have characterized the authoritarian way of Brazilian corporate governance. Demise of the Brazilian stock market? The future of the Brazilian stock market had become, by the end of the 1990s, a subject of wide speculation. Some analysts have stated concern that the growing use of ADRs by major Brazilian companies may eventually threaten the Brazilian stock market. They fear that this may take away blue-chip companies from the Brazilian stock exchange, leaving it only with companies unable to access foreign markets. Some acquisitions of Brazilian firms by foreign companies have been followed by a removal of the firm from the stock exchange and other foreign controllers are repurchasing shares in the market, also turning the firm virtually private (e.g., the Whirlpool group). A move that caused apprehension was the 2003 © CIPE and OECD

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announcement (January 2000) by Telefonica, the Spanish telecommunication firm that controls major firms in Brazil, of its intention to exchange the shares of their controlled affiliates in Brazil (Telesp, Tele Sudeste Celular), Argentina and Peru for Depositary Receipts (DRs) of the Spanish Holding company, which will then be traded in local stock exchanges. While legal, in practice this operation will tend to exclude from the local stock market a major blue chip company: Telesp. Most analysts agree that it is very improbable that securities of a foreign company will arouse the same interest as that of a local blue chip company in the stock market. There is concern that other foreign controllers of telecommunications companies may follow Telefonica’s path. Most market analysts we interviewed for this paper do not believe however that the Brazilian stock market will virtually perish like those of some other Latin American countries. Given the already sizeable weight of the Brazilian pension funds and the potential development of other domestic institutional investors there will always be a substantial support base for the Brazilian capital market. In addition, they believe in the cyclical behaviour of this market, insisting that if the necessary measures and reforms are undertaken it may increase its role in the finance of corporations and perform its function of signalling the efficiency of the allocation processes in the economy. IV. Changing the Authoritarian Nature of Corporate Finance The movement towards a more open and equitable style of corporate governance is still in its infancy and faces much resistance. The nature of Brazilian society and entrenched attitudes militate against greater justice for minority shareholders and the law is ineffective. Nevertheless, issues of social responsibility, accountability and regulation are beginning to be discussed more widely. The fact that corporate accountability and transparency are very feeble reinforces Brazilian society’s suspicion of and low esteem for corporations and the entrepreneurial class. This is important because it gives place to little legitimacy in society concerning the issues of corporate governance and stock market development. The authoritarian forms of absolutist family control – in a very unequal society in terms of income and wealth distribution – have prevented the development of broader social support for publicly held corporations. The mere dominance (in numbers) of non-voting shares – although they carry preferential dividend rights – indicates the lack of a “culture of participation” by stockholders. To a large extent the Brazilian way of corporate governance can be seen as a portrait of Brazilian society: unequal, with weak citizenship and a lack of deep-seated democratic rights. In a civil society that is weakly structured, minority shareholders have not yet learned how to associate and demand respect for their rights. Flaws in the corporate law facilitate the perpetuation of the authoritarian and highly concentrated family-owner grip on governance 58



structures. The organisation of investors to demand transparency, audit rights and effective participation is recent and incipient. The fact that the Brazilian judicial system is so slow and ineffective – the process allows for at least three levels of appeals just to decide on the substance of the matter, and then the litigator has to start again, on a new process, to get the due pecuniary compensation – means that legal demands can take a very long time indeed. Under such conditions societal demands for corporate transparency and social responsibility are tenuous and inarticulate. Nonetheless, in the case of the large formerly state-owned public utilities, the degree of social alertness about the quality and prices of the goods or services provided and the overall conduct of the now private corporations is beginning to increase. Regulatory agencies were belatedly created to oversee the utilities operating under public concession (oil & gas, electricity, telecommunications), although those agencies are still in the middle of their learning curves and the risks of their being captured by powerful private interests cannot be ruled out. In some sectors, e.g., transportation (railways and highways), privatisation has not been accompanied by the creation of regulatory bodies. Hence the public debate about the social accountability of those regulatory agencies and of some of the major private corporations created by privatisation (frequently operating as monopolists) is bound to grow, generate political heat and gain in density in the years ahead. Some of those corporations are also beginning to understand that the increasing societal demand for social accountability deserves more than a good public relations department. Management and board attention to social and environmental issues has gained importance.26 Positive action and social programs (e.g. health, education, care to abandoned children, etc.) are now frequently being promoted by foundations or other institutions sponsored by large corporations.27 But so far this process has had no substantial impact on corporate governance structures. Step by step, business leaders and public opinion are both moving forward, however slowly, towards more social-political accountability by the corporate sector. Nevertheless there is also resistance of conservative business sectors to translate this growing concern about social accountability into effective change in corporate-governance practices. Some are still voicing opposition to the proposal of granting voting rights to groups of shareholders or to allow such groups under certain conditions to appoint board members or audit committee members. Eventual proposals to appoint a community representative to corporate boards or of an ombudsman-like board member to account for society’s interests would certainly be fiercely opposed by the conservative business associations. The incipient stage of the corporate-governance debate in Brazil can also be seen in the lack of serious public discussion, and in the scarcity of reform proposals. As mentioned before shareholders only very recently created an 2003 © CIPE and OECD

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association (ANIMEC) to fight for their rights. Thanks to the mobilisation of renowned lawyers and a few investment bankers particularly interested in corporate governance, there seems to be a majority in Congress (and in public opinion expressed in the press) in favour of upholding the interests and rights of minority shareholders. The broader “social governance” – or “corporate social responsibility” – debate is nevertheless far behind that on -shareholder interests in terms of effective, practical reform proposals and public discussion. V. Reforms and Policy Recommendations A broad array of reforms and policies are required to speed up the modernisation of corporate-governance rules and practices in Brazil. The relevant agenda Legal and regulatory reforms destined to foster capital-market development may be classified in three categories: •

increasing the efficiency of the securities exchange commission (CVM);

•

additional changes in the new Public Companies Law to enhance the rights and protection of investors and of society’s interests;

•

reform of the judicial system. Clearly, legal changes are not sufficient to guarantee investor protection. Enforcement mechanisms are crucial, and constitute an Achilles’ heel in the corporate-governance system in Brazil as in many other developing countries.

In the case of the CVM, necessary measures would include augmented funding to improve its monitoring capacity, and to increase the staff of qualified personnel to speed up the analysis of processes. In order to increase the efficiency of the investigations, it is appropriate that the CVM be allowed to have access to financial transactions data of institutions and individuals under investigation. A first matter to be considered in a further reform of corporate legislation is the issue of dual class shares. The recent change in the law has reduced the proportion of non-voting shares back to 50 per cent of total shares in the case of new companies. For existing companies the two-thirds proportion of non-voting shares allowed has been kept. Abolishing non-voting shares (all existing ones would be converted to voting shares) is a measure that almost certainly could be contested on constitutional grounds. Other ideas include: (a) reduce the proportion of non-voting shares back to 50 per cent at all companies, giving them time to accommodate to this change;

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(b) limit future issues of non-voting shares; and (c) grant greater powers to non-voting shares (e.g., minimum board representation and increased monitoring powers through better representation on the audit committee). One respected legal opinion encountered in this research is that measures (a) and (b) are not worthwhile, and that the more convenient strategy would be to concentrate on measure (c), which could actually ensure greater investor protection in the short run and would also be easier to approve. The approval by Congress of the new Corporate Law in late 2001 with limited improvements has shown the extent of conservative resistance to change. The National Association of Capital Market Investors (ANIMEC) which champions the rights of minority shareholders wishes to go ahead with additional improvements. Their agenda suggests the following changes: •

end the transition phase (5 years) in order to enable immediate appointment of minority-shareholders’ representatives to corporate boards;

•

increase the number of board members appointed by minority shareholders as a proportion of each 5 per cent block of non-voting shares belonging to minority shareholders;

•

increase the number of audit committee members appointed by minority shareholders as a proportion of non-voting shares in the total capital;

•

increase the minimum dividend for non-voting shares from 3 per cent of the net worth of the firm to at least 5 per cent;

•

define more clearly what constitutes for controlling shareholders an abuse of power and a conflict of interests; and

•

transfer the final decision to a general shareholders’ assembly with one vote per share independently of the share class.

These more aggressive proposals by ANIMEC constitute a healthy driving force towards better corporate governance in terms of shareholders’ organisation and initiatives. The practical effect of all these measures would nevertheless depend on a comprehensive reform of the Brazilian judicial system, which is where the real difficulty lies. Without such a reform, enforcement of existing legislation is ineffective. And while judicial reform is a much-discussed topic in Brazil the road ahead is yet long and rocky. Any deeper analysis 2003 © CIPE and OECD

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of corporate governance in the country should therefore include a thorough study of the judicial system and its effect on the level of investor protection. Some European common law countries, like Italy and France, are conducting reforms of their judicial systems in order to comply with European Community standards. These cases could eventually provide valuable insights to improve the current process of reform in Brazil. Capital markets, governance and economic development One must also today reinstate the question of the relevance of stock market development for the Brazilian economy. Should the growth of capital markets be a major issue for public policy, and if so, which measures might foster this growth? An efficient stock market can be an important component of financial development. Local stock markets could be particularly important when it comes to providing capital to indigenous emerging firms and to technologybased enterprises (including biotechnology). Knowledge and expertise about the potential of these firms certainly requires the existence of local financial institutions and a national capital market which are able to perceive and support such opportunities. The experience of Silicon Valley in the United States suggests that capital markets can be instrumental in fostering this type of firms. Initial risk capital is provided by venture capital funds in the hope of realising large profits in the event of an initial public offering. One of the major difficulties of private equity and venture capital funds in Latin America is precisely the exit problem, since the absence of well-developed capital markets does not make an IPO very feasible or attractive. The lack of an efficient stock market may hinder Brazil’s ability to grasp opportunities linked to the new technologies. One might of course posit that the growing use of foreign stock markets by Brazilian firms could eventually replace the need for a local stock market. In fact, many Brazilian firms are issuing ADRs in the New York Stock Exchange, and recently the Madrid Stock Exchange has allowed Brazilian firms to list their shares directly (without the use of depositary receipts), which makes the process less expensive. One of Brazil’s largest companies, CVRD, is already listed there. But there are two caveats here. One is that informational asymmetries will certainly restrict access to foreign stock markets to a limited number of Brazilian firms; new ventures will have difficulty tapping equity finance in foreign stock exchanges. The other is the question of how much a country without a convertible currency and subject to speculative crisis can depend on foreign sources of finance. These sources, as noted earlier, can be quite volatile even in response to factors that lie far from Brazil. A local stock market is also necessary to facilitate the growth of the private pensions industry. Even in countries where pension funds are allowed to invest in foreign assets, the great majority of investments are made in the local 62



market. The newly elected Brazilian government has vowed to take initiatives to foster the growth of private pension assets in the medium run. Efficient governance structures – i.e., effective mechanisms for the protection of the rights of outside investors (shareholders and creditors) – are also a sine qua non condition for the expansion of the supply of long-term savings and therefore for the development of capital markets. It is basically through its influence on financial development that improved corporate governance will enhance the competitiveness of Brazilian firms. Improving the efficiency of boards Brazilian corporate law establishes two types of boards for public companies: a board of administration (the commonly understood “board”) and the “fiscal board” (an audit committee). The audit committee has no veto power over decisions taken by the board; its sole function is to monitor the firm’s accounts and to publicly denounce any proven irregularities. The election of members to these two bodies is conditioned by the dual-class share structure (voting and non-voting) prevailing in the country. Only shareholders with voting shares can participate in the election of board members. The number of board members and criteria for shareholder representation are established by the firm’s statutes. The new law, however, establishes some minimum criteria to assure the voting rights of shareholders. They can require the installation of an audit committee if it does not exist and can have at least one representative in the case of a three-member committee and two representatives in the case of a five-member committee. As a result of the dual-class share structure, kept by the new Brazilian corporate law, and of the prevailing ownership pattern, we usually have boards where only controlling shareholders are represented. Minority shareholders may choose one representative but from a list of three persons selected by controlling shareholders. Effective independent representation by minority shareholders can only take place after a five-year transition period through the appointment of only one board member. Therefore, boards are very rarely an effective locus for the defence of minority shareholders’ rights. To illustrate this point let us take a look at the boards of the “core” firms of Brazilian business groups. These firms are under tight family control; some of them are not even listed in the stock exchange. The country’s largest locally owned telecommunications group, the Globo network, has only its cable company listed in the stock exchange, all others are private companies entirely owned by the family. Another group, Camargo Côrrea, has withdrawn its major firm’s registry from the stock exchange in 1998. In those core companies that are listed, the Board has a purely figurative role. In some of them it is composed strictly of family members and some loyal employees. Others include prominent members, either from the political or corporate 2003 © CIPE and OECD

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scene, who have more of an advisory role, sometimes acting as lobbyists for government contacts. Boards gained importance, however, when these local business groups had to establish partnerships among themselves, pension funds, and foreign partners to participate in the privatisation process. In these shared-control companies the Board is the locus of negotiation and convergence of the interests of the controlling shareholders. In some of these companies, employees have gained a seat on the Board through their investment funds, which had privileged conditions in the acquisition of a certain amount of stock. It is still uncertain how much these shared-control boards will advance the interests of minority shareholders and lead to higher standards of disclosure. Nonetheless, the presence of these new structures will at least have an educational value in the country, since they will demand a greater degree of compromise among major shareholders and may foster the emergence of a culture of respect for certain procedures common in countries with more developed capital markets. A reform strategy should be directed to increasing the monitoring power of non-controlling voting shares and of non-voting shares. This could be done by changing the procedures for the election of audit committee members, expanding the powers of the audit committee, and altering the process for the choice of the independent audit firm. The audit committee members should be elected only by those shareholders who are not actually involved with the firm’s management. These same shareholders should also be the ones to choose the independent auditing firm. Controlling shareholders who are proved to exert managerial functions in the firm should not be allowed to elect members of the audit committee. The role of the audit committee must be expanded, eventually considering instances where it could block certain actions of the board. This matter is important. A policy towards more efficient boards must also analyse the possibility of expediting minority-shareholders’ right to a minimum board representation by cancelling the five-year transition period. The idea, however, to grant nonvoting shareholders the right to elect board members does not seem sufficient, given that they have efficient monitoring powers. It is important to raise here the question of whether boards are really an effective instrument for the exercise of corporate governance. Would new legislation establishing a stricter code of conduct for board members and imposing heavier penalties on misbehaviour actually increase the degree of investor protection in the country? First, even in countries with well functioning governance systems, like the United States, the actual power of boards in terms of governance is under question. Second, in a civil law country like Brazil, proving misbehaviour by board members is something very difficult to achieve, punishing it even more so.

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Enhancing the role of institutional investors (pension funds and investment funds) A factor that may have a great modernising effect on governance mechanisms in Brazil is the growth of institutional investors, particularly pension funds.28 The scope and effectiveness of pension fund activism is certainly a major issue in the discussion of the future of corporate governance in Brazil. Pension funds are important shareholders and exercise effective governance activity in such companies as CVRD, Embraer, Perdigão, Parapanema, Acesita and Inepar. Considering that at the end of 1999, Brazilian pension funds had around US$60 billion in assets and 30 per cent of this amount was invested in shares, we may say that these funds own approximately 15 per cent of the total value of companies listed on Bovespa. Of some 358 Brazilian pension funds, 11 have stakes in major companies that exceed 5 per cent of voting shares, which makes them major potential actors in corporate governance. Two major examples are presented in the Annex to this chapter. The emerging role of investment banks We have already commented that the large traditional commercial banks in Brazil on the whole show remarkably limited corporate-governance activity. One reason of course is that their commercial interests might be compromised in the event that the funds they manage adopted a more active attitude in terms of governance. Some investment banks and investment funds, on the other hand, are becoming active in the realm of governance. One of the investment banks we interviewed (Banco Fator – small but very active in governance) had members on the board of 13 firms. Management believed that activism was an effective way to gain more respect from portfolio firms and pension funds (greater disclosure and enhanced ability to influence) thus creating value for the bank’s investors. Some investors were attracted to this bank precisely because of its outspoken posture as an active investor. This bank also manages one of the three “governance funds” existing in Brazil. These “governance funds” are quite an ingenious instrument; they gather shareholdings of institutional investors and combine them to exert pressure on corporations in order to enhance performance. From our interviews with other local investment banks we also gathered information on the role of foreign investment funds. It was hoped that these funds would put pressure on portfolio companies to comply with disclosure and respect for shareholders according to standards similar to those of their country of origin. They do, in fact, demonstrate interest in matters related to governance, but most of them fear taking more concrete action, such as filing suits in the securities exchange commission or going to the courts. The deterring factor seems to be the complexities of Brazilian legislation and the inefficiency of the country’s judicial system.


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State-owned banks like BNDES and Banco do Brasil should be much more active in terms of corporate governance. Those banks could transfer the management of parts of their asset portfolios to the innovative investment banks engaged in active corporate governance, and could also improve their direct influence particularly on the corporations of which they are important shareholders. Active corporate governance is, in fact, both convergent to their own asset-value-maximisation interests and to a public-policy dimension (of better corporate governance) in which they should be engaged. A pro-active stance of state-owned banks on corporate governance should be initiated by Brazil’s highest economic authorities The development of the domestic capital market should also help to enlarge the opportunities for capitalisation of emerging new technology firms through better-organised venture capital funds. In this direction it is very important that state financial agencies help to develop “market makers” and dealers in order to support the liquidity of transactions in the Brazilian version of NASDAQ, known as SOMA. Both Banco do Brasil Investimentos – BBI – and BNDESPAR could certainly provide substantial help to the development of SOMA. Other institutions like SEBRAE (Small Business Support Service) and FINEP (Financiadora de Estudos e Projetos, a financial agency belonging to the Ministry of Science and Technology) should also help to structure “venture capital” and “emerging enterprise” funds whose management may be performed by private investment banks. It is of course very important that those initiatives aim at more efficient corporate governance models since absolutist owner-control, with its lack of transparency and accountability, is also a characteristic of Brazilian small firms. One exception to this picture is the small firms in the internet-related business. Many of those firms have been acquired by large foreign actors or have merged among themselves showing a flexible culture of sharing management and control with other investors. Therefore, there is a possibility that “new economy” firms can both stimulate and be stimulated by the local capital market and help create less concentrated ownership structures, through the development of partnerships between local business groups, investment funds and international corporations. Conclusions Ownership concentration and the quasi-absolutist exercise of power by family/ controlling shareholders is a fundamental characteristic of Brazilian corporate governance structures. These ownership structures are primarily a response to the domestic legal and macroeconomic environment in which companies operate. With the hope that the macroeconomic scenario will continue to evolve towards a favourable configuration (e.g., lower interest rates and country-risk rating) we emphasise the importance of reforms of the legal and institutional

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framework that regulates the local capital market and the functioning of corporate governance in this country. The dominant form of organisation of local capital is the family-controlled business group. When discussing these groups we have highlighted the role of the State in the creation of existing governance structures. An important conclusion is that the last two decades of macroeconomic crisis and stabilization policies have not been benign for the creation of globally competitive Brazilian business groups. Unfortunately the debt crisis, which began in Brazil at the end of the 1970s, precluded any possibility for the State to provide further financial leverage for the country’s local business groups.29 The creation of growth sustainability for the economy in the coming decade is undoubtedly a sine qua non condition for better corporate governance mechanisms. Throughout the 1980s and 1990s, Brazil witnessed extremely high interest rates and recurrent macroeconomic uncertainty, which virtually eliminated any local source of long-term financing for corporations. It is unquestionable that serious difficulty in tapping adequate sources of finance (which translates into very high capital costs) has hindered the competitiveness and growth of local business groups. An important milestone for corporate governance in Brazil was the privatisation process initiated in the early 1990s. As a result of this process we now have a few important publicly held firms in such sectors as steel, mining, energy and infrastructure, and one in the telecommunications sector, whose control is shared by local business groups, pension funds, investment funds and foreign companies. The efficiency of these new control arrangements remains to be confirmed, but their novelty is already important from a corporate-governance perspective. Also important is the fact that privatised corporations operating public concession utilities will be under increasing social-political pressure to account for their activities and policies. Although the issue of social-political governance is still very feeble in Brazil, one should expect it to attract public attention and generate political heat in the coming years. The Brazilian capital market, particularly the stock market, is small and illiquid. Capital market operations account for a small fraction of total financial needs of the private sector. Its is currently widely discussed whether changes in legislation would foster development of the stock market. Better disclosure rules and more effective protection for shareholders appear to be necessary conditions for the growth of this market. These are not, however, the only problems; there are also tax and macroeconomic issues that severely hinder the development of capital markets in Brazil. Deem it vital to boost institutions that form and/or capture long-term savings, particularly the private pensions industry. Besides promoting growth and innovation in capital markets, institutional investors may become important levers for the enhancement of governance structures. We find encouraging 2003 © CIPE and OECD

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evidence that large pension funds in Brazil are adopting a more active attitude in the sphere of governance. Private pension coverage is still very low, especially among the self-employed, and there is considerable space for growth. Given existing governance structures and the high cost and scarcity of sources of finance, one might doubt the growth potential of local business groups in a global economy. Nonetheless some of these groups are still considered competitive in the agribusiness, mining, steel, petrochemical, and pulp and paper sectors. It is not clear, however, if these groups will be able to merge and develop new growth strategies by themselves without the help of cheaper sources of finance (through BNDES) and without enhanced and more efficient governance structures. The evidence we have found in Brazil corroborates the view that a key challenge to corporate governance is to restrict the possibility of expropriation of shareholders by controlling ones. Further improvement of the legal and institutional environment is thus a vital move towards the creation of efficient governance structures. It also shows that in response to the domestic situation, the best performing corporations seeking external capital may opt into legal regimes that are more protective of minorities without explicit legal reforms (the ADR market). Reform of the Brazilian judicial system, slow and inept, is therefore a sine qua non condition for the new corporate law to be effective. Investors, particularly investors, need a reliable and speedy justice system to feel secure enough to engage in capital-market-channelled investment opportunities. One force that may lead to the improvement of prevailing governance structures is the growing activism of institutional investors. Pension funds are potentially great providers of equity finance to local corporations, and the fact that they are demanding higher standards of disclosure and shareholder protection from would-be partners may work as a significant lever of change. The Central Bank could also stimulate private banks to be more active, and federal credit institutions including the Banco do Brasil, Caixa Econômica and BNDES should foster and support the capital market and require enhanced corporate governance in their areas of influence. Another remarkable factor is the incipient but growing awareness of business leaders and of opinion makers in the press about the relevance of efficient corporate governance for economic development, through transparency, greater social accountability and effective protection for shareholders. It is absolutely important that high political priority be given to the passing of the new bankruptcy law, to improvements in the corporate law, to the reform of the judicial system, to the strengthening of the CVM, and to the reform of the 68



capital market, including more stimulating tax treatment for the advancement of institutional investors. Brazil’s new economic authorities seem to be aware of the needed reforms, and should engage in a coherent project of capital-market and corporategovernance development. ANNEX to Chapter 2 The Role of Pension Funds in Corporate Governance: Two Examples Previ The largest Brazilian pension fund is Previ, with assets of US$17.8 billion in 2000. It has a stated policy to be active in the sphere of corporate governance, always exercising its right to nominate members of boards. Notably, it has created an area dedicated to the management of its shareholdings in portfolio companies (GEPAR). The purpose of this area is to appoint members to the boards of firms where Previ has this right, train these board members, monitor their performance, analyse investment plans of these firms, and explore possible synergies between them. As of 2000, Previ had 115 firms in its portfolio and 61 (72 per cent of the value of all shareholdings) are included in the GEPAR portfolio. This means that in all these 61 firms, Previ has representatives on the boards and audit committees. Of these 61 firms, Previ is in the control block of 18, equivalent to 72 per cent of the value of GEPAR portfolio. The Director of GEPAR has stated very clearly that he sees his role in these 61 firms as that of a long-term investor. His idea is to help restructure these firms and stay in as an active shareholder, not to sell out and realise short-term gains. However, it is not their intention to actually run the business, which is why they usually establish strategic partnerships with firms knowledgeable in the particular field. In two companies where Previ and other pension funds had significant shareholdings (the aeronautics firm Embraer and the steel firm Acesita), the fund stimulated the sale of important stakes (a controlling one in the case of Acesita) to foreign groups, who are important players in their respective sectors. Previ is developing what it considers a model of corporate governance, through which it will monitor the relation between the pension fund, their appointed board members in portfolio firms and the firms. It will be the board members’ duty to fill out this control instrument with the required information indicated by the pension fund. Most of these appointed board members are retired employees of the fund’s sponsor (Banco do Brasil). In the future, the fund intends to appoint up to 15 per cent of board members from outside the sponsor’s ranks. A premise of this model is a policy of respect for minority shareholders, and to demand transparency and disclosure of information from management. Previ is also keen that portfolio companies have a very 2003 © CIPE and OECD

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professional management staff1. One case where Previ exercised its power was when the controlling shareholder (Whirlpool group) of a large white goods producer (Brasmotor) wished to turn the company private. The price offered to shareholders was judged unacceptable and Previ, as the largest shareholder, organised a pool of these shareholders to pressure for a higher offer price. This action prompted Whirlpool to negotiate and finally come to an agreement with this group of shareholders. According to the Director of GEPAR, the large pension funds had a more co-ordinated action in the sphere of corporate governance in the 1993-1996 period. More recently, this co-ordination is perceived as less effective. In the firms where a group of pension funds become part of the control block, there are cases of organised action. These actions are not however as organised as Previ thinks they should be. Finally, Previ´s policy is to take a stakeholder perspective when dealing with corporate governance. The Director of GEPAR stated that the fund looks beyond the business per se, and considers the firm’s stance towards employee’s rights, the community and the environment to be important Petros Another interesting case is that of Petros - Brazil’s fourth largest pension fund, with assets of US$3.4 billion in December 1999 – sponsored by the state oil company and a group of other state and private firms. We consider this fund an important player, because its new management team (which took over in September 1999) has expressed a clear policy in the area of governance and has created a governance department (subordinated to the Investments Director) to manage this issue within the fund2. Moreover, Petros has important shareholdings in major Brazilian firms. Of the total portfolio of shares (US$900 million), around 50 per cent is invested in firms where the fund has long-term positions. These positions comprise 21 firms where the fund has representatives in the Board. Management considers this proportion appropriate, although they wish to review the combination of firms in the longterm portfolio. The fund’s idea is to establish criteria for maintaining long-term shareholdings in a firm. One of them will certainly be the firm’s dividend policy; Petros is a defined-benefits fund and needs a certain cash flow to meet its obligations to retired participants. Another criterion to be considered in the choice is the amount of influence Petros will have in the company – it will not wish to keep long-term shareholdings in firms where it cannot be active in governance. Preference will also be given to firms where other pension funds are important shareholders, because this enhances the chances to monitor the controlling shareholder. In these firms, Petros will seek certain guarantees in the shareholders’ agreement. One of them is a “tag-along” clause, which 70



states that the controlling shareholder may not sell his control block without arranging for the same price to be paid to the fund’s shares, unless the fund agrees to stay with the new controlling shareholder. Petros’ management is also changing the procedure used to appoint representatives to boards. Previously, there were no clear-cut criteria to guide this policy. The fund’s idea is to nominate individuals to boards who would bear full responsibility for any misfortune, i.e., the directors of Petros and of the sponsoring firm. They expect to obtain greater accountability from this group. With this policy they wish to avoid what was happening in the past: the appointed board member acted as if he had forgotten he was a representative of a shareholder and assumed the role of a lobbyist for the firm inside the pension fund. The President of Petros agrees with Previ’s statement that there needs to be more co-ordination between the large pension funds in the sphere of corporate governance. He mentions some positive actions that were already taken, but believes there is still much to be done. It’s useful to have a common strategy with other funds, especially in the cases of poor performing firms where a group of pension funds are shareholders. Co-ordinated action is a means to reduce the costs of pension fund activism; he commented on a case where pension funds agreed to jointly pay for legal counsel against the controlling shareholders. It worth mentioning here that pension funds have already organised holding companies, through which they participated in the privatisation process and that congregate the shareholdings of many funds (Litel, GTD, Invitel, etc.). Thus, it is clear that pension funds are an effective and powerful force striving for better corporate governance practices and structures in Brazil. One should henceforth expect that rapid development of pension funds would contribute to accelerate the achievement of efficient corporate governance. Notes to Annex One of the companies controlled by pension funds – Perdigão – was mentioned by an important investment firm as model company in its relation with shareholders 2 Formerly Petros had an advisor for governance matters, but the present management believes in creating a more permanent structure in this field. 1


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Tables Table 1 – Number of Public Companies and New Issues Number of Public Period Companies 1995 874 1996 925 1997 968 1998 1047 1999 1029 Source: CVM

Number of New Issues Bonds

%

Shares

%

149 195 116 61 38

17% 21% 12% 6% 4%

31 24 23 20 10

4% 3% 2% 2% 1%

Table 2 – Primary Share Market (1995 – 1999) Total New Issue of Shares – US $ Million* Period

Voting

NonVoting

Total

GDP

GDP/ Total

1995 1996** 1997 1998 1999

653 4.847 526 2.634 649

1.459 4.308 2.979 850 810

2.112 9.155 3.505 3.484 1.459

705.000 775.000 801.001 775.001

0,30% 1,18% 0,44% 0,45%

* Dollar – Ask Price – Date of Register – Central Bank of Brazil ** Growth in 1996 is due to a public offering of US$ 8 billion by State bank Banco do Brasil. Source: Central Bank of Brazil and CVM

Table 3 – Primary Bond Market (1995 – 1999) Bond New Issues – US $ Million* Period 1995 1996 1997 1998 1999

Common 6.562 6.956 5.521 5.656 2.759

Convertible 1,012 1,333 1.355 3.019 862

Total 7.574 8.289 6.876 8.674 3.621

GDP 705.000 775.000 801.001 775.001

GDP/Total 1,07% 1,07% 0,86% 1,12%

* Dollar – Ask Price – Date of Register – Central Bank of Brazil Source: Central Bank of Brazil and CVM 72



Table 4 – Foreign Debt (US$ billions) 1992 93.4 42.5 135.9

Public Sector Private Sector Total

1996 84.3 93.8 178.1

1998 95.2 148.0 243.2

Source: Central Bank of Brazil

Table 5 – Number of Public Companies and Market Capitalization in Brazil Year 1992 1993 1994 1995 1996 1997 1998 Sep. 1999

Number of Public Companies 861 840 846 874 925 968 1047 1041

Values in US$ Billions (1)

Market Cap./ GDP

30.69 72.29 189.06 147.57 216.93 255.41 160.89 150.90

7.92 16.8 34.8 20.9 28.0 31.8 20.7

(1) Only companies listed in BOVESPA. Source: CVM.

Table 6 – Trading in the Stock Market (BOVESPA) according to Type of Investor (in %) Type of Investor

1 – 31st Dec. 1999

3rd – 31st Jan. 2000

Individuals Institutional Foreign Public / Private Firms Financial Institutions Others

16.5 17.3 21.9 3.9 39.5 0.2

18.5 16.6 22.1 4.2 38.0 0

Source: BOVESPA.


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(Endnotes) As an illustration of how such self-dealing is commonly undertaken via “third-party” transactions, a major Brazilian airline was recently investigated by the country’s Securities Exchange Commission (CVM) on a charge that uniforms for pilots and stewardesses were being bought by the company at the price of a luxury fashion item from a privately held firm owned by the airline’s controlling shareholder and his sons. Some foreign shareholders told us that they did not wish to engage in litigation with controlling shareholders given their limited understanding of legal procedures in the country. 2 In Brazil, important infrastructure sectors, including petrochemicals, steel, and telecommunications, have been created under state guidance and state ownership. The State assumed the role of amassing the necessary capital to build, alone or in partnership with local business groups, key industrial sectors in which local business groups – all of them family owned and controlled – have a vital source of competitive advantage in their privileged ties to the State. 3 Ribeiro do Valle (2000a). This dissertation covered the bond issues by the largest Brazilian pulp and paper companies launched from 1991 to 1998. Besides the cost of debt, the author researched companies’ financial performance and company- and country-ratings. He found that Brazilian companies in the sample paid a high yield spread in the international capital markets, and that the spread was partially explained by company-risk and country-risk factors. The findings also suggest that the high spread for Brazilian companies could be explained by the “Brazil mark” and the country’s sovereign ceiling rating in international capital markets, the Brazil Speculative Grade. (See also Ribeiro do Valle, 2000b.) 4 We use end-1998 data for ownership and November 1999 data for market capitalization [whereas La Porta, et al. (1999) use 1995 data]. 5 In Brazil, this second group of firms almost overlaps with the first, as it does in the developing countries included among those covered by La Porta, et al. (1999). 6 Following La Porta, et al. (1999) we define a firm as an affiliate of a foreign company if at least 50 per cent of its votes are directly controlled by a single foreign corporate owner. Our sample thus includes firms that are effectively controlled by foreign firms even though they have less than 50 per cent of the voting rights. 7 In both cases it is also possible to observe that foundations controlled by the major shareholders are also used to enhance control of group firms. 8 A similar result was found by La Porta, et al. (1999) for Australia, Canada, Ireland, Japan, Italy, and Switzerland (for the large company sample). 9 Bradesco has significant shareholdings in CVRD (Cia Vale do Rio Doce) and in CSN (Cia. Siderúrgica Nacional) and has joint ventures with local business groups in the communications and energy sectors. Bradesco’s management has recently (early 2000) decided to separate and concentrate its shareholding activities under a specialised investment firm (Bradespar - Bradesco Participações). Bradepar is increasingly showing a more proactive stance as far as corporate governance is concerned. In the very recent rearrangement (June 2000) of the cross-shareholding participations between CSN and CVRD, Bradespar has managed to appoint the CEO of CVRD. This move suggests that Bradespar is leaning towards an active role regarding its shareholding positions particularly in cases where its participation its significant. 10 Following the method of La Porta, et al. (1999) we consider that a controlling shareholder, who has at least 20 per cent of voting rights, has a potential monitor if there are one or more other shareholders who have a non-overlapping 10 per cent of voting rights. 11 A business group is a group of legally independent firms that are linked by shareholding ties, which guarantee common control over all assets of the group. 1

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Business groups are usually classified in two categories: associative (e.g. Japan) and hierarchical. The latter are centered around a holding company and adopt a pyramidal structure; monitoring and decision making are usually centrally organized. 13 The petrochemical industry in Brazil was created by government planners who organized three-way partnerships among a domestic private firm, a foreign firm and a subsidiary of the state-owned oil company, Petrobras. 14 Dyck and Zingales (2002), who use data on 412 control transactions in 39 countries between 1990 and 2000. 15 Another possibility that has scarcely been explored by family-owned business groups is to form strategic alliances through the selling of a control block of a core firm to a foreign company. This was done by Pão-de-Açúcar retail (supermarkets) group, which in 1999 sold 30 per cent of voting shares to French group Casino, and by Organizações Globo group, which sold 15 per cent of its strategic cable TV company to Microsoft. This strategy could allow the controlling family to enhance the firm’s growth potential, while keeping a large part of control benefits and capturing the control premium in the block sale to a foreign firm. 16 The portfolio of shares held by BNDESPar was estimated at US$ 7.3 billion in December 1999. 17 The large pension funds of state-owned companies were forced to buy shares with very low liquidity, hindering their portfolio performance. 18 Rodrigues Júnior and Melo (1999) 19 Rocca, et al. (1998) 20 ibid. 21 In February 2000, the two major Brazilian stock exchanges (Bovespa and the Rio de Janeiro Stock Exchange – BVRJ) merged in a move to foster competitiveness. 22 A World Bank study (Demirguç-Kunt and Maksimovic, 1996) calculated this same percentage at 30 per cent in the 1986-1993 period. 23 Rocca, et al. (1998) 24 According to information provided by the Bank of New York and reported in Gazeta Mercantil, 17th December 1999. 25 According to data from the Brazilian securities exchange commission (CVM). 26 One interesting example of greater care for social accountability was Petrobras’ recent reaction to a serious oil pollution accident in Guanabara Bay. Top management directly engaged in a major cleaning-up effort and responded quite openly and positively to non-governmental organizations’ demands for effective compensation to fishermen’s communities and for a deep overhaul of the company’s environmental practices. This example was certainly educative and precedent-setting for other corporations. 27 Another example of corporate concern about the issue of their social accountability is currently being shown by the campaign of the São Paulo Federation of Industries – FIESP – to develop more effective and visible programs of social responsibility by medium and large firms. 28 Rabelo (1998) 29 In this regard Brazil’s experience is quite different from that of Korea, say, where the possibility to escape from the 1980s debt crisis with the help of Japanese banks enabled the State to continue promoting large local business conglomerates (chaebols), some of which were able to place themselves competitively in the global economy. This did not however result in efficient corporate governance in Korea, but rather in the exacerbation of absolutist family control, which the Korean Government and Parliament are only now challenging, under strong societal pressure – and the actions of at least one important non-governmental shareholder-activist organization – for transparency and accountability of the chaebols. 12


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Chapter 3

CHILE: ENTER THE PENSION FUNDS Manuel R. Agosin and Ernesto Pastén*

C

hile’s corporate structure resembles that of many other developing states in that ownership is highly concentrated with small numbers of groups controlling large quantities of shares. But it has several special characteristics, including the existence of pension funds with large sums to invest and a ban on banks’ lending to related parties. Recent crises have resulted in reforms in the law governing corporate practices. Introduction The Chilean corporate structure can best be described as an “insider” system. Ownership of publicly traded corporations is highly concentrated, with the three largest shareholders often owning three-quarters of all shares. In addition, Chilean corporations are controlled by a few large groups, which organize their business activities in a pyramidal fashion, with one or more investment companies acting as the control centre.

The authors are grateful to Tomás Deimel, Jaime Leonart, and Gonzalo Oyarce, of Feller and Rate Clasificadora de Riesgo, for sharing their knowledge of Chilean capital markets, and to Pablo Castañeda, of Chile’s Ministerio de Hacienda, for providing important quantitative information with regard to the Chilean stock market. The views expressed are those of the authors alone. 2003 © CIPE and OECD

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In spite of these characteristics, corporate governance does not unduly discriminate against small shareholders or outsiders. The major drawbacks – such as norms governing public tender offerings and transactions among related parties – were largely corrected in a new law that went into effect from December 2000. Chilean capital markets are well developed, especially for a country of Chile’s income level. During the 1990s, there were numerous initial public offerings (IPOs), and the percentage of new share issues in stock market turnover was impressive. One important reason is the emergence of a privately run system of pension fund managers created by the social security reform of 1981. These firms – called Administradoras de Fondos de Pensiones (Pension Fund Managers) or AFPs – now have under management funds worth about 50 per cent of the country’s GDP. They provide monitoring functions for small shareholders, and the requirements that corporations must meet for AFPs to be allowed to buy their shares have helped to improve transparency and information disclosure in the corporate sector. Securities regulation and an activist supervisory agency have also been important in this respect. The issue of corporate governance is important for the development of capital markets. However, it must be seen in the right context. There are other variables that affect the development of an emerging capital market, the most important being external financial shocks. As capital flows to emerging markets surged from the late 1980s until the crises of the late 1990s, capital markets in recipient countries were buoyant. Since then, capital outflows and the loss of appetite among foreign investors for developing-country issues have been the major factor behind the stagnation that these markets have experienced. Checks and Balances In addition, any evaluation of a country’s corporate governance must consider not only topics related to the protection of shareholders’ rights – the subject emphasized in the literature on corporate governance – but also how the system operates as a whole. Questions that need to be asked include for example: Are there any institutional checks to the unbridled use of corporate assets to generate rents for corporate controllers? How does banking regulation restrict the ability of corporate controllers to use banks within their corporate group to siphon-off rents? Since the onset of the emerging-markets financial crisis in 1997, Chile’s capital markets have been in the doldrums. Confidence in Chilean firms by foreign portfolio investors has declined and, consequently, there have been net outflows of portfolio capital. Another factor making for a shrinking stock market has been a number of large take-overs of domestic corporations by 78


CHAPTER 3 | CHILE: ENTER THE PENSION FUNDS

multinationals. A third reason has to do with corporate governance issues. A few well-publicized cases of rent-extraction by corporate controllers appear to be an additional factor discouraging small investors, national and foreign, from taking equity positions in Chilean companies. In an attempt to revive a flagging market, the Chile’s Government decided to send to Congress a law reforming corporate practices. The law, which was passed by Congress in October 2000 and went into effect in December 2000, attempts to correct some vices in such practices. The law’s basic theme is the protection of minority shareholder rights. It has three main components: • • •

It regulates public tender offerings (PTOs) and requires that they be made pro rata to all shareholders. It severely limits the kinds of self-dealing that lead to rent extractions by controlling interests. It grants equal rights to ADR (American Depository Receipt) holders, who have come to constitute an important category of minority shareholders in the last decade.

