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					                          Private Profit or Public Purpose?
                   Shallow Convergence on the Shareholder Model

           Abstract:
           Evidence from twelve countries between 1989 and 1999 with an equity
           capitalization of $10.6 trillion suggests “shallow convergence” on the
           Anglo-American model of minority investor protections. There has been
           widespread reform of information and management practices but minimal
           adoption independent oversight or contests for control. Private
           blockholders and employee-managers have done little to support these
           minority investor protections, however, and have resisted these changes in
           many cases. Instead, process tracing of regulatory changes in these
           countries points to the state as the prime mover of governance reforms,
           motivated by the privatization of state-owned enterprises, moral hazard
           losses from poor governance, and pension funding costs.

What is causing corporate governance practices around the world to provide
greater minority investor protections – private markets or public purpose? A
sample of twelve European and Asian countries between 1989 and 1999 provides
a partial answer to this question, with a surprising twist.1 States rather than
private majority shareholders appear to be the engine of change in corporate
governance practices worldwide.

Foreign portfolio investors, largely based in New York and London, doubled
their share of total shareholdings in these countries over the past decade, while
demanding improved minority shareholder protections. On the supply side, over
that same time period, these countries adopted governance practices that provide
enhanced minority investor protections, often referred to for convenience as the
“Anglo-American” governance model. These practices include considerable
reform in information and management incentive practices, and limited adoption
of independent oversight or control institutions. The pattern of conformance
with the Anglo-American model varies widely by country and among
institutions, but the direction of change is unidirectional, towards enhanced
minority protections.

Is the relationship between this wave of foreign portfolio investment and
corporate governance reforms a straightforward process of supply and demand,
reaching a new equilibrium of minority protections in response to share price
incentives? Or is something more complex going on? Above all, what explains



1
 This sample includes six European (Belgium, France, Germany, Italy, the Netherlands, and Spain) and six
Asian countries (China, Japan, Korea, Malaysia, Singapore, and Taiwan), which together account for 42%
of the MSCI Global Market Index weighted by GDP, 27% of the total MSCI market capitalization in
current dollars, and over 75% of the non-U.S. and non-U.K. MSCI market value.
the variation in response to these convergence pressures among the countries in
this sample?

Two Models of Change

Two contrasting models of institutional change can be extracted from the
literature on international governance change. These models are rarely explicitly
invoked, and are usually obscured by the spirited debate whether governance
changes constitute full convergence on the Anglo-American model, shallow
convergence, functional convergence, or idiosyncratic country-level “path
dependence”. The first is the private markets model, and the other I term the public
purpose model.

In the private markets model, familiar to economists and widely assumed by
most financial professionals, the chain of causation that leads to changes in
governance practices begins with foreign portfolio investment (FPI), on the
demand side. These global investors pay a premium for shares in firms with
good governance. This price premium provides private blockholders with an
incentive to supply enhanced minority protections in exchange for higher
valuation by foreign investors, adopting better governance practices at the level
of the firm while lobbying their governments for regulatory reform.




The public purpose model starts the same way, with the FPI premium for
improved minority shareholder protections. But the state is the prime mover in
governance changes, rather than private blockholders. The government adopts
formal changes in governance practices because it is primarily motivated by the
prospect of proceeds from privatizing state-owned enterprises (SOE’s), moral
hazard losses, and pension funding problems. These enhanced minority
shareholder protections impose a “tax on blockholders” by making it harder for
them to extract private benefits of control, thereby inducing a gradual process of
reluctant governance reforms on the part of private blockholders. In this model,
the chain of causation between demand for enhanced minority protections and
the supply of reforms is more variegated, follows several pathways, and initially
has a public rather than private actor on the supply side.
Each of these models invokes different theoretical arguments and empirical
evidence from the corporate governance literature in specifying the causal link
between financial globalization and governance changes, although they both
begin with FPI and result in changes in corporate governance.

In the next section I briefly summarize the evidence linking FPI and changes in
corporate governance practices. I then examine the theoretical underpinnings of
each causal model, comparing the predictions of the private markets and public
purpose models with evidence from the sample. The paper ends with a brief
discussion of the theoretical and public policy implications of these findings.

