Strengthening Corporate Governance with the OECD Principles An

Strengthening Corporate Governance with the OECD Principles: An Outcome -oriented Approach Dr. William Witherell Director for Financial and Enterprise Affairs Organization for Economic Cooperation and Development (OECD) Academy of European Law Seminar Corporate Governance: Legal Implications for Europe and the United States Trier, Germany 7 -8 March, 2005 1

BACKGROUND AND OVERVIEW n n After Asian Crisis, corporate governance reform seen as a priority for emerging markets. OECD Principles agreed in 1999 and soon became the international benchmark. More recent wave of corporate scandals and large failures in major OECD advanced market economies undermined investor confidence and has lead to wide-spread governance reforms. OECD in 2003 -4 carried out a review and updating of the Principles in light of recent experience. 2

But why do national and international policymakers care about corporate governance? ? n The dominance of the joint-stock corporation n Institution building in less developed countries n The growth of the private corporate sector n The growth of equity markets n The growth of international private capital flows 3

Corporate Governance influences the outcomes at all stages of the investment process n n n The mobilization or raising of capital (in both domestic and international markets) The allocation of capital to its most effect uses The monitoring of how capital is employed 4

Why “core principles”? Enormous variation in ownership and control structures in the world n No single model of good corporate governance: but need for a global language n Detailed codes, best practices should be established at national and regional levels n Objective: to identify common elements or core principles underlying good corporate governance across the different systems: a multilateral policy framework 5 n

Implications of “core principles”: outcome-oriented The Principles cover the general features or functions to be in place, e. g. high level of accounting standards, diligent and capable directors. n These are termed outcomes. n They involve functional equivalence: they can be achieved in many different ways and with different institutions. n Principles need, therefore, to be adapted to the legal and institutional environment of each 6 country. n

The OECD Principles are based on a wide interpretation of corporate governance, which emphasises resource inputs : “Corporate governance … involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. ” 7

Moreover, n “Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and shareholders and should facilitate effective monitoring, thereby encouraging firms to use resources more efficiently”. 8

Two implications for the desirable characteristics (outcomes) of a corporate governance system n n Checks and balances A structure of incentives that is compatible with the checks and balances and with achieving the objectives of the company 9

Intended uses of the Principles n n n Primarily aimed to provide a conceptual framework for governments. Guidance also for stock exchanges, investors, corporations, commissions. A benchmark that facilitates convergence. 10

The Principles are the international benchmark n n Endorsed by the Financial Stability Forum as one of 12 Key Standards for Sound Financial Systems Used as the basis of the corporate governance component of the World Bank/IMF Reports on the Observance of Standards and Codes (ROSC) Recommended by the Emerging Markets Committee of the International Organization of Securities Commissions (IOSCO) Provide a basis for numerous national or sectorspecific codes and listing requirements. 11

The objectives of international cooperation under OECD-World Bank Corporate Governance Partnership n n n To build the rudiments of a global normative framework To build a corporate governance culture among corporations and investors To marshal human and financial resources at a global level in order to help regional and local, private and public efforts bear their fruits. 12

OECD-World Bank Regional Corporate Governance Roundtables n n n Public-Private regional dialogue. Participants are senior policy- makers, regulators, corporations, investor, professional organizations, labor, and others. OECD Principles are a framework for the dialogue. 13

Non-OECD Countries in the Roundtables n Asia: n Latin America: n Eurasia: n South n Russia Bangladesh, China, HK (China), India, Indonesia, Malaysia, Pakistan, Philippines, Singapore, Sri Lanka, Chinese Taipei, Thailand, Viet Nam Argentina, Bolivia, Brazil, Chile, Columbia, El Salvador, Peru, Uruguay, Venezuela Armenia, Azerbaijan, Georgia, Kazakhstan, Kyrgyz Rep. , Mongolia, Ukraine, Uzbekistan Eastern Europe: Albania, Bosnia. Herzegovina, Bulgaria, Croatia, FYR of Macedonia, Serbia and Montenegro, Romania 14

