37710 312 privatesector P U B L I C P O L I C Y F O R T H E NUMBER NOTE 2006 Self-Dealing SEPTEMBER Tatiana Nenova and Sneaking Corporate Value through the Back Door Catherine Hickey Self-dealing, prevalent in emerging markets, often harms minority PRESIDENCY Tatiana Nenova shareholders. The related-party transaction is one common technique, (tnenova@worldbank.org) VICE is a senior economist with especially in markets with weak law enforcement. Beyond self-dealing, the World Bank's South other methods of expropriation, such as insider trading and dilution Asia Finance and Private Sector Development Unit. of share value, can also harm minorities. Countries can use several Catherine Hickey tactics to combat self-dealing, including improving disclosure, DEVELOPMENT (chickey@ifc.org) is a strengthening regulatory enforcement, and increasing public research analyst in the International Finance awareness of good governance and investor rights. While not always SECTOR Corporation­World Bank successful, these measures often go a long way toward protecting Corporate Governance Department. minority investors. PRIVATE AND Successful entrepreneurs often expand their Commission accused the controlling share- business with the help of outside investors. But holder of Mexico's TV Azteca of engaging in an even as outside investment grows, founders and undisclosed debt transaction that netted him a FINANCIAL families tend to keep a disproportionate share US$109 million personal profit. of control. This imbalance between ownership Evidence of self-dealing abounds around the and control often creates opportunities for self- world. In the Russian Federation management dealing--the practice of transferring money or could divert funds so successfully that privatized assets from the company to a dominant corpo- assets sold at a 99 percent discount relative to GROUP rate owner, manager, or director (World Bank Western counterparts in the late 1990s (Boyko, Group 2006). Shleifer, and Vishny 1998). In India firms that BANK Some recent examples of self-dealing are receive unexpectedly high earnings have been notorious. Conrad Black, former chair and chief found to channel the extra cash disproportion- executive officer of publishing giant Hollinger ately to the controlling family (Bertrand, International, was indicted in 2005 on charges of Mehta, and Mullainathan 2002). Knowing that WORLD helping to skim US$51.8 million of the proceeds holding a controlling stake will lead to future from the sale of the company newspapers. In the opportunities for self-dealing, corporate owners THE same year the U.S. Securities and Exchange are willing to pay a significant premium for a S E L F - D E A L I N G S N E A K I N G C O R P O R A T E V A L U E T H R O U G H T H E B A C K D O O R controlling block of shares in a company (Dyck example, majority shareholders can dilute share and Zingales 2004; Nenova 2003). value by buying more shares at a discount while In the industrial world recent regulatory excluding minority investors from the deal. changes (such as Sarbanes-Oxley) testify to the Preemptive rights can curb the problem, though concern about the problem. In developing coun- stronger measures are sometimes needed (such tries smaller markets, weaker regulation, and the as the preemptive options used in Bulgaria).1 prevalence of firms with concentrated ownership Insider trading can hurt investors who trade mean that self-dealing is a far bigger issue. Yet without access to the information available to some developing countries have adopted suc- insiders. Complex regulations can help, includ- 2 cessful reforms to combat self-dealing, providing ing deal reversals, blackout periods around major lessons in good practice. Countries adopting corporate events, and fines up to triple the effective reforms will promote market integrity, amount of lost profit. South Africa has broad- attract more domestic and foreign investment, ened its insider trading rules to cover market build better relationships with stakeholders, and manipulation and the practice of advising some- help their economies grow. The World Bank one not to trade. Electronic surveillance has Group, through its Doing Business report and boosted enforcement power. Many minority Reports on the Observance of Standards and shareholders in South Africa have been compen- Codes, assesses corporate governance frame- sated for losses suffered through insider trading. works and helps guide policy reforms in private When company control changes hands, and financial sector development. minorities are often excluded from sharing in Because self-dealing is so prevalent in devel- the takeover premium. Equal pricing rules oping countries, it is important to know how and (such as in Poland) mandate that investors get why it occurs. Just as important is to know how the same price as that paid to the controlling countries can try to prevent it. owner. Tag-along rights extend this benefit to shares with limited or no voting rights, as in The basics of self-dealing Brazil's Novo Mercado (Nenova 2005b). Self-dealing occurs in many forms, from simple Minority expropriation can also occur when deals that favor owners and their friends to com- companies delist. Delistings can be frequent: in plex transactions hidden where the market isn't Peru in 1997­2003, 179 securities were delisted. looking. The most common form is the related- Just before delisting, the stock price is depressed, party transaction--a transaction