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Ownership Structure, Legal Protections and Corporate Governance

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Abstract

This paper surveys the issues and devises an analytical framework for policy makers and policy advisors concerned with corporate governance. The framework takes a functional approach, identifying six functions provided by a governance system. The paper highlights the possibilities and limits to governance reform through the adoption of legal protections and the use of ownership structure. I caution against excessive emphasis on legal rules themselves, demonstrating their insufficiency to provide the functions of governance. Instead, I first emphasize the importance of effective legal protections that require complementary governance institutions including political structure, the location of judicial authority, norms, and information/reputation intermediaries. Second, I draw attention to ownership structure, reviewing theoretical and empirical support for the beneficial effect of identity and concentration on the functions of corporate governance in the absence of effective legal protections. A review of the evidence from established and newly privatized firms reinforces these contentions. The paper concludes with four broad agenda items for both reformers and future research.
Ownership Structure, Legal Protections
and Corporate Governance
I.J. Alexander Dyck
Associate Professor
Harvard Business School
Boston, MA 02163
adyck@hbs.edu
April, 2000
**Comments Welcome **
Abstract
This paper surveys the issues and devises an analytical framework for policy makers and
policy advisors concerned with corporate governance. The framework takes a functional
approach, identifying six functions provided by a governance system. The paper
highlights the possibilities and limits to governance reform through the adoption of legal
protections and the use of ownership structure. I caution against excessive emphasis on
legal rules themselves, demonstrating their insufficiency to provide the functions of
governance. Instead, I first emphasize the importance of effective legal protections that
require complementary governance institutions including political structure, the location
of judicial authority, norms, and information/reputation intermediaries. Second, I draw
attention to ownership structure, reviewing theoretical and empirical support for the
beneficial effect of identity and concentration on the functions of corporate governance in
the absence of effective legal protections. A review of the evidence from established and
newly privatized firms reinforces these contentions. The paper concludes with four broad
agenda items for both reformers and future research.
Parts of this paper draw heavily on Dyck (2000), Privatization and Corporate Governance: Principles,
Evidence and Future Challenges.For helpful discussions, I thank Harry Broadman, David Ellerman,
Avner Greif, Roumeen Islam, Carl Kester, Rafael LaPorta, Jay Lorsch, Thomas McCraw, David Moss,
John Nellis, Katharina Pistor, Julio Rotemberg, Bruce Scott, Mary Shirley, Joseph Stiglitz, Philip Wellons
and seminar participants at the Harvard Business School and the World Bank. All errors that remain are my
own. I am grateful to the World Bank and the Division of Research of Harvard Business School for their
support.
2
Corporate governance systems increasingly are a focus of concern for policy
makers. Liberalization, deregulation and privatization policies have shifted decision-
making responsibility from government to private sector actors. Experience has shown
that the effectiveness of corporate governance mechanisms cannot be taken for granted.
Many investments in firms by suppliers, labor, management and financiers are not
exchanged simultaneously with payments but with a promise of future returns. Both the
explicit and implicit terms of such promises are routinely violated.
Russian firms provide vivid illustrations of grabbing handsof insiders in private
firms as they violate promises made to almost all investors. As one example, Black,
Kraakman and Tarassova (1999) report that following the privatization of Yukos Oil, one
of the largest Russian oil companies, the controlling shareholder skimmed over 30 cents
per dollar of revenue, while stiffing his workers on wages, defaulting on tax payments ...,
destroying the value of minority shares ..., and not reinvesting in Russias run-down oil
fields, which badly needed new investment.
Nellis (1998) reports such concerns echoing
across the transition economies leaving even countries with much better starting points,
such as the Czech republic, in precarious situations. As one foreign investor trumpeted in
a full page ad in the New York Times, think twice before you invest in the Czech
Republic. Otherwise, you could be left to twist in the wind.’”
1
Firms have been
tunneled out,left with debts, disenchanted workers and investors, and great difficulty in
raising capital to fund future investment projects. Johnson, LaPorta, Lopez-de-Silanes
(2000) report that tunneling activities do not stop here, being widespread in developed as
well as developing economies.
A revealing summary measure of the strength of private grabbing handsis
offered by measurements of the difference in the share prices of voting and non voting
shares within a country. Where such shares bring the same legal right to cash flows one
would think that the shares would trade at close to the same value. In most of the world
this simply isnt true. Voting rights bring power, including the power to grab and divert
returns. The weaker a countrys protection of minority shareholders rights, the more the
market estimates that power is worth, with just a 5 percent difference in the US, a 13
1
New York Times, Monday November 8, 1999. Numerous other papers provide illustrative anecdotes from Weiss and
Nitikin (1999) for the Czech republic to Djankov (1999) more generally for the transition economies.
3
percent gap in the UK, 45 percent in Israel, 32 to 54 percent in Korea, 82 percent in Italy,
and even higher percentages in the Czech republic and Russia.
2
Comparing the value the market places on comparable assets across countries
provides another indicator of grabbing hands,both private and public. For example,
Black et. al (1999) report that in May 1999, Yukos oils market value was just $90
million while it was estimated to be worth$50 billion based on its assets (556 times
less), Gazprom was valued at just $20 billion while it was worth$600 billion (30 times
less). While one can argue with the specifics of these estimates, the magnitude of the
discounts suggest the real financial costs associated with governance weaknesses.
More important than the redistribution of returns from promised channels is the
dynamic implication of the violation of promises - a reluctance to invest in firms that
have valuable investment projects. Laborers are reluctant to invest in training specific to
their firms out of fear that they will not get future payments to compensate for these
specific investments. Suppliers are reluctant to provide trade credit. Managers with good
reputations and ability are reluctant to work in many firms fearing that they will not be
able to demonstrate their ability to manage. Financiers are reluctant to provide capital
out of fear that they will never get anything back but the paper given in exchange for the
investment. Weak corporate governance limits investments in corporations with resulting
difficulties for growth and development
What steps can public and private decision makers take to promote promise
fulfillment and in so doing foster investment in corporations? Research going under the
title corporate governance provides insights and evidence. I do not offer a
comprehensive survey of this literature. Excellent surveys are already available (e.g.
Shleifer and Vishny (1997), Berglof and Von Thadden (1999)). Instead, this paper tries
to contribute by focusing on the role of national legal protections and ownership structure
in corporate governance systems. These variables have been the focus of much recent
work, most notably in a series of papers by LaPorta, Lopez-deSilanes, Shleifer and
2
These results, reported in Macey (1998), are based on Lease, McConnell and Mikkelson (1983) for the US,
Megginson (1990) for the UK, Levy (1982) for Israel, and Zingales (1994) for Italy. The Korean discount is presented
in Kim (1996) and cited in Pistor and Wellons (1999).
4
Vishny (hereafter LLSV) summarized in LLSV (1999a), and the findings have stimulated
academic and policy interest. I will argue that such work has often been misunderstood.
The papers principal contribution is to offer a framework to think about corporate
governance rooted in a functional approach. This framework captures the channels
through which ownership structure and legal protections affect firm and national
performance. The argument is that for ownership structure and legal protections to affect
investments they have to influence beliefs about promise fulfillment. Legal protections
deserve a position of prominence because the presence of effective legal protections
provides minority shareholders power when there are competing claims over the wealth
generated by the firm and lowers the cost of dispute resolution. With effective legal
protections, shareholders can be anonymous and diversified, the cost of funding
investment projects is low, and promising investment projects are funded.
The functional framing cautions against excessive focus on legal protections. The
goal of corporate governance reform is not to create specific legal rules, but to lower the
cost of providing the functions of corporate governance to foster investments in firms. A
review of the literature suggests that legal protections are not sufficient to provide these
functions. To change beliefs about promise fulfillment, legal protections need to be
complemented by additional corporate governance institutions that provide information
and manage incentives. Recognizing and understanding the specific institutions that
complement legal protections and the nature of this complementarity is argued to be an
important element of policy formation.
The functional approach also cautions against universal recommendations for
corporate governance policies. A review of the literature on ownership structure suggests
that it can be beneficial to not embrace the efficientownership structure of anonymous
small diversified shareholders common to the US, UK and economic theory. When legal
protections are ineffective, ownership identity and concentration can provide the
functions of a corporate governance system and enhance promise fulfillment. Identity
and concentration provide information, manage incentives and lower the costs of
resolving competing claims on the wealth generated by the firm. At a minimum, the
5
evidence on ownership structures suggests corporate governance recommendations
should be defined relative to the state of existing legal protections.
The second and third sections of the paper put more empirical flesh onto this
theoretical form by reviewing notable empirical contributions on legal protections,
ownership concentration and performance. This data provides international benchmarks
of corporate governance institutions. Comparing national governance infrastructure
against these benchmarks is a starting point for policy actions. These studies suggest the
significant potential gains associated with improvements in legal rights and
complementary infrastructure. Privatization evidence confirms and reinforces these
findings from established publicly-traded firms. Privatization experiences from transition
economies provide perhaps the most compelling evidence of the value of aligning
ownership structures with the state of existing legal protections.
The fourth section offers policy implications and areas for future research. There
is great potential to improve corporate governance through reforms in governance
institutions and policies. There is also ample opportunity to make things worse by not
properly interpreting the lessons from existing studies. This section suggests four broad
agenda items and a prioritization for both reform and future research.
The focus on corporate governance is the papersstrength and a weakness, for
effective governance is not a sufficient condition to maximize social welfare. With
effective governance, investors are willing to invest resources in corporations and
deadweight losses are avoided. But effective governance does not create new investment
projects. As Berglof and Von Thadden (1999) caution, this lack is perhaps a greater
problem in developing economies than weaknesses in governance. And without effective
competition and regulation, even perfectly governed privatized firms will not produce
social welfare. It is therefore important to simultaneously consider competition reform
and regulation and there interaction with governance mechanisms. Such a task is beyond
the scope of this paper.
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1 A Framework
Do investor protections and ownership structure matter for firm and national
performance? Thinking about a corporate governance system provides an intellectual
framework to understand the paths through which these variables operate.
1.1 A corporate governance system
There are different ways to approach corporate governance policy. An
institutional approach takes existing institutions as given – for example the bank-centered
governance systems of Germany and Japan - and asks how these institutions could
produce the services they offer more effectively. In contrast, Caves (1989) characterizes
the modern analytical economic approach that is treated by its practitioners as institution
free, exposing the consequences of fundamental human motives and technological
opportunities unclouded by any detritus of law, culture, language, custom or history.
3
It
ignores institutional factors and concentrates solely on the functions of governance. A
functional approach differs from both of these. It takes the functions of governance as
given and asks how different institutional arrangements address these functions.
This paper takes a functional approach. A functional approach does not presume
that there is only one institutional way to address governance concerns. It forces an
examination of the range of institutions and policies involved in governance, a range that
is much greater than that suggested by the institutional perspective. It is well suited to
understand the possibilities for reform.