The Wellspring of Good Governance

Both causal models share the premise that Anglo-American investors control the
bulk of global equity flows, carrying their preferences for minority investor
protections with them when they go abroad. Table 1 shows that these United
States (U.S.) and United Kingdom (U.K.) investors account for three-quarters of
the financial asset pool and 87% of all equity holdings among the “Big Five”
economies.

Table 1 : Institutional Investor Size, 1999 ($ billions)2

Country                Total Assets    % in Equity     Share of Total Equity
U.S.                   $15,800         .45             .72
U.K.                   $2,200          .67             .15
Japan                  $3,200          .19             .06
France                 $1,200          .30             .04
Germany                $1,200          .19             .02

It is also clear that the foreign ownership as a percentage of market capitalization
in the twelve countries in question almost doubled from 11.2 in 1989 to 21.2 in
1999. Table 2 shows the growth in FPI ownership of the total value of each
country’s market capitalization over the decade period. As a result, money-

2
   Carolyn Brancato, “International Patterns of Institutional Investment,” The Conference Board
Institutional Investment Report, April 2000, page 9.
managers in New York and London became minority shareholders with, on
average, a fifth of the control rights over all traded firms in these sample
countries, in a relatively short period of time.

Table 2: Changes in Foreign Equity Ownership


                         50



                         45


                                                                                                                     Belgium
                         40
                                                                                                                     China

                         35                                                                                          France

                                                                                                                     Germany
                         30
                                                                                                                     Italy
               FPI (%)




                         25                                                                                          Japan

                                                                                                                     Korea
                         20
                                                                                                                     Malaysia

                         15                                                                                          Netherlands

                                                                                                                     Singapore
                         10
                                                                                                                     Spain

                                                                                                                     Taiwan
                          5



                          0
                          1988   1989   1990   1991   1992   1993   1994   1995   1996   1997   1998   1999   2000
                                                                    Year




The value of stock markets in these countries soared during this period of FPI
influx. The market capitalization of traded equities in these countries trebled in
percentage terms from 1989-99 – a stunning increase in wealth, from $4.4 trillion
to $10.6 trillion (in current dollar equivalents).

Minority Protections and the Good Governance Premium

However, the governance literature provides conflicting conclusions about how
minority shareholder protections affect firms’ financial performance by reducing
either agency or expropriation costs, and whether these institutional protections
are reflected in higher or lower share prices.3

Most of the empirical work so far uses data from the United States, where there
is increasing support for the proposition that minority investor protections do
improve firms’ financial performance and, by extension, share prices.4 For
example, a recent study by Gompers et.al. found a significant correlation between

3
  This literature is summarized in several surveys including Andrei Schleifer and R. Vishny, 1997, “A
Survey of Corporate Governance”, Journal of Finance, 52, 737-83;
4
  Ira Millstein and MacAvoy, 1998, “The active board of directors and performance of the large publicly
traded corporation,” Columbia Law Review, 98.
minority investor protections and stock market valuation, based on an index
including 24 oversight, control, and management institutions for 1500 firms
between 1990 and 1999. Firms in the lower decile of the index (stronger
protections) earned abnormal returns of 8.5% higher than those in the upper
decile (weaker protections).5

Foreign portfolio investors also appear to factor these institutional practices into
share prices abroad, based on statistical, survey, and anecdotal evidence. 6 For
example, a McKinsey survey of two hundred investors found the average good
governance premium for a sample of twenty-two countries to be 21.6%, with a
low of 17.9% and a high of 27.6%; for the ten countries used in this paper’s
sample, the average premium was 20.9%.7 Mitton analyzed a sample of four
hundred firms in Korea, Malaysia, the Philippines and Thailand before and after
the Asian Financial Crisis of 1997-98 and found statistical evidence for a 12%
premium valuation on firms that had adopted superior information institutions;
moreover, firms that followed these two information practices came through the
perturbations of the Asian Financial Crisis trading at a 58% premium over those
Asian firms that did not follow these practices.8

However, there remain formidable obstacles to using the tools of statistical
inference to establish a causal link between the governance practices of
individual countries and the value of their firms as measured by either abnormal
share returns or some other proxy for valuation, such as Tobin’s Q. Much of the
reported financial data from firms is spotty and use different accounting
practices. So many independent variables affect country stock market valuation
that the effects of corporate governance practices are easily lost in the “noise”.
Moreover, there is only a small number of countries with reliable data, which
therefore limits the power of statistical tools to extract the impact of corporate
governance practices on share prices. As a result, both the private markets and
public purpose models stand on shaky empirical ground on this point, with
much econometric work still to be done.

