Convergence and Persistence in Corporate Governance

by Jeffrey N. Gordon, Mark J. Roe

Overview

Corporate governance is on the reform agenda all over the world. Is the Anglo-American model of shareholder capitalism destined to become the global corporate governance standard or will important differences persist? Well-known scholars address this question with sophisticated political economy analysis geared to the legal frameworks. The Enron scandal has stirred up an urgent round of corporate governance questioning. Will it stop a convergence that was in the works? This volume offers interesting insights into this question.

Product Details

ISBN-13:	9780521536011
Publisher:	Cambridge University Press
Publication date:	04/08/2004
Edition description:	New Edition
Pages:	396
Product dimensions:	5.98(w) x 9.02(h) x 0.87(d)

About the Author

Jeffrey N. Gordon is the Alfred W. Bressler Professor of Law at the Columbia Law School.

Mark J. Roe is the Berg Professor of Corporate Law at the Harvard Law School.

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Cambridge University Press
0521829119 - Convergence and Persistence in Corporate Governance - Edited by Jeffrey N. Gordon and Mark J. Roe
Excerpt

Introduction

JEFFREY N. GORDON AND MARK J. ROE

Corporate governance is on the reform agenda all over the world. The remarkable political economy of the post-Cold War era has made both democracy and market-oriented capitalism ascendant, even if not inevitably linked. Competition among radically different economic systems - communism vs. capitalism - has abated. States are withdrawing from ownership of the means of production by privatizing state-firms and withdrawing from strong control by deregulating widely. Economic decisions once made by the state are increasingly left to autonomous, privately owned firms. Even if private corporate governance characteristics continue to differ, the most general of economic contrasts - private vs. government direction - is fading.

Global economic integration has been a key factor in the salience of corporate governance questions. Once confined to local economies, differently governed firms now compete with one another, as multilateral trade agreements and regional economic blocks such as the European Union have internationalized product markets, capital markets, managerial markets, and, to a lesser extent, labor markets.

Globalization affects the corporate governance reform agenda in two ways. First, it heightens anxiety over whether particular corporate governance systems confer competitive economic advantage. As trade barriers erode, the locally protected product marketplace disappears. A country's firms' performance is more easily measured against global standards. Poor performance shows up more quickly when a competitor takes away market share, or innovates quickly.

National decisionmakers must consider whether to protect locally favored corporate governance regimes if they regard the local regime as weakening local firms in product markets or capital markets. So, the Americans debated in the 1980s whether bank-centered systems in Japan and Germany better monitored management and better encouraged long-term investment than the home-grown variety. Today, Europe wonders whether it will lag in product markets if it does not get active securities markets. International development institutions believe that corporate governance affects the rate and sustainability of developing country growth. A famous case is the International Monetary Fund's (IMF) criticism of the governance of Korean conglomerates, the chaebol, as allegedly producing unsustainable borrowing patterns that helped ignite the East Asian financial crisis of 1998. Concern about comparative economic performance induces concern about corporate governance.

Globalization's second effect comes from capital markets' pressure on corporate governance. First, firms have new reasons to turn to public capital markets. High tech firms following the US model want the ready availability of an initial public offering for the venture capitalist to exit and for the firm to raise funds. Firms expanding into global markets often prefer to use stock, rather than cash, as acquisition currency. If they want American investors to buy and hold that stock, they are pressed to adopt corporate governance measures that those investors feel comfortable with. Despite a continuing bias in favor of home-country investing, the internationalization of capital markets has led to more cross-border investing. New stockholders enter, and they aren't always part of any local corporate governance consensus. They prefer a corporate governance regime they understand and often believe that reform will increase the value of their stock. Similarly, even local investors may make demands that upset a prior local consensus. The internationalization of capital markets means that investment flows may move against firms perceived to have suboptimal governance and thus to the disadvantage of the countries in which those firms are based.

An independent factor in the corporate governance debate is the wave of privatizations of large state-owned enterprises in the infrastructure, natural resource, and manufacturing areas. This has often been accompanied by deregulation. Corporate governance reformers have sought accountability from large economic actors when privatization and deregulation have devolved important decisionmaking authority away from governments and into private firms. Often, political accountability and economic efficiency point in different directions. For example, in privatizing former state-owned enterprises, the state wants to maximize the price it gets from selling the firm, but it also wants to preserve political influence, often to control employment and service. The two do not always match.