When talking about corporate governance it is helpful to keep the transaction we
have in mind in constant view. The transaction at the heart of corporate governance is an
investment in a corporation that is not simultaneously met with payment but with a
promise of the distribution of future returns. There is a separation between the quid and
the quo.
4
I use the term promise deliberately to suggest factors in addition to contracts.
With any investment transaction there are natural limits to the ability to completely
specify actions under all future contingencies. In addition, the terms of the initial
3
Quotation drawn from Khanna (2000) based on Caves (1989), p. 1226.
4
I borrow this phrase from Greif (1997) who emphasizes the importance of this difference in his analysis of medieval
trade.
7
contract may themselves be violated. When making the investment, the investor therefore
calculates expected returns based not only based on specific terms in a contract, but on
the expected outcome from inevitable competing claims on the wealth generated by the
firm.
A corporation can be identified with many such transactions. Financiers
investments are obviously corporate governance transactions - payment is by definition
delayed. But we also need to think about other corporate governance transactions.
Laborers, when asked to invest in skills of use only to a particular firm rather than in
general skill formation and where payment for that investment is deferred, are engaged in
corporate governance transactions. Managersalso make investments in exchange for
promises, as they often invest in specific skills and knowledge and put their reputation at
risk with only limited security that they can retain their positions and have the discretion
to take actions that reveal their ability. The set of corporate governance transactions in a
given corporation thus depends on the specific investments required for an industry at a
point in time.
The definition of governance I employ follows naturally from this focus on those
investments that are uncertain. I define a corporate governance system broadly as the
complex set of socially-defined constraints that affect the willingness to make
investments in corporations in exchange for promises.
The papers focus on the security
of the promises made to all investors in the firm is broader than the definition of La
Porta, Lopez-de-Silanes, Shleifer and Vishny (1999a), for whom “Corporate governance
is, to a large extent, a set of mechanisms through which outside investors protect
themselves against expropriation by the insiders.” My approach closely follows that of
Williamson (1985) and particularly Zingales (1997), who defines corporate governance
as the complex set of constraints that shape the ex-post bargaining over the quasi-rents
generated by the firm.
The overriding function provided by a governance system is to facilitate resource
allocation to investment projects in corporations. More headway is made by focusing on
core functions that contribute to this objective. The outlines of a classification useful for
our purposes is provided by Merton and Bodie (1995) who categorize the functions
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provided by the financial system, a system that shares many things in common with a
governance system. Merton and Bodie identify core functions performed by the financial
system to include: (1) clearing and settling payments, (2) pooling resources and
subdividing shares, (3) transferring resources across time and space, (4) managing risk ,
(5) providing information, and (6) dealing with incentive problems.
With the exception of clearing and settling payments, these functions are also core
functions provided by corporate governance systems. Since many investments are beyond
the capacity of individual investors, a well functioning corporate governance system
provides a way to pool resources. Investments are also more likely when risks associated
with those investments are pooled, shared and allocated to those with greater risk bearing
capacity. Providing information and managing incentive problems are correctly placed at
the heart of analyses of governance systems because asymmetries in information
discourage investments by increasing the probability of adverse selection and moral
hazard.
But to this list must be added an additional function performed by governance
systems – (7) to resolve competing claims on the wealth generated by the corporation.
5
As Hart (1995) and others emphasize, when contracts are incomplete (as they inevitably
are) who is in control of the firm matters because they retain residual rights to specify
how assets are distributed in ways not specified in the original contract. Expectations
based on (a) who has residual rights and (b) their incentives will affect the willingness to
invest. Similarly, expectations as to (c) who has the power in society to enforce legal
protections and (d) their incentives will affect the willingness to invest as this defines the
prospect for contracting and the scope of incomplete contracts. In short, the costs of
resolving competing claims on the wealth generated by the corporation depends on who
has power in the firm and in society more generally.
In highlighting functions rather than institutions it is easy to characterize good
corporate governance. A good corporate governance system provides the functions of a
governance system at low cost and thus facilitates investments. It supports capital
investments by financiers, trade credit by suppliers, and investments in specific human
5
I thank Jay Lorsch who provided this phrasing.
9
capital by labor and management. Equivalently, a good corporate governance system
finds a way to address the most common corporate governance breakdowns that
discourage investments by redirecting resources from their promised uses - management
abuse, controlling shareholder abuse and state actor abuse.
1.2 Institutions and policies of corporate governance systems
Institutions of corporate governance and internal governance policies provide
these governance functions. Both institutions and internal governance policies affect
beliefs about whether promises will be fulfilled, influence expected future returns, and in
so doing influence investment choices. But they are different in that institutions are taken
as exogenous by investors in making their decisions, while policies are under the control
of at least some of the investors. The important questions are: what types of institutions
and policies improve promise fulfillment and how do they relate to each other?
1.2.1 National legal protections
The most prominent institution of corporate governance is legal protections for
financiers embodied in national laws.
6
The claim is that national legal protections have a
profound influence on the willingness to invest resources in firms. This point is not
universally agreed.
A view prominent in the law and economics literature is that the only legal
protection required is contracts and a judicial apparatus to enforce contract law. National
legal protections are neither required nor likely to be important. They are not required, as
sophisticated investors can negotiate complex contracts with sophisticated insiders in the
firm to anticipate eventualities and build in contractual safeguards. They may not be
important, as even in the presence of a national legal protections, sophisticated investors
can contract out of or expand on these protections.
The new legal protections approach, associated most closely with the pioneering
work of LLSV, challenges this view. This approach has emerged from the theoretical
work noted above that emphasizes the limits to contracting and the realization that no
6
In the spirit of recent work by Greif, I see institutions as social factors viewed as exogenous to investors in firms, that
affect beliefs regarding transactions yet are endogenous to societal decision making. Not all institutions of society are
10
countries rely solely on such simple legal solutions. Everywhere governments introduce
additional legal mechanisms that specify procedures and remedies for the most common
recognized governance breakdowns. A key assumption of this approach is that such
artificial constraints can improve outcomes by affecting the bargaining over competing
claims on the wealth generated by the corporation, and consequently the willingness to
invest in firms at all.
The work of LLSV has focused attention on those elements of the company code
that favor minority shareholders in corporate decision making as opposed to management
or a dominant shareholder. The vast majority of these mechanisms provide for little
interference with management during normal times, but allow for significant interference
with low transaction costs when a situation deteriorates. Specifically, LLSV focus on six
anti-director rights to indicate who holds power in firms: the right to vote by proxy
through the mail, shares are not blocked before meetings, the use of cumulative voting,
the presence of oppressed minority rights, the existence of a preemptive right to new
issues for existing shareholders, and a low threshold to call an extraordinary meeting.
They also collect information on the presence or absence of two additional provisions in
the company code, one share one vote rules that link cash flow rights to voting rights and
thus help protect the interests of minorities, and a mandatory dividend that also could
protect the interests of minorities.
A shared feature of these legal protections is their clear allocation of power.
Legal protections temporarily concentrate control and provide for the credible threat to
replace insiders, be they managers or controlling shareholders. In addition to shareholder
meetings, extraordinary actions hinge on such protections such as class-action lawsuits
and takeovers. In such a lawsuit, a group of equity investors seek to sidestep the board
and to directly stop current management actions, or actions approved by the board. In a
takeover, current controlling investors are replaced with a new controlling investor that
can redress problems in the current ownership structure, and take more forceful action
vis-a-vis management. Takeovers help to overcome the public good problem associated
with monitoring management faced by many small shareholders. These efforts to
institutions of corporate governance. This label is reserved for those institutions that are central to the governance
transaction of investments in corporations.
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temporarily increase ownership concentration can be very expensive to utilize and are
best viewed, therefore, as extraordinary measures.
LLSVs work also focus on legal protections for financiers in case of anticipated
and undesired outcomes, such as a failure to make promised distributions of returns.
Bankruptcy laws specify criteria for determining when promises have not been kept and a
procedure for reallocating control over the use of assets and the distribution of assets,
normally focusing control temporarily on a judge who often transfers it to a trustee
controlled by creditors. With strong protections, there are low costs of invoking these
protections and a speedy and predictable bargaining process to realize a new distribution.
1.2.2 Beyond national legal protections: complementary institutions
The legal protections approach runs the danger of shifting focus from lowering
the costs of providing the functions of a governance system to adopting specific laws. A
plausible (but misleading) interpretation of the legal protections literature is that legal
protections are the goal rather than the instrument.
7
But by themselves legal protections
do not produce the information necessary for investors to avail themselves of their
protections. By themselves, legal protections do not address the potential incentive
problems of the state actors tasked with resolving competing claims and enforcing
judgements. Unless parties believe enforcement will be efficient and that they will have
access to information, such legal protections will not affect expectations regarding
promise fulfillment.
There is ample empirical evidence of the insufficiency of legal protections alone
to improve governance. For example, Black, Kraakman and Tarassova (1999) suggest
that with the perfection of the legal protections in Russia (many of the laws which they
helped to draft) there was a worsening of the effective protections for investors.
[T]he principal problem is not that the laws arent strong enough, but that
they arent enforcedunhappy shareholders can rarely develop enough
facts to prove the rampant self-dealing that occurs every day. The courts
respect only documentary evidence, which is rarely available, given
limited discovery and managersskill in covering their tracks. ...pursuing a
case ... will take years, and when you're done, enforcing a judgment is
7
The authors consistently note that they are interested in both laws and their enforcement. However, the question of
enforcement has consistently received much less attention.
12
problematic, because enforcement is by the same biased or corrupt lower
court that the shareholder began at.
Russias experience is extreme but not unique. Disappointment with legal
reforms and the importance of enforcement and information have historical precedents.
To cite just one example, in 1964 the Brazilian government tried to use legal protections
reform to improve investor protections, closely copying US legislation. Such efforts
were sorely disappointed. As Goldstein (1998) recounts, “many notorious cases of gross
managerial irresponsibility or outright fraud by high-flying financiers” were left virtually
unpunished.
8
The presence of the legislative reforms did not improve information quality
or render the stock market watchdog effective. Brazils current position with corporations
largely based on majority control, little monitoring from the stock market and
institutional investors, and disregard for the rights of minority shareholders,occurs in
spite of efforts to create the opposite.
If legal protections are insufficient, what else is required? This cannot be
answered from theory alone. Reference to the history of institutions in markets that have
developed provides a guide. Literature that has adopted this approach suggests the
effectiveness of legal protections for providing the functions of corporate governance
rests substantially on four additional institutions: social norms, political structure to limit
the sovereign, the location of judicial authority and what I call information/reputation
intermediaries.
Social norms and judicial efficiency
Cooter (1996), among others, emphasizes that there needs to be social support for
legal reforms to have an impact. In states where laws are consistent with social norms,
the law is obeyed out of respect. Under such a system private citizens supplement
official enforcement of the law, which is critical because officials lack the information
and motivation to enforce the law effectively on their own.