5
   Paul Gompers, Joy Ishii, Andrew Merrick, “Corporate Governance and Equity Prices”, NBER Working
Paper 8449, August 2001, www.nber.org/papers/w8449. The authors make no claims about the arrow of
causation between good governance and performance, however.
6
   Stephen Davis, “Leading Corporate Governance Indicators: An International Comparison,” November
1999, www.dga.com; Sang Yong Park, “Value of Governance of Korean Companies: International
Investors Survey,” manuscript, April 1999.
7
   Robert Felton, Alec Hudnut, and Jennifer van Heeckeren, “Putting a value on Board Governance,” The
McKinsey Quarterly, No. 4 (1996); McKinsey Investor Opinion Survey, June 2000, www.gcgf.org. In this
survey, “good governance” was defined as a majority of outside directors, extensive disclosure, and use of
stock options for directors – a rather narrow range of governance institutions.
 8
   Todd Mitton, “A Cross-Firm Analysis of the Impact of Corporate Governance on the East Asian Financial
Crisis,” MIT manuscript, 3/15/2000. In these tests of the effects of information institutions, Mitton
controlled for firm size and financial leverage, and included both country and industry dummy variables,
with a sample size of 384 firms based on Worldscope data.
The Shifting Terrain of Governance

In the face of this presumed “good governance premium” offered by foreign
portfolio investors, the pattern of conformance in governance practices is
remarkably varied, although                         Table 5: The Shifting Terrain of Governance
the direction of change is                       INFORMATION
                                             Accounting   Audit
                                                                       OVERSIGHT
                                                                      NED      Duty
                                                                                            CONTROL
                                                                                       Voting Takeover
                                                                                                        MANAGEMENT TOTAL
                                                                                                           Incentive

consistently    towards      the Belgium
                                   China
                                                                                                                       2
                                                                                                                       0
Anglo-American model. The France   Germany
                                                                                                                       3
                                                                                                                       1
three charts in Table 5 Italy      Japan
                                                                                                                       0
                                                                                                                       1
operationalize seven corporate Korea
                                   Malaysia
                                                                                                                       0
                                                                                                                       3
governance     institutions   in Netherlands                                                                           1
                                   Singapore                                                                           4
terms of their conformance to Spain                                                                                    0
                                   Taiwan                                                                              0
the            Anglo-American TOTAL               0         5          3        2         4          0         1       15

governance model in a series of GROUP TOTAL
                                   % Conform    0.0%      41.7%      25.0%    16.7%     33.3%      0.0%      8.3%    17.9%
                                                            5                   5                    4         1

“snapshots” taken in 1989, % Conform                      20.8%               20.8%               16.7%      8.3%


1994, and 1999.9 Shaded boxes                              Corporate Governance Conformance: 1994
                                                 INFORMATION           OVERSIGHT           CONTROL      MANAGEMENT TOTAL
indicate     protection     for Belgium      Accounting   Audit      NED      Duty     Voting Takeover    Incentive
                                                                                                                      2
minority investors in line with China                                                                                 1
                                 France                                                                               4
the expectations of Anglo- Germany                                                                                    1
                                 Italy                                                                                0
American investors, and white Japan                                                                                   1
                                                      Korea                                                                      0
                                                      Malaysia                                                                   5
                                                      Netherlands                                                                3
9                                                     Singapore                                                                  5
  Accounting systems are coded 1                      Spain                                                                      1
(black box) if a majority of the listed               Taiwan                                                                     1
                                              TOTAL           4          8         3        2          4         0         3     24
firms use GAAP or IAS in their                % Conform     33.3%     66.7%      25.0%    16.7%     33.3%      0.0%      25.0% 28.6%
reporting, or if the deviations of the        GROUP TOTAL               12                  5                    4         3
country’s domestic accounting                 % Conform               45.8%               20.8%               16.7%      25.0%
                                                                       Corporate Governance Conformance: 1999
systems from IAS are minor. The                              INFORMATION          OVERSIGHT            CONTROL      MANAGEMENT TOTAL
former datum is taken from the                            Accounting Audit      NED       Duty    Voting Takeover     Incentive
                                              Belgium                                                                             2
reports of country stock exchanges            China                                                                               1
or survey agencies; the latter is based       France                                                                              5
on the opinions of professional Big           Germany                                                                             3
                                              Italy                                                                               3
Five auditors interviewed by the              Japan                                                                               2
author. Audit is coded 1 if third-party       Korea                                                                               5
                                              Malaysia                                                                            6
audit is a listing requirement.               Netherlands                                                                         3
Oversight is assigned using the mean          Singapore                                                                           6
                                              Spain                                                                               3
percentage of non-executive directors         Taiwan                                                                              3
on the boards of listed firms; where          TOTAL            8       10         5        6          6         0         7       42
NED’s are a majority, oversight is            % Conform
                                              GROUP TOTAL
                                                            66.7%    83.3%
                                                                       18
                                                                               41.7%     50.0%
                                                                                           11
                                                                                                   50.0%      0.0%
                                                                                                                6
                                                                                                                        58.3%
                                                                                                                          7
                                                                                                                                50.0%

