Comparative Corporate Governance: A Global Perspective

Corporate governance practices vary from country to country, and from region to region. Corporate governance is
path dependent. It had emerged through a long series of historical events that have shaped institutions and mentalities, and
the cumulative effect of these events had resulted in the systems we are able to observe today. Generalizations and
classifications are sometimes useful because they attempt to capture the salient features of complex economic phenomena.
Any classification, however, is bound to be incomplete. It will always tend to overgeneralize, while leaving many seemingly
secondary aspects unaccounted for.
The most common classification of corporate governance systems makes reference to the collective action. There
are four avenues to collective action: the family, social capital, arm's length contracts, and the coercive power of the
government. At the intermediate level (that is, the corporation), the most important elements are social capital and contracts.

Collective action = f(social capital + arm's length contracts)

Corporate governance is the bargaining process for the allocation of control among various claimholders.
Collective action can be achieved through a mix of informal norms embedded in the social and cultural fabric of society;
and a set of explicit rules, spelled out by contracts and laws. Corporate governance models can be thus (crudely) classified
into outsider and insider systems:

(i) Outsider systems are also known as arm's length contracting, or rule-based governance. Outsider systems are found, in
general, in common-law, Anglo-American countries. In arm's length systems most transactions are based on impersonal and
explicit agreements, the state is able to enforce contracts, and material information pertaining to corporations and financing
is available to the general public. The government invests in a rather large and sophisticated institutional infrastructure. The
upfront cost of such an investment is huge, but it has the advantage that, once in place, the regulation of securities and the
enforcement of contract have relatively low marginal costs. Outsider systems rely heavily on arm's length contracts because
the financial and legal system provide for a relatively inexpensive way to enforce contracts. Contract-backed trust represents
here the foundation on which the whole financial infrastructure is built. Trust is thus regarded as a public good.

(ii) Insider systems are also known as relation-based governance. Insider systems are found in the rest of the world. In a
relation-based system most transactions are implicit, the state cannot or will not enforce them impartially, and most relevant
information is only available to insiders. The preference for relation-based governance owes to the fact that many countries
find the impartial enforcement of arm's length contracts prohibitively expensive. This does not mean that the cost of social
capital is cheap either. There are countries that have no choice but rely on insider corporate governance - in spite of
generalized mistrust and opportunism - simply because their financial and legal systems are too rudimentary to allow for
impartial enforcement of arm's length contracts. Even when social capital is very expensive, it is still relatively cheaper than
contracts. Social capital here is treated as a private good.

In the case of industrialized countries, the underpinnings of each system represent a distinct philosophical approach
to mitigating what is believed to be the most severe conflict of interests. The arm's length system considers that the conflict
between large, controlling blockholders and small outside investors is more threatening; managerial discretion is regarded as
the lesser evil. Insider systems, however, consider that managerial discretion leads to massive expropriation of all categories
of shareholders; as a consequence, large, controlling shareholders represent the lesser evil as long as they are able to
effectively monitor and discipline the manager.
Outsider, or arm's length systems are easier to describe and exemplify. There are only a minority of countries that fit
the bill, and there is a greater level of homogeneity in characteristics across those countries.

Firm size

Relation-based governance systems is associated with smaller firms on average, which grow relatively slow, as
they mostly rely on internal accumulation of profits and bank loans. In arm's length systems, firms are usually larger, and
tend to grow faster because they have better access to capital markets and affordable financing. More firms are listed on
stock exchanges in arm's length systems, and they tend to be on average younger than those in insider systems. The age of
listed firms hints at the dynamism of the corporate sector and its capacity for renewal. In the 1990s, the average listed
British firm was on average 8 years old; in the United States it was 14 years old. Compare that to the average age of a listed
company in Germany, which was close to 60 years. In the 1990s, the average age of German IPOs was 57. In Japan, only

1
less than 1% of firms were younger than one-year, in the United States the same percentage was as high as 40%.

Ownership

Ownership patterns turn out to be one of the most visible characteristics of corporate governance practices. It is
only recently that economists have stared to conduct serious comparative studies in order to understand how investor
protection is achieved around the world. Among those studies, several stand out. In 1997, Andrei Shleifer and Robert Vishny
published an important research documenting various corporate governance practices used in various countries; and, in
1998 and 1999 Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny produced a series of
seminal studies in which they examined patterns of control in some 40 countries. In 2005, Randall Morck edited a volume
bringing together important surveys of corporate ownership, including countries such as Canada, France, Germany, China,
United Kingsom, United States, Sweden, and the Netherlands. These studies are rather complex and not all their contentions
can be summarized in a few paragraphs. There are, however several findings that dominate their conclusions.
Overall, in relationship-based governance systems (insider systems), ownership is very concentrated. In most cases,
the control is in the hands of wealthy families or the state. Germany and Japan are among the few countries traditionally
using a relationship-based governance, in which ownership, although concentrated, is not dominated by a handful of
families or the government. In the 1990s, about 25% of listed German companies had a single majority shareholder,
accounting for 65% of the value of all listed stock [Franks and Mayer (2001)] In Germany, other non-financial companies
are the most prevalent blockholders (about 40% of shares in the 1990s), followed by families and banks (about 14% of
shares). The public owned only 17% of shares versus 50% in the US. This figure had been in constant decline since the
1930s, and it is only very recently that the trend is reversing and public share ownership begins to increase again. As already
mentioned before, German banks have significant voting power because they vote the proxies on behalf of their many
individual shareholders and clients 1. Japan presents a similar image, yet the role of families is even less important than in
Germany.
All other countries considered insider systems are glaring examples of family capitalism; their economies are
dominated by a handful of rich dynasties who constantly exchange political favors with rather corrupt governments. This
incestuous relationship between the local oligarchy and politicians is called crony capitalism. Claessens, Djankov and Lang
(2000) documented corporate ownership in several Asian countries (except Japan); they found that the top 10 families in
each of the 8 countries studied controlled between 18% and 58% of the combined value of shares traded on local exchanges.
How can such a small number of investors concentrate so much control? How can they hold on to it for such a long
time? Most of insider systems use two methods for retaining control: Dual-class shares, and pyramidal ownership. Both lead
to a separation between cash flow rights and control rights. This approach achieves control with a relatively small initial
capital. Dual-class, or multiple-class shares give different voting rights to different classes of shares. They are popular in
many countries, including Canada. In Canada, for example, one could have class A shares with 10 votes per share, and class
B shares with one vote per share. Bombardier is a company controlled by the Bombardier family through dual-class shares.
Hollinger International was controlled by the infamous Conrad Black, who used dual-class shares to acquire 70% of total
votes. This arrangement was also used by Google when it first went public, although in the United States, dual class-shares
are less frequent than in Europe or Asia. Ford Motors is still under the dominance of the founding family who controls about
40% of votes, while holding only 4% of outstanding shares.
In other situations, the voting power from one class to another could change even more dramatically; thus was the
case with multiple-voting shares in the inter-war period in Germany. In the US, Berkshire Hathaway Inc. has class A shares
that have 200 times more voting power than class B shares. Of course, class A shares are in the hands of Warren Buffet. An
extreme example is Echostar Communications, in which the founder, Charlie Ergen at some point in time controlled about
90% of the votes with only 5% of outstanding shares. Again, multiple-class shares are rather the exception than the rule in
the United States, but they appear more visible because information here is more readily available.
In some cases, shares that have more than one vote have a lower dividend than shares with only one vote; but this
is not necessarily a rule. As such, dual-voting shares provide the best of two worlds. On the one hand, they allow the
founder or the family to retain control of the firm; on the other hand they allow the firm access to outside financing by
issuing shares that carry less voting power.
Corporate pyramids allow similar advantages. In Japan, a network of holding companies at the top can control tens
if not hundreds the companies downstream with a relatively small capital. A rich family in Italy needs at most 50% of total
capital to control a holding company at the top. This in turn needs at most 50% of capital to control other companies below
them, which in turn need at most 50% of capital to control other companies, and so on. These figures become more
spectacular when pyramids are combined with dual-class shares. With a capital of a few hundred million dollars, an astute
entrepreneur can end up controlling a multi-billion corporate empire.
1 Client's stock is often left on deposit with the hausbank, which handles dividend payment, and proxy voting.

2
 Recent studies have shown that, outside the United States, higher voting power shares command impressive
premiums, and that ownership patterns matter most outside the US. In the developed world, the highest voting power
premium is found in Italy, 82% (Zingales, 1994); and the lowest in Sweden: 6.5% (Rydqvist 1988) [Barclay and Holderness
(1989), Mikkelson and Regassa (1991), Chang and Mayers (1995)]. Block trades, are also priced at a premium ] [DeAngelo
and De Angelo (1985), Zingales (1995)].
This obviously means that rich investors desire control per se more than they seek wealth and money. In finance
lingo it is said that they value private benefits of control over financial returns. Effective control offsets the lack of investor
protection (appropriate regulation, reliable courts, enforceable contracts). Unfortunately, a large shareholder can
expropriate smaller shareholder by taking advantage of the same lack of protection for which control was acquired in the
first place. This can take the form of tunnelling (self-dealing), where transfer prices are used to push all profits at the top of
the pyramid, and the losses at the bottom. Moreover, controlling shareholders can simply bully other shareholders around,
as exemplified by the epic dispute between Conrad Black - who ruled Hollinger International as his own private fiefdom,
disdainful of other investors - and the rest of Hollinger's shareholders. Luckily for smaller shareholders, the dispute was
settled in a US court, and eventually Lord Black ended up in a correctional facility.
Other private benefits of control associated with large corporations involve wielding political influence and
capturing the government or the legislature in order to block legislation that would threaten the privileges of incumbents.
Many trade restrictions, capital regulations, and labor laws are influenced behind closed doors by oligarchs who want make
sure that competition is not about to undermine their economic and political power. More innocuous private benefits of
control involve the conspicuous displaying of public status and the right to brag about powerful connections.
Arm's length systems show a more widely held ownership pattern, which is generally approaching the idealized
description given by standard American finance textbooks. 2 Common shares tend to be widely held, and the average size of
large ownership stakes is rather small as a percentage of total votes. There are fewer pyramidal groups and multiple-voting
shares; hence, there is a better match between cash flow and control rights, and a more pronounced separation between
ownership and control (Canada being one notable exception). Managerial capitalism dominates among medium and large
firms. Entrepreneurial capitalism is associated with very young firms. The entrepreneur usually grows the firm in its early
stages, then exists the market, cashing out on his/her investment. This goes hand in hand with the existence of a well
developed primary market for capital, which encourages many companies to go public. Shares are actively traded and often
end up in portfolios administered by large financial institutions specialized in wealth-management (mutual and pension
funds). In the Anglo-American system, investors are more willing to give up control in exchange for liquidity and
diversification benefits.

