Business Removing

PROTECTING INVESTORS 53
FIGURE 7.4
Pyramid structures can mask related-party transactions
Controlling
family
1b
51%
51%
Choten
2b
Public
investors
Ichi
Ni
1b
1b
51% 51% 51%
51%
Futatsu-Ichi Futatsu-Ni Futatsu-San Futatsu-Yon
1b 1b 1b 1b
Source: Aikawa (1934).
51%
Total public
investment
4b
takes Choten public and raises almost an additional ¥1
billion. It then organizes 2 other businesses, Ichi and Ni,
each financed with ¥500 million from Choten and almost
¥500 million in public equity. Another 4 firms are
organized under Ichi and Ni with the same strategy (figure
7.4). Now the family fully controls 7 firms, with ¥5
billion in consolidated assets, by leveraging ¥4 billion
from small investors. To raise the same equity through
Choten alone, their ownership would have been diluted
to a minority 20%. Good for the family. But minority investors
are more vulnerable to expropriation if they are
unaware of how business between Choten and its subsidiaries
could benefit the controlling family.
Beneficial ownership. A third way to gain control is
through nominee accounts, trust funds, or brokerage
firms, where the identity of the buyer is not disclosed. 18
This practice is so popular in Indonesia, that by 1996
the Suharto family managed to amass control of 417
companies, 21 of them publicly-listed, using nominee
accounts and trusts. The practice is still permitted. In
contrast, Malaysia revised its regulation in 2001 to limit
nominee ownership.
Voting agreements. Fourth, shareholders may have
agreements that stipulate collective voting on strategic
issues or managerial appointments. If these agreements
are not disclosed, as in Jordan, the Philippines or Turkey,
small investors may lose out.
In addition to ownership disclosure, 2 types of financial
disclosure help investors.
Audit committees. The quality of financial information
is increased if the company law or securities law
requires internal audits before financial statements are
released to investors. The business can have an audit
committee that reviews and certifies financial data. Better
yet, the committee may include some outside members.
Korea has made the most progress, by mandating
audit committees and also requiring that two-thirds of
the committee members in large companies be outsiders.
External audits. Laws can also require that an external
auditor be appointed. Countries like Argentina and
Spain have both an internal audit committee and an external
auditor, while Hungary, like many other countries,
has a requirement only for an external auditor. One
caveat: in many countries external auditors are not so independent.
In Peru, for example, an estimated 6,000 auditors
vie for the business of 200 listed companies, which
pay the highest fees for auditing services. Sometimes, the
most malleable auditors get the job.
Public access to information. Finally, disclosure is
most effective when both ownership and financial information
are available to all current and potential investors,
either in stock exchange bulletins if the company
is public, or in annual reports, newspapers, or company
registries for privately held companies. One example. In
2000 the Australian Stock Exchange introduced a realtime
disclosure system that utilizes the Internet for reporting
information that may affect investors’ choices. It
also monitors the media for company announcements
that may have not been reported but fall under the disclosure
regulation. About 300 such announcements were
detected last year. Yet in countries like Saudi Arabia or
Venezuela, only the regulators have access to ownership
information.
The 7 ways of enhancing disclosure—by reporting
family, indirect, and beneficial ownership, and on voting
agreements between shareholders, by requiring audit
committees of the board of directors and the use of
external auditors, and by making such information
available to all current and potential investors—make up
the Doing Business indicator of disclosure (table 7.3).
Twenty four countries have 6 or more of these features.
Thirty others—almost all poor countries—have fewer
than two.
Legal protections
Disclosure of ownership and financial information is
just the beginning. Legal protections of the rights of
small investors are needed. In the Peronnet case, for example,
failure to disclose was not sufficient to void the
lease agreement with SCI. The court ruled that the decision
to lease was not taken with the sole intention of
benefiting the majority shareholder and served a legitimate
business purpose. It took no interest in the question
of whether the creation of SCI and the price it