WHY CORPORATE GOVERNANCE IS SO PROMINENT TODAY Inevitably,the privatisation wave has raised the issue of how the newly privatised corporations should be owned and controlled.In some countries,most notably the U.K., part of the agenda behind the massive privatisation program was to attempt to recreate a form of"shareholder democracy7(see Biais and Perotti 2000).In other countries great care was given to ensure the transfer of control to large shareholders.The issues surrounding the choice of privatisation method rekindled interest in governance issues; indeed Shinn (2001)finds that the state's new role as a public shareholder in privatised corporations has been an important source of impetus for changes in corporate governance practices worldwide.In general,privatisations have boosted the role of stock markets as most OECD sales have been conducted via public offerings,and this has also focused attention on the protection of small shareholders. 3.2 Pension Funds and Active Investors The growth in defined contribution pension plans has channelled an increasing fraction of household savings through mutual and pension funds and has created a constituency of investors that is large and powerful enough to be able to influence corporate governance.Table 1 illustrates how the share of financial assets controlled by institutional investors has steadily grown over the 1990s in OECD countries.It also highlights the disproportionately large institutional holdings in small countries with large financial centres,like Switzerland,the Netherlands and Luxembourg.Institutional investors in the U.S.alone command slightly more than 50%of the total assets under management and 59.7%of total equity investment in the OECD,rising to 60.1%and 76.3%respectively when U.K.institutions are added.A significant proportion is held by pension funds (for U.S.and U.K.based funds,35.1%and 40.1%of total assets 17A state-owned and-controlled company is indirectly owned by the citizens via the state,which has a say in the affairs of the company.In a"shareholder democracy"each citizen holds a small share in the widely 11/168
WHY CORPORATE GOVERNANCE IS SO PROMINENT TODAY Inevitably, the privatisation wave has raised the issue of how the newly privatised corporations should be owned and controlled. In some countries, most notably the U.K., part of the agenda behind the massive privatisation program was to attempt to recreate a form of “shareholder democracy”17 (see Biais and Perotti 2000). In other countries great care was given to ensure the transfer of control to large shareholders. The issues surrounding the choice of privatisation method rekindled interest in governance issues; indeed Shinn (2001) finds that the state’s new role as a public shareholder in privatised corporations has been an important source of impetus for changes in corporate governance practices worldwide. In general, privatisations have boosted the role of stock markets as most OECD sales have been conducted via public offerings, and this has also focused attention on the protection of small shareholders. 3.2 Pension Funds and Active Investors The growth in defined contribution pension plans has channelled an increasing fraction of household savings through mutual and pension funds and has created a constituency of investors that is large and powerful enough to be able to influence corporate governance. Table 1 illustrates how the share of financial assets controlled by institutional investors has steadily grown over the 1990s in OECD countries. It also highlights the disproportionately large institutional holdings in small countries with large financial centres, like Switzerland, the Netherlands and Luxembourg. Institutional investors in the U.S. alone command slightly more than 50% of the total assets under management and 59.7% of total equity investment in the OECD, rising to 60.1% and 76.3% respectively when U.K. institutions are added. A significant proportion is held by pension funds (for U.S. and U.K. based funds, 35.1% and 40.1% of total assets 17 A state-owned and -controlled company is indirectly owned by the citizens via the state, which has a say in the affairs of the company. In a “shareholder democracy” each citizen holds a small share in the widely 11/168
WHY CORPORATE GOVERNANCE IS SO PROMINENT TODAY respectively).These funds are playing an increasingly active role in global corporate governance.In the U.S.ERISA!regulations oblige pension funds to cast the votes in their portfolio responsibly.This has led to the emergence of a service industry that makes voting recommendations and exercises votes for clients.The largest providers now offer global services. Japanese institutional investors command 13.7%of total institutional investor assets in the OECD but just 8.3%of the equities.These investors are becoming more demanding and they are one of the forces behind the rapid transformation of the Japanese corporate governance system.As a percentage of GDP,the holdings of Italian and German institutional investors are small (39.9%and 49.9%in 1996)and well below the OECD average of 83.8%.The ongoing reform of the pension systems in both countries and changing savings patterns,however,are likely to change this picture in the near future. 