coded 1 (except for Germany and the           % Conform              75.0%               45.8%               25.0%      58.3%
Netherlands). Fiduciary duty is coded 1 if directors’ liability to minority shareholders has been enforced in
the courts on the basis of derivative or class-action suits. Voting rights is coded 1 if the principle of “one
share one vote” is observed in practice, in terms of statutory rights and procedures. If more than 50% of the
listed firms employ significant anti-takeover provisions, the box is coded 0. Incentive is coded 1 if the sum
of performance bonus and stock options exceeds 10% of total pay, based on a Towers & Perrin survey.
These conformance rankings are consistent with those of Davis Global Advisors and similar to those
performed by Déminor, with a few exceptions. For a discussion of the pitfalls of governance rankings, see
Eric Coppieters, “The Governance Scorecard” and “Governance Ratings in Europe”, Corporate
Governance International, March 2001.
boxes indicate little or no such protection. These rankings are based upon the
best data and indices available, although prone to error and an element of
subjective judgement.10

 As summarized in Table 6, on a country basis, the average conformance level for
this sample almost trebled over the decade, from 18% to 50%. By1999, the sample
ranged from a low of 1 (China) to a high of 6 (Singapore). The average
conformance for the Asian countries as a group was slightly higher than those of
the European countries in the sample. Two-thirds of the changes took place in
the five years between 1994-99.

Table 6: Conformance Level Summary

                                Conformance Levels               Changes in Conformance Levels
                             1989      1994      1999             89-94      94-99     89-99
         Belgium                   2         2         2                0           0         0
         China                     0         1         1                1           0         1
         France                    3         4         5                1           1         2
         Germany                   1         1         3                0           2         2
         Italy                     0         0         3                0           3         3
         Japan                     1         1         2                0           1         1
         Korea                     0         0         5                0           5         5
         Malaysia                  3         5         6                2           1         3
         Netherlands               1         3         3                2           0         2
         Singapore                 4         5         6                1           1         2
         Spain                     0         1         3                1           2         3
         Taiwan                    0         1         3                1           2         3
         Total                    15        24        42                9          18        27
         Mean                   1.25      2.00      3.50
         Avg %                  0.18      0.29      0.50
         Europe %               0.17      0.26      0.45
         Asia %                 0.19      0.31      0.55
         Eur changes                                                   4.00        8.00        12.00
         Asia changes                                                  5.00       10.00        15.00




Looking at institutional practices rather than countries, conformance levels for
accounting and audit practices increased from 20% to 75%, in both Asia and
Europe. Conformance oversight doubled, from 21% to 46%. There was little
change in voting rule conformance, from 33% to 50%, and zero change in
takeover rules, reflecting a blanket refusal to adopt the institution of market-

10
   The author tracked down the causes of changes in governance institutions in each country based on 120
field interviews with investors, financiers, private blockholders, managers, and government officials during
2000-2001. As a professional manager and then as an outside director, the author incorporated or managed
a firm in 9 of the 12 countries in the sample, and therefore had access to a network of bankers, attorneys,
accountants, and search firms with whom to verify both institutional practices and the proximate source for
these changes.
based contests for control, a.k.a. hostile takeovers, in both the Asian and
European sample. The practice of using long-term incentives (principally stock
options) for managers increased dramatically, from 8% to 58%.

