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Corporate Governance Project

Professor Florencio Lopez-de-Silanes

Yale University and


National Bureau of Economic Research

© Florencio Lopez-de-Silanes
Outline

I. The Recent Corporate Scandals


II. The Relevance of Conflicts of Interest and the Legal
Approach
III. Goals of the Project and Methodology
IV. The Structure of the Project
V. Preliminary Results
VI. Conclusion

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© Florencio Lopez-de-Silanes
Moving beyond the Promoter’s Problem
q We have shown investor protection through the laws for IPOs and
their enforcement is a key determinant of the structure of financial
markets across countries.

q This evidence points to the importance of mechanisms that facilitate


enforcement, the relevance of regulations that establish liabilities and
disclose conflicts of interests.

q The recent corporate governance scandals, the lack of independence


of board members, and the fact that most corporations have
controlling shareholders also suggest that in order to get a fuller
picture of corporate governance we need to focus on situations of
conflicts of interest.
àUnderstand how the law and its enforcement deal with abuse of
power by those in control.
© Florencio Lopez-de-Silanes
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The Relevance of Conflicts of Interest
q Top issue for corporations seeking legal advice around the world:
ü Multinationals in foreign markets fear inequitable inter-company
pricing, squeeze-outs, or appropriation of corporate opportunities.
ü Investment bankers and institutional investors are also concerned
with the risk of expropriation in foreign countries.

q Law firms deal with related-party transactions and minority


shareholders’ protection on a daily basis (e.g., joint ventures, start-
ups, private equity deals, etc.)
q It has climbed to the top of the public agenda and has become critical
for investors worldwide.
q There are enormous opportunities for constructive legal work, as firms
and governments are eager to gather reliable information and
guidance. 4
© Florencio Lopez-de-Silanes
Conflicts of Interest all Over
Ø Recent experiences (e.g. Ahold in
the Netherlands, ABB in
Switzerland, Vivendi in France,
Sibneft in Russia, SK Telecom in
Korea, Enron and Adelphia in the
US, or Toyota in Japan) show the
need for a better understanding of
related-party/self-interested
transactions if we are to understand
minority shareholder’s protection.

Ø Conflicts of interest arise all over


the world and are not exclusive of
certain countries. 5
© Florencio Lopez-de-Silanes
Conflicts of Interest:
The Fundamental Problem of Corporate Governance
q The fundamental problem of Corporate Governance is the abuse of
non-controlling investors by those that are in control (controlling
shareholders or managers).
q Private Benefits to those in control arise from situations of conflicts
of interest including:
ü Transfer pricing;
ü Transfer of assets;
ü Targeted issues and repurchases of securities;
ü Pursuit of non-profit maximizing projects.
ü Consumption of perks, compensation and loans to officers.
ü Corporate opportunities undertaken by directors.
q The main goal of a Corporate Governance system is to restrict this
behavior so as to facilitate external finance. 6
© Florencio Lopez-de-Silanes
The Legal Approach to Corporate Governance
q The law and its enforcement are key mechanisms of investor
protection.
q When investors finance firms, they receive rights or powers in
exchange. Without an ability to enforce rights, investors might end
up with nothing.

•Company law •Protect Investors


•Securities law
•Takeover law •Force timely disclosure of
•Courts accurate information
•Regulators

q Focus on self-interested transactions allows us to understand


minority shareholders’ protection across countries. 7
© Florencio Lopez-de-Silanes
Goals of the Project
1. Capture the “creative” mechanisms through which controlling
shareholders or managers divert cash flows from minority investors.
2. Identify the specific legal arrangements in company and securities
laws as well as the enforcement mechanisms that restrict such
expropriation in over 100 countries
Ø How do the law and courts deal with the most frequent types of
conflicts of interest in large listed companies?
3. Understand the crucial link between laws and enforcement in order
to:
Ø Develop strategies and contracts that may limit expropriation in
the current legal environment of some countries
Ø Suggest forms to overcome the deficiencies in the system
through corporate governance reform. 8
© Florencio Lopez-de-Silanes
Methodology
q Builds on prior experience with Lex Mundi firms in over 100
countries.

q Created a questionnaire around the most frequent situations of


self-interested transactions based on actual cases.

q Conducted a Pilot Questionnaire an worked with with nine Lex


Mundi firms to incorporate their opinions and revise the
questionnaire with their cooperation.

q The Revised Questionnaire is structured to provide:


1. A general overview of the law around self-interested
transactions and
2. The legal and enforcement mechanisms to address specific
self-interested situations.
© Florencio Lopez-de-Silanes
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Case 1: Transaction with a Director

Mr. James is a Director


on Buyer’s 5-Member Mr. James
Board

Mr. James owns


90% of Seller Co.

Buyer Co. Seller Co.


Buyer Co. buys
equipment from Seller
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© Florencio Lopez-de-Silanes
Case 2: Transaction with a
Controlling Shareholder

Mr. James

Mr. James owns Mr. James owns


60% of Buyer Co. 90% of Seller Co.
shares shares

Buyer Co. Seller Co.


