professor florencio lopez-de-silanes - lex mundi1. fiduciary duties of directors, officers and...

Corporate Governance Project

Professor Florencio Lopez-de-Silanes

Yale University and

National Bureau of Economic Research

© Florencio Lopez-de-Silanes

2© Florencio Lopez-de-Silanes

Outline

I. The Recent Corporate ScandalsII. The Relevance of Conflicts of Interest and the Legal

ApproachIII. Goals of the Project and MethodologyIV. The Structure of the ProjectV. Preliminary ResultsVI. Conclusion


Moving beyond the Promoter’s Problem

qWe have shown investor protection through the laws for IPOs and their enforcement is a key determinant of the structure of financial markets across countries.

qThis evidence points to the importance of mechanisms that facilitate enforcement, the relevance of regulations that establish liabilities and disclose conflicts of interests.

qThe 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.


The Relevance of Conflicts of Interest

qTop issue for corporations seeking legal advice around the world: üMultinationals 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.

qLaw 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.

qThere are enormous opportunities for constructive legal work, as firms and governments are eager to gather reliable information and guidance.


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.


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.


The Legal Approach to Corporate Governance

qThe law and its enforcement are key mechanisms of investor protection.

qWhen investors finance firms, they receive rights or powers in exchange. Without an ability to enforce rights, investors might end up with nothing.

qFocus on self-interested transactions allows us to understand minority shareholders’ protection across countries.

•Company law•Securities law•Takeover law•Courts •Regulators

•Protect Investors

•Force timely disclosure of accurate information


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 countriesØ 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 countriesØ Suggest forms to overcome the deficiencies in the system

through corporate governance reform.


Methodologyq 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.


Case 1: Transaction with a Director

Buyer Co.

Mr. James

Seller Co.

Mr. James is a Director on Buyer’s 5-Member

Board

Mr. James owns 90% of Seller Co.

Buyer Co. buys equipment from Seller


Case 2: Transaction with a Controlling Shareholder

Buyer Co.

Mr. James

Seller Co.Buyer buys

equipment from seller

Mr. James owns 60% of Buyer Co.

shares


shares


Case 2: Transaction with a Controlling Shareholder in a Pyramid

Buyer Co. (Non Publicly traded Co.)

Mr. James

Seller Co.

Mr. James owns 90% of Seller

Co.

Buyer Co. buys equipment from Seller Co.

Holding Co.(Publicly Traded Co).

Holding Co. owns 60% of its

subsidiary Buyer Co.

Mr. James owns 60% of Holding Co.

Shares.


Case 3: Transaction among Firms in a Group

Acme Co. XYZ Co.Acme supplies

XYZ with parts.

ABC owns 60% of Acme

ABC owns 75% of XYZ

ABC Co.


Methodology

qThe main areas covered are:

1. Fiduciary duties of directors, officers and shareholders2. Disclosure requirements of conflicts of interest3. Ratifications/approvals of self-interested transactions4. Challenging the transaction5. Liability of those who approved or were parties to self-

dealing transactions, including:1. Standing to sue2. Standard of liability3. Access to corporate information and discovery4. Burden of proof and standard of proof5. Remedies


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)?


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?


Progress So Far1. 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.


Case 2: Transaction with a Controlling Shareholder

Buyer Co.

Mr. James

Seller Co.Buyer buys

equipment from seller

Mr. James owns 60% of Buyer Co.

shares


shares


Approval Procedures

13.6%BOD (directors appointed by James abstain)

4.5%GSM (James votes)

20.5%GSM (James abstains)

52.3%BOD (directors appointed by James vote)

9.1%CEO

% of CountriesApproval Regime


Importance of Obstacles in Pursuing Suits Against the Company: Approvals

0%

5%

10%

15%

20%

25%

Shareholdingrequirements

Cost of approvals Difficulty ofsatisfying

proceduralformalities

Interested partiesinfluence

approvals

Lack ofrepresentation of

minorityshareholders

Percentage countries who ranked item as a mayor obstacle


Disclosures

41%Fairness report or equivalent

56%Disclosures to Regulator and/or Stock Exchange

71%Disclosures in periodic filings

51%Disclosures to shareholders before approval

47%Directors appointed by James make disclosures to BOD

% of countries


Importance of Obstacles in Pursuing Suits Against the Company: Disclosures

0%5%

10%15%20%25%30%35%40%

No lawrequiring

disclosuresof RPT

Disclosureslaws lackspecificity

Narrowdefinition of

RPT

Nodisclosuresof conflictsof interest

Failure tomake

disclosures

No access toinformation

by Sh.

Noenforcement

ofdisclosures

Percentage countries who ranked item as a mayor obstacle


Controlling Shareholders’ Civil Liability

2%James liable if shadow director.

2%James liable if he controls both sides.

52%James liable if he influenced the approval.

41%James not liable.

2%James liable if he votes.

% Countries

professor florencio lopez-de-silanes - lex mundi1. fiduciary duties of directors, officers and...

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