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Friday, September 3, 2010

Company Law - Politics in Corporate Governance

What is Corporate Governance?
Corporate governance has succeeded in attracting a good deal of public interest because of its apparent importance for the economic health of corporations and society in general. However, the concept of corporate governance is poorly defined because it potentially covers a large number of distinct economic phenomenon. As a result different people have come up with different definitions that basically reflect their special interest in the field. It is hard to see that this 'disorder' will be any different in the future so the best way to define the concept is perhaps to list a few of the different definitions rather than just mentioning one definition.
1.      "Corporate governance is a field in economics that investigates how to secure or motivate efficient management of corporations by the use of incentive mechanisms, such as contracts, organizational designs and legislation. This is often limited to the question of improving financial performance.”[1]
2.      “Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment.”[2]
3.      "Corporate governance is the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance”[3]
4.      "Corporate governance - which can be defined narrowly as the relationship of a company to its shareholders or, more broadly, as its relationship to society”[4]
5.      "Corporate governance is about promoting corporate fairness, transparency and accountability.”[5]
6.      “Some commentators take too narrow a view, and say that the corporate governance is the fancy term for the way in which directors and auditors handle their responsibilities towards shareholders. Others use the expression as if it were synonymous with shareholder democracy.
Corporate governance is a topic recently conceived, and yet ill-defined, and consequently blurred at the edge. Corporate governance as a subject, as an objective, or as a regime to be followed is for the good of shareholders, employees, customers, bankers and indeed for the reputation and standing of our nation and its economy.”[6]
Good corporate governance practices reward the companies who observe them regularly
or make it a part of their policy framework. One of the pre-requisites of the good corporate governance sys tem is the efficient functioning of the board. When board processes are efficient, they tend to lower the cost of capital resulting in higher value for the shareholders. There have been evidences of well-governed companies rewarding their shareholders higher than their peers. One such evidence suggests that there has been 5.8% differential of excess returns 4 between the companies with the good governance practices and the companies with poor quality governance practices. Not only this, there have been evidences that the investors are ready to pay 15% to 25% higher premium to the companies with good corporate governance practices vis-à-vis their counter parts. They regard good corporate governance practices as a key concern for their investments.
Good corporate governance practices tend to reduce the cost of capital of the funds, increase the returns to the shareholders, and satisfy the other classes of stakeholders. It evidently creates a win-win situation for all the stakeholders of the company. They ultimately build lasting investors’ confidence in the market institutions and thus contribute creating healthy and robust financial markets.

Many companies after successfully creating value for their shareholders satisfy themselves that they are observing good governance practices. Creating value for shareholder is a necessary but not the sufficient condition for good corporate governance practices. Good corporate governance is based on three pillars. They are:

1) Transparency, 2) Accountability and 3) Fairness

1) Transparency of operations
This means adequate and timely dissemination of information by a company of its operations to its stakeholders. These disclosures need not necessarily be governed by the rules and regulations imposed by a stock exchange or a security market regulator. The company on its own has to come out with adequate and timely disclosures of honest anticipation or actual happening of material events affecting the value of the company.

2) Accountability towards stakeholders
This means the board is responsible and accountable to its various stakeholders. The issue is: to which class of stakeholders the board should primarily responsible? Good corporate governance practices warrant that the companies should adequately compensate and take care of the interests of each class of stakeholders. In United States, the board’s primary responsibility is presumed towards the shareholders. In Germany and some of the East Asian economies, the favoured stakeholders may be employees, suppliers, or lenders etc.