Advanced Regulation By and large, Chilean capital markets function rather well. One reason is that banking regulation is fairly advanced for a country of its level of development. Banks, which are usually part of a business group, are forbidden from lending to related parties. This has prevented corporate controllers from using banks for their own ends, which was one of the causes of Chile’s banking crisis of 1982-83. Another factor working in Chile’s favour is its well-developed class of institutional investors (the AFPs) which can perform monitoring functions that are not possible for individual shareholders. This must be counted as an overlooked benefit of the pension reform. Unfortunately, however, these institutions must labour under a maze of regulations that do not always make sense. If they were allowed to hold larger stakes in corporations, their monitoring functions could be enhanced, to the benefit of all small shareholders and of capital-market development. The recent introduction of portfolio flexibility has increased these institutions’ incentives to take a more active role in monitoring how well the interests of minority shareholders are protected. The Chilean story illustrates the importance of factors not usually considered in discussions on corporate governance in developing-country settings, such as government action to create regulated institutional investors and to improve the regulation of the banking sector.


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Why Corporate Governance Matters A good point of departure for the analysis of corporate governance in Chile, or in any “emerging” economy for that matter, is the question of why the issue of corporate governance is important in developing countries. Corporate governance is central to the operation of capital markets, which in turn is fundamental in determining the extent to which firms can rely on external sources of finance for investment. All capital markets suffer from problems of asymmetric information, which lead to market failure. However, in highly developed capital markets (e.g., those of the United States) firms have a variety of alternatives for financing investments (issue of shares, bonds, bank credit) which are often absent in developing countries. Chilean capital markets are typical of those that can be found in middleincome countries: a small and largely illiquid stock market, an embryonic bond market, and a banking sector that lends mostly short-term. A large proportion of investment, even by large corporations, is financed with retained earnings or with lending from other corporate members of the business group to which they belong. However, a specific feature of Chilean capital markets not found in elsewhere in emerging markets is the existence of well-developed institutional investors. These are the private pension managers that arose from the pension reform of 1981. The reform replaced a pay-as-you-go defined-benefits system that had been run by the state with an individual-capitalization defined-contributions system that is run by heavily regulated private firms (the AFPs). All Chilean workers are obliged to choose an AFP, to which they must contribute 10 per cent of their monthly incomes (plus an administration fee). At retirement, they can opt between a lump-sum that must be converted into an annuity and a program of monthly withdrawals. The AFPs now manage assets that are worth about one half of the country’s GDP. In spite of the limitations imposed upon the AFPs in the kinds of investments they can make (discussed further below), they have been responsible for a significant deepening of the stock market. As the Chilean corporate-governance system is of the “insider” variety similar to that in continental Europe, corporate ownership is highly concentrated, the main owner often being a group with interests in a large number of companies and in several sectors of the economy. In these circumstances, a conflict arises between the controllers (or “blockholders”) and non-group shareholders. Indeed, there have been highly publicized attempts at rent-extraction on the part of blockholders, which have shown that such actions are possible and that company controllers have the incentives to engage in them. This may be acting to discourage potential small shareholders from entering the market.

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Regulatory Framework Another important institutional feature of the Chilean corporate scene which may account for its relatively high corporate-governance standards, in spite of the potential conflicts of interest noted in the above paragraph, is a highly developed regulatory framework for banks and other financial institutions. As in many other developing countries, the largest economic groups own banks, which can potentially be used by the groups’ controllers to further their own interest, to the detriment of those of other shareholders – other shareholders of the banks themselves, or of other firms belonging to the groups. Since 1983, however, such practices have been severely limited by an evolving system of prudential banking regulations. The remainder of this chapter is divided into seven sections. The first clarifies recent history relevant to an understanding of the role of Chile’s corporate sector in the country’s development, and describes that sector today. The second presents the legal framework regulating the activities of Chile’s publicly traded corporations, including a new law enacted in 2000 to protect the rights of minority shareholders. The third section assesses the current and prospective roles of AFPs in capital markets and in improving corporate governance. Section four describes two recent cases of attempted rentextraction by corporate controllers and the positive role that AFPs have played in blocking such actions. It also provides evidence on the size of the control premium in the Chilean stock market and describes what has happened in the Chilean stock market since the entry into force of the new corporate governance law. Section five addresses what Chile’s experience suggests is one of the key issues for corporate governance in developing countries: banking regulation. Section six assesses the extent to which the Chilean capital market does a good job in intermediating resources between savers and investors. The final section concludes. I. Chile’s Business Groups Over many decades the Chilean state actively intervened through industrial policy, but it has not done so for 30 years. Major enterprises have been by turns nationalized and privatised. Control of Chilean companies is largely in the hands of powerful groups, often arranged in pyramidal structures. Debt is low, cross-holdings are banned by law, and in a few cases different classes of shares are issued. The bond market is little developed. Recent History At present, for good or for ill, the government has no industrial policy and does not use the allocation of finance – through, say, a national development bank – to influence the allocation of investment. But it was not always so. Beginning in the late 1930s and until the military coup of 1973, the government 2003 © CIPE and OECD

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was very active in setting up firms and opening up new sectors of economic activity that required large investments that the private sector was unable or unwilling to undertake. Contrary to conventional wisdom, the Chilean state was very successful as an entrepreneur and set up large companies – mostly fairly well run – in sectors such as power generation and distribution, petroleum extraction and refining, steel, and sugar refining. The Frei Montalva Government of 1964-70 carried out a successful negotiation with the U.S. corporate owners of Chile’s copper companies (Kennecott and Ananconda) and purchased for the Chilean state 51 per cent of their equity. The remaining 49 per cent was expropriated during the Allende Government (1970-73), which also expropriated most of the country’s industrial firms, banks, and insurance companies. The first wave of privatisations came in 1974-79, when most of the firms taken over by the government during the Allende period (significantly, excluding Codelco, the company set up to run the copper mines), were sold off to new private owners, often different ones than those who had been expropriated. Powerful new groups emerged, many with a bank at their core. These groups proceeded to buy up other companies with loans from their main bank. Most of these groups went into bankruptcy during the debt crisis of the early 1980s. The government wound up taking over a large chunk of the banking sector and, with it, the bankrupt companies whose shares were held as collateral by the banks. This is what Carlos Díaz Alejandro (1985) has aptly called “the Chilean road to socialism.” The second wave of privatisations came in 1985-89, when the banks and industrial concerns were once again sold off to private interests. In addition, many of the companies that had been in the public sector well before the Allende Government (for instance, steel, electricity generation and distribution, sugar, telecommunications, and the national airline) were also sold off. The purchasers were either foreign companies (telecommunications and the national airline) or the managers of the state-owned firms themselves. In some cases, the AFPs took up part of the equity, and a certain portion was sold at low prices to the firms’ employees. A scheme by which a certain portion of the purchase price was made tax deductible was also set up to encourage small shareholders (“capitalismo popular”). The Corporate Sector Today A good part of the current corporate landscape in Chile emerged in this fashion. The other important participants are family-owned firms, which started mostly in one sector and evolved into powerful and diversified economic groups. These have also experienced important changes over time. Many of the groups that had been formed during the period of import substitution (in textiles, for example) disappeared with the radical trade liberalization carried 82



out during 1974-79. Others adapted to the changes in relative profitability between sectors and gradually switched out of declining manufacturing industries and into natural-resource-processing sectors. Most Chilean corporations, be they of family or state origin, share a high concentration of ownership. They are managed by a “group,” which owns a high proportion of their capital. These groups function as investment firms or holdings; they have a large number of firms under their control and minority stakes in many others. These groups are very powerful and, while they concentrate their activities in a single industry, they have important interests throughout the economy. At the beginning of the 1990s, assets controlled by the five largest groups accounted for 30 per cent of the market capitalization of the Santiago stock exchange (see Table 1). Together, they had interests in 301 companies. On average, their investments in their main industry accounted for over 50 per cent of their equity.1 The number of directors controlled by the five largest groups (as a share of the total number of directors in affiliated companies) fluctuates between 76 and 95 per cent. These figures are much higher than the share of equity owned by controlling parties in the Chilean conglomerates, which is only 57 per cent for all conglomerates and 56 per cent for the five largest.2 Pyramids Chilean groups function mainly as pyramidal structures. Sometimes there exist several layers of investment companies before one gets to the level of operating firms. The latter may also control several individual companies, sometimes in unrelated sectors of the economy. Groups often enter into joint ventures with multinational corporations (MNCs) in order to develop specific projects. Operating companies, and sometimes second or third layer investment companies, are listed in the stock exchange and, therefore, have outsider shareholders. Groups seek control basically through pyramidal structures, mainly because cross shareholdings – a technique widely used in other countries, particularly in Asia – are prohibited by Chilean law. Another instrument that corporate insiders can use to obtain greater control over a company (greater than their level of equity ownership) is the issuance of different classes of shares. While permitted by Chilean law, if approved by 75 per cent of votes at a shareholders’ meeting, it is not a widespread practice. In a sample of 281 public firms in December 1999, only 21 had dualclass shares.3 However, in one celebrated case (the Chispas case, discussed below), the issue of different classes of shares was an essential feature in an attempt to expropriate minority shareholders. 2003 © CIPE and OECD

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A recent study finds that Chilean corporate insiders have a much larger share of equity (over 50 per cent) than the level that is strictly necessary to exercise control.4 Clearly, cash flow is also valued (and is significant). The study suggests that conglomerate size and corporate insiders’ share of equity ownership are positively associated with corporate insiders’ holding options on new ventures in a changing environment, while fending off competitors. According to this interpretation, a group’s connections to the authorities and access to domestic and international finance are all positively related to corporate size and, probably, also to the group’s ownership of equity. Shallow markets, heavy intra-group lending A simpler explanation is that the underdeveloped nature of Chile’s bond market and the shallowness of its stock market make it difficult for corporate controllers to raise non-equity capital or shed part of their equity without considerable loss. The value that they apparently attach to cash flow could be another aspect of the same problem. Since raising investment funds in financial markets is difficult and normally expensive, it is good to hold on to cash reserves. We collected data for the largest 177 firms listed in the stock exchange (out of a total listing of 282 in 1999). Of these, 149 had stock-owning relationships with other companies, some included in the sample, some not. The information was taken from the September 1999 FECU form of the Superintendencia de Valores y Seguros (SVS), the government entity in charge of capital market regulation.5 This form has information on current operations, balance sheets, ownership structures, and sources and uses of funds. Table 2 shows some basic information for these 177 firms grouped by economic sector. The first and most important thing to emerge from these tabulations is the very high degree of concentration of ownership in the Chilean corporate sector, comparable to that of Continental Europe. Almost three-quarters of the average company’s shares are owned by the three largest shareholders, and almost 90 per cent by the largest 10 shareholders. These very high levels of concentration do not vary much by sector of economic activity. However, in the construction and finance sectors the participation of the largest three shareholders is somewhat lower than the average, a difference that disappears when one considers the largest 10 shareholders. Among minority shareholders, one finds the AFPs, ADR holders, domestic and foreign mutual funds, and individuals. Another interesting feature of Chilean corporate balance sheets is that debtequity ratios are extremely low by the standards of other developing countries (e.g., they reached levels of over 300 per cent on average before the 1997 crisis in Korea, whereas in Chile they surpass 100 per cent only in two sectors) or even as compared to some developed countries (e.g., Japan). This is, in itself, quite surprising, since, in “insider” systems, managers will prefer to 84



finance projects with debt rather than with new share issues that dilute their ownership and control.6 The cause for such low levels of indebtedness in Chilean companies is partly related to the undeveloped nature of Chilean capital markets. Though some large Chilean companies issue bonds domestically, the organised bond market is extremely shallow, with very few daily transactions. The big purchasers of bonds are the AFPs and insurance companies, which tend to hold them to maturity. AFPs are restricted to a maximum of 20 per cent of any single bond offering. Since there are only eight AFPs, the same AFPs appear as purchasers of practically all new bond issues. The only two sectors in which bonds represent a high percentage or their liabilities are electrical companies and telecommunications, and a good share of their bonds are issued in international markets. In our sample of 177 corporations, only 30 issue bonds at all. For only 15 corporations does the share of bonds exceed 25 per cent of total liabilities. Several of these companies are the main Chilean bond issuers on international markets.7 The Chilean corporate sector may not have relied heavily on the issue of debt in recent years for yet another reason, related to the finding that controllers own more equity than is necessary for control. As we shall see below, during the 1990s firms raised substantial amounts of capital through the issue of new shares, a development that could be understood as an effort by controllers to reduce their “excessive” participation in ownership. Banks are the main source of corporate debt. Since banks rarely lend for investment purposes, this limits the extent to which corporations can use debt financing. As the concentration of ownership increases (measured by the equity share of the three largest shareholders), the debt-equity ratio tends to rise. This provides weak evidence that firms with more concentrated ownership tend to rely more on debt than on the issue of equity. However, what rises most is debt with related parties. As the degree of concentration rises, the proportion of bank debt in total debt remains unchanged, and the proportion of bonds in fact declines. An important clue to the operation of Chilean capital markets is thus the heavy corporate reliance on intra-group debt. Such debt represents on average over 20 per cent of the liabilities of the Chilean corporate sector. Besides companies that have access to international bond markets, Chilean corporations tend to finance their investments with retained earnings and transfers of funds between member companies of the same group. In heavily indebted companies (with a debt-equity ratio higher than 100 per cent), intragroup debt is also the highest. Thus, these figures provide some evidence that an important rationale for the existence of groups is to internalise imperfect and incomplete capital markets. 2003 © CIPE and OECD

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This phenomenon is also in evidence when we look at data on sources and uses of funds in the Chilean corporate sector (Table 3). In 1994, almost twothirds of funds came from internal resources. Of this total, one-half was from retained profits and depreciation accounts. At the same time, over 37 per cent of funds were used to make financial investments, which undoubtedly were, to a large extent, in firms of the same group. Macroeconomic evidence supports the contention that business saving (retained earnings plus depreciation funds) is the main source for financing investment. Econometric evidence spanning the period 1940-96 shows that private investment and business saving are jointly determined, and company data for 1985-94, show that gross corporate saving are a significant determinant of corporate investment.8 II. The Legal Framework Investor protection is more advanced than might be expected, given the origins of Chilean corporate legislation. However, sensitive information may be “reserved” and until recently public tender offers could be made to some shareholders but not others. Auditing committees are required to have a majority of independent directors. The observation that the property structure of Chilean corporations is highly concentrated implies that we are in the presence of an “insider” system in which the main problem of corporate governance is the possibility that majority shareholders (or blockholders) may be in a position to extract rents from minority shareholders. When there is a serious conflict between nongroup shareholders and blockholders, the only recourse left to the former is the sale of their shares. However, the high concentration of ownership and the shallowness of the Chilean stock market can render the exit solution very costly. This, in itself, tends to render the stock market illiquid. The literature on corporate governance distinguishes between four “families” of corporate legislation: those of English common-law) and French, German and Scandinavian civil-law origin. Countries with English common-law systems are seen as affording the highest protection to shareholders.9 As a result, they have tended to evolve “outsider” corporate-ownership structures with relatively low degrees of ownership concentration. The French system is seen as affording the lowest degree of shareholder protection, with the German and Scandinavian systems falling somewhere in between. Countries with the latter three systems tend to have “insider” corporate ownership structures exhibiting high degrees of property concentration. Like the rest of the Latin American countries, the Chilean legal system has a French origin, but it shows a surprising degree of investor protection, which has evolved in recent years partly through the pressure of institutional investors. 86



Protecting minorities The kinds of variables that are thought to determine the extent to which the system of corporate governance protects outsider (and, especially, minority) interests (variables which are characteristic of the English system) include the following: (1) the one share-one vote principle, (2) proxy vote by mail allowed, (3) shares not blocked before a shareholders’ meeting, (4) cumulative voting with proportional representation, (4) oppressed-minority rights10, (5) pre-emptive rights to new share issues that can be waved only in writing, and (6) low percentage of share capital needed to call an extraordinary shareholders’ meeting. In Chile, the principle of one share-one vote is protected by law. However, as already noted, it can be evaded through the issue of different classes of shares.11 Proxy votes by mail are not allowed (not being able to vote by mail makes it more costly for small shareholders to exercise their rights). In addition, before the new law on corporate governance was passed by Congress in October 2000, the rights of ADR holders were vested in and exercised by the Chairperson of the Board of Directors. Since several large Chilean corporations have been issuing new shares on the New York Stock Exchange for a decade, this provision resulted in even greater concentration of power in the hands of controllers and reduced the incentive of foreign investors to hold Chilean shares through the ADR modality. All shares that are registered five days before a shareholders’ meeting may vote on the principle of one share-one vote, with the exceptions noted above. Five per cent of share capital is required to call an extraordinary shareholders’ meeting. This percentage is on the low side, in comparison with international experience, and, therefore, would seem favourable to the protection of shareholders’ rights. Corporate law contains oppressed-minority provisions. As we shall see, they were exercised recently in a landmark case. Access to information There exist other provisions in current legislation which weaken the access to information on the part of all shareholders. The law authorizes the management of a firm to declare certain information as “reserved” if an action is still under negotiation and making such information public could be prejudicial to the interest of the company. For information to be declared “reserved” it must be approved by at least 75 per cent of the votes of the Board of Directors. Such information must be communicated to the SVS, under confidentiality, the day after the vote. This provision could allow a company’s 2003 © CIPE and OECD

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controllers to hide information from minority shareholders and from the public, in order to use it for their own benefit. Finally, until the approval of the recent law, PTOs could be made to some shareholders, to the exclusion of others. The old legislation established a vague duty to inform the public of a party’s intention to make a tender offer. It was silent on subjects such as the minimum information that must be made available, the scope of the tender, the principle of non-discrimination, the right to revoke the acceptance of the tender, and the role of directors and managers during a tender. The main problem to which this legal vacuum gave rise was discrimination against small shareholders and holders of ADRs, who could be excluded from tender offers and later had to face much lower prices for their shares. The new law (called popularly the “PTO law” but encompassing a much broader spectrum of corporate governance issues) which went into effect on December 20, 2000, attempts to regulate corporate governance in two main fields: prices for the sale of a company’s shares during a PTO and rent extraction from controllers. One of the key objectives of the law is to generate a higher level of efficiency in contracts, in order to minimize the manager-shareholder agency problem. The law sets up auditing committees and requires that the majority of their members be independent directors. It gives these committees ample powers of oversight over corporate activities. Its main duties are: examining financial results, proposing to the Board external auditors or risk evaluators, monitoring managerial wages and other rewards, and others activities dealt with by extraordinary shareholders’ meetings. The law also regulates dealings between related parties (as in the Terra case described below) in order to ensure that controllers do not extract rents from non-controlling shareholders. In such transactions, when the Board of Directors cannot reach agreement, it must designate independent evaluators. Moreover, shareholders representing at least 5 per cent of outstanding shares may request an extraordinary shareholders’ meeting to resolve such matters, which require the consent of two thirds of shareholders. A further reform in this direction is the granting of full rights to ADR holders. Finally, shareholders are granted withdrawal rights if the controller acquires more than two thirds of the shares outstanding or if more than 50 per cent of a company’s total assets are sold or collateralised. The principal means to ensure that minority shareholders have full rights is requiring PTOs to be made to all shareholders for sales of a large or controlling percentage of a company’s shares. One of the purposes of the law was precisely to introduce this requirement. As a sop to current controllers, it 88



gives corporations a three-year opt-out from the tender-offer provisions of the law, if approved by a majority vote at an extraordinary shareholders’ meeting. An opt-out may make minority shareholders exit the firm, leading to a further shrinkage in liquidity and greater concentration of ownership. However, these are likely to be transitional problems, since in a maximum period of three years the tender offer provisions will apply to all publicly-owned corporations. III. The Pension Funds Pension funds are important players in Chilean capitalism, though their activities are closely circumscribed. Although the motives may be commendable – to protect the interests of their beneficiaries – the effect is to limit their powers to monitor the companies in which they invest. The AFPs are legally authorized to invest in corporate shares. As already mentioned, they have been responsible for a substantial deepening of the stock market. However, current legislation limits AFPs to the role of minority shareholders. Before a reform introduced in mid-2002, which affected investment limits, the AFPs were allowed to invest only up to 37 per cent of their portfolios in shares and were limited to a maximum of 7 per cent of an issuer’s equity. This maximum declines if the issuer is related to the AFP, if its shares are illiquid, if its property is highly concentrated, or if it is classified as being too risky by independent risk-classification firms. The law also prohibits different AFPs from colluding or constituting formal voting blocks. The rationale for these limits is to protect contributing workers, who are the ultimate owners of AFP funds. Thus AFPs are required to invest in safe vehicles and to diversify their portfolios in order to prevent undue risk exposure. In order to prevent AFPs from extracting rents from the companies in which they invest, the law also forbids them from becoming controllers of corporations and severely limits their individual share in a company’s capital. However reasonable they may sound, these provisions inhibit the AFPs from being stronger monitors of the corporations in which they invest. Not only are they relegated to the status of minority shareholders with reduced influence on the actions of corporations. They are also limited to investing a relatively small share of their portfolios in equities.12 Given their significant financial power, they could play a more important role in corporate governance. This would require, of course, strong regulation in order to avoid the problems identified in the current legislation. AFPs could also play a more important role as intermediaries between savers (the working public at large) and innovative investors. Unfortunately, regulation prevents them from doing so at present. AFPs face legal limitations in the bond market. They can subscribe a maximum of 20 per cent of any new bond issue, and only through open purchases on the stock market. They are not allowed to invest in below-investment grade bonds.13 This eliminates any 2003 © CIPE and OECD

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possibility that they may provide bond finance to new and potentially high-risk companies or investments. They are also barred from participating in venture capital investments. The recent reform created five funds among which contributors may choose. The funds differ in the degree of implicit risk associated with their portfolios. Contributors may now choose the fund that best suits their financial needs and appetite for risk. With regard to corporate governance issues, the new regulations establish higher ownership limits for the riskier funds. The overall ownership limits, therefore, now depend on the decisions of contributors with respect to where they want their funds invested. Higher flexibility implies larger incentives for AFPs to monitor controllers and to structure their portfolios so as to yield higher profitability and bear greater risk. IV. Abuse of the System The structure of Chilean corporations does sometimes make it possible for those controlling them to take advantage of minority shareholders. Rent extraction has been relatively infrequent in recent Chilean corporate history. This may in part be due to stringent banking regulation, which prohibits bank loans to group-related firms, provisions which are now strictly enforced. The infrequency of rent extraction may also be due to a very active and efficient securities regulation agency (the SVS) which has stringent corporate reporting requirements that render the operations of corporations quite transparent. In recent years, the AFPs have been a positive force in defending the interests of non-controlling shareholders. In one case, they succeeded in overturning a PTO on very unfavourable terms for non-controllers. In another, ongoing case, they are suing controllers for alleged losses from the sale of assets to another firm in which the controlling interest has a high stake. The Chispas case In 1997, Enersis, the largest Chilean holding operating in the electrical utility sector was sold to Endesa España, a Spanish multinational corporation in the same sector, under highly irregular conditions that bestowed inordinate benefits on Enersis’ controllers and which was eventually turned back by the Chilean courts. Enersis has a public origin: Chilectra Metropolitana, which was privatised in the late 1980s. Workers and managers were allowed to purchase shares in the company. The former manager of the company became its controller. After a restructuring, the company’s name was changed to Enersis, and it became a holding company for a large number of investments. Enersis itself was controlled by a series of investment companies whose owners were its 90



former employees. Through these companies, the so-called Chispas, the employees came to control up to 32 per cent of Enersis. The conglomerate acquired control of Chile’s main electricity generating company, Endesa Chile. This purchase and various other acquisitions allowed Enersis to multiply its value 50 times, becoming one of the most important conglomerates in Latin America, with business interests in Chile, Argentina, Peru, Brazil, and Colombia. At the moment of the tender offer by Endesa España, the old employees of the state-owned originator of Enersis were not the only owners of the Chispas. Several AFPs had important interests in one of the Chispas – Sociedad de Inversión Luz. In spite of the large amount of funds invested by the AFPs in Enersis, their power within the firm was minimal. The reason was that, in each Chispa, there were two classes of shares, A and B. Class A shares, while having the right to higher dividends, had no voting rights. Enersis was really controlled by Class B shareholders, who owned 0.06 per cent of the company. The old manager of the state-owned company was a major owner of Class B shares. Endesa España negotiated directly with the controllers of Enersis and made a PTO for Class A and B shares, but offered to pay a price 840 times higher for Class B shares (CLP 220 for Class A shares and CLP 185,000 for Class B shares).14 In addition, Endesa España gave Class B shareholders the option of buying at a preferential price up to 5 per cent of its own shares and assured them that they would be retained as managers of Enersis for a period of at least 5 years. The small individual shareholders (mostly former employees) were quite happy with the deal, since they had seen the share price of Enersis multiply several times in just ten years. However, the AFPs had better information and attempted to abort the operation, because they considered that the benefits from the tender offer were very unevenly distributed. In addition, they argued that there were incentives for oppressive actions against minority shareholders who decided not to accept the tender offer for Class A shares. The AFPs succeeded in voiding the tender offer. In 1999 Endesa España eventually succeeded in buying Enersis and its subsidiary Endesa Chile, but the former controllers of Enersis had been legally forced out of the picture. Some authors15 argue that the value to Enersis of Class B shareholders was large enough to warrant the special treatment afforded to them in the investment companies’ ownership structure. In this view, the premium that Endesa España was willing to pay for the Chispas’ Class B shares represented a kind of reward for the real value of those shares. The controllers had been able to increase the value of Enersis several times over, with Class A shareholders also benefiting. Whether the prospect of making the kinds 2003 © CIPE and OECD

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of profits that Class B shareholders would have reaped, had the deal gone through, was necessary to induce them to exercise their considerable financial abilities on behalf of all shareholders is something we will never know. The Terra case In the late 1980s, Telefónica España (another Spanish MNC) bought a controlling stake in the Chilean telephone company, CTC. A recently created subsidiary of CTC, Telefónica.net is a thriving Internet company. In 1999, Telefónica.net was sold by Telefónica Chile (the name to which CTC was changed in 1998) to the Spanish subsidiary of Telefónica España, Terra Network, for a price of less than US$ 60 million. The alleged reason for the sale was the policy of Telefónica España of concentrating all of its Internet investments in its Madrid subsidiary. Once again, the eight AFPs, which together owned 18 per cent of Telefónica Chile, objected, on the grounds that Telefónica.net was worth US$ 201.7 million, according to two studies that they had commissioned. Some observers even considered that figure to be very conservative. Templeton, a foreign mutual fund that had stakes in Telefónica Chile, also objected to the sale. After several months, Templeton decided not to file suit, mainly because the costs of doing so exceeded the expected benefits. In early June 2000, the eight AFPs decided to sue the nine directors of Telefónica Chile who had voted in favour of the sale of Telefónica.net. They alleged that, on the basis of their studies, they had lost US$ 28.7 million (18 per cent of the difference between the sale price and their valuation of the company).16 The AFPs contended that the controller of Telefónica Chile, Telefónica España, is illegitimately extracting rents from them by selling assets at a lower price than their market value to another company in which it has a higher stake. Thus the loss in Chile is more than compensated by the gain in Spain. This conflict, which has not yet been resolved, shows that certain actions by controllers can be detrimental to minority shareholders. It also shows that the law does provide for redress and that AFPs have the incentive and the financial clout to defend the interests of non-controllers in the courts. Control premia If the control of a corporation by insiders has a value for those who obtain it (because of their ability to use that control to derive private “rents” through, say, self-dealing) one would expect to find a “control premium” in the price paid in PTOs. The control premium can be calculated as the excess in the share price paid in a tender offer over the price observed before the tender offer was made public. In a sample of 23 observations, the range of the estimated control premium was between 0 and 234 per cent, with an average of 33 92



per cent.17 Clearly, prospective controllers are willing to pay a premium for obtaining control. The control premium in Chile has a high dispersion around its average, which suggests that there are many variables that affect it, some of which are undoubtedly sector-specific. Impact of the new law The best way to protect oneself from being eaten by another fish is to be the largest fish. In the same way, in an environment that is aggressive with minorities, the strategy used by Chilean groups to avoid being subjected to rent extractions is to wield strong control. Since conditions have changed after the PTO law entered into force in December 2000, several important phenomena have occurred. One is that just before the law came into force, several corporate controllers made tender offers with the objective of taking their companies private. Chilectra (owner of the principal electrical distribution network) and Laboratorio Chile (one of the biggest pharmaceutical manufacturers) are examples. Though difficult to prove, these groups appear to have sought to introduce “noise” into the market in order to lower the share price and then be able to purchase outstanding shares at a lower cost. Minority shareholders were induced to sell their shares because, after the PTO, they would become highly illiquid. Another is that of the approximately 270 firms registered as open companies in the Santiago securities exchange (Bolsa de Valores), 92 decided to postpone the full applicability of the PTO law for a period of three years, as the law allowed. This temporary opt-out decision appeared tantamount to an announcement of a corporate policy of aggressiveness with minority shareholders and led to sales of the stock and a fall in its price. There is however no evidence that the average share price of companies applying the temporary opt-out clause performed worse than the overall index. Various factors may help explain this apparent paradox. Agents may for example punish the whole stock market, owing to the uncertainty of which firms would decide to apply the clause, and when they would apply it. Other firm-specific news, such as an announcement by the controller of major new project, may also have affected prices in a positive direction, helping to counter-balance the prospect of the company’s resorting to the three-year opt-out clause. In any case, whereas an important objective of the PTO law was to deepen the Chilean stock market, more than two years into the application of the law this has not happened. The average daily volume traded has not significantly increased. Nor have there been new initial public offerings or issues of new shares, whether in the local market or abroad via ADRs. An explanation widely accepted by market operators is more related to economic conditions 2003 © CIPE and OECD

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than to the functioning of the PTO law: Since 1998 Chile’s economic growth has slowed sharply, and interest rates have declined to historic lows, allowing firms to resort to bank lending rather than equity issues. V. The Importance of Banking Supervision Lessons have been learned from the financial crash in the early 1980s and much stricter regulation of the banking sector introduced. Groups may not own banks, which may not lend to related parties and are subject to regular inspection. There have been important improvements in corporate governance since the debt crisis of the 1980s. The improvements have been due partially to the adoption of banking supervision practices that limit the power of controllers to misuse bank lending for their own benefit and to the detriment of noncontrolling shareholders, depositors, and taxpayers. The Chilean story shows that, in developing country settings, there are enormous synergies between improved corporate governance and improved banking supervision. The liberalization of the financial system during the period 1974-81 was undertaken without the strengthening of banking and securities market supervision. The corporate law in force in those days allowed economic groups to own banks and other financial institutions. Even though there were some limits on dealings between banks and firms belonging to the same group, these were poorly enforced. Groups also got around these limits using other financial intermediaries, such as mutual funds. The groups that were formed during that period acquired banks, which were used to purchase yet other corporations. The groups acquired firms with resources lent to them by their bank and other financial institutions, using as collateral the assets of yet other firms that had been previously acquired. Several of these banks had access to international syndicated loans at low interest rates. Besides the enhanced commercial risks that the groups were taking on with each new purchase, they also were incurring in ever-increasing exchange rate risk, since loans were indexed to the exchange rate and the assets purchased were in pesos. Moreover, borrowing firms themselves were often in the non-traded sector (construction of malls and luxury apartment buildings) and did not earn foreign exchange. Banks themselves developed severe currency and term mismatches between their assets and liabilities. Banks lent without a proper evaluation of credit, since a large proportion of loans were to related parties. A fixed exchange rate, announced by the government to be “forever”, fostered the illusion that there was no currency risk.

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Weak regulation These financial dealings by the main groups of the day clearly represented a serious problem of corporate governance, aided and abetted by weak financial market regulations. It was thought at the time that financial markets, and especially banks, were capable of self-regulation. Thus groups were able to lay their hands on financial resources to expand very rapidly, incurring in risks that the minority shareholders of the various companies of the groups and the banks involved would not have run. The growth of the major groups, in terms of assets controlled, was spectacular. At the end of 1982, the two principal economic groups absorbed 50 per cent of lending by the private banking sector. Their shares had a representation of 68 per cent in the portfolios of mutual funds, and 83 per cent of the turnover of the Santiago Stock Exchange was in shares of their corporations.18 Finally, the banks used the state as an insurer in case of bankruptcy, since the government itself had given signals that it would act in that manner by taking over some troubled financial institutions between 1977 and 1981. Given the enormous adverse macroeconomic externalities of bank failures, the state was obligated to intervene in cases of crisis, but it had abdicated the regulatory tools needed to prevent such an event from taking place. When the terms of trade deteriorated in 1981 and the Federal Reserve raised interest rates sky high, Chile, like most other heavily indebted Latin American countries, began to face serious problems in servicing its debts. After the Mexican debt crisis, the whole castle of cards fell. Foreign credits were not renewed, banks began to call in their loans, the two main groups (and smaller ones as well) collapsed, and the banks were unable to pay their foreign creditors. The Central Bank had to intervene by, in effect, nationalizing private debts and taking over the banks themselves. This story, which may seem like history today, has important implications for corporate governance. When groups are allowed to own banks, they are tempted to use the funds of depositors for their own purposes, to the detriment of non-group shareholders, depositors, and, ultimately, the state. The consequence is that capital markets cease to function: they are prone to crises that spread rapidly to the real economy. In the Chilean case, the crisis led to a fall in GDP of 15 per cent in 1982-83, a rate of open unemployment that reached 22 per cent at the trough of the depression, and a complete cessation of investment. The financial system in effect collapsed. More sophisticated norms As a consequence of the crisis, Chile adopted much more sophisticated norms of banking regulation. Banks are strictly prohibited from making loans to related parties, they must match assets and liabilities in foreign currency, 2003 © CIPE and OECD

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and regulators evaluate the quality of their portfolio periodically. Norms for classifying assets as non-performing have been tightened, banks must make adequate provisions for bad loans, and regulators have the authority to force banks to increase their reserves when they deem that asset quality has deteriorated. The corporate sector has also gone through a learning process and is more aware of the dangers of taking on excessive debt, particularly in hard currency. As already noted, the level of debt of most Chilean corporations in very conservative. Most of the Chilean groups that survived the crisis have a strong base in a single sector of economic activity. The freewheeling conglomerates of the late 1970s simply disappeared. VI. Does the Capital Market Work Well? The evidence is conflicting. Corporate control is vested in the hands of a small number; but the law does offer small shareholders a relatively high degree of protection and until 1998 the stock market attracted substantial levels of investment. Chilean corporate governance structures have certain deficiencies, the corporate sector is highly concentrated, and control over much of the corporate sector is exercised by a very small number of powerful groups. These traits would suggest that the capital market functions poorly as an intermediary between savers and investors. On the other hand, Chilean corporate law is considerably friendlier to the interests of non-group shareholders and outsiders than what one would expect to find in an “insider” system of corporate governance. In addition, for the last 15 to 20 years Chilean capital markets have witnessed the emergence of important new institutional investors. These institutional investors are beginning to provide an important counterweight to controllers. Their very existence has improved the transparency of markets, as firms wishing to place their issues with such investors must provide by law considerable more information about their operations. As noted, banking regulation has also helped to improve corporate governance. So has an activist securities regulator. Large market, low liquidity It is difficult to judge the extent to which the capital markets are fulfilling the function traditionally assigned to them: to provide efficient mechanisms to intermediate between savers and investors. As already noted, one segment is still quite undeveloped: the bond market. In addition, there is little that can be called “venture capital” in Chilean capital markets.

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But the Chilean stock market is relatively large. As a share of GDP, during the 1990s, market capitalization fluctuated between 71 and 134 per cent, depending on the buoyancy of the stock market. The Chilean corporate sector undertakes a large share of all private investment. However, the liquidity of the stock market is still very low. As can be seen in Table 4, the ratio between turnover and market capitalization fluctuated between 6 and 15 per cent during the 1990s, which compares very unfavourably not only with the New York Stock Exchange (46 per cent in 1992) or the London Stock Exchange (61 per cent) but with ratios found in other insider systems (Frankfurt, 75 per cent, and Tokyo, 27 percent).19 The low share of turnover in capitalization is due, no doubt, to the high degree of concentration of ownership in Chilean corporations: large owners do not trade their shares. Of the almost 300 companies that are listed, only a handful trade every day. The Chilean stock exchange has, on the other hand, been an interesting vehicle for the issue of new shares. Indeed, a surprisingly large percentage of all turnover is represented by the issue of new shares. This percentage reached the phenomenal figure of two-thirds in 1997. New share issues Corporate-governance problems have not inhibited non-controlling investors from snapping up new share issues, and have not impeded firms from attempting to raise capital for new projects. Up until 1998, the 1990s were in fact a good period for issuing new shares, since equity prices rose very significantly as the economy boomed. Between 1991 and 1997 the number of firms the number of firms listed on the Santiago Stock Exchange rose from 223 to 294, as the number of firms going public rose. Until the early 1990s most of the new firms making their appearance on the stock exchange were privatised state-owned enterprises. Before that there were no initial public offerings (IPOs) in the technical sense – that is, companies going public and retaining the services of an investment bank to do so. By contrast almost all the new firms going public during the 1990s were companies that were formerly privately-held and were now offering shares through IPOs. The IPOs were fairly big by Chilean standards. The average size for the entire period 1991-1997 (involving 44 IPOs valued at about US$1.16 billion) was US$ 32 million; that average rose to almost US$ 70 million in 19961997. IPOs, which represented almost 5 per cent of all market turnover during that period20, also included a wide array of companies – from group affiliates to family-owned firms to subsidiaries of MNCs – in various sectors of the economy: pharmaceutical retailers, department stores, supermarkets, footwear producers, consumer goods, fisheries, and mining. Most of these 2003 © CIPE and OECD

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IPOs were successful, moreover, in the sense that share prices rose well above the levels of the initial offer. This was especially so for IPOs earlier in the decade. However, due to the downturn in the stock exchange caused by contagion from the Asian crisis, no new firms have gone public since 1997. An attempted IPO in 1999 by an assembler of buses failed and was withdrawn. A handful of the IPOs launched late in the process experienced price declines, and their shares were subsequently repurchased by their majority owners. Therefore, it cannot be argued that problems with corporate governance have significantly inhibited the capital market from performing its role. Undoubtedly, more transparent practices of corporate governance would improve the functioning of capital markets, and the authorities are keenly aware of this. Tentative Conclusions Although flaws remain in Chilean corporate governance – notably in the form of conflicts of interest – and the stock market does not fully play its part, nevertheless corporate governance standards are quite advanced, for reasons linked to supervision of the banks. The presence of institutional investors has also played a positive role and the pension funds could help create a genuine bond market. The Chilean system of corporate governance is a typical example of the “insider” variety. Its main problem is the conflict of interest that arises in such systems between controllers, usually a large group, and outside interests, normally AFPs, national and foreign mutual funds, insurance companies, holders of ADRs, and individuals. The result is that the stock market is rendered more illiquid than it would be otherwise, and its usefulness as a mechanism to raise investment funds is reduced. Nor can the Chilean corporate sector fully take advantage of the benefits of insider systems. By reducing the agency problem between managers and owners (which tend to be the same), an insider system should make potential bondholders more willing to lend to a company with the characteristics of the typical Chilean corporation. However, the bond market is poorly developed in Chile. The only issuers of bonds on a significant scale are public utilities, telecoms, mining companies, and a handful of very safe manufacturers. And an important proportion of these bonds are issued on international markets, not the Chilean market, which is highly illiquid for this type of instrument. Chilean banks normally do not lend for investment purposes. Banks face a problem of asymmetry of risks in making long-term loans: if the project for which they lend does not succeed, they risk losing their entire loan; if the project succeeds, they do not share in the pay-off.