Boards and CEOs

Insider systems have boards dominated by...insiders, that is individuals who have close ties to the management
and/or large ownership stakes in the company. In Japan, board structure is single-tier (like in the US) but most directors are
insiders; outside directors are rare, except in the case of large banks, whose representatives participate on the boards of the
firms they control. The monitoring power of banks is such that management turnover is higher in firms controlled by banks.
In general, however, shareholders rarely remove directors; and proxy fights are unheard of.
Other countries, such as Germany and Austria have two-tier boards. In Germany, the two-tier board is made of a
Supervisory board (Aufsichstrat), with strategic oversight role (in firms with more than 2,000, half of this must consists of
employees; the chair has a tie-breaking vote and represents the shareholders); and a Management board ( Vorstand), in
charge of the day-to-day management (it consists mostly of senior managers). In France and Italy, companies have been
recently given a choice between a two-tier board and a single-tier board, in which oversight over the management is given
to outsiders. These relatively recent trends have been prompted by: the emergence of the free-market philosophy as the
dominant cultural paradigm in the wake of the fall of communism; the recent wave of world-wide liberalization and
financial reform that triggered the globalization of the 1990s; and the recent wave of corporate scandals.
Insider models display a large variety of managerial styles and attitudes towards running the company. The
internal management style in Japan is less authoritarian and more communitarian than in the Anglo-American model.
Emphasis is on long-term consensus building, sharing of information, and personal relations. Important decisions are made
following informal interactions. Relationships rely very much on trust, reputation-building, and honorable exit strategies.
Responsibility is collective rather than individual. In Germany, the relationship between management and workers is more
egalitarian than in France or Italy. French corporations are impressive bureaucratic structures in which managers are more
autocratic than in Japan or the US, and relations are highly formal and impersonal. In Japan and Germany, accounting is
more conservative; in the US it is more aggressive.
In rule-based corporate governance system, CEOs are able to extract significant compensation packages. In most
2 This was first popularized by two American economists, Adolf Bearle and Gardiner Means in a 1932 book titled "The Modern Corporation."

3
cases, CEO pay is not something that shareholders vote on, but it is rather decided by the board. When the board is captured
by management, compensation packages can be quite high. In general, firms in countries with equity-oriented capital
markets and firms with higher growth opportunities use more equity-based compensation [Bryan, Nash and Patel (2002)].
Equity compensation is a form of pay performance; it represents a high-powered incentive because its value varies directly
with the valuation of the firm. Another high-powered incentive is represented by stock options granted to senior mangers
and directors. In relation-based governance systems manager compensation is mostly in the form of fixed salaries and
bonuses, and in some cases the compensation of directors must be approved by shareholders (unlike the US).

Capital markets

In rule-based corporate governance systems, capital markets tend to be well developed, very liquid, and
sophisticated. Trading in bonds, equities, and derivatives is wide-spread. A significant part of assets is securitized. The ratio
of market capitalization to Gross Domestic Product is very high. External financing has higher fixed costs (more complex
infrastructure: institutions, regulating agencies, courts, investment banks, information disclosure, etc.), but lower variable
costs (significant economies of scale). The relative cost of producing information is lower for larger firms [Novaes and
Zingales (1998)]. External equity (which is always more expensive than debt), tends to be less expensive in Anglo-
American countries due to lower perceived moral hazards, and better protection of shareholders' rights. As a result, non-
financial firms in rule-based governance countries generally use more external capital than their counterparts in relation-
based governance countries. [Emmons and Schmid (1999)]. Venture capital is almost entirely an Anglo-American
phenomenon. The innovative firm gets more than one chance in its attempt to convince investors of the merits of its
technology. There is a high volume of IPOs in good times.
Financial intermediaries tend to be large and sophisticated. They provide a variety of services and products; from
bond and equity brokerage to complex hedging and arbitraging strategies. Due to better regulation and liquid markets, the
flotation costs of common shares are smaller than in insider systems. However, the cost of issuing long-term debt might be
larger because the special, intimate relationship between creditors and firms is lacking. Bond issues tend to be more
impersonal and costlier to administer.
Relation-based corporate governance systems have less developed, less liquid, and less sophisticated markets; a
smaller proportion of assets is securitized and outside equity financing is less frequent. Bond issues are also less frequent
than long-term bank loans. In some cases, like in post-war Japan, they are almost non-existent.
In general, relation-based financing has a comparative advantage at promoting physical-asset intensive industries,
simply because physical assets can be used as collateral against claims held by lenders. Physical-asset-intensive industries
are also better understood and more predictable. The bank has an easier time overcoming information asymmetries, and sees
lesser risk in lending to the firm. This is why Germany and Japan, which have both a well-developed banking systems, have
both excelled at promoting classical industries, requiring high quality craftsmanship and engineering. They have been
lagging behind the United States in terms of innovating technologies, mostly because relation-based finance is not well
suited for high risks. Innovative entrepreneurs have less opportunities to show their potential; most times they do not get a
second chance to prove their worth. Relation-based corporate governance raises barriers to entry for newcomers and
outsiders. The ones who have the greatest incentives to promote change also have the hardest time to access capital. While
insiders have an easier access to capital, they also have more interested in preserving the status-quo.
By some accounts, European financial systems were as developed, if not more than those in the United States
around the 1900s [Rajan and Zingales (2003)]. Countries such as Germany, Austria, Belgium, the Netherlands, and Sweden
- not to mention the United Kingdom- had large equity markets, more companies publicly traded, and more external equity
financing relative to their population than the United States. About a century ago, however, things turned around, and the
United States began taking the lead. Many explanations have been proposed to elucidate this phenomenon. Stulz and
Williamson (2001), following in the steps of Max Weber and Francis Fukuyama (1995) suggest cultural influences as the
main explanation. Another interpretation pertains to the Great Depression that triggered profound changes in legislation and
corporate governance in the United States. The Glass-Steagall act, which separated commercial banking from investment
banking, together with subsequent legislation, favored the rise of arm's length contracting and dynamic capital markets. In
Europe, the trend was running in the opposite direction. Germany moved towards more concentrated ownership and less
wide shareholding.3 France had a traditional distaste for bankers, financiers, and speculations a la bourse; hence, financial
markets in France had always been underdeveloped and a little backward, compared to those of neighboring countries. Only
the United Kingdom had significant capital markets. To this day, London remains the main financial hub of the world.
While the New York Stock Exchange might have overtaken the London Stock Exchange in terms of volume and market
capitalization, London still holds the lead in terms of foreign exchange and banking.
3 Until 1992 there was a 1% on the value of new equity raised. Secondary market trading was subject to transaction taxes

4
 The advent of the European Union, and the massive economic and social integration that emerged in the last
decades in the wider European zone had brought about major changes. Changes became more manifest, especially after the
introduction of the euro in 1999. No doubt, the process of European integration had the result of increasing economic
competition, and reducing the resistance to financial markets. It opened up domestic intermediaries to foreign competition,
and most importantly, constrained the efforts of incumbent capitalists or bureaucrats to undermine the development of
arm’s-length markets. As Raghuram Rajan and Luigi Zingales point out, the divergence of interests inside the European
Union will make coordination and lobbying in favor of local interests, and against competition more difficult, reducing the
political threats to markets. But it is also true that European bureaucrats have taken so far a pro-market stance, because
arm's length markets have been associated with globalization and international integration. However, this could easily
reverse in future, under the pressure of economic cataclysms, international terrorism, nationalism, or simply shifts in
ideologies.
Another consideration is the large size of the integrated European market.. While the global volume of foreign
exchange diminished after the introduction of the euro (less foreign exchange was needed once 12 main European
currencies vanished), the amount of debt issues almost tripled. In some other aspects the change is even more dramatic. In
1980, the United States had more than one derivatives exchanges; in Europe, only London had an active exchange. At the
same time, Amsterdam was in the process of opening one. In less than two decades, the weight of European derivatives
exchanges went from less than 1% to almost 30%. Domestic corporate debt grew from 13% of GDP to 17% of GDP and
international corporate debt grew from 2.4% of GDP to 6% of GDP.

Evolution of corporate debt 1989-2001: Domestic corporate debt to GDP

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

EU average 0.134 0.138 0.137 0.13 0.156 0.138 0.132 0.133 0.132 0.138 0.143 0.148 0.167

United States 0.222 0.222 0.229 0.233 0.236 0.227 0.229 0.229 0.226 0.236 0.241 0.240 0.241
Source: BIS, IMF financial statistics and Rajan and Zingales (2003)

Evolution of international corporate debt 1993-2001: Domestic corporate debt to GDP

1993 1994 1995 1996 1997 1998 1999 2000 2001

EU average 0.024 0.022 0.022 0.025 0.028 0.028 0.035 0.047 0.061

United States 0.070 0.007 0.007 0.008 0.011 0.013 0.019 0.023 0.031
Source: BIS, IMF financial statistics and Rajan and Zingales (2003) “Banks and Markets:The Changing Character of European Finance"

The benefits of capital markets are countless. They allow corporations to access external capital; they provide
invaluable price signals needed to allocate resources efficiently; they provide risk management mechanisms; and they
provide corporate governance mechanisms. Every major exchange in the world today has a long list of best corporate
governance practices that must be observed. In many cases, corporations have to comply with them, or else explain why
they deviate from their provisions.

Disclosure

Disclosure in relation-based system is less encompassing than in rule-based systems. This owes to the manner in
which the parties interact with each other and information is generated and shared. Insider systems predominantly generate
information that is implicit, not directly observable or publicly verifiable, and specific to a given person or relationship. The
relationship is truly functional when all parties involved are willing to commit to certain course of action, are willing to
honor contracts, and are able to work out conflicts of interest and seek compensation when prejudice is occurring.
Obviously, a functional relation is based mostly on trust, personal loyalty, and shared expectations. By its very
nature, trust cannot be delegated, hence, the monitoring and enforcement of implicit contracts can only be achieved inside
the relation. This explains why insider corporate governance systems work well even without extremely developed and
sophisticated disclosure and enforcement mechanisms. It suffice to have basic respect for the rule of law, social stability,
and the absence rampant predatory behavior and cheating.
Disclosure in arm's length systems is the backbone of corporate governance. It is not possible to have enforceable
contracts without quality information. The system is specialized in generating public information, verifiable by third parties.
The level of disclosure is much higher in rule-based systems. A small and apparently innocuous anecdote following the
merger of Chrysler with Daimler in the late 1990s is very telling of the differences between the two systems: Analysts and
financial researchers were used to heads-up from Chrysler pertaining to the operating performance of the firm. After the

5
merger (which in all honesty proved to be more of a takeover of Chrysler by Daimler) the trail of peeks at the firm's
financial performance went cold. The information coming out of the firm slowed to a trickle, a frustrating situation for Wall
Street analysts used to be lavished with pre-announcement reports , earnings warnings, and other sorts of inside scoops.
In countries like Mexico or even Italy (until recently), if you were not a member of the ruling family or an insider
to the board, you had little hope of getting any meaningful information. Most of the knowledge on tightly controlled public
firms take the form of corporate lore rather than reliable and objective data.