9
Critically, he argues that
legal protections will simply be ignored where the legal protections is inconsistent with
social norms.
8
Armijo (1993), p. 276, cited in Goldstein (1998).
9
Cooter (1996), p. 191, emphasis added.
13
There is growing recognition of the interaction between behavioral patterns and
legal institutions. The most recent Transition report by the EBRD (EBRD (1999)) goes
to great length to emphasize the importance of such social capital, and points to its lack
as a source of difficulty in reform. Likewise, some discussions in the aftermath of the
Asian crisis emphasize that reforms introduced by many Asian countries are unlikely to
have the desired impact because they do not coincide with societal beliefs. As the Far
Eastern Economic Review put it in an article summarizing the Thai experience and other
reforms in asia, “New laws arent enough to stimulate financial restructuring. Changing
a culture is necessary.
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Political structure and judicial efficiency
For legal protections to matter, there must also be expectations that those laws
will be followed. The efficiency of the judiciary does not just come from sophistication
in the organizations of the state that interpret and implement judicial judgements, it
comes from their interest in enforcing the law. Such an interest has been linked to
political structures that limit the power of the sovereign relative to other interest groups in
society.
A precondition for the development of external finance in the United Kingdom, as
North and Weingast (1989) argue, was not specific refinements in the statutory or
common law, but rather was the creation of political institutions that gave the common
law courts true authority relative to the crown. The dominance of the common law waned
in the 1600s under the Stuart monarchy, with the increasing role of perogative courts, the
centralization of power in the Star Chamber and the use of the executive power of pay
and appointment of judges to influence their decisions. To resurrect the role of the
common law, complex organizational reforms were introduced including the abolishment
of perogative courts, new legislation that made judicial appointments for life and removal
only with the assent of both houses of Parliament (or in case of criminal behavior), and
constraints on the sovereign, including the Bill of Rights. These changes were supported
by inducements and credible threats for the sovereign, including a fiscal revolution that
provided a steadier stream of revenues and by the successful replacement of two
10
Goad et. al, “Debts to Society,Far Eastern economic Review, Oct. 7, 1999, pp 87-88.
14
sovereigns over the previous fifty years. In short, what made the common law courts
predictable venues to resolve commercial disputes was the creation and development of a
complex set of self-supporting political institutions.
Rajan and Zingales (1999) present similar arguments that emphasize political
structure. Based on their reading of capital market development and then retraction in a
number of European countries, they argue that legal protections can be changed by a
determined government. More important than legal protections for investment in their
view are structural features that limit the ability or willingness of government to change
the rules of the game.
Location of judicial authority and judicial efficiency
A different approach to understanding judicial efficiency emphasizes not political
structure writ large, but how the government organizes and allocates judicial authority.
The argument here is that to provide information and lower the costs of enforcement it
may be optimal not to keep judicial authority in the general court system, but to delegate
authority to a specific regulatory agency tasked with that job, or even to allow that
regulator to delegate further to private sector organizations. This is not an argument that
delegation is always superior, giving authority to a specialized institution might lead also
to abuse, but that the location of authority can affect efficiency.
An analogy to agency problems within firms is appropriate. Firms neither
completely centralize or decentralize decision making, but rather identify who has the
relevant information, and combine a provision of incentives with an allocation of
delegated authority to those with information. The same logic applies one level up. A
system of legal protections will be ineffective if it merely demands information or
sanctions. A more effective system involves identification of those with potential access
to information, delegation of authority, and a way to harness the incentives of these
delegated decision-makers.
Many examples could illustrate the complementary role of the design of oversight
institutions so that legal protections fulfill their desired functions of providing
information and incentives for promise fulfillment, and lowering the costs of resolving
competing claims over the wealth generated by the firm. One of the best examples is the
15
formation of the US Securities and Exchange Commission (SEC) and its impact on
equity markets, a system that to this day facilitates greater equity investment in
corporations than anyplace else in the world.
11
The importance of quality information for investors had long been appreciated,
but the great stock market crash of 1929 revealed the inadequacy of previous attempts to
address information asymmetries through simple disclosure rules. Restoring the faith of
investors was intimately entwined with the passage of the Securities Act of 1933, the
Securities Exchange Act of 1934 (that created the SEC) and years of work by SEC
officials to get the details right. To reduce information asymmetries, and increase
incentives for disclosure and enforcement, some penalties were imposed by the SEC
itself. Particularly important were those that had an effect immediately, even if subject to
later judicial review.
12
But as important, McCraw (1982) emphasizes, was the SECs
focus on critical third-party agencies rather than the firms issuing securities themselves.
By regulating those intermediaries and granting them significant powers, including the
power to police themselves, the SEC utilized their informational advantages and lowered
transaction costs for investors in case of conflict. Importantly, these third parties were
not subject to the legal due process required if public agencies attempted to institute the
same rules.
Johnson and Shleifer (1999) provide more recent evidence of the importance of
legal protections and their enforcement through specific regulatory authorities rather than
relying on a laissez-faire approach backed by the general court system. As they recount,
Poland and the Czech republic started their reforms with roughly similar (low) levels of
investor protections but had dramatically different experiences with corporate governance
concerns. The Czechs suffered widespread looting of firms by managers and insiders
and the rapid loss of faith in the stock market with delisting of firms and no new private
companies. Poland, in contrast, has many fewer reports of investor dissatisfaction and
many more new firms able to raise external capital. Part of the relative success of Poland
11
I thank Rafael LaPorta for encouraging me to explore this example in more detail, and my colleague Tom McCraw
for helpful clarifying discussions.
12
Among other factors, the SEC required a 20-day cooling off period to scrutinize documents before issuing securities
and had the power to place a stop-order,that legally simply suspended the issue. This was a simple but powerful tool
as it shattered investor confidence in the issue, regardless of whether the SEC was overturned on appeal.
16
is attributed to the far more stringent regulation of securities in Poland, including the
ability of the security regulator to control financial intermediaries through licensing, and
its much wider demand for disclosure by issuers of securities. In contrast, there was little
initial regulation in the Czech republic and few changes in the approach despite
deteriorations in economic performance.
Delegating authority to a specialized agency in credit markets, when combined
with incentives to focus on oversight, can similarly lower the cost of providing functions
of governance. Central banks and bank regulators are particularly important as they
collect information and can coordinate responses through their influence over financial
intermediaries. Their powers include the ability to withdraw licenses, to impose capital
adequacy conditions (e.g. the Cooke ratio), to circumscribe loans to classes of debtors,
and even the power to trigger bankruptcy proceedings for firms or for the bank itself.
The point is that lowering the costs of providing the functions of governance
involves design at two levels. First, there is the choice of the general courts or a
specialized regulatory authority with specific rules. Second, there is the choice where the
regulator delegates power, given the existing intermediaries. In the US, this delegation
harnessed the incentives of intermediaries and in the end the regulators of the SEC did
not use their authority, as they might have, to reward themselves. It is likely that the
narrowing of the specific tasks of the SEC and its use of delegated monitors enhanced the
ability for their respective organizations to tie rewards to the fulfillment of these specific
goals.
Efficient collection of information
Information, in addition to an efficient judiciary, is essential for anonymous
minority shareholders to avail themselves of the power granted them by legal protections.
Without information received in a timely manner, investor resources will be squandered.
With the information, investors can use their powers embodied in legal protections to
change the allocation of resources or simply exit the firm. In short, investors will factor
in the efficiency of information intermediaries in calculating the impact of any legal
reforms.
17
The institutional requirements to support information for anonymous exchange in
equity and capital markets are significant. Publicly audited income statements and
balance sheets require professional accounting firms. But the short recounting of the
formation of the SEC suggests information does not come exclusively from firms
responding to state mandates about information disclosure. Rather in developed markets
information intermediaries emerge to lower the transaction costs of collecting
information and to improve the overall information flows. The expected efficiency of
information intermediaries, which is what matters for investor confidence, depends on
access to information, capabilities to process the information, and on incentives. In some
cases, intermediaries incentives stem from the prospect of penalties imposed by a
regulatory agent of the state. But in many cases, the incentives that drive conduct are self-
interested concerns that they could lose their reputation (and future business) if they fail
to perform.
Intermediaries that are important in environments that rely on legal protections
are those that provide information in channels open to existing and potential investors.
For example, intertwined with the rise of trade credit for American retailers in the 19
th
century was the development of financial reporting, external auditors, and credit rating
agencies. No longer was information about reliability just possessed by those with past
experience, but rather specialized agencies collected the information and made it
available to clients. Similarly, organizations that provided information on assets and
those with liens on the assets, such as property registries, helped to facilitate credit and
the use of collateral. For equity markets, intermediaries that proved important were
accounting firms, financial analyst firms, and stock markets.
Summary
In sum, historical evidence from developed economies that have been able to
support anonymous investments backed by legal protections suggests surprising
requirements for institutional depth. Legal protections are an immensely helpful
institution of corporate governance, but to provide the functions of corporate governance
legal institutions need to be accompanied by other institutions of corporate governance.
These institutions are not just those directly targeted on clarifying competing claims, but
18
institutions such as social norms, political structure, the location of judicial authority, and
self-regulating organizations that indirectly but significantly affect the costs of resolving
competing claims. It is the interaction of these institutions of corporate governance that
history and theory suggests will matter.
1.2.3 Internal governance policies: Ownership structure
An entirely different approach to addressing the functions of corporate
governance is to look inside the firm and focus on policies at the discretion of those in
control. One could evaluate many such policies that produce information, manage risks
and incentives and resolve competing claims such as the structure and role of the board of
directors, the design of executive compensation, and financial structure. These are all
important but beyond our focus. Here we concentrate on ownership structure, both the
identity and the concentration of owners. To what extent can ownership structures that
deviate from the hypothesized anonymous small diversified shareholder fulfill the
functions of corporate governance at lower cost?
The impact of ownership structure on the functions of governance is not nearly as
straightforward as the impact of legal protections. Deviations from corporations owned
by anonymous small shareholders has ambiguous effects in theory. The main argument
advanced here is that there is significant support for the proposition that where legal
protections are weak due to institutional weaknesses, the advantages of employing
identity and concentration can outweigh the costs. Ownership structure can, like legal
protections, provide the functions of corporate governance.
Promise fulfillment through ownership identity
Where there are no legal protections, investors are likely to be extremely reluctant
to give up resources to someone else in exchange for a promise because if that promise is
violated they have no clear penalty they can impose. There is the danger of no
investments in corporations. The theory of repeated games suggests one way out of this
trap. The prospect of linking current violations of promises to future penalties can lead
those in control of investor resources to honor their promises. But bilateral reputation
mechanisms will often not achieve an efficient level of investment. Insiders in the firm
might violate the interests of one financier and lose the ability to appeal to him again for
19
finance, but this threat is a weak deterrent if he can freely access finance from other
financiers. Such reputation mechanisms can be made more effective if a way is found to
magnify the penalty in case promises are unfulfilled in effect replacing bilateral
reputation with multilateral reputation.