3) Fairness in dealing
This is essentially related to ethical behaviour of the companies. In their attempt to achieve higher returns in the short term, companies often indulge in unethical or unfair practices, like tax evasion, exploiting the labour or the supplier, willful default in servicing the debt etc. This is not restricted only at the company level, but is also applicable to inter se relationship among the shareholders. For example, a few promoter management groups have been observed to indulge in siphoning off corporate resources to their private associates by awarding corporate contracts at artificially high prices, oppressing the minority shareholders. A well governed corporate cannot be built on the foundations of unethical means

So we can say that “Corporate Governance” is one of the critical issues in business today.For companies, good governance means securing access to broader-based, cheaper capital. For investors, a commitment to good governance means enhanced shareholder value. For both, good governance equals good business.
Corporate governance” is the process by which a corporation’s management is held accountable to its residual owners (the stockholders). Because of Enron and scores of other corporations currently embroiled in accounting and managerial scandals, the New York Stock Exchange (NSYE) and the NASDAQ Stock Market (NASDAQ) have approved sweeping new listing standards and the Congress has enacted wide-ranging federal legislation (the Sarbanes-Oxley Act of 2002) that will profoundly affect the nature of and control over corporate governance in the United States.
The questions that lie at the centre of our analysis are, how do political factors influence the shaping of corporate governance institutions, and how do politics determine the reform process of insider models in an era of internationalised economic relations? In this
Perspective, we largely follow the theoretical perspective elaborated by authors like Roe (2003) and Gourevitch and Shinn (2004), who both stress the central importance of political variables in the reform of corporate governance system.

Politics in Corporate Governance

Factors affecting corporate governance methods

Why do corporate governance systems differ quite substantially around the world? The American model supervises managers through a board representing a diffuse mass of external shareholders whose rights are defended by a variety of institutional rules (such as those governing insider trading, antitrust, and an open market for corporate control) and by watchdog “reputation intermediaries” (such as accountants, securities analysts, and bond-rating agencies). The claims of employers, suppliers, and buyers are subordinated to shareholder rights. The German model, in contrast, supervises managers by concentrating ownership in blockholders, permitting insider relationships, allowing substantial horizontal coordination among producers, and accepting a variety of “stakeholder” claims on the firm besides those of the shareholders. Japan, as well as Sweden, Austria, and other continental European countries, resembles the German model to varying degrees, while the United Kingdom, Canada, Australia, Ireland, and New Zealand bear closer resemblance to the American system. Just why these differences exist is an object of vigorous debate.
Political forces[7], are one of the major reasons which account for the difference in choice of corporate governance models among advanced industrial countries. Corporate governance arrangements inside the firm interact deeply with a nation’s politics. Political forces— party systems, political institutions, political orientations of governments and coalitions, ideologies, and interest groups—are the primary determinants of the degree of shareholder diffusion and the relationships among managers, owners, workers, and other stakeholders of the firm. Whatever the formal specifications of corporate law, politics shapes daily the calculations made by all players. It can be seen that where social democracy is strong, shareholder rights are weak, and shareholder diffusion is low[8]. Social democracy gives voice to claims on the firm in addition to those of the shareholders: employee job security, income distribution, regional or national development, social welfare and social stability, and nationalism, to name a few. To counter these competing claims, blockholders resist diffusion of shares in order to maintain leverage in the boardroom, and investors shy away from a system in which they lack protection or dominance. To test this theory degree of shareholder Concentration must be correlated to various indicators of social democratic power, such as partisan composition of governments, employee protection in labor law, and income equality. There would be strong evidence that would show that weak labor correlates with strong this political argument can be used to confront directly a very influential alternative interpretation—the Quality of Corporate Law. Countries with similar levels of QCL, it has been observed, differ in the degree of shareholder diffusion. Therefore, other variables must be in play. The critical one is politics. Mark J. Roe[9] demonstrates that for his sample of countries, the political account correlates more strongly than QCL with shareholder diffusion. Advanced industrial countries with high QCL vary considerably in the degree of shareholder diffusion; thus, something else must be at work. That something is the degree of social democratic influence. Roe tests LLS&V’s impressive data collection with his own substantial data on political variables, and concludes, in my view convincingly, that politics does better than QCL. QCL can matter, Roe argues, when politics enables it to matter—that is, when property rights are assured, when enforcement and independent judges are allowed to work, and when the political balance in society gives it a place. Even then, the consequences for corporate governance of any given set of laws are driven by politics. Roe’s is the only account in the law-and-economics tradition that makes politics explicitly central to an explanation of corporate governance in a comparative and international perspective. For him, political forces not only define the law—they also determine how the law actually operates. No one really doubts that politics has something to do with corporate governance, but theorists vary considerably in the status they give to politics in a causal model. Roe is unique among major authors in seeing politics as continuous, ongoing, and primary. For other theorists, politics operates in the distant past, or indirectly, or barely at all.
In the QCL model (LLS&V’s argumentation), the difference between governance systems arises from the effects of common versus civil-law legal traditions; politics exists only in the initial choice of legal system in a given jurisdiction. LLS&V then focus on the consequence of this initial act upon the development of corporate governance systems  and shareholder diffusion.
Yet what a country does with its legal tradition and system turns on politics: the rules that determine the extent of economic competition within and between countries; the laws and decrees that structure banking, corporate finance, and the securities industry; the rules that shape the markets for capital and labor; and the degree of state involvement in the economy. LLS&V make reference of politics in their analyses of QCL, referring to rule of law, judicial efficiency, and corruption. But politics has no distinct causal status in their argument and, after the initial choice of systems, no longer plays a role in shaping the actual content or use of law.
Roe’s political theory and the QCL theory are themselves criticisms of an important literature in economics that argues that the efficacy of the market makes regulation unnecessary and renders variation among governance forms unimportant or nonexistent. Competition in product and capital markets forces firms to adopt “rules, including corporate governance mechanisms,” that minimize costs in the drive to efficiency. In situations of vigorous competition, the remaining details of corporate governance are irrelevant.
The status of politics in interpretations of corporate governance and to examine the different meanings that can be given to political explanations can be evaluated. There are, thus, two steps to such a discussion. First, how does politics compare to other arguments? Second, which among several political arguments is the most convincing?  In my view, the first step is very powerful; Politics dominates explanations about corporate governance. In taking the second step, however is neither completely convincing nor exhaustive of the political forces at work