3.3 Mergers and Takeovers The hostile takeover wave in the U.S.in the 1980s and in Europe in the 1990s,together with the recent merger wave,has also fuelled the public debate on corporate governance. The successful $199 billion cross-border hostile bid of Vodafone for Mannesmann in 2000 was the largest ever to take place in Europe.The recent hostile takeovers in Italy (Olivetti for Telecom Italia;Generali for INA)and in France (BNP-Paribas;Elf Aquitaine for Total Fina)have spectacularly shaken up the sleepy corporate world of continental Europe.Interestingly,these deals involve newly privatised giants.It is also held company,having a direct interest and-theoretically-say in the affairs of the company. 18 ERISA stands for the Employee Retirement Income Security Act of 1974. 1One note of caution.The figures for Luxemburg and Switzerland illustrate that figures are compiled on the basis of the geographical location of the fund managers,not the origin of the funds under management.Judging from the GDP figures,it is very likely that a substantial proportion of the funds administered in the U.K.,the U.S.,Switzerland and the Netherlands belong to citizens of other countries. For governance the location of the fund managers matters.They make the investment decisions and have 12/168
WHY CORPORATE GOVERNANCE IS SO PROMINENT TODAY respectively). These funds are playing an increasingly active role in global corporate governance. In the U.S. ERISA18 regulations oblige pension funds to cast the votes in their portfolio responsibly. This has led to the emergence of a service industry that makes voting recommendations and exercises votes for clients. The largest providers now offer global services. Japanese institutional investors command 13.7% of total institutional investor assets in the OECD but just 8.3% of the equities. These investors are becoming more demanding and they are one of the forces behind the rapid transformation of the Japanese corporate governance system. As a percentage of GDP, the holdings of Italian and German institutional investors are small (39.9% and 49.9% in 1996) and well below the OECD average of 83.8%. The ongoing reform of the pension systems in both countries and changing savings patterns, however, are likely to change this picture in the near future.19 3.3 Mergers and Takeovers The hostile takeover wave in the U.S. in the 1980s and in Europe in the 1990s, together with the recent merger wave, has also fuelled the public debate on corporate governance. The successful $199 billion cross-border hostile bid of Vodafone for Mannesmann in 2000 was the largest ever to take place in Europe. The recent hostile takeovers in Italy (Olivetti for Telecom Italia; Generali for INA) and in France (BNP-Paribas; Elf Aquitaine for Total Fina) have spectacularly shaken up the sleepy corporate world of continental Europe. Interestingly, these deals involve newly privatised giants. It is also held company, having a direct interest and – theoretically – say in the affairs of the company. 18 ERISA stands for the Employee Retirement Income Security Act of 1974. 19 One note of caution. The figures for Luxemburg and Switzerland illustrate that figures are compiled on the basis of the geographical location of the fund managers, not the origin of the funds under management. Judging from the GDP figures, it is very likely that a substantial proportion of the funds administered in the U.K., the U.S., Switzerland and the Netherlands belong to citizens of other countries. For governance the location of the fund managers matters. They make the investment decisions and have 12/168
WHY CORPORATE GOVERNANCE IS SO PROMINENT TODAY remarkable that they have not been opposed by the social democratic administrations in place at the time.Understandably,these high profile cases have moved takeover regulation of domestic and cross-border deals in the European Union to the top of the political agenda. 3.4 Deregulation and Capital Market Integration Corporate governance rules have been promoted in part as a way of protecting and encouraging foreign investment in Eastern Europe,Asia and other emerging markets. The greater integration of world capital markets (in particular in the European Union following the introduction of the Euro)and the growth in equity capital throughout the 1990s have also been a significant factor in rekindling interest in corporate governance issues.Increasingly fast growing corporations in Europe have been raising capital from different sources by cross listing on multiple exchanges (Pagano,Roell and Zechner 2002).In the process they have had to contend more with US and U.K.pension funds. This has inevitably contributed to the spread of an 'equity culture'outside the US and U.K.. 3.5 The 1998 Russia/East Asia/Brazil crisis The East Asia crisis has highlighted the flimsy protections investors in emerging markets have and put the spotlight on the weak corporate governance practices in these markets. The crisis has also led to a reassessment of the Asian model of industrial organisation and finance around highly centralised and hierarchical industrial groups controlled by management and large investors.There has been a similar reassessment of mass insider privatisation and its concomitant weak protection of small investors in Russia and other transition economies. the power to vote the equity in their portfolios and the sheer size of the numbers suggests that fund 13/168