In particular, where networks exist that provide information, allow for
coordinated action, and can enforce coordinated actions, the identification of an
individual who receives the investment with a network can create a multilateral
reputation mechanism. Greif (1997) documents that such augmented reputation feedback
mechanisms had a position of prominence in driving the commercial revolution. He
shows that the Community Responsibility System whereby any member of a community
could be held liable for unmet promises of another member, the identification of traders
with specific religious communities such as the Maghribi traders, and even artificial
communities created by merchants such as the German Hansa, were all examples
whereby the identification of an individual with a larger community helped to increase
the scope of investment opportunities.
The key point is that when the controller of investor resources is not anonymous
but has an identity it is possible to go from no investment to investment. In exchange
based on bilateral reputation, such exchange is personal, the information demands are
large, and the scope for investments is limited. With exchange based on multilateral
reputation, trade can be impersonal, information demands for individual investors are
lower and the scope for investments is increased. Information demands for individual
investors are lower in that an investor need not know the history of the controller of the
investment, but rather needs to know the community affiliation of the individual to whom
he entrusts his resources. This identification with a community conveys information
about the penalties that will be imposed if the controller of the investment violates the
terms of the agreements. Community affiliation affects investorsbeliefs.
This deceptively simple logic constructed to explain historical evidence on the
emergence of long-distance trade has much broader scope. It helps to explain why some
economic agents are able to support investments in current day situations while others
have more difficulty.
20
For example, family-centered and ethnic-based business groups common to much
of the developing world are networks where identity matters. For members of the
business group, the information that can be gathered and the penalties that can be
collectively enforced are greater than for individuals that are not member of the
community. In theory, this helps to facilitate investments that are insupportable in the
absence of these community ties. It is consistent with the observed pattern of much
broader diversification of such firms than in developed economies.
Khanna (2000) summarizes available evidence on the impact of group affiliation.
The general sense is that group affiliation helps rather than harms performance,
consistent with the framing described above, but also consistent with other theories of
group formation. One of the more notable individual studies is provided by Khanna and
Rivkin (1999) where for 14 emerging markets they find that group affiliation improves
outcomes using accounting measures of performance for four countries, and only
produces negative performance for one. These findings are consistent with individual
country studies that employ accounting measures and Tobins Q.
Business associations are artificial communities that can also support investments
in firms, if they collect information, coordinate action and have the incentives to enforce
penalties for non-compliance. There is recent evidence of their ability to support trade
credit in weak legal environments of Vietnam, (McMillan and Woodruff (1998)) Poland,
Romania, Russia and Ukraine (Johnson, McMillan and Woodruff (1999)).
Certain owners are also, in effect, members of networks. Foreign owners, when
they assemble a controlling stake for example, become subject to stricter regulations of
their home country (both legal requirements and any additional requirements demanded
by the stock exchange that lists their shares). These regulations often require them to
disclose far more information than demanded by the country where the investment is
located and the penalties for violating these rules are often the same as if the investment
was in the home country. Penalties can also be applied to assets in the firmshome
country. Thus, the foreign owner has posted something greater than his word when he
operates in a foreign country. Evidence consistent with this contention has been found in
the superior performance of foreign controlled firms in India (Chhibber and Majumdar
21
(1999)) and, as described in more detail below, in the transition economies (e.g.
Frydman, et al (1999), Djankov (1999))
The argument that identity supports investments is not an argument that identity is
optimal. There are clear costs with the use of identity in investment relationships. The
ability to pool investments, allocate them across space, and manage risks are all
constrained by the need for those controlling investments to have clear ties to an
identifiable community. There may be inefficiently low levels of information collection
by investors.
13
There are also dynamic costs. As Johnson, McMillan and Woodruff
(1999) found, investors relying on informal mechanisms to support investments are
inclined to maintain these relationships rather than use other mechanisms even when
there are costs to doing so. The costs can be deep, producing inflexibility. Members of a
community that that collect private benefits from the networkspresence have a strong
interest in seeing that these mechanisms are maintained even if they are no longer the
most efficient mechanism.
While not optimal, factors such as identity should not be dismissed out of hand.
When there are no effective legal protections, mechanisms such as identity can provide
the functions of governance. What is clear from the evidence cited above is that identity
can improve outcomes in developing economies with weak legal protections. This is
consistent with the argument that identification with a larger community helps to provide
the functions of governance, substituting for an inability to appeal as an anonymous
owner to the state for enforcement of legal protections. Where legal protections are
stronger, the costs of identity may very well exceed the benefits as there is another
channel available to provide the functions of governance.
Promise fulfillment through ownership concentration
A second deviation from anonymous disperse shareholding that can enhance
promise fulfillment is ownership concentration. The traditional motivation for
concentration is that it reduces the public good problem associated with monitoring. The
13
In the Community Responsibility System, for example, an investor knows that he can get payment from any member
of that community, so he has little incentive to examine the capabilities of the controller of the investment and the
viability of the proposed investment project. Bad projects will be pursued and punishment will come by the
community only after the fact.
22
greater the ownership stake, the greater the personal returns to monitoring and exercising
voice and the more information that these owners will collect. Coffee (1999), among
others, suggests the corporate finance evidence shows that the activism of shareholders is
proportional to the extent of ownership concentration. Concentrated owners often become
what Jensen (1991) calls the active investor, one who holds large equity and/or debt
positions and actually monitors management, sits on boards, is sometimes involved in
dismissing management, is often closely involved in the strategic direction of the
company and, on occasion, even manages.
A more recent rationale for concentration is offered by Bebchuk (1999).
Consistent with this papersframing, he focuses on how concentration can resolve
competing claims on the wealth generated by the corporation. He suggests concentrated
structures are the only viable arrangement in countries with weak legal protections.
Where legal protections are weak, the scope for redirection of resources is large. Faced
with this situation, if a single owner wants to sell a stake he would be much better off
selling a large controlling stake in the firm, rather than selling disperse shares. The
problem with dispersion is that each disperse shareholder anticipates that someone will
assemble a controlling stake and will use that control to redirect resources to themselves.
Concern for this eventual theft will lower share prices today. The single shareholder
maximizes his returns to sale by maintaining control - control protects rents.
In Bebchuks story, concentration primarily affects distribution of rents rather
than efficiency. In fact, the pure efficiency impact is negative, as concentrated
shareholders do not benefit from diversification. But concentration may be efficiency
enhancing. With possibilities to divert returns and disperse shareholding, it may not be
clear initially which of the disperse shareholders will assemble a controlling stake. In
such a situation, those with limited control but uncertainty about future control, have an
incentive to dilute quickly and destructively. In contrast, if control is delivered by having
a large cash flow stake in the firm, those in control know they will keep it and their
temptation to dilute is limited by their ownership stake. At least to some extent, they are
simply stealing from themselves. Concentrated control may not only be the only viable
option in countries with weak legal protections, it may be more efficient than efforts to
introduce disperse shareholding.
23
Other researchers have argued that it may be optimal to have more than one large
owner in environments with weak legal protections, particularly if that owner has
identifiable characteristics tied to the functions of corporate governance. For example, a
potential investor with financial capital might be more willing to invest if suppliers or
buyers also have stakes because even without legal protections these agents have
potential leverage vis-a-vis the insider (hold-up power). The small investor knows that if
insiders attempt to reallocate promised returns, financiers and suppliers as co-financiers
can credibly threaten to penalize them directly and consequently such diversion can be
reduced. Aoki (1984) underscores how labor might be able to police against abuse due to
its ability to withhold its services. Financial institutions are very well positioned to serve
this role. Their hold-up power derives from their ability to provide long-term finance, but
more importantly from their ability to cut off the supply of short-term capital if a firm has
committed to a particular banking relationship.
Up through the early 1990s, many analysts of German and Japanese corporate
governance systems suggested that a key to the relatively strong performance of firms in
these countries has been the ownership and control structure that involved banks, workers
and concentrated owners. These parties have information, the ability to impose
sanctions, and the incentive to use their powers. Investors believed that the presence of a
bank mattered and this affected their willingness to invest. Kaplan (1993) and Kaplan
and Minton (1995) show that, at least for management turnover, there is little difference
in sensitivity of turnover to changes in financial performance between these countries that
rely more heavily upon informal mechanisms than in the US with its largely formal
system. In addition, Hoshi et. al (1990a,b) show that Japanese firms with bank
relationships have greater access to capital and lower costs of resolving financial distress.
As with ownership identity, the argument here is not that ownership concentration
is optimal. Rather, the argument is that ownership concentration can provide the
functions of governance, and particularly where legal protections are weak, the benefits
provided by concentration outweigh the costs.
In fact, the costs can be sizable. Most obviously, with concentrated ownership,
there is no longer a separation and specialization based on comparative advantage of
24
those providing management and those with capital to invest. There is an inferior
management of risks and a more limited pool of investors. Second, as Bolton and Von
Thadden (1998) emphasize, there is a loss in liquidity, with a resulting decline in the
value of shares. Third, with concentrated ownership, those in control are difficult to
dislodge. When these insiders are not well motivated, there will be a decline in
efficiency. Aghion and Blanchard (1996) for example emphasize the particular problems
that arise when workers or managers have control over the firm. Recent literature on the
Japanese and German systems also now sees bank affiliation as costly, with bank
involvement leading to overlending, and deferred restructuring (e.g. Weinstein and Yafeh
(1998)).
Fourth, to the extent that initial owners maintain their concentration through
voting rights rather than cash flow rights this is costly as it reduces incentives to use
control in the interests of minority shareholders. There are various vehicles through
which an owner can maintain control by reducing cash flow stake, for example through
shares with different voting rights, through cross shareholding, or through pyramid
structures. As discussed in more depth below, Claessens, Djankov and Lang (1999)
provide evidence of costs associated with concentration of control when it is not
associated with similar cash flow rights in their study of Asian firms.
Summary
In sum, by examining ownership structure it is clear that governance policies, like
institutions, provide the functions of corporate governance. Relative to a situation with
anonymous, disperse shareholder, owners identified with a network, and with significant
concentration can have a comparative advantage in providing information, managing
incentives and lowering the costs of resolving competing claims over the wealth of the
firm. Evidence in support of this contention comes mainly (but not exclusively) from
countries where legal protections are weak. This is consistent with theory, which shows
that with weak legal protections other ownership structures are not supportable, and even
costly. When legal protections are strong, the theoretical results are more ambiguous, as
is the evidence.