In sum, there is reasonably good empirical support for the argument that foreign
portfolios pay a price premium for shares in firms and in countries with better
minority shareholder protections. The weight of FPI has increased substantially
in this sample, and the pattern of conformance to the Anglo-American model
apparently reflects this price incentive at work, although with considerable
variation between countries and among institutions.

What drove this process of change– private markets or public purpose? The
private markets and public purpose model provide different explanations for
what links the FPI governance premium and the pattern of changes in these
conformance levels.


The Private Markets Model

According to the private markets model, the prime movers on the supply side of
governance reform are the majority shareholders (“private blockholders” in
governance parlance) who control most publicly-traded firms abroad. Prior to the
influx of FPI, private blockholders and employees supported domestic
governance practices that allow the former to extract expropriation costs and the
latter to extract agency costs from the firm, both at the expense of minority
shareholders.11 Face with the potential good governance premium from FPI,
private blockholders defect from this arrangement and trade their private
benefits of control for higher valuation by FPIs. Private blockholders encourage
professional managers support these new practices (and abandon any sense of
solidarity with line employees) by means of stock options that align them with
the shareholders rather than other employees.

Blockholders then ensure that firms adopt informal best practices where they
can, such as enhanced disclosure and independent oversight, while lobbying the
state for formal regulatory where governance practices are fixed by statute. The
state is a passive agent of voters and special interests (such as private
blockholders). The agent state responds accordingly to lobbying pressures by
these private principals: formal governance regulations gradually change to
provide enhanced minority investor protection. Private blockholders gradually
sell down their concentrated holdings to portfolio investors, trading their private
benefits of control for higher valuation.
11
 See Marco Pagano and Paolo Volpin, “The Political Economy of Corporate Governance,” paper
presented at the European Corporate Governance Network, 10/99.
Predictions and Evidence

How well does the private markets model hold up to the evidence from this
twelve-country sample? Is there evidence of private blockholders accepting a
“good governance” deal from FPIs?

Recent studies on underlying ownership suggest that private blockholders do
control a large percentage of listed firms (weighted by market value) in most
countries in this sample.

Table 7: Ownership Pattern (%)12

Country         Private Blockholder               State            Employee-Manager

Belgium         47                                13               40
China           0                                 100              0
France          50                                20               30
Germany         40                                20               40
Italy           80                                10               10
Japan           8                                 2                90
Korea           68                                5                27
Netherlands     20                                10               70
Malaysia        60                                25               15
Spain           30                                30               40
Singapore       60                                30               10
Taiwan          65                                5                30

Mean            44                                23               33
2              25                                26               25

Compared to the mean value of the sample, three countries are clearly
dominated by private blockholders: Italy, Korea, and Taiwan. Many of the
Korean corporate groups, or chaebol, show small nominal ownership percentages
by the controlling family; but when the veil of indirect control is pierced, the
underlying pattern of concentrated family control is revealed – over two-thirds
of the market value is in the hands of a few families. Singapore and Malaysia also
have high private blockholder concentrations, mostly in the hands of a small
12
  European cases are based on data collected by Christoph van der Elst, “The Equity Markets, Ownership
Structures and Control: Towards International Harmonization?” Universiteit Gent Working Paper 2000-04,
9/2000; European Corporate Governance Network, www.ecgn.org; Marco Becht and Colin Mayer, The
Control of Corporate Europe, forthcoming; and Becht and Boehmer, op. cit. The Asian cases are based on
data collected by Claessens op. cit. plus papers from the OECD Forum on Corporate Governance in Asia
and the author’s own calculations.
number of Overseas Chinese (hua qiao) families, coexisting with a large state-
controlled sector.

Belgium, France, and Germany are above the mean for both private blockholders
and manager-controlled firms, with a relatively small state-owned sector. Spain
is an ambiguous case, close to the mean for all three ownership types. In China
the state dominates as the ownership type, while Japan and the Netherlands are
dominated by manager-controlled firms. In Japanese manager-controlled firms
there is ultimately no private shareholder, no blockholder, with a motive or
means to maximize shareholder value.13 This suggests that for at least 3 and
possibly 4 country cases in the sample, private blockholders are too few or
simply absent as a engine for change in corporate governance practices, as
assumed by the private markets model.