Buyer buys
equipment from seller
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© Florencio Lopez-de-Silanes
Case 2: Transaction with a Controlling
Shareholder in a Pyramid
Mr. James owns Mr. James
60% of Holding Co.
Shares. Mr. James owns
90% of Seller
Co.
Holding Co.
(Publicly Traded Co).
Holding Co.
owns 60% of its
subsidiary Seller Co.
Buyer Co.
Buyer Co.
(Non Publicly traded Co.)
Buyer Co. buys equipment
from Seller Co.
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© Florencio Lopez-de-Silanes
Case 3: Transaction among
Firms in a Group

ABC Co.

ABC owns 60% of ABC owns 75% of


Acme XYZ

Acme Co. XYZ Co.


Acme supplies
XYZ with parts.
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© Florencio Lopez-de-Silanes
Methodology
q The main areas covered are:
1. Fiduciary duties of directors, officers and shareholders
2. Disclosure requirements of conflicts of interest
3. Ratifications/approvals of self-interested transactions
4. Challenging the transaction
5. Liability of those who approved or were parties to self-
dealing transactions, including:
1. Standing to sue
2. Standard of liability
3. Access to corporate information and discovery
4. Burden of proof and standard of proof
5. Remedies 14
© Florencio Lopez-de-Silanes
Main Issues Addressed
1. Conflicts of Interest:
• How does the law view duties of directors, officers and
shareholders?
• Who is considered conflicted or non-independent?
• How do approval requirements handle conflicts of interest?
• How well are conflicts or potential conflicts disclosed?

2. Legal Vulnerability:
• What legal mechanisms allow controlling investors to
expropriate from minorities?
• What makes them less vulnerable? How do they avoid court
scrutiny or liability within the realm of the law?
• Do difference in legal vulnerability explain difference in
control mechanisms and corporate structures (i.e. pyramids)?
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© Florencio Lopez-de-Silanes
Main Issues Addressed

3. Enforcement:
• What are the mechanisms available to sue across
countries?
• What is the role of disclosures and discovery?
• How are the laws actually applied by courts?
• Do some laws lead themselves to easier enforcement?
• Does this depend on the quality/structure of the existing
judicial system?
• Is there a deep connection between laws and
enforcement?

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© Florencio Lopez-de-Silanes
Progress So Far
1. We have sent all sections of the Questionnaire containing the
overview of the laws and enforcement of corporate governance
provisions and the specific cases.
2. We have received finalized answers from 95% of the firms.
3. The quality of the responses varies from country to country. We
have been in contact with some law firms in several countries asking
them for clarifications in certain areas.
4. We have started to analyzed those answers to obtain results in some
key areas
5. We will follow up with each firm with some complimentary
questions and completion memo that tries to clarify their answers as
we finalize our understanding of the structure of the processes and
key drivers. 17
© Florencio Lopez-de-Silanes
Case 2: Transaction with a
Controlling Shareholder

Mr. James

Mr. James owns Mr. James owns


60% of Buyer Co. 90% of Seller Co.
shares shares

Buyer Co. Seller Co.


Buyer buys
equipment from seller
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© Florencio Lopez-de-Silanes
Approval Procedures

Approval Regime % of Countries

CEO 9.1%

BOD (directors appointed by James vote) 52.3%

BOD (directors appointed by James abstain) 13.6%

GSM (James votes) 4.5%

GSM (James abstains) 20.5%

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© Florencio Lopez-de-Silanes
Importance of Obstacles in Pursuing Suits
Against the Company: Approvals
Percentage countries who ranked item as a mayor obstacle

25%

20%

15%

10%

5%

0%
Shareholding Cost of approvals Difficulty of Interested parties Lack of
requirements satisfying influence representation of
procedural approvals minority
formalities shareholders
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© Florencio Lopez-de-Silanes
Disclosures

% of countries

Directors appointed by James make 47%


disclosures to BOD
Disclosures to shareholders before approval 51%

Fairness report or equivalent 41%

Disclosures to Regulator and/or Stock 56%


Exchange
Disclosures in periodic filings 71%

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© Florencio Lopez-de-Silanes
Importance of Obstacles in Pursuing Suits
Against the Company: Disclosures
Percentage countries who ranked item as a mayor obstacle

40%
35%
30%
25%
20%
15%
10%
5%
0% No law Disclosures Narrow No Failure to No access to No
requiring laws lack definition of disclosures make information enforcement
disclosures specificity RPT of conflicts disclosures by Sh. of
of RPT of interest 22
disclosures
© Florencio Lopez-de-Silanes
Controlling Shareholders’ Civil Liability

% Countries

James liable if he votes. 2%

James liable if he controls both sides. 2%

James liable if shadow director. 2%

James liable if he influenced the approval. 52%

James not liable. 41%

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© Florencio Lopez-de-Silanes

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