Marco Becht and J. Bradford DeLong

February 2002

Review of Sanford Jacoby, "Corporate Governance on Comparative Perspective: Prospects for Convergence," forthcoming in the _Comparative Labor Law and Policy Journal_

Marco Becht (European Corporate Governance Institute and Brussels Free University) and J. Bradford DeLong (University of California at Berkeley and National Bureau of Economic Research

February 2002

For _Foreign Policy_...

In today's rich developed post-industrial economies, large corporations are bossed by an elite of largely self-selected managers: the past occupant of a job (or that past occupant's boss) has a lot to say about who will fill his (or occasionally her) shoes. But this does not mean that the managers' rule is free and unconstrained. In different economies one or more of five sets of forces constrains how top executives are chosen, what they have the power to do, and how long they remain in their jobs. These five sets of forces are (i) the prospect of a takeover or merger of the corporation due to a low stock price, (ii) the judgment of the executives of a large "universal" bank voting both the shares it owns and the shares other owners have delegated it to vote, (iii) the opinion of rich families of financiers exercising control through pyramids of holding companies and special classes of stock, (iv) pressure from labor unions with which companies live, and (v) pressure from the government and from other political institutions and groups. The most extraordinary thing about these five sets of forces is how much their strength varies across advanced post-industrial economies that are--in political institutions, levels of economic development, industrial structure, technological capability, and overall culture--remarkably similar.

For example, in the United States today the principal forces constraining top executives fall into groups (i) and (v). The extraordinary decline in private-sector labor union membership since the mid-1970s has removed most of the pressure that unions could exert on private corporations in the days of Waler Reuther, John L. Lewis, or even George Meany. Not since before the election of Franklin D. Roosevelt in 1932 have the employees or partners of major commercial or investment banks been able to exercise any appreciable degree of oversight, control, or even influence on top executives. Founders and their descendants have exercised control over firms like Ford, Hewlett-Packard, and Microsoft, but there are few parallels in the U.S. of the pyramidal industrial empires of the Wallenbergs in Sweden or the Agnellis in Italy: group (iv) never flourished on American soil. Only group (v)--the government and other politicial forces, exercised through a variety of channels, one of the most important of which is the Delaware Chancery's interpretation of the "fiduciary duty" that executives owe their shareholders--and group (i)--the fear that insufficient profits plus the belief that other managers could do better will lead to a low stock price, the acquisition of the company by another, and the wholesale replacement of the existing groups of top executives. This past fall's financial news of the collapse of Enron has highlighted one of the drawbacks of the U.S.-style system in which groups (ii) and (iii) have been very weak: decentralized ownership and control creates a collective action problem on the part of shareholders, so no one group has sufficient incentive to keep close watch on the honesty and reliable of the corporation's financial accounts, and as a result a management and auditors that wish to hide bad financial news can hide a remarkable amount of it for a surprisingly long time.

Sanford Jacoby's article points out that in other countries the strengths of these five groups of forces are very different. In Germany the union movement--through its raw organizational strength and through co-determination--and the "universal" banks like the Deutsche exercise substantial influence over managers. In Sweden the Wallenberg family sits atop of pyramid of holding companies and has the potential to exercise control over the management of an astonishingly large proportion of Sweden's industry.
Sanford Jacoby asks whether the corporate-governance structures--the constraints on the top bosses--of other rich developed post-industrial economies-are converging to the configuration found in the United States. And he answers this question with a resounding "No." The basic problems of corporate governance--"how to make managers accountable to those who have made investments in the corporation, and... what constitutes an 'investment'... that warrants the right to... direct management"--are common, but there is "stunning international variety." Moreover, no one country's system seems to be durably and obviously superior.

So Jacoby concludes that political differences, organizational inertia, and the absence of clear durable superiority in efficiency will keep national corporate governance systems widely divergent for the forseeable future.

Certainly the strength which which Jacoby argues for his particular conclusions strikes us as premature. We know remarkably little about just how our current corporate governance structures arose. We know remarkably little about how well they work, or rather would work if separated from their particular institutional and cultural context. Our collective views on their relative success or failure have oscillated wildly over the past two decades, with each model of corporate governance, in turn, taking its own place in the sun. Jacoby's conclusions are definitely counter to the most recently-fashionable assessment, which had become conventional wisdom during the internet bubble. In the past decade and especially during the recently-popped internet bubble, financial markets have become increasingly globalized, U.S. growth has accelerated, and the U.S. stock market has boomed. Managers in other countries have looked enviously at the magnitude of the flows through U.S. (and British) financial markets and the easy terms on which funds can be raised. And there have been signs that corporate-governance systems in Europe, Japan, and emerging markets have been shifting in the American direction as foreign firms seeking U.S. listing have tried to make their systems of governance understandable and comfortable to American investors. But Jacoby believes that the conventional wisdom is far ahead of reality: costs of changing governance systems are high, the likelihood of gains uncertain, and present claims of macroeconomic advantage from the U.S. system are likely to be as durable as claims two decades ago for the superiority of Japan's bank-based "patient capital" system.

We think that Jacoby is right that the cost of changing systems is high. However, history shows that systems can be changed by radical reform, so this not unsurmountable. Calls for radical reform worry us because the scientific assessment of past radical reform programmes is still in its infancy. This is something the US-inspired (and to some extent US-led) global corporate governance reform programme the OECD, World Bank and IMF have embarked on should keep in mind. At least there should be flanking measures, like reform evaluation programmes, that today are standard for reform programmes of such magnitudes in the United States proper.

We believe that there is a move towards stock markets playing a bigger role in the World's financial system (and from other research we are a bit worried about that too). This is driven by demography and the need to convert at least a portion of existing pay-as-you-go pension programmes into capitalised pension plans). Since demographic realities are not easily reversed, this seems inevitable (particularly in Europe): in Chile, for example, the fact of recent pension reform explains its favorable attitude toward stock markets and more American-style corporate governance, and appears to overrule whatever institutional and cultural legacy was the result of colonization by Spain. The ability to tap the New York and London capital markets is likely to be a very important factor in the next two decades. Firms that that have a broad shareholder base, with many investors holding small amounts of cash-flow rights, have an easier time tapping pension fund money via stock markets. "Ownership" is likely to continue slow convergence toward an American-style system.

However, the implications for "control" are less clear. Nothing requires that all these firms with decentralized shareholder bases will in the end be governed and controlled in the same way. The dispersed cash-flow rights of broad, distributed "ownership" come with a number of different forms of corporate control. They come with dispersed voting rights and contestable board control, as is often found in the UK. They come with uncontestable board control that is nominally exercised in the interest of shareholders, as is often found in US corporations with poison pills and entrenched directors. Or they come with priority shareholders who possess the sole right to nominate directors for election to the board, as is often found in the Netherlands. (Although there are some signs of change in the Netherlands, pension fund-led shareholder activism in the US has been largely unsuccessful in making US corporations rescind their takeover protections.) It is likely that Jacoby is right in his belief that institutional diversity in "control" patterns will continue to flourish, even if he is wrong in his belief that "ownership" patterns will also remain divergent.