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That is why it is so important to have an active stock market. Individuals and firms with good ideas are more likely to be able to raise funds in stock markets than through bank lending. The Chilean stock market is playing this role only partially. There have been substantial placements of new share issues on the Chilean stock exchange since the early 1990s. However, the larger firms prefer to issue ADRs in New York. For the smaller firms, the venture capital market is still in its infancy, and the junk-bond market is non-existent. Improving corporate governance can play a role in deepening capital markets and in making them more effective instruments for channelling resources to firms with good investment projects. In recognition of the importance of the issue, a new law on corporate governance was passed by the Chilean Congress in October 2000. This law ought to do away with some of the most notorious vices of the system as it has existed in recent years. However, the opt-out provisions with regard to tender offers (for a period of three years), together with a lacklustre economic environment and low interest rates, are probably leading to a further, if temporary, drying up of liquidity in the stock market. By developing country standards, then, corporate governance practices are quite advanced in Chile, for reasons that are not usually discussed in the corporate governance literature. In this respect, the Chilean experience has some positive lessons for other countries that are usually overlooked. Good corporate governance in Chile is intimately related to appropriate banking supervision. Per contra, most developing countries have poor banking supervision practices, and, consequently, suffer from severe problems of corporate governance that corrupt the workings of capital markets. In most developing countries, economic groups own banks, through which they are able to extract rents not only from non-group shareholders but also from very broad sectors of society, including the government, which is left with little option but to guarantee the safety of depositors. Corporate governance improved in Chile since the banking crisis of 1982-83, mainly as a consequence of the adoption of good banking supervision. The other lesson from the Chilean experience is that corporate governance improves substantially when well-regulated institutional investors enter the scene. This may have been an unexpected bonus from the pension fund reform of 1981. Countries contemplating a pension fund reform could well chalk up improvements in corporate governance to the asset side of the reform ledger. Of course, putting into place a well-functioning private pension fund system has its own regulatory requirements. But the system, when it functions well, can add transparency to the operation of capital markets and can perform the function of monitoring controllers. Because of collective action problems, small shareholders cannot perform this task. Individual action is too costly 2003 © CIPE and OECD

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relative to the benefits even for a relatively large shareholder (as shown by Templeton’s withdrawal from the Terra suit), and each small shareholder always has the temptation to behave as a free rider. The AFPs have the potential for playing a much more important role in disciplining corporations and limiting the extraction of rents by controllers. As noted, in recent years, they already have been a positive force in this direction. If their role as investors in corporations were increased, transparency in corporate governance could be improved still further, and the stock market’s liquidity could thereby be increased. The AFPs can also be instrumental in helping to create a genuine and liquid bond market. Corporate bonds are very appropriate vehicles for the AFPs, since they have a long-term horizon and are particularly concerned about the security of their investments. At present, despite the recent introduction of risk-segregated portfolios, the AFPs are still hamstrung by overly stringent regulations. They are allowed to hold a small proportion of the value of a company’s capital, which limits the power they can exercise over company affairs. In the bond market, they cannot purchase non-investment grade bonds. This is a major reason why there is no junk bond market in Chile. AFPs could even be allowed to invest part of their resources in venture capital undertakings, something they cannot do at present. These weaknesses in Chilean capital markets increase the difficulties that small and untried firms encounter in raising investment capital resources. For big AFPs, these regulations are particularly onerous, since they make it very difficult for them to change the structure of their portfolios. While seeking to protect the interests of contributing workers, such regulations hamper the development of capital markets. Perhaps the rules that govern the investments of AFPs could be made more flexible, at the same time strengthening the supervision of their activities. Ultimately, then, the development of capital markets is not just a matter of improving corporate governance. The evolution of capital markets is part of the process of economic development. Where capital markets fail or are undeveloped – as in most emerging markets, including Chile’s – they need to be supplemented by public action. In this area, the basic issue for developing economies is how to ensure that small and medium size firms have adequate access to investment resources. A more liquid stock market might help. But one suspects that is not enough and that a specific role for government in fostering the creation of missing markets is unavoidable.

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Tables

Directors controlled by group

Total Directors of member companies

12.4

86

x

27

29

Luksic

3,844.3

5.7

93

x

38

40

Matte

5,232.2

7.7

69

x

13

16

Pathfinder

1,764.7

2.6

18

x

13

17

Sigdo Koppers

825.8

1.2

37

x

30

39

20,093.8 29.6

301

121

141

TOTAL

State

8,426.8

Family

Angelini

Share of market capitalization

Market value (million US$)

Origin

Groups

Number of related firms

Table 1 Chile’s five most important groups in 1994

Source: Majluf et al. (1998).


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Longterm

Total

Banks

Bonds

Related parties

Share in liabilities

Shortterm

Debt-equity Ratio

10 largest

Cumulative ownership 3 largest

Sample

Table 2 A characterization of the Chilean corporate sector, September 1999 (177 companies, percentages)

Agriculture

20

72.9

90.4

31.9

24.8

56.8

52.0

0.0

17.0

Mining

6

79.3

93.3

19.7

19.2

39.0

30.0

0.4

15.6

Manufacturing

53

76.0

90.5

35.3

20.9

56.2

32.9

6.8

19.0

Electricity and water

18

75.5

86.3

22.7

57.3

80.1

27.2

7.7

24.7

Construction

1

61.1

89.9

29.1

3.3

32.4

1.9

0.0

29.2

Commerce

10

76.2

92.8

88.2

47.6

135.8

43.4

0.0

23.4

11

80.7

93.5

76.9

63.5

140.4

25.8

11.3

25.0

50

68.1

85.9

24.2

23.9

48.1

39.4

2.9

24.7

8

74.1

78.2

68.2

31.6

99.8

34.5

1.7

14.8

177 73.6

88.6

37.0

30.4

67.4

36.4

5.5

21.4

Sector

Transport and communications Finance Services Total

Source: Authors’ calculations based in Superintendencia de Valores y Seguros, FECU form, September 1999.

Table 4 Stock market indicators, 1991-99 (in millions of US dollars)

1991 1992 1993 1994 1995 1996 1997 1998 1999

Number of enterprises traded 223 244 263 279 282 290 294 287 282

Market Market Market capitalization turnover capitalization (% of GDP) 1,922 2,072 2,659 5,480 10,740 8,255 7,119 4,307 6,388

28,381 29,808 45,179 67,992 72,718 66,243 72,081 51,961 67,160

81.9 71.2 101.6 133.5 106.1 96.6 95.1 71.2 99.9 c

New share issues .. .. .. 2,119 2,307 3,430 4,809 1,951 721d

Sources: Authors’ calculations, based on Bolsa de Comercio de Santiago, Reseña Anual. and Celis and Maturana (1998, p. 16). a October 1991- December 1992. b January 1996 102



Table 3 Sources and uses of funds in Chilean corporations: 1981–94 (percentage of total)

Sources of funds Own resources Cash flow Debt Bonds Share issues Total

1981

1986

1990

1994

51.1 (7.3) 47.5 -1.3 100.0

78.1 (37.0) 18.2 1.8 1.9 100.0

65.3 (35.8) 21.8 7.2 5.7 100.0

63.7 (32.6) 15.2 5.2 16.0 100.0

18.0 68.6

25.0 40.8

36.0 24.1

22.1 37.5

18.7 6.8

21.5 9.3

16.3 26.1

16.8 20.5

-12.1

3.4

-2.5

3.2

100.0

100.0

100.0

100.0

Uses of funds Fixed investments Financial investments Decrease in debt Dividends Investment in working capital Total

Source: Agosin, Crespi, and Letelier (1999), p. 123.

IPOs, total value -162a 171 87 112 624b .. .. ..

IPO, average value -20 16 22 28 69 .. .. ..

Turnover/ New issues/ Capitalization Turnover (%) (%) 8.2 7.0 5.9 8.1 14.8 12.5 9.9 8.2 9.5

.. .. .. 38.7 21.4 41.6 67.6 45.3 ..

IPOs/ Turnover (5) 7.8 6.4 1.6 1.0 7.6 .. .. ..

. Volumes from 1991 through 1999; data of Superintendencia de Valores y Seguros; - May 1997. c 1999 GDP is estimated. d January - June 1999. 2003 © CIPE and OECD

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(Endnotes) Information as of end-1994 (Majluf et al., 1998). On the basis of consolidating balance sheets for all publicly traded affiliates, Lefort and Walker (2000) calculate even higher degrees of concentration. According to their figures, in 1998 the largest group controlled 23 per cent of the total assets of all publicly traded corporations, up from 14 per cent in 1994; and the five largest controlled 54 per cent of market capitalization (as compared with 51 per cent in 1994) 2 Lefort and Walker (2000). 3 Ibid. 4 Lefort and Walker (2000) reach this conclusion on the basis of consolidated balance sheets for conglomerates. 5 This form contains standardized information for all open corporations, which must report to the SVS on a quarterly basis. 6 Agency theory also tells us that bond markets prefer to lend to companies with highly concentrated ownership, since the agency problem between owners and managers tends to be much less intense in such companies than in those with widely disperse ownership patterns. 7 These companies include Embotelladora Andina (soft drinks), Gener (electricity generation), Endesa (electricity generation), Metrogas (gas distribution), Embotelladora Arica (soft drinks), Celulosa Arauco (pulp and paper), and Telefónica del Sur (telecommunications). 8 Agosin (2001) and Agosin, Crespi and Letelier (1999). 9 La Porta, et al. (1998). 10 These include the right to challenge the directors’ decisions in court, or the right to force the company to repurchase shares of the minority shareholders who object to certain fundamental decisions of the management or of shareholders, such as mergers or asset sales. 11 Whether the existence of different classes of shares with differing voting rights has an economic rationale in not at issue. Here we are interested in the possibility that it gives controllers for extracting rents from non-group shareholders and the adverse impact that this may have on the liquidity of the stock market. 12 They invest most of their funds in Central Bank paper and other fixed income assets. Since 1992, they have been allowed to invest an increasing share of their portfolios abroad (now up to 20 per cent), but the kinds of foreign instruments they can purchase is strictly controlled. The recent change in regulations also raised somewhat these limits. 13 It should be noted that all bonds (and stocks) undergo a process of classification by independent risk evaluating companies, according to strict criteria established by the SVS. AFPs can invest only in stocks and bonds that have obtained a minimum risk classification. 14 The average exchange rate in 1997 was US$ 1 = CLP 419.31. 15 See Raineri (1999). 16 Information from the Chilean financial press. See El Diario, 6 June 2000. 17 Using different data Dyck and Zingales (2002) found average corporate-control premia of about 15 per cent in Chile, as compared for example to less than 2 per cent in the United States, Great Britain, France, Hong Kong and South Africa, but 65 per cent in Brazil, 37 per cent in Italy and 16 per cent in Korea. 18 Barandiarán and Hernández (1999). 19 The Frankfurt and Tokyo data, both for 1991, are from Majluf, et al. (1998). 20 Information based on 36 of the 44 IPOs that took place during this period, from Celis and Maturana (1998). 1

104


Chapter 4

INDIA: THE TIDE RISES GRADUALLY Omkar Goswami

T

he past few years have seen an extraordinary movement by Indian enterprises to sign up for codes of corporate governance; first voluntary, later compulsory. This is not the consequence of any scandal but the direct result of the recognition by a new breed of managers and entrepreneurs that good corporate governance is intimately linked to sound business and opens the road to sources of finance. There is still some way to go: bankruptcy and accounting procedures need improvement, the stock and bond markets need to perform better and pension funds should play a fuller role. But there are real grounds for optimism. Introduction It is strange but true that early initiatives for better corporate governance in India came from the more enlightened listed companies and an industry association. This was quite different from the USA or Great Britain, where the drivers of corporate governance were shareholders’ groups, activist funds and self-regulatory bodies within capital markets, or South-East and East Asia, where the impetus for better governance was the result of conditions imposed by the IMF and the World Bank in the wake of the financial collapse of 199798. When India embarked on its corporate governance movement in 1996-97, the country faced no financial or balance of payments crisis. It did not have any powerful, activist mutual or pension funds to speak. Neither the capital market regulator nor the stock markets had understood the importance of good 2003 © CIPE and OECD

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corporate governance, of creating a milieu of confidence for domestic and international portfolio investors or of the need to issue a set of clear guidelines for listed companies. True, there were three financial scandals that highlighted the need for greater corporate transparency and accountability, and these brought the phrase “corporate governance” into the lexicon of the financial papers. Nevertheless, it is astonishing to note in hindsight that there were no major internal or external pressures that could have created an urgency for better corporate governance. Yet, it has happened — and in a very short space of time. The corporate governance movement began in 1997 with a voluntary code framed by the Confederation of Indian Industry (CII). In the next three years, almost 30 large listed companies accounting for over 25 per cent of India’s market capitalization voluntarily adopted the CII code. By 1999, the Securities and Exchange Board of India (SEBI) — India’s capital market regulator — had got into the act, and set up a committee to mandate international standards of corporate governance for listed companies. From April 1 2001, over 140 listed companies accounting for almost 80 per cent of market cap were due to follow a mandatory code which is in line with some of the best international practices. By April 2003, every listed company was due to follow the SEBI code. Liberalization and competition How did this sea change occur without the presence of sufficient internal or external pressures? The answer has to do with the change in corporate mindset brought about by economic liberalisation and competition of the 1990s. Simply put, yesterday’s giants — those who lived off protection and cared precious little for generating greater shareholder value — have been dwarfed by market forces. Compare this with the new players in the corporate sector. This evidence is even more revealing, and shows how economic liberalisation, competitiveness and dismantling of controls have reduced entry barriers, and permitted new entrepreneurs to race to the top. The dominant characteristic of today’s top 50 companies is the preponderance of first generation enterprise or professionally run businesses. In 1991, 22 out of the top 50 companies were controlled by family groups that held their sway during the licence-control regime. By 2000, the roles were reversed: 35 were professionally managed, of which 14 were first generation businesses; only four out of the 50 were run by older business families. This change has augured well for corporate governance. The new breed of managers is not wedded to the mechanics of capture of yesterday’s dirigiste regime. Instead, they believe in professionalism and the credo of running 106


CHAPTER 4 | INDIA: THE TIDE RISES GRADUALLY

business transparently to increase corporate value. Thus, the need for good corporate governance is being appreciated as a sound business strategy, and as an important facilitator to tap domestic as well as international capital. Although India has a long way to go to rank among the best in the world in corporate governance, the driving force is exactly right. A large number of CEOs realise that their companies need financial and human capital in order to grow to scales necessary to survive international competition. They also understand that such capital will not be available in a non-transparent corporate regime that is bereft of international quality of disclosures and accountability. It is this realisation which is driving the corporate governance movement in India, and which has greater chances of delivering substance than ticking mandated governance check-lists. Having said this, it is important to note that there are still lacunae in different aspects of corporate governance. India still has poor bankruptcy laws and procedures; Indian accounting standards still do not mandate consolidation — although this is due to change. Stock markets are still inefficiently run, and do not have the adequate depth or breadth to give shareholders greater comfort. The bond market is in its infancy. Pension funds need to invest much more in equity, and play an activist role. Mutual funds need to walk the talk in corporate governance. Even so, it is necessary to recognise that corporate India has come a long way in the business of governance, especially in the last four years — and the more so given its legacy of the past. Since the second half of the 19th century, most modern industries and services in India have been structured under the English common law framework of joint-stock limited liability. Despite this long corporate history, the phrase “corporate governance” remained unknown until 1993.1 It came to the fore because of a spate of corporate scandals that occurred during the first flush of economic liberalisation. The first was a major securities scam that was uncovered in April 1992, which involved a large number of banks, and resulted in the stock market nosediving for the first time since the advent of reforms in 1991.2 The second was a sudden growth of cases where multinational companies started consolidating their ownership by issuing preferential equity allotments to their controlling group at steep discounts to their market price.3 The third scandal involved disappearing companies in 1993-94. Between July 1993 and September 1994, the stock index shot up by 120 per cent. During this boom, hundreds of obscure companies made public issues at large share premia, buttressed by sales pitches from obscure investment banks and misleading prospectuses. The management of most of these companies siphoned off the funds, and a vast number of small investors were saddled with illiquid stocks of dud


107


companies. This shattered investor confidence, and resulted in the virtual destruction of the primary market for the next six years. These three episodes led to the prominence of “corporate governance” within the financial press, some financial institutions, more enlightened business associations, and then the regulatory agencies and the government. The point to note is that, unlike Southeast and East Asia, the corporate governance movement did not occur as the result of a national or regionwide macroeconomic and financial collapse. Indeed, the Asian crisis barely touched India. The need for good governance and better financial and nonfinancial disclosures became prominent well before the Thai baht began to nose-dive in June 1997. The need for transparency Today, more and more listed companies have begun to realise the need for transparency and good governance to attract foreign as well as domestic capital. A growing tribe of chief executive officers now recognise that complex cross-holdings, opaque financial disclosures, rubber-stamp boards and inadequate concern for minority shareholders is a recipe for being shut out of competitive capital markets. Section I gives a historical overview. This is essential to understand the structure of corporate India and why corporate governance meant so little until the last six or seven years. Section II describes the present structure of corporate India. It gives details of the number of companies, the percentage that is listed, the size of stock exchanges and so on. Section III comments on two types of agency costs in the Asian context: one that affected efficiency and hence corporate value, and another that aided expropriation of minority shareholder rights. Section IV looks at the legal and procedural barriers to good corporate governance. Section V examines corporate financial and non-financial disclosures, and how these match up with the best international practices. Section VI analyses the de jure and de facto role of the board of directors. Section VII discusses corporate governance of state-owned enterprises (SOEs), which account for a significant share of secondary and services sector GDP. Section VIII describes recent corporate governance initiatives, and how these have positively affected governance, disclosure, fairness and transparency. I. Historical Backdrop: 1900 to 1990 When it achieved independence India was a very poor country, but one with a manufacturing base and a tradition of stock markets, a developed banking system and a corporate sector. But political decisions to impose regulations, trade barriers and high taxes, coupled with a system that encouraged incompetence and idleness were a sure recipe for inertia, waste and misgovernance. 108



At the time of independence in 1947, India was one of the poorest nations in the world with a per capita income of less than $30. Yet, manufacturing accounted for almost a fifth of the country’s national product, and half of that (10 per cent of GDP) was contributed by the modern factory sector which included cotton textile mills, jute mills and collieries, iron and steel mills, nascent engineering units and foundries, cement, sugar and paper.4 From the 1870s, growth of this sector was structured along corporate lines through joint-stock limited liability companies — most of which were floated in India and listed on local stock exchanges.5 The Bombay Stock Exchange (BSE) was formed in 1875 under the name of Native Share and Stockholders Association, and it began trading three years before the Tokyo Stock Exchange. At the beginning of the 20th century India had four fully functioning stock exchanges – in Bombay, Calcutta, Madras and Ahmedabad – with welldefined listing, trading and settlement rules. By independence, there were over 800 listed rupee companies, and many of them had sizeable floating stock. The vehicle for corporate growth was the ‘managing agency’. It worked something like this: every major corporate group had a closely held company or partnership called a managing agency. In effect, these functioned like holding companies. Managing agencies would float companies, and their imprimatur sufficed to ensure massive over-subscription of shares.6 Given excess demand, most of these companies could split shareholdings into small enough allotments to ensure that nobody — barring the managing agency — had sufficiently large stocks to ensure their presence on the board of directors. Thus, dispersed ownership allowed managing agencies to retain corporate control with relatively low equity ownership — a trend that continued right up to the mid-1980s and early 1990s. From the corporate governance point of view, therefore, the tendency for management in India to enjoy control rights that are disproportionately greater than its residual cash flow rights goes back to the early years of the 20th century.7 On the positive side, however, because much of corporate growth in preindependent India was financed through equity, India’s urban investors developed a sophisticated equity culture by the mid-20th century. Moreover, the banking sector was surprisingly well developed for a country as poor as India. Every major bank that exists in India today was in operation well before independence. They were privately owned, advanced working capital, maintained prudential lending and accounting norms, and were backed up by sound recovery laws and efficient processes.


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Corporate law Since modern industrial growth was structured along corporate lines, it is not surprising that colonial India quickly put in place a substantive body of corporate law. The 1956 Companies Act — which, with its periodic amendments, substantially governs the legal and regulatory aspects of public and private limited companies — derives from the Indian Companies Acts of 1866, 1882 and 1913. The Indian Trusts Act was passed in 1882 to regulate the functioning of all public and private trust funds. Legislation aimed at prudent regulation of banks began with the Reserve Bank of India Act, 1934, and was extended by the Banking Regulation Act, 1949. The law that regulates stock exchanges and the transactions of securities, the Securities Contracts (Regulation) Act, was also passed in 1956. Thus, India at independence in 1947 had a sizeable corporate sector accounting for at least 10 per cent of GDP; it had well functioning stock markets and a developed banking system; it had a substantial body of laws relating to the conduct of companies, banks, stock markets, trusts and securities; and it had an equity culture among the a section of the urban populace. It was probably the least equipped de-colonised country to practice good corporate governance, maximise long term corporate and protect stakeholder rights. But it did not. To understand why and how India squandered its early advantages, it is necessary to examine the post-independent regulatory regime. Barriers to investment The first barrier to investments came with the Industries (Development and Regulation) Act, 1951 (IDRA), which required all existing and proposed industrial units to obtain licences from the central government. The IDRA continued for four decades before being dismantled in June 1991. The pervasive licensing regime under IDRA fostered entry barriers through pre-emption of industrial licences which, in turn, facilitated widespread rent seeking. Entrepreneurial families and business houses that had built their fortune in textiles, coal, iron and steel and jute now used licences to secure monopolistic and oligopolistic privileges in new industries such as aluminium, paper, cement and engineering. Over the years, licensing became increasingly stringent and was accompanied by multiple procedures that required clearances from a large number of uncoordinated ministries. A still more serious barrier to entry occurred in 1956, when the Industrial Policy Resolution (IPR) adopted the maxim of “a socialist pattern of society” and prescribed that the public sector would occupy “the commanding heights” of the economy. Schedule A of the IPR listed 17 industries whose 110



future development would be “the exclusive responsibility of the State,” and 12 Schedule B industries where “the State will increasingly establish new undertakings.”8 By a single stroke, India succeeded in creating yet another barrier to private investment. With it, the government also created a massive state-owned industrial and services sector which brought its specific dysfunctionalities, inefficiencies, cost disadvantages and corporate governance problems. These are discussed in Section 7. The late 1960s and early 1970s witnessed a more intensified trend to limit private investment and foster inefficient manufacturing scales. The Monopolies and Restrictive Trade Practices Act, 1969 (popularly known as MRTP) linked industrial licensing with an asset-based classification of monopoly.9 With the passing of MRTP, private sector businesses whose assets exceeded a paltry amount had to apply for additional licences to increase capacities and, more often than not, such applications were rejected. MRTP was followed by widespread nationalisation, which began in 1969 with the insurance companies and banks, and in 1970 encompassed petroleum companies and collieries. Among other things, nationalisation made employment preservation a political objective. The 1970s and early 1980s saw successive governments taking over financially-distressed private sector textile mills and engineering companies — thus converting private bankruptcy to high cost public debt. In addition, the government made a fetish out of “small is beautiful.” This occurred in two ways. First, successive governments sponsored the setting up of mini-plants, and the 1980s saw a mushrooming of technologically nonviable mini-steel, mini-cement and mini-paper units whose profitability hinged upon heavy tax concessions, high initial leveraging, subsidised long term finance, high tariffs and import quotas and the munificence of government orders. Second, governments actively encouraged small-scale industries. While this is not necessarily a bad thing — small and medium enterprises are often more efficient and flexible compared to larger firms — the smallscale sector was fostered through a plethora of artificial means, such as tax concessions and product reservations. Even today, there are over 800 product lines reserved for the small-scale sector, of which more than 600 are not even manufactured in India! Tariffs, quotas and taxes Naturally, these distortions could not have existed in an outward-oriented, open economy. They were eventually supported by a regime of high tariffs and import quotas. Despite preferential tariffs for Britain and the Empire countries, there were no major barriers to trade during the colonial era. Consequently, the major industries that existed prior to independence — cotton textiles and yarn, jute, tea and coal — were internationally competitive, and two of them (jute and tea) were driven by exports. Things began to change especially from 2003 © CIPE and OECD

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the mid-1960s, intensifying with the import-substituting regime of the 1970s and early 1980s. Import substitution made it incumbent upon a company to demonstrate to bureaucrats the “essentiality” of any import, and the doctrine of “indigenous availability” ensured the purchase of Indian inputs even at higher price-lower quality configurations. Import substitution was sustained by quantitative restrictions and high tariffs.10 To be sure, some of the policies helped to promote a setting-up of industrial capacities, especially in engineering, drugs and pharmaceuticals, chemicals, fertiliser and petrochemicals. But they also created highly protected markets, fostered noncompetitiveness and promoted large scale rent-seeking through a nexus between companies and bureaucrats and politicians — a fertile ground for sowing the seeds of corporate misgovernance. Added to this was the corporate and personal income tax structure. At its peak, the corporate tax rate was as high as 55 per cent, and the maximum marginal personal income tax rate was an astronomical 98.75 per cent. Such rates created phenomenal incentives for cheating which took many forms — undeclared cash perquisites, private expenses footed on company account, complicated emolument structures and complex cross-holdings of shares to confound calculations regarding dividend and wealth tax. The message was simple and profoundly negative. What mattered was how to expropriate larger slices of a small pie, and do so in ways that escaped the tax net. There were absolutely no incentives to grow the pie, create wealth and share it among stakeholders in transparent and equitable ways. Development finance Curiously, the instrument that the government used to foster widespread industrial growth – subsidised long-term loans as “development finance” for creating fixed assets – militated against good corporate governance. In many ways, the story is similar to that of South Korea and requires some elaboration. After independence, the Government of India set up three all-India development finance institutions (DFIs). These were the Industrial Finance Corporation of India (IFCI), the Industrial Development Bank of India (IDBI) and the Industrial Credit and Investment Corporation of India (ICICI). In addition, state governments set up their State Financial Corporations. From their inception up to the early 1990s, the raison d’être of these public sector DFIs was to foster industrialization by advancing long-term loans at low, often subsidised, real interest rates for setting up plant and machinery. There is nothing wrong with a fiscally surplus government’s pushing subsidised long-term funds for creating competitive industrial capacities. South Korea’s huge industrial base is a testimony to the efficacy of such a policy. However, 112



when careful project appraisal is abandoned for loan pushing — DFIs were judged on the amount of loans sanctioned and disbursed, and not by their asset quality — and when this occurs in a tightly controlled, rigidly licensed, highly protected, import-substituting milieu, it invariably results in crony capitalism, rent seeking, setting up of inefficient capacities and corporate misgovernance with public funds. This is precisely what occurred in India in the 1970s and 1980s. There are two strands to the corporate misgovernance story à la DFIs. The first has to do with excess leveraging, and the second with the role of DFIs as shareholders. By the early 1980s, many term loans for industrial projects were sanctioned with a long-term debt-to-equity ratio that exceeded 2.5:1, and a total debt-to-equity ratio that went over 4:1. This kind of gearing allowed the “promoters” to start projects with a relatively low equity base. In fact, their equity contribution was lower still. During the industrial expansion of the 1970s and 1980s, average share ownership of the controlling groups declined to 15 per cent. In other words, it was possible to embark on a Rs.500 million project with only Rs.100 million of equity, of which a mere Rs.15 million came from the promoters and sufficed for control.11 The stage was thus set for moral hazard of limited liability. Given subsidised loan funds and various tax incentives to set up industries, most promoters recovered their relatively meagre equity within a year or two of operation, if not earlier. Thereafter, in good states, DFIs could count on their loans being repaid. In bad states, debt took a hit while equity had already recouped its outlay. The nexus between business groups and politicians ensured that debts would be invariably rescheduled in the event of systematic default — in the name of “rehabilitating” financially “sick” industrial companies. Played out in the context of inefficient implementation of bankruptcy laws, this created widespread corporate misgovernance, the least damaging consequence of which was major diversion of DFI funds for other ventures. State holdings in private sector companies The other aspect of poor governance had much to do with the shareholding of government-owned financial institutions. Even today, more than a decade after the advent of economic liberalisation, a substantial proportion of the equity of India’s private sector companies is held by the DFIs, the nationalised insurance companies, and the government-owned mutual fund, the Unit Trust of India, or UTI. This kind of indirect state ownership of equity fostered poor corporate governance through inefficient monitoring. The institutional shareholders insisted on nominating their directors on corporate boards. Given their shareholdings, nobody could argue with that. However, at best, most of these nominee directors were incompetent; at worst, they were instructed to support the incumbent management irrespective of performance. 2003 © CIPE and OECD

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Chart A plots a scatter of India’s top 397 listed companies, ranked according to market cap. The mean shareholding of state-owned financial institutions is 20.1 per cent.

Such significant errors of omission cannot be fully explained by the nexus between industrialists, bureaucrats and politicians. Much of it has to do with state ownership of these financial institutions, where nobody was rewarded for profit making or punished for adverse wealth and income consequences of inaction. Thus, the institutional shareowners, who could have played an important governance role, chose not to do so. Soon, promoters knew that they had the support of anything between a fifth and a third of the voting stock. Not surprisingly, their control rights vastly exceeded their cash flow rights. In theory, the three all-India DFIs were very well placed to play the role of corporate governance watchdogs in the 1970s and 1980s. They were like the large German hausbanks — being major lenders as well as substantial shareholders. If the DFIs had done their job well, they could have simultaneously reduced the agency costs associated with debt and equity. They did not. On the equity side, the failure had to do with distorted incentives of government ownership and management of the DFIs, and the state–business nexus that induced nominee directors invariably to vote with the promoters. On the debt side, it had much to do with inadequate income recognition and provisioning norms, as well as poor processes for bankruptcy and debt recovery.12 114



By the time India embarked on economic liberalisation, the waters had got very muddied. On the one hand, the country had an equity base which was substantially greater than most developing countries; it had laws that regulated companies and protected the rights of shareholders; and it had a very large and active industrial sector ranging from complex petrochemicals to simple toy manufacturing. On the other, a combination of licensing, protection, quotas, high gearing and poor board-level accountability had created an environment that didn’t punish poor corporate governance. II. The Structure of Corporate India In the space of 10 years there has been a revolution in the hierarchy of Indian companies, with newcomers benefiting from liberalisation racing past olderestablished enterprises. There is a substantial corporate sector and firms with wide shareholdings account for two thirds of the book value of paid-up capital. Although small in number, government companies account for almost two fifths of paid-up capital. Freely tradable shares account for about 30 per cent of the equity of companies listed on the two principal stock exchanges but trading volumes are modest. Before describing India’s corporate sector at the end of the 20th century, it is useful to emphasise the great churning that was unleashed by economic liberalisation in the 1990s. Nothing highlights this churning more than two simple effects — the fall from grace of yesterday’s corporate giants, and the rise of the new kids on the block. To illustrate, let us consider the top 100 companies ranked according to market capitalisation as 1st April 1991 and again on 28th February 2000. How were they treated by the market? Very poorly indeed: • • •

The rank of the top 10 companies fell by an average of 65 points; The rank of the top 50 companies fell by an average of 112 points; For the top 100, the average fall in rank was 167 points.

Simply put, in relative terms, yesterday’s giants have been dwarfed by the forces of change.13 What about the new kings of the bourse? When did these firms come into being? These data are even more revealing, and show how economic liberalisation, competitiveness and dismantling of controls have reduced entry barriers, and permitted new entrepreneurs to race to the top of the market capitalisation table. • • •

Seven of the top 10 companies ranked by market cap as on 28th February 2000 either did not exist or were not listed on any stock exchange in 1991.14 Twenty-eight of the top 50 companies were in identical circumstances. While information technology stocks rule the roost, other industries are represented as well (see Table 3).


115


The emergence of a new generation The dominant characteristic of today’s top 50 companies is the preponderance of first generation enterprise or professionally run businesses. In 1991, 22 out of the top 50 companies were controlled by family groups that held their sway during the licence-control regime. By 2000, the roles were reversed: 35 were professionally managed, of which 14 were first generation businesses; only four out of the 50 were run by older business families. This change has augured well for corporate governance. The new breed of managers is not wedded to the mechanics of capture of the dirigiste regime of the past. Instead, they believe in professionalism and the credo of running business transparently to increase corporate value. The need for good corporate governance is being appreciated as a sound business strategy, and as an important facilitator to tap domestic as well as international capital. India’s corporate sector consists of closely held (private limited) as well as publicly held (public limited) companies.15 Among the latter are those which are listed in one or more stock exchanges. Table 1 gives the data for 199799. Table 1: Basic statistics of India’s corporate sector, 1997-99 1997

Share

1998

Share

1999

Share

Number of companies Closely held (Private limited)

386841

86% 415954 86%

440997

86%

Widely held (Public limited including listed)

64109

14%

71064

14%

All companies

450950 100% 484500 100% 512061 100%

68546

14%

Paid-up capital (Rs. billion) Closely held (Private limited)

588

32%

718

34%

790

34%

Widely held (Public limited including listed)

1257

68%

1409

66%

1503

66%

All companies

1845

100%

2127

100%

2293

100%

Number of companies

1220

0.30% 1223

0.30%

1240

0.24%

Paid-up capital (Rs. Billion)

797

39%

890

39%

Government companies 43%

824

Source: Ministry of Law and Justice, Department of Company Affairs, Government of India

The total of closely held companies vastly outnumbers the publicly held ones, and constitutes the bulk of small-scale enterprises. However, the public 116



limited companies including the listed ones account for almost two-thirds of the book value of equity. The other point worth noting from Table 1 is the size of the government corporate sector: while it accounts for a mere 0.24 per cent of the number of companies, it speaks for 39 per cent of corporate India’s paid-up capital. A little over 10,000 listed firms form a sub-set of public limited companies. While there are 23 registered stock exchanges in India, many are moribund — and exist only because the law insists that any listed company must at least register with the stock exchange that is located nearest to the company’s registered address.16 Only two stock exchanges matter in terms of size, efficiency and liquidity. These are the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE), which came into being in the late 1980s. It is fair to say that any company worth its reputation in corporate India is listed in either BSE or NSE, or both. Market capitalisation and liquidity In December of 2002, the market capitalisation of companies listed on the BSE or NSE stood at about US $271 billion – an amount equivalent to about 54 per cent of the country’s GDP. Moreover, if the NSE and the BSE are counted separately, they rank 7th and 8th in the Asia-Pacific stock-exchange league table, as shown in Table 2 (if the market caps of the NSE and BSE are combined, India would rank fifth in the table – or fourth if Hong Kong and Shanghai are combined, putting China in second place and Australia in third): Table 2: Market capitalisation of Asia-Pacific stock exchanges, December 2002 (US $ bn) Stock Exchange Tokyo Hong Kong Sydney Shanghai Taipei Seoul NSE (890 cos.) BSE (5650 cos.) Kuala Lumpur Bangkok Jakarta Manila

Market cap 2069 463 380 333 261 216 140 131 126 46 30 19

Source: World Federation of Exchanges; BSE; NSE; Shanghai S.E.


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A remarkable feature of listed Indian companies is the relative size of the state-owned enterprises. For example, the BSE lists only 73 government companies — which account for less than 2 per cent of the number of companies listed. Yet, these stocks account for almost 15 per cent of market capitalisation. The typical listed SOE is thus much larger than its private sector counterpart. This has policy implications for corporate governance, which are discussed in Section 7. While information technology stocks are at the top of the table, very many industries have their place in the sun among listed companies. Table 3 gives a list of sectors that account for 1 per cent or more of BSE’s market capitalisation. Table 3: An illustrative list of sectors represented in stock exchanges Sectors

Share

Computer software

17.76%

Computer hardware

17.47%

Diversified

11.06%

Refinery

5.58%

Banks and DFIs

4.53%

Drugs & pharmaceuticals

4.44%

Telecommunication services

3.99%

Trading

2.46%

Crude oil & natural gas

2.33%

Commercial vehicles, cars, 2 & 3 wheelers

1.99%

Tobacco products

1.96%

Communication equipment

1.36%

Cement

1.13%

Finished steel

1.13%

Aluminium and aluminium products

1.03%

Cosmetics & toiletries

1.00%

Electricity generation

1.00%

Source: CMIE, Prowess

How wide and deep are the two main stock markets? Not enough, by the standards of most developed countries. Public shareholding ought to cover shares owned by individual investors, mutual funds, insurance companies and DFIs. In India, it would be wrong to consider this aggregate as a measure of 118



freely traded shares. DFIs and, to a lesser extent, the nationalised insurance companies hardly trade in the market. Hence, a more realistic concept of “freely tradable shares”, or market liquidity,” should be limited to the holdings of individual investors and the mutual funds. This share varies considerably across listed companies, as Chart B shows.

About 30 per cent of the shares of a “typical” listed company can be theoretically treated as freely tradable. The average trading volume is far less. For liquid, pivotal stocks, no more than 20 per cent of the freely tradable shares are actually traded on active days. Simply put, while the market cap of Indian companies is very impressive — especially given India’s per capita income of $410 — the actual market for trading tends to be thin even in active exchanges like the BSE and the NSE. That also explains the relatively high volatility of share prices, especially narrow-based share indices such as the BSE Sensitivity Index (or Sensex) or the NSE-50 (popularly called Nifty). Current legislation If an entity is incorporated as a company — which accounts for the vast majority of corporate India — it is primarily governed by the provisions of the Companies Act, 1956. Based largely on its British counterpart, many sections of the Companies Act have been amended from time to time.17


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Three other pieces of legislation are also very important from the point of view of corporate governance. They are: •

Securities Contracts (Regulation) Act, 1956: covers all types of tradable government paper, shares, stocks, bonds, debentures and any other form of marketable securities issued by companies, including the “rights and interest in securities” — thus effectively allowing for options. The SCRA defines the parameters of conduct of stock exchanges as well as its powers.

•

Securities and Exchange Board of India (SEBI) Act, 1992: established the independent capital market regulatory authority, SEBI, with the objective to protect the interests of investors in securities and to promote and regulate the securities markets.

•

Sick Industrial Companies (Special Provisions) Act, 1985: popularly known as SICA, lays down the framework for bankruptcy restructuring of financially distressed companies. SICA will be critiqued in section 4.

India thus has a sizeable corporate sector, with companies registered as closely or widely held under the Companies Act. Although widely held firms account for only 14 per cent of the number of registered companies, they account for 66 per cent of corporate India’s book value of paid-up capital. The government sector plays a significant part among the widely held (though not necessarily listed) public limited companies: government companies constitute only 0.3 per cent of the number of companies, yet account for 39 per cent of paid-up capital. There are over 10,000 listed companies, the more reputable of which are listed on the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). Private-sector listed companies account for almost 80 per cent of BSE’s market cap; the remaining 20 per cent are made up of listed government companies. Listed companies represent all possible commercial activity, covering every major branch of manufacturing and services. As in most stock exchanges, a large number of companies constitute a very small proportion of the market cap, while relatively few make up of the bulk: the top 10 per cent of private sector firms (450 firms) account for over 96 per cent of the private sector’s market cap. Freely tradable shares account for roughly 30 per cent of the equity of listed companies. However, even on very active days, no more than 20 per cent of this stock is traded — and that estimate is on the high side. Thus, despite the size of corporate India’s market cap, trading volumes are quite thin. That also has implications for the future of take-overs through open offers.

