June 6, 2007  nº 499  -  Vol. 5

"It is not because things are difficult that we do not dare, it is because we do not dare that things are difficult.”

Seneca 

We continue to explore the most significant legal issues currently impacting the legal industry. After last week's discussion of FCPA, today's subject inGrammatigalhasis: "What is good corporate governance?"

• Top News

Judges at Guantanamo throw out 2 cases

With one word — "unlawful" — the only two war-crimes trials against Guantanamo detainees fell apart in a single day, marking a stunning setback to Washington's attempts to try dozens of detainees in military court. Two military judges dismissed charges Monday against a Guantanamo detainee accused of chauffeuring Osama bin Laden and another who allegedly killed a U.S. soldier in Afghanistan. Salim Ahmed Hamdan of Yemen and Omar Khadr, a Canadian who was 15 when he was arrested on an Afghan battlefield, were the only two of the roughly 380 prisoners at Guantanamo charged with crimes under a reconstituted military trial system. Monday's rulings stand to complicate efforts by the United States to try other suspected al-Qaida and Taliban figures in military courts. Defense attorneys and legal experts blamed the rush by Congress and Bush last year to restore the war-crimes trials after the U.S. Supreme Court threw out the previous system, declaring it unconstitutional. In a remarkable coincidence, it was Hamdan's lawsuit that wound up in the Supreme Court. In both of Monday's cases, the judges ruled that the new legislation says only "unlawful enemy combatants" can be tried by the military trials, known as commissions. But Khadr and Hamdan previously had been identified by military panels here only as enemy combatants, lacking the critical "unlawful" designation. "The fundamental problem is that the law was not carefully written," said Madeline Morris, a Duke University law professor. "It was rushed through in a flurry of political pressure from the White House ... and it is quite riddled with internal contradictions and anomalies." Prosecuting attorneys in both cases indicated they would appeal the dismissals. But the court designated to hear the appeals — known as the court of military commissions review — doesn't even exist yet, said Marine Col. Dwight Sullivan, chief of military defense attorneys at Guantanamo Bay.

Global legal industry? Danone files suit in U.S. over ventures in China

Groupe Danone SA said it filed a lawsuit in the U.S. against two companies and two people it alleges are infringing on a noncompete clause in China. The suit was filed Monday in Los Angeles. Danone alleged in April that its longtime partner, Chinese multimillionaire Zong Qinghou, had been selling and bottling beverages through his own businesses, in violation of an agreement and other exclusivity contracts. Danone said the U.S. lawsuit was against Ever Maple Trading Ltd., a British Virgin Islands company registered in Los Angeles; Hangzhou Hongsheng Beverage Co.; and two unnamed individuals. Danone alleges that Hangzhou Wahaha Food & Beverage Sales Co. -- a unit of Hangzhou Hongsheng, which is controlled by Ever Maple -- is illegally selling products that are the same as those sold by Danone's Wahaha ventures in China. "Groupe Danone has filed this U.S.- based complaint to put a stop to the defendants' collective scheme to wrongfully interfere with its customer relationships and business prospects," the French firm said.

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• Grammatigalhas

Legal Meaning Is Not Everyday Meaning

Sweetheart deal

A merger, a sale or an agreement in which one party in the deal presents the other party with very attractive terms and conditions. The terms of a sweetheart deal are usually so lucrative that the offeree cannot easily justify turning the offer down.

This term can be used to describe a variety of deals, but in general, a sweetheart deal is a transaction that simply can't be passed up. For example, a merger may be a sweetheart deal for the top executives of the target firm because they get very healthy buyout packages. This kind of sweetheart deal is usually considered unethical, however, because it may not be in the best interests of shareholders.

Everyday "Legal" Jargon 

What is good corporate governance?

This book draws on a rich array of deviant corporate behavior from economies in transition to craft lessons for corporate governance theory. The very first lesson from transition is that standard corporate law theory needs a better definition of good corporate governance. Theorists have long used the term freely, but rarely explained just what they mean. We define corporate governance by looking to the economic functions of the firm. On the basis of this definition, we develop a typology that comprehensively shows all the channels through which bad corporate governance can inflict damage on a country’s real economy. Many of these channels are far more visible when approached from the transition angle, but they are present in rich economies, just harder to spot. 

In developing our definition, we use the Russian experience in the first post-Soviet decade for our primary case, in part because it exhibits such a rich array of deviant corporate behavior. Overall, Russian industry performed poorly after privatization. The voluminous literature on transition economies explains this poor performance primarily in terms of continued bureaucratic meddling, poor macroeconomic and tax policy, and low human capital; problems in corporate governance often are mentioned as well but little analyzed.