25
2 International Data on Legal Protections and Ownership Structures
The previous section provided a conceptual framework for thinking about
governance focusing on the functions performed by a governance system and linking
institutions and policies to these functions. Recent research provides statistical evidence
to evaluate the relevance of these institutions and policies and their impact on firm and
national performance.
2.1 Data
This paper does not provide any new data, but instead brings together data from
international cross sectional studies by LLSV(1998), LLS(1999), Pistor (1999),
Claessens, Djankov and Lang (hereafter CDL) (1999), and Becht and Broell (1999),
reproduced in appendix Table 1 and 2. LLSV (1998) collected information on corporate
governance characteristics of countries and cash flow ownership for a cross-section of 49
countries. This sample is heavily weighted to higher income economies, covering 93% of
high income economies and 62% of upper middle income economies, but still covers a
significant number of developing countries, with a third of the sample defined by the
World Bank as low or middle income.
14
Pistor (1999) extended this sample to include
data on legal protections for 24 transition economies, both in 1992 when the transition
began and in 1998.
LLS (1999) provide an alternative measure of ownership concentration for a
different sample of 691 firms from the 27 most developed countries in their original
sample. This study has been complemented by more detailed studies of the concentration
of voting rights in particular regions. Studies of 8 European countries under the umbrella
of the European Corporate Governance Network based on 1381 firms are reported in
Becht and Broell (1999). Another example is the study of 9 East Asian countries by CDL
(1999) of the World Bank based on 2,980 firms.
2.2 Legal Protections for Equity Investors
The data reveals a surprising lack of investor protections and a dispersion of
approaches to protections when one looks around the world. Of a maximum score of 6
14
The choice of countries emerged after imposing the restrictions that a country had to have 5 publicly-traded
companies without significant government ownership and not be a former socialist country.
26
for anti-director rights, the highest score is five and the average for the sample is just 3.
The subsequent research by Pistor to collect evidence on legal protections for the
transition economies expands our understanding of legal protections in non high income
countries. Echoing the LLSV findings, there is a widespread variation in the extent of
legal protections across countries and many countries have a relatively low level of
protections. In 1992, protections averaged just 1.8. In 1998, the level raised to 3.0,
identical the level in the established economies investigated by LLSV. Interestingly, the
scores for anti-director rights are not driven by differences in per capita income, with
average levels indistinguishable at different income quartiles.
The change in the extent of legal protections from 1992 to 1998 in the Pistor
sample demonstrates one reason why legal protections have become such a variable of
policy interest. Unlike the complementary institutions described above, legal protections
can be changed very rapidly indeed. And efforts of the international community do
matter. As Pistor (1999) shows, countries that received US aid have higher legal
protections than other countries in the sample, including those preparing for membership
in the EU.
2.3 Complementary institutions
Existing statistical research has not focused on measures of the complementary
institutions of social norms, judicial efficiency, and information intermediaries that
produce publicly available information. Where these complementary institutions have
found a way into the analysis, this has come through relatively crude proxies, also
included in Table 1. A number of studies use rule of lawindices compiled by experts in
commercial risk agencies as proxy measures for judicial efficiency. To capture the
presence of publicly available information, these studies make use of an index of whether
90 factors that accountants identify as useful indicators of the financial affairs of a firm
are included in firm annual reports.
15
The rule of law measure reveals significant attention to legal practices. The
average level is 6.8, with almost a quarter of countries receiving a perfect score of 10,
and half of the countries scoring higher than 7. The extent of the rule of law is very
15
See LLSV(1998) for a further description of these variables and their source.
27
closely linked with per capita income. The correlation coefficient between the log of gdp
per capita and the rule of law measure is 0.87. The measured accounting standards vary
from a low of 24 for Egypt to a high of 83 for Sweden, while this data is unavaiblable for
some countries. The correlation coeficient with respect to log gdp per capita is a lower
but still significant 0.51.
One additional variable included in these analyses is a countrys legal family. The
work of LLSV, building on the classification provided by comparative legal scholars,
focus on two legal traditions and four legal families. In the common law tradition of the
UK, the US, and Commonwealth countries, the law evolves as judges resolve specific
disputes. Civil law, in contrast is a system that relies upon written statutes often based on
abstract principles, with its roots in Roman law. There are three distinct variants: French
civil law, German civil law and Scandinavian civil law. A good case can be made that
legal families are exogenous to policy makers. The legal family was adopted long in the
past, and often as a result of colonization.
The exogeneity of legal families makes legal family a good variable for statistical
purposes. It also has explanatory power. There is a significant effect of legal families on
antidirector rights, and on other variables. The strongest difference comes from
comparing countries with a french civil law origin and those with a common law origin.
The mean index for anti director rights, rule of law and accounting standards is all higher
in common law countries, with the difference significant for anti-director rights.
For policy purposes, legal family has much less use. The exogeneity of the
instrument makes it relatively uninteresting, as by definition it cannot be changed. It is
also unclear for policy purposes what the variable legal familyactually captures. In
subsequent work, LLSV suggest that the common law evolved to protect private property
against the crown and that civil law is correlated with greater interference in economic
activity. Thus the legal origin in a sense proxies for the other institutions of corporate
governance that we describe above, particularly measures of political structure.
For the purposes of this paper, I create a more direct index that captures the
argued complementary nature of the presence of legal protections, quality information
and enforcement and also include this in Table 1. It is constructed by taking the simple
28
product of adjusted measures of anti-director rights, the index of information, and the rule
of law measure.
16
The weighting used is arbitrary, but at least captures the hypothesized
interactions between these institutions.
2.4 Ownership Structure
Who controls firms? Recent research has added greatly to our understanding of
types of ownership structures around the world, with results from four of the most cited
studies in this literature reproduced in Table 2. LLSV (1998) collected data on cash flow
ownership for the same sample of 49 countries described above. The higher the cash flow
ownership of the most concentrated owner(s), the greater alignment of that owners
interests with those of the firm. But cash flow ownership might not capture who controls
firms when voting concentration can differ from cash flow concentration. LLS(1999)
focus on concentration of voting rights. To measure whether there is an entity with
sufficient voting rights to have control of a firm, they use a methodology to identify
voting rights that involved tracking ultimate owners through pyramids and cross
shareholding arrangements. A shareholder with a direct or indirect voting stake of 20
percent is said to have control.
So what does ownership look like? The strongest result from all of these studies
is that firms held by anonymous disperse shareholders are the exception rather than the
rule when one looks around the world.
This is clearly demonstrated in the first column, which shows that the combined
stakes of the 3 largest shareholders (using cash flow) averages a surprisingly high 46
percent. Only in the United States, the United Kingdom, Taiwan and Japan are cash flow
ownership stakes less than 20 percent. Using voting rights as the concentration measure
reinforces this result. Defining control as a 20 percent direct or indirect voting stake,
only 36 percent of the largest firms in countries in the LLSV sample are widely held.
These results are robust. The limited role of dispersed shareholders is evident in Europe,
where based on the data in Becht and Roell (1999), only 22.4 percent of firms from
Austria, Germany and Netherlands have a controlling shareholder with less than a 25
percent stake. This result is echoed in Asia, where CDL (1999) report only 32 percent of
16
The index is created after transforming the variables to have a similar range to the antidirectors rights index.
29
firms are widely held. What is true for the largest firms around the world holds with even
greater strength for medium sized firms. In the LLSV voting right sample, for example,
the percentage of medium sized firms that are widely held is just 24 percent. One also
finds within the sample of large firms that the smaller the size, the greater the likelihood
of a controlling shareholder.
The distinction between cash flow rights and voting rights noted above turns out
to be important for cash flow rights are routinely separated from voting rights. The
evidence shows that the most common way to break these rights is through the use of
pyramid structures. Less common is the use of cross shareholding, although this is
important in countries such as Japan. Surprisingly rare are instances of issuing multiple
shares with different voting rights.
Jensens contention based on US evidence is consistent with the international
evidence. With a controlling shareholder the distinction between owners and managers is
eliminated in most cases. When a family is the controlling shareholder they participate
directly in management 69 percent of the time in the LLSV sample and 67 percent of the
time in the Claessens et al sample for East Asia.
This evidence also allows for an examination of the theoretical argument that
having multiple large shareholders might facilitate investment in firms. When a family
is in control, other concentrated owners are only found 25 percent of the time in the LLS
sample. This is seen even more clearly in the European evidence, where the median stake
of the second largest shareholder was almost always below the minimum reporting level
of 10 percent. Interestingly, a second large shareholder is far more common in the CDL
sample of East Asian economies. In this more economically diverse sample, in 49
percent of such firms there was another shareholder with a significant stake. This
evidence reopens the question whether such multiple large shareholders are important to
governance in less developed economies.
3 Findings
Armed with this statistical data on legal protections and ownership, a growing
number of authors have related these variables to other firm and national performance
measures. It is only possible to scratch the surface of this work here. I organize the
30
discussion around the impact of legal protections first on ownership structure, second on
financial measures, and third on investment and growth. In addition to the data from
established publicly-traded firms, I also relate legal protections to privatization evidence.
3.1 Legal protections, ownership structure and performance in established firms
Legal protections and ownership
Figures 1 and 2 provide a visual of the raw data described in the previous section
and the relationship between these variables. In figure 1, the top two plots relate the
index of anti-director rights and the rule of law index to ownership concentration
measured using cash flow rights, while the bottom two plots focus on concentration
measured using voting rights. For the voting rights measure I use the average levels of
concentration reported from the LLSV and CDL samples. Figure 2 presents data using
my index of effectivelegal protections formed by the interaction of anti-director rights,
the rule of law measure and the accounting measure. In all figures, I also plot the
predicted line of best fit based solely on these variables.
The main result, regardless of presentation, is of a strong negative relationship
between legal protections and ownership structures in large firms reflected in the
downward sloping line of best fit. Even without control variables, legal protections
matter. Analysis by LLSV(1998) that control for other contributors to concentration bear
out these results. The conclusion is that in established publicly traded firms ownership
concentration is a substitute for legal protections in providing the functions of corporate
governance.
An advantage of this presentation focusing on the raw data is to suggest that while
anti-director rights are important, other dimensions of legal protections matter, as well as
the interaction of the various elements. For the raw data, the explanatory power (r
squared) provided by anti director rights and rule of law alone are comparable, with anti-
director rights explaining 15-16 percent of the observed variation in cash flow and voting
rights concentration respectively, while rule of law explains 21 and 19 percent. Figure 2
reveals the value of considering the interaction of governance institutions. This measure
of effective protections alone explains 36 - 30 percent of the variation in cash flow and
voting rights concentration respectively. When combined with controls for the average
31
size of firms, the explanatory power rises to 44 and 56 percent respectively. The point
here is not to offer a new evaluation of the data but to reveal the empirical support for the
contention that complementary factors are critical contributors to the observed
relationships between legal protections and other variables.
A second result, apparent in the raw plots of data is of the particular difficulty of
supporting anonymous diversified shareholders in countries with weak legal protections.