WHY CORPORATE GOVERNANCE IS SO PROMINENT TODAY remarkable that they have not been opposed by the social democratic administrations in place at the time. Understandably, these high profile cases have moved takeover regulation of domestic and cross-border deals in the European Union to the top of the political agenda. 3.4 Deregulation and Capital Market Integration Corporate governance rules have been promoted in part as a way of protecting and encouraging foreign investment in Eastern Europe, Asia and other emerging markets. The greater integration of world capital markets (in particular in the European Union following the introduction of the Euro) and the growth in equity capital throughout the 1990s have also been a significant factor in rekindling interest in corporate governance issues. Increasingly fast growing corporations in Europe have been raising capital from different sources by cross listing on multiple exchanges (Pagano, Röell and Zechner 2002). In the process they have had to contend more with US and U.K. pension funds. This has inevitably contributed to the spread of an ‘equity culture’ outside the US and U.K.. 3.5 The 1998 Russia/East Asia/Brazil crisis The East Asia crisis has highlighted the flimsy protections investors in emerging markets have and put the spotlight on the weak corporate governance practices in these markets. The crisis has also led to a reassessment of the Asian model of industrial organisation and finance around highly centralised and hierarchical industrial groups controlled by management and large investors. There has been a similar reassessment of mass insider privatisation and its concomitant weak protection of small investors in Russia and other transition economies. the power to vote the equity in their portfolios and the sheer size of the numbers suggests that fund 13/168
CONCEPTUAL FRAMEWORK The crisis has led international policy makers to conclude that macro-management is not sufficient to prevent crises and their contagion in an integrated global economy.Thus,in South Korea,the International Monetary Fund has imposed detailed structural conditions that go far beyond the usual Fund policy.It is no coincidence that corporate governance reform in Russia,Asia and Brazil has been a top priority for the OECD,the World Bank and institutional investor activists. 3.6 Scandals and Failures at Major U.S.Corporations As we are writing,a series of scandals and corporate failures is surfacing in the United States,a market where the other factors we highlighted played a less important role.20 Many of these cases concern accounting irregularities that enabled firms to vastly overstate their earnings.Such scandals often emerge during economic downturns:as John Kenneth Galbraith once remarked,recessions catch what the auditors miss. 4 CONCEPTUAL FRAMEWORK 4.1 Agency and Contracting At a general level corporate governance can be described as a problem involving an agent the CEO of the corporation-and multiple principals-the shareholders,creditors, suppliers,clients,employees,and other parties with whom the CEO engages in business on behalf of the corporation.Boards and external auditors act as intermediaries or representatives of these different constituencies.This view dates back to at least Jensen and Meckling (1976),who describe a firm in abstract terms as "a nexus of contracting relationships".Using more modern language the corporate governance problem can also governance is a topic in its own right. 2 Recent failures include undetected off-balance sheet loans to a controlling family (Adelphia)combined with alleged self-dealing by CEOs and other company employees(Computer Associates,Dynegy,Enron, Global Crossing,Qwest,Tyco),deliberate misleading of investors(Kmart,Lucent Technologies, WorldCom),insider trading (ImClone Systems)and/or fraud (Rite Aid)("Accounting Scandals Spread Across Wall Street",Financial Times,26 June 2002). 14/168
CONCEPTUAL FRAMEWORK The crisis has led international policy makers to conclude that macro-management is not sufficient to prevent crises and their contagion in an integrated global economy. Thus, in South Korea, the International Monetary Fund has imposed detailed structural conditions that go far beyond the usual Fund policy. It is no coincidence that corporate governance reform in Russia, Asia and Brazil has been a top priority for the OECD, the World Bank and institutional investor activists. 3.6 Scandals and Failures at Major U.S. Corporations As we are writing, a series of scandals and corporate failures is surfacing in the United States, a market where the other factors we highlighted played a less important role.20 Many of these cases concern accounting irregularities that enabled firms to vastly overstate their earnings. Such scandals often emerge during economic downturns: as John Kenneth Galbraith once remarked, recessions catch what the auditors miss. 4 CONCEPTUAL FRAMEWORK 4.1 Agency and Contracting At a general level corporate governance can be described as a problem involving an agent - the CEO of the corporation - and multiple principals - the shareholders, creditors, suppliers, clients, employees, and other parties with whom the CEO engages in business on behalf of the corporation. Boards and external auditors act as intermediaries or representatives of these different constituencies. This view dates back to at least Jensen and Meckling (1976), who describe a firm in abstract terms as “a nexus of contracting relationships”. Using more modern language the corporate governance problem can also governance is a topic in its own right. 