After the fall of Russian communism, state enterprises were privatized rapidly, stock markets created, and a corporate legal code adopted. However, even at its peak, before the 1998 collapse, the total stock market capitalization of Russia’s two hundred largest companies only reached about $130 billion—less than that of Intel Corporation. In early 1999 the numbers were “phenomenally abysmal; if they could sink any further, shares would literally have a value of zero. As it is, the entire market is made up of penny stocks.” These numbers represent a trivial fraction of the apparent value of the underlying corporate assets controlled by Russian corporations. The low prices reflect severe corporate governance problems, including the high probability that the firms’ underlying assets will be mismanaged grossly and that whatever cash flow is produced will be diverted to benefit insiders or reinvested in unproductive projects. What were the consequences of these corporate governance problems for the real economy in Russia?

To answer this question, we define corporate governance in a way that looks to the economic functions of the firm rather than to any particular set of national corporate laws. Firms exhibit good corporate governance when they both maximize the firm’s residuals6—the wealth generated by real operations of the firm—and, in the case of investor-owned firms, distribute the wealth so generated to shareholders in a pro rata fashion. Bad corporate governance is just the failure of a firm to meet one or both of these conditions. Whether managers operate their firms in ways that meet these conditions depends on the structure of constraints and incentives in which they operate, a structure that depends in part, but only in part, on the prevailing legal system. We can give more precision to the idea of “bad” corporate governance by developing a novel typology of the kinds of damage to the real economy that loosely constrained and poorly incentivized managers can inflict. By canvassing a rich array of deviant behavior, we identify why this damage has been particularly severe in Russia.

Our analysis is not confined to the Russian experience alone; rather, it provokes rethinking of corporate governance theory more generally. For the first time and in a comprehensive way, we link poor corporate governance to real economy effects. We create an analytic tool that identifies the complete set of vulnerabilities to corporate governance problems that may arise in any economy and that helps to generate more tailored policy responses than previously possible. This article summarizes the complete framework of corporate governance pathologies. We will arrive there by defining what counts as good corporate governance, and then by drilling down to each of the ways that governance can go wrong.

A Typology of Corporate Governance Failures

A. A Simple Definition

Commentators on transition economies invariably discuss the consequences of “poor corporate governance” but without specifying what that means. What little commentary does exist tends to focus on some idealized set of corporate law rules. In contrast, we measure the quality of corporate governance in terms of the social welfare impact of firm decision making. We make no prejudgments about which institutional arrangements work best in any particular country. Under our definition, good corporate governance requires two things: 

• managers must maximize their firm’s residuals;  

• firms, at least investor-owned firms, must distribute those residuals on a pro rata basis to shareholders.

Let us consider each element in turn. The first key feature of a well-governed firm is that its managers make decisions that seek to maximize the residuals that the firm generates over time, discounted to present value. Residuals are defined as the difference between what a firm pays at contractually predetermined prices to obtain its inputs and what it receives for its output. We define this criterion in terms of residual maximization rather than share value maximization to avoid foreclosing the possibility that labor- or consumer-owned firms may be optimal in certain situations. In an ordinary investor-owned corporation, however, the residuals go to shareholders who provide the firm’s equity-based capital, which is the only input not obtained at contractually predetermined prices. Thus, for such a firm, maximizing share value is equivalent to maximizing residuals.

The conclusion that it is socially desirable for a firm to maximize its residuals flows from two assumptions, both of which are standard in simple models of the corporation: 

• that the firm purchases its inputs and sells its outputs in competitive markets, 

• that there are no important externalities or subsidies. 

Thus, the contractually predetermined prices the firm pays for its inputs (other than its equity-based capital) are equal to the value of what the firm takes from society; similarly, the firm’s selling prices for its output equals the value of what it gives to society. Maximizing the difference in value between inputs and outputs maximizes the firm’s contribution to society and hence constitutes efficient behavior.

In the case of an ordinary investor-owned firm, the second feature of good governance is that the residuals are distributed to shareholders and in a pro rata fashion. Meeting this second condition is not strictly necessary for one-period, static efficiency. For a single period, all that is necessary is that the residuals be maximized, regardless of who receives them. The pro rata distribution condition is helpful, however, in achieving the efficient allocation of resources over time because pro rata distribution greatly increases the ability of firms to raise capital by issuing new equity.

For a firm to raise capital by selling equity at a price worthwhile to its owners, a firm needs credibly to promise to abide by both principles of good corporate governance—striving to maximize its future residuals and guaranteeing shareholders some determinable proportion of these residuals as dividends or other distributions. The expectation of eventually receiving such distributions is what makes worthwhile holding a share as a financial instrument and what induces outsiders to provide cash in return for shares. A firm gains credibility in several ways: by developing a record of abiding by its promises, by being subject to a binding legal system, and by structuring incentives so that managers gain if they fulfill their promises and suffer if they do not. If a firm acts contrary to its promises, it undermines its own record and becomes less able to acquire new equity financing. Note, also, that when a legal system fails to punish such a firm, an individual firm’s decision to break its promises imposes externalities: investors become generally less willing to buy equity of other firms governed by the same legal system. In other words, weak corporate governance in existing firms poisons the well for new firms that hope to use equity markets.