Thus there are two different audiences for the corporate governance debate: one, the national political elites concerned about accountability and national economic performance; the other, the corporate elites concerned about the success of their own firm and their stakes in that firm. The interests of the two elites are not necessarily the same; indeed, corporate elites may be divided, depending on the economic stakes at risk. The old players might be fond of the incumbent corporate governance system; new entrants might more readily see the virtues of change.

***

Reforming corporate governance often requires changing laws (and not just the basic rules of corporate law, but also labor law, financial regulatory law, and tax law). Changing law ordinarily requires a political consensus, making agreement among political and corporate elites necessary. Other reforms can move forward independently through internal governance decisions. Corporate governance plays out on several levels, and some levels could converge while others persist, with some levels requiring national change and others able to move forward firm by firm, from the ground up. Keeping these different levels of institutions conceptually separate is crucial to understanding what is at stake. For example, consider two key corporate governance institutions: the share-ownership structure (whether ownership is concentrated or diffuse) on the one hand, the role of the board of directors on the other in say, monitoring managers. One may persist, while the other moves.

Consider further the interaction between these two elements: the board's role may be conditioned by the share-ownership structure. Most practitioner attention has focused on the role of the board and is manifested in a proliferation of best practice codes and other corporate governance guidelines. We might see considerable pressure for tighter review of management actions in publicly owned firms, increased accountability, and even increased managerial turnover. So where public firms predominate, there might be practical convergence, with different means (takeovers, charged-up boards, bank pressure) doing the job. True, there is bound to be residual divergence at the microstructure level, but it is plausible to imagine converging corporate governance standards for those firms that are fully public.

At the same time, though, ownership structures might move more slowly. Moreover, the best governance regime for "insider" systems associated with monitoring by blockholders differs from the best regime for monitoring by and for dispersed shareholders. So if differing ownership structures persist then board-type convergence will lag as well.

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The chapters in this volume address whether the forces of convergence will triumph, the mechanisms by which convergence might emerge, and the forces that induce systems to persist. Several assess the political economy that underlies both the current diversity in national regimes of corporate governance and the prospects for convergence. "Politics" is evaluated in several dimensions: first, the grand compromises in particular societies over the ends and mechanisms of corporate governance, second, the positional interests and private gains created by the extant system that may affect the possibilities for change, and third, a nation's geopolitical commitments, meaning the extent to which it is committed to the project of transnational economic and political integration.

Could convergence emerge even if governments and entrenched corporate elites oppose it? Several chapters consider how it could. First, fundamental product market and capital market pressures arising from globalization may force convergence of local regimes towards the dominant international model; to do otherwise, it's supposed, would lead to the economic decline of dissenting countries and firms. Second, individual firms may opt out of an inefficient local governance regime or opt into higher-quality foreign regimes, for example, by listing on stock exchanges that impose more exacting disclosure and other governance standards. This presumably too promotes convergence on the international model (unless opting in and out go in differing directions). Third, supranational institutions may promote convergence, either through unleashing regulatory competition or promoting harmonization. In the European Union, for example, the 1999 Centros decision¹ and the November 2002 Überseering decision² of the European Court of Justice call in question the "real seat rule" that subjects a corporation to the corporate law of the state where it has its "center of gravity." If pursued, this could lead to regulatory competition that in the United States led to substantial convergence on Delaware corporate law. And the European Union has also promoted convergence through efforts to "harmonize" the laws of member states, or to at least establish minimum standards, although such efforts in corporate law have not been notably successful. But because harmonization entails a political process, the "convergence" that it produces could vary from competitive convergence. Indeed, politically driven harmonization might be aimed to induce some nations to converge on an alternative to an emerging model.

Could differing corporate governance systems persist, even if competitive pressures were high? Several chapters suggest that no one system of corporate governance has yet been shown to be a sure competitive winner. Elites, both corporate and political, continue to disagree, say, on whether a free-flowing market in corporate takeovers improves well-being or not. As long as competitive superiority is uncertain, structures once built have, some argue, tended to persist. Moreover, differing economic tasks may yield differing corporate governance structures, with the differences persisting even when the tasks change. Several chapters suggest how these mechanisms of persistence have been in play thus far.