Banks

Insider systems are subject to what Rajan and Zingales (2004) call the "tyranny of collateral." This shapes both the
nature of banking and the type of capital available to corporations and entrepreneurs. The provision of finance in relation
based corporate governance systems is almost invariably linked to tangible assets that serve as collateral. Most of debt
capital is provided by banks holding privileged information. Banks can thus tolerate higher levels of debt. To the point,
German firms have historically recorded higher debt levels than US firms 4 (61% vs. 50% on average). The active
involvement in corporate governance of hausbanks or of any other financial firms thus mitigates agency problems. The
same is true of Japanese banks, which are at the same time shareholders and creditors.
While good for corporate governance, the bundling of financial claims results in some rather higher level of
unsystematic risk for the financier. This has an important consequence: it reinforces banks' preference for investments in
tangible assets, and proven technologies. The collusion between creditors, workers, and managers aimed at minimizing risk
nudges corporations away from R&D and human capital intensive industries. This, coupled with the lack of a developed
venture capital market explains why corporations in insider systems have never excelled at bold innovations and
breakthroughs. In many notables cases, such as Germany and Japan, corporations have gained world-wide reputation for
refinement, craftsmanship, and engineering, but less often for cutting-edge, earth-shattering advances in the fields of
computer technology, software, and bio-technology (as already explained earlier).
The bond between the bank and the borrower creates powerful barriers to entry in pretty much every important
industry [Rajan and Zingales (1998)]. As already explained somewhere else in this text, outsiders do not stand too many
chances to prove their worth. Access to finance is probably the most effective barrier to entry, and this clearly favors
incumbent firms and their CEOs.
Entrepreneurial high tech innovation is much more encouraged in outsider systems. There is no coincidence that
firms like Microsoft, Apple, Netscape, Google, Facebook, and many others have sprang in the US and not in Europe or
Asia. It is not that American banks are more eager and willing to gamble on risky projects than German or Italian banks do.
The difference owes to the existence of a vibrant market for venture capital 5.
It is not that banks in the US particularly prefer arm's length finance over relation finance. All big financial
institutions would probably welcome even more power over non-financial firms. There are several important factors that
over the years contributed to shaping the US financial landscape. The most important of all is the American mob mentality
intolerant of monopolies, government control, and encroachment on free markets. To this add the regulation passed in the
first half of the 20th century, aimed at busting industrials cartels, separating commercial from investment banking, ensuring
transparency and fairness, and protecting smaller outside investors.
It appears, however, that central banks prefer a relation-based system because it leads to more control over the rest
of the financial system. More control reduces the need for exhaustive regulation. The role of central banks is to conduct
monetary policy and to ensure the stability of the banking system. As the recent financial meltdown has proved it with great
eloquence, these functions are hindered by the unchecked movements of capital in competitive, recalcitrant and volatile
markets. Economists have found that in rule-based systems, monetary policy seems more effective. More specifically, in
countries using German-style financial and corporate governance systems, monetary policy appears to be twice as effective
as in the US [Cecchetti (1999)]. Not surprisingly, this partially explains why the US government had to throw trillions of
dollars into the financial system in order to stabilize it, while other countries got away with less money and with a shorter
recession.
While bank domination in relation-based systems is greater than in rule-based systems, its importance can be
greatly exaggerated. La Porta et all. (1999) find that in Germany, Sweden, Norway, Finland, Denmark, Italy, and France big
banks control one or maybe two of the top ten largest non-financial firms. In Germany, many large banks have embraced a
manifest policy of retreat from the governance of non-industrial firms. In Japan, the stakes of banks in other keiretsu firms

4 Bradley Michael, Cindy A. Schipani, Anant K. Sundaram, and James P. Walsh "The Purpose and accountability of the
corporation in contemporary society: Corporate governance at a crossroads"
5 Venture capital is an example of relation-based finance par excellence coexisting symbiotically with the arm's length
finance represented by big financial institutions and free capital markets.

6
rarely exceed 10%. The power of banks stems, not from their direct ownership stakes in non-financial corporations, but
rather from the privileged position of creditor in the absence of strong bond and equity markets as alternatives. But this is
quickly changing. As argued elsewhere, after a long period of relative apathy and lethargy bond and equity markets have
began to grow and diversify considerably, both in Europe and Asia.

Market regulation

Market regulation in arm's length systems is extensive and offers significant protection for shareholders. Large
blockholders have fewer avenues for expropriating smaller shareholders or creditors. The well developed judicial and
administrative system makes regulation relevant and, most importantly, enforceable. The aim of regulation in outsider
systems is to provide a fair and competitive financial environment. Fairness is ensured through transparency and disclosure.
Competitiveness is ensured through access to information and access to finance. The underpinning philosophy of regulating
markets and corporations in arm's length systems is that free, transparent, and fair markets will allocate resources in the
best possible way.
Insider systems' market regulation is aimed more at restricting access to outsiders. While in many industrialized
countries regulation is reasonably well developed and encompassing, it eventually acts as a barrier to entry. Also, there is
no denying that outside investor protection is somewhat weaker than in arm's length systems. Without strong protection,
outside investors are reluctant to provide capital. Markets are thus slower to develop, less liquid, and corporations rely more
on accumulated internal equity and bank loans.

Financial distress and bankruptcy

In arm's length systems, bankruptcy regulation is aimed at giving the corporation another chance to re-organize and
survive. Distressed corporations first attempt reorganization, and failing that, eventually move towards liquidation.
Given the nature of arm's length contracting, and the large number of claimholders, the cost of financial distress can be quite
high, especially when it comes to public bankruptcies. Bankruptcies have elaborated and complicated proceedings. The
hardest part is the recapitalization of the firm, in which existing claims are exchanged for new ones. For example, some
bondholders might be offered equity in exchange for their fixed claims, or they might be offered new debt claims with
different yield and maturity. New creditors who are willing to lend fresh money might get seniority over existing creditors,
and so on. Obviously, the process of reassigning claims is tedious and involves negotiating, cajoling, and even bullying.
When there are holdouts, the deal is off, and everyone goes to court where a judge rules on how the company should be
reorganized. The cost of these bankruptcies can reach up to 10% of the value of firm's assets and can last for years.
The recent bankruptcy of GM was an exception to the rule. GM re-emerged from bankruptcy after only 40 days -
which is exceptionally fast - but the price tag was enormous; workers, shareholders and bondholders had to make important
concessions, and both the US and Canadian taxpayers poured billions of dollars into restructuring the firm. A more typical
example was the 2003 bankruptcy of Air Canada. It lasted much longer and required harrowing negotiations and a dramatic
search for a potential white knight to keep the company going. The case of Revco in the late 1980s represents another iconic
example.
In spite of very frequent variations and shifts in market prices and other economic variables, arm's length corporate
governance systems are better at handling large-scale financial disasters or severe economic downturns. Time and again,
these systems have bounced back and have proven very resilient in the long-run to the vagaries of economic forces.
Insider systems of corporate governance are are good at handling small-scale financial distress, especially in
countries with strong financial institutions or strong industrial cartels. Germany and Japan are countries with a proven track
record of being able to localize and contain small and medium financial failures. The bankruptcy of Mazda in the 1970s
eloquently speaks to the strengths of Japanese keiretsu. In both Germany and Japan, financial distress and reorganization is
conducted privately when possible. They represent an internal affair of the business group. Reorganization is handled
smoothly and swiftly by the hausbank (Germany) or organ bank (Japan), which have excellent inside information on the
strengths and weaknesses of the distress firm. Since there are fewer creditors, it is much easier to negotiate a reorganization
deal; there are fewer holdouts. There is an added incentive to settle matter privately: in most European and Asian countries,
regulation strongly favors creditors. Public bankruptcies are bound to result in dismemberment and liquidation.
Large-scale financial crises are potentially catastrophic for insider systems. The deep financial crisis that engulfed
Japan in the early 1990s is a poignant reminder. Japan experienced a real estate crisis that led to a financial and banking
crisis, not unlike the one experienced by the US and the UK in 2008. While at the beginning of the crisis, Japanese banks
managed to keep the lid on, the number of failed firms and the volume of bad loans simply grew too large to handle. Ever
sine the early 1990s Japan has been a sluggish economy with structural economic problems. For over a decade, the country

7
had never quite fully recovered from the crisis - it was too severe to handle by the system.
There is more to be said about the "tyranny of collateral." While collateral-backed lending appears as a very sound
financial practice, it nevertheless harbors hidden dangers. It can lead to destructive credit cycles [ Kiyotaki and Moore
(1997)]. Tangible assets, such as buildings, plant and equipment see their value fluctuate in sync with economic cycles.
During a downturn, they trigger a double whammy: on the one hand, less demand leads to less income to the borrower from
which to reimburse the loan used to purchase the assets in the first place; on the other hand, the market value of collateral
assets dips, which makes the claim of the creditor far riskier than initially envisaged. In some cases, the borrower would
find it cheaper to walk away, and let the bank confiscate a devalued asset, rather than having to pay back the loan.

The market for corporate control

Outsider systems have a very active and vibrant market for corporate control. Mergers and acquisitions come in
waves, and their volume is quite high. Acquisitions, especially hostile takeovers lead to replacing the incumbent
management team. It is believed that this disciplining function represents a central feature of arm's length corporate
governance systems. As already discussed earlier, however, too buoyant a market for corporate control could also represent
the symptoms of managers out of control, magnanimously squandering the money of shareholders on value-reducing
deals6.
Insider systems have historically shunted mergers and acquisition, considering them too rogue and aggressive.
Until the 1980s, there were virtually no hostile acquisitions in Europe or Japan. In Japan, the terminology used to refer to
acquisitions is evocative of prostitution, bribes, and hijack (Miurisuru,
Baishu, and Nottori). In addition to the cultural aversion toward them, the system made it unlikely that hostile bids would
succeed. Interlocking shareholdings, and uncontested control by large owners discourage would-be bidders, or make the
cost of transactions prohibitively high.
Notwithstanding these consideration, subtle changes in the mentality of investors and regulation made M&As more
palatable than they were 20 years ago. Europe proved very receptive to the latest trends and saw a spectacular increase in
the number and volume of deals. If in the US, the volume of M&A grew by 230% in the 1990s compared to one decade
earlier; in Europe the growth was of 1,275% over the same period. Germany saw a spectacular M&A boom, with an
increase of almost 2,000% in the 1990s compared to the 1980s 7. Some of the largest deals ever took place in Europe. Even
Japan, so impenetrable to foreign capital saw a faint liberalization and opening of its market for corporate control. Iconic
companies, such as Nissan and Mazda are now partially owned by Renault and Ford. This would have been unconceivable
in the 1970s, when Mazda first experienced financial troubles.