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III. Agency and Expropriation Costs Indian companies were until recently vulnerable to the abuses affecting both US (and UK) corporations and Asian enterprises – that latter showing, incidentally, that a firm can be profitable while having poor corporate governance. The discussion of agency costs in the corporate-governance literature has mostly focused on efficiency. That is not surprising given the disproportionate role US corporations have played in authors’ attempts empirically to validate agency-costs arguments. Following the work of Jensen and Meckling (1976), and a series of Jensen’s articles [Jensen (1986, 1988, 1989, 1993)], the view has become widespread that the dominant consequence of poor corporate governance is erosion of corporate value due to dispersed shareholding and the separation of ownership from control.18 The Anglo-Saxon example Modern U.S. and British corporations are characterized by almost complete separation of ownership and control. Managers of vast corporations ran their empires with very little or no shareholding. Therefore, they had little incentive to align their managerial behaviour and decisions in line with those desired by the shareholders. Until the mid-1980s, this was facilitated by widely dispersed share ownership, and by the absence of powerful pension and mutual funds that could have used their relatively concentrated stockholdings to demand greater shareholder value. According to Jensen and his followers, this was the prime cause for the spate of junk-bond-financed take-overs and leveraged buyouts from the mid-1970s to the mid-1980s. Jensen’s description fits US corporations of the 1970s and early 1980s like a glove. But here lies the rub. Intense Japanese competition after the second oil price shock, the warning bells pealed by leveraged buy-outs during 197585, and the rapidly increasing power of large pension funds like CalPERS and TIAA-CREF have changed the Jensenian model of corporate America. More important, the Jensen description does not seem to fit the story of corporate control in most parts of Asia. The Asian model There are three dominant themes that characterize corporate ownership and control in most parts of Asia. First, relative to their size, most Asian companies have low equity. This has been traditionally facilitated by highly geared shortterm credit- and long-term lending-driven growth. Second, given the low equity base, promoters have found it relatively cheap to own majority shares. This is true for many companies in Hong Kong, Indonesia, Malaysia, Philippines, Thailand and China. In many instances, the entrepreneur and his family own up to 75 per cent of the equity, which thwarts all possibilities of equity-triggered 2003 © CIPE and OECD

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take-overs. Third, as in the case of Korea and Japan, equity ownership is invariably camouflaged through complex corporate cross-holdings. None of this conforms to the model of the modern U.S. corporation — with its large equity base, dispersed shareholding and profound separation of ownership from management. However, that does not reduce the importance of agency costs. Contrary to Jensen’s model, these costs have not affected corporate efficiency so much as they have affected minority shareholder rights. A promoter who controls management and directly or beneficially owns over 75 per cent of a company’s equity cannot be expected to perform in a value-destroying manner in the way that many US corporate managers and boards did up to the mid-1980s. However, he can do a large number of things that deprive minority shareholders of their de jure ownership rights, without adversely affecting pre- or post-tax profits. These involve fixing the election of board members, packing boards with crony directors, ensuring that key shareholder resolutions are vaguely worded and inadequately discussed at shareholders’ meetings, fobbing off minority shareholder complaints, issuing preferential equity allotments to the promoters and their allies at discounts, transferring shares through private bought-out deals at prices well below those prevailing in the secondary markets, and the like. In most parts of Asia, such acts did not necessarily destroy corporate value, and until the Asian crash of 1997-98 most listed companies of South-east Asia enjoyed consistently good valuations. Much of that may be because of thin and inefficient capital markets, greedy investors, and corporate governance structures that placed no value on proper financial and nonfinancial disclosures. Thus, from the late 1980s right up to the crash, poorly governed Asian companies did very well for themselves. They earned large profits, bagged greater and greater debt, grew in scale and scope and, most important, managed to maintain high valuations. The tycoons were honoured citizens who were admired for creating national wealth — not reviled as inefficient perquisite-grabbing managers and directors of the Jensenian corporations of the US in the mid-1980s. The point, then, is that poor corporate governance is not only about destroying shareholder value through managerial inefficiency arising out of the disjunction between share ownership and corporate control. Firms that consistently outperform the market and earn returns that exceed the opportunity cost of capital can have poor corporate governance. And this can manifest itself in a steady expropriation of minority shareholder rights. The Indian experience Until the mid-1990s, India had the worst of both types of costs. Dysfunctional economic and trade policies combined with low equity ownership to allow companies to thrive in uncompetitive ways — which began to have 122



their dénouement when the economy started opening up to international competition. There was a major erosion of corporate value, measured in terms of economic value added (EVA), which is the difference between the return on capital employed and the opportunity cost of capital. During the four-year period between 1995 and 1998, the top 363 listed Indian companies ranked by sales lost EVA to the tune of Rs.564 billion ($13 billion), which amounted to almost 6 per cent of the aggregate value of sales.19 Added to this value destruction was the expropriation of minority shareholder rights. In part, this expropriation was facilitated by the nominee directors of banks, financial institutions and DFIs who invariably voted with management. But laws did their bit as well. Until a few years ago, there were provisions in the Companies Act which put restrictions on acquisition and transfer of shares. Section 108B stated that if the government was satisfied that any share transfer might result in a change in the board of directors, and if it considered this “prejudicial to the interest of the company or to the public interest”, it could prevent such a transfer. Section 108D allowed government to restrict share transfer if it could lead to a change in the controlling interest that might be prejudicial to the company or public interest.20 These provisions are fortunately things of the past. There is now a transparent legal framework for facilitating the market for equity-driven corporate control. Besides, the introduction of paperless trading through de-materialisation of shares has drastically reduced transactions-costs and allowed minority shareholders to enter and exit at will. Moreover, the market has begun severely to punish under-performing companies as well as those that have disregarded minority shareholder interests. IV. The Rights of Debt and Equity A major flaw in the Indian legal system is the lack of provision for swift and efficient bankruptcy and liquidation procedures. The rights of creditors can be limited, while those of managers and shareholders may be privileged. New rules, however, give investors greater protection when firms are taken over. Curiously, while the market for corporate control has greatly improved on the equity side with a well-defined take-over code, the debt side remains as bad as it was in the licence-control days. It is hardly coincidental that countries with ineffective bankruptcy laws and procedures also have widespread corporate misgovernance. Poor protection of creditors’ rights gives enormous — and ultimately deleterious — discretionary space to inefficient management. It allows companies to reallocate funds to highly risky investments (since management fears neither attachment nor bankruptcy); it needlessly raises the cost of credit; it debases the disciplining role of debt; and it eventually ruins the health of a country’s financial sector. Unfortunately, India still has very poor bankruptcy reorganisation laws and procedures, and the liquidation procedures are worse still. 2003 © CIPE and OECD

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Bankruptcy restructuring Bankruptcy reorganisation of large industrial companies is governed by Sick Industrial Companies (Special Provisions) Act, 1985 or SICA, and the process is directed and supervised by the Board for Financial and Industrial Reconstruction (BIFR). A quick look at the law and BIFR will demonstrate the flaws of poorly designed and inadequately implemented bankruptcy procedures. There are five fundamental flaws with the SICA-BIFR process. These are: •

Late detection. The law defines financial distress as erosion of net worth. This is much worse than bankruptcy — which is basically debt default. When a company loses so much as to erode its net worth, the probability of a successful turnaround becomes very low. Not surprisingly, between July 1987 and November 1998, only 11 per cent of the 1954 cases that BIFR considered “maintainable” were able to re-establish a modicum of financial health, i.e., were no longer “sick.” A losing record of 89 per cent reflects both late detection and time-consuming procedures.

•

Cumbersome and time-consuming procedures. Between 1987 and 1992 the mean delay in arriving at a decision in BIFR was 851 days. That was bad enough. It has worsened since then. Between January 1997 and March 1998, the mean delay for cases that were sanctioned restructuring schemes was almost double at 1664 days; while those that were recommended liquidation took 1468 days. Such delays are caused by tedious quasi-judicial procedures where cases continue to go through multiple loops before a final decision is taken. These delays, of course, confer additional bargaining power to the management of the bankrupt company at the expense of secured and senior creditors.

•

Indefinite stay on all claims of creditors. From the time the company is registered and until the case is disposed, BIFR will not allow creditors to exercise any claims. All reasonable restructuring processes confer timebound stays. This is based on the assumption that the value of the whole is greater than the sum of its parts, and that a company must get some breathing space to reorganise itself and offer a viable restructuring plan. In BIFR, however, delays exceed four years. That makes the legal stay a key strategic device for the promoters of debtor firms. All they need to do is to get the case registered, and then secure protection from creditors’ claims for four years or more.

•

Debtor in possession. Neither SICA nor BIFR recognises that incumbent management always has great informational advantages compared to outside creditors. Therefore, a procedure that allows existing management to control and run a bankrupt company during the period when it is being reorganised invariably results in secured creditors

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having to take big hits on their exposures at the expense of shareholders and management.21 •

Violation of absolute priority rule. This rule says that in any bankruptcy restructuring or liquidation process, senior creditors have to be settled in full before junior creditors are entertained at all. BIFR procedures violate this principle by often rewarding incumbent management and old shareholders (despite net worth being negative) at the expense of fully secured creditors.

A better system It is not difficult to design a far better bankruptcy reorganisation system. The key features of an expeditious, market-driven and incentive-compatible procedure must incorporate the following features: •

The definition of bankruptcy should be altered to debt default instead of erosion of net worth. That will detect financial distress much earlier and, all other things being equal, increase the probability of a successful turnaround.

•

Up to a point, bankruptcy restructuring should be voluntary for the company. The onus must be on the company to convince its secured and senior creditors with a satisfactory rescheduling and cash flow plan. This should be outside BIFR.

•

Only if negotiations break down between the company and senior creditors should the case be taken to BIFR, which can give an extra time-bound chance to re-negotiate. If that does not succeed, BIFR must appoint an independent administrator with the mandate to advertise for the sale of the company. During the advertising and sale period, BIFR should impose a strictly time bound stay on creditors’ claims on the company’s assets. In the meanwhile, an independent financial professional can determine the liquidation value of the company. That will serve as the confidential reserve price.

•

The sealed bid offers must be submitted within the given time period. During this period, subject to a confidentiality bond, all prospective bidders should be permitted to conduct due diligence. Existing promoter(s) can also bid.

•

The bids should be in two parts: (a) the post-restructuring profit and loss account, balance sheet and cash flow projections, and (b) the financial bid, which can be in cash or in recognised securities.

•

Secured and senior creditors should vote within their class on (a). Those bids that secure the assent of 75 per cent of secured and senior credit


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should be short-listed. The best financial bid of the shortlist is the winning bid. •

If the winning bid happens to be less than the liquidation value, then the company should go for liquidation. If it is greater than the liquidation value but less than the secured debt, then the proceeds should be pro-rated across secured creditors (including wage dues), with unsecured creditors getting nothing. If the bid is high enough to meet the outstanding of unsecured creditors, then all claimants get their dues. And if it was higher still, then old equity obtains the residual value.

In this scheme of things BIFR will act like a facilitator, instead of behaving like a court. All cases are designed to get cleared within a specified time period, and in a market-driven manner. Bankruptcy liquidation or winding up If bankruptcy restructuring under BIFR is tedious, liquidation under the Companies Act is virtually impossible. Major delays in High Courts to wind-up companies that are beyond redemption have been proven by evidence. Table 4 below gives the data as of 1992-93 for 1,859 companies that were under winding up in courts. Table 4: Delays in Winding Up in Courts 0-10 yrs

10-20 yrs

20-30 yrs

30-40 yrs

40-50 yrs

>50 yrs

774

506

346

186

44

3

(41%)

(27%)

(19%)

(10%)

(2%)

(1%)

Note: numbers in parentheses indicate percentage of total. Source: Ajeet N. Mathur, “Industrial restructuring and the National Renewal Fund,” ADB, 1993.

These delays reflect two factors of the law and legal administration: • lack of appreciation that it is of prime importance to preserve the value of the assets of a company that is being wound up – which is best achieved by ensuring that these assets are quickly re-allocated to productive use by more efficient entrepreneurs; •

failure to realise that the parties worst affected by delays in winding up are workers and secured creditors.

By law, creditors have prior claims over shareholders. When their contractual obligations are not adhered to, creditors can do one of three things — demand bankruptcy reorganisation under SICA/BIFR or file for winding up of the 126



company, or apply for receivership. As we have seen, BIFR leaves much to be desired, and filing for winding-up is a losing proposition. These are hardly credible threats. The speed with which creditors can obtain a receivership decree varies according to High Courts. It is quite efficient in Mumbai, extremely inefficient bordering on impossible in Calcutta, and somewhere in between in other High Courts. A third option Since 1993, banks and DFIs have recourse to a third option — that of filing for recovery of dues at the Debt Recovery Tribunals (DRTs). These quasijudicial bodies were set up in response to inordinate delays in the standard judicial system. However, the DRTs are riddled with their own problems. For one, many of them have not yet been set up because of either administrative delays in finding an appropriate presiding officer, or because injunctions have been filed against the appointment of such officers. For another, the DRTs have also got clogged up, and they have no infrastructure support to decongest their traffic. On balance, creditors have very little protection in reality. A consequence of this is extreme risk aversion, especially in a new milieu where public sector bank managers have to stop pushing loans and focus on their bottom-line. As a result, banks are in a peculiar situation. On the one hand, they are flush with depositors’ funds. On the other, they avoid lending to anyone other than blue chip companies. The remainder they invest in treasury bills — which are risk free, do not impair capital adequacy, give a return that is at least 300 basis points above the average deposit rate and, most important, require no effort at project appraisal. This pervasive debasing of debt is choking off funds to small and medium enterprises and — unless rectified by better implementation of creditors’ rights — will have serious negative implications for the future structure and sustainability of industrial growth. Market for equity-driven take-overs Thankfully, the equity side of the market for corporate control has been reformed in substantive ways. Credit for this goes entirely to the capital market regulatory body, the Securities and Exchange Board of India or SEBI, which came into being under the Securities and Exchange Board of India (SEBI) Act, 1992.22 Until February 1997, companies could structure quietly negotiated take-over deals, which more often than not, left minority shareholders in the lurch. This changed with the SEBI (Substantial Acquisition of Shares and Take-overs) Regulation, 1997, which is popularly known as the Take-over Code. The major provisions are:


127


• Disclosure. Any person or body corporate whose shareholding crosses the 5 per cent threshold has to publicly disclose this to the relevant stock exchange and to SEBI. • Trigger. SEBI initially specified a 10 per cent trigger. If an acquirer’s shareholding crossed 10 per cent, he (the person or body corporate) had to make an open offer for at least an extra 20 per cent of the shares. In other words, for market purchases, a slow rise in shareholding from 9.9 per cent to say 11.9 per cent is no longer permissible. If the acquirer crosses the 10 per cent threshold, he must purchase at least 30 per cent. Given the structure of share ownership in corporate India, SEBI believes — and rightly so — that 30 per cent generally suffices to give a controlling interest. Recently, the trigger has been raised from 10 per cent to 15 per cent. • Minimum offer price. Any such public offer must carry a minimum price which is the average of the market price for the last six months. • Creeping acquisition. Existing management is allowed to consolidate its holdings through the secondary market so long as such acquisition does not annually exceed 2 per cent of the shares. This has been subsequently raised to 5 per cent. The creeping acquisition provision is aimed to allow management to gradually consolidate its ownership without detriment to minority shareholders. • Escrow. To ensure that the takeover bids are serious, there has to be an escrow account to which the acquirer has to deposit 25 per cent of the value of his total bid. He loses this in the event of his winning the bid but reneging on timely payment. The SEBI regulation has had two beneficial effects. First, it has created a transparent market for take-overs. Second, by legislating in favour of open offers, it has ensured that minority shareholders will have the right to obtain a market driven price in any take-over. Moreover, while friendly take-overs are still the norm, hostile take-overs have begun. And the SEBI Take-over Code has already been tested in at least half-a-dozen hostile bids, and has come out more robust than before. V. Disclosures India is unusual in the Asian region in that it requires relatively rigorous disclosure in the context of a strong body of corporate law. But accounting procedures fall short of best international practice, notably in the field of consolidation, and access to relevant information can be difficult. All companies are statutorily required to prepare audited annual accounts which are first submitted to the board of approval, then sent to all shareholders, and finally lodged with the Registrar of Companies. Listed companies have 128



three other requirements. •

Annual accounts have to be submitted to every stock exchange where a company is listed.

•

Companies must prepare abridged unaudited financial summaries for every quarter.

•

In addition to all the disclosure requirements mandated under the Companies Act for public limited companies, listed firms have to submit a cash flow statement.

In theory, the most substantive financial disclosures of companies are to be found in their annual reports — particularly the balance sheet, profit and loss account and their relevant schedules. All these sheets have to give the data for the current and the previous financial year. The gist of such disclosures follows, along with a critique: A.) Balance Sheet SOURCES OF FUNDS

•

Capital: This gives the share capital of the company, backed up by a schedule that gives details of the number of equity shares authorised, issued and paid-up. Taken together, these are sufficiently transparent.

•

Reserves and surplus. The summarised version is supported by a detailed schedule that classifies the reserves under various heads. The mandated items are (i) capital reserve, (ii) share premium reserve, (iii) debenture redemption reserve (iv) investment allowance reserve, (v) general reserves less the debit balance in the profit and loss account, and (vi) the surplus, i.e., balance in profit and loss account after providing for dividends, bonus or reserves. Again, this is up to international standards.

•

Secured loans. The accompanying schedule gives full line-by-line disclosure of debentures. The data on loans and advances from term lending institutions and banks is also quite detailed, and includes the description and extent of charge on each loan, with separate disclosure on foreign currency loans. In some cases, the problems lie with loans and advances from subsidiaries. Unfortunately, Indian accounting standards do not follow the principles of consolidation.23 As a result, companies can, and do, underor overstate such transactions for strategic purposes, often involving self-dealing by insiders.


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•

Unsecured loans. All heads of unsecured loans have to be listed.

APPLICATION OF FUNDS

•

Fixed Assets. Although the listing of fixed assets in the schedule is quite exhaustive, it suffers from two types of problems. First, gross block is valued at historical cost. A more realistic approach will be to value all the elements at either market prices or replacement cost. Second, the depreciation schedule used in annual accounts has no bearing with that which is permitted for computing the corporate income tax liability. This is an historical anomaly that could be rectified by allowing for deferred tax liability.

•

Investments. These are split between long and short term, with the latter covering a period of a year or less. Investments in quoted securities have to be marked to market, while those in unquoted instruments are evaluated at cost. While the disclosures look tight on paper, this is the area of maximal opaqueness. Again, the reasons have to do with the lack of consolidation. This is what often occurs, especially in companies that care little for corporate governance and shareholder value. For example, suppose a listed company A has 20 closely held subsidiary investment companies. Quite often the management will siphon-off investors’ funds from A to the subsidiaries. Since the latter are private limited entities, it becomes very difficult for investors to track the second round of transactions, leave aside the third and fourth. Within a space of weeks, massive sums of money can be taken out as investments of a listed company — only to be parked in the subsidiaries, and then further muddied through complex intercorporate transactions. For a few years, these “investments” will be reflected as such in the accounts of A. Thereafter, these will be gradually “written down” on the premise that the investments are souring. In the meanwhile, the funds will have effectively disappeared. The best solution is to mandate consolidation according to US-GAAP or Internationally Accepted Accounting Standards (IAAS), and insist on full disclosure of all related party transactions. Until these two changes are brought about, there will always be unscrupulous management intentionally misallocating investors’ funds. In fact, according to bankers, the single largest reason for corporate financial distress in India is diversion of funds. Investment in subsidiary companies is a great vehicle for such siphoning.

•

130

Loans, advances and deposits. In the absence of consolidation, entries on this account can also be used to misallocate corporate 2003 © CIPE and OECD


funds. It is only a matter of eventually writing down the loans and advances as doubtful or bad. •

Inventories are normally well captured, especially for medium and large scale manufacturing companies. Smaller companies tend to play around a bit with work-in-progress, but that is quite minor.

•

Sundry debtors can occasionally be used to artificially inflate sales in the profit and loss account. It works as follows. Companies book extra sales in the last month or two before the end of the financial year, knowing that the revenue is not intended to be received by the year-end. The top line on the profit and loss account gets inflated and, all else being equal, the bottom line as well. Fully anticipated unpaid dues get booked as receivable under sundry debtors. Sometimes this gets a bit more sinister. Output is siphoned out to a host of subsidiary or “front” dealer companies through dummy sales. No payment is intended to take place. The amount languishes receivable for a few years and is then written down — first as doubtful, and then as bad debt.

•

Cash and bank balances. Usually reflects the true picture.

B.) Profit and loss account By and large, the disclosures required in the profit and loss account are quite exhaustive and up to international standards. The Companies Act requires detailed schedules for: •

“other income,” i.e., income other than what the company earned from its sale of goods and services,

•

expenditure on raw materials and intermediate goods,

•

wages and employee costs,

•

“other expenses”, which includes consumables, energy charges, repairs and maintenance, rents, rates and local taxes, advertising and selling costs, R&D expenses, travelling expenses, directors’ fees and commissions, and other heads,

•

inventories, including work-in-progress and finished goods

•

interest, which includes interest on fixed term loans and debentures and on other loans, less interest received.

There are two areas for fiddling the books. The first relates to manufacturing expenses, which can be inflated up to a point. Beyond that it requires collusion 2003 © CIPE and OECD

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with the government’s sales tax and excise duty officials. The second has to do with selling, distribution, administration and other expenses. However, the scope for mis-reporting on these two heads is far less than for investments and loans on the balance sheet. And, by and large, most of the records in the profit and loss account tend to reflect the true and fair picture of a company. C.) Cash-flow statement Listed companies have to submit a three-part cash flow statement consisting of cash flows from (i) operating activities, (ii) investing activities, and (iii) financing activities. This statement is quite detailed and any reasonably wellequipped financial analyst should be able to arrive at a company’s free cash flows for a given year. As far as incorporated companies go, the quality of financial disclosure in the annual accounts is determined by three agencies: (i)

The Department of Company Affairs, which administers the Companies Act,

(ii)

SEBI, which mandates special disclosure requirements for listed companies, and

(iii)

The Institute of Chartered Accountants of India (ICAI) — the body which lays down the parameters of Indian accounting standards.

While these standards are better than what prevails in most of Asia, including Korea and Japan, they are behind the norms laid down by US-GAAP. The critical differences between Indian accounting standards and US-GAAP are given in the Annex. Of these, the three most serious lacunae are (i) the absence of consolidation, (ii) lack of segment reporting, and (iii) low standards of disclosure of related-party transactions. Enforcement While the Companies Act specifies punishments for non-compliance of financial disclosures, these are light. In most instances, the maximal penalty is either imprisonment for six months, or a fine of no more than Rs.2000 ($48), or both. In practice, there has hardly been any instance of imprisonment. For instance, if a company does not comply with proper audit practices or does not make available the necessary financial documents for audit, the penalty is a fine that does not exceed Rs.500 ($12). If the auditor’s signed reports are not in conformity with the law, the maximum penalty is Rs.1000 ($24). In practice, the Indian system is thus quite lax. Huge judicial delays further diminish the minimal deterrence that such penalties are supposed to inflict. Moreover, some ethically questionable acts are considered par for the course. 132



To give an example, certain auditing firms are known to cast benevolent eyes towards contingent liabilities, and ensure that the notes on account — while on the right side of the law — are sufficiently benign to give comfort to management. Such acts are routinely overlooked. And, while the ICAI prescribes detailed standards for external auditors, rare are the instances when it has taken any serious action against its members. If anything, stock markets are doing their own enforcement. Increasingly, companies are enjoying premia for good corporate disclosures, and these have increased the demand for hiring the services of internationally respected and independent audit firms. Indian companies are increasingly finding the need for a reputed auditor for seeking foreign capital. This might clean up the system faster than enforcement that is mandated by law. Credit rating Since the early 1990s, the law prescribes that companies have to be rated by approved credit rating agencies before issuing any commercial paper, bonds and debentures. At present there are five rating agencies, of which four — CRISIL, CARE, ICRA and Duff and Phelps — are well established.24 Each of these agencies has a set of ratings from very-safe to poorerthan-junk bond status. The rating has to be made public, and must be accompanied by the rating agency’s perceptions of risk factors that can affect payment of interest and repayment of the principal. Company management also exercises its right to comment on these risk factors. In the past there has been a tendency to do “rating shopping” — namely, to approach more than one rating agency and then publish the one which is most beneficial to the company. Section 8 highlights the code of best practices suggested by the Confederation of Indian Industry (CII). At this juncture, it is important to note that the CII code has commented on this practice, and recommended that: “If any company goes to more than one credit rating agency, then it must divulge in the prospectus and issue document the rating of all the agencies that did such an exercise. It is not enough to blandly state the ratings. These must be given in a tabular format that shows where the company stands relative to higher and lower ranking. It makes considerable difference to an investor to know whether the rating agency or agencies placed the company in the top slots, or in the middle, or in the bottom.” [CII, Desirable Corporate Governance: A Code, April 1998, Recommendation 15, pp. 9-10]


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Share ownership The Companies Act requires all companies to maintain a register of “members” or shareholders, which has to be updated each time that share transfers take place. In any given year, there are two dates for book closure (typically covering two weeks prior to the date of the AGM) for final updating of the register for payment of dividends. Although the register is legally public domain information, and a list of shareholders has to be sent to the Registrar of Companies, in practice it is not as public as made out to be, especially for closely held, unlisted companies. It is easier to access shareholding information for listed companies–at least in terms of broad aggregates. Stock exchange listing agreements require shares to be declared on the basis of individual promoters, DFIs, foreign institutional investors, mutual funds, foreign holdings, other corporate bodies, top 50 shareholders, and other shareholders. While better than unlisted companies, this classification often fails to give a fully transparent picture of share control —thanks to the prevalence of fairly complex cross-holdings across most family or group controlled conglomerates. Traditional family-dominated business groups — which constitute a sizeable chunk of listed companies — have tended to protect their interest through complex cross-holdings. Contrary to popular opinion, the main objective of this practice was not so much to thwart take-over bids, but to avoid steep wealth and inheritance taxes that characterized pre-1991 India. Abolition of both these taxes as well as the tax on individuals for dividend income, and a reduction of personal income tax rates to a little over 30 per cent has led to many business groups slowly unwinding their cross-holdings.25 The process of moving towards cleaner and more transparent share ownership is also driven by an increasingly active stock market. Foreign institutional investors, who now account for anywhere between 24 per cent and 30 per cent of the equity of highly traded companies, avoid companies with complex cross-holdings. Desire to raise market capitalisation and access international capital are finally doing the right things for the pattern of equity-holdings. There is another factor that has diminished the importance of crossholdings: the meteoric rise of new, technologically oriented companies such as information technology and drugs and pharmaceuticals. Today, two internationally recognised IT companies share the pride of place among the top-five in market cap (Wipro and Infosys). Eight drug companies feature in the top 25. These firms are run along highly professional lines; their management is outward oriented and attuned to best principles of disclosures and corporate governance.

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Infosys and other examples Consider the case of Infosys. The company discloses its accounts in keeping with GAAP requirements of India, the United States and six other countries. It follows the CII code and the Cadbury committee recommendations on corporate governance, has a highly acclaimed and independent board with Audit, Remuneration and Nomination Committees. From 1996 onwards — three years before it issued an ADR and got listed on NASDAQ — Infosys has been making full-fledged disclosures under section 10-K of the SEC. Its annual reports contain an exhaustive management discussion and analysis as well as other financial disclosures that go beyond best international practices. Other highly acclaimed companies in terms of disclosure include NIIT, Bajaj Auto, Hindalco, Nicholas Piramal, Wipro, BSES, Housing Development Finance Corporation and Dr. Reddy’s Laboratory. All of them have voluntarily gone well beyond the mandated disclosures of the Companies Act, and have done so in their self-interest. They have also been amply rewarded by the market for their transparency. Disclosures about directors The Companies Act is fairly exhaustive in its requirements about disclosing details of directors, senior management, and selling agents. Registers are required to be maintained that disclose material transactions of directors visà-vis the company, and whether they are related to each other. Annual reports of companies have to furnish details about the remuneration to the directors as a whole, including salaries, commissions, and directors’ fees. However, many of these disclosure are not detailed enough — for example that of directors’ remuneration is given in the aggregate. Many others are made only at the time of appointment, and are not required on an annual basis. And other still, while technically in the public domain, are not made fully public in the sense of being disclosed in the annual report. The CII code has suggested major changes, and companies that abide by the code now make such disclosures in their annual reports (see Section VIII). Related-party transactions and other disclosures Perhaps the greatest drawback of financial disclosures in India is the absence of detailed reporting on related-party transactions. At the level of the balance sheet, there is no requirement to report which investments and loans made by the corporation are to subsidiaries and associated companies. And while the Companies Act insists upon maintaining registers on sole selling agents and the company’s business relationships with the directors, no such disclosure is separately made in the annual report. In this context, the Working Group on the Companies Act made certain important recommendations, as listed below: 2003 © CIPE and OECD

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•

Comprehensive report on the relatives of directors — either as employees or board members — should be a part of the Directors’ Report of all public limited companies.

•

The fact a company has to maintain a register which discloses interests of directors in any contract or arrangement, and that it is open for inspection by any shareholder, should be explicitly stated in the notice of the AGM of all public limited companies.

•

Details of loans to directors should be disclosed as an annex to the Directors’ Report in addition to being a part of the schedules of the financial statements. Moreover, such loans should be available only to executive directors.

•

A tabular form containing details of each director’s remuneration and commission should form a part of the Directors’ Report, in addition to the usual practice of having it as a note to the profit and loss account.

•

All listed public limited companies must give segment information as a part of the Directors’ Report in the Annual Report. This should encompass (i) the share in total turnover, (ii) review of operations during the year in question, (iii) market conditions, and (iv) future prospects. In the first instance, the cut-off was recommended at 10 per cent of total turnover. The practice of segment reporting is rare.

•

If a company has raised funds from the public by issuing shares, debentures or other securities, it must give a separate statement showing the end-use of such funds, namely: how much was raised versus the stated and actual project cost; how much has been utilised in the project up to the end of the financial year; and how the residual funds are invested. This disclosure should be in the balance sheet, as a separate note forming a part of accounts.

•

In addition to the present level of disclosure on foreign exchange earnings and outflow, there should also be a note containing separate data on of foreign currency transactions that are germane in today’s context: (i) foreign holding in the share capital of the company, and (ii) loans, debentures, or other securities raised by the company in foreign exchange.

•

Differences in assets and liabilities between the end of the financial year and the date on which the board approves the balance sheet and profit and loss account must not be limited only to the Directors’ Report. These should be clearly stated under the relevant sub-heads, and presented as a note forming a part of the accounts.



Insider trading Section 11 of the SEBI Act, 1992, clearly states that one of the functions of the capital market regulator is “prohibiting insider trading in securities”. The law also defines insider trading quite explicitly: “Insider trading takes place when insiders or other persons who, by virtue of their position in office or otherwise, have access to unpublished price sensitive information relating to the affairs of a company and deal in the securities of such company or cause the trading of securities while in possession of such information or communicate such information to others who use it in connection with the purchase or sale of securities.” As in most countries, the problem with insider-trading rules lies in their implementation. The example of the SEC shows that, even with sophisticated detection devices, it is very difficult to pinpoint insider trades. In the US, less than 1 per cent of the trades that are initially identified as potential cases of insider trading are actually investigated; fewer still are the subject of charges and conviction. In India there are three sets of problems. The first, despite the BSE and NSE having full-fledged screen-based trading, it is still difficult to flag a trade as a possible case of insider trading. Second, given the number of brokers and middle-men who operate in the market, it is possible for a person who has insider information to create enough fire-walls between himself and the traders – which militates against identifying the real insiders. Third, and most important, SEBI does not have judicial powers like courts. It can conduct an investigation, prepare a report and even suggest a penalty; but it cannot inflict that penalty. The act of implementing the punishment is vested in the courts. Given the judicial delays in India, such penalties do not count for much.26 Financial disclosures of banks and DFIs Although Indian banks and DFIs disclose more than their counterparts in East and South-east Asia and, indeed, Switzerland, these fall short of what is desirable. In particular, neither banks nor DFIs need to disclose the structure and extent of their asset-liability mismatch — something that says a great deal about their future financial health. Moreover, while they follow the Basle standards for recognition of non-performing assets, this does not take into account some of the institutional realities of India. To give an example, a case that is referred to BIFR should not be expected to be resolved in anything less than four years. Therefore, prudential accounting should treat that loan as bad, and write it off the books — to be added back as profits if and when something is recovered. Similarly, any case going for winding-up under court should be written off. More often than not, such practices are followed in the breach. 2003 © CIPE and OECD

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In this context, ICICI has taken a lead. Driven by the objective of becoming India’s first truly universal bank, ICICI decided to tap the US capital market via an American Depository Receipt launched in late 1999. In order to access the US market, ICICI voluntarily re-cast its accounts for the year ended 31 March 1999 in terms of US-GAAP. The exercise eroded ICICI’s bottom-line by a third, but it has also created investor confidence — arising from the comfort that a large DFI was not afraid of using the toughest accounting standards. Not surprisingly, ICICI’s domestic IPO (concluded on 13 September 1999) was over-subscribed by 80 per cent.27 To summarize: •

Unlike most countries in East and Southeast Asia, India has a strong body of corporate law that requires fairly exhaustive disclosure of financial data. By and large, the annual accounts of the larger listed companies give a “true and fair” picture.

•

There are, however, certain gaps. Despite a mass of details required in the annual report, Indian companies still do not need to disclose relatedparty transactions and consolidate the accounts of subsidiaries and associate companies. Moreover, while most of the disclosures regarding directors are required to be maintained in registers, these are not as much in the public domain as printed and widely circulated annual reports.

•

Nevertheless, there is a discernible trend towards increased disclosures in line with best international practices. This trend is voluntary and is being driven by the desire of professionally managed companies to access international capital markets.

VI. Boards of Directors The quality and composition of boards of directors pose real problems. The best companies have adopted the best international practice – if only because it is in their own interests. But many enterprises have directors who are not genuinely independent when they are supposed to be, or follow narrow selfish interests or fail to understand their duties. Board meetings can be perfunctory and agendas misleading. Perhaps the greatest drawback of corporate governance in India is the lack of independent directors on the vast majority of boards. Part of the reason is the lack of supply — despite a population in excess of a billion, there are not that many people who can be good, proactive independent directors. Part of it has to do with demand: until recently, there was a pervasive attitude that boards are empty legal constructs meant for justifying the perpetuation of existing management.

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What the law requires Corporate law clearly stipulates the requirement of a board of directors and that all directors are fiduciaries of the shareholders. The Companies Act emphasises the fiduciary aspect in several ways: •

Directors are elected by shareholders, and can be removed by them.

•

Directors are accountable to shareholders, and an expression of this is to be found in the Directors’ Report to the shareholders, which is mandated for every company.

•

The remuneration of directors has to disclosed in the annual report, and their relationships and material interests with the company have to be disclosed in separate registers that are available to all shareholders.

Despite all legal trappings of being fiduciaries, most boards did not satisfy any of the conditions that accompany the principle of independent oversight. Listed below are the conspicuous absences. i)

While there is a distinction between “whole time” directors and other non-executive board members, there is no legal definition of independence.28 Even today, a sample of the board composition of the top 100 companies would reveal that truly independent directors hardly account for more than a fifth of the board.

ii)

In most companies until a year or two ago, non-executive directors did not constitute even a third of the board. More often than not, the non-executives were family members, recently retired CEOs and company managers, representatives from the firm that offers legal advice, and disinterested nominees of DFIs, LIC. GIC and UTI.

iii)

Quite often the agenda papers for the board meeting arrived just a day or two before the date of the meeting. Sometimes these were given to the directors the night before at the time of checking in to their hotel. Moreover, there were two types of agenda papers. The first was the ‘thin agenda’, which contained very little prior information of what would be discussed by the board. The second was the ‘thick’ agenda. This has been the preserve of government companies. Such agendas run to several hundred pages — most of which concern irrelevant items that should never have been brought to the board in the first place. Rarely does one come across the ‘right sized’ agenda, which concisely outlines the issues to be discussed, their importance, and the tasks before the board for that meeting. Companies presenting thin agendas either have nothing worthwhile to discuss


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in the board, or table extremely important issues under “Any Other Item” — which are then expected to be discussed and ratified with no prior reading or preparation. Those with thick agendas often slip in key board resolutions towards the end — on the assumption that the non-executive directors would be too exhausted going through reams of inane matter. iv)

Except for a couple of dozen companies, board meetings lasted less than half a day. They began at about 10.30 a.m. and closed at 1.30 p.m. — in time for a leisurely lunch.

v)

Until very recently, there was no law or regulation, either under the Companies Act or via listing agreements that required boards to have Audit, Remuneration or Nomination Committees.29 The fact that roughly two dozen large companies had one or more such board-level committees reflected their desire to follow international corporate governance standards.

vi)

More often than not, management shared very little substantive information with outside directors. Indeed, outside directors were generally so chosen as to not bother too much about such information.

vii) While the bulk of non-executive directors played a passive role, perhaps the most non-performing and dysfunctional ones were the employees of public sector banks, DFIs, LIC, GIC and UTI. To begin with, most of these “nominee directors” failed to understand that they are fiduciaries of the company where they have been elected to the board. Instead, their major interest — if any at all — was to protect the exposure of their parent company. Moreover, in the majority of cases, they brought with them little specialised knowledge of any aspect of a corporation and, hence, contributed very little to the deliberation. Worse still, they sometimes demanded special treatment — which was acquiesced to, given that they controlled credit and/or a large equity stake. The sad aspect of institutional nominee directors is that while they are, in theory, well placed to exercise effective oversight, they have hardly ever discharged this role in practice. Since the management recognised them as necessary evil, they were borne with patience but little else. Better Boards How can one make the boards of Indian companies more active and aligned to the interests of maximising shareholder value? Despite SEBI’s recent initiatives (see Section 8), this cannot be mandated with any degree of success. A couple of things, however, are possible to create the right kind of milieu. The first is a positive, and has to do with remuneration of directors. At 140



present, the vast majority of directors get paid a sitting fee, which has been recently increased by the government to a ceiling of Rs.5,000 per meeting (or $115). This is hardly a compensation for properly exercising fiduciary responsibilities. To align directors towards short- and long-run maximisation of corporate value, companies must begin to offer a combination of commissions on net profits and stock options. The second suggestion is in the nature of a stick. Listed companies should be mandated to disclose in their annual reports the attendance record of the directors. Moreover, shareholders should not generally elect directors who have less than 50 per cent attendance record (either physically present or participating in a board meeting through tele- or video-conferencing). No doubt, attendance does not substitute performance. But publishing the attendance record would certainly dissuade directors from missing one board meeting after the other. Having severely critiqued the de facto board structure in India, it is also necessary to state that there are major changes occurring in the boards of the top 20 or 30 private sector companies. Most of them have a majority of nonexecutive directors (if not genuinely independent ones). Most have at least an Audit Committee comprising of a minimum of three independent directors; some even have Remuneration and Nomination Committees. To attract good talent, these companies pay a commission to directors over and above the token sitting fees; a few are contemplating stock options. All of them send the right kind of agenda papers well in advance of the board meetings; and the meetings themselves stretch over a full day. In some instances, key board meetings — such as the one which approves the annual accounts or fixes the operating budgets for the following year — can continue over two days, with various functional heads being invited to make detailed presentations about their departments. VII. State-Owned Enterprises The state-owned enterprises account for a fifth of market capitalisation but are run under conditions that are almost the opposite of optimal. State intervention, a play-safe mentality, external constraints including noncommercial obligations and fear of criminal proceedings make the job of even the best managers intensely frustrating. Unsurprisingly, many leave for the private sector. Given the size of state-owned enterprises (SOEs) among listed companies — which account for 20 per cent of market capitalisation — it necessary to touch upon their governance structures. These are companies that can be best described by a phrase: “Agents without principals.” Shareholders (or principals) of private sector companies are direct beneficiaries of profitable performance. Therefore, in theory, they have an incentive to monitor management so that it maximises corporate value. In contrast, 2003 © CIPE and OECD

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most government companies, especially the unlisted ones, do not have a substantial body of informed private shareholders whose income depends upon the performance of these companies. If anything, the major shareholder of SOEs has distinctly different objectives. Commercial viability, profitability, quality, cost minimisation, optimal investment decisions and corporate value creation rarely figure among the concerns of a typical member of parliament or a minister. Next in the hierarchy of shareholders’ representatives come the civil servants. By their very training, bureaucrats specialise in slavishly adhering to laid-down procedures, irrespective of their relevance. This training creates an inconsistency between the organisational forms of governments and those of modern financial and industrial entities: governments and their agents are process oriented, whereas firms have to be results oriented. The mismatch gets exacerbated by a civil servant’s aversion to risk taking. Thus, when a civil servant serves on the board of an SOE, he typically toes the ministry’s line, ensures that the SOE follows “proper” procedures, and avoids any risky decision that may have harmful consequences for his ministry. Given the non-commercial objectives of the principal, most chief executives of SOEs quickly adopt the line of least resistance, develop the “don’t rock the boat” syndrome and avoid changes that may alienate any powerful element among the shifting and fuzzy coalition of interests. Thus, important organisational changes are not made, erring staff remain undisciplined, lossmaking plants are neither downsized nor closed, wages are not linked to productivity, and redundant workers are not retrenched. The role of “the State” Above all this sits Article 12 of the Constitution of India, which defines “the State” as “the Government and Parliament of India and the Government and Legislature of each of the States and all local or other authorities within the territory of India or under the control of the Government of India.” Since most SOEs have more than 50 per cent government ownership, they fall under the ambit of “the State.” This has affected SOEs in several adverse ways. •

All SOEs are expected to achieve a wide variety of non-commercial objectives which are imposed by the ministries and the Parliament.

•

One of the most difficult to maintain is employment reservation. Every SOE must adhere to the affirmative action norms, and ensure that the share of employment under reserved categories (scheduled castes, scheduled tribes, other backward castes, physically handicapped persons, and exmilitary or dependants of those killed in military or para-military action) is identical to the central government ministries. Employment reservation is monitored at five levels: by the administrative ministries, the Department of Public Enterprises under the Ministry of Industry, the Departments of

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Personnel and Training under the Ministry of Labour, the Parliamentary Committee on the Welfare of Scheduled Castes and Scheduled Tribes, and the National Commission for the Scheduled Castes and Scheduled Tribes. The chief executive of an SOE has to ensure that the reserved quota is maintained not just on incremental employment, but increasingly on the average – and deviations, particularly in the higher paid categories, invite immediate Parliamentary questions and show-cause notices.30 •

The annual audit by the Comptroller and Accountant General (CAG) in addition to the audit by the statutory auditor. The area where CAG audits inflict the greatest ex ante damage is in purchases and tenders. SOE managers and board members invariably veer towards selecting the lowest bid, even when they know that the quality is poorer. Innumerable CAG allegations of financial impropriety adduced only on the basis of rejecting the lowest bid have taught SOE executives and directors that propriety dominates profitability.

