The Mongolian Corporate Governance Context

Published Date: 02 Nov 2017

CHAPTER 3

Much has been achieved by the Mongolian government to improve the legal and regulatory framework or corporate governance. Also, the corporate governance framework should impact overall economic performance, market integrity and incentives, and transparent and efficient markets. Mongolia’s policy-makers should guide and require companies to improve their corporate governance. More specifically, the government should provide the Bank of Mongolia (BoM), Financial Regulatory Commission (FRC), Mongolian Stock Exchange (MSE) and other regulatory sector with the necessary resources and ensure for their independence so that they may rigorously, consistently, and fairly enforce laws and regulations. Therefore, Bank of Mongolia (BoM) launched a set of corporate governance regulations for banks, and a number of amendments were made to modernize the company law, with further amendments planned for the securities law. Corporate governance practice as carried-out by Mongolian publicly listed companies. In December of 2012, there were 384 joint stock companies listed on the Mongolian Stock Exchange (MSE). The Mongolian Stock Exchange (MSE) was established in 1991 as a vehicle to implement the government's plan for privatization of large state-owned enterprises. In an attempt to ensure an equitable distribution of assets, the Mongolian government chose to initiate a voucher based scheme; one blue voucher worth MNT 7,000 was issued to every citizen born before 31 May 1991 for the purchase of shares in large enterprises and red vouchers worth MNT 3,000, which could be used to purchase assets in smaller enterprises not listed on the exchange. Auctions officially began on February 7, 1992. During this first phase, trading was only open for two hours, one day per week. In 1995, parliament passed the ‘Law on Securities’, allowing the MSE to operate as a regular stock exchange open to both domestic and foreign investors. This also established the two tiered exchange with the primary market for IPOs and the secondary market for subsequent trading. Trading is now open between 11.00 and 13.00 every weekday for the both primary and secondary markets. Trading can also be done over the internet. The revision to the Securities and Exchange Law adopted by the Parliament in December 2002, transformed MSE into a 100 per cent state owned company. The MSE signed ‘memoranda of understanding’ with the Korean, Singaporean and Hong Kong Stock Exchanges, to help with its development and attract more foreign investment. In April 2011, the MSE formally agreed to a partnership with the London Stock Exchange (LSE) aimed at transforming MSE to operate on an international scale. The partnership agreement provides for the development of systems infrastructure, the support of senior experienced people to manage the transformation and skills and policy development. The intention is to increase the ability to trade and to make it an attractive option for Mongolian companies and overseas investors. There are currently around 329 companies listed on the MSE, over one-fifth of which are involved in mining, the most common sector for foreign investment. As of yet there is no restriction on foreign ownership of shares, although in the uranium sector, for example, ownership must be approved by the Nuclear Energy Agency, which could in theory refuse the transfer of shares to a foreign entity. In accordance with the partnership agreement, MSE has launched new trade and payment system in cooperation with London Stock Exchange in July 2012. In 2012 The main indicator of Stock market (see Table A.3 p.64 on Appendix), following there registered 329 the private and state-owned enterprises. Some 277 private companies are now listed on the MSE, with total market capitalization of MNT 1,180 (billion).

Figure 3. Number of Company in Mongolian Stock Exchange

Source by Annual report of Financial Regulatory Comission (2011 year)

The Financial Regulatory Commission, in 2011 year reporting period, included for capital market with highest market value companies are Tavan-Tolgoi LC /579.3 bill/, APU LC /312 bill/, Baganuur LC /274.8 bill/, Shivee Ovoo LC /205.3 bill/, Shariin Gol LC /96.7 bill/.

TOP-20 Index, defining a general tendency of 20 listed companies in the capital market with highest market values and liquidity, has reached to 2168.5 points by the end of 2011, which has increased by 997.2 points or 46.9 percent increased for compared to same period of previous year. (shows in following graphic)

Figure 4. Market value ( billion tugrug)

Source by Annual report of Financial Regulatory Commission (2011 year)

The operation of the capital market is not viewed as being reasonably transparent. The corporate governance framework does not ensure for high levels of financial and non-financial disclosure and transparency. Insider trading and market manipulation remain issues of concern for many market participants, and market intermediaries are not thought to operate in a transparent manner. The authorities do not develop policies, laws, and regulations on the basis of effective consultation with stakeholders. While some authorities place draft laws on the parliament’s website, and FRC has a "project discussion" menu on its website and itself places drafts of its regulation online for public discussion, most governmental bodies fall short of good practice as they do not actively solicit comments, organize roundtable events to gather feedback and buy-in, and publish comment online. For example, the MCGC was largely developed and drafted by the Asian Development bank (ADB); and though the MCGC was approved by the FRC in 2007, only three public consultation workshops were held, targeting the FRC, financial intermediaries, and NGOs. The legal and regulatory framework is not used in an arbitrary or inconsistent manner incompatible with the rule of law, but too complex for some companies. While laws and regulations are not used in an arbitrary manner by the authorities, a number of laws are not enforceable as they are too complex to comply with by some Mongolian companies. Thus, unlisted joint stock companies that by most accounts would qualify as SMEs are required to apply International Financial Reporting standards is preparing their financial reports, against good practice.