Convergence

The history of the post-war period have taught us important lessons. On the one hand, insider systems in
industrialized countries engender rapid economic growth and prosperity to the point that freer and more liquid markets
become a logical necessity. In order to sustain and continue growth, these systems must allow outsiders to access capital
more readily. More liquid and accessible markets require better investor protection, which in turn leads to changes in
corporate governance practices. The breakdown of the Bretton Woods agreement in 1971 (bringing an end to the Gold
Exchange Standard) is due in great part to pressures coming from corporate governance and financial markets. Until 1971,
the Gold Exchange Standard tolerated restrictions on free capital movements and allowed national governments to interfere
and collude with the banking system; this prevented and delayed the development of arm’s length markets. In the 1970s,
the situation was ripe for a change: governments and incumbent elites could not stem the flow of outsiders demanding
liberalization of financial markets and more investor protection. [Rajan and Zingales (2003)].
Insider systems are effective as long as the insider elite is relatively less numerous and relationships are stable in
the long-term. Beyond a certain point, fresh blood must be let in to allow further growth; but opening the gates to outsiders
can lead to chaos. The Asian currency crisis of the late 1990s occurred in the wake of liberalizing capital markets and
financial systems. Liberalization in Eastern Europe led to period of rapid and radical change, accompanied by institutional
and political volatility. The political and governance vacuum becomes a fertile ground for looting and cheating. There is
little wonder why economic and financial liberalization is often associated with turmoil and crises.
On the other hand, arm's length systems suffer from lack of long-term engagement. With so many new entrants, it
is difficult to remain committed to a limited number long-term relationships. When things are not going well, many
investors find it more convenient to exit rather than challenge the governance of the firm. Not everyone is a Carl Icahn.

6 Denis Diane K. and John McConnell (2003) “International Corporate Governance,” Journal of Financial and Quantitative Analysis, 38, 1
7 Bradley, Michael, Cindy A. Schipani, Anant K. Sundaram, and James P. Walsh “The Purpose and accountability of the corporation in contemporary
society: Corporate governance at a crossroads”

8
 After riding the wave of economic growth and competitiveness, arm's length systems do eventually lead to the
concentration of power and wealth in fewer and fewer hands. This seems to be a natural and inescapable process, consistent
with the nature of complexity. Over-regulation and too much openness seems to render the system vulnerable to the
rapaciousness of managers. In order to preserve structure and stability, rule-based governance changes with time, reverting
to some extent to insider-dominated systems. Beneath the image of a corporate governance that becomes more equitable,
transparent, and regulated, things are surreptitiously leading to new type of economic elite, in which insiders are more
difficult to tell apart (as they would not necessarily share family ties, or belong to the same ethnic group). Instead of blood,
insiders are now brought together by strong social ties (education, profession, ideology, cultural or religious affinities) that
delineate and help protect their privileges against outside intrusion. The lines of demarcation become more subtle and
nuanced.
Superimposed on these trends, and closely related to them, we can observe an ever-growing economic
interdependence and globalization process. International trade becomes generalized, capital movements are increasingly
unrestricted, capital markets expand beyond national boundaries the number of major currencies shrinks as a result of
regional integration, various countries have no choice but to collaborate on global issues such as climate change, and many
corporations become truly global in nature, without any allegiance to clear-cut national constituencies. Is this the hallmark
of a convergence process among various corporate governance systems? Are governance structures around the world
moving towards a system in which the most important characteristic is the ability of individuals to enter into enforceable
contracts? It certainly appears so. More and more corporations become cross-listed on various international exchanges.
They raise equity and debt globally. Their outsource their R&D, production, and service globally. They appear to be
adopting harmonized corporate governance practices. Regulation in many countries becomes generic, and more centered on
investor protection. Whether this process reaches deep bellow the surface, or it remains expedient and superficial remains to
be seen. The jury is still out.

Legal systems and corporate governance .

Recent corporate governance scandals have made it painfully clear that the expropriation of investors turns out to
be a major issue even in countries with developed markets, large financial intermediaries, and reliable legal and judicial
systems. In developing countries the expropriation of investors is truly catastrophic.
Without adequate investor protection there is no provision of capital. Outsider creditors and shareholders who feel
vulnerable simply do not extend financing to firms in which they have no control. Shareholders are much more vulnerable
to expropriation than other stakeholders, simply because once they provide capital, they are not needed anymore. Workers,
on the other hand, have more leverage because if they are not paid in time they will stop working. Suppliers will stop
delivering if they do not collect their money; and utilities firms will cut off power, telephone, and internet to those that do
not pay their bills. What is an outsider shareholder to do, when, after subscribing to an IPO, the controlling family uses
corporate funds to buy themselves a luxury yacht?
Who ensures that the managers, or the controlling family do not squander the capital raised from investors? Why
keep the promise and pay interest and dividends? The legend has it that Carl Furstenberg, a prominent German banker once
quipped that shareholders are stupid and impertinent. Stupid because they give their money to somebody else without any
effective control over what this person is doing with it, and impertinent because they ask for a dividend as a reward for their
stupidity.
It turns out that “shareholder stupidity and impertinence” is inversely related to legal protection. Where investor
protection is weak, expropriation is extensive and the technique for expropriation need not be too sophisticated. The
controlling family, or shareholder simply siphons off money from the company through tunneling, self dealing, or using the
company's coffers as a private cash machine. As investor protection improves, the methods for expropriating outside
investors become more sophisticated and elaborated; and of course, less effective. This is why nepotism and overpay are the
more common ailments in developed countries. Beyond a certain point, however, looting becomes so risky and expensive
that one is better off playing by the rules.
In less developed countries, investors enter in financing relationships only with those they trust: family, friends,
and such. this is why insider systems are so widespread, practically representing the dominant corporate governance system
on the planet. In arm's length systems, the claims of investors can be enforced in court; the quality of enforcement, however,
varies with the nature of legal system. There are two main legal traditions in the world: Common-law and Civil law.

Common law

Common law originated in England in the Middle Ages and was inherited by most of Britain's former colonies.
Common law is a system in which a good portion of law originates from court decisions made by judges. In a common law

9
system, the law is thus based on precedents and future judgments have to make reference to those precedents. The judge has
in fact the duty to create precedents. Hence, courts do not merely upheld the law, they create new law all the time. In
addition, the legislature enacts statues, which represent another important, yet secondary source of law.
At the heart of the system lies the principle of stare decisis, according to which similar cases are to be decided
using consistent principles in order to reach similar results. When making a judgment, a court has to follow several steps.
First, it must consider the facts as they occurred. Second, the courts must identify all similar previous cases and rulings that
relate to the matter at hand. From those precedents, the court must extract the general principles and analogies that led to
each particular ruling. More recent rulings and rulings by superior courts carry more weight than earlier rulings made by
lower courts. Based on these principles, the judge determines what the law is in the matter before the court and hands down
the ruling. Of course, the court can decide that the matter at hand is different from precedent rulings and create their own
principles, given rise to a new precedent. Hence, new law is created.
Common law is fairly flexible and adaptable to changing social and economic conditions. It also engenders a
gradual, bottom-up approach to changing in law. It brings about incremental change, in accordance with a social culture that
generally rejects upheaval and social cataclysms. The other side of the coin is that common law is fairly predictable,
especially when it comes to commerce, and finance; the contracting parties have in general a fairly good idea of what the
limits of legality are, based on precedents.
Common law around the world

Source: Wikipedia [Link]

As a rule of thumb, English-spoken countries have a common law system. English is spoken in the United
Kingdom, Ireland, Canada, United States, Australia, New Zealand, India, South Africa, Zimbabwe, and in other former
British colonies.

Civil law

Civil law is the oldest law system in the world. It has a honorable tradition that goes back to the Roman Empire.
Unlike common law, civil law is based on extensive codification of the law. Codification is a concept first encountered in
Babylon, and exemplified by the code of Hammurabi. The most relevant codification occurred during the reign of emperor
Justinian, in the 6th century: Corpus Juris Civilis. All modern civil law can be traced back directly to Corpus Juris Civilis.
Later, in 1804, the French emperor Napoleon Bonaparte modernized Corpus Juris Civilis into what became known as
French civil law. Other important offshoots of civil law are represented by German and Scandinavian civil law. During the
20th century, the Soviet Union, and all of Eastern Europe adapted French civil law into what became known as socialist law.
German civil law was copied extensively by many Asian countries, including Japan, Korea and Taiwan.
In civil law systems. the main source of law is the statue, usually enacted top-down by an elected legislature.

10
Courts have to base their decisions on general principles contained by statutes with little reference to precedents. They are
expected to apply the law, not to create it. In France the judges are merely la bouche de la loi. In all countries using French
civil law, judges are educated and trained separately from attorneys, and are only eligible to function as judges. In common
law systems, by contrast, judges are chosen among reputable and competent attorneys.
Countries speaking Latin-based languages have a French Civil-law system. The six Latin-based languages in the
world are: Spanish, French, Italian, Portuguese, Romanian, and Romansh. French is spoken in France, Quebec, parts of
Belgium, parts of Switzerland, parts of Lebanon, and in the former French colonies overseas. Portuguese is spoken mainly
in Portugal, Brazil, and a handful of former Portuguese colonies, like Angola and Mozambique. Italian is spoken only in
Italy, and parts of Corsica. Romanian is spoken only in Romania and Moldova. Spanish is spoken in Spain, Central and
South America (except Brazil), and the Philippines. Romansh is almost extinct, spoken only by a handful of people in
Southern Switzerland (less than 1% of the total population, that is, less than 40,000 people still use it). German civil-law is
used in Germany Austria, Switzerland, Taiwan, South Korea and Japan (which adopted it after the Meiji Restoration).
Scandinavian Civil-Law is in use in Denmark, Finland, Norway, and Sweden. The former communist countries of Eastern
Europe used a modified version of the French Civil Law system. La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei
Shleifer, and Robert Vishny (1998 and 1999) provide an interesting classification. Some observations can be disputed (for
example, Brazil is a mix of French and German civil law, but appears only under French civil law), yet it is fairly accurate
and insightful. Although this classification does not consider all the countries in the world it is relevant nonetheless and the
conclusions reached by this study have became one of the most cited pieces of research in corporate governance.
Law systems: Country classification
Common-Law Civil-Law (Scandinavian) Civil-Law (German) Civil-Law (French)
Australia Denmark Austria Belgium
Canada Finland Germany France
Ireland Norway Japan Greece
New Zealand Sweden South Korea Italy
United Kingdom Taiwan Mexico
United States Switzerland Netherlands
Honk Kong Portugal
India Spain
Kenya Argentina
South Africa Brazil
Sri Lanka Colombia
Zimbabwe Ecuador
Peru
Uruguay
Venezuela
Source: La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny (1998)