•

Constraints on appointment of senior management personnel, which can only be done through the Public Enterprise Selection Board (PESB) and, thereafter, clearance from the Department of Personnel, the Home Ministry, and, in many instances, by the Office of the Prime Minister. This has led to delays, non-appointment of CEOs and executive directors and excessive emphasis on seniority. In such a milieu, biding time dominates corporate accomplishment. A study sponsored by the Standing Committee on Public Enterprises (SCOPE) in 1992 found that only 64 companies of a sample of 101 central SOEs had full-time chairmen or executive chairman-cum-managing directors; and the post of 30 chief executives and 66 executive directors were lying vacant. The study also found that only 13 per cent of the chief executives and 5 per cent of the functional directors remained in employment for the full five-year contract period; they reached the mandatory retirement age in an average of 18 months. Matters have not improved since.

•

Since SOEs are parts of “the State,” they are subject to writ petitions to the Supreme Court under Articles 32, and High Courts under Article 226 of the Constitution.

•

Again by virtue of being considered as servants of “the State,” managers as well as directors of SOEs are, in principle, subject to criminal investigation by the Chief Vigilance Commissioner and the Central Bureau of Investigation.

•

State status limits managers from downsizing plants, retrenching or redeploying employees.

•

Finally, the directors of SOEs have little autonomy in finalising investment decisions.


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In the final analysis, there can be no real solution to SOEs without systematic and transparent privatisation. This has been recognised by the present government and clearly enunciated in its policies. However, progress has been poor — partly because of resistance from entrenched, rent-seeking bureaucracy, and partly due to the lack of sufficient political will. In the meanwhile, even the better run SOEs are suffering on two counts. First, there has been a major fall in corporate value, measured in terms of EVA. Second, there has been a far more important loss — that of skilled and trained managers leaving for the private sector. Unless these companies get privatised, and managers realise that they will be rewarded for performance and risk-taking, this exodus will continue. And with it, the deterioration of SOEs will exacerbate. VIII Winds of Change – Recent Corporate Governance Initiatives There have been two major corporate governance initiative launched in India since the mid-1990s. The first is by the Confederation of Indian Industry (CII), which is India’s largest industry and business association. The second is by the SEBI. The CII Code More than a year before the onset of the Asian crisis, CII set up a committee to examine corporate governance issues, and recommend a voluntary code of best practices. The committee was driven by the conviction that good corporate governance was essential for Indian companies to access domestic as well as global capital at competitive rates. The first draft of the code was prepared by April 1997, and the final document Desirable Corporate Governance: A Code was publicly released in April 1998. The code focuses on listed companies. Given below are excerpts that highlight the rationale of the exercise, and summarise the key recommendations. “First, there is no unique structure of corporate governance … Thus, one cannot design a code of corporate governance for Indian companies by mechanically importing one form or another. Second, Indian companies, banks and financial institutions (FIs) can no longer afford to ignore better corporate practices. As India gets integrated in the world market, Indian as well as international investors will demand greater disclosure, more transparent explanation for major decisions and better shareholder value. Third, corporate governance goes far beyond company law.” “The objective of good corporate governance [is] maximising long-term shareholder value. Since shareholders are residual claimants, this objective follows from a premise that, in well performing capital and financial markets, whatever maximises 144



shareholder value must necessarily maximise corporate prosperity, and best satisfy the claims of creditors, employees, shareholders and the State.” BOARD OF DIRECTORS •

“The key to good corporate governance is a well functioning, informed board of directors. The board should have a core group of excellent, professionally acclaimed non-executive directors.”

•

“The full board should meet a minimum of six times a year, preferably at an interval of two months.”

•

“Any listed company with a turnover of Rs.1 billion and above should have professionally competent, independent, non-executive directors, who should constitute at least 30% of the board if the Chairman of the company is a non-executive director, or at least 50% of the board if the Chairman and Managing Director is the same person.”

•

“No single person should hold directorships in more than 10 listed companies.”

•

“To secure better effort from non-executive directors, companies should: •

Pay a commission over and above the sitting fees for the use of the professional inputs.

•

Consider offering stock options, so as to relate rewards to performance.”

•

“While re-appointing members of the board, companies should give the attendance record of the concerned directors. If a director has not been present for 50 per cent or more meetings, then this should be explicitly stated in the resolution that is put to vote. As a general practice, one should not re-appoint any director who has not had the time to attend even one half of the meetings.”

•

“Key information that must be reported to, and placed before, the board must contain: •

Annual operating plans and budgets, together with up-dated long term plans.

•

Capital budgets, manpower and overhead budgets.


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•

Quarterly results for the company as a whole and its operating divisions or business segments.

•

Internal audit reports, including cases of theft and dishonesty of a material nature.

•

Show cause, demand, and prosecution notices received from revenue authorities which are considered to be materially important. (Material nature if any exposure that exceeds 1 percent of the company’s net worth).

•

Fatal or serious accidents, dangerous occurrences, and any effluent or pollution problems.

•

Default in payment of interest or non-payment of the principal on any public deposit, and/or to any secured creditor or financial institution.

•

Defaults such as non-payment of inter-corporate deposits by or to the company, or materially substantial non-payment for goods sold by the company.

•

Any issue which involves possible public or product liability claims of a substantial nature, including any judgement or order which may have either passed strictures on the conduct of the company, or taken an adverse view regarding another enterprise that can have negative implications for the company.

•

Details of any joint venture or collaboration agreement.

•

Transactions that involve substantial payment towards goodwill, brand equity, or intellectual property.

•

Recruitment and remuneration of senior officers just below the board level, including appointment or removal of the Chief Financial Officer and the Company Secretary.

•

Labour problems and their proposed solutions.

•

Quarterly details of foreign exchange exposure and the steps taken by management to limit the risks of adverse exchange rate movement, if material.”

•

“Listed companies with either a turnover of over Rs.1 billion or a paid-up capital of Rs.200 million should set up Audit Committees within two years. Audit Committees should consist of at least three members, all drawn from a company’s non-executive directors, who 2003 © CIPE and OECD


should have adequate knowledge of finance, accounts and basic elements of company law. Audit Committees should assist the board in fulfilling its functions relating to corporate accounting and reporting practices, financial and accounting controls, and financial statements and proposals that accompany the public issue of any security and thus provide effective supervision of the financial reporting process. They should periodically interact with the statutory auditors and the internal auditors to ascertain the quality and veracity of the company’s accounts as well as the capability of the auditors themselves.” DESIRABLE DISCLOSURE •

• •

• •

“Listed companies should give data on: high and low monthly averages of share prices in a major stock exchange where the company is listed; greater detail on business segments, up to 10% of turnover, giving share in sales revenue, review of operations, analysis of markets and future prospects. “ “Major Indian stock exchanges should gradually insist upon a corporate governance compliance certificate, signed by the CEO and the CFO.” “If any company goes to more than one credit rating agency, then it must divulge in the prospectus and issue document the rating of all the agencies that did such an exercise. These must be given in a tabular format that shows where the company stands relative to higher and lower ranking.” “Companies which are making foreign debt issues cannot have two sets of disclosure norms: an exhaustive one for the foreigners, and a relatively minuscule one for Indian investors.” “Companies that default on fixed deposits should not be permitted to accept further deposits and make inter-corporate loans or investments or declare dividends until the default is made good.”

The CII code is voluntary. Since 1998, CII has been trying induce companies to disclose much greater information about their boards. Consequently, annual reports of companies that abide by the code contain a chapter on corporate governance that discloses: •

The composition of the board: executive, non-executive and independent directors. An independent director is (i) not a formal executive and has no professional relationship with the company, (ii) not a large customer and/or vendor to the company, (iii) not a close relative of the promoter and/or any executive directors, (iv) not holding a significant stake, and (v) not a nominee of any large shareholder/creditor.

•

The number of outside directorships held.


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•

Family relationship with other directors.

•

Business relationship with the company, other than being a director.

•

Loans and advances taken from the company.

•

Remuneration — consisting of salaries and perquisites, sitting fees, commission and stock options, if any.

•

Attendance of directors at board meetings, including those of special committees of the board. These have to be tabulated as number of meetings held versus those attended.

In addition, companies are encouraged to disclose •

details about their monthly high and low share prices in various stock exchanges, and compare these with the market indices;

•

data on the distribution of shares across various types of shareholders and according to size classes;

•

classes of complaints received from shareholders regarding share transfers, and how these have been addressed;

•

economic value added (EVA), return on capital employed (ROCE) and return on net worth (RONW);

•

details on risk factors, especially foreign exchange and derivative risks;

•

details on contingent liabilities;

•

data on outstanding warrants and their effect on dilution of equity, when converted;

•

segment-wise information, wherever appropriate, in a chapter on management discussion and analysis.

The fforts have started to bear fruit. Already for the financial year ended 31 March 2000, over 30 large listed companies accounting for 25 per cent of India’s market cap had fully or partly adopted the CII disclosure norms. Indeed, companies such as Infosys have long overshot such norms. A subtler, yet pronounced, effect of the CII initiative is a distinct trend among larger listed companies to look positively towards corporate governance, and to stop discounting it as “the flavour of the month.”

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SEBI’s Corporate Governance Initiative The other major — and mandatory — corporate governance initiative has been taken by SEBI. In early 1999 it set up a committee under Kumar Mangalam Birla. By early 2000 the SEBI board had accepted and ratified key recommendations of this committee and informed all stock exchanges accordingly. SEBI’s key recommendations are mandatory and apply to listed companies, to be enforced at the level of stock exchanges through listing agreements. The main ones are: •

Independent directors are defined as those who, apart from receiving directors’ remuneration, do not have any other material pecuniary relationship or transactions with the company, its promoters, its management or its subsidiaries, which in the judgement of the board may affect their independence of judgement.

•

Not less than 50 per cent of the board should be comprised of nonexecutive directors. The number of independent directors would depend on the nature of the chairman of the board. In case a company has a non-executive chairman, at least one-third of board should be comprised of independent directors and in the case that a company has an executive chairman, at least half of the board should be independent.

•

Every listed company must, according to its size and a three-year timetable, set up a qualified and independent audit committee at board level. The audit committee should have a minimum of three members, all being non executive directors, with the majority being independent, and with at least one director having financial and accounting knowledge; the chairman of the committee should be an independent director, who should be present at the Annual General Meeting to answer shareholder queries; the Company Secretary should act as the secretary to the committee. To begin with the audit committee should meet at least thrice a year. One meeting must be held before finalisation of annual accounts and one necessarily every six months. The audit committee should have powers to (i) investigate any activity within its terms of reference, (ii) seek information from any employee, (iii) obtain outside legal or other professional advice, and (iv) secure attendance of outsiders with relevant expertise, if necessary.

•

Among other things, the audit committee should (i) oversee a company’s financial reporting process and quality of disclosure of financial information, (ii) recommend the appointment and removal of external auditor, (iii) review with management, external and internal auditors the adequacy of internal audit function and the annual financial statements before submission to the board, including financial risks and risk management policies.


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•

The board of directors should decide the remuneration of non-executive directors.

•

The following disclosures should be made in the section on corporate governance of the annual report: (i) all elements of remuneration package of all the directors i.e. salary, benefits, bonuses, stock options, pension etc. (ii) details of fixed component and performance linked incentives, along with the performance criteria, (iii) service contracts, notice period, severance fees, and (iv) stock option details, and whether issued at a discount as well as the period over which accrued and over which exercisable.

•

Board meetings should be held at least four times in a year, with a maximum time gap of four months between any two meetings.

•

To ensure that directors give due importance and commitment to their fiduciary responsibilities, no director should be a member in more than 10 board-level committees or act as chairman of more than five committees across all companies in which he is a director.

•

In every company’s annual report, there should be a detailed chapter on Management Discussion and Analysis. This should include discussion on industry structure and developments, opportunities and threats, segmentwise or product-wise performance, outlook, risks and concerns, internal control systems and their adequacy, relating financial performance with operational performance, and issues relating to human resource development.

•

For appointment or re-appointment of a director, shareholders must be provided with the following information: (i) a brief résumé of the director, (ii) nature of his expertise in specific functional areas, and (iii) companies in which he holds directorships.

•

Information such as quarterly results, presentations made by companies to analysts should be put on the company’s website and sent in such a form so as to enable the stock exchange on which the company is listed to put it on its own web-site.

•

A board committee under the chairmanship of a non-executive director should be formed to specifically look into the redressing of shareholder complaints like transfer of shares, non-receipt of balance sheet, nonreceipt of declared dividends etc.

•

There should be a separate section on corporate governance in the annual reports of companies. Non-compliance of any mandatory recommendation with their reasons should be specifically highlighted. This will enable the shareholders and the securities market to assess

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for themselves the standards of corporate governance followed by a company. While most of SEBI’s recommendations follow from the CII code, there is no question that the regulator’s mandate has much more teeth. CII’s code is, by its very nature, voluntary. In contrast, the substantive aspects of the SEBI code are mandatory. And there is a need to put in place certain mandated aspects of corporate governance. Problems There are, however, a couple of questions. The first relates to policing and punishment. The SEBI envisages that all these corporate governance norms will be enforced through listing agreements between companies and the stock exchanges. A little reflection suggests that for companies with very little floating stock — which is the case of more than 85 per cent of the listed companies — de-listing because of non-compliance is hardly a credible threat. SEBI can, of course, counter that by stating that it is first focusing on the big fish, namely the Group A and S&P CNX 50 companies. Here, the reputation effect of delisting can induce compliance and, hence, better corporate governance. The second issue is more problematic, and it has to do with form versus substance. There is a fear that by legally mandating several aspects of corporate governance, SEBI might unintentionally encourage the practice of companies ticking checklists, instead of focusing on the spirit of good governance. The fear is not unfounded. Take, for instance, the case of Korea. After the crash of 1998, a part of the IMF bailout package was that a fourth of the board of every listed Korean company must consist of independent directors. They do, but the directors are hardly independent by any stretch of imagination. For most part, they are retired executives of the chaebols, friends of business groups and politicians that have supported the business in the past. And, in any event, they do not do what was intended — namely, to speak for shareholders and ensure that management does what is necessary to maximise long-term shareholder value. This raises a question of how to trace the line that divides voluntary from mandatory. In an ideal world with efficient capital markets, such a question need not arise — because the markets would recognise which companies are well governed and which are not, and reward and punish accordingly. Unfortunately, ideal capital markets exist only in theory. The reality is quite different. Markets are often thin and shallow and operate on the basis of ebbs and flows of pivotal stocks; informational requirements are lax; and regulatory and policing devices leave much to be desired. Thus what is needed a small corpus of legally mandated rules, buttressed by a much larger body of self-regulation and voluntary compliance. This will surely happen in India. When all listed companies are forced to follow 2003 © CIPE and OECD

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the SEBI guidelines, the better ones will voluntarily raise the bar so as to be measured according to best international practices. That will happen because of the desire of the high performers to be separated from the chaff — and to emphasise this separation in order to attract international funds. Conclusion Although corporate governance has been slow in making its mark in India, the next few years will see a flurry of activity. This will be driven by several factors. First, and most important, is the force of competition. With the dismantling of licenses and controls, reduction of import tariffs and quotas, virtual elimination of public sector reservations, and a much more liberalized regime for foreign direct and portfolio investments, Indian companies have faced more competition since the mid-1990s than they did since independence. Competition has forced companies to drastically restructure their ways of doing business. Under-utilised assets are being sold, capital is being utilised like never before, and companies are focusing on the top and bottom line with a hitherto unknown degree of intensity. Moreover, while there have been losers in liberalisation, competition has led to greater over all profits. Thus, the aggregate financial impact of competition has been positive — the more so for those who went through the pains of restructuring in the relatively early days of liberalisation. And there is every indication that while many companies will fall by the wayside, many more will earn greater profits than before. Second, there has been a great churning taking place in corporate India. Many companies and business groups that were on the top of the pecking order in 1991 have been relegated to the bottom. Simultaneously, new aggressive companies have clawed their way to the top. By and large, these are firms managed by relatively young, modern, outward-oriented professionals who place a great deal of value on corporate governance and transparency — if not for themselves, then as instruments for facilitating access to international and domestic capital. Therefore, they are more than willing to have professional boards and voluntarily follow disclosure standards that measure up to the best in the world. Third, there has been a phenomenal growth in market capitalisation. Consider a common sample of 1,322 companies that were listed in 1991. Their market capitalisation on 1 April 1991 was Rs.678 billion (or $38 at the prevailing exchange rate). On 28 February 2000, their market cap stood at Rs.5.52 trillion (or $127 billion). For all companies taken together, the market cap on 28 February 2000 was Rs.10.3 trillion (or $236 billion). Today, notwithstanding the severe drop in stock markets around the world, the total in India is still higher. This growth has triggered a fundamental change in mindset from the earlier one of appropriating larger slices of a small pie, to doing all that is needed to let the pie grow, even if it involves dilution in share ownership. 152



Creating and distributing wealth has become a more popular maxim than ever before — the more so when the maxim is seen to be validated by growing market cap. Fourth, one cannot exaggerate the impact of well-focused, well-researched foreign portfolio investors. In December 1993, the cumulative net foreign portfolio investment was $827 million. In December 1999, it stood at $10.2 billion. These investors have steadily raised their demands for better corporate governance, more transparency and greater disclosure. And given their clout in the secondary market — they account for over 15 per cent of the average daily volume of trade — foreign portfolio investors have voted with their feet. Over the last two years, they have systematically increased their exposure in well-governed firms at the expense of poorly run ones. Fifth, the pressure on corporate governance will intensify with the entry of foreign pension funds. Indian equity offers very attractive dollar-denominated rates of return on capital, which is bound to make funds like the California Public Employees’ fund CalPERS, Hermes in the United Kingdom or America’s TIAA-CREF begin to invest in Indian stocks. These funds hold on to their investments much longer than mutual funds; and their fund managers will be looking even more closely at corporate governance before making their investments. Indeed, it is fair to predict that in the next five years, the biggest pension funds will invest in India, and some of them will, like CalPERS, put Indian companies on their corporate governance watch. Sixth, India has a strong financial press, which will get stronger with the years. In the last five years, the press and financial analysts have induced a level of disclosure that was inconceivable a decade ago. This will increase and force companies to become more transparent—not just in their financial statements but also in matters relating to internal governance. Seventh, despite serious lacunae in Indian bankruptcy provisions, neither banks nor DFIs will continue to support management irrespective of performance. Already, the more aggressive and market oriented DFIs have started converting some of their outstanding debt to equity, and setting up mergers and acquisition subsidiaries to sell their shares in under-performing companies to more dynamic entrepreneurs and managerial groups. This will intensify over time, especially with the advent of universal banking. Penultimately, Indian corporations have appreciated the fact that good corporate governance and internationally accepted standards of accounting and disclosure can help them to access the US capital markets. Until 1998, this premise existed only in theory. It changed with Infosys making its highly successful Nasdaq issue in March 1998. This was followed by five more US depository issues — ICICI (which is listed on NYSE), Satyam Infoways (Nasdaq), ICICI Bank (NYSE), Rediff (Nasdaq), and WIPRO (NYSE). This trend has had two major beneficial effects. First, it has shown that good 2003 © CIPE and OECD

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governance pays off in spades, and allows companies to access the world’s largest capital market. Second, it has demonstrated that good corporate governance and disclosures are not difficult to implement — and that Indian companies can do all that is needed to satisfy US investors and the SEC. The message is now clear: it makes good business sense to be a transparent, wellgoverned company incorporating internally acceptable accounting standards. Finally, India will soon move to full capital account convertibility. When that happens, an Indian investor will seriously consider whether to put his funds in an Indian company or to place it with a foreign mutual or pension fund. That kind of freedom will be the ultimate weapon in favour of good corporate governance. Thankfully for India, the companies that matter have already seen the writing on the wall. Thus it may not wrong to predict that, by the end of 2005, India might have the largest concentration of well-governed companies in South and South-east Asia.

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Annex to Chapter 4 Some Differences Between US-GAAP and Indian Accounting Standards US GAAP

India

Consolidation of accounts is compulsory, with line-by-line aggregation for subsidiaries and equity pro-rated adding-up for associate companies.

Consolidation is neither statutory, nor is it at all popular. As on date, no more than half a dozen Indian companies have voluntarily chosen to fully adopt consolidation according to either USGAAP or IAAS.

All assets and liabilities, including physical assets, are recorded at market value, wherever possible.

Assets and liabilities are recorded at historical value, except for quoted securities.

Depreciation is charged according to fair value or salvage value as calculated by management.

Depreciation is charged according to rates specified in the Companies Act. These rates are rigid and often anachronistic. More seriously, there are two sets of depreciation rates — one for computing profits in the profit and loss account (as per the Companies Act), and another for income tax purposes (as per the Income Tax Act, 1961). Anomalies between the two are embedded in the provision for income tax. These differences frequently induce management to adopt the lowest possible rates for the profit and loss account (thus showing large profits before tax), and the highest ones for income tax calculations. Consequently, good analysts never look at PBT. Instead they examine trends in PBDIT, PBDT and PAT.

Segment reporting is compulsory.

Although manufacturing companies are supposed to give some details about category-wise production, capacity utilisation and sales, such data is quite fragmentary. It is fair to say that there is no real segment reporting that is worth the name.

Accounting for deferred tax liability is compulsory.

Not accounted for at all.


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Contingent liabilities are exhaustively specified.

One of the poorest aspects of Indian accounting is the cavalier attitude that many auditors take in disclosing details of contingent liabilities either in the ‘Notes on accounts’ or in their qualifications.

Detailed discussion on risk management is expected to form an integral part of the section on management discussion and analysis (MD&A).

For one, very few companies publish annual reports having a detailed MD&A chapter. The preferred substitute is a blandly disclosed Directors’ Report which, more often than not, doesn’t go beyond the minimum that is needed by the statutes. There is hardly any discussion on risk, barring one or two cursory paragraphs on Y2K.

Related party disclosure is very elaborate.

Companies Act requires a small element of related party disclosures — which must be kept separately in a register. However, this is nowhere near as elaborate and informative as US-GAAP.

All foreign currency losses have to provided for in the year of occurrence.

Foreign currency losses can be amortised over a period of time.

(Endnotes) This is not surprising. In the USA, corporate governance came into prominence only after the second oil shock in 1979 — when activist pension funds started demanding board level performance for its investors, and junk-bond funded raiders began to target under-performing companies. In the United Kingdom, corporate governance started to be spoken of only in the late 1980s and early 1990s in response to the collapse of the BCCI and malpractices of the Maxwell group, which led to the press questioning the City on its efficacy in monitoring British public limited companies. 2 Essentially, a cartel of bull players in the stock market led by a person called Harshad Mehta illegally used the liquidity provided by inter-bank credit and debit receipts to drive up the prices of pivotal stocks. Given the lack of width and depth of the market at that point of time and the herd mentality of followers, Mehta’s cartel succeeded in pushing up the index (the Bombay Stock Exchange Sensex) by almost 150% between December 1991 and April 1992. When the ‘scam’ was discovered, the markets crashed from a peak of 4475 on 22 April 1992 to 2548 on 5 August 1992, and then to a low 2218 on 29 March 1993, before the next boom began. The crash destroyed a large number of small retail investors and brokers who followed every move of Mehta’s, and questioned the ability of banking and capital market regulators to ensure transparency and safety. 3 This was designed as a low-cost strategy for equity consolidation and hence, as protection against corporate takeovers. It was facilitated by section 79(2) of The Companies Act, 1956, which allowed companies to issue shares at a discount so long as this was authorised by shareholders through a resolution and ratified by the 1

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Company Law Board. Such blatant instances of corporate misgovernance — where one block of equity holders were treated more equal than others — was publicised by the financial press until the government put an end to it in November 1994. For details, see Goswami (1996), 124-25. 4 For detailed expositions on the growth of Indian industry since the early 20th. century, see Bagchi (1972), Ray (1979) and Morris (1983). For national income estimates during the period 1900-47, see Sivasubramonian (1965, 1977) and Heston (1983). 5 Carr-Tagore and Company, the first joint-stock limited liability company in India was incorporated as early as 1848; and one of the ‘promoters’ of this company was an Indian — Dwarkanath Tagore. For details of this company, see Kling (1976). 6 Those who floated (or promoted) companies were called ‘promoters’ — a term that exists in ordinary and legal lexicon until this day. Promoters invariably managed the companies they floated. 7 Occasionally, this strategy had its dangers. In some industries, Indian merchants who were long term corporate vendors or purchasers also happened to be stockholders. Given the rudimentary nature of technology and low barriers to entry, some of these traders began to accumulate shares in the secondary market and then demand seats on the boards. This happened in a significant way in the jute and coal industry even during the colonial era. Goswami (1985, 1989, 1990) chronicles the market for takeovers in the jute industry and collieries during 1920-1950. Even so, it would be fair to say that low equity ownership coupled with complex cross-holdings allowed most promoters to control listed companies with relatively low ownership. 8 The genesis, growth, and problems of India’s state owned enterprises are discussed by Mohan and Aggarwal (1990) and Bhandari and Goswami (2000). 9 Interestingly, MRTP did not apply to state owned enterprises — on a wishful assumption that public monopolies were not inimical to either the nation’s or the consumer’s interest. 10 Quotas came in the form of various types of import licenses. Among them were Actual Users (Industrial) Licenses, Actual Users (Non-industrial) Licenses, Capital Goods Licenses, Customs Clearance Permits, Supplementary Licenses, Import Replenishment Licenses, Special Import Licenses, Additional Licenses, canalisation of imports and Open General Licenses. Over the years, industrial tariffs continued to be raised until the peak rate exceeded 300 per cent. By 1985, the mean tariff rate for intermediate goods was 146 per cent (standard deviation 56 per cent); and for capital goods it was 107 per cent (standard deviation 48 per cent). At that point of time, China’s mean tariff rates were 79% for intermediates and 63% for capital goods. See Kelkar, Kumar and Nangia (1990). 11 To understand the extent of leveraging, one needs to take a cursory look at corporate data for the financial year ended 31 March 1991 — just before the beginning of economic reforms. In that year, 528 listed manufacturing and non-banking services companies posted sales in excess of Rs.500 million. Some 65 per cent of their total capital employed of Rs.1,145 billion (or $64 billion at the prevailing exchange rate) was accounted for by borrowed funds. Almost 20 per cent of borrowings was supplied by the three all-India DFIs. The mean gearing (ratio of total borrowing to net worth) was 1.25, the median was 1.44 and a third of the sample were leveraged in excess of 2.50 (data are computed from Prowess). 12 Right up to the late 1980s, banks and DFIs were allowed to book interest income on an accrual basis irrespective of actual payment, and rare was the case when a loan asset was properly written down. Thus, most accounts were never non-performing. Not surprisingly, all banks and FIs made “profits.” India took 1993-96 to gradually introduce proper income recognition, asset classification and provisioning according to the Basle standards. When it did, the profits of most banks and financial institutions nose-dived, and the government had to spend in excess of $5 billion to recapitalise impaired banks. 2003 © CIPE and OECD

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(Bankruptcy is discussed below in Section IV. For non-performing loan assets and problems in the banking system, see also Confederation of Indian Industries, 1999.) 13 Indeed, some of these companies have even eroded their absolute value of market cap — despite a 420% growth in market capitalisation for this sample of 100 companies. 14 Among these are Infosys (ranked third with a market cap of almost $14 billion and the first company to be listed on Nasdaq), Zee Telefilms (ranked fourth with a market value of $13 billion), and Reliance Petroleum (which is putting up Asia’s largest refinery in Jamnagar in Gujarat, and has a market cap in excess of $7 billion). 15 There is no category called listed company in The Companies Act, 1956. That is defined in the Securities Contract (Regulation) Act, 1956, and the Securities and Exchange Board of India Act, 1992. 16 In fact, many of these “regional” stock exchanges see no active trade whatsoever, and survive only on the basis of the annual listing fees of the companies located in its region. 17 In fact, there have been so many disjointed amendments that the Act has now become unwieldy and, in many instances, unrepresentative of the times. 18 Well before Jensen, Adam Smith had highlighted the efficiency aspect of agency costs. Speaking of managers of joint-stock companies, Smith wrote, “The directors [managers] of such companies, however, being managers of other people’s money than their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private co-partnery frequently watch over their own… Negligence and profusion, therefore, must always prevail more or less in the management of the affairs of such a company” (Smith, 1776). 19 Goswami, et al. (1999). It is of course difficult to ascertain how much of this value destruction was due only to poor corporate governance, and how much also to these companies’ inertia and historical inability to deal with increasing competition. 20 These provisions were tested in 1983, when Swraj Paul, a British citizen of Indian origin, launched a takeover bid for two major companies, Escorts and DCM. In both companies, the promoters controlled corporate affairs despite owning less than 5% of the equity. Paul might have succeeded in getting on to their boards, if not wresting control, had not the government used these provisions to prevent the share transfers. 21 Studies by the Committee on Industrial Sickness and Corporate Restructuring (Goswami Committee, July 1993), Anant, et al. (1994), Anant and Goswami (1995) and Goswami (1996) clearly show that secured creditors of BIFR companies had to make large write-offs on their exposure, while management and shareholders did not. 22 The Board consists of a chairman and five other members, two of whom are from the central government and one from the central bank, the Reserve Bank of India (RBI). Among other things, SEBI is empowered to (i) regulate stock exchanges and any other securities markets, (ii) register and regulate brokers and sub-brokers, share transfer agents, bankers and registrars to an issue, underwriters, domestic and foreign portfolio managers, investors in securities, independent financial advisers, trustees of trust deeds, mutual funds and venture capital funds, credit rating agencies, depositories and custodians of securities, and self-regulatory securities market organisations, (iii) prohibit fraudulent and unfair trading practices, including insider trading; (iv) regulate public offers for the takeover of companies; and obtain information from all securities market institutions and intermediaries and conduct inspections, inquiries and audits. 23 It is a different matter that some of the outward oriented, better governed companies are giving separate financial disclosures involving consolidation and related party transactions according to US-GAAP. 24 Historically, three of the credit rating agencies — CRISIL, ICRA and CARE — were set up with shareholdings from the three all-India DFIs, namely ICICI, IDBI and IFCI. Recently, SEBI has insisted that these agencies not be allowed to rate any of their 158



shareholding companies or their subsidiaries. 25 Even so, at this point, it would be quite difficult to use the stock exchange ownership classification to construct a share-ownership matrix like the ones required under Form 10-K of the US Securities and Exchange Commission (SEC), for example. 26 Despite SEBI’s handicap, it has initiated several cases of insider trading. Most of them have been directed to relatively small players. There has been one exception: two years ago, India’s largest market cap company was subjected to a pre-merger insider trading investigation. Although SEBI declared it to be a case of insider trading, the matter was overturned by the Appellate Authority. 27 On 28 March 2000, ICICI Bank, a subsidiary of ICICI, also got listed on the NYSE, and thus conformed to all SEC disclosure standards. 28 Recently, SEBI has mandated such a definition, which is discussed in section 8. Until then, a few companies defined an independent director one who is (i) not a formal executive and has no professional relationship with the company, (ii) not a large customer and/or vendor to the company, (iii) not a close relative of the promoter and/or any executive directors, (iv) not holding a significant stake, and (v) not a nominee of any large shareholder/creditor. 29 This has changed with the recent SEBI Corporate Governance Code, which is discussed in section VIII. 30 Presently, for all state agencies the minimal reservation quotas are 15% for Scheduled Castes, 7.5% for Scheduled Tribes, and 27% for Other Backward Classes – making it 49.5% of total employment. For the relatively lower paid, lower skill jobs, there is an additional quota of 3% for the physically disabled, and 14.5% to 24.5% for ex-military and dependants of those killed in military or paramilitary action. These quotas are particularly restrictive in selecting people for technically specialised jobs.


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Chapter 5

SOUTH AFRICA: AFTER APARTHEID Stephan Malherbe and Nick Segal*

C

ocooned and protected until the end of apartheid, the corporate world in South Africa has been transformed over the last decade. The need for capital, to promote growth, and through growth to raise employment and social standards, have brought with them the need for high standards of corporate governance. When foreign investors returned to South African markets in 1994 they had strong criticisms of corporate structure, governance and performance. Much remains to be done in the areas of director remuneration, director disclosure and the market for corporate control. Two key points are the need for involvement by institutional investors, and the necessity for convergence between Johannesburg and London in levels of corporate governance and takeover regulation, if the domestic capital market is to survive. The need to promote black involvement in the economic life of the country has led to the introduction or retention of mechanisms which may have political merit but are not necessarily conducive to good governance. Steps towards improving the standards of governance have been taken with the introduction of codes of behaviour. The challenge is to turn the codes into conduct. The authors acknowledge fieldwork and research conducted by Robin Lee and Paul Semark, and assistance and advice especially in the early stages from Philip Armstrong, Ann Bernstein, Jim Leatt and Rias van Wyk. They also gratefully acknowledge financial support provided by the Anglo American Chairman’s Fund, the Institute of Directors and the Johannesburg Stock Exchange. *1


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Introduction By the late 1980s, many of South Africa’s corporations were bloated, unfocused and run by entrenched and complacent managers. These firms survived thanks to an environment very different from that in advanced economies. The key factor was isolation. Tariffs and political isolation shielded firms from foreign product competition, while financial sanctions kept international institutions out of the domestic capital market and South African firms out of international capital markets. Corporate law and practices fell behind international norms. After the 1990s, little of that comfortable, introverted world remains. South African corporations, their managers and domestic shareholders have been exposed, in swift succession, to a new political system, rapid trade liberalisation, demanding international investors, an emerging-markets crisis, and wholesale regulatory reform. Corporate structure has changed irrevocably. As recently as a decade ago, six mining finance houses − corporate structures peculiar to South Africa (though reminiscent of the Japanese pre-World War II zaibatsu, and formed in similar circumstances) − dominated the economy. Today the mining finance house no longer exists. Two of the most widely imitated characteristics of the mining finance house – diversified holdings and the entrenchment of control through pyramid structures – have also fallen from favour. Conglomerates have been unbundled and elaborate control structures dismantled. Legislation, regulations, listing rules and accounting standards are converging to international norms as well. Upon taking power in 1994, the ANC government chose to eschew confiscation of property, and instead to seek growth, which, among other things, could fund expanded social services and more employment. To attain higher growth, South Africa needed – and will need – to mobilise far more domestic and foreign capital than before, as well as to use that capital more efficiently. Hence the central role of the capital market and private firms in the government’s plans. Corporate governance (the quality of corporate monitoring and decisionmaking) thus impacts the country’s social stability as well as its prospects for growth. The most important force for corporate governance reform in South Africa has been the market. Market discipline, imposed through falling equity prices, has led to radical changes in corporate structure and conduct. Undoubtedly one element of South Africa’s equity culture – widespread executive share compensation – helped bring home the impact of market disenchantment. 162


CHAPTER 5 | SOUTH AFRICA: AFTER APARTHEID

But the leading role was played by foreign institutional investors, who robustly criticised corporate structure, governance and performance upon their return to South African markets in 1994. The government, regulatory agencies, the accountancy profession and the stock exchange have also been forces for change, motivated largely by the desire to apply international standards in South Africa. New legislation against insider trading led to a palpable change in market attitudes and conduct, while improved listing requirements and accounting standards have eliminated some of the backlog of South African levels of disclosure compared to international practice. Indeed, within 36 months, corporate governance changed in South Africa from being a “soft,” mainly ethical, issue to a “hard” issue, recognised as pivotal to the success and revitalisation of the country’s capital markets and, ultimately, the prospects of the corporate economy. These high stakes have produced a succession of measures aimed at transforming corporate governance in the economy. Any firm is governed within its particular corporate structure, and participants’ interests and mindset are important factors. In South Africa, these have always reflected the country’s political economy. Consider structure: at the start of the 1990s the economy was dominated by giant, centrally controlled diversified conglomerates with a domestic focus. This was a consequence of a tangle of political and economic factors. Another legacy of South Africa’s development path is a deeply-rooted equity culture. Corporates depend heavily on equity finance, and often turn to the comparatively large domestic equity market to raise capital. The Johannesburg Stock Exchange provides an example of how such a market can nurture and cull new firms. “New economy” and smaller “emerging” companies in particular have taken advantage of this funding route. The role of equity finance is reflected in modest debt-to-equity ratios, lending stability to the corporate sector. The equity culture permeates the economy in many ways. For more than a decade share incentive-schemes have formed a big part of the compensation of most senior executives. And the bulk of household savings have for a long time been invested mainly in equities. These savings are for the most part intermediated through domestic insurance and private pension-fund institutions that by emerging-markets standards are very large relative to the size of the economy. Given the central role of equity financing, three major events since the mid1990s have provided the impetus for overhauling corporate governance. •

South Africa re-entered the global economy in the mid-1990s. Sharp


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falls in equity prices registered both the competitive pressures on firms and the disenchantment particularly of foreign investors with distortionary governance structures and practices. •

The emerging-markets crisis of 1997-1998 saw an early consensus that widespread poor corporate governance prepared the ground for the crisis in the worst-hit countries. If accurate this view meant, as seen from South Africa, that the negative externalities of poor governance in developing societies are bigger than previously realised; better governance is needed for long-term macroeconomic stability.

•

Since late 1998, new equity issues in South Africa’s domestic market have virtually come to a halt, most markedly for small and medium-sized companies.

The problems in raising equity capital are, to be sure, partly cyclical; but there are signs of a structural shift. South Africa’s most active multinationals − in mining, beer, computer networking and retail financial services − have shifted domicile and primary listing to London in search of cheaper funding. Part of the appeal to offshore investors has been the prospect of improved corporate governance in the new jurisdiction. It is not yet clear how far this trend will go, and how it will affect the health of the domestic market. What is more, the lack of funding for smaller firms seems to be tied in part to widespread investors’ perceptions that they are unable to assess and monitor the managements of these firms. These developments at both ends of the corporate size spectrum − both mirroring trends in some other emerging markets − threaten the health of South Africa’s domestic capital markets. In the face of these pressures, the practice and regulation of corporate governance in South Africa are in the midst of a wholesale renewal that involves various actors and mechanisms: •

Capital markets have forced governance changes. Pressure by global providers of capital on the country’s largest corporates, the mining finance houses, has culminated in a radical overhaul of their structure, strategy and governance.

•

Domestic institutional investors are shifting into a new role concerning the governance of the firms, in which they are invested. The large institutions have shifted from a controlling (or at least board-represented) interest in their largest investments to a more indirect role in monitoring governance and performance.

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The legislator has achieved signal success in the governance field with new legislation against insider trading. There is also renewed emphasis on corporate and director liability.

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Self-regulation, via the Johannesburg Stock Exchange, has led to proposals for novel and significantly more stringent corporate governance requirements to counteract the detrimental developments of the last few years.

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An early exercise in voluntary compliance, the King Code, has been revisited and strengthened.