The bottom left corner in all of these figures is pretty much a blank space. This finding is
consistent with theory that suggests disperse shareholding with weak legal protections is
unsustainable. The raw data suggests that the rule of law is of particular importance. For
example with the voting rights measure of concentration, when the rule of law measure
falls below 7 only South Korea has more than 10 percent of its firms that are widely held.
The relationship at high levels of legal protections is not so striking. While high levels of
protections are necessary to support small diversified shareholders, there are many
countries with strong legal protections that still utilize concentrated ownership structures.
32
33
34
Legal protections and financial performance
Some of the most striking results relate institutions of corporate governance to
financial measures of performance. LLSV (2000) report that firms in countries with
stronger legal protections are more likely to disgorge earnings through dividends.
Consistent with this result and with theory, LLSV (1999b) and CDL (1999b) also show
that legal protections enhance the value of shares (measured using Tobins Q). The
interpretation here is that by conveying power to minority shareholders through legal
protections, the market places a higher value on such shares. As with studies relating
legal protections to ownership, the impact of legal protections comes not only through
antidirector rights but also through other variables. Legal families and to a lesser extent
anti-director rights raise the value of shares.
These studies also show concentrated ownership through cash flow stakes is
valued. To avoid confounding concentration with control, they look at concentration in
firms that are controlledaccording to their measure of direct and indirect control.
CDL(1999b) finds strong evidence, consistent with theory, that concentrated cash flow
ownership improves value, while concentrated voting rights reduces value. LLSV
(1999b) present weaker evidence of the benefits of concentrated cash flow ownership.
Johnson, Boone, Breach and Friedman (2000) illustrate that legal protections
might matter during times of crises even more so than during normal times. They show
that countries in Asia with weaker formal mechanisms suffered larger declines in share
prices and currency values than countries with stronger protections. These institutional
variables have at least as much predictive power as standard macroeconomic variables.
Legal protections, investment and growth
Probably the most interesting findings are those that get directly at the goal of
governance to foster investments in firms. LLSV (1997) provide evidence that the
extent of legal protections is correlated with the depth of equity markets and the rate of
initial public offering activity. The rationale for this finding is straightforward. With
effective legal protections investors have good reasons to expect their promises will be
fulfilled. They are more willing to exchange their resources for promises, the costs of
finance drop and financial markets develop.
35
Wurgler (2000) shows further that the efficiency of the allocation of investment is
related to legal protections. In his study, he estimates a greater sensitivity of investment
to growth opportunities in countries with more developed financial markets (an indirect
link to legal protections) and a greater willingness to cut funding from declining
industries in countries with weak legal protections. Consistent with the presentation
above, his measure of legal protections is a measure of effective legal protections,in his
case the product of rule of law and the sum of creditor and anti-director rights.
The links between legal protections and growth and performance remain indirect
but very suggestive. Other studies (e.g. Rajan and Zingales (1998), Levine and Zervos
(1998)) show strong links between the extent of financial development and subsequent
growth and development.
3.2 Legal protections, ownership structure and performance in privatized firms
Privatized firms provide another data set to examine whether legal protections
help explain ownership structure and performance. In many ways, privatized firms are
ideal. They are often large firms for which governance concerns are most important.
The initial ownership at the time of privatization is in many ways a choice variable, so
examining initial structures reveals whether political decision makers believe the existing
state of legal protections imposes some constraints on their actions. Most importantly,
this is a good data set to see whether the effectiveness of legal protections affects the
evolution of ownership structures and firm performance. If legal protections are a
binding constraint, this should be reflected in disappointing performance and an
instability to disperse ownership structures in environments with weak protections. In
these same environments, concentration and identity should contribute to better
performance.
Legal protections and initial ownership structures
No studies have provided the same systematic information on ownership
concentration for privatized firms as collected for established publicly-traded firms. As
an (imperfect) proxy, for which there is data, studies by Megginson, Nash, Netter and
Poulsen (2000) and Bortollotti, Fantini, Siniscalco and Vitalini (1997) examine the
relative tendency of governments to use asset sales as opposed to share issue (SIPs) as the
36
privatization method in countries with established private sectors. Share issue
privatizations are likely to produce ownership structures where there is no controlling
shareholder. Asset sales in contrast are usually associated with sales of a majority stake to
a single investor or a consortium of investors arranged before the sale. Governments
often establish pre-qualification criteria prior to the sale and conduct the sale through an
auction or through a more direct sale to a targeted investor. Investigation of winning
consortia show in almost all circumstances the presence of a core investor. Thus, asset
sales are likely to produce a controlling shareholder.
Using this data, the empirical results are broadly consistent with the results for
established publicly-traded firms. In regressions for privatizations from 80 countries that
control for a variety of factors, Megginson, Nash, Netter and Poulsen (2000) report that
legal protections and the governments ability to credibly commit to property rights are
both significant explanatory variables in the privatization design choice. The UK, for
example, with excellent legal protections relied upon share issue privatizations with
widely dispersed shareholding. The average ownership stake of the largest shareholder
for a sample of 25 electricity and water supply companies privatized in the United
Kingdom was 4.6 percent. in the year of privatization.
17
Privatizations in middle income
countries with weak effective legal protections such as Argentina, Mexico and Bolivia in
contrast used asset sales, accounting for 89%, 91% and 100% of transactions
respectively. In the Mexican privatization program, for example, Lopez de Silanes (1997)
describes how controlling stakes were sold in 87 percent of firms in his privatization
sample and when non-controlling stakes were sold, in 83 percent of the cases the shares
were bought by the preexisting controlling shareholder.
The transition economies, in contrast, do not follow the patterns found in
established publicly-traded firms and in privatized firms elsewhere. Figure 3 makes this
point graphically. On the vertical axis I identify the primary approach to privatization
based on the EBRD (1999) classification of economies by whether direct asset sales,
management and employee buy-outs or voucher privatization was the primary approach
to privatization. A voucher privatization is a share issue privatization that results initially
17
For further information on the companies included in this comparison see Cragg and Dyck (1999).
37
in disperse ownership. Direct asset sales, like in the rest of the world, result in more
concentrated ownership. Management and employee buy-outs are somewhere in between
direct sales and voucher privatization at creating concentration at the time of
privatization. On the horizontal axis I provide a rough characterization of the level of
effective legal protections. Pistor (1999) provides precise data for antidirector rights and
this is included in Table 1, but all of the legal protections must be considered ineffective
given initial weaknesses in rule of law and accounting standards. The key difference
between this figure and the preceding ones is the large number of countries in the bottom
left quadrant. In an environment with ineffective legal protections many countries did not
adopt a privatization approach that facilitated concentrated ownership initially, and they
largely eschewed attempts to identify owners that had the capability to enhance promise
fulfillment. They followed a path without empirical support and with little theoretical
backing.
38
Figure 3 – Legal protections and approaches to privatizationtransition
Direct sales
concentrated ownership
with openness to
outsiders
Bulgaria
East Germany**
Estonia*
Hungary*
Kazakhstan*
Latvia
Poland*
Hungary*
Slovak Republic*
Primary
approach to
privatization
Direct sales
concentrated ownership
to management and
employees
Romania
Slovenia*
Belarus*
Turkenistan
Ukraine
Uzbekistan*
Voucher
predominantly disperse
ownership
Czech republic
Lithuania
Armenia
Azerbaijan
Georgia
Krgyzstan*
Moldova
Russia
Low High
Effective Legal Protections at time of privatization
Source: EBRD Transition Report 1999, Table 2.2. with modifications by the author. Growth data and region
definition from IMF data presented in Havarylyshyn and Wolf (1999)
Note: * indicates that country had growth 1991-1998 that exceeded the mean for their region. The regions
considered are central and eastern Europe, the Baltics and the Commonwealth of Independent States.
** eastern Germany has no direct comparison group
Interestingly, contrary to many descriptions, a number of countries held to
international benchmarks, reflected in their presence in the top left quadrant. Estonias
privatization program, for example, followed closely that of Germany.
18
While vouchers
were used, in most instances only minority stakes of approximately 40 percent were
targeted to voucher holders, while 60 percent was sold to a strategic investor. Most
strategic investors were foreign, with Swedes and Finns of Estonian descent playing an
important role. The German experience is also illustrative. They had significant freedom
to choose the degree of ownership concentration, with many demands for a widespread
distribution of shares to eastern Germans. However, as Dyck (1997) describes, their
approach in using asset sales instead of share issues, with openness to foreigners and a
preference for firms that had established experience in the sector and management
capabilities, resulted in eastern German firms being bought by established western
German firms. The result was that eastern German firms inherited the corporate
18
Nellis (1996) provides a description of this program.
39
governance structure of established western German firms, a governance structure that is
viewed internationally as very effective in addressing both types of governance problems.
Legal protections, financial performance and the evolution of ownership
There have been no systematic efforts to evaluate whether the initial ownership
structure at the time of privatization relative to the legal environment helps to explain
subsequent performance experiences. But, in broad strokes, the evidence is consistent.
As Megginson and Netter (2000) emphasize in a comprehensive survey of available
privatization evidence, the financial impact of privatization is overwhelmingly positive,
with the exception of the transition economies. Within the transition economies, a simple
examination of the relationship between the initial approach to privatization and
subsequent growth is thought provoking.
To a large (and perhaps surprising) degree the initial approach to privatization
predicts very well the countrys subsequent growth experience. As revealed in Figure 3,
those that held to international benchmarks have done better than average in their regions.
Those that did not have done worse, sometimes spectacularly worse. In terms of the
figures, countries have tended to remain in the quadrant in which they started, with little
movement rightward to show increased effective protections, and only limited movement
upward to increase concentration.
More convincing is microeconomic evidence that controls for confounding factors
that might influence the ownership choice as well as differences in country starting
points. In the transition economies, there is a growing body of microeconomic evidence
to draw from and a few results are clear. Based on the discussion in section 1, the
following statement from the EBRD (1999) should not be surprising, “Unambiguously
positive results have been found only for those enterprises privatised to strategic foreign
investors or to other types of concentrated outside owners.Specific studies supporting
this contention include Djankov (1999) for the CIS and Frydman, Gray, Hessel and
Rapaczynski (1999) for the Czech Republic, Hungary and Poland. The Djankov (1999)
study for example found that for privatization to have a positive impact, the ownership
stake needed to be greater than 30 percent and the owner had to be a foreigner.
40
A recent survey of 3,000 enterprises completed by the World Bank and the
EBRD, reinforces these results. While this study does not control for possible
confounding factors, it has the advantage of broad coverage and a consistent
methodology. Chart 1, reproduced from EBRD (1999) shows the significant impact of
ownership concentration with privatization. For all indicators of restructuring - from
reducing workforce, to new products and technology, to sales and employment increases
– reform is much greater in firms with less than three shareholders than in more
diversified firms with more than three shareholders. Chart 2, also reproduced from EBRD
(1999), shows that identity in addition to concentration is required to improve
governance. Using the same survey it is evident that firms privatized to foreigners
outperform state-owned firms and firms privatized to domestic citizens again on all
fronts. Firms privatized to domestic insiders do not perform consistently better than
state-owned firms, although their performance is stronger outside of the commonwealth
of independent states.
