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Corporate governance: strengthening conditions for investment. Presentation to the OECD Forum 2003, Paris.

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Presentation to OECD Forum 2003 Paris

Monday, 28 April 2003 2.30pm

SUBJECT: "Corporate Governance - Strengthening Conditions for Investment"

Thank you very much, John [Rossant - Moderator, European Editor Business Week]. Can I start off by saying I do not think we need to re-think the concept of a corporation. And if we did, it would be long outside the political cycle that any of us are familiar with. I think we know what a corporation is there to do. It is to give limited liability to people who want to share their capital for joint economic purpose, for a hope of return. What we may have to do, is, we may have to educate the public on what a corporation stands for and, in particular, the word risk. I heard Daniel [O'Keefe - Managing Director, Protiviti] mention that. As a general rule, the higher the return, the greater the risk. And we have lived through a bull market which encourages people to believe that high returns could be obtained without risk. And it is only at the end of that bull market, that the old laws are proven again that return goes hand in hand with risk. And you cannot take risk out of investment. The moment you legislate against risk, you will legislate against the opportunity to return profit. And it is very important not only that lawmakers understand that point. It is important that investors understand that point.

Now, from a lawmaker's point of view, we always have two competing issues that come at us in this area. On the one hand, we do not want to stifle entrepreneurial activity, so we want low transactional costs. On the other hand, we want to protect investors so that we have confidence in our markets. And it is these two competing issues that come at us every time, from which we need to try and strike a balance, which can preserve the concept of a corporation and confidence of investors, which is necessary to make it work.

Now, when theorists look at those two competing issues they say, well how can you reconcile them? And they always come up with the word transparency. Transparency means that a legislator does not have to tell a corporation what to do. They can decide what to do as long as they tell everybody. And an investor can be protected because they know what is going on.

But I think where this has broken down, is, that as the general public, mass investors, have developed with privatisation projects and so on, your ordinary investor does not have the sophistication to be able to assess the kind of information that is coming out from a company. Prospectuses are too long, analysts use their own jargon, and during a bull run, who cares anyway because you are always getting a good return. Nobody is really interested in the information.

And so we have the rise of the professional manager. And it was thought that the professional manager would understand all of this disclosure. He would protect the investor, he would get them a good return, they could put their trust either in terms of the collective investment, or a pension plan, in the professional manager.

Now, I will put to you, and I am going to make four points here, that professional managers are a very large part of the problem. They were being rewarded by returns which gave them incentives to pump the stock. There was not enough transparency on the managers themselves. And although I would not legislate it, I would certainly recommend to people, to go to analysts who charge a fee rather than take an equity position. I am not sure that the managers themselves learned how to distinguish between their own incentive and that of their clients. I think also the tendency became very short-term. Quarterly returns, quarterly rating. Nobody was interested in long-term investment and I think that undermined the idea of the company.

The second thing I am going to suggest is, it is essential to look very carefully at your tax system. There were biases in the tax system for capital returns, which again gave incentives to pump stock. Most developed countries now have a lower rate of tax on capital than they do on income. That is one bias in favour of a capital return. Those countries that offer a classical taxation system, tax income twice - both in the hands of the company and the hands of the shareholder. That gave an incentive to pump stock rather than to earn income - and I welcome moves in some countries now to move to a system away from the classical taxation system. We, in our country, operate a full dividend imputation system so that income is only taxed once, and the incentive is therefore for a corporation to derive income.

And thirdly, transactional costs on share buying and selling should be kept low so that people have the opportunity to exit. Stamp duties on share transactions and so on are bad things if you want to get discipline into markets. Should you have ease of entry, ease of exit in order to have discipline on the corporations themselves.

The third thing I am going to suggest that we found very useful in Australia is continuous disclosure. We do not have quarterly reporting, but for listed corporations we have continuous disclosure. That is, anything that can materially affect the share price must be immediately disclosed to a stock exchange. It does not give you the opportunity to make an announcement early in a quarter which does not have to be announced for some time. And we are going to back that up with on-the-spot fines, with a failure to disclose will incur an on the spot fine from the regulator. You have the right to contest that in court if you want to, but you run the risk of what we call an on-the-spot infringement notice, which of course puts enormous pressure on the corporations to get the information out. By the time it has gone off to court, everybody has lost interest in the actual information.

The fourth, and the last, point that I want to underscore, and numbers of people have already made it in this presentation, is peer group pressure. Peer group pressure was in many respects a force for ill, I think, in the bull market run of the late '90s. That is, if you were a company director that did not have a deal going, you were considered rather indolent or not working as hard as your shareholders would expect. If you were in the so-called old economy, rather than the new economy, this would open you up to criticism. And the tendency became, I think, for chief executives, they had to leave their mark in corporations by doing a deal somewhere to realise shareholder value. You do not hear too many people these days adversely contrasting old economy stocks to new economy stocks. That is a language that seems to have died in the late 1990s for obvious reasons. So just as peer group pressure could be a force for ill, it can be a force for good.

The importance of non-government institutions, I would underline the Institute of Company Directors, stock exchange rules and public pressure. We have had examples in our country where chairmen of boards that have lost shareholder value have foregone remuneration. Now, that is a very good signal, I think, to the investing public, and I think it is a very good arm of peer group pressure in relation to other company directors.

The other thing I would put in there, that we are thinking very carefully about in relation to enforcement, is civil enforcement as against criminal enforcement. We found particularly in western legal systems, the criminal standard beyond reasonable proof, the rules of evidence, mean that proceedings can take a very long period of time. Civil proceedings, different standard of proof which is the balance of probabilities, financial penalty which follows, maybe a disqualification penalty from being a company director, which for a professional company director is equivalent to a life sentence to be banned from

being a company director, allows you to much more quickly access the court system and get some kind of verdict out there. And this is absolutely important for the investors. At the end of the day, the investors need to know that it is safe to go back into the water, and a government that can reassure them on that I think is going to get an economic benefit.

One last point I will just make in closing, John. From an economic point of view, we have always thought about the importance of fiscal policy, the importance of monetary policy, the importance of tax policy, structural policy. We see corporate governance very much as an arm of structural policy. Rather than a race to the bottom, which you sometimes get in tax policy, a race to the top in relation to corporate governance can actually give a country and a business environment a competitive advantage that people who want to invest in your jurisdiction know that it will be done well. Companies that are competing in your jurisdiction know that the regulation will be independent so that people will not get advantages, and of course investors feel free to be able to reinvest. So corporate governance, as an arm of economic policy, which is why I as a Treasurer got interested in it, and I think if you think of it in that way, you can actually make it a great benefit and positive.

Thanks very much.

© Commonwealth of Australia 2000