Defective corporate governance means that a firm does not meet one or both elements of our definition. Most attention in reports on transition economies has focused on problems relating to non–pro rata distributions: for example, when insiders dilute shares of outsiders, loot companies, fail to pay dividends, or engage in other tactics that deprive outside shareholders of their pro rata share of the wealth generated by the firm. Non–pro rata distributions indeed do help explain low stock prices and the poor performance of the corporate sector. But failure to maximize residuals has the same effect, indeed even more directly. The vast transition economy literature never makes clear which failure dominates in any particular enterprise fiasco. Instead, bad corporate governance becomes a catchall explanation for problems that should be understood as being quite distinct. Pinning down and separating out these distinctions should prove helpful when it comes time to prescribe policy cures.

A cautionary methodological note is in order at the outset, however. The study of corporate governance is hampered by two problems:

First, serious firm-level econometric study of corporate governance changes is difficult, if not impossible, if meaningful hard data on enterprise behavior are hard to come by. Firms may not publish credible accounts of their own performance, because managers hid their ongoing thefts of firm assets from outside shareholders and from others, including labor and the mafia, who likewise sought to steal those assets themselves. Back-tax debts, which pervade the corporate sector, meant that any reported income might be seized, making the effective tax rate 100 percent. Thus, income statements and balance sheets may be fictional. 

Second, econometric work testing propositions about corporate governance based on country-level comparisons of economic performance is similarly difficult. Good corporate governance is neither a necessary nor a sufficient condition for achieving a developed capitalist economy—it simply helps. 

These two problems mean that we are left with anecdotal accounts and surveys as our main sources of empirical information. These sources involve their own biases; nevertheless, they present a reasonably coherent picture of the landscape of corporate governance failures. Imposing a theoretical framework on this picture yields a plausible and informative account of the relationship between corporate governance and national economic performance.

B. The Failure to Maximize Residuals

In this section, we identify five distinct pathologies that loosely constrained and poorly incentivized managers may inflict on firms and that may result in the firms’ failure to maximize residuals. We focus first on this prong of bad corporate governance because it is crucial to explaining why insiders sometimes do not operate their firm even to maximize their own joint benefit. As we shall see, the initial structure of ownership makes firms particularly vulnerable to these five corporate governance pathologies. When the initial ownership structures intersect with untenable firm boundaries, the pathologies we identify here become self-reinforcing and even more intractable.

Pathology 1: continued operation of value-destroying firms

Any economy has some unreformable value-destroying firms that should be shut down immediately. Continued operation of these firms, even if undertaken as efficiently as possible, represents a negative net present value decision from a social point of view: The cost of operation in the current period results in a social loss too great to be offset by social gains, if there are any, from continued operation in subsequent periods. Despite the social harm, institutional arrangements in an economy nevertheless may permit such a firm to continue operating. 

In the case of many unreformable value-destroying firms, poor corporate governance is the main cause of their continued operation, and hence the reason for identifying this problem as the first type of potential corporate governance pathology. Firm managers wish to continue operations in order to hold on to their jobs and the associated perquisites. Because they are not constrained by effective corporate governance mechanisms, the managers get their way. In other cases, however, good corporate governance is not necessary to shut down a firm that in fact should be closed. And in yet other cases, good corporate governance is a necessary but not a sufficient condition to close the firm. Making these distinctions is important for identifying effective policy responses.

a. When Is Corporate Governance Relevant? 

Retain the assumption for a moment that an unreformable value-destroying firm purchases inputs and sells outputs in competitive markets; that there are no important externalities; and that credit and other finance is extended to firms only on a reasonably informed, rational basis. Even with no new investment, such a firm’s ordinary operations result, in the current period, in a negative cash flow (one that is sufficiently negative that expected future cash flow, discounted to present value, would, even if positive, be unable to offset it). The firm thus would lack enough current cash flow to purchase the inputs it needs to continue production and would lack cash flows in the future to use as a basis to obtain credit or other finance sufficient to cover this deficit.

The importance of corporate governance here depends entirely on whether the firm has any cash reserves or assets with significant salvage value. Without reserves or salvageable assets, the firm would be forced to close immediately, regardless of how much its managers wanted to continue operations, and regardless of how ineffective existing corporate governance mechanisms were in restraining the managers. Russia’s generally outmoded factories suggest that many firms lacked assets with any significant salvage value. There was also a general cash shortage. Thus, absent subsidies and problems in the way credit is extended, many firms whose continued operation was value destroying would have shut down promptly even though the corporate governance regime was highly ineffective. Neither improved corporate governance nor an effective bankruptcy regime would have been necessary to eliminate such firms.