The story told in these pages has been playing out against a backdrop of dramatic political change in South Africa. The end of apartheid could have occasioned a radical reassessment of the role of private corporations in the South African economy. In the event, the post-1994 government has put markets and private firms at the centre of its economic strategy. Given the scarcity of savings and the need for growth, the government has recognised that a capital market that effectively mobilises and allocates capital is a priority, and much of the government’s corporate governance reform has been aimed at achieving this. Continued political acceptance of the role of corporations requires that black South Africans make rapid strides as owners, leaders and managers of corporations. This process, known as black empowerment, and the involvement of business in political processes are also crucial to the future of corporate governance in South Africa. I. Windfall and Disaster: the Role of Corporations in the Political Economy The corporate sector has long played a dominant role in the South African economy. Private and state-owned corporations produce the bulk of South Africa’s output and exports, manage most of its capital stock, are increasingly central to the allocation of investment, and are responsible for virtually all of the country’s savings. The low level of domestic savings means that largescale portfolio and other inflows are needed to finance investment levels consistent with higher growth. That in turn requires correct standards of corporate finance. South African history, the historian C.W. de Kiewiet once observed, tends to proceed by economic windfall and political disaster. The geological windfall of large precious mineral deposits and the extended political disaster of apartheid explain much about how South Africa’s corporate sector developed. Corporations drive the economy Three-quarters of South Africa’s productive capacity (capital stock) is owned and managed today by business corporations – a share that has grown from 2003 © CIPE and OECD

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about 60 per cent prior to the 1990s (see Table 1). Because mining has always largely been left to private enterprise, private-sector corporations have dominated economic activity in South Africa since the late-19th century. They have owned and managed about half of the country’s productive capacity since the 1950s. During the 1990s, corporations were also responsible for 83 per cent of South Africa’s gross domestic investment (Table 2), 70 per cent of which was made by private corporations, and for close to 80 per cent of exports.1 Listed companies, i.e., those listed on the Johannesburg Stock Exchange, today generate close to half of GDP. The role of the state-owned enterprises (SOEs) is more recent. They first became important in the 1920s, particularly in power, telecommunications, transport and steel. Yet, at the end of the Second World War they still owned less than 5 per cent of total capital stock. During the next 35 years that share increased rapidly, peaking at 25 per cent in 1990 – a consequence not of nationalisation, but of the National Party’s use of SOEs to achieve industrialization and self-reliance. The high point of SOE expansion occurred in the 1970s, during which the capital stock controlled by SOEs tripled in real terms. Much of this occurred in energy, including oil-from-coal plants (subsequently privatised) and power plants (now due for privatisation). From the early 1980s the government embarked on a limited privatisation program. This was halted during the transition to democracy in the early 1990s, as the ANC at that point espoused nationalisation. Yet the recent ceding of operational control of some SOEs to “strategic” foreign partners means that some parts of the capital stock now categorised as SOE-owned are actually privately controlled. Corporate role in national savings South Africa’s savings performance lags that of the developing world, having fallen from 24 per cent of GDP (roughly the current developing world average2) in the 1980s to around 15 per cent during the late 1990s. Although the government has sharply reduced its dissaving, household (or personal) savings have collapsed, reaching a level in 1999 less than one-tenth in real terms of the levels of the 1980s. The non-financial corporate sector is central to the savings that do occur (Table 3). During the 1990s the savings of privately owned corporations amounted to 72 per cent of gross domestic savings, and that of SOEs to 33 per cent. Total corporate savings exceed 100 per cent of gross domestic savings, because the rest of the economy (households and government) are, taken together, dissavers. During the second half of the 1990s, as household savings plummeted, private corporations increased their share of gross domestic savings to 76 per cent, up from their traditional contribution of about half. 166



Corporations thus play a critical role not only in the transformation of financial capital into machinery and mortar (or human capital or technology) but also earlier, “upstream,” when savings are entrusted to the financial system or reinvested internally. The dismal level of domestic savings also highlights South Africa’s marked need for large-scale international portfolio and other financial inflows, required to finance investment levels sufficient to allow the country to achieve higher growth. Such flows are becoming more sensitive to standards of corporate governance. History, Geology and Politics shaped corporate structure and conduct Gold deposits and the political system had a marked effect on corporate structure and conduct in the 20th century, before internal and external forces caused the rapid unravelling of the apartheid model over the last ten years. The lynchpin of the economy was the mining finance house, which evolved little in the decades after World War II. Equity capital was essential. Not all firms benefited from apartheid measures as the Afrikaaner movement was backed chiefly by white farmers and the white working class. An effect of discriminatory measures was to empower the white working class, weaken black labour and raise costs for manufacturers. The state also owned and operated enterprises and monopolies largely in the interests of Afrikaners. The rise of the mining finance house The South African economy was long epitomised by a small number of giant business groups, characterized by diverse operations, an inward focus, intragroup transactions, control blocs and disempowered minorities. The most prominent among these were the mining finance houses, formed, in the late 19th and early 20th century, to exploit the Johannesburg gold deposits and ultimately to finance the national gold mining industry. The houses eventually ingested the diamond industry, pioneered coal and platinum mining, and funded the country’s manufacturing base. They were central to the development of South Africa’s capital and money markets, and at times owned important stakes in South Africa’s largest banks. Little wonder that the financial structures and decision-making habits of the houses ultimately permeated the entire private corporate sector. The houses were notable for their continuity. All seven major houses at the end of World War II still dominated mining, and much else, in 1990 (although two had merged, and another had merged with an industrial company). The corporate and industry structure of the houses in 1990 was virtually identical to that in 1946. Changes of corporate control were unusual, and hostile takeovers virtually unknown. The mining finance house structure was fashioned according to the needs of the industry. The Witwatersrand gold deposits, though plentiful, were 2003 © CIPE and OECD

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deep below the surface, usually in reefs with relatively low gold content. The exploitation of these deposits required organisations that could, on a large scale, mobilise both capital and mining engineering skills. Also, the uncertain pay-off of any particular dig encouraged firms to consolidate their holdings into large firms with many properties. So, after making a geological discovery, houses would float the mining development on the Johannesburg Stock Exchange to obtain the development capital required, while maintaining management control. The reputation of the mining finance house was key to obtaining the capital – given the extreme information disadvantage particularly of the foreign investor with respect to the feasibility of the venture to be floated. The information asymmetry could only be overcome by a mining house’s sponsoring the mine by putting both its reputation and significant equity capital behind the new venture. Note the use of equity capital: in mining lies the root of South Africa’s strong equity culture. Considerations of capital-raising and the optimal use of scarce skills thus led to the mining finance house structure that dominated for most of the 20th century. Its key features were applied in development after development: •

Finding new opportunities through exploration or purchase of mining rights;

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Mobilising capital thorough sponsored listing of mines over which management control is retained. Minorities provide the fresh capital;

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Central provision of skills: mining engineering for development of the mine, geology and metallurgy for the on-going running of the mine, accounting, legal and treasury services;

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Central purchasing department for material, to benefit from scale;

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Diversification, which gained speed after 1960.

A key part of system was the provision of skills and capabilities by the mining finance house to the operating mine. This ensured the effective use of very scarce resources, but at the same time it built related-party transactions into the structure: the mining finance house was, in current parlance, a control bloc engaged in an on-going flow of transactions with the operating mine, with the terms of transactions determined by the house. The house-mine transactions ultimately encompassed exclusive provision of services from the house to the mine, as well as various service fees payable to the house, some of which were simply calculated as a proportion of the revenues of the mine, not linked to the delivery of specific services or to any performance objectives. Ultimately, the corporate structures and conduct that had evolved to meet the needs of the mining pioneers permeated the rest of the economy. 168



The apartheid hothouse Powerful as they were, the houses were not a world unto themselves. Around them a political system was being built up. The race-based politics of the 20th century intruded in corporate boardrooms in many ways, not least in determining that corporate ownership and leadership would be overwhelmingly white (this remains true today). Other effects, more subtle and indirect, explain much about the structure, governance and mindset of South African business firms. Firms and their owners often benefited from apartheid measures – and, surprisingly, quite often did not.3 Policy during the founding years of apartheid, 1910-1960, was for the most part a direct expression of white democracy, populism and Afrikaans identity. Only for two comparatively brief periods (1920-24 and during the Second World War) was political power exercised primarily on the part of, respectively, mining capital and urban capital. For most of the founding years, capital was in opposition, and governments depended on the support of white labour and the white agricultural sector.4 Both these groups were predominantly Afrikaans and formed the core constituency of the Afrikaner Nationalism movement. Between 1924 and 1960, then, a framework of policies, of which the kingpin became apartheid, was put in place to protect the interests and values and identity of white labour and white agriculture. The main apartheid policy elements impinging on business firms were: •

Strengthening the white working class. White workers received strong organisational and other support from government policy. As early as 1924-25, tariff protection and access to government tenders were made conditional on preferential hiring of white workers at high rates of pay. At the same time, legislation provided for white trade unions and gave white workers a key role in determining occupational structure, access to training and determination of industry minimum wages. Whites were also given access to superior schooling.

•

The emasculation of black labour. Blacks received rudimentary schooling, were forbidden to organise trade unions or engage in collective action; many were forcibly removed to rural areas distant from centres of economic activity, were widely (if not always successfully) forbidden to work in urban centres, and in mining operations were proscribed by law from filling skilled and better-paid jobs. The apparent contradictions in these policies are resolved by the insight that they were put in place to reduce competition faced by white workers.

•

Protection to extract rents from consumers.


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policies raised costs for manufacturers.5 Add to that other costs of sustaining the apartheid state, and it was clear that South African manufacturers could not survive in open competition. Therefore trade protection was sharply increased in 1925-26 as a companion strategy to that of increasing the rents accruing to labour. Both sides of this policy equation – white labour power and protection for industry – would be reinforced in the 1950s, following the coming to power of another white-populist government, that of the National Party. •

State patronage to advance group interests. The state intervened in the development process as entrepreneur, regulator and owner. The state expanded its activities in the industrial sector in two spurts − the mid-1920s and the 1950s − correlated with the regaining of power by strongly white-populist governments. By 1960 state-owned companies dominated rail transport, steel, telecommunications, postal services, airlines and air cargo, the ports, pipelines, oil and gas exploration, oil-from-coal extraction and armaments manufacture. Many of these SOEs were granted statutory monopolies. The parastatal monopolies were aggressively used to provide employment for surplus white (mainly Afrikaner) unskilled workers, and eventually to create an Afrikaansspeaking managerial class. These efforts were effectively funded by rents extracted from the rest of the economy through monopoly pricing and the tax regime.

Apartheid measures were an unambiguous loss to the economy and society.6 But the success of manufacturing protectionism in establishing a vibrant and diversified base of economic activity and industrial knowledge should not be gainsaid. During 1961-65, real manufacturing output growth averaged 10 per cent per year, and during 1966-1970, 7.4 per cent. By the 1970s, the area around Johannesburg had reportedly become the largest area of industrial activity south of Turin. By 1990, manufacturing produced 25 per cent and services 52 per cent of GDP, while mining contributed less than 10 per cent. Much of this activity occurred in distorted markets, but it established an economy different from any other in sub-Saharan Africa. Corporations in the hothouse economy For businesses, government policies during the era came down to this: high costs imposed by segregation, compensated for by safe profit margins made possible by protection against foreign competition. From 1960 onward, the profound effects on corporations became clear. In that year, the violent suppression of a political demonstration in the black township of Sharpeville set off a capital flight. This led in turn to the imposition of exchange controls on resident individuals and companies, elements of which are still in force today. 1960 also saw organised international opposition to apartheid, and the country left the British Commonwealth. This was the start of the slow and relentless accumulation of economic sanctions by foreign countries, limiting 170



access to foreign markets and capital. Product market protectionism was now reinforced by strict controls on financial outflows and increasing political isolation. The country was gradually slipping into autarky. The business environment reflected this change: •

Corporations focus inward. Consider how the costs of segregation and ubiquitous protection distorted the opportunities faced by managers in manufacturing and services. The costs − and small scale − all but ensured that a business’s core product could not be sold profitably in export markets at world prices. The protection ensured that there were rich opportunities available domestically, often in unrelated markets. The rational response was to diversify domestically, rather than to specialise internationally. Political isolation reinforced these tendencies (tendencies which also contrast sharply with the growing export orientation of the economic success stories of Asia).

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Weaker capital-markets supervision. A similar combination of isolation and distortion operated in the financial sector. The savings flows mobilised by South Africa’s financial institutions were confined to the domestic market, and found a ready outlet in South African firms. These flows were principally intermediated by two life insurers, Old Mutual and Sanlam, both owned by their policy-holders. In practice this meant negligible owner supervision over strong and independent management teams, as voting procedures were dominated by management. A selfperpetuating management elite was created. The insurers built up important stakes in virtually all large listed South African corporates, and assumed directorships on the boards of these companies. Yet, in the clubby world of South African business, institutional shareholders rarely exercised effective monitoring over their investments, and equally rarely − given their limited options − voted with their feet. The market for corporate control barely existed. In fact, the mining finance house, conglomerate, family control and insurance mutual structures all served to protect incumbent managers. And related-party transactions within mining finance houses and conglomerates were so ubiquitous that they were barely remarked upon by minority shareholders or anyone else.

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Mining houses as an instrument of capital allocation. The truncated access of South African firms to international capital markets and investment opportunities precluded the mining finance houses from pursuing the most natural path of expansion: to be a conduit of capital from the international financial centres to mining opportunities in high-risk developing environments. Instead of becoming global mining specialists, the houses became diversified national conglomerates.


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By 1960, when the major Free State gold fields had been developed, the capital needs of the gold mines slowed and the surpluses of the industry increased. Now the mining finance house model was turned on its head. Designed to mobilise capital, it now became a source and allocator of capital, not only in mining activities but increasingly in the rest of the economy, as domestic mining proved unable to absorb all the capital it was now generating. Industrial companies, many expanding behind the country’s high tariff barriers, eagerly absorbed the surpluses generated by mining. However, the centralised structures of control that worked well for mobilising capital and skills for mines were less appropriate for allocating capital to unrelated ventures. And the very success of the mining activities allowed managers to become complacent and passive. Together, these trends would lessen capital-market discipline on the houses while at the same time causing their businesses to become more complex. The South African mining finance house model of industrial investment and control tended, in sum, to be static and protective of existing commercial interests and alliances, rather than encouraging specialisation and dynamism. Distortions and weaknesses Over time, corporate South Africa, and ultimately, the economy, began to display the maladies of autarky: weak competition, falling cost competitiveness and management complacency. By the 1970s and 1980s, labour productivity had become essentially stagnant, despite a steadily increasing amount of physical capital per worker. In short, given the small size of the South African economy, a policy of protectionist self-sufficiency was bound to fail, and did. At the corporate level, three consequences of apartheid autarky were particularly damaging: •

Market concentration. The South African economy has always been a tiny fraction of the global economy. Isolation from foreign suppliers of goods and services consigned a large number of product markets to one or two domestic producers. These often produced at a sub-optimal scale. Circumstances were also conducive to collusion – visible in the prevalence of so-called import-parity pricing, whereby products were priced no lower than the tariff-inflated import prices.7

•

Falling competitiveness. Apartheid protectionism proved to be devastating for the cost competitiveness of South African firms. The costs of apartheid were reflected in the cost structure of every firm. Low investment in human capital began to take a toll. Given the opportunity to operate profitably in small markets, manufacturers were locked into

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operations at sub-optimal scale. The lack of competition bred laziness and complacency. The increasing isolation tended to erode what little there was in terms of external market positions. •

A closed and complacent managerial mindset. In the inert commercial environment promoted by the high level of protection, a market position, once achieved, became a franchise: stable, profitable and well protected against rivals. The market position, requiring little further management, became an asset in itself. This resonated with the mining industry, where a good deposit, once secured and the production infrastructure put in place, required little active management. So the South African management mindset was trained on the acquisition of assets in a stable environment, and not the active management of a business in a constantly changing one.

1990s: a brave new world The political transition ushered in during the early 1990s resulted in the country’s first fully democratic election in 1994. The new ANC government, despite a long-standing ideological commitment to socialism, embarked on far-reaching economic reforms. These included a progressive reduction of import tariffs and similarly removal of exchange controls. Underlying these and other macro policies was a recognition that, to augment the country’s low savings, South Africa had to engage with the global economy if it was to attract foreign investment. Within only a few years, the main building blocks of apartheid autarky had been dismantled. The inefficiencies engendered and tolerated by the traditional corporate structures were starkly revealed. The market response was brutal, particularly from foreign portfolio investors, who had become pricesetters for the equities of South Africa’s larger companies. •

Mining finance houses were down-graded, and traded at a large discount to the value of their holdings;

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Diversified industrial companies saw large profit squeezes from tariff reform, and their business portfolios were questioned by the market;

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Family-controlled firms, particularly where control was buttressed by share pyramids or differential voting shares, lost the favour of the market;

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The mutually-owned insurers, requiring capital to expand their operations internationally, came under pressure to demutualise;

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The government was under strong pressure to privatise SOEs − in telecommunications, postal services, transport, power and other utilities − or to allow more competition in these sectors.


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Government and others called for a rapid increase in black ownership of publicly traded companies.

A new model of corporate structure and governance was called for. We examine its gradual development, after looking first at the depth of South Africa’s equity culture, and that culture’s effect on how corporate activity is funded. II. Equity Culture and Corporate Finance For historical reasons South African corporations have always relied heavily on equity capital and that continues to be the case. This phenomenon underlines the need for good corporate governance if external capital is to be attracted. South Africa’s equity markets were a by-product of the development of the mines, the risk profile of which made it unattractive to providers of debt. It is only because of the Witwatersrand gold deposits that the city of Johannesburg exists, and similarly the Johannesburg Stock Exchange (JSE), one of the oldest stock exchanges outside Europe and North America. Where does South Africa’s deep equity culture come from? Apart from the legacy of mining finance, other factors contributed. Strong non-bank financial institutions such as pension funds and life insurance companies developed early on, and channelled a large part of household savings into equity. South Africa’s commercial law and business culture, derived from Great Britain, contain a predisposition for equity finance. Finally, the equity market provided an avenue for investors to profit directly from South Africa’s mineral bounty as well as from the comfortable industrial profit margins achieved in the hot-house economy. Between 1950 and 1990, the mining finance houses and other prominent companies on the JSE proved to be good long-term investments. Equity has continued to play a central role in new funding of non-financial firms in South Africa. The link between funding structure and the quality of corporate governance is indirect but important. Poor governance scares off external capital, leaving the ambitions of firms limited to those that can be funded by their internal source of capital, i.e. retained earnings. The quality of corporate governance may also affect the mix of external capital, with lower quality governance favouring debt capital, which allows banks to compensate for poor general governance by insisting on security (often relied upon in the crisis countries of 1997-98) or by requiring strict loan covenants (contractual obligations placed upon the borrower by the lender). An analysis of firms listed on the JSE reveals a funding structure which, if it is to continue, depends greatly on market perceptions that the corporates involved are soundly governed.

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Funding structure of listed companies The balance sheets of listed companies reveal their sources of funding. Table 4 shows data for 1999, which can be compared with similar annual data since 1994 (not shown). The table divides the firms into four main categories, of which the largest is “industrial and commercial” firms (firms whose aggregate assets amounted in 1999 to R342 billion8). This group is in turn divided into four sub-categories of firms: manufacturing; non-financial services; so-called “new economy” or TMT – technology, media, telecommunications – firms; and small recent listings which we can call ‘emerging’ firms. The three other main firm categories in the table are mining (other than in gold mining, for which data are not available); the ‘London Three’ that shifted their primary listing from the JSE to London (Anglo American, Billiton and South African Breweries9); and SOEs. The overall picture: •

External funds, as opposed to retained earnings, account for a relatively large proportion of corporate funding (about two-thirds of funding on average for industrial and commercial firms, an even greater share for SOEs as well as – though less surprisingly – for small emerging firms). This reliance on sources other than retained earnings has slightly risen since 1994.

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Equity finance accounts for a considerable share of those external funds (half or more for most categories of firms, a quarter even for SOEs). Though not new, this relatively heavy reliance on equity funding has also tended to increase in recent years and in certain sectors.

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Debt-equity ratios thus tend to be relatively conservative, i.e., low. Data from 1994 point to a rising importance for debt, the mix of which is also shifting from short- to long-term (on year maturity or longer) debt.

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Traded debt (such as bonds) is hardly used by any firms other than SOEs; long-term corporate debt in the private sector consists largely of bank and group loans.

Within this overall picture: •

Manufacturing firms show a remarkably stable funding structure over 1994-1999, with somewhat less reliance on equity issues than some other types of firms. A lack of investor interest in the sector in recent years helps explain these firms’ comparatively heavier reliance on retained earnings and debt.

•

Non-financial services firms have developed a more aggressive


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funding structure since 1994 by increasing their use of external finance, particularly equity, and reducing their reliance on retained earnings. Their average debt-equity ratio, 53 per cent, is also the highest among the table’s categories. •

“New-economy” firms expanded their assets four-fold in 1994-1998, with new-equity issues funding some 69 per cent of the expansion, retained earnings 24 per cent, and new debt 7 per cent. Relatively stable average debt-equity ratios of around 20 per cent underscore these firms’ reliance on equity to fund expansion during that period.

•

Newly listed or “emerging” companies show an even more pronounced use of equity finance. This sector encompasses the JSE’s two junior boards, sections of the market where listing requirements have been relaxed to allow firms with truncated financial records to raise capital. Although small in terms of assets, this sector has seen many companies list, particularly in technology businesses. (The recent capital markets experience of these companies, and the role of corporate governance problems in it, is discussed below.)

•

Mining companies have undergone a financial transformation, moving to 40 per cent reliance on retained earnings in 1999, up from 23 percent in 1994. With an average debt-equity ratio below 10 per cent in 1999, and a reduced role for equity finance, the sector’s financial structure may reflect reduced interest from investors, possibly matched by reduced new funding needs.

Where is the debt? Compared to the funding patterns of firms in many developing and “emergingmarket” countries, South African companies’ limited use of debt finance, and particularly long-term debt, is striking. In part it reflects the country’s precocious development of a short-term money market, and in part an underdeveloped market for long-term corporate debt. The short-term money market was created in the mid-20th century to manage the large positive and negative cash balances generated by mines at different stages of development and production. Yet, two other sources of debt capital remain underdeveloped. First, South Africa does not have an active market in corporate bonds, despite a highly liquid exchange trade in government bonds (although that may change in the near future). Second, the country’s otherwise well-developed banking sector usually balks at providing long-term fixed interest loans to corporates. The central role of equity financing would not have been possible without a strong equities market and large domestic financial institutions. The depth of South Africa’s domestic equity market is highly unusual among its developing 176



country peers (Figure 1). The market value of the JSE compared to GDP far outstrips the same measure for other developing countries other than Malaysia. Note also the absence of market-traded private debt across the developing world, with the partial exceptions of Korea and Chile. The JSE is deep relative to the size of the economy even when compared to advanced economies (excluding financial centres), as Figure 2 shows. How the equities market evolved during the 1990s. The JSE is essentially a member-owned private organization, consisting of a (self-) regulatory authority, a trading platform and a clearing and settlement system. In all those respects, the 1990s were a period of rapid change and improvement. As foreign investors returned to South Africa and the JSE found itself under pressure from banks servicing these investors as well as from South African corporates, it underwent a wholesale renewal. It allowed corporate and foreign membership, awarded stock exchange licences to all who met a standard list of requirements, closed its trading floor, moved to a transparent electronic trading system, relaxed short-selling rules, modernised its indices to allow for easier cash-futures arbitrage, developed three boards for new companies, raised the listings and disclosure requirements of its main board, and started to move towards a dematerialisation of scrip. Among the key consequences of this change, which is still underway: •

Greater competition led to sharply lower trading costs, particularly for institutions.

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Foreign institutions became the price-setters for larger South African stocks, and foreign-owned brokerages now dominate the market, placing more than half of all trades on the JSE.

•

A larger and more liquid, and more effective, equities market emerged. Trading volumes rocketed, with a corresponding increase in liquidity: In the early 1990s only 4 per cent of the total market capitalisation of the JSE was traded over the course of a year; by the end of the decade that figure rose to 40 per cent.

•

Total JSE market capitalisation (excluding pyramid holding companies) rose from 152 per cent of GDP at the start of the decade to 190 per cent at the end of 1999. And while the number of listed companies (again excluding pyramid holding companies) fell slightly (from 696 to 610) the market capitalisation of the average company doubled in real terms (in nominal rand it rose from R526 million to R2.5billion).

Domestic Institutional Investors. The growth of large equity and government bond markets has been supported 2003 © CIPE and OECD

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by a financial sector that is unusually old, large and sophisticated for a developing country. South Africa’s private pension funds control monies in excess of R600 billion (slightly less than annual GDP), while the insurance and banking sectors each controls funds close to GDP. The unit trust (mutual fund) industry is about one-fifth the size of the pensions industry, but has grown particularly swiftly in recent years. South Africa’s institutional sector is large even by advanced country standards. The appetite of these institutions for equities in which to invest has been a critical element in the development of South Africa’s equity market. As competition among various investment services and products increased during the 1990s, the large institutional investors intensified their focus on returns. At a time when structural changes in the economy were rendering the traditional sectors less profitable, the large institutions led a portfolio shift that triggered some of the valuation shifts seen above. At the same time, investor demand for Rand-hedged investments and foreign exchange relaxation led together to a sharp increase in foreign holdings by the institutions, although still below 15 per cent of total assets. Private Equity and Smaller Firms Not all equity capital is formally raised on the JSE. South Africa has a sizeable private equity sector, with an estimated 30 funds of an average size of perhaps R500 million, which provides financing to unlisted firms (see Table 5). But even with private equity-funding, the most common exit strategy for the fund is a JSE listing after the provision of mezzanine financing. This implies that private equity financing is really a part of the JSE listing process, and depends on the success of the JSE as a primary and secondary market. The practice of raising capital in anticipation of or in preparation for a JSE listing occurs in other guises too. For example, firms will often raise the bulk of their capital from a private placement with institutions or other preferred shareholders before listing; these capital raisings are not included in the official data for capital raised, although the funds thus raised may commonly be three to four times as large as the new shares offered to the public. Listing and capital-raising activities on the JSE come in three forms: •

Listings. These are initial public offerings (IPOs): a previously unlisted company is quoted on the JSE following a public offer of newly issued shares. The public offer is commonly used to ensure that the company meets JSE requirements that a certain percentage of the stock be owned by the public. The offer is usually preceded by a private placing where most of the fresh capital is raised.

•

Capital introductions. If a firm already has the required spread of public shareholders, it may decide to eschew the offer to the public, and to list

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without it. This form of listing is called a capital introduction. In many cases, the firm will at the same time raise capital through a private placing of shares. •

Rights offers constitute the only way in which secondary public offerings may be made on the JSE. This is done by issuing pro rata to existing shareholders the rights to subscribe to the new issue of shares.

Listing and capital-raising activity peaked in 1998, when 90 firms listed through capital introductions alone for a combined value of about R35 billion. But since the last quarter of 1999, there has been a spectacular collapse in the amount of capital raised from the public. Capital raised through public offerings on the JSE fell in 1999 by 75 per cent to the lowest level since 1994. The situation deteriorated even further in 2000, when capital raised from the public during the first semester fell to just 6 per cent (an annualised rate of R1.8 billion) of the amount raised during 1998. Smaller firms hard hit Mostly “new economy” and “emerging” firms, their balance sheets depend heavily on equity finance. With an average market value upon listing of less that $25 million, these firms are the natural point of entry for non-establishment entrepreneurs and businesses. Unlike the South African corporate giants, which are increasingly able to access international capital markets such as the London Stock Exchange and Nasdaq, they are far too small to gain such access. Yet, after offering a congenial source of capital for such smaller firms, the JSE has essentially dried up. Several factors seem to explain this disappearance of the market for smaller stocks. Doubtful corporate governance seems to be central to the problem, particularly the inter-related issues of disclosure, self-dealing and insider trading. A number of smaller stocks have generated controversy in these areas, and the market has evidently concluded that it cannot differentiate between good prospects and bad or to monitor these companies. The information characteristics of the market for smaller stocks are important in this regard. In South Africa as elsewhere, institutional investors, needing to invest large sums in liquid instruments, shun smaller companies. Purchasers of smaller stocks are mostly private investors. (“Emerging-company” mutual funds were starting to emerge, but have effectively been killed off by the poor market performance.) In other words, institutions, the usual solution to the problems of information asymmetry and collective action endemic in investment markets, barely operate in this market. The upshot is that the information asymmetry between the promoters and managements of the smaller firms, on the one hand, and the private investors, on the other, is particularly acute. If so, then the conventional view on small 2003 © CIPE and OECD

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stock or “emerging-company” boards, that these must set more relaxed listing and other requirements, is wrong-headed. Regulation may be required to solve the significant market failures that seem to operate in this market segment. State-owned enterprises One legacy of the era of Apartheid autarky is a number of large stateowned enterprises (SOEs). The four largest are power utility Eskom, telecommunications provider Telkom, transportation company Transnet and armaments manufacturer Denel. Another important SOE is Acsa, the operator of South Africa’s major airports. Until the late 1980s, the SOEs were run as government departments under particular ministries. Political fiat was absolute, and losses were routinely covered by transfers from the fiscus. At that point, the government’s approach started to shift from viewing the organizations as policy tools to preparing them for eventual privatisation. The firms were “corporatized,” i.e., given a corporate legal form, complete with a board appointed by the government as the sole shareholder. SOEs’ current funding structure The SOEs have funding structures that will differ radically from those of their private-sector counterparts in two respects: •

With an aggregate debt-equity ratio of 127 per cent in 1999, SEOs rely far more on debt financing than do private firms (e.g., “industrial and commercial” firms’ aggregate debt-equity ratio that year was 46 per cent). Transnet had the highest debt-equity ratio at 176 per cent.

•

Unlike the listed firms with negligible traded debt, the SOEs rely on traded debt − mostly bonds − to fund 85 per cent of debt requirements, almost half of their total funding. Other than the sovereign, Eskom is the most important rand bond issuer in South Africa and abroad, with its R37 billion in bonds trading at a small discount to treasuries.

Corporate governance reform in SOEs Upon inheriting these entities, the 1994 government had to find its own balance between using the SOEs to effect service delivery to the poor and adopting the internationally prevailing approach of privatisation. During 19941999 the government emphasized service delivery and the appointment of black management, although there were significant sell-offs of minority stakes in Telkom, South African Airways (a part of Transnet) and another SOE that operates South Africa’s major airports. All of the incoming shareholders are well-known international operators in the respective industries, and in two cases (telecommunications and airports) they were given management 180



control. In August 2000 the government announced a comprehensive privatisation policy for the major SOEs (for political reasons the term “restructuring” is used in the policy document). Certain SOEs are to sell minority stakes to “strategic” investors that have foreign operating experience, and some operations are to be wholly privatised. The new policy is guided by a view that the government is constructing in South Africa a “strong democratic developmental state.” As a part of this effort, the government believes, SOEs, whether partially privatised or not, need to extend services to poor South Africans and otherwise assist in economic development. So, while each corporatised SOE will have the trappings of corporate governance, such as a board and sub-committees, its conduct will in fact be determined by a “shareholder compact” with the government. The compact will spell out its future strategies and objectives. In the case of SOEs that now have a minority “strategic” shareholder, governance arrangements are contained in a shareholders’ agreement negotiated with the strategic shareholder. The shareholders’ agreement usually confers a strong operating role, and often management control, on the strategic shareholder. The agreement also spells out the development role and objectives of the company, to which the strategic shareholder then commits. Neither of these approaches addresses the needs of minority shareholders that come on board once the SOE lists. It is disappointing that the policy announced does not spell out more appropriate transitional governance arrangements for those SOEs that are shortly to go public. III. Corporate Control Structures It might have been thought that the reforms of the 1990s would see the end of traditional control structures that gave certain groups much more power than others. But the need to empower the black community made it necessary to use devices that would give it control in some areas though it lacked the finance and so some elements from the past were retained. The effects on corporate governance are not beneficial. Arrangements that magnify the power of a certain group of shareholders − control blocs, dispersed shareholding, control pyramids and differential voting shares − are well-known in the South African corporate sector. All these structures were pioneered by mining finance houses in their efforts to combine management control with limited commitment of own capital, and were subsequently adopted by many other South African firms. These techniques complement the use of equity to raise capital, as they counteract the one drawback of raising equity finance: dilution of the founder’s control. 2003 © CIPE and OECD

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In the 1990s, as foreign investors returned and the country’s capital markets modernised, companies that use these mechanisms were starting to face investor resistance. But support for these mechanisms came from an unexpected source: the new political climate, which stressed the need for rapid black economic empowerment, the process by which black investor groups gain control of listed firms. Among other things, black empowerment status was thought to put a company at an advantage in applying for state tenders or regulatory licenses. The black investor groups needed mechanisms that would enable them to achieve control despite a modest capital commitment. Back into vogue came N-shares, pyramid structures, and sometimes combinations of the two. These mechanisms were initially accepted by the investment community, and as this became apparent, there was a resurgence in the use of the mechanisms by other, non-empowerment, companies. They nevertheless distort the relationship between share in cash flow and share in voting power, thereby encouraging abuses of corporate governance and weakening the oversight of the capital market. How corporate control structures influence governance Control blocs and dispersed shareholding Partly due to the influence of the mining finance house, South Africa’s equities market was traditionally dominated by firms that answered to control blocs. Of the 20 largest firms by market capitalisation in 1989 − and accounting for 51 per cent of the market’s total capitalisation − 17 were controlled by shareholder blocs. Ten of the top twenty companies fell within one sphere of influence, the Anglo American/De Beers grouping. The 1990s have seen the deployment of market pressure to reduce actions taken to benefit dominant shareholders at the cost of minorities. This quiet revolution, while it has not eliminated all instances of abuse, has within a few years transformed the structures and strategies of the largest corporations in South Africa. By 1999, after heavy restructuring, only eleven of the top twenty companies were subject to control blocs. Where controlling blocs remain, minorities have to rely on legal rules governing conflict of interest. These rules were until recently underdeveloped in South Africa, despite the prevalence of the mining finance house and other control blocs. South Africa has recently seen strong growth in the category of firms with a dispersed shareholding. In 1989, only three of the top 20 listed companies by market capitalisation were widely held; by 1999, nine were. This reflects 182



not only the restructuring of the 1990s, but also the demutualisation of two life insurance companies, Old Mutual and Sanlam. During these listings shares were allocated to more than a million policyholders. In general the same situation and trends apply to the 700-odd companies below the top 20: control blocs continue to predominate − often founding families or groups of founders. The number of widely held companies may also be increasing, particularly among the top 100 firms. Control blocs and related-party transactions When controlling shareholders divert the firm’s wealth to their own pockets, their role in ensuring that the firm makes good on its obligations to other creditors and produces a surplus is compromised, and the firm is weakened. Related-party transactions are those between a public company and a group of powerful insiders, whether a bloc of controlling shareholders or management. While not all related-party transactions are harmful, abuse often occurs. The banking industry offers a ready example: the phrase “connected lending” refers to loans extended to banks’ owners or managers and their related businesses; if connected lending is rife, the political or personal interests of bank insiders may be allowed to impinge on lending decisions. A South African example of the use of control blocs, widespread until the 1990s, was the mining finance house described earlier. The house would often control a listed operating mine through a fairly small effective shareholding, and through its control monopolise certain lucrative supply services to the mine. In addition, the house would levy so-called management fees. To the extent that these were not commercial, minority shareholders in the operating mines were being disadvantaged to the benefit of the controlling house. While these arrangements have now been dismantled, other control-bloc situations, like family-controlled firms, remain. There are often attempts by insiders to perpetuate control even when their shareholding falls below 50 per cent. This can be achieved through the use of low-voting shares or pyramid structures, both of which have been features of the South African equity market during the 1990s. These artificially wrought control blocs have, in some cases, led to opportunistic self-dealing. Controlling blocs whose voting rights exceed their cash flow rights by a wide margin have had an incentive to diminish the firm’s profits in order to reap benefit where they have a greater share in the cash flow. It is possible that investments were made that maximise opportunities for “creaming off” rather than maximizing returns. They have also effectively shielded many South African firms from the market for corporate control, an important discipline on firms.


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While there is no evidence of systematic abuse by South African firms, it is important to remain vigilant. Foreign investors are sensitive to the possibility of such abuses in emerging markets, making it necessary for South Africa to have appropriate measures in place. If not, investors, domestic and foreign, may shy away from the market as a whole, penalising both good and bad firms. The first line of defence against control bloc abuse is voting rights reform. The aim of that is to minimise the number of control bloc situations, and to expose incumbents with less than a majority stake to the market for corporate control. The second line of defence, particularly important in the face of an entrenched controlling bloc, is legal rules governing conflict of interest. It is ironic that such rules remain underdeveloped in South Africa, given the important role of shareholder blocs in the recent past. Dispersed shareholding and management opportunism Classical corporate governance studies posit that dispersed shareholding may encourage management to act in its own, and not in shareholders’, interests. Because of the historical prevalence of control blocs in South Africa, there has been limited experience with dispersed shareholding situations. However, a number of firms with dispersed shareholding and no control bloc have emerged from the corporate restructuring of the 1990s. These include two of the large banks, the two demutualised life insurance companies, and (more recently) the two largest mining companies. One consequence may be a revitalisation of the annual general meeting. Voting rights are the principal mechanism of shareholder protection against management abuse. However, dispersed ownership can make concerted action against management difficult, as classic collective action problems occur. There are ways to address this problem. It is a policy priority in South Africa to ensure that dispersed shareholders can exercise their control over the company effectively. Disclosure requirements, proxy rules, agenda control and voting procedures are important. Most important, dispersed shareholders need some mechanism to aggregate their votes to enable meaningful intervention in the management approach of the firm. As the number of firms in South Africa with dispersed shareholdings increases, the country will have to develop its “aggregation mechanisms” such as the market for corporate control and the role of institutional investors. Control distortions: pyramid structures and N-shares Pyramid structures. Mining holding companies were among the first to use pyramids to raise equity capital without losing control of the operating 184



company. In recent years pyramid structures have mainly been used to allow a founding family to retain control despite no longer having a majority of shares. Pyramids effectively inure the controlled company against hostile takeover. According to the JSE a pyramid company has two characteristics. Firstly, the pyramid company can exercise 50 per cent or more of the total voting rights of the equity securities of a listed company. Secondly, the pyramid firm derives 75 per cent or more of its total attributable income before tax from the listed controlled company, or the shareholding in the controlled company represents 50 per cent or more of its total assets. The JSE allows the listing of first stage pyramids, but will not list any new second stage pyramid (a pyramid company on top of another pyramid). Existing second stage pyramids have been allowed to continue as listed entities. The number of pyramid companies listed on the JSE decreased drastically between the end of 1989 and the end of 1999. In 1989 seven percent of the companies listed on the JSE, or 53 companies, were pyramid companies; the market value of companies controlled by of pyramids that year was R44 billion, or nearly 12 per cent of the total JSE market value. By the end of 2000 only 16, or 3 per cent of the number of companies listed on the JSE, and only 6 per cent of market value, were pyramids. This trend reflects unbundling of conglomerates and the general disenchantment of investors with pyramid structures. N-shares. N-shares are a special class of share designed to have the same economic characteristics as a normal share, notably the same dividend and payout upon liquidation, but with low or no voting rights. They are listed on the JSE alongside the normal share, with N added on as a suffix. Until the early 1990s companies refrained from listing N-shares on the JSE, although they were not prohibited. During the early 1990s N-shares gained after being recognised as a black empowerment technique, although the first company to issue shares under the new dispensation was the mining house Anglovaal. New Africa Investments Limited (NAIL) was the first black empowerment company to issue N-shares. Subsequently many companies that are not black empowerment firms have used N-shares to entrench their power, enabling holdings of between 2 per cent and 36 per cent to have effective control. Market sentiment has turned against low-voting shares. The number of Nshares listed on the Johannesburg Stock Exchange fell to 14 from 26 at the end of 1996. Among the high-profile companies that have in response to shareholder pressure announced plans to convert N-shares into full voting stock are pioneers Anglovaal and NAIL. 2003 © CIPE and OECD

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The N-share discount. N-shares usually trade at a discount to the price of the ordinary share. This reflects the lower voting power as well as uncertainty as to whether N-shares enjoy the same minority protection status as ordinary shares in take-over situations. Surprisingly, given market antipathy to Nshares structures, the average N-share discount has reduced over time, from 16 per cent in December 1996 to 10 per cent in March 2000. This may reflect recent market expectations that many of the N-shares will be converted to ordinary shares. Another view is that the market depresses the value of both ordinary and N-shares of companies with differential voting shares. There is anecdotal evidence to this effect, as well as a plausible rationale: such companies have taken themselves out of the market for corporate control and, further, the protection against take-over breeds management complacency. Given how widespread control blocs, pyramids and differential-voting shares are in South Africa, and the array of business heavyweights that represent companies with these distortions, it was unlikely that remedies would be put in place any time soon. Surprisingly, that is what has happened in recent months. IV. Mechanisms to Improve Corporate Governance Recent years have seen a series of major initiatives to reform corporate governance, some the result of outside pressures, some driven from the inside. Exposed to outside competition and interest, enterprises had to abandon traditional practices and conform to more widely-recognised standards. The process is not complete and institutional investors need to be more closely involved. Along with the dramatic political developments of the 1990s came a brace of other changes that transformed the commercial environment, resulting in poor performances by the corporate stalwarts: •

In 1996, South Africa entered the World Trade Organisation, and the subsequent tariff reform hit profits in hitherto protected industries.

•

The new political dispensation encouraged the entry of foreign players into markets with historically fat margins, increasing the level of competition.

•

The 1990s saw an intensification of the long-run down-trend in commodity prices, hurting the traditional mining sector. In particular, the gold industry was caught in a vice of rising costs and falling gold prices as the metal lost its status as a financial store of value: during the 1990s the gold sector’s proportion of the value of the JSE declined from 17 to 4 per cent.

•

Due to a range of factors, the most attractive growth and margins were found in the non-traded services sector, with media, financial and information technology services sectors achieving impressive returns and

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a strong investor following. As corporate performance waned, market and institutional forces alike sharpened focus on the management and governance of listed companies. The result: during the latter part of the 1990s there has been a spate of measures to improve corporate governance. Important events include: a)

Perhaps most forcefully, market pressures, brought to bear on the mining finance houses in particular;

b)

a new role for institutional investors;

c)

an experiment in voluntary compliance (the King Code);

d)

tighter listings requirements by the JSE as the self-regulator of the equities market;

e)

an important accounting-standards innovation in disclosure aimed at exposing conflicts of interest; and

f)

successful legal reform (the Insider Trading Act).