Financing and ownership

How do various legal systems stack up? We have insightful data pertaining to general financing patterns, market
activity, ownership patterns, and investor protection. In terms of debt financing, there is relatively difficult to draw
definitive conclusions. There are variations from country to country. The US and Canada use relatively more debt than Italy
and Mexico, and than most of Scandinavian countries. German civil law countries seem to use more debt than common law
countries. Let us not forget that the data was collected in the 1990s, at a time when Japan was going through a deep
recession, experiencing its own version of the sub-prime meltdown; and Germany was in the pangs of reunification. By
contrast, the US was experiencing its longest uninterrupted growth period since the end or World War II, and corporate
profits were soaring. There is evidence, however, that, as expected, bank debt is more prevalent in civil law countries.
Common law countries, with the exception of England appear to rely to a much lesser extent on banks loans; as already
mentioned they prefer bond issues to long-term loans.
Business sector debt to GDP
Common-Law Business Civil-Law Business sector Civil-Law Business sector Civil-Law Business sector debt
sector debt to (Scandinavian) debt to GDP (German) debt to GDP (French) to GDP
GDP
Australia na Denmark 34.00% Austria na Belgium
Canada 72.00% Finland na Germany 112.00% France 96.00%
Ireland na Norway na Japan 122.00% Greece
New Zealand na Sweden 55.00% South Korea 74.00% Italy 55.00%
United na Taiwan na Mexico 47.00%
Kingdom
United States 81.00% Netherlands na
Source: Emmons, William R. and Frank A. Schmid (1999) “Corporate Governance and Corporate Performanc,” Working Paper 1999-018A, Federal

11
Reserve Bank of St. Louis

Business sector debt owed to banks

Common-Law Business Civil-Law Business sector Civil-Law Business sector Civil-Law Business sector debt
sector debt (Scandinavian) debt owed to (German) debt owed to (French) owed to banks
owed to banks banks banks
Australia na Denmark na Austria Belgium
Canada 86.00% Finland na Germany 99.80% France 93.00%
Ireland na Norway na Japan 96.00% Greece
New Zealand a Sweden na South Korea na Italy 98.00%
United 96.00% Taiwan na Mexico
Kingdom
United States 75.00% Netherlands
Source: Emmons, William R. and Frank A. Schmid (1999) “Corporate Governance and Corporate Performanc,” Working Paper 1999-018A, Federal
Reserve Bank of St. Louis

The contrast is very stark when considering outside equity financing. Common law countries rely to a much greater
extent on external equity than do civil law countries. This is especially true for French civil law countries where outside
equity financing is of secondary importance. Until the 1980s stock market activity was actually decreasing in countries such
as Italy and Germany.
As mentioned before, IPO activity has been rather dismal in civil law countries, especially French civil law. It
appears that common law countries, driven mainly by the US and UK recorded IPO activity up to ten times higher than that
in France and Italy. Accordingly, three to five times more firms were listed in common law countries than in French civil
law countries, relative to population.
Since the 1990s, however, when this data has been collected, outside equity financing had increased significantly
all over the European continent. The New York Stock Exchange and EuroNext have recently merged into the largest global
stock equity market. This move, combined with wider and deeper pan-European economic integration has greatly boosted
equity markets in Europe.

Outside equity to GDP

Common-Law Outside equity to Civil-Law Outside equity to Civil-Law Outside equity to Civil-Law Outside equity to
GDP (Scandinavian) GDP (German) GDP (French) GDP
Denmark 21.00%
Canada 71.00% Germany 13.00% France 23.00%
Japan 62.00%
Sweden 51.00% South Korea 44.00% Italy 22.00%
Mexico 8.00%
United States 58.00%
Average 60.00% 30.00% 46.00% 21.00%
Source: Emmons, William R. and Frank A. Schmid (1999) “Corporate Governance and Corporate Performanc,” Working Paper 1999-018A, Federal
Reserve Bank of St. Louis

IPOs and listed firms relative to population

Common-Law Civil-Law (Scandinavian) Civil-Law (German) Civil-Law
(French)
IPOs per 1 million inhabitants 2.33 2.14 0.12 0.19
Listed firms per 1 million 35.45 27.26 16.79 10
inhabitants
Source: Emmons, William R. and Frank A. Schmid (1999) “Corporate Governance and Corporate Performance,” Working Paper 1999-018A, Federal
Reserve Bank of St. Louis

Ownership is more concentrated in civil law countries than in common law countries, and the difference between
the systems is very poignant. The United Kingdom has the most widely held large corporations in the world. Large
American firms are also widely held, with a very few notable exceptions discussed earlier. At the other extreme, Mexico and
Argentina have practically no widely held firms. Italy and France, also show a high level of ownership concentration among
large firms. Depending on the measure used, Germany and Japan show relatively moderate levels of ownership
concentration because ownership is exercised quasi-collectively, by a group of shareholders. There are interlocking
ownership patterns in Japanese keiretsu groups, and consortium ownership in Germany. In most French civil law countries,
large shareholders are represented by families. By contrast, families play a minor role in Germany and Japan. The most
important shareholders are other firms. Banks play an important role in corporate governance in both Germany and Japan,
yet their ownership stakes are rather limited.

12
Fraction of 10 largest firms controlled by a family, the state or a widely held firm
Common-Law Fraction of 10 Civil-Law Fraction of 10 Civil-Law Fraction of 10 largest Civil-Law Fraction of 10
largest firms (Scandinavian) largest firms (German) firms controlled by a (French) largest firms
controlled by a controlled by a family, the state or a controlled by a
family,the state or family, the state or widely held firm family, the state or
a widely held firm a widely held firm a widely held firm
Denmark 50.00%
Canada 40.00% Finland 50.00% Germany 15.00% France 35.00%
Norway 60.00% Japan 0
Singapore 80.00% Sweden 55.00% South Korea 5.00% Italy 65.00%
United 0.00% Switzerland 10.00% Mexico 100.00%
Kingdom
United States 20.00% Argentina 95.00%
Source: Emmons, William R. and Frank A. Schmid (1999) “Corporate Governance and Corporate Performanc,” Working Paper 1999-018A, Federal
Reserve Bank of St. Louis

Median ownership of 10 largest firms by three larges shareholders

Common-Law Median ownership Civil-Law Median ownership Civil-Law Median ownership of Civil-Law Median
of 10 largest firms (Scandinavian) of 10 largest firms (German) 10 largest firms by (French) ownership of 10
by three larges by three larges three larges largest firms by
shareholders shareholders shareholders three larges
shareholders
Denmark 40.00%
Canada 24.00% Finland 34.00% Germany 50.00% France 24.00%
Norway 31.00% Japan 13.00%
Singapore 53.00% Sweden 28.00% South Korea 20.00% Italy 60.00%
United 15% Switzerland 48.00% Mexico 67.00%
Kingdom
United States 12.00% Argentina 55.00%
Source: Emmons, William R. and Frank A. Schmid (1999) “Corporate Governance and Corporate Performanc,” Working Paper 1999-018A, Federal
Reserve Bank of St. Louis

Fraction of 10 largest firms widely held

Common-Law Fraction of 10 Civil-Law Fraction of 10 Civil-Law Fraction of 10 largest Civil-Law Fraction of 10
largest firms (Scandinavian) largest firms (German) firms widely held (French) largest firms
widely held widely held widely held
Australia Denmark 40.00%
Canada 60.00% Finland 35.00% Germany 50.00% France 60.00%
Norway 25.00% Japan 90.00% Greece
Sweden 25.00% South Korea 55.00% Italy 20.00%
United 100.00% Switzerland 60.00% Mexico 0.00%
Kingdom
United States 80.00% Argentina 0%

Source: Emmons, William R. and Frank A. Schmid (1999) “Corporate Governance and Corporate Performanc,” Working Paper 1999-018A, Federal
Reserve Bank of St. Louis

Quality of governance

Among the most interesting topics is the measurement of the quality of corporate governance legal framework. Of
course, there is a great deal of subjectivity and bias involved in such an exercise. The conclusions are, nevertheless,
insightful. There are two distinct aspects to this issue. One is the extent of explicit investor protection. The second one is
the quality of enforcement. Common law countries clearly have more explicit protection for both shareholders and
debtholders. Rich countries provide much better enforcement than poorer countries.
Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny(1998) provide a seminal study in
which they identify five variables that may proxy for the intangible degree of the rule of law in a country:
1. The efficiency of the judicial system, as ranked by Business International Corp.;
2. The assessment of the law and order tradition, provided by International Country Risk, a credit-rating agency;
3. An index of government corruption, also from International Country Risk;
4. The risk of expropriation, also from International Country Risk;
5. The risk of repudiation of a contract by the government, also from International Country Risk

13
 In terms of creditor rights, the United States and the United Kingdom provide the best balanced approach
(according to an American study), followed closely by Germany and Japan. Although bankruptcy laws in Europe are
favoring creditors over shareholders, French and Scandinavian civil law countries appear to fare poorly here. Shareholders
are best protected in common law countries, yet the best enforcement is by far found in Scandinavian countries. The Finns,
Swedes, and Norwegian appear to be the most law abiding corporate citizens in the developed world. Although investor
rights are extensive in the Anglo-American world, the quality of enforcement is average. Enforcement appears dismal in
French civil law countries, especially in South America, although Italy is not far behind.

Measures of corporate governance

Common-Law Civil-Law (Scandinavian) Civil-Law (German) Civil-Law
(French)
Creditor rights *** * ** *
Shareholder rights *** * n/a **
Rule of law * *** ** n/a
Total 7 5 4 3
Source: Emmons, William R. and Frank A. Schmid (1999) “Corporate Governance and Corporate Performanc,” Working Paper 1999-018A, Federal
Reserve Bank of St. Louis
Richer countries have more widely held firms.
Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny(1998) also identify several metrics that
evaluate the rights given to shareholders. These measures are:

1. Anti-director rights allow shareholders to censor and even get rid of incompetent directors. anti-director rights
determines the balance of power between the board and the firm's shareholders.
2. Proxy voting by mail allow shareholders to exercise their voice even when they are not able or not willing to
participate to general meetings
3. Shares are not blocked before a general meeting. This measures the power that the board can exercise in order to
censor shareholders; it is to some extent the mirror measure of anti-director rights
4. Cumulative voting or proportional representation measures the power of the controlling shareholder. When the
voting is cumulative (or proportional), minority shareholders have a chance of electing their own representatives to
the board. Straight voting is a winner-takes-all proposition in which minority shareholders could easily be
marginalized.
5. An oppressed minority mechanism: this allows either judicial redress or a mandatory buyout
6. of shareholders who are opposed to fundamental changes in company bylaws, such as
7. voting rules. In less developed countries, abusive changes to corporate bylaws by majority shareholders represent a
serious problem, resulting in the expropriation of minority shareholders. Similarly, the percentage of voted needed
to call for an extraordinary meeting is a measure of shareholder power
8. Pre-emptive rights to purchase new equity issues protect shareholder against the dilution of earnings, ownership
stakes, and market value.