For firms with reserves or salvageable assets, however, effective corporate governance is necessary to shut down the firm immediately. Even if the legal regime reflects a sound model, there is still the problem of enforcement. With weak enforcement, managers can indulge their desires to continue operation. Where cash reserves are available, the cash can be used directly to buy the needed inputs. Where the firm has salvageable assets, cash can be raised by selling the assets or using them as a basis for gaining credit. Many value-destroying Russian firms did have assets with significant salvage value. Manufacturing businesses, for example, often were located inside large cities on real estate with far more value in other uses. If a firm has a negative cash flow, its managers nevertheless may be able to keep operating by cashing out the salvage value of these assets to acquire needed inputs. Even with a positive cash flow, closing the firm may be socially desirable once the rental value of the land is counted properly as an opportunity cost.

b. The Role of Subsidies and Inappropriate Credit and Finance. 

Now, drop the assumptions made above concerning subsidies, credit, and finance. Where there is a subsidy, or where credit or finance is extended on other than a reasonably informed and rational basis, a firm can have a positive cash flow even though the social benefit from the firm’s output might be less than the social cost of its inputs. Under such circumstances, the firm’s continued operation, even though involving a social loss, can be perfectly consistent with maximizing residuals. Corporate governance mechanisms that push a firm’s managers to maximize residuals will not lead by themselves to the socially desirable result of closing down these firms. Indeed, for firms without reserves or salvageable assets, the quality of corporate governance is not even relevant. Such firms will be shut down, regardless of the quality of corporate governance, only if the subsidies or inappropriate credit provision is ended.

Russia continued to provide many subsidies, particularly in the energy area. The system by which input suppliers were paid, often involving barter, was highly chaotic, implying that credit was not extended in a rational, well-informed fashion. Workers often became involuntary creditors when firms did not pay them. All this suggests that, while many Russian firms that were continuing to operate should have been shut down immediately, improved corporate governance would not, or would not by itself, have solved the problem. Instead, elimination of subsidies and improvement of the credit process were necessary reforms.

In sum, Russian firms that should have been shut down immediately fall into three groups. The first consists of firms with no cash reserves or assets with significant salvage value that did not benefit from subsidies or unsuitable credit extensions. These firms were presumably closing on their own, no matter how bad their corporate governance mechanisms. In the second group are firms with no cash reserves or assets with significant salvage value but that did benefit from subsidies or unsuitable credit extensions. Given the pervasiveness of the problems that existed in the economy, particularly the provision of energy at below world market prices, this second group may well be much larger than the first.34 Effectively addressing the subsidy and credit problems will cause these firms to close, but they will not close otherwise. Improvements in corporate governance will have no effect on this second group. The third group, which is also large, includes firms with cash reserves or assets with significant salvage value that also benefited from subsidies or unsuitable credit extensions. These firms will not close unless there is both an improvement in corporate governance and an end to the subsidies and unsuitable credit extensions.

Pathology 2: failure to use existing capacity efficiently

The second type of pathology arises when continued operation, if undertaken as efficiently as possible and without new investment, would be a positive net present value decision, but operation is not done as efficiently as possible. Costs are not minimized, the best price is not obtained for a given level of output, or a non-profit-maximizing output level is chosen—again. Thus, residuals are not maximized. Such firms should not shut down, but they should deploy existing facilities more efficiently. Their residuals shortfall represents a social welfare–diminishing corporate governance failure.

The widespread existence of Pathology 2 may mask the potential extent of Pathology 1. If firms generally are not using their inputs efficiently, the marginal products of these inputs are likely to be lower, and thus, in a competitive economy, the price that needs to be paid for them and the opportunity cost of their use will be lower as well. A wholesale reduction in Pathology 2 will increase the price and social opportunity cost of at least some, and quite possibly all, major classes of inputs. Input price adjustments may sharply increase the number of firms displaying Pathology 1 as the increased opportunity cost of their inputs makes their continued operation socially undesirable.

Pathology 3: misinvestment of internally generated cash flow

The third type of pathology arises when a firm uses its internally generated cash flow to invest in new negative net present value projects. Instead of making bad investments, such a firm should pay out this cash flow to shareholders. Shareholders could invest these funds better elsewhere in the economy. An example of Pathology 3 includes the seemingly responsible act of using funds labeled by accountants as depreciation to replace worn-out plant and equipment, if doing so is a negative net present value project. Pathology 3 can arise in conjunction with, or independently of, Pathology 2. 

First, consider the paucity of interfirm cash flows in Russia. In any economy, good investment opportunities are unlikely to be spread so evenly among existing enterprises that interfirm transfers of cash flows through capital markets are not called for. Nor is the quality of existing firms’ opportunities likely to be consistently superior to the opportunities that could be found by new firms. Thus, some existing firms (capital-surplus firms) will have cash flows greater than what is needed to fund all their positive net present value projects; other existing firms (capital-deficit firms) will have insufficient cash flows to fund all such projects. In addition, there will exist new firms that have positive net present value projects but that, by definition, have no cash flows at all. Thus, interfirm cash flow transfers are called for from surplus firms to deficit firms and new firms. In a market economy with clearly distinct firms, these transfers are accomplished when surplus firms pay dividends and deficit firms and new firms enter the capital markets, through, for example, the offering of new equity. In Russia, firms paid little or nothing in the way of dividends and equity finance was negligible. The lack of interfirm transfers strongly suggests that the surplus firms were instead displaying Pathology 3 and likely investing in negative net present value projects.