40
Appendix Table 1 - Institutions of Corporate Governance: Legal Protections
LLSV Sample Pistor Sample
COUNTRY Legal
Origin
Anti-director
Rights
Rule of Law Accounting
Standards
Effective legal
protections'
COUNTRY Anti-director
Rights 1992
Anti-director
Rights 1998
Australia Eng 4 10.00 75 90 Albania 3 3
Canada Eng 5 10.00 74 111 Armenia 2,5 5,5
Hong Kong Eng 5 8.22 69 85 Azerbaijan 2,5 2
India Eng 5 4.17 57 36 Belarus 1,5 1,5
Ireland Eng 4 8.75 na na
Israel Eng 3 4.82 64 28 Bosnia 0 0,5
Kenya Eng 3 5.42 na na Bulgaria 4 4
Malaysia Eng 4 6.78 76 62 Croatia 0 2,5
New Zealand Eng 4 10.00 70 84 Czech Rep 2 3
Nigeria Eng 3 2.73 59 15 Estonia 2 3,75
Pakistan Eng 5 3.03 na na FYR Macedonia 0 2,5
Singapore Eng 4 8.57 78 81 Georgia 2,5 3
South Africa Eng 5 4.42 70 47 Hungary 2,5 3
Sri Lanka Eng 3 1.90 na na Kazakhstan 2,5 5,25
Thailand Eng 2 6.25 64 24 Kyrgyzstan 2,5 2,25
UK Eng 5 8.57 78 101 Latvia 3,5 3,5
US Eng 5 10.00 71 107 Lithuania 2,5 3,75
Zimbabwe Eng 3 3.68 na na Moldova 3 3,5
Argentina Fra 4 5.35 45 29 Poland 3 3
Belgium Fra 0 10.00 61 0 Romania 3 3
Brazil Fra 3 6.32 54 31 Russia 2 5,5
Chile Fra 5 7.02 52 55 Slovak Rep 2,5 2,5
Colombia Fra 3 2.08 50 9 Slovenia 0 2,5
Ecuador Fra 2 6.67 na na Ukraine 2,5 2,5
Egypt Fra 2 4.17 24 6 Uzbekistan 2,5 3,5
France Fra 3 8.98 69 56 Average 1.8 3.0
Greece Fra 2 6.18 55 20
Indonesia Fra 2 3.98 na na
Italy Fra 1 8.33 62 16
Mexico Fra 1 5.35 60 10
Netherlands Fra 2 10.00 64 39
Peru Fra 3 2.50 38 9
Phillippines Fra 3 2.73 65 16
Portugal Fra 3 8.68 36 28
Spain Fra 4 7.80 64 60
Turkey Fra 2 5.18 51 16
Uruguay Fra 2 5.00 31 9
Venezuela Fra 1 6.37 40 8
Austria Ger 2 10.00 54 33
Germany Ger 1 9.23 62 17
Japan Ger 4 8.98 65 70
South Korea Ger 2 5.35 62 20
Switzerland Ger 2 10.00 68 41
Taiwan Ger 3 8.52 65 50
Denmark Scan 2 10.00 62 37
Finland Scan 3 10.00 77 70
Norway Scan 4 10.00 74 89
Sweden Scan 3 10.00 83 75
Average 3.0 6.9
Source: LLSV (1998), Pistor (1999) and calculations by the author.
41
Appendix Table 2 - Ownership concentration
Country Combined cash flow
stakes of 3 largest
shareholders (LLSV
(1998))
Percentage of large firms with a
controlling shareholder using 20%
def. (LLS(1999), CDL (1999))
Percentage of medium sized firms with a
controllling shareholder using 20% def.
(LLS(1999), CDL (1999))
Argentina 0.53 100 100
Australia 0.28 35 70
Austria 0.58 95 100
Belgium 0.54 95 80
Brazil 0.57
Canada 0.40 40 40
Chile 0.45 0
Colombia 0.63
Denmark 0.45 60 70
Egypt 0.62
Finland 0.37 65 80
France 0.34 40 100
Germany 0.48 50 90
Greece 0.67 90 100
Hong Kong 0.54 90 100
India 0.40
Indonesia 0.58 95 94
Ireland 0.39 35 37
Israel 0.51 95 90
Italy 0.58 80 100
Japan 0.18 10 70
Malaysia 0.54 95 88
Mexico 0.64 100 100
Netherlands 0.39 70 90
New Zealand 0.48 70 43
Nigeria 0.40
Norway 0.36 75 80
Pakistan 0.37
Peru 0.56
Phillippines 0.57 95 84
Portugal 0.52 90 100
Singapore 0.49 85 60
South Africa 0.52
South Korea 0.23 45 70
Spain 0.51 65 100
Sri Lanka 0.60
Sweden 0.28 75 90
Switzerland 0.41 40 50
Taiwan 0.18 85 64
Thailand 0.47 95 94
Turkey 0.59
UK 0.19 0 40
US 0.20 20 10
Venezuela 0.51
Zimbabwe 0.55
average 0.46 68.13 75.27
Source: LLSV (1998), LLS(1999), CDL(1999).
Note: LLS measure used when LLS and CDL disagree.
42
Finally, looking at more focused studies that examine the evolution of ownership
concentration there is clear support for Bebchuks contention that disperse ownership
structures are unsustainable. In one such study, Claessens and Djankov (1999) examine
the developments in measures of ownership concentration for Czech firms and report
steady increases in concentration over time.
Offsetting benefits to deviating from international benchmarks are hard to find.
Pistor (1999) presents evidence that countries that pursued mass privatization programs
did start with higher levels of legal protections (2.55 versus 1.85 in 1992), and that the
difference between mass privatizers and others has been maintained (3.61 versus 2.71 in
1998). But the improvements in protections often were introduced after privatization
rather than before and possible benefits with these legal protections appear to have been
undermined by poorer market oversight. Pistors index reveals that despite starting with
higher levels in 1992, by 1998, the level of oversight was lower in mass privatization
countries than in those that did not pursue mass privatization.
4 Policy Implications and Future Research
So what does this functional framing and evidence suggest should be priorities for
policy makers interested in improving corporate governance systems? I identify four
broad agenda items, in declining order of importance.
First, policy makers should benchmark a countrys corporate governance system.
The impressive recent performance of the US economy, an economy characterized by
effective legal protections and anonymous diversified shareholders, has stimulated
interested in replication. Appreciation of the real requirements of such an undertaking
demands a stocktaking of a countrys corporate governance infrastructure. This
stocktaking includes legal protections, but also the efficiency of the judiciary, social
norms, and the extent of existing information/reputation intermediaries.
After completing a stock taking, policy makers can target their scarce time and
resources to the areas that will improve the situation the most. Without such a stock
taking, there will be many uncoordinated policies. As suggested by the discussion above,
some of these policies might be unsustainable at best, and at worst harmful. The research
43
described here has made significant progress in outlining the tools to conduct such a
benchmarking. Much work remains to fill in the details.
One tool is identification of a sequence, if any, in the introduction of various
institutions of corporate governance that support anonymous diversified shareholders.
The source of such evidence lies not in cross sectional studies, but in more in-depth
historical studies of economies that have successfully introduced effective legal
protections. There appears to be considerable support for the contention, offered most
recently by Rajan and Zingales (1999), that political constraints on the sovereign deserve
prominence as they are a precondition for legal protections to matter. More precision on
these dynamics from the history of countries that have developed legal institutions could
only help guide the allocation of scarce resources.
For legal protections, the technique of LLSV to identify key legal protections for
financiers is a good starting point. As the authors are the first to acknowledge, it is also
incomplete. Other legal protections not found in the company law can substitute for the
protections they discuss to lower the cost of competing claims over the wealth generated
in the firm. Expansions to the list of legal protections, like those offered by Pistor
(1999), are worth consideration.
Whether the set of legal protections should also include protections for other
stakeholders in the firm remains an open question. Theoretically, it is clear that labor,
management, and suppliers, like financiers, condition their willingness to provide
resources based on their expectations whether the explicit and implicit promises
exchanged for these investments will be fulfilled. It is an empirical rather than a
theoretical question whether legal protections for these investments should be included.
To my knowledge, such work remains to be done.
A second institution of corporate governance that needs benchmarking is the
efficiency of a nations judiciary. Summary measures of efficiency as viewed by
participants in the system or by commercial agencies provide a strong signal of efficiency
and perhaps the best currently available. But there is ample scope for better measures.
Pistor and Wellons (1998) provide some alternatives. In their study of Law and Asian
economic development, they focus on collecting information on the time it takes to get
resolution of cases, the willingness to take cases to court, and the fraction of cases that
44
rule against the sovereign. More importantly, it would be useful if we had indicators of
what structural variables at the discretion of policy makers contributed to judicial
efficiency. The historical evidence from developed economies, and the correlation
between common law tradition and some efficiency measures, suggests features such as
constitutions, the distribution of powers among branches of government at the federal
level, the degree of decentralization of federal authority, and the degree of devolution of
power and taxing authority to regional and local levels might matter. More systematic
work would clearly aid understanding.
A third institution to support anonymous investment in firms by diversified
shareholders is information/reputation intermediaries that provide information through
open channels. In most developing economies, the creation of such intermediaries is
likely to rely on using intermediaries headquartered in other countries, creating
conditions to facilitate the entry of foreign intermediaries, or the transformation of
existing closed intermediaries such as banks into producing information for public
purchase. Recent research by Kang, Khanna and Palepu (1999) that uses IBES data on
the extent and accuracy of analyst activity across the world reveals one way to
benchmark such activity. More research is needed here to decide if this is a priority area
for policy making.
Second, improve the effectiveness of legal protections. Theory and empirical
evidence support the contention that the functions of corporate governance are provided
at lower cost when investor protections are stronger, there is judicial efficiency, and there
is information available to anonymous investors. While each institution has value, there is
greater value when they occur together. In other words, the aim of corporate governance
policy reform should not be to increase an index of legal protections alone but to increase
an index that includes an interaction term that measures the effectiveness of legal
protections as I have done in the figures above. Crudely put, if it was equally costly for
policy makers to raise an index of institutional efficiency by one point for legal
protections, judicial efficiency and information, and each institution was at say 2 on a
five point scale, policy makers would get a greater return for their investment if they
raised each by 1, than if they raised legal protections alone by 3. The end level in
effectiveness would be 27 as opposed to 20.