between insiders shares are illiquid, and investors are forced to sell and the company they control. Examples include for next to nothing. Withdrawal rights at inde- sales of goods or services to the company at pendently determined fair value prices are a inflated prices or purchases from it at excessively remedy used in almost all countries. lowprices,loanstoorfromthecompanyonadvan- Minority expropriation mechanisms can be tageous terms, and even an outright transfer of varied, so some countries use a catchall remedy company assets to the controlling party. Under lax known as appraisal rights. Such provisions estab- corporate and securities rules, these deals can be lish the right of aggrieved or dissenting share- fully legal (Johnson and others 2000). holders to sell their shares back to the corporation Good regulations require that related-party at a fair market price following controversial transactions be concluded at market prices and changes in company policy. approved by a board committee or, for large transactions, the annual general meeting. In Enforcing self-dealing rules: what works? most developing countries, however, company Countries use a range of regulatory rules to com- disclosure is too poor to deter self-dealing, and bat self-dealing. But what rules can best be regulators' enforcement power too weak. enforced in developing countries? Other types of minority expropriation Corporate reporting and disclosure Self-dealing is not the only way for controlling A country's first line of defense against self- owners to steal from minority investors. For dealing is to improve corporate reporting. Accurate, timely, and publicly available corpo- This is easier said than done. In poorly devel- rate information is essential. Transparency of oped markets the business community is so ultimate corporate ownership is especially small that financial and personal interests often important, because controlling shareholders in conflict. And special corporate bodies charged developing countries often also are managers with oversight of conflicts of interest, such as and dominate the board. As a result, corporate audit committees or fiscal boards, often treat matters are controlled by insiders, and minority their positions as honorary appointments that investors are left in the dark. require little responsibility. Even perfect laws cannot be enforced without 3 adequate corporate disclosure, at least to the reg- Courts or securities supervisors? ulator. Enforcing the public transparency of cor- The most effective means of enforcement porate decisions can also help shareholders against self-dealing in the United States is a civil identify potential insider abuse and take private shareholder suit against controlling sharehold- action with the regulator or the court. In some ers. The court has broad enforcement powers: it countries the media has used corporate disclo- can impose civil and criminal penalties, request sure to combat self-dealing through "naming evidence from a wide range of sources, summon and shaming." witnesses, and enforce decisions. Countries Still, companies can get around disclosure such as France have set up specialized courts requirements in many ways. In some countries, with magistrates that receive training in securi- such as Russia, investors hold their shares in ties law. In weak legal regimes, however, this complex chains of custodians and nominees remedy has serious limitations because of slow that can effectively hide the identity of the true and unspecialized courts. owners. In other countries shareholders acting Enforcement by securities supervisors, with in concert can work together and even control greater securities and corporate expertise, might a company without individually triggering prove more effective. But supervisors often suf- thresholds for disclosing ownership shares. fer from understaffing, inadequate powers, and lack of operational and financial independence. Active corporate boards In Georgia, for example, enforcement efforts by Enforcementofself-dealingrulesstartswithacom- the National Securities Commission are often pany's board of directors. In India the law requires ineffective despite strong provisions in the secu- the board to have an investor grievance committee rities law, because of lack of clarity on the pro- that meets quarterly to consider shareholder cedural rules. Countries with ineffective courts rights and investor complaints. In other countries and weak regulators can instead develop alter- minority shareholders can nominate and elect native dispute resolution mechanisms, which their own directors to the board, through cumu- can be a fast (though expensive) means of lative voting or proportional representation. If the addressing corporate governance conflicts. board is composed of insiders, it probably will not The choice of enforcement mechanism actively defend minority interests. should fit local conditions. Brazil's securities The law often prescribes the duties of direc- and exchange commission actively uses its pow- tors, one of which may be to act in the interest ers to resolve shareholder disputes, providing of all shareholders. But fiduciary duties are an alternative to sluggish courts. Lithuania's poorly understood by most directors. In Hong efficient courts make action by the securities Kong (China), for example, less than 40 percent regulator unnecessary. Colombia, where both of directors understand their liability and the the court and the regulator