***

Another theme we see is of "functional" vs. "formal" convergence. Different systems may obtain functionally equivalent results though the legal rules formally diverge. At the most basic level, all successful economic systems have functional similarities. For example, every system holds managers accountable for their performance in some way, to some degree. Some governance features are acquired due to regulation, others due to private adoption. Functional convergence focuses on adaptability: when it's strongly in play, different regimes, despite formal differences, can cobble together, or adapt, existing institutions to fulfill new demands.

A claim on behalf of functional convergence is in tension with another theme explored in the chapters, the theme of "complementarity": that some key corporate institutions are built on one another and take enough of their value from their interaction such that changing one without changing the others is hard. When complementarity is very high convergence is harder, because too many institutions have to change in a coordinated way. Even functional convergence might drag, when even incremental, small adaptations undermine an effective integration of institutional components. A private player considering the incremental change would reject it, if the net costs due to complementarities are high enough.

***

The corporate governance and financial reporting problems revealed by the failures at several major US firm over late 2001-2, including Enron, WorldCom, Tyco, and Adelphia, shed new light on the convergence debate. First, the scandals emerged just at the moment when many thought that the US model was about to claim the prize as the "best in show." Systems that seem dominant, the US in the 1990s, Japan in the 1980s, recurrently prove vulnerable, and this vulnerability seems to emerge before other systems converge.

Second, the "Enron problems" powerfully illustrate the importance of institutional complementarities. In a regime in which managers receive stock-based compensation, a number of institutions seem particularly important, for example: strenuously independent accountants, robust secondary stock markets, adequately funded public securities regulators, and credible third party evaluators, such as securities analysts and credit analysts. We are made to realize that "corporate governance" consists not simply of elements but of systems. This realization - as parties come to understand the scope of the required institutional change - may in some cases speed up convergence, whether formal or functional; in other cases, it may slow it down. Transplanting some of the formal elements without regard for the institutional complements may lead to serious problems later, and these problems may impede, or reverse, convergence.

Third, the US regulatory reaction to the Enron problems may, independently, affect convergence. Congressional enactment ("Sarbanes-Oxley"), SEC (Securities and Exchange Commission) regulations, and new New York Stock Exchange listing requirements create many new mandatory elements of US corporate law, in board structure and responsibility, in financial reporting and disclosure, in obligations of accountants and lawyers. Most of these requirements will, as of now, apply to foreign corporations who choose to list on US exchanges. If foreign issuers continue to believe that this way of accessing US capital markets is important, or wish to "bond" themselves to this particular high-quality governance regime, then ironically the upshot of Enron might be greater convergence on the US model than otherwise. On the other hand, many foreign firms may well regard these intrusions as inconvenient and dysfunctional. Their aversion may well be supported by national regulators, possibly resentful of what might be seen as US overreaching. Thus some foreign issuers may delist from US exchanges and others might change their intentions in that regard. US capital can be tapped from foreign markets and the heightened requirements might enhance the importance of London, say, as a trading center, and the importance of other exchanges' listing requirements. If so, then Enron may lead away from convergence.

Thus as the chapters demonstrate, the questions about convergence of corporate governance have deep economic and political roots. The Enron fallout illuminates both what is at stake and the complexity of the question.

Systemic convergence: Henry Hansmann and Reinier Kraakman's "End of corporate history"

In "The end of history for corporate law," Henry Hansmann and Reinier Kraakman articulate the "strong" convergence position. They boldly argue not only that corporate convergence on a shareholder-oriented model is both desirable and inevitable, but that corporate governance has already largely converged to that kind of model. This convergence is ideologically driven: a consensus has emerged that corporate law "should principally strive to increase long-term shareholder value"; and this "normative convergence" is inducing "practices of corporate governance and in corporate law" to converge toward a "shareholder-oriented model," one that is today best exemplified by the large Anglo-American public firm. All around the world, they claim, there is now "a widespread normative consensus that corporate managers should act exclusively in the economic interests of shareholders." Similar rules of corporate law and practice are, due to the power of the ideology of shareholder primacy, emerging everywhere and will in short-order dominate, if they haven't already.