Objectives of the Roundtables n n Improve understanding through discussion and exchange peer Identify areas for improvement and formulate reform agenda: the White Papers Facilitate regional participation in global dialogue on corporate governance Identify needs and facilitate provision of technical assistance. 15

Core Elements of the OECD Principles 1. 2. 3. 4. 5. 6. Assuring an effective framework(1) The rights of shareholders The equitable treatment of shareholders The role of stakeholders Disclosure and transparency The responsibility of the boards (1) This chapter added in 2004 16

Setting the new Chapter 1 aside until later, let us look briefly at chapters II to VI in reverse order to better understand the overall logic of the original Principles. 17

VI. The responsibilities of the board “The corporate governance framework should ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board’s accountability to the company and the shareholders. ” Thus the board serves as the fulcrum, balancing the ownership rights enjoyed by shareholders with the discretion granted to managers to run the business. 18

V. Disclosure and transparency “The corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, and governance of the company. ” n n The process of disclosure and the integrity of the accounting and financial reporting systems should be overseen by the board. Disclosure should include information about the control structures and ownership of the firm which should make potential conflicts of interest (i. e. the incentive structure) 19 transparent.

Principles II, III and IV concern shareholders and stakeholders, who have an important role in effecting checks and balances II. The rights of shareholders “The corporate governance framework should protect shareholders’ rights. ” III. The equitable treatment of shareholders “The corporate governance framework should ensure the equitable treatment of all shareholders, including minority and foreign shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights. ” 20

n IV. The role of stakeholders in corporate governance “The corporate governance framework should recognize the rights of stakeholders as established by law and encourage active co-operation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises. ” “Stakeholders” include employees, creditors, depositors, pensioners 21

In sum, n n The Principles thus comprise checks and balances: the board oversees management and is in turn overseen by shareholders, creditors and stakeholders who must be sufficiently informed to do this. Information should also make it possible to understand the incentive structure facing the board and management and thus make the checks and balances effective. 22

The 2002 call by OECD Ministers for an assessment/review of the Principles 23

Policy concerns and driving forces n n n Corporate scandals and large failures…. New awareness of links between corporate governance arrangements and growth Revealed need for improving: » Implementation and enforcement » Transparency and disclosure » Alignment of incentives » Monitoring by boards » Shareholder rights 24

Recent Legal or Regulatory Changes in G-7 Comply or Explain with Principles or codes United States Comply only Germany Defining audit functions and limits on auditors X X France United Kingdom 1/2 Italy Canada Japan X Defining and controlling conflicts of interest Improving or easing voting; greater role for AGM Role for independent directors X X X X X Improving transparency X X X X 25

OECD Ministers at their 2002 Annual Meeting n n n Observed that the integrity of corporations, financial institutions and markets is essential to maintain confidence and economic activity and to protect the interests of stockholders. Agreed to implement best practices in corporate and financial governance which entails an appropriate mix of incentives, balanced between government regulations and self regulation, backed by effective enforcement. Agreed to survey recent experience and assess the Principles of Corporate Governance. 26

The Review Process n n n OECD’s Steering Group on Corporate Governance carried out the Review (30 OECD Governments, World Bank, IMF, IOSCO, BIS, Basel Banking Committee, BIAC, and TUAC) Consultations held with a wider group of interested parties, with non-OECD countries, and with several highlevel roundtables chaired by the Secretary-General A survey of corporate governance developments in OECD countries since 1999, and a summary of experiences in non-OECD countries were produced. Draft revisions placed on web for comment. 2004 Revision of the Principles endorsed by OECD Ministers in May 2004 27

The key reference OECD PRINCIPLES OF CORPORATE GOVERNANCE 2004 Available for free download at www. oecd. org/corporate

And for developments in the OECD and non-OECD countries: • CORPORATE GOVERNANCE – A SURVEY OF OECD COUNTRIES – 2004 • EXPERIENCE FROM THE REGIONAL CORPORATE GOVERNANCE ROUNDTABLES – 2003