For the 8 countries that do have a weight of private blockholders above 40%, the
private profit model predicts that private blockholders will unilaterally adopt
good governance standards for informal institutions they can control at the firm
level and then lobby their governments for changes in formal institutions. This is
not borne out by evidence from sample. Table 8 ranks governance institutions by
increasing formality. Firms are free to innovate in the first three areas; the latter
four require formal changes in government statutes. The rate of change is equal
in both groups of practices, with no discernable pattern of informal change
preceding formal changes.

Table 8: Informal and Formal Change (units, from table 4)
Institution                   1999 Conformance            1989-99 Change

Informal Practices (set by management norm)
Management: incentive compensation 5                                          4
Oversight: outside directors              5                                   2
Control: anti-takeover devices            0                                   0

Formal Practices (set by government statute)
Information: audit                          7                                 3
Information: accounting systems             7                                 7
Control: voting                             5                                 2
Oversight: fiduciary responsibility         5                                 3


13
   “Cross-shareholdings have altered the concept of the stock company in Japan. They have freed
management substantially from the influence of shareholders. Stable shareholders are selected by and are
dependent on management, and cannot therefore play a disciplinary role on corporate management…..This
leaves the main source of disciplinary pressure coming from the need to satisfy employees.” Seiichi
Masuyama, “The Role of Japanese Capital Markets” in N. Dimsdale and M. Prevezer, editors, Capital
Markets and Corporate Governance, page 334.
Digging deeper into the country cases, there is little evidence that private
blockholders lobbied the state for governance changes, either singly on a
collective basis. For every country in this sample in which business firms engage
in collective lobbying through a group such as the Federation of Korean Industry
(FKI), Germany’s Bundesverband der Deutscher Industrie (BDI) or Spain’s Circulo de
Empresarios, these collective business entities have been passive or hostile with
regard to corporate governance reforms, despite active lobbying across a wide
range of other regulatory issues. Business federations have been most hostile to
governance reforms in the three countries with the highest concentration of
private blockholders: Italy (80%), Korea (68%), and Taiwan (65%).

As for the private market model’s prediction that private blockholders should
incrementally liquidate their concentrated holdings to take advantage of the FPI
premium for good governance, there is no evidence of this taking place in any
country in the sample. Although confirmation of changes in the portfolio
concentration of private blockholders must wait until a second round of control
studies in Europe and Asia provides a second set of data points, scattered and
anecdotal evidence for this twelve country sample suggests no liquidation of
control by private blockholders. In Korea, the top thirty chaebol blockholders
have increased their concentration within affiliated groups in recent years, in the
face of pressure from the state and incentives from FPI to do so. 14 Anecdotal
evidence from Italy, Taiwan, Malaysia, and Singapore shows no signs of large
private blockholders reducing their holdings in order to profit from higher FPI
valuation; on the contrary, as in Korea, many owner-families have been
concentrating their ownership holdings. Nor have private blockholders of
established firms in any of the European countries in this sample engaged in a
sell-down to FPI’s - though some have sold out to multinational corporations or
to private equity funds.15

No-go on the Good Governance Deal

What explains this apparent failure of private blockholders to accept the “good
governance deal” from FPI’s? Either blockholders were not motivated to adopt
governance reforms because the private benefits continued to outweigh the FPI
valuation benefits, or the blockholders were motivated to accept the “good
governance deal” but were unable to press through governance reforms for other
reasons.

14
   Myeong-Hyeon Cho, “Corporate Governance in Korea”, paper for UCSD Conference on Corporate
Restructuring in Korea, 10/2000.
15
   The ownership pattern data presented in Table is static - essentially a snap-shot, drawn for this sample
from the first wave of ownership disclosure in Europe and Asia that began in the mid-1990’s. Until this
analysis is repeated to provide at least a second set of more recent data points, it will not be clear how much
ownership concentration has changed overall, and thus whether liquidation has taken place.
It is possible that private benefits are extremely hard to replace with higher
market valuation, for a combination of tax, psychological, and uncertainty.

The good governance deal exposes the private blockholder to the tax collector,
whereas private benefits can be hidden or routed through offshore tax havens.
Anecdotal evidence suggests that many of the countries with the highest private
blockholder weights also exhibit patterns of capricious taxation by the authorities
and widespread tax evasion by business owners, as in Italy, Korea, Malaysia,
Spain, and Taiwan.