Intriguing about this list is the diversity of actors, and the complementary nature of many of the contributions. We consider them in turn. a) Market pressure: the end of the mining finance house Once foreign financial institutions had returned to South African markets, they did not like what they saw. The lack of specialization, the complex and opaque shareholding structures, the conflicts of interest inherent in control blocs, the poor systems of governance − factors such as these meant they were soon openly critical of the returns and management practices of the mining finance houses. At the same time, local institutions were shifting portfolios to the technology sector and to foreign bourses. These investors demanded a sharp improvement in corporate structures and governance. The institutions, foreign and domestic, became the buyers and sellers at the margin on the JSE, and so exerted considerable influence on price levels. Mining finance houses, families and other control blocs – having a large part of their wealth in equity − were sensitive to falling share-prices. This was also true of senior managers who by the early 1990s were widely incentivised through shareoption schemes. The pressure for change from shareholders focused on two related issues: poor returns on capital invested, and the mining-finance-house discount. Poor returns on capital invested. Senior mining executives acknowledge 2003 © CIPE and OECD

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that poor corporate governance and management played a role. As a top executive in the industry pointed out: “Capital was appallingly misapplied. Real returns of 7 per cent were considered acceptable, while the norm abroad was 15 per cent or higher, depending on the risk of the project. Risks were perceived to be low, but in fact they were not.” Another industry leader pointed to the lack of capital markets discipline in the capital-rich houses: “There was little sense of key measures of capital efficiency such as return on assets and return on equity. The companies were technically strong, but financially and commercially in the stone-age.” The mining finance house discount. The most direct cause of restructuring was the discount of the value of mining finance houses relative to the market value of the underlying assets (in the mining house model, many of the assets of the mining house are also listed, and hence given a transparent market value). By the early 1990s the valuation of mining finance houses implied a significant discount, usually between 5 and 20 per cent and therefore in the billions of rand, relative to the value of assets. This was a simple and compelling indictment: it implied that investors considered that the house would not wisely invest the dividend flows and/or capital values of their assets. The discount also gave investors an easy rationale for encouraging restructuring: unbundling of the underlying assets, for example, would at once release the amount of the discount to investors. By removing the house as a control bloc, governance problems such as relatedparty transactions would also be eliminated from the firms being unbundled. Also, now that structural changes in the economy had reduced the appeal of many conglomerate holdings, international and focused expansion became a more compelling strategy. Unbundling tallied with this change in approach. The mining finance house restructures. As the 1990s unfolded, South Africa’s mining sector restructured. No traditional mining finance house remains. The industry is now home to diverse types of firms with diverse strategies: small mines dedicated to high-productivity exploitation of marginal ore; single-commodity companies mining long-life high-yielding deposits; mining venture-capitalists and global mining concerns. Mining services and supplies, once internally provided by the mining finance house, are now commonly outsourced to a wide range of independent firms. The elements of the restructuring were usually: •

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Unbundling. Mining houses reduced − in some cases sharply − the diversity of their investments. The discount at which many of the conglomerates were trading meant that shareholders would receive an immediate increase in value upon distribution of shares in the underlying holdings. Billiton, then known as Gencor, divested itself of its paper, oil 2003 © CIPE and OECD


and consumer interests through an unbundling process. The most recent mining house unbundling, of Anglovaal, is an interesting example of market pressure at work. The market threatened to withdraw support for the company until the founding families, ensconced in an elaborate control structure, relinquished control. This has duly been announced, and the mining, consumer good and engineering divisions unbundled into three focused listed entities. •

Full ownership of operating companies. The traditional mining houses turned into holding companies − Billiton, Anglo American, Gold Fields − with 100 per cent ownership of their operating entities. As a result, the number of listed mining companies on the JSE fell from 45 in 1992 to 14 in 1999. The buying out of minority interests eliminated the discount, avoided the usual ‘control bloc’ conflicts of interest and made it easier to direct cash to new opportunities without incurring company tax.

•

Outsourcing and lean corporate organisation. A combination of outsourcing and decentralisation slashed head office functions and staff of these holding companies. Billiton, for example, spun off its technical division.

•

Down-sizing and portfolio shifts. Operations, particularly in gold, downsized, following the realisation that the price levels seen in the 1980s were not going to reappear. The large mining groups closed unprofitable shafts and sold off marginal shafts better operated by smaller companies. Within many operations, a high-grading strategy was followed, with mines refraining from mining unprofitable areas.

The pioneer of mining house restructuring, Gencor/Billiton, provides the classic example of these processes. It is explained in Annex 2. b) Institutional investors assume a more active governance role South Africa’s insurance, pension fund and mutual fund sectors are, relative to the size of the economy, among the largest in the developing world. Such institutions exist, among other reasons, to exploit the enormous economies of scale of the investment process, including the analysis, selection and monitoring of investments. Institutions are a neat solution to the collective action problem that undermines the monitoring of companies by individual investors. However, institutional involvement in corporate governance has been slow to come to the fore in South Africa, and in some quarters there is antipathy to the idea. For example, the King committee adopted a surprisingly sceptical stance to the role of institutional investors, pointing to possible insider trading problems and suggesting that institutions may be reluctant to co-operate with one another. The committee concluded that institutions would have to 2003 © CIPE and OECD

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approach any role in this respect “with the agility of a trapeze artist.” Institutions, too, have been reticent. This may in part reflect an unwillingness on their part to be seen to assume a powerful role in South African corporate life. Such a profile may bring with it government attention and possible obligations, in a country where the notion of prescribing investments for institutions remains popular with some politicians. Hence the unwillingness among South African institutions thus far to form an investor protection council of the kind now operating in the United States and Britain. The sceptics’ views may be based on a misunderstanding, and may profit from investigating the role of large institutional investors and the investment councils abroad. Their model is not to become controlling shareholders, directing the affairs of the company from a privileged position on a board. The idea is not for the institutions to become directly involved in the governance of the firms they have invested in, it is for institutions to monitor and assess the governance of the company, and to enforce good governance with the mechanisms shareholders have at their disposal. There are signs of a tentative shift to this model in South Africa. One sign is the views of the JSE, as expressed in their proposed new principles of governance, three of which deal with the role of institutions: 1.

Companies should be ready, where practicable, to enter into a dialogue with institutional shareholders based on the mutual understanding of objectives.

2.

Institutional shareholders have responsibility to make considered use of their votes.

3.

When evaluating a company’s governance arrangements, particularly those relating to board structure and composition, institutional shareholders should give due weight to all relevant factors drawn to their attention and to eliminate unnecessary variations in criteria which each applies to the corporate governance arrangements and performance of the companies in which they invest.

The three principles read like an invitation to the institutions to assume the more activist role of their counterparts in the US and Britain. c) Voluntary standards: the King Code on Corporate Governance The main effort in South Africa at using voluntary compliance with a publicly defined standard of good corporate governance has been the King Code on Corporate Governance, one of the earliest such efforts in an emerging economy. The Code, released in November 1994, and updated in 2002, was the product of a committee convened by the Institute of Directors following 190



Institutions as Guardians of Good Corporate Governance: The NAIL affair The so-called NAIL affair is a recent and important example where shareholder pressure, fanned by the institutions, succeeded in scuttling a breach of good corporate governance. Buried in the agenda for the 1999 annual general meeting of New Africa Investments Ltd (NAIL) was a resolution that would have transferred, at no cost, assets with an estimated current value of R100 million to four executive directors. The campaign against the measure was an intricate dance in which the law played a role by virtue of requiring shareholder permission in the first place, institutions provided information and exerted pressure on the company, and the media played an important part by bringing the issue to the public’s attention. Ultimately the proposed resolution was withdrawn, and two of the four directors resigned. These events provide a powerful example of how institutions (and the media) can be a force for good governance. This precedent is likely to be followed when similar issues arise in future. the publication of the Cadbury Report in Britain. The committee was chaired by Mervyn King, a lawyer, and businessman. The committee and its work subsequently gained the support of a number of business associations, as well as of the Johannesburg Stock Exchange. The committee was given an almost impossibly wide brief, but its key output was to be a Code of Corporate Practices and Conduct. The committee was instructed to ‘‘have regard to the special circumstances existing in South Africa, more particularly the entrance into the business community of members of disadvantaged communities.” It also assigned a task group to consider “stakeholders and stakeholder communications.” The “director task group” considered “the responsibilities of executive and non-executive directors, and the frequency, substance and form of information to shareholders.” The task group focused on disclosure, ‘in recognition of the fact that by and large South Africa’s philosophy of regulation of companies, in keeping with that of the Anglo-American tradition, is by means of disclosure’. This philosophy is reflected throughout the report, and is encapsulated in the following statement: “While it is of the utmost importance that companies operate from a base of integrity, we believe that the focus must be on a participative entrepreneurial approach rather than a dominant one. Likewise, the participation process must not become so dominant that it stifles or obstructs the notion of business risk for reward in a free enterprise system.” 2003 © CIPE and OECD

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The committee for the 1994 Code extensively used the Cadbury Report as a guide for its work, using the same structure for its report. The approach seems to have been as follows. A task group would consider what the governance ideal was, mostly with reference to the Cadbury Code. Then it would, as instructed, consider whether there were “special circumstances prevailing in South Africa” that necessitated a deviation from this approach. For example, the report agrees with Cadbury that the splitting of the roles of chief executive and chairman “is undoubtedly correct in principle,” but then goes on to say, “There are, however, many circumstances in South Africa where the positions of chair and chief executive are combined in the same individual, due to force of circumstances. There are, for example, ‘family companies’ in South Africa, many of which are listed on the Johannesburg Stock Exchange.” Another example arises with the issue of ensuring the independence of nonexecutive directors. Cadbury recommends that there be a minimum of three independent non-executive directors ‘of sufficient calibre to bring independent judgment to bear’. This is again supported in principle, after which the report notes: “In South Africa the question arises as to whether there is a sufficient pool of trained and experienced people available to serve as independent non-executive directors. Also as a result of this limited pool of skilled people, conflicts of interest often arise. “There are large conglomerates in South Africa with diverse investments and it is sometimes in the interests of shareholders that senior directors of major subsidiaries should serve on the main board of the holding company. The skills shortage has also resulted in retired executive directors continuing to serve on boards as non-executive directors.” Focus on the shareholder/management divide. The Cadbury code aimed at ensuring proper oversight by dispersed shareholders over the management of the company, focusing on disclosure to shareholders and the functioning of the board. In contrast, in the past, and to a large extent still today, the corporate governance problems in South Africa arise within control bloc situations. The conduct of mining finance houses is one example. As in other emerging markets, it is a priority in South Africa to ensure that control blocs do not abuse their positions, ultimately to the detriment of other providers of capital, such as minority shareholders. Here disclosure, conflict-of-interest rules and the certain aspects of shareholders’ meetings are more important. The board has a less important, but not negligible, role. In following the Cadbury approach so closely, the 1994 King committee neglected the control situations that predominate in South Africa, and the governance concerns that arise from them. The Code was silent on the conflicts that arise in a control situation, and is likewise silent on conflict of interest rules. The committee’s decision not to insist on truly independent nonexecutive directors was, in this context, a blow. As a consequence, there has 192



regrettably been little public debate about the benefit of corporate governance solutions for these situations. Once exception to this, in the area of accounting standards and dealing with related-party transactions, is discussed below. Focus on the board information and operation. The 1994 King Code successfully focused attention on the need for proper board composition, information provision, monitoring and participation in decision-making. The report and its appendices contain useful discussions on the role and functioning of the board, and in particular the audit and remuneration committees. These sections of the report have been influential, and the committee performed a valuable service in drawing attention to these issues. The Code required that audit and remuneration committees be established, and specifies a prominent (but not necessarily majority) role for non-executive directors on these committees. The appointment and independence of non-executive directors. However, the Code’s good work on the role of specialist committees was not matched by an equivalent rigour with respect to the appointment and independence of the non-executive directors who play a key role in these pivotal areas. The two major deviations from the Cadbury Code were here: the requirement that nonexecutive directors be independent of management was abandoned, and the requirement that the chairman be non-executive is watered down. In addition, there was no mention in the Code of the nomination process for new directors, or the need for or the procedure of a nominating committee. This brings into question those board functions where independence from management is important. In conclusion, the King committee’s approach in 1994 was not powerful enough to address problems in either the management supervision or the control bloc contexts. The effect of the 1994 Code. The Code was remarkably successful in raising public consciousness about corporate governance. It is not clear that it has been widely implemented in practice. While, there has not been a study of the extent of implementation, the market impression is that, even among listed companies, full compliance remains the exception. The slow adoption of the Code in practice may have been the result of its extensive nongovernance content, which consists of a series of wide-ranging but somewhat vague stipulations on communication to stakeholders, worker participation, affirmative action, and a code of ethics. King Report II. The King Committee published for comment a second report (“King Report II”) which reviews the first report in the light of subsequent events and proposes a revised Code of Corporate Practices and Conduct. Philip Armstrong, the 2003 © CIPE and OECD

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Secretary of the King Committee, summarised the changes as follows: “King Report II has far-reaching implications for South African listed companies (as well as public sector corporations and agencies and the financial and banking sectors). The final version of King Report II is expected to come into force early in 2002 and will apply to listed companies whose financial years start on or after 1 March 2002. Already, it has been observed that a number of companies are already structuring themselves to accommodate these new requirements as soon as possible. Boards, directors and senior management/ executives will find that the much more detailed guidelines will increasingly test their conduct and accountability for performance and behaviour.” •

King II introduces much more rigorous tests of independence for nonexecutive directors, especially in relation to the constitution of board committees and around issues of delegation of authority, while calling for full disclosure of any form of remuneration enjoyed by directors on an individual basis in support of the requirements of the JSE which were to come into force from 1 March 2002.

•

King II recommends that boards should perform a self-evaluation on an annual basis, evaluating the board, each director individually, and all board committees.

•

King II strongly advocates the separation of the roles of chairman and chief executive officer. Where this is not possible, this should be justified annually by the board and any combination of these two functions should be countered by the presence of a strong, lead independent non-executive director in the position of deputy chairman.

•

Much more stringent disclosure requirements are called for generally, but specifically in regard to activities and functions of board committees, reelection of directors, resolutions proposed at shareholder meetings, and in respect of management of risks and internal controls.

•

King II emphasises that the board, collectively, and directors, individually, are ultimately responsible for risk management and that full annual disclosure must be provided as to the steps taken by the board to obtain the necessary assurances as to identified operational and financial risks.

•

The importance of an independent, objective internal audit function is reiterated with guidelines while the role of the audit committee is emphasised, with particular attention paid to issues such as going concern assessments, non-audit services, membership and structure of the audit committee itself, etc.

•

King II looks at strategic non-financial issues for South African companies, taking into account international developments around the so-called “Triple Bottom Line” approach taking into account a range of economic,

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social and environmental issues relevant to South African companies. These are blended with a number of specifically South African priorities, such as HIV/AIDS, black economic empowerment, gender and ethnic mix on boards of directors, human capital development and others. •

In King II, 24 recommendations are given around issues of compliance and enforcement ranging from changes to the Companies Act through to a more active participation by institutional investors in the governance of South African companies.

•

The Code contained in King Report II is intended to remain self-regulatory in nature.

d) New JSE listing requirements The JSE has reacted swiftly to the twin blows of the departure of the primary listings of South Africa’s largest companies to London and the collapse of the initial public offering market noted earlier. It has made extensive changes to its listing requirements, with corporate governance receiving much attention: •

Structures that distort voting power are no longer accepted. Pyramid companies and companies with differential voting shares will no longer be allowed to list on the JSE. (However, pyramid companies and low-voting shares that are already listed will be allowed to retain their listing.)

•

Move to more stringent accounting standards compatible with IAS. First, listed companies will henceforth be required to adhere to Generally Accepted Accounting Practice as defined by the South African Institute of Chartered Accountants, which amounts to, or exceeds, the International Accounting Standards (firms may also elect to adhere directly to IAS). Previously, firms only had to adhere only to what was generally practised, a lower and more slowly changing accounting standard.

•

Governance disclosure requirements. Improvements have been made to disclosure on corporate governance, with disclosure of the following now required: i. Information pertaining to directors’ qualifications and probity. Prior to listing, companies will be required to submit a declaration by each director, which is designed to evaluate the qualifications, experience and integrity of the directors. The information required is extensive, including other directorships, any liquidations or special creditor arrangements with any of these companies, convictions in relation to indictable offences, public rebukes of the person by regulatory or professional bodies, and whether the person has ever been disqualified by a court from acting as a director. In addition, companies will be required to update and disclose similar information on a regular basis.


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ii. A summary of the directors’ powers and responsibilities with respect to self-dealing. Specifically, the company has to disclose the rules governing the ability of directors to vote on proposals or arrangements in which they are materially interested, including (but not limited to) remuneration, credit extension to directors and retirement arrangements for directors. iii. A statement of all interests per director, direct and indirect, in the share capital of the company. The disclosure will distinguish between beneficial and non-beneficial interests. iv. A statement, per director, of all forms of remuneration. This needs to be disclosed in detail annually, specifying all material benefits received from the company, including fees, salary, bonuses, expense allowances, pension contributions, commission or profit-share and share-options. v. All dealings by directors in the securities of the company. The purpose of this provision is to limit insider trading, and to make the dealings of directors in the securities of companies in of which they are directors more transparent. vi. A directors’ statement on the extent of compliance with the King Code. Directors will be required to issue a statement commenting on the extent of the company’s compliance with the King Code. Compliance with the Code remains voluntary. vii. Further, a general obligation of disclosure has been created – of “events or circumstances that has or is likely to have a material effect on the financial results, financial position or cash flow of the issuer”, “information necessary to avoid the creation of a false market in its listed securities” and “developments in its sphere of activities that is not public knowledge and that may lead to material movements in the share price”. viii. Substantive governance recommendations. The further innovation in the new JSE listing requirements is a further set of corporate governance principles for all listed companies. This new set of principles goes beyond the recommendations of the King Code and seems likely to become more important in practice. Yet, like the King Code, it is not compulsory, and firms are required only to disclose their level of compliance. But the value of the new principles lies in their emphasis on aspects not adequately covered in the King Code, including for the first time, a requirement concerning the independence of non-executive directors. It is expected that the King II Code will ultimately replace this set of principles.

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Important innovations are: •

The board should have a formal schedule of matters specifically reserved to it for decision, and should record its conclusions in discharging its duties and responsibilities.

•

Directors should receive appropriate training upon joining the board.

•

Directors should receive further briefing from time to time particularly on relevant new laws and regulations and changing commercial risks.

•

The majority of non-executive directors should be independent of management and free from any business or other relationship which could materially interfere with the exercise of their independent judgment.

•

Directors should have unrestricted access to all company information, records, documents and property.

•

Remuneration of executive directors, both at the level of policy and individual packages, should be set by a remuneration committee comprising a majority of non-executive directors.

•

No director should be involved in fixing his or her own remuneration.

•

The directors should, at least annually, conduct a review of the effectiveness of the group’s system of internal control and should report their findings to shareholders.

•

A mandatory audit committee made up of a majority of non-executive directors and chaired by one of them, with written terms of reference.

The main elements and guidelines of the new JSE set of governance principles are in Annex 3. The definition of independent directors merits further discussion. The principles insist that the majority of non-executive directors be independent of management and, more vaguely, of other business relationships which could materially interfere with the exercise of their independent judgment. To be truly independent, these directors − a minority on the board − also need to be independent of the controlling shareholders or control bloc. Such a requirement is not spelt out, and if it were, would elicit resistance from the many family and founder-controlled firms on the JSE. Given the concerns about control bloc abuse, it is necessary that at least a minority of directors be independent both of management and the controlling shareholders.


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e) Accounting Standards: a breakthrough on related-party transactions Related-party transactions are a common feature of business. Enterprises often carry on different parts of their business through separate subsidiaries, which may have different shareholders as is the case in joint ventures. Related-party transactions are less innocuous when they are transactions of substantially different entities (with different shareholder profiles) that would not have been entered into between unrelated parties, or would have been entered into at a different price. These are cases of self-dealing, the most important corporate governance problem where shareholder blocs exercise effective control. The major South African instruments dealing with governance − the Companies Act, the King Code on corporate governance and the new listings requirements of the JSE − neglect the problems caused by related-party transactions other than those where directors are involved. The South African Institute of Chartered Accountants − the guardian of what constitutes Generally Accepted Accounting Practice in South Africa − addressed the issue in 1999 by issuing a new addition to GAAP (Accounting Statement 126) that will require disclosure of related-party transactions. The essence of the rule is to require disclosure of transactions, including amounts and descriptions of the transaction that have occurred between related parties. Parties are considered related where “One party has the ability to control the other party or exercise significant influence over the other party in making financial and operational decisions.” The definition of related parties is further expanded to include individuals who have significant influence over either enterprise, their close family members and interests, as well as key management personnel, their close families, and interests. In addition, related-party relationships where control exists are to be disclosed irrespective of whether or not there has been a transaction. Even with the new listings requirements of the JSE in place, the statement potentially provides the strongest weapon against the abuse of control bloc situations in South Africa. Yet there are some concerns about implementation: •

Auditors are struggling to define and monitor related-party transactions, particularly in complex groups. The statement’s application and effects are untested. In some firms management information systems will need to be upgraded to produce the data required to comply with the statement.

•

Disclosure is after the fact.

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One way to buttress this arrangement is to provide a role for the board, or a board committee, to assess large-scale related-party transactions before they are finalized. While such a requirement falls outside of the scope of the accounting profession, it can conceivably form part of the JSE listing requirements or, alternatively, of companies legislation. The accounting statement is based on International Accounting Standard (IAS) 24, and attests to the persuasive power within professional communities of international norms. The South African version has been expanded beyond IAS 24 to include related-party transactions with jointly controlled entities, and to include related-party transactions where both parties are controlled by the state. f) Legislation The 1998 Insider Trading Act When insider trading is committed by a director, senior executive or bloc shareholder with privileged access to non-public, price-sensitive information, it falls within the realm of corporate governance. It is a particular type of related-party transaction in which shareholders are disadvantaged to the private benefit of the insider. The media and other market observers have long considered insider trading to occur regularly on emerging markets exchanges such as the JSE. There is little direct evidence for this, but run-ups in share-prices ahead of announcements have occurred on the JSE, particularly in smaller equities. High perceived levels of insider trading in a market or a corporation are often taken to be a sign of other, perhaps hidden, problems, such as related-party transactions generally, abuse of minorities, and perhaps even share-price manipulation.10 On the JSE minority investors have periodically withdrawn from companies − and categories of companies − where insider trading is reputed to be rife. Based on preliminary results, South Africa’s Insider Trading Act, passed in 1998, is an example of successful insider-trading legislation despite limited prosecutorial resources. In the first six months of operation the Insider Trading Directorate achieved six settlements (“settlements” play an important role), and in the following three months it proceeded with two further civil suits and one criminal prosecution. The market reaction has been striking. In six cases the identity of the person involved was disclosed, and extensive media coverage followed. In the cases where the person involved was a senior executive, company share prices fell by 8 to 20 per cent within a week. In one case a company was forced by its falling share price had to abandon its takeover strategy and was ultimately acquired by another company. In another case the managing director was implicated and ultimately dismissed. 2003 © CIPE and OECD

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Why the strong market reaction? An insider-trading settlement or prosecution involving a senior executive is probably taken by investors to be a signal of poor corporate governance. The companies involved in these actions were small or medium caps, and the adverse investor response seems to have affected this part of the market more broadly. Along with the market reaction has come a palpable change in sentiment: previously many investors did not consider insider trading as odious; now not only institutional investors, but also retail investors and corporate managers, consider it unacceptable to trade on inside information. Why these early signs of success? Insider trading legislation around the world is fairly standards, and in many respects the South African law is in line with that of its peers. But the legislation does contain three innovations: •

The Act provides, beside the usual criminal liability for insider trading offences, for civil liability, which has a lower burden of proof. The criminal burden of proof has often proven almost insuperable.

•

Possible offences are investigated by the Insider Trading Directorate, which can offer to withdraw further litigation in return for a payment. These “settlements” are announced in the media, usually naming both the company and individual involved. These settlements have had a dramatic effect on the share-prices of firms involved and reportedly also on market attitudes to insider trading. In the absence of a settlement the Directorate can pursue either a criminal prosecution or a civil suit, depending on the facts and evidence of the case.

•

Settlements and other damages are deposits in a fund to be distributed to shareholders who had traded in the share during the period of the offence and had suffered losses as a result of it.

Directors’ Liability Business corporations in South Africa have legal personality and are bound by criminal and civil law, including a common-law duty of care towards employees. Corporations are held criminally liable for crimes committed by their employees or agents on corporate instructions or with corporate permission. In other words, shareholders indirectly suffer financial loss when the firm has incurred either a civil or criminal liability. But this situation is not fully satisfactory, because neither shareholders nor their directors suffer direct financial damage and, unless they were personally involved, they cannot go to jail. When the critical conversations or instructions have not been recorded, it is difficult to prove the direct involvement of key individuals.

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•

Corporate accountability in health, safety and the environment. In recent years South African legislation has attempted to sharpen corporate accountability for corporate actions by declaring certain corporate or workplace misconduct or negligence to be criminal offences. Important examples are in mining safety (in the Mine Health and Safety Act of 1996) and environmental degradation (in the National Environmental Management Act of 1998). Either responsible officials (the Acts require that all corporations nominate these) or the company itself can be found guilty of a crime. Responsible officials − who are employees and can be, but do not have to be, directors − face a fine or a prison sentence; if the company is found guilty of a crime, it can be fined. While these provisions have caused little litigation, they have had reportedly had a major effect on the attitudes of corporate leadership to health and safety issues.

•

Limits to director criminal liability for corporate crimes. Until recently, when a company was found guilty of an offence, its directors were also deemed guilty of the offence as individuals. Directors in this position were personally liable for punishment unless they could prove that they did not take part in the contravention and could not have prevented it. This is a difficult onus, and in 1997 South Africa’s Constitutional Court declared the section (which had become law in 1977) invalid, as it violated the constitutional right to presumption of innocence. More recently, the National Environmental Management Act used a similar provision to create criminal liability for directors in the case of the company having been guilty of environmental degradations declared to be criminal in the Act. This provision has not yet been tested for constitutionality. While these type of provisions are potentially important, they have rarely, if ever − not even while there was no cloud of unconstitutionality hanging over them − been used.

•

Director civil liability for reckless corporate trading. When a company has traded recklessly or fraudulently, a court may declare that a director (or any other person) who was knowingly a party to these activities is personally liable for all or any debts or liabilities of the company as the court decides. This provision, unlike the two previous issues, has been the subject of litigation a number of times.

V. Black Empowerment and Corporate Governance How to ensure a more equitable distribution of power, wealth and influence to the Black community in South Africa following the collapse of apartheid and the arrival of democracy, when the Black community starts from so disadvantaged a position and a radical transfer of resources is ruled out? Partly by financial engineering techniques, partly by action by firms themselves. But the pace has faltered in recent years and black empowerment has sometimes had a negative effect on the quality of corporate governance.


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Following the arrival of democracy in 1994, it has been an objective of society to shift the racial distribution of income, wealth and economic power in South Africa. Labour, licensing, procurement and civil service policies all reflect this objective. “Black economic empowerment” (BEE) has been an important element of this effort. The notion refers mainly to transactions that increase black ownership and control of private businesses. These efforts at economic redress occurred against a backdrop of the ANC government’s having accepted market economics and much else besides, including the role of the established “white” companies, property ownership, shares and other financial claims and contractual rights generally. Government’s embrace of capitalism created a political imperative for black capitalists and black corporate success. And, for a dazzling period in the mid-1990s, the market delivered rapid and significant increases in black corporate ownership and control. Within 52 months, companies which blacks “control or have significant influence over” went from 1 per cent of JSE market capitalisation to 16.3 per cent. Landmark deals − involving two medium-sized life insurers, large English and Afrikaans language media houses, a large IT concern, the number two national mobile telephony firm and a venerable mining house − created a slew of leading black-controlled companies and resulted in the emergence of a small number of senior black business leaders. The deals were driven by two forces. The first was financial engineering techniques that enabled black organisations and investors to take strategic and often controlling stakes in listed entities without supplying any of their own funds. The second force was the need for many established firms to position themselves favourably in the eyes of government. South African direct government expenditure exceeds a quarter of GDP; state-owned enterprises control an asset base of more than 12 per cent of GDP; and government regulation and licensing are pivotal to commercial success in numerous industries, including finance, telecommunications, broadcast media, mining, fishing and beverages. The early successes, though remarkable, fell far short of South Africa’s demography. It did, however, enable observers, in and out of government, to postulate further rapid increases in black economic power. But this did not happen. In fact, black control of the JSE fell in 1999 and has not recovered. This reversal is due in large part to the vulnerability of the techniques used in the face of the prolonged market downturn of the late 1990s. The techniques have also had important consequences for corporate governance. The financial engineering behind black empowerment The main challenge of empowerment has often been described as creating capitalists without capital.

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The financing stratagem. An empowerment transaction would typically involve four economic entities: i) a black investment group (often not incorporated); ii) an established company in which the investment is to be made; iii) a financial institution to proved funds; and iv) a “vehicle” company. The empowerment process would start with the established company whose parent, or own directors, have made a strategic choice to become a part of the process. The black empowerment group, consisting of prominent individuals or groups (such as unions), would be identified to make a strategic or controlling investment, and shares in the established company would be offered to it at a discount, typically of 10-20 per cent of market value. The discount was critical to the financing structure. In the conventional and early incarnation of the process, the empowerment group would not put up any money or assume any risk or debt. Funds would be provided by the financial institution, such as a bank or an insurer, as a portfolio investment. The funder would lend the funds to a “vehicle” company created by the empowerment group to house its investment (the loan would usually be in the form of variable-rate “interest-bearing” preference shares, repayable after 3-5 years, for tax reasons). The funder would also take some non-voting equity in this vehicle company. Much of the equity, and all voting equity, would be issued to the empowerment group at no cost. The economic effect of this transaction was quite simple. If, as was invariably assumed, the shares of the listed company increased in value beyond some threshold, the increase in value would be shared by the black empowerment group and the funder, often on a roughly 50-50 basis. In other words, the black empowerment group, which had no capital at stake or repayment risk, received the equivalent of a free option in the shares of the listed company. The funder, on the other hand, faced real credit risk, with no recourse to the empowerment group, if the shares in the listed company did not perform as anticipated. Listed empowerment vehicles. The most prominent empowerment companies went on to a second stage, during which either the black investor group or the investment vehicle was listed on the JSE. This enabled the now listed empowerment firm to raise capital, enabling it to also do deals to which it had to commit its own capital. To retain the profile of an empowerment company, the empowerment vehicles had to ensure that the original black investors retained control upon listing, despite the dilution of their shareholding. This was often effected by issuing non-voting shares to the public or by putting in place a pyramid structure, or both. The effect of the emerging markets turmoil on empowerment. The vulnerability of this structure to financial stress was duly revealed by the market turmoil of 1998. All the action happened in the balance sheet of the investment vehicle. During that year, as the emerging-markets crisis spread to South Africa, prices 2003 © CIPE and OECD

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of the shares of listed companies plummeted, and have in many cases never fully recovered. At the same time, short-term interest rates shot to the highest levels since World War II as the South African Reserve Bank tried to stabilize the currency. This combination, by increasing the debt liabilities of the investment vehicle while simultaneously decimating the value of its only asset, reduced the equity value of the investment vehicle to zero, often pushing it to the brink of bankruptcy. In many cases the empowerment groupings were left unscathed, but with no upside. And the funders were faced with an invidious choice: either be seen to undermine and unravel empowerment efforts, or continue to fund an investment that made no commercial sense. Most of the agreements stipulated that upon default by the vehicle company, the shares in the company originally invested in would be transferred to the funder to allow it to recoup it losses, but also removing the original empowerment effect. Not all the empowerment transactions have failed. Notably one black media and telecommunications group, Johnnic, has succeeded on the back of the strong share performance of its mobile telephone unit. But the pace has slowed. Overall, fewer empowerment transactions are now done than in the mid-1990s, black control of JSE market capitalisation has not increased beyond it previous peak, and the objectives and techniques of empowerment are being reassessed. Empowerment structures and corporate governance A factor that has contributed to market disenchantment with BEE Mark I has been the ambiguous and sometimes negative effect of these structures on the quality of corporate governance. It is important that this should be seen in the context of a long history of weak governance among South African corporates. Black empowerment companies happened to come along at the time that the market was becoming more sensitive to governance abuse generally. But the conventional empowerment structures did pose some particular problems. Recall the four entities typically involved in an empowerment transaction. Although corporate governance is important in all of these, the focus of the market has been on the effect of empowerment transactions on the governance and management of entity ii, the operating company ultimately invested in. That company tends to be by far the largest, has business operations and an asset base that need to be actively managed, and is usually listed, with a large institutional minority shareholder base. Another focus has been on the governance of those empowerment groupings that have themselves listed. Three governance issues have come to the fore in empowerment: The financing mechanism leads to a separation of risk and control. One criticism of the conventional structure is that control is captured by a group, the empowerment investors, with skewed incentives: the group shares in the 204



upside above a given threshold, but has no risk on the downside. This may make it rational for the group to undertake very risky ventures in those cases where the investment’s value has fallen below the threshold, and therefore has a zero value for them. Shareholder democracy is intended to work differently, and to lead to a risk-adjusted maximization of the value of the firm. However, compelling as this concern is in theory, it is not clear that it has been a problem in practice. One very high-profile case, involving a mining house, may be construed as a such a gamble for redemption. But in may cases the empowerment bloc did not gain control; and where they did, their behaviour may have been circumscribed by funders, who are aware of the problem created by skewed incentives. Generally, empowerment blocs have been too little involved in corporate decisions, rather than too much. Empowerment groupings have an incentive to diversify holdings and relinquish focus. Because the empowerment group is not investing its own capital, each investment is in effect a free option on the shares of an operating company. It is perfectly rational for the group to collect as many of these free options, in as diverse a set of industries, as possible, in the hope that a number will come off. This trend led to a loss of focus by many empowerment groups, and reduced their ability to contribute to corporate decision-making in any particular investment, or to monitor effectively the managements of the operations they had invested in. Ironically, the broader-based, and therefore more attractive, the empowerment group, the less likely they were to participate actively in the governance of the operating company. Empowerment has contributed to the revival of N-share and pyramid control structures. As empowerment firms graduated from the no-capital approach and listed on the JSE to raise their own capital, they were caught in a dilemma. In order for the original empowerment bloc to retain control, and therefore the all-important name of a “black” company, it raised capital by issuing novoting shares (N-shares) or retained control through a pyramid structure. These abnegations of shareholder power were fixtures of the JSE in the past, and the tide, driven by international investor sentiment, was turning against them. According to folk wisdom, in the mid-1990s the Exchange was about to outlaw new N-share issues when their adoption by empowerment groups buried the issue. As empowerment deals gave pyramids and N-shares newfound respectability, their use among non-empowerment groups picked up markedly. The road ahead for empowerment acceleration Political power, the transformation of the civil service, improved education and a more equal commercial playing field will drive black advancement in society and in corporations. But the pace so far has been slow, and political 2003 © CIPE and OECD

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and other pressures will seek to accelerate this process. Chief among these may be the role of pension funds. In terms of South African pensions law, 50 per cent of pension fund trustees represent employee (or member) interests. These trustees, particularly those in the public sector, increasingly include empowerment as a consideration in their choice of asset managers. By this they mean the identity of the asset managers and, more importantly, the investment of funds in ventures that promote black empowerment. According to one estimate, government pension fund and other empowerment-influenced money will account for around 70 per cent of total growth in industry assets under management in the next two years. What is attractive about this dynamic is that it is self-correcting. Trustees will always seek to ensure that returns on their members’ investments are satisfactory, particularly as most of the empowerment-sensitive funds are defined contribution funds. That will impart a market discipline on empowerment investment. A second trend is a rethink on the reliance on debt that characterized the empowerment deals of the 1990s. The limitations of debt finance for empowerment purposes arise from the fact that the critical factor for corporate growth is to generate and reinvest free cash-flow. Acquiring a company by what is effectively a leveraged buy-out diverts that cash flow to service debt, rather than to build the company. Black empowerment will in future, like community empowerment processes around the world, rely more than before on group savings and the leveraging of operational skills. Both of these trends − the increasing involvement of institutional money and commitment of own capital and skills − will contribute to healthy governance of empowerment corporations. Business and Political Processes By the 1970s it had become clear to business in South Africa that the political and economic status quo could not be maintained. Events both inside and outside the country forced enterprises to re-examine their activities and responsibilities and accept that they had a social role. Indeed many were in the vanguard of the forces promoting change, though the most “progressive” were not always pioneers in the reform of corporate governance. Our discussion so far has been about the accountability of a company, represented by its board of directors, to its owners (shareholders), about the accountability of executive management to the board, and about the company’s access to new capital. This view of what corporate governance is all about, which originated in Great Britain and the United States and has spread widely with the globalisation of capital markets, is wholly valid. It nevertheless turned out to be insufficient for the demands faced by South African companies from the 1970s onwards. 206



Until the 1970s, South African companies and their managers adhered to a narrow view of their role in which they were primarily accountable to the controlling shareholders, whether a mining finance house or a founding family. Political and social involvement was rare, and where it was present, would be animated by the world-view of an enlightened founder, rather than be part of the ordinary conduct of the company. As black activism increased throughout the 1970s, large South African companies realised they could no longer − despite their best efforts − focus solely on commerce, while remaining oblivious to the disruptive events, realpolitik and moral imperatives (roughly in that order) emanating from South Africa’s political system. Three events in particular sounded the alarm: •

The Soweto riots of 1976 shattered the complacency of the white elites in politics and business. The riots highlighted the appalling conditions under which the urban blacks, also those employed by large firms, lived, travelled to work and were educated. Most of all, the riots undermined the government’s confidence in the effectiveness of its apartheid policy, and the confidence of the business sector in the country’s political stability.

•

The organisation of African labour unions in the 1970s brought the political struggle to the factories and mines of the large firms. For decades business had lived comfortably with a prohibition on African workers organising or joining unions, participating in the collective bargaining process designed for white workers, or striking. Mine riots and strikes by African workers at Durban factories in 1973 signalled the end of this era.

•

The 1970s also saw the start of South Africa’s international isolation, a process that accelerated in the 1980s, and ultimately had direct commercial consequences for those very large firms, such as Anglo American and South African Breweries, that had international ambitions.

In the reaction of the large business firms to the events of the 1970s one can see the seed of conception of the social roles and responsibilities of corporations broader than that envisaged by either the Anglo-Saxon model or South African practice until that time. These traditional approaches did not incorporate the wider social roles played by companies, or allow for the fact that there are always a variety of interested parties beyond the owners, directors and managers in any company. Unless these parties are satisfied with conduct of the business − as an entity, but also as part of the business sector − they can adversely affect its performance. These considerations abruptly became a reality in the 1970s. The broader conception of the role of a corporation and how it is governed took hold fitfully and partially among South Africa’s large businesses from the late 1970s. A small number of highly influential companies led the process, and it is chiefly their efforts that we briefly describe below. But over the next 2003 © CIPE and OECD

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two decades even the most recalcitrant of the large firms shifted towards a broader sense of its responsibilities. The social role of corporations in practice From 1976 onwards, large businesses and the organisations in which they were represented adopted for the first time an active political and policy role. A critical mass of firms accepted, at least, that some reform was required. Corporate efforts were aimed at accelerating reform, starting with the proximate causes of the actions in Soweto and at companies, namely urban conditions and the labour rights of African workers. In 1976 the Urban Foundation was founded by large businesses to address the problems of housing, infrastructure provision and education in the country’s cities. The Foundation lobbied the government to relax its policies on the rights of Africans to live in “white” cities as well as to scrap policies that forbade the free movement of Africans around the country. Large firms also directed corporate responsibility funds to urban and education projects. Labour reform. A number of influential business executives also called in the mid-1970s called for a commission of inquiry into collective bargaining rights for African workers. Following the Wiehahn commission’s report in 1979, African unions were legalised. By 1982, all the major employer bodies had recognised the major African unions in their industries, and from 1984 African employees had the same employee rights as white employees. Many businesses opposed these measures; a few others, such as mining house Anglo American, had actively lobbied for the changes and allowed the new African and non-racial unions access to its workers for recruitment. By the late 1980s, all big firms with mining and manufacturing interests were engaged annually with the new unions in bargaining processes which often involved strikes and other forms of collective action. The unions won large improvements in wages and conditions of employment for African workers and, more subtly, undermined the traditional authoritarian management style and forced a more consultative approach. Moreover, from the mid-1980s, as political repression intensified and international isolation grew, some large firms directed their efforts to encourage changes to the political process. Executives were involved in early talks with the then-banned African National Congress, and a business body, the Consultative Business Movement, provided the secretariat to the 1992-94 negotiations that led to the democratic elections in 1994.

