Company reforms must shed more light
Sunday 10 August 1997
In the wake of such scandals as Bremer Vulkan and Metallgesellschaft in Germany, Banesto and Seat in Spain, and Ferruzzi in Italy, reform of corporate governance has become a priority for European policy-makers. What's more, there is growing pressure from outside Europe, as many US- based institutional investors diversify their portfolios and begin to question incumbent management. Increasingly too, there is pressure from within, as European countries seek to restructure their pension systems.
But the corporate governance problem is not staightforward. In the UK, as in the US, it can be summarised as "weak owners, strong managers"; in continental Europe, it is better characterised as "strong blockholders, weak minority investors". In the latter case, the notion of "shareholder value", often presented as the guiding principle for corporate governance, is less clear when large blockholders are able to exploit minority investors.
Solutions to these problems are being sought both by individual countries and by the EU itself. But research suggests that reformers should tread carefully. Corporate law and corporate finance are intimately related, often in ways that economists and analysts do not yet understand. Reforms may thus have unexpected effects, as I discussed in an article in Economic Policy No 24.
Recent research by L A Porta et al clearly establishes the link: countries with strong legal protection of minority shareholders have less concentrated ownership of equity than countries where the rules leave more discretion to managers and controlling investors. It is important not to jump to conclusions regarding causality. Indeed, patterns of finance and law may well be jointly determined by history, in particular by factors related to legal origins: for example, on most accounts, investors in countries with laws of French origin fare worse than their counterparts in legal systems of German or Anglo-Saxon origins.
The connection between corporate law and corporate finance is vital for economic growth. A 1993 paper by King and Levine claims that financial development is the single most important explanation of differences in economic growth among countries. In a paper presented to the Centre for Economic Policy Research's Corporate Governance network, Rajan and Zingales suggested that financial development affects industrial development: industries with large external finance requirements are less developed in countries with weak securities markets. And another paper by La Porta et al links financial development to investor protection and hence to legal origins: countries with French-style corporate laws tend to have less developed securities markets.
But despite legal differences, corporate financing patterns in Europe are much more similar than is generally believed: in most countries, internal finance is the most important source of funding for firms; debt is the most important external source; and the net contribution of equity finance to the corporate sector is limited.
The real differences across countries lie in the patterns of ownership and control. In continental Europe, ownership is concentrated and investors are "control-oriented", giving up opportunities for diversification to take on large stakes in individual companies. Ownership is dominated by families and private companies, and the principle "one-share-one-vote" is frequently violated. In contrast, the UK corporate landscape is dominated by dispersed owners with "arm's-length" relationships with the firms they own. These differences in ownership and control are matched by important variations in corporate legal structures.
The mechanisms for corporate governance differ between control-oriented and arm's-length systems. In the former, any initiatives for change come from large investors or creditors with a close long-term relationship with the firm. This has implications for the role of corporate institutions: the board of a firm where one owner controls most of the shares cannot be expected to act as an independent monitor of management.
In the latter, corrective actions are often initiated by outsiders. Nevertheless, hostile takeovers are rarely important in disciplining firms. In most countries, they are extremely unusual, and even in the UK, they do not normally target poorly performing firms. Work published in 1995 by Franks, Mayer and Rennebog suggests that corrective actions in such firms tend to be initiated by a single investor, often another company, with a large blockholding. This is much as in continental Europe.
Moreover, the turnover of controlling stakes is higher in control-oriented governance systems than is generally believed: the difference is that these transactions take place outside the official exchanges. It is also a misconception that control is never challenged. Research on Germany by Jenkinson and Ljungqvist documents cases where outsiders have been able to implement policies hostile to controlling investors and incumbent management often with the help of the company's house bank.
So what are the implications of this research for plans to reform corporate governance? Certainly, any attempts must take into account the links between corporate governance and corporate law. But more importantly, national differences must be recognised, especially between the UK and continental Europe. Different problems require different solutions and any EU-wide reform is likely to fail even if it were able to gain the necessary political support. A "voluntary code of conduct" is also probably a non-starter: the European Commission is unlikely to give up its right to regulate and such a code would tend to attract large firms that already meet the requirements.
Instead, I would argue that reform should have a national focus and if a single guiding principle is needed, protection of minority investors is probably the best choice. At the same time, it is important to recognise that there are costs to protection: maximum protection is not desirable since managers and controlling owners need some degree of discretion as well as incentives to work effectively.
An important goal of any financial system of reform should be to make securities markets more liquid. But liquidity should be pursued directly, not through restrictions on investors' ability to exercise governance. Making institutional investors more active may be important in the UK, but it is not the most urgent issue elsewhere in Europe at the moment. US-based institutions are likely to take the lead, but as pension reform proceeds, the new European pension funds must become active investors.
If there is to be a European corporate governance policy, the focus should probably be on transparency of ownership and control arrangements. For example, an investor buying stocks in a firm that is part of an Italian pyramid, in a Dutch firm with golden shares, or in a Swedish company with crossholdings, will have difficulties in evaluating the investment. Greater transparency improves liquidity which lowers the cost of capital and facilitates transfers of controlling blocks.
The EU's Transparency Directive is an important first step towards greater transparency. But as recent work by European researchers on corporate governance shows, a great deal remains to be done. Examples from Austria, Germany and the Netherlands demonstrate the weaknesses in the implementation of the directive so far.
This article draws on research reported in 'Reforming Corporate Governance: Redirecting the European Agenda' by Eric Berglof, published in Economic Policy 24 (April 1997) by Blackwells. Berglof is Director of the Stockholm Institute of Transition Economics and East European Economies at the Stockholm School of Economics and is associated with ECARE in Brussels. He is a Research Fellow in CEPR's Financial Economics, Industrial Organisation and Transition Economics programmes, and a co-ordinator of CEPR's Corporate Governance network. For further information about CEPR, telephone 0171 878 2917.
Hamish McRae is away.
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