The question arises as to why do the original owners of a firm sell shares to the public? The deductive version of this process postulates two motives:
1) A preference by owners to diversify their assets so as to reduce risk and
2) The necessity for firms to seek more capital.
Both motives lead to the selling of stock, and thus to share dispersion.[10] This creates a problem of managerial agency costs. As owners step away from active management, they need to hire agents to run the firm who will make sure that those managers do not exploit their positions at the expense of shareholders. Potential investors realize this risk. Without protection against insider abuses, the founding family will have trouble selling shares, and the firm will have trouble raising capital through the sale of equity. The solution is a regulatory structure that protects shareholders from managerial agency costs: vigorous accounting, full disclosure of information, financial regulation, antitrust, and other instruments. Where regulation is of high quality, diffusion will occur; if the protections are not there, block holding will remain.
Ownership separates from control when managerial agency costs (abuse by managers) are low. If these costs are high, diffusion will not happen. In the United States and the United Kingdom, for example, the high degree of separation is marked by deep equity markets and substantial diffusion of shareholding in public firms. Yet, this process has not happened to the same degree in many other countries such as Germany and others in the European continent. What explains the divergence?
Effective regulation in the United States and the United Kingdom keeps managerial  agency costs low so diffusion can occur. By implication, regulation in much of continental Europe must be less effective, allowing for higher agency costs and less extensive diffusion. Roe’s political interpretation collides with the QCL theory in explaining this important difference. For QCL adherents, the “‘protection of shareholders by the legal system is central to understanding the patterns of corporate finance in different countries.” Roe cites numerous law professors, business school experts, and  economists—including Nobel laureate Franco Modigliani—who articulate, develop, or analyze this argument.
The QCL story is, as Roe notes, straightforward: If a nation’s law poorly protects minority stockholders, a potential buyer may fear that the majority stockholder will shift value to himself and away from the buyer. The prospective buyer therefore “does not pay pro rata value to sell, concentrated ownership persists, and stock markets do not develop.” The seller may wish to fragment ownership to prevent a controller from diverting value. But the buyers would still have reason to fear that an outside raider could capture control and divert value to himself, so again the sale price is depressed. Good corporate law protects both buyer and seller. Rules on the structure of boards, proxy rights, legal rights toward directors, the right to call meetings, and full information disclosure are among the variables that LLS&V look at. James Shinn examines accounting, audit procedures, disclosure, insider trading, the market for control, the composition of boards, standards setting and third-party analysis, and other rules shaping the composition and duties of boards. QCL includes not only “law-on-the books,” but the “quality of the regulators and judges, the efficiency, accuracy and honesty of the regulators and the judiciary, the capacity of the stock exchanges to manage the most egregious diversions, and so on.”If these protections are of high quality, buyers and sellers will consider the managerial agency problem as under control, and share trading will occur. The quality of corporate law is thus the main driver of the type of corporate governance system and the degree to which we have Berle-Means firms. Where do we find high-quality corporate law? LLS&V argue that we are more likely to have it in common-law countries than in civil-law ones. They have classified countries around the world into different legal families, then classified the corporate law protections in each, and ultimately compared these to the data on patterns of control. They find strong correlations between shareholder diffusion and common law.
 Roe provides three sets of criticisms of the QCL position:
Deductive, Economic and Political.