The second source of indirect evidence for Pathology 3 relates to firms’ failure to make pro rata distributions of residuals. One way that controlling shareholders can divert a disproportionate share of residuals to themselves is to have the firm invest in projects personally benefiting these shareholders. On balance, controlling shareholders may prefer to fund such projects, even if they have a negative net present value—their personal benefits more than outweigh the reduction in share value from implementing the project. Controlling shareholders will be able to indulge these preferences if the mechanisms to constrain non–pro rata distribution of dividends are weak. 

Pathology 4: failure to implement positive net present value projects

The fourth pathology of residual non-maximization arises directly or indirectly when a firm identifies, but then fails to act on, positive net present value projects. If others do not pick up the opportunity, the firm’s failure reduces social welfare, because of the forgone chance to deploy funds to produce a return greater than the cost.

Pathology 4 is a direct result of corporate governance failures in cases in which managers, because of weak control mechanisms, reject a positive net present value project because they wish to avoid personal risk. Managers tend to be risk averse because they cannot diversify away the unsystematic risk associated with any individual firm project. If managers can get away with it, they may reject projects with high expected returns if the projects have high unsystematic risk as well, even though such rejections are not in the interests of shareholders or society as a whole. By contrast, portfolio shareholders, who can diversify their holdings, are risk neutral with respect to unsystematic project-level risk. Management risk aversion causes problems everywhere, but the problems were likely accentuated in established Russian firms because incumbent managers typically internalized a high degree of risk aversion through Soviet-era careers in which punishment for major mistakes far exceeded gains from major successes. The type of private owner matters, with firms controlled by the prior incumbent managers typically undergoing less successful restructuring.

Corporate governance failures also can lead firms indirectly to forgo positive net present value projects. Consider a firm with willing managers and with the prospect of a value-creating project that is nevertheless unable to proceed because financing is unavailable at a price equal to the capital’s social opportunity cost. The lack of financing may be an externality imposed by corporate governance failures in other firms. When firms generally fail to make pro rata distributions and to maximize residuals, they may severely undermine the ability of firms with good projects to acquire financing through new equity offerings. Banks are the usual alternative sources for outside finance, but in Russia, banks are still providing little long-term corporate lending. The lack of a vibrant new equity market or of bank financing proves fatal for good projects in firms that do not generate sufficient internal funds to self-finance the project.

Pathology 5: failure to identify positive net present value projects

The fifth type of pathology arises when a firm’s managers fail even to identify positive net present value projects that the firm, through its specialization and the resulting accumulation of knowledge, is particularly well positioned to find. Organizational capacity to identify these opportunities is related to the incentives available to firm employees for identifying such projects as well as the incentives for them to help one another in a joint endeavor to do so.

In the United States, venture capital significantly reduces the social costs of Pathology 5 by making available funds for promising projects that employees identify, but managers misassess. Venture capital also significantly lessens the effects of Pathology 4 on the U.S. economy by making spinoffs possible whereby employees suggesting promising projects can implement the proposal by creating a new firm, despite the employer’s rejection. The possibility of getting rich in a spinoff gives employees substantial incentives to identify positive net present value projects even if they work for firms that ultimately may not implement the ideas. Furthermore, when spinoffs occur, Pathologies 4 and 5 do not harm the economy, because the project is implemented anyway.

C. The Failure to Make Pro Rata Distributions

The second feature of good corporate governance is that a firm makes the residuals it generates available on a pro rata basis to the residual claimants, that is, to the common shareholders in an investor-owned company. Much of modern corporate law has been built around this principle, not only in rules requiring that dividends and distributions be made pro rata, but also in the basic fiduciary rules policing non-arm’slength transactions involving insiders and the corporation. In post-privatization Russia, violation of this second feature has been the most visible and widely reported symptom of bad corporate governance. Just as non-maximization comes in different flavors, firms have exhibited a wide range of non–pro rata distributions, which we simplify into two main groups, each with many variations. Loosely, one type is what we call “diversion of claims” and the other, “diversion of assets.” We explore each in turn.

Pathology 6: diversion of claims

To give just a few illustrations, ranging from blatant to subtle, managers divert claims of the corporation when they refuse to register share purchases by outsiders, refuse to recognize board directors properly elected by outside shareholders, dilute stock in ways that freeze out outsiders by issuing shares to insiders for inadequate consideration, or engage in fake bankruptcies that wipe out shareowners’ interests.