Measures of shareholder rights in different law systems

Common-Law French Civil-Law German Civil-Law Scandinavian Civil- World
(18 countries) (21 countries) (6 countries) Law (49 countries)
(4 countries)
Anti-director rights index 4 2.33 2.33 3 3
Proxy by mail 39.00% 5.00% 0 25.00% 18.00%
Shareholders not blocked before meeting 100.00% 57.00% 17.00% 100.00% 71.00%
Cumulative voting 28.00% 29.00% 33.00% 0 53.00%
Oppressed minority mechanism 94.00% 29.00% 50.00% 0 53.00%
Preemptive rights 44.00% 62.00% 33.00% 75.00% 53.00%
10% or less of capital to call ESM 94.00% 52.00% 0 0 78.00%
Source: Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny

Common law countries score the highest in terms of anti-directors rights, proxy by mail, shareholders not being
blocked before a meeting, oppressed minority mechanism, and votes required to call an extraordinary meeting.
Scandinavian civil law countries score best in terms of shareholder not blocked before a meeting and preemptive rights.
German civil law countries score best in terms of cumulative voting. French civil law countries come in second or third
place in all categories.
The tally of shareholder rights presented here reinforces the picture presented earlier. Common law countries have
the best shareholder rights, but enforcement of those rights is not always perfect. Scandinavian and German civil law

14
 countries have excellent enforcement, although they grant less rights to shareholders, especially Germany. French civil law
countries are trying to catch up in terms of shareholder rights, but enforcement remains a problem.
Another interesting statistic pertains to insider trading. Insider trading can be viewed as a serious expropriation
threat to outside investors. Following the lesson learned during the Great Depression, The United States moved swiftly to
curtail it. Presently, more and more countries consider this practice unethical and as a result, changes in legislation are
design to mitigate this deficiency. However, many countries are slow to catch on. With the exception of France and Sweden,
most European countries enacted insider trading legislation in the late 1980s, and early 1990s. Germany, for example, where
the anti-shareholder sentiment goes back to the inter-war period, waited until 1994. Enacting legislation is one thing.
Enforcing it is yet another. Yet again, many countries waited at least several years before deciding to finally enforce it.

Insider trading legislation

First insider trading legislation Legislation first time enforced
Austria 1993 -
Belgium 1990 1994
Denmark 1991 1996
Finland 1989 1993
France 1967 1975
Germany 1994 1995
Greece 1988 1996
Ireland 1990 -
Italy 1991 1996
Luxembourg 1991 -
Netherlands 1989 1994
Portugal 1986 -
Spain 1994 1998
Sweden 1971 1990
United Kingdom 1980 1981
United States 1934 1961
Source: Rajan, Raghuram G. and Luigi Zingales (2003)“Banks and Markets:The Changing Character of European Finance

Rajan and Zingales' study: More of the same

Another insight into corporate governance practices and investor rights is offered by Raghuram Rajan and Luigi
Zingales. This time, the analysis pertains chiefly to geographical differences. Southern Europe, however is dominated by
French civil law countries, while Northern Europe is dominated by a mix of common-law, German civil law, and
Scandinavian civil law. United States is obviously a common law country.

Corporate governance and investor protection in Europe

Shareholder Creditors' Days to Days to evict Judicial Rule of Corruption Tax Accounting Value of Average
rights rights collect a a tenant system law compliance standards control number of
check employees
Northern Europe 2.4 2.1 171.09 201.7 9.48 9.46 9.3 3.54 67.78 0.09 9.9
Southern Europe 2 1.5 381.75 347.5 6.38 7.75 7.04 2.06 54.25 0.2 4.8
EU average 2 1.64 252.92 264.27 8.2 8.82 8.37 2.89 60.4 0.14 7.7
United states 5 1 54 49 10 10 8.63 4.47 71 0.01 n/a
Source: Rajan, Raghuram G. and Luigi Zingales (2003)“Banks and Markets:The Changing Character of European Finance

Methodology used by Rajan and Zingales:

• Shareholders’ rights is an index from 1 to 5 of the rights minority shareholders have against incumbents
• Creditor’ rights is an index from 1 to 5 of the rights creditors have in bankruptcy. Both are from La Porta et al.
(1998).
• Days to collect a check is the total number of days (completion of service, trial, and enforcement) it takes to collect
the money on a bounced check. Source: Djankov et al. (2002).
• Days to evict a tenant is the total number of days (completion of service, trial, and enforcement) it takes to evict a
tenant that does not pay. Source: Djankov et al. (2002).
• Judicial efficiency is an assessment, produced by country risk rating agency Business International Corp, of the
``efficiency and integrity of the legal environment as it affects business, particularly foreign firms". The scale is
from 0 to 10 and the source is La Porta et al. (1998).
• Rule of law is the “assessment of the law and order tradition in the country produced by the country risk rating
agency International Country Risk (ICR). Scale from zero to 10, with lower scores for less tradition for law and

15
 order, source: La Porta et al. (1998).
• Corruption is an index of the pervasiveness of corruption (higher number means less corruption), source: La Porta
et al. (1998).
• Tax compliance is the “assessment of the level of tax compliance. Scale from 0 to 6 where higher scores indicate
higher compliance. Data is for 1995. The source is the Global Competitiveness Report 1996 as reported in La Porta
et al. (1999).
• The value of control is the premium paid to acquire a controlling block lock as a percentage of the value of equity.
The block premia is computed taking the difference between the price per share paid for the control block and the
exchange price two days after the announcement of the control transaction, dividing it by the exchange price two
days after the announcement and multiplying the ratio by the proportion of cash flow rights represented in the
controlling block. Source: Dyck and Zingales (2003).
• The average number of employees is the ratio between the total number of workers and the total number of firms in
1992-92. Source Kumar et al. (2000)

Overall, this survey reinforces the assessment of other credible sources. On paper, The United States has the
strongest shareholder rights, followed by Northern Europe. Northern Europe, however, has the strongest creditor rights. The
American bankruptcy process is usually geared towards protecting the corporation in distress; the number of firms
undergoing reorganization under Chapter 11 is relatively large. Germany and Scandinavian countries on the other hand
follow bankruptcy laws that favor the interests of creditors over those of the shareholders.
It takes less than two months on average to collect a check in the United States, yet it takes more than one year to
do so in Italy, Greece, Spain, or Portugal. It takes less than 50 days to evict a bad tenant in the US, yet it takes almost a year
to do so in Italy, Greece, Spain, or Portugal. The judicial system appears best in the United States and Northern Europe, and
average in Southern Europe. The same can be said about rule of law, tax compliance, and accounting standards. Corruption
is lowest in Northern Europe, and highest in Southern Europe.
Control blocks sell at a higher premium in Southern Europe than in Northern Europe, than in the United States.
Zingales (1994) finds the highest control block premium in Italy, at over 80% of market price. Clearly, the less effective the
protection offered to investors, the more valuable control rights are because they allow shareholders to make up for the lack
of protection. Finally, as already known, firms in Northern Europe tend to be higher on average than those in Southern
Europe.

A question of law

The general picture that emerges from the above studies is very complex. It appears that the legal system does
indeed play a role in determining the nature of corporate governance. Common law countries have fostered arm's length
systems, while civil law countries have fostered relation-based systems. But why is common law more protective of
investors than civil law? Why does it encourage arm's length contracts more than civil law? Perhaps the vague fiduciary
duty principles of the common law are more protective of investors than the bright line rules of the civil law, which can
often be circumvented by sufficiently imaginative insiders 8. The way in which the two law systems have evolved historically
also reveals a certain preference for, or aversion to free capital markets.
The Middle Ages in Europe witnessed a bloody contest between property owners and monarchies for supremacy. It
was a fluke that in the seventeenth century, the English monarchy lost control of the courts, which came under the
dominance of property owners. Ever since, common law has evolved in the direction of curtailing the power of the
centralized monarchy or state and protecting private property against the arbitrary rulings of the monarchy or state. As
England went through the industrialization period and emerged as the dominant economic and military superpower of the
world, the British monarchy lost its clout and became relegated to a merely symbolic status.
One of the most important legacies of the English common law system is the concept of rule of law. This is
eloquently embodied in the United States Constitution. The Americans inherited common law from the English settlers. The
American Constitution is in fact a meta-law, that is, a law above all other laws that prescribes what laws are acceptable or
not. The Supreme Court of Justice is the watchdog in charge with ensuring that all statues adopted by Congress are in
agreement with the Constitution. In general, the rule of law requires that all citizens should agree beforehand on what laws
should be permitted and what powers should be relegated to governments and lawmakers. The rule of law is intricately
related to the concept of self-ownership and individual rights. They all originated together as a political and philosophical
system in late medieval England. The rule of law limits what a majority can do with the law. An elected majority can never