1) The deductive criticism questions the logic of the reasoning that derives diffusion from QCL.
2) The economic criticism points out the neglect of a key variable, the degree of economic competition.
3) The political criticism argues for the superior explanatory power of political factors over the purely legal ones of QCL.

a) Deductive Flaws

The first criticism of the QCL theory argues that high-quality corporate law is, in incentive terms, compatible with various corporate governance forms. Specifically, high QCL does not lead inexorably to a diffuse ownership model because there are other incentives at work that may reward movement to the strong blockholder model; better corporate law may simply make distant shareholders more confident in blockholders. For example, the regulatory system in the United States focuses primarily on personal abuse by insiders. In particular, it seeks to prevent the diversion of shareholder resources for the insiders’ personal gain— looting the firm through loans and gifts, improper assignment of resources, and padding the payroll, to name a few. But shareholders can lose as much
Or even more money from bad management.

b) Economic Forces: Competition

The second critique of QCL turns to the economics of the market. It must be asserted that it is market conditions, not the law itself that shape the demand for protection against managerial agency costs. Where there are vigorous product and capital markets, there are fewer opportunities to accrue monopoly rents and thus lower agency costs. It is where such rents are high that we find struggle within the firm over who gets the “monopolist’s rectangle,” the surplus captured from the consumers as a result of restraint on competition.
 Firms can be decomposed. They are made up of shareholders, managers, employees, and customers. These players also compete for the rents. Competition for rents and that monopoly rectangle is not just between firms but also inside firms as the players inside the firm—shareholders, managers, employees—compete to grab a piece of that rectangle. (And outside the firm, consumers seek to prevent the monopolist from extracting that rent for the inside-the-firm players.) The way the players compete for those rents is reflected in corporate governance institutions inside the firm and political organizations inside the polity. In such situations, owners have an incentive to retain direct control in the firm in order to make effective claims on the distribution of those rents. They will shy away from the diffuse ownership model for fear someone else will capture the rent, either other players in the firm, or external investors seizing block control. All the players in a situation of low competition—workers, managers, owners—have an incentive to protect their situation. Thus, the QCL theory has an omitted variable: competition.