Five sets of issues at the forefront of discussions n n n Ensuring an adequate regulatory framework for corporate governance, taking account of costs; The effective exercise of share ownership and the increasing role of institutional investors; The changing nature and role of the board; Dealing with conflicts of interest Stakeholder concerns 30

Issue 1: Ensuring an adequate regulatory framework for corporate governance, taking account of costs 31

Implementation and enforcement of laws, regulations and codes n n Enacting laws, regulations and codes that meet international standards is the easy step; effective implementation and enforcement is much more difficult. Scope and content of self regulation is under scrutiny; incentives facing the professions may conflict with their integrity and credibility to uphold and enforce expected standards. Capacity and independence of regulatory and enforcement authorities are a serious concern, especially in emerging market and transition countries. Legal and regulatory framework should provide shareholders opportunity for effective legal redress. 32

Key elements of disclosure and transparency n n n Major share ownership and voting rights Material foreseeable risk factors Full financial disclosure Governance structure and policies Information should be prepared audited and disclosed in accordance with high standards of accounting, audit and nonfinancial disclosure Regular disclosure 33

The integrity of the disclosure process and of transparency have been called into question n n Rules-based accounting leads to “show me I cant do it mentality”. Holes such as derivative, pension and options accounting are too wide. Audit independence called into question. They think they are employed by management. Standards of the big 4 not what they were expected. Peer review failed. 34

Reactions n n n Auditor independence strengthened both structurally and by rules. Move effective responsibility to another organ than management Convergence of accounting standards -but implementation an issue. Greater consideration of disclosure of material information More calls for non-financial disclosure 35

Auditors in G-7 Auditors: Independent of consulting? Auditors: rotation? Britain France Germany Japan USA Italy Canada Recommended (comply or explain) Voluntary NO YES YES 5/7 years (voluntary) NO (two auditor system) NO YES (7 years) YES (5 years) YES (9 years) YES (7 years) 36

IOSCO released (Oct. 2002) principles for national standards covering auditor independence and auditor oversight…. n Reflect a growing international consensus. n n n Many in OECD consider these principles to be minimum requirements. Importance of audit firms establishing internal monitoring and control systems. Auditors should be subject to an independent auditor oversight body, or if a professional body plays that role, it should be overseen by an independent body. 37

The Financial Stability Forum has “…underscored the importance of progress towards a single set of high quality principles-based accounting standards, with due regard to financial stability concerns. ” n n US moving closer to a principles-based system. Process in place to work towards convergence of IAS and US GAP. EU (including its candidate states), Australia, NZ, Hong Kong, Russia, Singapore to adopt IAS. Indeed, GAAP Convergence 2002 survey of 59 countries indicated that all but three ( Japan, Saudi Arabia and Iceland) intend to converge with IAS. 38

A number of countries have moved to require better disclosure of board and executive compensation… n n Nomination and appointment of the board is a key corporate governance decision; transparent and evenhanded nomination and recruitment process is needed. Remuneration including information on the structure of compensation schemes and termination conditions relevant not only for financial implications but also for assessing incentives and performance. Some countries call for disclosure of individual remuneration; others ask for only aggregate board compensation. NYSE and NASDAQ have proposed independent compensation committees; codes and principles in other 39 countries go in same direction.

Ensuring that corporate service providers work in the interests of shareholders… n n n In exercising ownership rights, shareholders have to rely on agents (brokers, investment advisors, analysts, rating agencies) for information. Recently a number of cases of serious conflicts of interest and inappropriate incentives have come to light. Responses include changes in stock exchange rules and professional codes of conduct, structural changes such as firewalls, and increased disclosure, e. g. , of material conflicts of interest. 40

The Principles: Ensuring an adequate regulatory framework for corporate governance, taking account of costs ( A new Chapter 1) n n n Clear objectives for policy in establishing a system leading to transparent and efficient markets. Legal and regulatory instruments to be transparent and enforceable. Clear division of responsibilities between domestic authorities Supervisory, regulatory and enforcement authorities should have authority, integrity and resources to fulfil duties. Greater role for shareholders and improved transparency Improved financial market integrity (see next slide) 41