The key feature of these non–pro rata distributions is that the people perpetrating them, usually insider owner-managers, are keeping the firm, including its assets and opportunities, intact. They gain instead by manipulating the corporate legal system and the bankruptcy law and other laws in an effort to reduce or eliminate the claims of some or all of the firm’s shareholders on the firm’s residuals—usually wiping out the outside minority shareholders. As one investor put it, “‘A 51% share-holding interest in a Russian company conveys to the owner a license to steal from the remaining 49%.’”

And managers were not the only ones diverting control. Reports suggest that local and regional governments with minority-share interests began engaging in the same game, forcing firms into bankruptcy over unpaid taxes and then asserting control, in essentially a form of renationalization in cases where tax rates are absurdly high, exceeding 100 percent marginal rates. Also, outside shareholders such as those associated with financial-industrial groups (FIGs) have taken over firms, replaced managers, and then also froze out minority shareholders, including employees.

Pathology 7: diversion of assets

The second major class of non–pro rata distributions, and the last pathology in our framework, involves direct diversion of assets and opportunities belonging to the firm. The key feature of this type of corporate governance failure is that insiders leave the ownership structure intact as they hollow out the firm. For managers, diversion of assets may be accomplished by outright looting of the firm—taking cash or assets belonging to the firm and effectively giving title to themselves. Or it may take the form of sweetheart business deals with firms controlled by insiders or their families, using, for example, transfer-pricing agreements that move profits to subsidiaries or parents in which the insiders have a larger interest. According to one report, “Protecting sweetheart financial deals is behind much of the hostility to outside investors. Virtually every Russian enterprise, big or small, is surrounded by “independent” companies set up by managers or their families. In many cases, sales and purchasing contracts are structured to go through these firms, raking off profits from the main enterprise.”

Russian firms also engage in non–pro rata distribution of residuals when they continue to pay for redundant shareholder employees or when they provide public services without compensation or relief from reasonably and equitably imposed tax obligations. 

Neither the diversion of assets nor the diversion of claims noted in the previous section necessarily decreases social welfare in a static analysis—the diversions merely redistribute wealth from one group of owners to another. But moving to a dynamic analysis changes the story. If outsiders do not believe that they will receive pro rata distributions, then they will be unwilling generally to treat shares as financial assets, and they will be unwilling to provide equity finance in exchange for anything less than total control. Because potential outside investors cannot protect against ex post diversions of their investments in firms that turn out to be successful, they have little ex ante incentive to invest on terms that would be appealing to firms with positive net present value projects.

D. A Simple Framework Meets Complex Failures

Real-world cases do not fit neatly into one or another of the boxes we describe, but rather represent complex mixtures of several failures. To start, if managers are neither sufficiently constrained nor given incentives to prevent the diverting of claims, they similarly will be able to divert assets—both types of diversion may be undertaken at once, often in ways that are hard to tease apart. Next, there is a potential interaction between the failure to make pro rata distributions and the failure to maximize residuals.

Some tactics used to effect a non–pro rata distribution of a firm’s wealth have no direct effect on residual maximization. This generally would be true of diversion of claims and of brazen, outright theft of assets. Other tactics, however, do reduce a firm’s residuals; for example, when owner-managers grant themselves unjustifiably large perquisites, make non-arm’s-length sweetheart deals involving the company and its insiders, or engage in direct thefts of assets that require considerable efforts to cover up.

Finally, a management intently focused on, and especially skilled in, diversions may have neither the time nor the ability to give adequate attention to maximizing residuals as well. 

For the next step, we need to examine in more detail how firm performance is linked to the key elements of good corporate governance. That is, how do the mediating effects of law, owners and managers, and stock markets affect firm behavior and its impact on the real economy?

Source: Corporate Governance Lessons from Transition Economy Reforms, Edited by Merritt B. Fox & Michael A. Heller, 2006, Princeton University Press.

As If Your Life Depended On It... or How to get to Carnegie Hall? - Practice, practice

Let's face! it! - English is a crazy language.

Four all who "reed" and "right"

We'll begin with a box, and the plural is boxes,
but the plural of ox became oxen not oxes.
One fowl is a goose, but two are called geese,
yet the plural of moose should never be meese.

You may find a lone mouse or a nest full of mice;
yet the plural of house is houses, not hice.
If the plural of man is always called men, 
Why shouldn't the plural of pan be called pen?

If I spoke of my foot and show you my feet, 
And I give you a boot, would a pair be called beet?
If one is a tooth and a whole set are teeth, why
shouldn't the plural of booth be called beeth?

Then one may be that, and three would be those,
yet hat in the plural would never be hose,
and the plural of cat is cats, not cose.

We speak of a brother and also of brethren,
but though we say mother, we never say methren.
Then the masculine pronouns are he, his and him,
but imagine the feminine, she, shis and shim.

Let's face! it! - English is a crazy language.

There is no egg in eggplant nor ham in hamburger; 
neither apple nor pine in pineapple.
English muffins weren't invented in England. 
We take English for granted.