20 Recent failures include undetected off-balance sheet loans to a controlling family (Adelphia) combined with alleged self-dealing by CEOs and other company employees (Computer Associates, Dynegy, Enron, Global Crossing, Qwest, Tyco), deliberate misleading of investors (Kmart, Lucent Technologies, WorldCom), insider trading (ImClone Systems) and/or fraud (Rite Aid) (“Accounting Scandals Spread Across Wall Street”, Financial Times, 26 June 2002). 14/168
CONCEPTUAL FRAMEWORK be described as a "common agency problem",that is an agency problem involving one agent(the CEO)and multiple principals(shareholders,creditors,employees,clients(see Bernheim and Whinston(1984,1985 and 1986).21 Corporate governance rules can be seen as the outcome of the contracting process between the various principals or constituencies and the CEO.Thus,the central issue in corporate governance is to understand what the outcome of this contracting process is likely to be,and how corporate governance deviates in practice from the efficient contracting benchmark. 4.2 Ex-Ante and Ex-Post Efficiency Economists determine efficiency by two closely related criteria.The first is ex-ante efficiency:a corporate charter is ex-ante efficient if it generates the highest possible joint payoff for all the parties involved,shareholders,creditors,employees,clients,tax authorities,and other third parties that may be affected by the corporation's actions.The second criterion is Pareto efficiency:a corporate charter is Pareto efficient if no other charter exists that all parties prefer.The two criteria are closely related when the parties can undertake compensating transfers among themselves:a Pareto efficient charter is also a surplus maximizing charter when the parties can make unrestricted side transfers. As closely related as these two notions are it is still important to distinguish between them,since in practice side transfers are often constrained by wealth or borrowing constraints. 21 A slightly different,sometimes broader perspective,is to describe corporate governance as a multi- principal-multi-agent problem,where both managers and employees are seen as agents for multiple classes of investors.The labelling of employees asagent'or principal'is not just a matter of definition.If they are defined as'principal'they are implicitly seen as participants in corporate governance.When and how employees should participate in corporate governance is a delicate and politically sensitive question.We discuss this issue at length in section 5.6 below.For now,we shall simply take the view that employees are partly 'principal'when they have made firm specific investments,which require protection. 15/168
CONCEPTUAL FRAMEWORK be described as a “common agency problem”, that is an agency problem involving one agent (the CEO) and multiple principals (shareholders, creditors, employees, clients (see Bernheim and Whinston (1984, 1985 and 1986).21 Corporate governance rules can be seen as the outcome of the contracting process between the various principals or constituencies and the CEO. Thus, the central issue in corporate governance is to understand what the outcome of this contracting process is likely to be, and how corporate governance deviates in practice from the efficient contracting benchmark. 4.2 Ex-Ante and Ex-Post Efficiency Economists determine efficiency by two closely related criteria. The first is ex-ante efficiency: a corporate charter is ex-ante efficient if it generates the highest possible joint payoff for all the parties involved, shareholders, creditors, employees, clients, tax authorities, and other third parties that may be affected by the corporation’s actions. The second criterion is Pareto efficiency: a corporate charter is Pareto efficient if no other charter exists that all parties prefer. The two criteria are closely related when the parties can undertake compensating transfers among themselves: a Pareto efficient charter is also a surplus maximizing charter when the parties can make unrestricted side transfers. As closely related as these two notions are it is still important to distinguish between them, since in practice side transfers are often constrained by wealth or borrowing constraints. 21 A slightly different, sometimes broader perspective, is to describe corporate governance as a multiprincipal-multi-agent problem, where both managers and employees are seen as agents for multiple classes of investors. The labelling of employees as ‘agent’ or ‘principal’ is not just a matter of definition. If they are defined as ‘principal’ they are implicitly seen as participants in corporate governance. When and how employees should participate in corporate governance is a delicate and politically sensitive question. We discuss this issue at length in section 5.6 below. For now, we shall simply take the view that employees are partly ‘principal’ when they have made firm specific investments, which require protection. 15/168