Also assuring financial market integrity n n n Better disclosure by the company including related party transactions Boards to focus on overseeing internal controls and major accounting assumptions through independent audit committee. More emphasis on auditor independence and reference to IOSCO standards. Accountability of external auditors to shareholders and duty of professional care to the company Those providing analysis and advice to be free of conflicts of interest 42

Issue 2: The effective exercise of share ownership and the increasing role of institutional investors 43

The corporate governance framework should protect shareholders rights n n Right to have shares registered and secure Should be able to take part in shareholder meetings and in major decisions concerning the firm Equitable treatment of all shareholders, foreign and minority especially Should not be abused by insiders 44

But in practice the rights are often weak and redress is difficult n n Need for greater voice through strengthened voting rights and information More active institutional investors and disclosure of their conflicts of interest In presence of major shareholders improve protection of minority shareholders Takeovers often blocked 45

Improving Shareholder voice… n n n The ability of shareholders to elect board members of their choice, to table proposals and ask questions of directors is, in reality, very limited in a number of countries. Should shareholders be given more decision rights with respect to board and executive compensation? Need to avoid shareholders second guessing management 46

Ownership and shareholding structures n n n The transparency of ownership and shareholding structures, including pyramids that result in control rights being greater than cash flow rights, is limited in many cases. The Regional Roundtables have called for improvements in the disclosure of beneficial ownership to assist in efforts to curb abusive related party transactions. Beneficial ownership information also is important for the battle against international financial crime 47

Regional Roundtables on shareholder rights and equitable treatment… n n n Typically high degree of concentrated ownership, with control through pyramids and cross-holdings, combined with weak shareholder protection and insufficient disclosure: equitable treatment of shareholders is a pivotal issue. Need to facilitate the exercise of shareholder rights. Minority shareholder rights in relation to changes in capital structure, in corporate control and delisting a concern (lack of pre-emptive or tag-along rights, etc. ) Voting of depository receipts. Frequent abuse of related party transactions; improved disclosure needed. 48

Improving and facilitating the exercise of voting rights… n n Exercise of voting rights varies widely VOTES CAST BY INVESTORS AS A % OF TOTAL U. S. Japan U. K. 83% 71 -80% 50% Greater use of electronic communications? Institutional investors that act as fiduciaries being pressed to be more active. Legal and practical problems to cross-border voting widespread among the OECD countries. 49

Over The Past Two Decades Institutional Investors Have Grown Significantly In Size and Importance Source: OECD Institutional Investors Statistical Yearbook 2003 50

Financial assets of institutional investors as a per cent of GDP – Some individual countries 1991 2001 United States 124. 2 191 United Kingdom 116. 3 190. 8 Sweden 82. 8 153. 5 France 56. 4 131. 8 Japan 73. 3 94. 7 Korea 49. 5 77. 2 Australia 56. 2 129. 7 Source: OECD Institutional Investor Yearbook 2003 51

The rights and responsibilities of institutional investors. n n n While institutional ownership is growing in size and importance, institutional investors typically play a limited role in corporate governance. The issue is not always to add to their already established rights as shareholders. The problem is that they do not make use of them. This is partly due to a lack of proper incentives and sometimes due to restrictions on their ability to set aside sufficient resources to carry out key ownership functions in an informed way. 52

Should those who act as fiduciaries disclose their voting policies? If they do, it would also be natural to ask that they disclose how they, in practice, will implement these policies; for example what resources will they set aside to carry out their ownership functions 53

The Principles: The effective exercise of share ownership and the increasing role of institutional investors n n Call for effective shareholder participation in key decisions such as the nomination and election of board members, proposing resolutions and making views known on compensation policy Improved possibilities for shareholders to consult with each other on key governance issues. Eliminating impediments to cross border voting Call for institutional investors acting in a fiduciary capacity to declare voting policies and how they are handling conflict of interests 54