Moreover, the residue of nonshareholder-oriented institutions, already minimal, is shrinking and ought to shrink further: even a society that wants its private economic institutions "to serve the interests of society as a whole" should and will, if they have not done so already, do so through an ancillary set of regulatory institutions in labor, the environment, and the like, rather than vary the "standard" model of shareholder governance. (Rhetorically, they call the pure shareholder model the "standard" model, making variations nonstandard.)

Product market competition and ideology drive their three-stage argument, in which the shareholder model defeats all of its rivals. In summary: first, Hansmann and Kraakman argue that alternatives organized on different principles are not viable competitively (or, as we would formulate it, it is only the historical lack of product market competition that has enabled the "nonstandard" models to have survived thus far). Second, they argue that the competitive pressures faced by firms around the world are cracking and then eliminating the viability of the alternative models. And, third, they argue that the shareholder model creates and sustains a supportive ideological and political consensus in its favor.

Hansmann and Kraakman set up three rivals that competed with the victorious shareholder model: the managerial-oriented model, the labor-oriented model, and the state-oriented model. Each defeated rival has been based on the idea that a viable firm could seriously attend to objectives other than shareholder value. The "manager-oriented" model, associated with the United States in the 1950s and 1960s, was based on the view that "professional corporate managers could serve as disinterested technocratic fiduciaries who would guide business corporations to perform in ways that would serve the general public interest." They claim that this model of social benevolence collapses into self-serving managerialism, in which managers end up serving their own interests with significant costs from resource misallocation. These costs imperil the competitiveness of the model and thus account for its replacement by the shareholder-driven model in the United States.

The "labor-oriented" model, exemplified most explicitly by German codetermination but manifested in other nations, has governance structures amplifying labor's voice. Hansmann and Kraakman argue that such mechanisms are likely to be inefficient and disruptive because of the heterogeneity of interests among employees themselves and between employees and shareholders. Hence, such firms will lose out in competitive product markets. Contractual or labor regulatory solutions are superior means of labor influence, because they avoid a division of authority and interests within the firm.

The "state-oriented" model, associated particularly with France and Japan, entails a large state role in corporate affairs, either through ownership or close bureaucratic engagement with the firm's managers, to guide private enterprise in the political elite's view of the public interest. Hansmann and Kraakman argue that the turn away from socialism and the recent poor performance of economies organized on corporatist lines have discredited this model.

Thus the first stage of the convergence argument is: rival models to shareholder primacy are inefficient and would lose out in competition.

The second stage of the Hansmann and Kraakman argument is their case for competitive convergence to the superior shareholder model. Superior models do not always win out. What makes this one a winner? What is inducing firms to converge to the superior organizational form is the increasing internationalization of product and financial markets, and firms' increasing need to get "access to capital at lower cost (including conspicuously, start-up capital), [to] . . . develop . . . new product markets, [and the] stronger incentives to reorganize along lines that are managerially coherent." Even if older firms organized on the other models persist, the new shareholder-oriented firms are growing more rapidly, especially in important product markets in which access to capital is important. Eventually they will come to dominate, if they haven't already.

The third stage of the argument, perhaps their boldest, is the claim that convergence on the shareholder model will be sustained by a parallel political convergence. A public shareholder class is, or will, emerge and counteract interest groups that might oppose the shareholder model. The new shareholder political class will be able to beat back employees, managers, and state bureaucrats who promote, or seek to preserve, the old "managerial-oriented," "labor-oriented," and "state-oriented" models. The new class will also neutralize potential resistance from controlling, big block shareholders of the kind that have dominated in several European countries. This powerful new interest group will arise because of the diffusion of equity ownership - "we are all shareholders now" - and because, as institutions such as pension funds and mutual funds strengthen economically, their political clout will increase as well.

They might point to the recent Europe-wide report on takeovers, which in endorsing a takeover regime of shareholder choice comes very close to embracing shareholder primacy in a way that is much less managerial-, state-, or labor-oriented than the incumbent regimes in Europe.³ The "Winter Report" fits their model of ideological convergence on a shareholder-model, an ideology that could then drive law, which in turn could drive corporate structures, practices, and governance. Since the votes so far have defeated convergence by harmonization on takeovers, however, there's still some way to go for events to catch up to the convergence theory here.