3)  Politics

Markets drive governance, and markets are politically determined; thus, politics drives corporate governance. This leads to the third and the most major critique of QCL. It is politics, Roe argues, that best explains ownership separation. All the major variables that shape the incentives structuring corporate governance derive from conditions set by politics. The characteristics of competition, and of QCL itself, are all expressions of political decisions. Struggles inside the firm are connected to struggles outside of it. Power in the boardroom connects to power in the polity. Claims to the profits of the firm derive from obligations defined by a country’s political processes. That is a general point about politics. It needs one more step— specifically, a positive theory about which political variables structure political life. The central political variable is social democracy. Where social democracy is strong, shareholder diffusion does not take place; where it is weak, diffusion occurs[11]. Roe develops this point deductively and empirically. Deductively, he models the incentives that cause owners not to sell when faced with labor and other strong claimants on the firm. Job protection, social insurance charges, union bargaining on wages and working conditions and a variety of other regulations all obligate managers to include concerns other than shareholder value, thereby depreciating the value of the firm to shareholders. Owners therefore have an incentive to preserve power through large, concentrated blockholding in order to better confront labor and to steer the firm through the complexities of political life both inside and outside the firm.

There are, Roe argues, alternative models of efficient firms. Roe rejects the triumphalist claim of many U.S. analysts that the American model is the most efficient and is destined to sweep away all other alternatives. Rather than one form of governance being superior, it may be that each type has offsetting advantages and disadvantages. In fact, the concentrated stakeholder model does some things quite well, often better than the diffuse model. The blockholder system allows a long-term relationship to develop between capital and management, and between the firm and the many participants, in a system of production with investment in “specific asset” strategies of production. The production system that emerges out of that model of corporate governance seems to have advantages for some kinds of activity: for example, very high quality engineering and low product-defect rate—virtues popularly associated with Germany and Japan.
There are important differences across firms and among countries—income distribution, welfare systems, education and training, and unemployment patterns which also leave their impact on the corporate governance system of a country.
 Roe resents substantial empirical material to confirm his hypotheses. First, he measures political coloration of governments and correlates this with governance models and shareholder diffusion. Then he provides qualitative process tracing for an important set of countries. Finally, he sets up tests pitting the political coloration-of-governments argument against the QCL argument. Let us turn to each of these.

 Partisan Political Conflict and Ownership Separation

Roe’s first step is to regress degrees of left-right political party control of governments in highly industrialized democracies on degrees of ownership concentration. The former indicates labor power, so the higher the left score, the greater the disincentive to disperse shares and the higher the expected degree of concentration. This is indeed what the data show[12]. To measure shareholder concentration/diffusion, we must look at the portion of mid-sized firms in those countries without a twenty-percent blockholder in 1995.[13] The correlation between the two variables is quite high: The more the country is to the left politically, the less the shareholder diffusion.
The time period chosen by Roe could have affected these results; the eleven-year period.[14]
Commenting on the absence of data at a certain point in the discussion, Roe makes an important observation, the meaning of which he should have explored more deeply: “Political coalitions come and go; corporate structures are the result of long-term expectations of governmental orientation.” First, he regress employment security on ownership. Where labor is strong, employment protection should be high and ownership not diffuse. Indeed, the empirical data support this. The United States has the weakest employment protection and the highest diffusion; Italy has the strongest protection and is among the countries with the least diffusion.
 Next we look at income inequality, which can be taken as a proxy for social democratic strength as these parties would be major forces  demanding policies that reduce such inequality. Again, weaker stock markets and less ownership diffusion are found in countries with greater income equality.
At this point, we can conclude that a strong prima facie case exists and  that politics plays a substantial role in explaining variance in systems of corporate governance.


In this paper we tried to examine the status of politics in an interpretation of corporate governance. Roe has successfully argued that politics matters in an explanation of corporate governance patterns. This makes his position distinct from other theories. LLS&V recognize the role of politics in their discussion, but they do not privilege it in either their data or at the level of theory. To them, politics was involved in an original choice among legal systems—common versus civil—but not in the actual functioning of the legal systems and their impact on corporate governance.
For Roe, diffusion will not happen, even with high QCL, if politics inhibits it either by strengthening the claims of non shareholders or by instituting unfavorable policies on competition, labor markets, and equality of income.
Faced with identical bodies of law, even of high quality, actors will behave differently depending on the various claims, derived from politics that can be made on the firm.