Also control abuse between related companies n n n Clear statement on fiduciary duties of board members to the company and not to the company group. Explicit statement that boards to review related party transactions using independent directors Stronger annotations on disclosure of related party transactions Stronger principle on board and executive disclosure of material interests Stronger call for protection of minority shareholders 55

Issue 3: The changing nature and role of the board 56

He’s becoming insufferably ‘More transparent than thou!’ 57

Towards independent and more effective boards… n n Moves towards increasing not only the number of nonexecutive directors but also ensuring they are “independent”: 1. UK - Higgs Report 2. Japan – new company law 3. US – Commission on Public Trust and Private Enterprise NYSE Sarbanes-Oxley Independence of judgement and independence from management. 58

Board Integrity Issues Responsibility to Whom? Is it Clear? n Duty of Loyalty / Duty of Care n Status of Independent Directors n Legal Status of Committees n Alternate / Supplementary Directors n 59

Legal requirements for boards in the G -7 Britain Independent No (comply or directors explain if a half not in a majority independent) on board? Separate chairman and CEO? France Germany Japan USA Italy Canada NO YES (supervi sory board) NO YES (NYSE and NASDAQ listing requierment) NO No. Comply or explain No. Voluntary No. comply or Voluntary YES explain (supervi sory board) No. Voluntary Comply or explain 60

The Principles: The changing nature and role of the board n n More general statement of board independence to cover “those in a position to influence the company and not just management” Greater possibilities for shareholders to question boards and to participate Tightening of fiduciary responsibility of boards Strengthened principle calling for boards to establish ethical guidelines and effective compliance procedures 61

The board (continued) n n n Boards to oversee internal controls and provide confidential access to whistleblowers Disclosure of mandate, working procedures and composition of board committees Boards to align key executive and board remuneration with the longer terms interests of company and shareholders and establish a remuneration policy 62

Issue 4: Dealing with conflicts of interest 63

The Principles: Dealing with conflicts of interest n n Institutional investors called on to disclose conflicts of interest and how they manage them. Providers of advice to investors, such as analysts and brokers, should provide advice free from conflicts of interest Tighter conditions specified to ensure no material conflict of interest by auditors and thereby guard auditor independence Tightened disclosure standards to the board and 64 to the market

Issue 5: Stakeholder Concerns 65

The role of stakeholders in corporate governance n n n Stakeholders include creditors, depositors and employees Encourage active co-operation between company and stakeholders Performance enhancing mechanisms should be available Redress for violation of legal rights Access to relevant information 66

Stakeholders Issues are complex and difficult. Best to consider two major groups- creditors and employees – separately Creditor rights are important for the terms and conditions of finance… n These rights arise from bankruptcy and other laws, but in some countries these rights are deficient and/or the courts are poorly structured to enforce them. n Recent reforms in Germany, Japan and Italy. n Reorganization procedures and the rights of creditors to remove management vary widely. n World Bank and UNCITRAL developing principles. 67

Regional Roundtables have stressed their concerns about corporate practices that impede the opportunities for employees n to seek redress for violation of their rights. n To communicate their concerns about illegal or unethical transactions they have observed or asked to undertake. Such complaints can provide important information to shareholders. 68

The Principles: The role of stakeholders n n n Recognise the role of stakeholders to creating value and therefore corporate governance framework should recognise their interests. Whistleblower protection is now a principle covering individuals and their organisations Better disclosure to stakeholders and of company policy towards them. Improved powers for shareholders and greater pressure for institutions to disclose voting policies important for pensions. Principle that board should set company ethics and establish a compliance policy will benefit employees 69

Summary of steps toward implementing more robust corporate governance regimes n n Review regulatory costs of any proposed measure and whethere any more effective instruments at hand. Strengthen market disciplines as they are the most effective continuing discipline on management. Give emphasis to getting incentives aligned properly. Strengthen the ownership function of shareholders. Monitor the governance system – particularly the effects of new measures. 70