45
A few observations flow from the complementarity of these institutional factors
and the need to consider the interaction of different institutions. The fact that the depth of
complementary institutions differs across countries suggests that efforts to devise a
checklist of legal protections that should be introduced everywhere are misguided. While
there might be a common set of legal protections that countries can aspire to, the specific
legal protections appropriate to a country need to take into account the existing
institutions to be most effective. Where these complementary institutions are very
inefficient, little should be expected from changes in legal protections and scarce policy
attention might be better directed to either developing these complementary conditions or
to other approaches to improve governance. Again, this returns us to a question of
sequencing and the lessons from history.
Recent research hints that positioning judicial authority can enhance legal
efficiency. The work of McCraw (1982) on the history of the US SEC and Johnson and
Shleifer (1999) on regulatory authorities in the Czech Republic and Poland suggest the
value of an independent securities and exchange commission that focuses its scarce
resources on regulating intermediaries rather than the issuers of securities. Effective
functioning also requires that the regulator not abuse this authority. The US experience
suggests the additional value of harnessing the incentives of existing intermediaries and
fostering the development of self-regulating organizations so that concentrated authority
in a regulatorshands does not lead to abuse. Pistor (1999) provides a possible index of
the strength of such institutions.
Third, governance policies should be aligned with the existing state of legal
protections. Institutions are amenable to change, but changing the effectiveness of legal
protections only occurs in the medium to long-run. My reading of the existing evidence,
particularly the privatization evidence, is of large costs associated with a misalignment of
ownership structure with the legal environment. Not only are anonymous, disperse
ownership structures unsustainable, but the recognition of their lack of sustainability
encourages socially wasteful activities. A possible rationale for such an approach, that it
will stimulate an increase in effective legal protections, does not have significant support.
The lesson I draw for countries with weak existing legal protections is of the importance
of identity and concentration to support the functions of governance.
46
The implications for privatization design are to align ownership structure to legal
protections at the time of privatization. With weak legal protections, concentrated
ownership, and owners with identities that facilitate promise fulfillment, (e.g. foreign
owners), despite their weaknesses, are likely to enhance the willingness to invest
resources in firms. The implications for established firms is caution with policies to
transform established ownership patterns. Increasing cash flow ownership and reducing
the gap that might exist between cash flow ownership and voting rights (e.g. limiting
pyramiding) are policies likely to be beneficial. But attempts to move towards disperse
structures are problematic. There are costs with such structures relative to anonymous,
disperse shareholding, but that does not imply that benefits of such arrangements do not
overwhelm these costs where legal protections are weak.
This conservative perspective on ownership is controversial. I do not disagree
with scholars that see in some ownership structures the source of a lack of development.
As Colin Mayer (2000) argues, in developing countries the retention of control in the
hands of political and business oligarchies is probably the single most important
impediment to economic development.” CDL (1999) agree suggesting that family groups
with concentrated structures are the major obstacles to legal reform. If the role of a
limited number of families in the corporate sector is large and the government is heavily
involved in and influenced by business, the legal system is less likely to evolve in a
manner to protect minority shareholders, and more generally to promote transparent and
market-based activities.” But the available evidence is not convincing that efforts to
replace such structures with anonymous owners will be any improvement. In my reading
of existing evidence, the ownership structure is more of a response to the institutional
environment than the source of that environment.
More generally, policy actions that produce marginal improvements in developed
economies, might have opposite effects in economies with poor investor protections.
Simply put, economistsintuition based on the assumption that contracts will be upheld
can be misleading in environments with weak legal protections. This suggests caution
with approaches that suggest one common practice to address governance concerns.
Policy makers are advised to focus on fostering the functions of effective governance
systems rather than creating identical institutions.
47
Consider legislation that raises the costs of takeovers. An economistsintuition is
that such legislation is costly, making it more difficult to overcome the public good
problem associated with monitoring management. In environments with weak legal
protections, as investors in Czech and Russian firms have learned, takeovers can be part
of the problem rather than the solution. Opening up a firm to takeovers can expose the
firm to raiders far more expert at dilution than existing insiders. Moreover, in any
competition amongst raiders, the ones skilled and interested in dilution are always willing
to pay more.
There are also examples from developing economies, where the lowest cost way
to reduce information asymmetries and resolve disputes could easily be within groups or
banks rather than a marginal change in information intermediaries. For example, it is
costly to introduce information intermediaries that provide open information, for there
may be insufficient demand for services to just perform one role or indivisibilities in
scarce management talent. If an intermediary attempts to perform multiple roles, their
ability to do so will be downgraded by the markets concern over conflicts of interest.
Banks or other networks can use information internally with less concerns about conflicts
of interest (although they need not do so). In Germany for example, there has historically
been no active corporate bond market for medium sized firms. Instead, large banks have
floated their own bonds and onlent to medium sized firms using their own internal
information on firms to evaluate their reliability. At some stages in development, such an
approach appears to be a much cheaper way to address this function.
Fourth, there is scope for improvement in corporate governance policies in
countries with weak legal protections. When one sees the goal of governance policy to
enhance promise fulfillment, a range of additional actions can be considered. That there
is scope for improvement is revealed in the data. I started this paper talking about the
governance problems with oil and gas companies in Russia and the discounts of market
value relative to worthof 30-556 times. What I did not mention was that another
Russian company in the same industry, Lukoil, had a significantly lower estimated
discount of market value relative to worth. Black et. al (1999) report this to be only 7.5
times ($6 billion market/ $45 billion worth). While it remains to be seen what Lukoil
does differently so that the market increases its estimate, what is clear is that if such
48
practices could be identified and transferred the gains are astounding. The combined
value of Gazprom and Yukos alone would increase by $ 67 billion if they could improve
to this discount.
An approach that has worked in countries with weak legal protections is to
identify domestic companies with well functioning foreign networks. An important
example of this is efforts to piggyback on legal protections of established economies by
having domestic companies cross list their shares on foreign exchanges. The firm is no
longer anonymous, but has identified itself with a foreign exchange. When foreign
companies list on US stock exchanges, for example, they are required to comply with
international accounting standards and to increase their information disclosure. Equally
as important, this exchange presumably has the incentive to delist the firm if they violate
their commitments to the exchange. This has costs when the firm values the option to
raise future capital and has limited other windows to international capital sources. By
allying themselves with the exchange, they enhance beliefs about promise fulfillment.
Investors and firms are apparently pleased with foreign listings. Reese and
Weisbach (2000) provide evidence that more capital is raised with subsequent share
issues, both through the US and through domestic markets. The extent of the increase in
listings is greater for countries with weak legal protections. Johnson and Shleifer (1999)
emphasize the growth of the Neuer Markt in Germany, a creation of the Frankfurt stock
exchange with higher listing requirements, that has served as the vehicle for many new
listings both in Germany and from surrounding countries. Interestingly, privatized firms
have led the way in cross listing. Most of the privatized foreign companies that have
pursued share issues rather than asset sales have included a tranche listed on a western
stock exchange.
While the early evidence is promising, limitations to this approach must also be
noted. This approach is of little help for remaining competing claims over the wealth
generated by the firm. Disputes are still resolved in the firmsdomestic court that faces
problems of judicial inefficiency. The experience with shares of Chinese companies
floated on the Hong Kong stock exchange (so called H shares) is cautionary. Despite the
greater disclosure rules from listing in this more transparent exchange, this did not stop a
number of firms from violating terms of their prospectus to the detriment of minority
49
shareholders. In addition, questions emerge about the penalties associated with delisting.
This is only a significant penalty if those in charge of the firm value the continued access
to finance through that channel, and if they think delisting from one foreign exchange
will eliminate their possibilities of listing on other foreign exchanges. There are multiple
possible listing sights and little coordination at present.
A second way forward is to foster the development of domestic networks that offer
a reliable channel to follow promise fulfillment with sure penalties. Business associations
are one such potential channel to improve information and penalties when courts are
arbitrary or unlikely to side with investors. They have the potential to collect information
and to impose penalties upon their members, particularly if business associations require
a large bond to join the association and if continued membership is valuable. In that
circumstance, investors need only to know of a firmsmembership to increase their
beliefs that their promise will be upheld.
This approach also has its limits though. An investor is likely to have legitimate
doubts that an association will truly impose penalties on its members for non-compliance.
There are legitimate questions about the possible strength of such incentives. There is
also an incentive for firms that have no interest in complying to pretend to comply, for
example forming a competing business association. Where such mimicking is possible,
and the real characteristics are only known in the long run, this will undermine the
prospects for such business associations.
5 Conclusions
Policy makers are right to concern themselves with systems of corporate
governance. The evidence suggests that when the functions of a corporate governance
system are not provided, or provided at high costs, promises are violated, resources for
new investment projects dry up with resulting costs for growth and development.
This paper has suggested the value of approaching the question of corporate
governance reform with the functions of corporate governance in mind, not specific
institutions. The functional perspective leads to two main points. First, little can be
expected from reforms that take one common set of legal protections and apply them in
many countries. Legal protections are insufficient to provide the functions of
governance. Effective legal protections require complementary institutions, from
50
structural restrictions on the sovereign, to social norms, a carefully designed delegation of
judicial authority, and a surprising depth of information and reputation intermediaries.
Second, adopting governance policies without an appreciation of the existing state
of effective legal protections can be extremely costly. This is clearly demonstrated with
ownership structure. Evidence shows that disperse shareholding is unsupportable in
countries with weak legal protections, and privatization evidence from transition
economies indicates the costs with mis-aligning ownership structure with legal
protections. Ownership structure can substitute for legal protections in providing the
functions of corporate governance.
There are great possibilities to tie the grabbing handsof public and private
actors in private sector firms. Keeping the functions in mind is a worthwhile place to
start.
51
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Source: Survey of industrial firms (excluding new enterprises) with over 200 employees, EBRD (1999), Chart 9.3
Chart 1- Restructuring and Ownership concentration
0 10 20 30 40 50 60 70 80 90
Over 10% workforce
reduction
Discontinuation of a
product line
Major reorganisation
Upgrading of technology
New product line
Sales increase
Export increase
Employment increase
Percentage of firms reprting activity over last three years
Firms with more than three shareholders
Firms with at most 3 shareholders
56
Chart 2 - Ownership Type and Restructuring
Central and eastern Europe and Baltics
0 10 20 30 40 50 60 70 80 90
Over 10% workforce reduction
Discontinuation of a product line
Major reorganisation
Upgrading of technology
New product line
Sales increase
Export increase
Employment increase
Percentage of firms reporting activity over last three years
foreign-owned privatized domestic state-owned
57
Commonwealth of Independent States
0 10 20 30 40 50 60 70 80 90
Over 10% workforce
reduction
Discontinuation of a
product line
Major reorganisation
Upgrading of technology
New product line
Sales increase
Export increase
Employment increase
Percentage of firms reporting activity over last three years
foreign-owned privatized domestic state-owned
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