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Tripartite participation In the uncertain political environment of the early 1990s, large businesses intensified their non-commercial participation in political processes and society. One form this took, in addition to a number of business social programs,11 was participation in tri-partite policy bodies. The 1994 government formalised in legislation an informal tripartite structure for policy consultation and negotiation that had formed during the transitional period of the early 1990s. The statutory body, called the National Economic, Labour and Development Council (or Nedlac), provides for representation from government, labour unions and business organisations, as well as, to a more limited extent, from non-governmental organisations. The government is committed by law to negotiate labour legislation in Nedlac with the business and labour representatives; only if agreement is not reached may the government move ahead with its own legislation. Business representation at Nedlac is chiefly organised through an umbrella body of sectoral bodies and chambers of commerce called Business South Africa. Business South Africa proceedings are ultimately dominated, although indirectly, by large companies and their interests, as these are the only entities with the resources and stamina to participate in the sector bodies, Business South Africa meetings and Nedlac sessions. As the ANC has gained experience in government, and having confirmed a large popular mandate in the 1999 elections, the importance of Nedlac as a consultative forum used to inform government departments of the views of prominent interest groups such as businesses and labour unions has come to the fore. A relationship with corporate governance? The South African companies that pursued a wider social agenda during the 1980s and 1990s did so within their traditional structures of governance. While some mining houses did study the concept of worker directors during the early 1990s, no such structural changes occurred (in 1999 one mining company, Anglogold, did appoint a union leader as an ‘ordinary’ director). Ironically, the companies that were socially progressive were not also pioneers in improved corporate governance in terms of the role of the board, disclosure of director remuneration or splitting of the roles of chief executive and chairman. The South African companies that were socially the most active were control bloc companies. Perhaps, under propitious circumstances, such companies can more easily act in ways that are novel, unpopular and that cut against the accepted grain. However, the role of particular individuals, both owners and managers, was, in all cases, critical. And the times were unusual. One cannot 2003 © CIPE and OECD

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tell from this experience whether a particular structure would make a company more responsive to social needs than would others. Conclusions Corporate governance and the emerging-markets crisis of 1997-1998 The emerging-markets crisis of 1997-98 drew attention to the nexus between sound corporate governance and effectively functioning capital markets. While the crisis was set off by currency, interest-rate and asset-price volatility, it was perpetuated by vulnerable corporate and bank balance sheets that were unable to absorb the volatility. The vulnerable balance sheets, in turn, raised questions about how corporations were governed. Balance sheets in the modern economy are linked: one firm’s liabilities are another’s assets. The value of those obligations is very sensitive to financial volatility when firms are highly geared, as was the case to an extraordinary extent in crisis countries. Balance sheets were weak in other ways too. Currency and maturity mismatches and interest-rate risks carried by both financial-sector and real-economy firms were excessive and not well understood. Asset quality was revealed to be a further problem: subsequent analysis showed that new investments by listed corporates in the crisis countries were destroying value throughout much of the 1990s (investment returns were systematically lower than the cost of funds). Investments and loans were often made for the benefit only of special (connected) interests; and too much faith was placed in the feverish market values of equity holdings during the boom times. Such is the perfection of hindsight! Yet, with the benefit of that perspective, we can see the corporate pathologies at the heart of the crisis − connected lending, politically inspired investment and excessive risk-taking − which point up deficiencies in corporate decision-making and governance. The severity of the crisis also showed that poor corporate governance can have massive negative externalities, providing grounds for possible policy intervention. For most advocates such intervention would be to strengthen, rather than weaken, the role and functioning of capital markets: financial opacity, a lack of protection for minorities and entrenched control in a corporate economy can lead to low availability of funding even for exemplary firms. Yet this explanation raises questions. Why did capital markets in the crisis countries not require sound governance as a precondition for providing capital? The answer is not well understood (in the crisis narrative, to paraphrase Sherlock Holmes, capital markets were the dog that did not bark in the night). Investors (including banks) showered capital on firms with poor governance and conduct − and then, as the crisis intensified, withdrew capital precipitously and indiscriminately. Under what circumstances are capital markets better at 210



the “meta” level of insisting on sound governance structures? How can this role be strengthened? South Africa’s experiences during the 1990s, and the many fronts along which reforms are taking place, shed some light on these questions. Within a fairly short period, corporate structures that had been in place for many decades were thrown asunder, replaced by more rational and internationally acceptable approaches. One clear lesson is that capital-markets discipline can, at least in some cases, enforce sound corporate governance. It would be valuable to analyse the factors that contribute to market forces playing such a sentinel role, as well as to discuss the limits to what the market can do on its own. In the South African case, certainly, non-market devices – such as sound legislation, a vigilant regulator and the setting of voluntary industry standards – will be essential. The importance of being modest. In the South African debate, the protection of shareholders, and the long-term maximization of the value of a firm, have been the main driving forces behind governance reform. There has been less emphasis than elsewhere on the potential role of better governance in forestalling future crises of the Asian type. Perhaps that is just as well. The emphasis on corporate governance in the crisis-aftermath, while very welcome, calls for some caution. Clearly, if more companies in the crisis countries had stuck to prudent funding practices, financial turmoil would have been less; yet sound corporate-governance principles alone will not inoculate economies against the systemic build-up of dangerous imbalances in corporate and banking balance sheets. The prudence exercised by corporate governors tends to be relative in approach: is our firm out of line with our peer firms? It would be difficult for anybody in the corporate governance chain − whether manager, board member or brokerage analyst − to assess an economy-wide trend, for example increased use of short-term foreign-currency funding. No doubt again one day circumstances will be such as to persuasively rationalise generalised imprudence, irrespective of how sound the governance. As past Federal Reserve chairmen Paul Volcker once said: as long as greed and fear remain part of the human genetic make-up financial crises will happen. Sound corporate governance will not often stand in the way of system-wide build-ups of risk. However, sound corporate governance has benefits for developing countries that are more pervasive, if less dramatic. In the case of South Africa, as noted at the outset of this conclusion, sound governance is required to bolster the flow of foreign and domestic savings, to ensure the most economically effective allocation of limited capital resources, to promote stable capital markets, and to contribute to a sense of fairness in the corporate sector. 2003 © CIPE and OECD

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Hence the need for corporate governance reform, at the individual company level, at market level, and at the level of national legislation and supervision. While it is not yet clear what the optimal capital-markets arrangement is for developing countries, one thing is certain: whatever the eventual shape of a developing country’s financial markets, widespread sound governance will a prerequisite for effective capital markets and, increasingly, a precondition for market access by individual companies. Corporate governance and South Africa’s growth path On assuming power in 1994, the African National Congress, hitherto a socialist movement, gingerly embraced capitalism, which the party embedded in a latter-day social democratic program. The program combined strengthened labour rights and expanded social services with conservative fiscal and monetary policy, reserving a central role for capital markets in the allocation of resources and for private firms in production. Government taxation and spending have redistributed resources to the poor, but it is recognised that government action alone cannot achieve the advances sought by black South Africans. Instead, the government has gambled that the orthodox capitalist part of its program will deliver GDP growth, resulting in employment gains and higher living standards. The name of the government’s 1996 economic stabilization package − the Growth, Employment and Redistribution policy, or GEAR − encapsulated this approach. Upon these policy foundations is built South Africa’s post-1994 modus vivendi. Blacks enjoy political power and increased social services and expect, through growth, better prospects. Whites have been spared confiscation of their assets, and are able to continue to work and invest in a capitalist economy. But it is a reluctant consensus, with sniping from both left and right. What has been missing is the growth. South Africa’s economic performance has been better in almost every respect in the period since 1994 than in the preceding five years. But growth has disappointed, averaging 2 percent, with higher unemployment and growing numbers of South Africans in poverty. Were growth to remain this low, the tentative consensus on which post-1994 South Africa is based could be in danger. Various explanations are given for the poor growth performance, ranging from the emerging-markets crisis of 1997-1998, to a poor skills-base, to numerous micro-economic inefficiencies. Yet many observers agree that a proximate cause of the low growth is the country’s low investment rate, which has hovered barely above the replacement rate of capital stock. And, given the country’s poor savings performance during the late 1990s, limited capital inflows have further constrained investment.

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These constraints mean that a high premium is placed on South Africa’s capital markets and private corporate sector (a) succeeding in attracting savings, particularly foreign inflows; and (b) ensuring that capital is allocated and managed as efficiently as possible. Upon these factors rest the importance of corporate governance for South Africa’s future development. South Africa’s private corporations play a dominant role in the management of capital stock, in control over savings, in the allocation of investment and in the generation of output and exports. How these corporations are governed and monitored, and how decisions are made within them, have an impact on international and local participation in South Africa’s capital markets, and in the efficiency with which capital is deployed. Difficulties in monitoring companies, self-serving decisions by control blocs, insider trading and rent-capturing by complacent managements harm not only the company, but also − if these abuses are widespread − South Africa’s capital markets, and ultimately its economy. The pivotal role of corporate governance and management has now been recognised in South Africa. This is evident from the spectrum of instruments that have effected improvements in governance, ranging from market discipline, to voluntary compliance, to legislation. While the efficacy of these measures must closely be monitored, it would also be unwise to succumb to a kind of capital-markets fundamentalism. While corporate governance and capital markets are important, they are not a developmental silver bullet. Ultimately, well-functioning capital markets light up the true costs and opportunities in an economy, and direct resources accordingly. Foundational conditions for growth become, if anything, more critical under effective capital markets. These growth foundations include high savings rates, a sound general education system, well-functioning labour and product markets, and good public administration. Indeed, while efficient capital markets reflect the growth prospects of a country, the direct feedback from capital-market signals to these critical policy areas is often weak and indirect. Healthy capital markets and sound corporate governance need to be complemented by sound and courageous political government.


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Annex 1 to Chapter 5 South Africa’s Life Insurers: From Mutual to Shareholder Control Why did the mutual structure entrench management? South Africa’s mutually-owned insurers were owned and therefore ostensibly controlled by their policy-holders. Upon purchase of a life policy, the purchaser would gain a vote in the company’s proceedings. This resulted in a highly diffuse voting corps, with large voting blocs entirely absent. This situation is reminiscent of the Berle and Means view of the corporation, and led to the same collective-action problem identified by them. No policyholder had sufficient incentive to justify the burden of aggregating policyholders’ votes to oppose management. The mutual structure meant that the factors usually behind the aggregation of votes against the status quo ? corporate take-over and well-resourced institutional investors with large holdings ? were absent. Hence the entrenched position of management. Other factors may also have played a role. Commonly all employees of a mutual took out a small policy upon being appointed. At general meetings, usually held at the companies’ main offices, employees, unstintingly loyal to management, were disproportionately represented. Also, the mutual’s performance would have been difficult for policyholders to assess, given the opacity and complexity of life-policies, an absence of readily available standards of comparison, and the lack of financial knowledge of most policyholders. Finally, one mutual, Sanlam, was seen by its mostly Afrikaans policyholders as an instrument of Afrikaans economic empowerment, thus enabling management to justify their actions in non-financial terms. What has changed under demutualisation? When demutualisation occurred in the late 1990s (for reasons explained later) policyholders became shareholders, in a flash creating a shareholder base as diffuse as the voting base had previously been. This initially places management in a strong position, but that is sure to change. Active institutional shareholders are now, increasingly, present, and take-over attempts become a possibility, thus providing two means of aggregating votes in opposition to the status quo. The two demutualised insurers, Old Mutual and Sanlam, have taken strikingly different paths, which may have an effect on their governance. Old Mutual has shifted its domicile to the United Kingdom, and is now part of the FTSE 100 Index, an important benchmark for UK institutional investors. The heightened scrutiny is a world apart from the comfortable life enjoyed by managers under the mutual structure. Sanlam remains domiciled in South Africa, and, its institutional shareholder base is mostly South African, which, while flexing its governance muscles, 214



currently provides less scrutiny than UK institutions. Yet, though large by South African standards, Sanlam is vulnerable to take-over, perhaps by a foreign group. The desirability and future stance towards domicile shifts is currently one of the most important and difficult policy issues in South Africa. Going forward, the Old Mutual and Sanlam experiences may shed some light.

Annex 2 to Chapter 5 Six steps in transforming a traditional mining house The mining group Billiton, known previously as Gencor, pioneered the restructuring of the mining finance house in the early 1990s. First: The unbundling of Gencor Management concluded that the centre ‘provided no value enhancement’ to a number of industrial and commercial holdings. These holdings were in activities removed from the core of mining and metals processing activities. For the non-core activities supervision by the centre was ‘just another hurdle’. These interests were unbundled in 1992, the first process of its kind in South Africa. Companies unbundled included paper company Sappi and industrial holding company Malbak. Second: Deciding on the core holdings The remaining assets were grouped into five business areas. This begged another round of consideration about distinctive capabilities. Should a mining company be multi-commodity or single-commodity? They chose a multicommodity base metals and coal strategy, and decided to exclude precious metals. This would provide the company with critical mass. Skills were transferable and similar across the commodities chosen. The company also decided that forward integration would be limited to smelting. Third: Accessing global capital markets Gencor, like other mining companies, needed to go where the deposits are; that is, to operate globally. South Africa’s exchange controls made foreign acquisitions difficult to finance. In 1997 Gencor changed its name to Billiton, shifted its primary listing to London, joined the FTSE index and raised $3 billion. This provided Billiton with a strong offshore balance sheet and good access to global capital markets. Fourth: Consolidating holdings As a mining house, Gencor/Billiton ‘looked like a unit trust’, with large stakes in listed companies with minorities. Cash was trapped in various operating companies. So, during the bottom of the cycle, the company took full control of coal and other interests.


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Fifth: Enhancing the portfolio The company now pursues large opportunities around the globe. For an acquisition to make a difference to Billiton it must make $50-100 million per year in profits. Otherwise the transaction costs are too high. The important attributes in a metal are: scale, growth and the right opportunity. Sixth: Splitting precious metals from the rest Precious metals producers are rated differently from other mining companies. Therefore, it made sense for gold and platinum activities to be housed in a separate company, which was subsequently merger with the South African gold producer Gold Fields of SA.

Annex 3 to Chapter 5 Principles of corporate governance issued by the JSE A A1 A2

A3 A4 A5 A6

216

Directors The board - Every listed company should be headed by an effective board which should lead and control the company. Chairman and chief executive officer - There are two key tasks at the top of every public company − the running of the board and executive responsibility for the running of the company’s business. There should be a clear division of responsibilities at the head of the company that will ensure a balance of power and authority, such that no one individual has unfettered powers of decision. A decision to combine the posts of chairman and chief executive officer in one person should be publicly justified. Whether the posts are held by different people or by the same person, there should be a strong and independent non-executive element on the board. Board balance - The board should include a balance of executive and non-executive directors such that no individual or small group of individuals can dominate the board’s decision taking. Supply of information - The board should be supplied in a timely manner with information in a form and of a quality appropriate to enable it to discharge its duties. Delegation of duties There should be a formal procedure for certain functions of the board to be delegated, describing the extent of such delegation. Appointments to the board There should be a formal and transparent procedure for the appointment of new directors to the board. Procedures for appointments to the board should be formal and transparent, and a matter for the board as a whole, although in practice nominating will usually emanate from the chairman or chief executive officer. 2003 © CIPE and OECD


B B1

B2

C C1 C2 C3

D D1 D2 D3

E

Directors’ remuneration The level and make-up of remuneration - Levels of remuneration should be sufficient to attract and retain the directors needed to run the company successfully, but companies should avoid paying more than is necessary for this purpose. Procedure for determination - Companies should establish a formal and transparent procedure for developing policy on executive remuneration and for fixing the remuneration packages of individual directors. No director should be involved in deciding his or her own remuneration. Accountability and Audit Financial reporting - The board should present a balanced and understandable assessment of the company’s position and prospects. Internal control - The board should maintain a sound system of internal control to safeguard shareholders’ investment and for maintaining the appropriate relationship with the company’s auditors. Audit committee and auditors - The board should establish formal and transparent arrangements for considering how they should apply the financial reporting and internal control principles and for maintaining an appropriate relationship with the company’s auditors. Relations with shareholders Dialogue with institutional shareholders - Companies should be ready, where practicable, to enter into a dialogue with institutional shareholders based on the mutual understanding of objectives. Shareholder voting - Institutional shareholders have responsibility to make considered use of their votes. Evaluation of governance disclosures - When evaluating a company’s governance arrangements, particularly those relating to board structure and composition, institutional shareholders should give due weight to all relevant factors drawn to there attention and to eliminate unnecessary variations in criteria which each applies to the corporate governance arrangements and performance of the companies in which they invest. Restricted periods Every listed company should practice the imposition of a restricted period in dealings in its securities by directors, officers and other selected employees preceding the announcement of its financial results or in any other period considered sensitive.


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Table 1. Corporate control over South Africa’s capital stock: 1950-1999 % of total capital stock held by Total capital Private Corporate SOEs stock as % Corporations Sector of GDP 1950-59 154.1 56.0 5.5 61.5 1960-69 154.1 51.8 6.4 58.3 1970-79 180.9 46.4 11.2 57.6 1980-89 216.2 44.0 16.6 60.6 1990-99 220.8 51.2 23.5 74.7 1990-1994 226.1 49.7 24.4 74.1 1995-1999 215.5 52.8 22.5 75.2 *Real growth is expressed as compound average annual growth. Source: SA Reserve Bank

Real growth in capital stock (%)* Private Corporations 4.7 3.8 4.0 3.2 2.0 1.2 2.1

SOEs

7.9 7.8 12.2 0.7 0.1 0.5 0.1

Economy

4.9 4.7 5.4 2.4 1.0 0.5 1.3

Table 2. The role of corporations in domestic investment: 1950-1999 % of total GDI by

1950-59

Real growth in gross investment (%)*

GDI as % of Private Corporate SOEs GDP Corporations Sector 23.6 63.4 7.5 41.0

Private Corporations 1.5

SOEs

Economy

4.8

3.5

1960-69

23.8

59.7

8.7

68.3

6.6

12.4

7.0

1970-79

27.6

51.9

16.1

68.1

0.8

8.4

2.1

1980-89

23.7

57.9

18.1

76.1

-0.7

-5.9

-2.0

1990-99

16.3

70.2

13.3

83.5

0.6

1.7

-0.1

1990-1994

16.2

68.7

12.9

81.5

1.7

-4.5

-0.1

1995-1999

16.4

71.7

13.8

85.5

-1.9

3.3

-0.9

*Real growth is expressed as compound average annual growth. Source: SA Reserve Bank

218



Table 3. Savings behaviour and composition in South Africa: 1950-1999 Composition of gross domestic savings (%) GDS as % of GDP 1950-59

20.2

Private Corporations 51.9

5.0

General government 25.1

1960-69

23.7

40.8

5.1

24.6

29.6

1970-79

25.2

1980-89

24.3

44.8

11.2

20.2

23.9

56.8

21.5

8.0

13.7

1990-99

16.3

33.1

-14.7

72.1

SOEs

Households 18.0

9.5

1990-1994

17.4

68.5

33.6

-15.5

13.4

1995-1999

15.1

76.1

32.5

-13.7

5.1

Source: SA Reserve Bank

Table 4. Funding of corporate assets (aggregate balance sheets), 1999 Industrial and Commercial London New ManuEmerging Mining Three SOEs Total facturing Services Economy companies (TMT) Assets (R billion) Internal v. External funds Internal sources External sources

342

198

100

43

1

54

117

135

34% 66%

41% 59%

24% 76%

30% 70%

0% 100%

40% 60%

53% 47%

24% 76%

Source Equity Retained earnings Debt Long-term Short-term Total funds Of which traded debt

35% 34% 31% 19% 12% 100% 2%

32% 41% 27% 17% 10% 100% 2%

42% 24% 34% 23% 12% 100% 2%

52% 30% 18% 12% 6% 100% 2%

78% 52% 23% 0% 40% 53% 22% 8% 23% 12% 4% 15% 10% 3% 8% 100% 100% 100% 1% 0% 4%

Risk indicators Debt-equity ratio 46% 37% 53% % of debt short-term 39% 37% 34% Source: Financial accounts, BFA McGregor’s, Genesis


22% 34%

28% 47%

8% 46%

20% 24% 56% 43% 13% 100% 48%

30% 127% 34% 23%

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Table 5. Estimated value of various corporate sectors, 2001 Fixed Assets Estimated % of GDP % of Total Valuation Basis (Rbn) Value (Rbn) Market Listed private co.’s 539 407 1,348 154% 48% capitalisation on 12/10/01 Estimated on 3.2 ratio of fixed Unlisted private co.’s 996,128 304 973 111% 34% asset base to market value SOEs n/a 326 424 49% 15% Market estimate Hybrids: SOEs with 3 43 90 10% 3% Market estimate private investors Total 996,670 1,080 2,835 325% 100% Category

#

Source: Genesis Analytics, based on data provided by McGregor-BFA

Figure 1. Development of capital markets: South Africa compared to developing economies* (market value as a % of GDP): 1999

* Excludes international financial centres. Source: FIBV, Genesis calculations

220



Figure 2. Development of capital markets: South Africa compared to advanced economies (market value as a % of GDP): 1999

Source: FIBV, Genesis calculations


221


(Endnotes) Corporate exports are probably dominated by companies that are not state-owned, are listed on the JSE, and are for the most part South-African owned (or owned by South African companies that have recently shifted domicile to the United Kingdom). A rough estimate of the corporate share of GDP in the 1990s can also be made since virtually all production is in the hands of private-sector corporations in five of the national economy’s 11 main sectors – mining, manufacturing, construction, wholesale and retail trade, and financial and business services – and these five contributed 62 per cent of GDP, while two sectors dominated by SOEs − electricity, gas and water, and transport and communications − provided a further 12.5 per cent. Corporations thus appear to account for close to three-quarters of South Africa’s GDP. 2 World Development Indicators (2000). The high developing world averages reflect, among other things, the strong savings performance in East Asia. 3 The tabulation of the benefits and costs of apartheid to business firms, and the attitudes of the business sector to the main tenets of apartheid have been subject to much academic investigation: the reader is referred to Lipton’s magisterial work in this area, Capitalism and Apartheid. Business did play an active role in the transition to democracy, being active in negotiation forums with black unions for a long period, lobbying for change from the mid-1980s and providing the secretariat to the transitional talks in the early 1990s. 4 Lipton, (1986), p. 256. 5 Ibid., p. 242. 6 While the racial social engineering was unique, some of this framework is similar to the policies of countries in Latin America and elsewhere that pursued import-substitutingindustrialization strategies of national development. 7 Low levels of market competition did not have a single cause. Factors include production and distribution technology (high fixed cost relative to total market size); conglomerates’ preferential use of in-house providers; the powerful strategic position of cash-rich established firms; and the unwillingness of the capital market to finance newcomers. Nevertheless, whatever the causes, the lack of competition allowed firms to pass on high costs throughout the economy. Managers in protected manufacturing markets could to an extent set their own prices, a situation forgiving of lax cost management. 8 The exchange value of South Africa’s currency fluctuated considerably during the 1990s. The rand started the decade at R2.50 and ended it at R6.11 to the dollar. Its depreciation has not been gradual, however, nor has it closely shadowed inflation differentials. Showing dollar equivalents for much of the data contained in this chapter would create misleading trends. Readers are advised to interpret more recent rand amounts at R6.00 to the dollar, and to infer trends from the rand amounts. 9 Two more have since done likewise: Old Mutual and Dimension Data. 10 In recent years the number of jurisdictions with laws in place to combat insider trading has surged, to 87 in 1998 compared to 34 in 1990. But developed and emerging markets alike have struggled to use the legal weapons. By 1998, only 24 per cent of emerging markets with legislation in place had achieved even one prosecution (and even fewer a conviction); overall less than half of all jurisdictions have reached the prosecution stage. 11 In 1992 the Joint Education Trust, a body aimed at improving the black education system, was founded, financed by the business sector but directed by business, political, labour and community leaders. In 1995 Business Against Crime was founded to provide resources and research for the state’s efforts to combat crime. In the late 1990s, the Business Trust was formed: listed companies have agreed to contribute one percent of their market capitalisation to the Trust, which will ultimately invest several billion rand in tourism and education and training. The Trust’s governance structure provides for the involvement of the national president and senior cabinet ministers. 1

222


APPENDIX

Participants in the Policy Dialogue (2001) and/or the Workshop (2000) Manuel R. Agosin Professor of Economics University of Chile Santiago Stanton D. Anderson Attorney at Law McDermott, Will and Emory Washington, D.C. Thomas Andersson Deputy Director Directorate for Science, Technology and Industry OECD Walter Appel CEO Banco Fator São Paulo, Brazil Phillip Armstrong ENF Corporate Governance Advisory Services Johannesburg, South Africa Robert Beadle Development Finance, Private Sector Development Co-operation Directorate, OECD Igor Belikov General Director Institute of Stock Market and Management Moscow, Russia 2003 © CIPE and OECD

223


Erik Berglof Professor of Economics University of Stockholm Sweden Jacques Blanché Conseil Français des Investisseurs en Afrique Paris Hans Blommestein Financial Affairs Division Directorate for Financial, Fiscal and Enterprise Affairs OECD John A. Bohn Chairman Center for International Private Enterprise Washington, D.C Amy Bondurant US Ambassador to the OECD Paris Olivier de Boysson Chief Economist, Emerging Markets Crédit Agricole Indosuez Paris Tobias Broër Consultant OECD Development Centre Willem Buiter Chief Economist EBRD London John Burke Director of Listings Johannesburg Stock Exchange South Africa Laura Campbell Counsel Asian Development Bank Manila, Philippines

224


APPENDIX

Montri Chenvidyakarn Secretary-General Financial Sector Restructuring Authority Bangkok, Thailand Bernard T.R. Chidzero Chief Executive International Capital Corporation Ltd. Harare, Zimbabwe Theodore Chong Chief Executive Hong Kong Institute of Corporate Secretaries Alvaro Clarke de la Cerda Chairman Securities Commission Santiago, Chile Luciano Coutinho Director Economics Institute University of Campinas Brazil John Crihfield Economist and Financial Advisor US Agency for International Development Washington, D.C. Michelle Edkins Corporate Governance Executive Hermes Investment Mangement Ltd. London Jesus P. Estanislao President Institute for Corporate Directors Manila, Philippines Luiz Tarquinio Ferro President PREVI Banco do Brasil Rio de Janeiro Richard Frederick Corporate Affairs Unit Directorate for Financial, Fiscal and Enterprise Affairs OECD 2003 © CIPE and OECD

225


Winston Fritsch President Dresdner Bank Rio de Janeiro Brasil Bob Garratt Chairman Organisation Development Limited London and Hong Kong Karugor Gatamah Executive Director Private Sector Corporate Governance Trust Nairobi, Kenya Michael Gillibrand Director, Management & Training Commonwealth Secretariat London Andrea Goldstein Principal Administrator OECD Development Centre Eduardo Manhães Ribeiro Gomes Head of International Affairs Securities Commission Rio de Janeiro, Brazil Omkar Goswami Chief Economist Confederation of Indian Industry New Delhi Mame Adama Guèye Western Africa Enterprise Network Dakar, Senegal Tom Heller Professor Stanford Law School Stanford, CA Ulrich Hiemenz Director OECD Development Centre

226


APPENDIX

Hasung Jang Chair, People’s Solidarity for Participatory Democracy (shareholders’ watchdog NGO) Professor of Finance and Director, Center for Finance and Banking Research, Korea University, Seoul Ranne Jayamaha Special Advisor Commonwealth Secretariat London Simon Johnson Professor MIT School of Management Cambridge, MA Shanthi Kandiah Formerly Securities Commission of Malaysia Kuala Lumpur Mary Keegan Chairman, UK Accounting Standards Board Formerly Head of Corporate Governance PricewaterhouseCoopers London Timothy Kenney Gérant de fonds Société Générale Asset Management Paris Seiichi Kondo Deputy Secretary-General OECD Larry Lang Chair Professor of Finance Chinese University of Hong Kong Chad Leechor Private Sector and Finance Unit, Africa Region The World Bank Washington, D.C. Cyril Lin Department of Economics Oxford University Oxford, UK 2003 © CIPE and OECD

227


John Litwack Senior Economist (Russia) Economics Department OECD Guy Longueville Directeur adjoint Banque Nationale de Paris Paris Jorge Braga de Macedo President OECD Development Centre Stephan Malherbe Chief Executive Officer Genesis Analytics Johannesburg, South Africa Maria Maher Regulatory Reform Team Economics Department OECD Rafael Mariano Manóvil Partner, Saldivar-Manóvil & Associates Professor of Commercial Law University of Buenos Aires Maria Silvia Martella Commissioner Securities Commission Buenos Aires, Argentina Nicolas Meisel Consultant OECD Development Centre Roberto de Michele Undersecretary for Transparency and Anti-Corruption Policies Ministry of Justice and Human Rights Buenos Aires, Argentina J. Mark Mobius President Templeton Emerging Markets Fund Singapore 228


APPENDIX

Young-Sook Nam Non-Member Economies Division Economics Department OCDE Rabindra Nathan Shearn Delamore & Co. Kuala Lumpur and Singapore Stilpon Nestor Head Corporate Affairs Division Directorate for Financial, Fiscal and Enterprise Affairs OECD Wiseman Nkhuhlu Economic Advisor to the President President’s Office Pretoria, South Africa Encik Md. Nor Ahmad Deputy President Kuala Lumpur Stock Exchange Malaysia Charles Oman Head of Project OECD Development Centre Mary O’Sullivan Associate Professor INSEAD Fontainebleau, France Pang Eng Fong Singapore High Commissioner London Wilson Peres United Nations Economic Commission for Latin America and the Caribbean (ECLAC) Santiago, Chile Charles Pigott Economics Department OECD


229


Carlos Quenan Professeur d’Economie Université Paris III Paris Flavio M. Rabelo Professor of Business Administration Getulio Vargas Foundation São Paulo, Brazil Jean Rogers Deputy Director Center for International Private Enterprise Washington, D.C. Isabella Saboya de Albuquerque Securities Commission Rio de Janeiro, Brazil Silvia Sandoval Manager, Synergy Fund Head of Research, Banco Fator São Paulo, Brazil Bonnie Santiago de Albornoz Undersecretary for Financial Services Economics Ministry Buenos Aires, Argentina Bernadette Sarmiento Programme for Brazil Centre for Co-operation with Non-Members OECD Nick Segal Director, Graduate School of Business University of Cape Town South Africa Mark Scher Finance and Development Branch Department of Economic and Social Affairs United Nations New York, NY James Shinn Director Longitude Capital New York, NY 230


APPENDIX

Ajit Singh Professor of Economics University of Cambridge Cambridge, UK David Stannard Executive Director, Corporate Finance Securities and Futures Commission Hong Kong Joseph Stiglitz Professor of Economics, Columbia University New York, NY John D. Sullivan Executive Director Center for International Private Enterprise Washington, D.C. Teh Kok Peng President, GIC Special Investments Private Limited Government of Singapore Investment Singapore R. Thillainathan President Malaysian Economic Association Kuala Lumpur Elaine Thompson-Flores Investment Director PETROS – Petrobras’ Pension Fund Rio de Janeiro, Brazil Daochi Tong Commissioner China Securities Regulatory Commission Beijing, China Marcelo Villegas Partner, Nicholson & Cano Abogados Buenos Aires, Argentina Christine Wallich Head, Private Sector Group Asian Development Bank Manila, Philippines 2003 © CIPE and OECD

231


Gert Wehinger Economics Department OECD Ted White Manager, Corporate Governance Unit California Public Employees’ Retirement System Sacramento, CA Franck Wiebe Chief Economist, The Asia Foundation San Francisco, CA

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About the Authors Manuel R. Agosin is currently on leave as Professor of Economics at the University of Chile and works at the Inter-American Development Bank, where he is the Chief Economist of the operations department for Central America, Mexico, Haiti and the Dominican Republic. He has previously served as economist and manager in charge of research and technical assistance at the United Nations in areas related to development and international trade, finance, and foreign direct investment. Adviser to several Latin American governments and consultant to ECLA, UNCTAD, UNDP, IADB, the World Bank and the OECD, he holds a Ph.D. in Economics from Columbia University and has published numerous articles in international journals and edited books. Luciano Coutinho is a Full Professor of International Economics at the University of Campinas, and a partner in an investment bank that specializes in mergers and acquisitions. He also serves as a consultant to many large business groups in the area of São Paulo, Brazil. Omkar Goswami is the Chief Economist of the Confederation of Indian Industries. Holder of a Master’s degree from the Delhi School of Economics and a Ph.D. in Economics from Oxford University, he currently serves on the boards of Infosys, Dr. Reddy’s Laboratories (two of India’s most prestigious knowledge-based companies), DSP-Merrill Lynch Fund Managers Ltd., and Infrastructure Development Finance Co. Ltd. Chairman of the Indian government’s Committee on Industrial Sickness and Corporate Restructuring (1993), he served also on the Working Group on the Companies Act, the Kelkar Committee on Direct Tax Reforms, the Naresh Chandra Committee on Auditor-Company Relationships, the Commerce Ministry’s Trade Advisory Council, the Railway Infrastructure Committee, and the CII’s Committee on Corporate Governance. Author of publications on economic history, industrial economics, the public sector, economic policy, bankruptcy, corporate finance, tax enforcement and legal reforms, he has taught and researched economics at Oxford, the Delhi School of Economics, Harvard, Tufts, Jawaharlal Nehru University, Rutgers and the Indian Statistical Institute. Stephan Malherbe is the founder and Chairman of Genesis Analytics, in Johannesburg, South Africa. A specialist in financial policy in Africa and in financial sector development, financial stability, competition economics and corporate governance in emerging markets, he advises corporate, sovereign and multilateral clients. He holds a Master’s degree from Harvard University’s John F. Kennedy School of Government, and Commerce and Law degrees from the University of Stellenbosch.


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Charles P. Oman heads research on Corporate Governance at the Development Centre of the Organization for Economic Co-operation and Development. He has previously led policy-oriented research, consulted, and published on the effects of Competition to Attract Foreign Direct Investment, New Forms of International Investment in Developing Countries, the Policy Challenges of Globalization and Regionalization, and the Evolution of Thinking on Development. Holder of a Ph.D. in Economics from the University of California at Berkeley, he has taught there and at the Graduate School of Business Administration in Lima, Peru. Advisor to several governments, he has also served as a founding director of a small corporation. He currently serves as well on the Advisory Boards of the Centre for the Study of Globalization and Regionalization, in the United Kingdom, and the Russian Institute of Directors. Ernesto Pasten is an Economic Analyst at the Central Bank of Chile. Holder of a Master’s degree in Economics from the University of Chile, he has also worked on macroeconomic stability, financial development, technological change, unemployment, and economic growth. He has previously worked for Chile’s Ministry of Planning and for the United Nations’ Economic Commission for Latin America and the Caribbean in Santiago de Chile. Flavio Marcilio Rabelo is an Adjunct Professor of Business Strategy at the School of Business of the Getúlio Vargas Foundation, in São Paulo, Brazil. Holder of a Doctorate in Economics from the University of Campinas, he specializes in corporate governance and private pensions. He has also acted as a consultant, among others, for the Brazilian Association of Pension Funds, Brazil’s federal Social Security Ministry, the World Bank and the OECD. Nick Segal is the Dean of the Graduate School of Business at the University of Cape Town, South Africa. A chemical engineer by initial training (University of Witwatersrand) who holds a Doctorate in Economics (Oxford University), he currently serves on the boards of Kumba Resources, the National Business Initiative, and the Centre for Development and Enterprise. Having worked on India at the World Bank in Washington D.C., and established his own international consultancy in England, he returned to South Africa in 1992 where he entered the mining industry as a director of two major corporations. He has served as President of the Chamber of Mines (1996-97) and Deputy Chairman of Business South Africa (1996-98) and been a member of the Presidential Labour Market Commission (1995-96) and the Council on Higher Education (1998-2002).

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The Development Centre of the Organisation for Economic Co-operation and Development was established by decision of the OECD Council on 23rd October 1962 and comprises twenty-two member countries of the OECD, as well as Chile since November 1998 and India since February 2001. The Commission of the European Communities also takes part in the Centre’s Governing Board. The purpose of the Centre is to bring together the knowledge and experience available in member countries of both economic development and the formulation and execution of general economic policies; to adapt such knowledge and experience to the actual needs of countries or regions in the process of development and to put the results at the disposal of the countries by appropriate means. OECD DEVELOPMENT CENTRE 12 Bd. des Iles (Bat. B) 92130 Issy-les-Moulineaux France Phone: (33) 1.45.24.82.00 [email protected] www.oecd.org/dev

The Center for International Private Enterprise is an affiliate of the U.S. Chamber of Commerce, established in 1983 to promote private enterprise and market-oriented reform worldwide. As a principal participant in the National Endowment for Democracy, CIPE supports strategies and techniques that address market-based democratic development. CIPE also receives support from the U.S. Agency for International Development (USAID), as well as private corporations and foundations. Since its inception, CIPE has funded more than 700 projects in 80 countries and has conducted business association management training programs in Africa, Asia, Central and Eastern Europe, Eurasia, Latin America, and the Middle East. CENTER FOR INTERNATIONAL PRIVATE ENTERPRISE The Madison Office Building 1155 15th Street, NW Suite 700 Washington, DC 20005 USA Phone: (202) 721 - 9200 Fax: (202) 721 - 9250 [email protected] www.cipe.org 2003 © CIPE and OECD Development Centre

Corporate Governance In Development: The Experiences Of Brazil, Chile, India, And South Africa (Oecd Development Centre)

African Economic Outlook 2010 (OECD Development Centre)

The Rise of China And India: What's in It for Africa? (Development Centre Studies)

Logics of Empowerment: Development, Gender, and Governance in Neoliberal India

Democracy and Development in Africa

Development and Global Governance

Democracy and Development in Africa

Corporate Governance: A Survey Of Oecd Countries

Development Centre Studies Informal Institutions: How Social Norms Help or Hinder Development (Development Centre Studies) (Development Centre Studies)

Latin American Economic Outlook 2011 (Oecd Development Centre)

Perspectives économiques en Afrique 2010 (OECD Development Centre)

From Defence to Development: Redirecting Military Resources in South Africa

Governance in a Changing Environment (Canadian Centre for Management Development Series on Governance and Public Management)

Africa Development Indicators 2006 (African Development Indicators)

Development of psychological thought in India

The OECD and Transnational Governance

Human Rights and Development in Africa

Information Systems Development: Asian Experiences

Corporate Ethics and Corporate Governance

Information Systems Development: Asian Experiences

Regional Development Policies in OECD Countries

Corporate Ethics and Corporate Governance

The Enterprising City Centre: Manchester's Development Challenge

Rule of Law, Legitimate Governance And Development in the Pacific

Corporate Ethics and Corporate Governance

Globalization, Development and The State: The Performance of India and Brazil since 1990 (International Political Economy)

Corporate Governance Around the World (Routledge Studies in Corporate Governance)

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Corporate Governance In Development: The Experiences Of Brazil, Chile, India, And South Africa (Oecd Development Centre)

African Economic Outlook 2010 (OECD Development Centre)

The Rise of China And India: What's in It for Africa? (Development Centre Studies)

Logics of Empowerment: Development, Gender, and Governance in Neoliberal India

Democracy and Development in Africa

Development and Global Governance

Democracy and Development in Africa

Corporate Governance: A Survey Of Oecd Countries

Development Centre Studies Informal Institutions: How Social Norms Help or Hinder Development (Development Centre Studies) (Development Centre Studies)

Latin American Economic Outlook 2011 (Oecd Development Centre)

Perspectives économiques en Afrique 2010 (OECD Development Centre)

From Defence to Development: Redirecting Military Resources in South Africa

Governance in a Changing Environment (Canadian Centre for Management Development Series on Governance and Public Management)

Africa Development Indicators 2006 (African Development Indicators)

Development of psychological thought in India

The OECD and Transnational Governance

Human Rights and Development in Africa

Information Systems Development: Asian Experiences

Corporate Ethics and Corporate Governance

Information Systems Development: Asian Experiences

Regional Development Policies in OECD Countries

Corporate Ethics and Corporate Governance

The Enterprising City Centre: Manchester's Development Challenge

Rule of Law, Legitimate Governance And Development in the Pacific

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Globalization, Development and The State: The Performance of India and Brazil since 1990 (International Political Economy)

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