8 La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny (1998 and 1999)

16
be allowed to suppress or violate individual rights and freedoms, and private property. An elected majority can never be
above the law. As such, the rule of law does not condone the tyranny of the majority any more than it allows for the tyranny
of a monarch. The despotism of 51% of citizens is no different than the despotism of a king or dictator. This is why
totalitarian regimes and extreme ideologies never quite found a fertile social ground in Anglo-american countries. This also
why civil rights movements originated predominantly in common law countries.
It was also a fluke that the French monarchy won the battle against land owners and created one of the most
centralized states known in history. France under the reign of Louis XIV was the ultimate absolutist monarchy. There is no
wonder that civil law evolved in the direction of enforcing the power of the centralized state, and curtailing the influence of
property owners.
The French have a long and venerable love-hate affair with despotism. Since the seventeenth century, France had
oscillated between mob rule and hyper-centralized government. The eighteenth century French royal court was opulent and
magnificent. By comparison, the English king looked pauper and puny. The British monarchy, censored and restrained by
Parliament looked with envy at the unchallenged power and extravagance of the French king. The 1789 revolution - aimed
against despotism - quickly turned red in tooth and claw and led to yet another despotic regime. After having helped
overthrow the monarchy, Napoleon Bonaparte proclaimed himself emperor and immediately moved to consolidate the
central authority of his government. He set out to revamp the legal system and quickly found that Justinian's Corpus Juris
Civilis, was a perfect candidate for the top down approach to enacting and enforcing the law. Justinian himself had devised
it in order to consolidate his autocratic rule; of course, he had placed himself above the law, and so did Napoleon.
The nineteenth century turned out to be a tormenting period for France. The monarchy was restored, only to be
challenged by a new revolution. France got yet again another emperor (Napoleon III), only to be defeated and deposed by
France's archenemy, Germany. Paris became the scene of the first communist revolution, only to be drowned in the blood of
its own citizens. In the twentieth century, the country oscillated between socialism and the far right. Both ideologies
despised free markets and ownership rights. The strong hand of the government, however, was never put into question.
Other civil law countries, such as Italy, Spain and many South American countries had similar experiences. They all flirted
with extreme ideologies - far left or far right - but in the end they embraced the comfort of a hyper-centralized, omniscient
government as the best solution for keeping the economy functioning.
Unlike common law countries, civil law countries do not have a strong tradition for the rule of law, individual
rights, and self-ownership. While the notions of equal rights, and individual freedoms burst out of the 1789 French
Revolution, they were somewhat drowned by subsequent events. In a civil law democracy, there is more tolerance towards
an elected majority restricting the rights of a minority. Democracy is not synonymous with the rule of law, although, there is
a link among these two notion notions. This is why dictatorial regimes, such as fascism and communism originated in civil
law systems. Both the 1917 Russian Revolution and Mussolini's regime in Italy had initial popular support. Adolf Hitler was
dully elected to the Reichstag in 1933. It was only after taking power that both communists and fascists proceeded to curtail
civil rights, freedoms, and eventually the democratic process itself. In most modern industrialized nations with civil law
systems, however, the notion of individual rights and rule of law has come of age and is now fairly similar to those in
Anglo-American countries. If anything, it is the Anglo-American democracies who experienced a setback in terms of rule of
law, especially after the tragic events of 9/11.
In the end, historical, cultural, and political circumstances explain why Anglo-American countries have law-
abiding citizens yet suspicious of authority, whereas civil law countries have citizens who embrace the ideal of powerful,
centralized governments but are relatively unruly. These attitudes carried over in the realm of corporate governance. In
common-law systems, where the rule of law and private ownership are sacred, equal protection to all investors came natural.
In civil law countries, ownership is seen more as a privilege that can only be preserved by denying entry to outsiders.

17
Liberalization is an investment in building new institutions with high present costs and uncertain future returns.

Gorton and Schmid (2000): higher ownership by the large shareholders is associated with higher valuation of corporate
assets in Germany.
• Claessens, Djankov, Fan, and Lang (1999) use a sample of East Asian firms to show
• that greater insider cash flow ownership is associated with higher valuation of corporate assets, whereas greater insider
control of voting rights is associated with lower valuation of corporate assets.
• Using a sample of firms from 27 wealthy economies, La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1999b) find that
firms in countries with better shareholder protection have higher Tobin’s Q than do firms in countries with inferior
protection. They also find that higher insider cash flow ownership is (weakly) associated with higher corporate valuation,
and that this effect is greater in countries with inferior shareholder protection.

If CF rights < CNT rights, insiders will maximize private benefits of control, otherwise they will max value

Johnson, Boone, Breach, and Friedman (2000): In countries with poor protection, the insiders might treat outside investors
well as long as future prospects are bright. When future prospects deteriorate, however, the insiders step up expropriation;
governance variables, such as investor protection indices and the quality of law enforcement, are powerful predictors of the
extent of market declines during the crisis.

Beck, Levine, and Loayza (2000): financial development can accelerate economic
growth in three ways:
• It can enhance savings.
• It can channel these savings into real investment and thereby foster capital accumulation.
• To the extent that the financiers exercise some control over the investment decisions of the entrepreneurs, financial
development allows capital to flow toward the more productive uses, and thus improves the efficiency of resource
allocation.

• Aoki and Patrick (1993) and Porter (1992): far-sighted banks enable firms to focus on long term investment decisions.
• Hoshi, Kashyap and Scharfstein (1991): banks also deliver capital to firms facing liquidity shortfalls, thereby avoiding
costly financial distress. Finally, banks replace the expensive and disruptive takeovers with more surgical bank intervention
when the management of the borrowing firm underperformed.
• Kang and Stulz (1998) Japanese banks perpetrate soft budget constraints, over-lending to declining firms that require
radical reorganization.
• Weinstein and Yafeh (1998) and Morck and Nakamura (1999), Japanese banks, instead of facilitating governance,
collude with enterprise managers to deter external threats to their control and to collect rents on bank loans.
• Edwards and Fischer (1994) and Hellwig (1999), German banks are likewise downgraded to ineffective providers of
governance.
• La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1997) show that, on average, countries with bigger stock markets also
have higher ratios of private debt to gross domestic product (GDP), contrary to the view that debt and equity finance are
substitutes for each other. The prevalent financing modes generally do not help with the classification. Another way to
classify financial systems is based on the existence of Glass-Steagall regulations restricting bank ownership of corporate
equity

Despite the difficulty of classifying financial systems into bank- and market centered,
economists at least since Gerschenkron (1962) have engaged in a lively debate as to which one is superior, focusing on the
hypothesis that bank-centered systems are particularly suitable for developing economies.

Recent research points to some crucial principles of investor protection that reforms need to focus on:
• Legal rules do matter
• Good legal rules are the ones that a country can enforce.
• Glaeser, Johnson, and Shleifer (2000), is that government regulation of financial markets may be useful when court
enforcement of private contracts or laws cannot be relied upon
The successful regulations of the U.S. securities markets, the Polish financial markets, and the Neuer Markt in Germany
share a common element: the extensive and mandatory disclosure of financial information by the issuers, the accuracy of
which is enforced by tightly regulated financial intermediaries. Leaving financial markets alone is not a good way to

18
encourage them
Rajan, Raghuram G. and Luigi Zingales (2003)“Banks and Markets:The Changing Character of European Finance,”

Relationship-based financing:
Tend to protect mature incumbent firms that get into trouble. In normal times, this lends stability to the system. In times of
extraordinary change, this can keep resources far too long in unproductive uses. Ex: the rescue of Mazda by Sumitomo bank
in the 1970s.

• Is naturally more prone to government direction because it depends more heavily on the government to maintain the
restrictions on competition that enable it to work.
• Perform better when markets and firms are smaller, legal protection is weaker, when there is little transparency, and
when innovation is mostly incremental, rather than revolutionary. It works best in the early stages of industrialization where
the industries to be financed are physical asset intensive, where the legal system is ineffective, and where skill-based or
idea-based industries are of limited import. Also in small, homogenous, closed economies.

Facts:
• The United Kingdom, which has more developed arm’s-length markets, has larger firms than any other European
country (Kumar et al, 2000)
• Haber (1997) shows that Brazil, following its political revolution, liberalized finance, and saw the textile industry grow
faster and become less concentrated than the Mexican textile industry
• The National Recovery Administration, which was set up under the New Deal, sought to fix prices in industry in order to
eliminate “ruinous” competition
• Morck et al. (2000) in the United States market-wide movements explain only 3 percent of the daily variation of
individual stocks, while in developing countries such as Taiwan and Poland they explain far more (approximately 40
percent and 60 percent respectively).
• Peek and Rosengren (1998): In the early 1990’s, Japanese banks increased their lending to the U.S. commercial real
estate market. At their peak in 1992, the U.S. subsidiaries of Japanese banks accounted for one-fifth of all commercial real
estate loans held in the U.S. banking sector. Then, in response to a severe decline in real estate prices in Japan, the
Japanese banks cut back their lending in the U.S. even as U.S. prices were rising (and lending by non-Japanese banks
increasing), while at the same time expanding their lending in the domestic Japanese market where prices were
plummeting. Thus, rather than cutting their losses in Japan -- or at least not abandoning their profitable opportunities in
the U.S. -- Japanese banks poured more money into their unprofitable Japanese relationships.

Relationship-based financing and arm’s-length financing are sensitive to different type of euphoria:
• The former is more sensitive to institutional euphoria
• The latter to individual euphoria.
Rajan and Zingales (2000) physical capital is becoming less important, while human capital is taking the center stage.
Relationship based systems find it more difficult to finance human capital firms, especially when these human capital-
intensive firms are involved in disruptive innovation. Hence the relative benefit of an arm’s length system may grow as firms
change their nature.

Denis Diane K. and John McConnell (2003) “International Corporate Governance,” Journal of Financial and
Quantitative Analysis, 38, 1

Individuals are not necessarily endowed with both managerial talent and financial capital. The ability to separate
ownership and control allows the holder of either type of endowment to earn a return on it.

The ultimate effect of managerial ownership on firm value depends upon the tradeoff between the alignment and
entrenchment effects.

The private benefits of control can be innocuous from the perspective of other shareholders, i.e. a blockholder may simply
enjoy the access to powerful people.
The ultimate effect of blockholder ownership on measured firm value depends upon the tradeoff between shared benefits of
blockholder control and private extraction of firm value by blockholders.

19
LLSV (1998): the legal system is a fundamentally important corporate governance mechanism.

Boards of Directors
Hermalin and Weisbach (2003):
• Higher proportions of outside directors are not associated with superior firm performance
• Higher proportions of outside directors are associated with better outcomes in acquisitions, executive compensation and
CEO turnover
• Board size is negatively related to both general firm performance and quality of decision making
• Poor performance, CEO turnover, and changes in ownership structure are often associated with changes in the
membership of the board

Kaplan and Minton (1994): In Japan the appointment of outside directors stabilize and modestly improve corporate
governance

Wymeersch (1998): UK, Switzerland, and Belgium most focused on shareholder welfare. Codes of best practice have been
issued in many countries, but compliance on the continent more difficult than in the UK due to the presence of controlling
s/h. LSE require that all firms indicate whether they are in compliance, although the Code is not mandatory.

Franks, Mayer, and Renneboog (2001): boards dominated by outsiders impede discipline of poorly performing managers.

Two-tier boards are mandatory in Germany and Austria and optional in France and Finland.

• Blasi and Schleifer (1996): Russian boards are controlled by insiders. Government decrees urging boards to use 2/3
outsiders has been generally ignored.
• Murphy (1999), Core Guay, and Larcker (2003): Pay-performance sensitivity has increased in the US over time, due to
options and common stock.
•
Ownership and control

Holderness (2003): the relationship between blockholders and firm value in the US is sometimes negative, sometimes
positive, but never strong.

Gorton and Schmid (2000): positive relation between firm performance and concentrated equity ownership.
Claessens and Djankov (1999): firm profitability and labor productivity directly related to ownership concentration.