The role of shareholders: Shareholders are able to participate in key of corporate governance decision, in particular with respect to the remuneration of board members (Art.66.5.14 Company Law), though it is not clear whether this only includes the remuneration of non-executive directors or is also thought to encompass executive compensation. Also the corporate framework does not require companies to publicly disclose their capital structures. Shareholders holding ten percent or more of shares may demand that the company provides them with a list of the number of shares held by each shareholder (96.3 CL), and shareholders are required to inform the FRC when they, individually or jointly, own more than five percent (and ensuring increments of five percent) or one-third of the company. The FRC is in turn required to publicly disseminate information on owners holding five and more percent (MC 6-1), but does not appear to do so in practice. Companies are not required or encouraged to disclose group structure, shareholder agreements, or special voting rights. In practice, ownership structures are thought to be opaque, and even the BoM and FRC are often unaware who the beneficial owners of a bank or company are.

The Bank had discovered that Mongolia has a significant and flourishing local private sector, and many current opportunities being developed by the Banks are indeed with local enterprises. Of particular note is the need for equity. Privatization of large state-owned enterprises has slowed down, those remaining being either financially unviable or to be kept under state control for strategic reasons. Moreover, the development of private businesses will remain the main pillar of the Bank’s strategy. The Bank will explore possibilities of direct financing especially in the form of equity in a number of key sectors, including mining, agribusiness, cashmere/textile, hotel and tourism, property and services, which will contribute to the diversification of the economy.

Capital structure affects a company’s overall value through its impact on operating cash flows and the cost of capital. Since the internet expense on debt is tax deductible in Mongolia, a company can reduce its after-tax cost of capital by increasing debt relative to equity, thereby directly increasing its intrinsic value. While finance textbooks often show how the tax benefits of debt have a wide-ranging impact on value, they often use too low a discount rate for those benefits. In practice, the impact is much less significant for large investment-grade companies (which have a small relevant range of capital structures). Overall, the value of tax benefits is quite small over the relevant levels of interest coverage. For a typical investment-grade company, the change in value over the range of interest coverage is less than 5 percent.

The effect of debt on cash flow is less direct but more significant. Carrying some debt increases a company's intrinsic value because debt imposes discipline; a company must make regular interest and principal payments, so it is less likely to pursue frivolous investments or acquisitions that don't create value. Having too much debt, however, can reduce a company's intrinsic value by limiting its flexibility to make value-creating investments of all kinds, including capital expenditures, acquisitions, and, just as important, investments in intangibles such as business building, R&D, and sales and marketing.

Managing capital structure thus becomes a balancing act. In our view, the trade-off a company makes between financial flexibility and fiscal discipline is the most important consideration in determining its capital structure and far outweighs any growth potential, which is negligible for most large companies unless they have extremely low debt.

Mature companies with stable and predictable cash flows as well as limited investment opportunities should include more debt in their capital structure, since the discipline that debt often brings outweighs the need for flexibility. Companies that face high uncertainty because of vigorous growth or the cyclical nature of their industries should carry less debt, so that they have enough flexibility to take advantage of investment opportunities or to deal with negative events.

Not that a company's underlying capital structure never creates intrinsic value; sometimes it does. When executives have good reason to believe that a company's shares are under- or overvalued, for example, they might change the company's underlying capital structure to create value either by buying back undervalued shares or by using overvalued shares instead of cash to pay for acquisitions.

Other examples can be found in cyclical industries, such as commodity chemicals, where investment spending typically follows profits. Companies invest in new manufacturing capacity when their profits are high and they have cash. Unfortunately, the chemical industry's historical pattern has been that all players invest at the same time, which leads to excess capacity when all of the plants come on line simultaneously. Over the cycle, a company could earn substantially more than its competitors if it developed a countercyclical strategic capital structure and maintained less debt than might otherwise be optimal. During bad times, it would then have the ability to make investments when its competitors couldn't. Suppose a company can't develop its capital structure without understanding its future revenues and investment requirements. Once those prerequisites are in place, it can begin to consider changing its capital structure in ways that support the broader strategy.

The following next chapter included the objective firms are pursuit of performance. This has been accepted as key to survival of firms by practitioners, which to say the least may be contradictory to norms of running a business efficiently. Therefore, next chapter study will test and analyze hypotheses relating to growth strategy, liquidity and capital structure of firms and its impact on the performance of these firms.