are weak, is experi- rest give it low priority (Ho 2003). Moreover, menting with alternative dispute resolution. successful prosecutions of directors for neglect- ing fiduciary duties are almost nonexistent in Monitoring by creditors and large investors developing countries. Monitoring by banks may help improve minor- An alternative regulatory solution has been ity rights, especially when creditors' interests to require independent directors on the board. align with those of shareholders. Bank monitor- S E L F - D E A L I N G S N E A K I N G C O R P O R A T E V A L U E T H R O U G H T H E B A C K D O O R ing depends on the health of the banking system market with new stock issues to unilaterally and regulatory environment and the availability improve their corporate governance. Similar of credit and other information. In developing concerns can prompt companies to voluntarily countries creditors may not be effective moni- list on "model corporate governance" tiers on tors in part because most lending is backed by the stock exchange, such as the Novo Mercado viewpoint collateral and relatively short term. in Brazil, where the 15 firms now listed fetch pre- Large institutional investors in theory have miums of up to 100 percent. greater incentives than small individual investors is an open forum to to monitor management and try to influence its encourage dissemination of decisions rather than simply sell their stock when public policy innovations for dissatisfied. But they do not always fulfill this Notes private sector­led and promise, for several reasons. In Hong Kong This Note is based on Nenova (2005a). market-based solutions for (China), although institutional investors account 1. Preemptive rights give existing shareholders a development. The views for 40 percent of local market transactions, they chance to purchase shares of a new issue before it is published are those of the mainly trade blue chip stocks and are not active offered to others. Options on such rights prevent control- authors and should not be in monitoring corporate management. In India ling shareholders from taking advantage of minority apa- attributed to the World institutional investors seldom take actions against thy or cash constraints. Bank or any other affiliated management because they have cheaper ways to organizations. Nor do any of enforce their interests. As lenders as well as block References the conclusions represent holders, they have veto power over shareholder Bertrand, Marianne, Paras Mehta, and Sendhil official policy of the World resolutions. Mullainathan. 2002. "Ferreting Out Tunneling: An Bank or of its Executive Another reason lies in close ties to the bank- Application to Indian Business Groups." Quarterly Journal Directors or the countries ing system. Institutional investors often are part of Economics 117 (1): 121­48. they represent. of large banks that want to do business with the Boyko, Maxim, Andrei Shleifer, and Robert Vishny. companies in which they invest. Finally, in many 1998. Privatizing Russia. Cambridge, Mass.: MIT Press. To order additional copies emerging markets the institutional investor sec- Dyck, Alexander, and Luigi Zingales. 2004. "Private contact Suzanne Smith, tor may still be in the early stages of development. Benefits of Control: An International Comparison." managing editor, Prodding by foreign investors, however, has Room F 4K-206, Journal of Finance 59: 537­600. led to palpable improvements in corporate gov- The World Bank, Ho, Simon S. M. 2003. "Corporate Governance in 1818 H Street, NW, ernance in many countries. Shareholder activists Hong Kong." Research Paper 1. Chinese University of Washington, DC 20433. have pushed for major corporate governance Hong Kong, Centre for Accounting Disclosure and changes in Korean companies, for example. Corporate Governance. Telephone: Johnson, Simon, Rafael La Porta, Florencio López-de- 001 202 458 7281 Naming and shaming Silanes, and Andrei Shleifer. 2000. "Tunnelling." American Fax: The media can play an important part in disci- Economic Review 90 (2): 22­27. 001 202 522 3480 plining managers and controlling owners, espe- Nenova, Tatiana. 2003. "The Value of Corporate Email: cially when enforcement is weak. Indeed, free Voting Rights and Control: A Cross-Country Analysis." ssmith7@worldbank.org media has been shown to help pressure compa- Journal of Financial Economics 68 (3): 325­51. nies into improving their corporate governance ------. 2005a. "A Corporate Governance Agenda Produced by Grammarians, practices. In Korea many of the concerns about for Developing Countries." Contaduría y Administración Inc. corporations' activities have been shared on the (Universidad Nacional Autónoma de México), no. 217: Internet. 181­222. Printed on recycled paper Shareholder activism, voluntary codes, and ------. 2005b. "Corporate Law and Control Values in investor education can go a long way toward rais- Brazil." Latin American Business Review (Federal University ing awareness of corporate governance prob- of Rio de Janeiro) 6 (3): 1­37. lems. In 2000 the Romanian Shareholders' World Bank Group. 2006. Doing Business 2007: How to Association successfully promoted an amend- Reform. Washington, D.C. ment to the securities law that enhanced investor protection. Reputation concerns can prompt listed firms that expect to return to the T h i s N o t e i s a v a i l a b l e o n l i n e : h t t p : / / r r u . w o r l d b a n k . o r g / P u b l i c P o l i c y J o u r n a l