Morck, Schleifer, and Vishny (1988): entrenchment dominates alignment beyond 5% mrg ownership in the US
Short and Keasey (1999): entrenchment dominates alignment beyond 12% mrg ownership in the UK – mgrs become
entrenched at higher levels of equity ownership in the US (better ability to monitor in the UK and less able mgrs to mount
takeover defenses)

Morck, Schleifer and Vishny (1988), McConnell and Servaes (1990): the alignment effects of inside ownership dominate the
entrenchment effect over some ranges of managerial ownership.
Himmelberg, Hubbard, and Palia (1999): mgr ownership and firm performance are jointly determined; the relationship is
endogenous.

Overall, there is more significant relation between ownership structure and firm performance in non-US firms: US banks
are prohibited from taking a large governing role; is this prohibition interfering with optimal governance or other aspects
of US governance reduces the value of bank involvement?

• Dewenter and Malatesta (2001): higher profits are not directly linked to privatization, rather the increase in profits
occurs immediately prior to privatization – governments may choose to privatize firms that have become profitable, or the
prospect of privatization may prod the firm to improve performance.
• Megginson and Netter (2001): exhaustive survey of 225 studies on privatization.
• Makhija and Spiro (2000): share prices are positively correlated with foreign ownership and ownership by insiders.
• Frydman, Gray, Hessel, and Rapaczynsky (1999): performance does not improve when ownership resides with insiders;
it improves with outsiders, though.

20
• Frydman, Pistor, and Rapaczynsky (1996): domination by corporate insiders in Russia prevents funds from
accomplishing meaningful change.
• D’Souza, Megginson, and Nash (2001): greater foreign ownership is associated with greater efficiency gains post-
privatization.
• Claessens and Djankov(1999): concentrated ownership leads to better performance in newly privatized Czech firms.

Second generation of studies

• LLSV (1998): in countries with low investor protection, there is more highly concentrated equity ownership and less
developed public equity market; strongest protection: common law countries; weakest protection: French civil law
countries. Enforcement stronger in German and Scandinavian law countries and weakest in French civil law countries. If
the law does not protect minority investors, the owners will seek to become controllers.
• LLSV(1997): better legal protection results in lower required rates and more use of external finance. Use of outside
finance is higher in common law countries and lowest in French civil law countries.
• LLSV(2002): firms in countries with better investor protection have higher Tobin’s Q ratios.
• Lemmons and Lins (2003) Tobin’s Q in asia falls with the risk of expropriation of minority s/h: ownership structure more
important in bad times.
• Dyck and Zingales (2003): individual voting premiums are negatively related to the degree of investor protection.
• JLLSV (2000): Controlling s/h extract value through “tunneling” more likely to occur in civil law countries; or through
pyramid structures
• Johnson, Magee, Nagarajan, and Newman (1985): positive price reaction to the death of founding CEOs
• Morck, Schleifer and Vishny (1988): among older firms, Tobin’s Q is lower when managed by a member of the founding
family.
• Demsetz and Lehn(1985): ownership is endogenous, aimed at matching the characteristics of the firms.
• Lins(2003) stronger positive relation between ownership and performance in countries with less legal protection

Convergence

Rajan and Zingales (2000): relationship-based governance can overcome the lack of investor protection; rule-based
governance is better at raising long-term capital and allocating it efficiently.

LLSV (1999) the controlling s/h of the world will fight to protect their private benefits of control and will fight laws
protecting minority s/h, thus legal system convergence might be difficult – firms however can list on multiple exchanges.

Hansmann and Kraakman (2001) –drive towards consensus due to:

• Failure of alternative models
• Competitive pressures of global product markets
• Shift of interest groups influence in favor of the s/h class (we are all s/h)
Schleifer and Vishny (1997): governace in US, Japan, and Germany are converging

Khanna, Kogan, and Palepu(2002) find:

• De jure convergence at a regional level
• Little evidence of de facto convergence
• Globalization has induced adoption of some common corporate governance practices, but that’s all

European corporate governance: Trading off liquidity against control

Marco Becht, European Economic Review 43 (1999) 1071}1083

A certain degree of ownership dispersion is a pre-requisite for liquid stock markets. Stocks must be held by a diversity of
investors and they must be willing to trade. However, the spread of ownership gives rise to problems in taking collective
action.

The ideal solution to this problem has three elements.

• One, it must provide a mechanism that concentrates voting power and, thereby, allows for direct monitoring.
• Two, the concentration of voting power must not tie up large share blocks and destroy liquidity. Three, those who

21
command the voting power must have the right incentives.

The European Corporate Governance Network (1997) has collected evidence on voting power concentration for 7
European countries and the United States (Barca and Becht 1999).
• La Porta et al. (1997, 1998, 1999): differences in shareholder protection explain ownership concentration (in terms of
cash-flow rights), control arrangements (in terms of voting rights) and the size of debt and equity markets around the world.
• Roe (1994) argues that (over-)regulation make it expensive to hold blocks or prevent institutions from holding blocks at
all. This is the case in the United States.
• Coffee (1991): many institutional investors in the US trade off control against liquidity.

Bradley, Michael, Cindy A. Schipani, Anant K. Sundaram, and James P. Walsh “The Purpose and accountability of the
corporation in contemporary society: Corporate governance at a crossroads”

Like Germany, Japan emphasize protection of employee and creditor interests at least as much as those of shareholders?
Employees have incentive todevelop and supply firm-specific human capital
No need for poison pills or takeover defenses. The governance system itself is one giant poison pill.

US: governance is addressed in the context of info asymmetry, self-interested behavior of mgmt, s/h, and d/h.
Germany and Japan: governance focuses on transaction efficiency and the scope of the firm (and keeping control in the
hands of an elite)

The system biases the firm towards strategies that emphasize survival and market-share maximization, rather than max
of s/h value.

Facts: Labor costs in Japan and Germany erode the competitiveness of the firms in the global marketplace.

Labor entrenchment leads to higher unemployment.

Labor productivity lower in Germany and Japan (or is it labor intensity?)

Smaller role of pension funds

Changes

Changes in US governance towards stronger contractarian focus

German banks are encouraged to divest.

Daimler-Benz; diversified during the 1980s, mkt value declined from Dm 50 b (1986) to Dm 25 b (1993), operating income
from DM6 b to -DM6.8b

Faced with CF problems Daimler Benz listed on the NYSE, divested Fokker aircraft division, and merged with Chrysler in
1998 – what an Anglo-americanization of the 3rd largest German firm.

“Germany is being shaken by a profound shift of power away from banks and toward broad-based equity markets (anti-
elitist trend?)

Conclusion:
Purpose of corporation is to maximize the value of residual claims within the constraints imposed by law, social norms, and
customs.

Why?
• The ability to attract capital
• Global competition in product markets (to be more profit-driven)?
• More flexible and adaptable to changes in the global marketplace

Frank Easterbrook: law itself is an output of the drive towards economic efficiency, rather than the other way around.

22
The spread of the Anglo-American contractarian governance model needs an adequate infrastructure: international
institutions to enforce the contraxts that are the threads which keep the fabric of the contractarian model from unraveling:
• Disclosure rules
• Contract law to establish the terms of trade
• Impartial judiciary to enforce the contracts
• Flexibility and adaptability

Harmonious integration of different systems: WTO, EU, NAFTA pave the way.

The deepest challenge: enact communitarian sentiments (spirit) in a contractarian world.

Li, John Shuhe (2003) “Relation-based versus Rule-Based Governance: an Explanation of the East Asian Miracle and
Asian Crisis,”Review of International Economics, 11(4), 651-673, 2003

Enigmatic inconsistency between the Asian Miracle and the Asian Crisis
Existing answers are all ex-post rationalizations based on hindsight – Krugman’s (1998) “crony capitalism.”

Defining features of the East Asian Economies:

• Agreements are largely implicit, personal, and enforced outside courtrooms
• Governments, banks and firms have close relations
Relation-based governance is defined in terms of information and enforcement

The Japanese model:

• Owing to entry restrictions, one political party (clique) holds a monopoly in the political sector
• Some dozen banks are dominant in finances
• Some dozen industrial groups are dominants in industry
Generally accepted view until now: The miracle of Asian economies due to successful government policies:
• Macroeconomic stability
• Investment in human resources
• Export drive

Aoki et al (1997) – market enhancing view: success was due to the respective governments correction of market failures
by fostering intermediary organizations (banks) rather than by direct intervention – or no action at all.

Ex-post rationalisation
Krugman (1998) government guarantees induced financial intermediaries to take too much risk – gov protection can
induce a moral hazard crisis.
Rajan and Zingales (1998) – low contractability of the relationship-based financial system as opposed to the arm’s
length Western financial system led to the crisis.
Radelet and Sachs (1998) panic was the main culprit; ratio of short-term foreign debt to foreign exchange reserves was
significant; inconsistent IMF policies, monetary and fiscal contractions might have aggravated the crisis.

Coase theorem: when all contingencies can be specified in enforceable contracts costlessly, bargaining can result in
efficient allocation; there is no role for property rights, corporate governance or economic government intervention in
a world of complete contracts.

When important control rights and benefits cannot be specified in enforceable contracts, the allocation of residual
rights is necessary for efficiency.
• Contractual governance: enforcement mechanisms of specified rights
• Corporate governance: enforcement mechanisms of unspecified (residual) rights
The establishment of rule-based governance is a long evolutionary process since rules can be implemented only when the
players have mutually consistent beliefs that are common knowledge. For the common knowledge to take hold the
informational infrastructure (accounting, auditing, notary, and rating agencies) must reduce noise and become trustworthy,
otherwise, rules are ink on paper – see traffic laws in various countries.

23
various national systems resemble each other less closely as time goes on. Emmons, William R. and Frank A. Schmid (1999)

Rajan and Zingales (2003)

• Arm’s length markets also develop under the pressure of outsiders. The migration of business to friendlier political
entities is a very strong disciplinary force for keeping policies market-friendly; where there is political competition, the
effect of local legislation can be easily undone by neighboring states, destroying the return to lobbying. The cause of
markets is also greatly enhanced by the formation of common trade areas across countries

• The failure of Arthur Andersen to uncover the accounting irregularities at Enron is most likely due to the excessively
cozy relationship between Enron and its auditors; these scandals show that opaque relationships breed abuses and frauds.
• The development of arm’s length markets requires better enforcement and more transparency, hurting incumbents’
traditional ways of doing business through contacts and relationships. They might collectively have a vested interest in
preventing financial development and might be a small enough group (Olson (1965), Stigler (1971)) to organize
successfully against it. The Banking Act of 1933 (the Glass Steagall Act) removed banks from the boardroom, and the
Dollar Exchange System allowed the United States to conduct an independent monetary policy regardless of external
consideration. As a result, the U.S. monetary authorities had less to fear from markets.
• Rajan and Zingales (2003a), periods when and countries where borders were open to foreign trade and capital coincided
with periods of intense financial development.

24