Hansmann and Kraakman are convergence optimists. Perhaps their most optimistic claim is that societies can converge on the shareholder model for its efficiency properties while maintaining very diverse conceptions of the good society. On their view, Germany, for example, might continue to protect incumbent labor interests, but this regime could and will be implemented, for competitive efficiency's sake, through "labor law" (anti-layoff rules, strong collective bargaining endowments, etc.), rather than through corporate governance and codetermination. That is, incumbent labor interests could continue to have great influence, but they would exercise that influence not through corporate law and corporate governance, but through labor law and labor contracts.

Similarly, a country may desire strong environmental amenities, but this regime could and will be implemented through "environmental law" (emission limits, liability for hazards created, etc.), rather than by, say, putting a Green on the board.

This might be a soft spot in their analysis: if regulatory regimes persist and interest group pressures continue, the impact on the firm could be roughly the same whether the effects on the firm are "external" through regulation and contracting or "internal" via governance. It's also possible that if every nation has some of these features, then all firms will bear some of these costs on behalf of the local consensus, leaving them all competitive. (Just as all firms must pay their inputs, all firms must pay for some of this local ideology or interest group pressure.) If the costs are about the same, variety might persist (more Green in one country, more labor-oriented in another). And from here, the powerful impulse to corporate governance convergence might weaken: if the firm is bearing this cost, it might make little difference in product market success (the principal convergence driver) whether the cost comes through "external" regulation and contracting or through "internal" corporate governance.

Hansmann and Kraakman are also optimists in that they assume that favorable economic conditions will continue for the substantial period of time necessary to entrench the shareholder model. Firms governed by the shareholder model tend to respond rapidly to economic change because the expected future cash flow changes will immediately be impounded in stock prices. As they put it, this may lead to "more rapid abandonment of inefficient investment." The shareholder-oriented firm will strive to shift the incidence of these adjustment costs away from shareholders. This is, of course, a change from the view that managers should understand that the firm's employment practices are part of the social safety net, a view common in several nations. Implementing this sea change, which invariably shifts some economic risk to individuals, is much easier in circumstances of low unemployment than otherwise.

They do, though, hedge their bets - and temper their optimism - by adding the possibility of inefficient convergence toward a managerialist model. They consider this possibility to be real, but that the managerial tilt would be slight. That does, though, open up the possibility of diversity not convergence, as different nations and different firms have differing degrees and modes of a managerial model, especially if the "slight . . . tilt" overall turned out to be pronounced in one or another nation, here and there. But, after conceding that a persisting slight managerial tilt is a possibility, Hansmann and Kraakman draw back and conclude that "[t]he triumph of the shareholder-oriented model of the corporation over its principal competitors is now assured." The shareholder model is more effective in competition than any of the others, and increasing product market competition throughout the world is thus driving out the old models. Or has already done so.

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© Cambridge University Press

Table of Contents

List of contributors; Acknowledgments; Introduction Jeffrey N. Gordon and Mark J. Roe; Part I. System Issues: 1. The end of history for corporate law Henry Hansmann and Reinier Kraakman; 2. A theory of path dependence in corporate ownership and governance Lucian A. Bebchuk and Mark J. Roe; 3. Path dependence, corporate governance and complementarity Reinhard H. Schmidt and Gerald Spindler; 4. Convergence of form or function Ronald Gilson; Part II. Government Players: 5. The international relations wedge in corporate convergence Jeffrey N. Gordon; 6. Property rights in firms Curtis Milhaupt; 7. Modern politics and ownership separation Mark J. Roe; Part III. Specific Institutions: 8. Norms and corporate convergence David Charny; 9. Ungoverned production Charles Sabel; 10. Substantive law and its enforcement Gérard Hertig; 11. Cross-holding in the Japanese keiretsu J. Mark Ramseyer; Index.

Editorial Reviews

'Convergence and Persistence in Corporate Governance is impressive in its theoretical and jurisdictional breadth. … a valuable and high quality snapshot of contemporary corporate governance debate. While recognising economic forces driving convergence, the book provides sophisticated analysis of other constraining forces within a broader regulatory ecosystem. This analysis supports continued diversity in comparative corporate governance.' Sydney Law Review

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