But if we explore its paradoxes, we find that quicksand
can work slowly, boxing rings are square and 
a guinea pig is neither from Guinea nor is it a pig.
And why is it that writers write but fingers don't fing,
grocers don't groce and hammers don't ham?

Doesn't it seem crazy that you can make amends,
but not one amend?
If you have a bunch of odds and ends, and get rid
of all but one of them, what do you call it?

If teachers taught, why didn't preachers praught?
If a vegetarian eats vegetables, what does a humanitarian eat?

Sometimes I think all the folks who grew up speaking English
should be committed to an asylum for the verbally insane.
In what other language do people recite at a play and 
Play at a recital?

Ship by truck and send cargo by ship?
Have noses that run and feet that smell?
How can a slim chance and a fat chance be the same, 
while a wise man and a wise guy are opposites?

You have to marvel at the unique lunacy of a language
in which your house can burn up as it burns down,
in which you fill in a form by filling it out 
and in which an alarm goes off by going on.

If Dad is Pop, how come Mom isn't Mop?
Or park on a driveway and drive on a parkway?
-- Author unknown -- or is it "Knot known"?

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• Historia Verdadera

• Brief News

Republican rivals go head-to-head

Republican presidential candidates in the US have sparred over policy differences in a live TV debate. The 10, including frontrunners Rudy Giuliani, John McCain and Mitt Romney, took questions from journalists and voters in the state of New Hampshire. The most heated exchanges were sparked by a controversial immigration bill.  McCain said it was needed to meet "national security challenges", while Giuliani called the legislation "a typical Washington mess". "The litmus test you should have for legislation is - is it going to make things better? When you look at these compromises it is quite possible it will make things worse," Giuliani said.

Lula calls for ethanol investment

Rich countries must be ready to pay to help developing countries preserve their environment, Lula said. This should include investment for African nations to develop biodiesel and ethanol. Lula has been invited to attend a G8 meeting in Germany this week that will focus on global warming.

Colombia starts releasing rebels

The Colombian government has begun the process of freeing imprisoned rebels in a move President Uribe says is a unilateral goodwill gesture. The first 56 of some 200 rebels were moved from jail to attend a four-week rehabilitation course prior to release. Uribe on Monday freed a guerrilla leader at France's request.

Censorship 'changes face of net'

Amnesty International has warned that the internet "could change beyond all recognition" unless action is taken against the erosion of online freedoms. The warning comes ahead of an Amnesty organized conference where victims of repression will outline their plights. The "virus of internet repression" has spread from a handful of countries to dozens of governments, said the group. Amnesty accused companies such as Google, Microsoft and Yahoo of being complicit in the problem.

US lawmaker faces bribery charges

US Democratic Congressman William Jefferson, who allegedly hid $90,000 in his freezer, has been charged with 16 counts of bribery and corruption. Prosecutors accuse Jefferson of using his official position to broker deals in several African nations and demand kickbacks for himself. Jefferson, who represents a Louisiana district, was re-elected last November while under investigation.

Rate review

The European Central Bank is expected to raise interest rates to 4% from 3.75% following its latest meeting. UK interest rates are expected to remain at 5.5% after the Bank of England's latest meeting, but analysts say a rate rise remains a possibility. The Fed next meets to consider interest rates on 27-28 June, and most analysts expect rates to remain at 5.25%, where they have been for more than a year.

Carbon trade scheme 'is failing'

The EU's carbon trading scheme has increased electricity bills, given a windfall to power companies and failed to cut greenhouse gases, it is claimed. It is essentially a permit to pollute. Power generators received their allowances free of charge but were allowed to reflect the value of those in increased prices to customers, as if the companies had actually had to buy the allowances. And according to one government estimate, that delivered windfall profits to the generators in that year

Nigeria sues drugs giant Pfizer

Nigeria has filed charges against the pharmaceutical company Pfizer, accusing it of carrying out improper trials for an anti-meningitis drug.

The government is seeking $7bn in damages for the families of children who allegedly died or suffered side-effects after being given Trovan. Kano state government has filed separate charges against Pfizer. The firm denies any wrongdoing, saying the trials were conducted according to Nigerian and international law.

Soros invests 900 million dollars in Brazil's ethanol, calls for lower tariffs

International stock investor George Soros said on Tuesday that he had invested 900 million U.S. dollars in Brazil's ethanol production and will continue to invest, but he warned that demand may not keep up with the expansion of the production unless the international market opens fairly to Brazil's ethanol. At the Sao Paulo Ethanol Summit 2007, organized by the Union of Sugarcane Industries (Unica), the billionaire admitted being a "speculator", who is currently speculating on Brazil's ethanol industry. He has joined the 900-million-dollar plan to buy sugarcane land and build ethanol distilleries in western Brazil. Brazil could increase its ethanol production ten-fold, but there are problems to overcome, Soros said. The Brazilian market for ethanol is almost saturated, so exports are essential for industry growth. But trade barriers from other countries dampen exports, the investor said. The United States and the European Union levy high tariffs on Brazil's ethanol, which makes it expensive. The question is "how to open up the market in the USA, Europe and Japan," and how "to create an environment with stable prices.”