The second debate concerns the attributes of politics that produce outputs. Here, Roe’s argument is both important and incomplete. Leftist political power does matter; he has shown this convincingly. But its effects can be better understood when placed in the framework of coalitions and institutions. While alternative models examined in this Review share Roe’s emphasis on the importance of politics, coalitions and institutions provide alternative political channels to the forces that constrain or expand the primacy of shareholder rights and the degree of shareholding diffusion. Instead of seeing “stakeholder claims” in terms of “social democracy,” as Roe does, such claims could be recast as “coordinated” or “organized” market-economy principles. Labeling them this way suggests that different mechanisms are at work, with different implications for refuting and testing theories. In Roe’s model, if a researcher shows the left is not the vital player in shareholder diffusion, the finding would disconfirm his argument. But in a “coordinated economy” model of politics, such a finding does not constitute a full rebuttal, as a weaker left could nonetheless be an important participant in coalitions that bring other sources of support to the table and could be reinforced by the impact of political institutions. Roe solves the puzzle of weak leftist presence in low-diffusion countries with “path dependence.” Another related way to solve the same problem, though, is to talk more about cross-class coalitions, bargains, and institutions. The various authors in this debate know too much to deny altogether the relevance of each others’ variables: Politics, law, judges, the role of the state, norms, private mechanisms, and path dependence appear in all of their writings. They differ in how these variables act in a causal sequence, and how they are privileged relatively in a model. All of the models discussed here make some contribution to our understanding.
In this light, Roe’s book is a substantial and welcome contribution, as well as a challenge, to all the disciplines involved: law, economics, business, politics, and sociology. Politics, Roe persuades us, is involved in every aspect of explaining corporate governance. Politics must therefore become integrated into the way these disciplines explain governance. That in turn compels more communication across them.

[2] The Journal of Finance, Shleifer and Vishny [1997, page 737].
[3] OECD April 1999. OECD's definition is consistent with the one presented by Cadbury [1992, page 15
[4] from an article in Financial Times [1997]
[5] J. Wolfensohn, president of the Word bank, as quoted by an article in Financial Times, June 21, 1999.
[6] Maw et al. [1994, page 1].
[7] Mark Roe’s new book, Political Determinants of Corporate Governance, vigorously presents the “politics school,” of which he is the pioneer and an important leader

[9] David Berg Professor of Law, Harvard Law School.

[10] Alternatively, the motives could lead to the use of loans. The choice of bonds versus equity has been one of the major distinctions to be explored in this literature, but here has given way to examining shareholder diffusion.

[11] Definition of social democracy is not that of a specific political party, but, more loosely, the use of government to restrict capital for a wide variety of purposes (such as to benefit labor). This definition has strengths (parsimony for research) but also problems (confusion on the political location of critics of the market).

[12]Roe places Sweden on the farthest left, followed by Austria, Australia, Norway, Finland, Italy, France, the Netherlands, Belgium, Denmark, Switzerland, Canada, Germany, the United States, Japan, and the United Kingdom.

[13] Percentages range from 0% for Austria, France, and Italy, to 60% for the United Kingdom and 90% for the United States. The most striking outlier is Germany, whose diffusion level, at 10%, is quite low given its political placement on the right

[14] The 1990s marked a general shift of several countries to the left: Margaret Thatcher and John Major were replaced by Tony Blair in 1997, Ronald Reagan and George H.W. Bush by Bill Clinton in 1993, Helmut Kohl by Gerhardt Schröder in 1998, and the Liberal Democrats in Japan by more complex coalition politics. But at the same time, Italy moved to the right with Silvio Berlusconi (briefly in 1994 and again since 2001), as did Spain with Jose Marie Aznar (in 1996 and again since 2002), France with conservatives gaining control of both the presidency and the National Assembly in 2002, and the United States with George W. Bush winning the presidency in 2000 and the Republican Party controlling both houses of Congress in 2003.

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