Arcelor Mittal almost buys out its Brazil arm for $5.4 billion

Arcelor Mittal, the world's largest steelmaker, has acquired 191.3 million outstanding shares, or 90 per cent of the minority shares, in its Brazilian arm - Arcelor Brasil - from other shareholders, bringing the company's stake to 96.6 per cent. Arcelor Mittal said it would pay $3.699 billion plus 27 million shares for the tendered shares, representing a total price of $5.412 billion (10.3 billion reais) to raise its stake from the previous 67.1 per cent. Shareholders outside the US would be able to choose an all-cash offer or a combination of 10.82 reais plus 0.3568 common shares of the parent company, it said in a statement. The sell-out right for shareholders who decided not to tender their shares will start on June 5 and end on September 4, in accordance with Brazilian financial markets regulations.

Bracing for Battle

U.S. patent law, already shaken up by a Supreme Court ruling this spring, is facing its biggest overhaul in 50 years, amid a legislative battle that pits drug companies against some major players in the financial and high-tech sectors.

Germany court upholds teacher headscarf ban 

A German state court Tuesday upheld a ban on religious headscarves  in public schools and affirmed the right of a school not to employ a teacher who said she would be unable to follow that law. The teacher argued the law was discriminatory and violated religious freedom. In upholding the law and finding the headscarf to be a sign of religious belief, the North Rhine-Westphalia court said that the ban ensured state neutrality toward the religions of students and parents. Numerous German states, as well as various countries around Europe, have considered headscarf bans over the last several years.

• Daily Press Review

Africa

It's bloodbath as police strike back at Mungiki
East African Standard, Liberal daily of Nairobi, Kenya

Unions seek to widen public-service strike
Mail and Guardian, Liberal daily of Johannesburg, South Africa

Don't allow corrupt leaders to hide their loot in your countries ñ G8 told
Times of Zambia, Government-owned daily of Lusaka, Zambia

Americas

Find a solution together
Barbados Advocate, Independent daily of St Michael, Barbados

Kirchner lets Macri have it, both barrels
Buenos Aires Herald, Liberal daily of Buenos Aires, Argentina

Visa denial brings Winnie Mandela to tears
The Globe And Mail, Centrist daily of Toronto, Canada

Still illiterate! -  Teachers claim grade four reading programme has failed
Jamaica Gleaner, Centrist daily of Kingston, Jamaica

Asia Pacific

LDP releases upper house poll platform Pension woes, 'Beautiful Japan' campaign focus
Daily Yomiuri, Conservative daily of Tokyo, Japan

Chinese vice premier Huang Ju's remains cremated
People's Daily Online, Pro-government daily of Beijing, China

Bali nine denied chance to plead
The Sydney Morning Herald, Centrist daily of Sydney, Australia

Five Tourists Injured in Dhading Mishap
The Himalayan Times, Independent daily of Kathmandu, Nepal

Govt rejects OIC on MNLF camps
The Manila Times, Pro-government daily of Manila, Philippines

PM to wed Jeanne Abdullah on Saturday
The Sun, Independent daily of Kuala Lumpur, Malaysia

Europe

Kremlin Rejects Bush Criticism on Democracy
Deutsche Welle, International broadcaster of Cologne, Germany

Blood-sucking vampire moth becoming more common in Finland
Helsingin Sanomat, Centrist daily of Helsinki, Finland

Recognition  of  Kosovan  independence would worsen ties with Belgrade - Jeremic
Interfax, Government-owned news agency, Moscow, Russia

Coroner in stark cocaine warning after five deaths
Irish Examiner, Centrist daily of Cork, Ireland

Bush Says Russia Derailed Reforms
The Moscow Times, Independent, English-language daily of Moscow, Russia

Putin: A living riddle, wrapped in a mystery, inside an enigma
The Scotsman, Centrist daily of Edinburgh, Scotland

Parties fight to conquer the 'center'
Turkish Daily News, Independent daily of Istanbul, Turkey

Middle East

Blame game
Al-Ahram Weekly, Semi-official, English-language weekly of Cairo, Egypt

Virtue Commission Member Calls for Fairness From People
Arab News, Pro-government, English-language daily of Jidda, Saudi Arabia

Army goes back on offensive against Fatah al-Islam
The Daily Star, Independent, English-language daily of Beirut, Lebanon

Cyclone Gonu makes land
Gulf News, Independent daily of Dubai, United Arab Emirates

IDF kills 2 Palestinians in West Bank, Gaza attacks
Ha'aretz, Liberal daily of Tel Aviv, Israel

Ahmadinejad: Iran serving global peace and security
Islamic Republic News Agency, Government-owned news agency of Tehran, Iran

Israel to ask Washington for limits on Saudi missile deal
The Jerusalem Post, Conservative daily of Jerusalem, Israel

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