Stock market valuation can motivate blockholders with money, but it cannot
compensate blockholders for the psychological benefits of control, in terms of
prestige, nationalism (as in the case of the chaebol founder-chairmen whose firms
built the Korean “economic miracle”), or the satisfaction of placing children into
jobs in the family firm.

The good governance deal involves a good deal of uncertainty. Stock markets
themselves can be capricious, and blockholders observed the rapid run-up and
abrupt crash of emerging market valuations during the latter half of the 1990’s,
which increased the discount rate they assigned to the “good governance deal”.
In contrast to these market uncertainties, although the private blockholder is
exposed to high firm risk because of his concentrated holdings, he also has the
benefit of insider knowledge and (usually) accumulated expertise in his
industrial sector. Moreover, since many blockholders control a horizontally
diversified group of firms – with some family firms in Asia holding horizontal
interests in industries including flour milling, semiconductors, and banks – the
portfolio gains from the good governance deal may be limited.

If on the other hand these problems can be circumvented and private
blockholders are still motivated to accept the “good governance deal”, as
predicted by the private markets model, they still face a formidable transactions
problem in selling off ownership in small increments to foreign portfolio
investors while recovering the control premium. For a smooth transition to take
place, the blockholder must issue a credible promise not to steal from the firm,
and the FPI’s must promise to compensate the blockholder for giving up those
private benefits of control – in effect, paying a premium over the current value of
traded minority shares in that firm. If done in small increments, the marginal
transaction that transfers control from the blockholder to the new minority
investor must carry a price that embodies all the private benefits of control – a
big price tag. No rational minority investor will enter this transaction, since all
the previous shares were acquired at the lower traded price. Yet without such a
price premium, no rational blockholder will sell to the point where control is
threatened.
Unless this transaction problem is solved, blockholders’ support for the “good
governance deal” may grind to a halt at the transfer of the 51st percent of control,
leaving the private blockholder in charge and minority shareholders still
exposed.

Private Blockholders’ Collective Action Hurdle

Even if blockholders are motivated to accept the governance deal and find a way
around the control transactions problem, they encounter two collective action
problems that may explain their apparent inaction in supporting governance
reforms. The first problem is trust. In a market dominated by other blockholders
and with weak governance institutions to protect minority shareholders, what
blockholder will be brave enough to go first, adopting good governance
institutions that limit his own private benefits, and exposing himself to
expropriation as a trusting minority shareholder?

If the solution to “who goes first” is collective lobbying for governance reform
through the industrial federation, which binds all blockholders to the same new
rules, the private blockholders must contend for control of the business
federation with the professional managers of semi-privatized state-owned
enterprises (SOE’s) and large manager-controlled firms. These are usually larger
than private blockholder firms and more skilled at interfacing with the
bureaucracy, and they tend to dominate the agenda of big business federations in
many economies, exhibiting only limited sympathy for the efforts of private
blockholders to change the governance rules to enrich themselves.

For example, in France, blockholders engaged in an extended struggle for control
of the corporate governance agenda of the Mouvement des Éntreprises de France
(MEDEF) with professional employee-managers, especially the cadre of state
managers known as “ENArchs”, a term for graduates of the elite schools such as
the École Nationale d’Administration (ENA) who move back and forth between
government posts and managerial positions in the state sector. German
blockholders also failed to mobilize the Bundesverband der deutscher Industrie
(BDI) in the pursuit of corporate governance reforms, in the face of resistance by
the Big Three banks and a handful of large firms controlled by managers.

On balance, the evidence from this twelve country sample does not support the
predictions of the private markets model, and most of the anecdotes suggest that
the “good governance deal” between FPI and private blockholders never made it
past the first stage, blockholders apparently deciding that the private benefits of
control continue to outweigh the gains from higher valuation. If the evidence
does not support the private markets model at work, then how are we to account
for the remarkable shifts in the governance terrain in this twelve country sample?

The Public Purpose Model

According to the public purpose model, the changes on the supply side of
corporate governance are driven by the state – an active state, not a passive
“agent” state, and a state with vital stakes in corporate governance practices.

From the standpoint of governments – defined as the bureaucratic elites who
calculate budgets and the politicians who must submit these budgets (and taxes)
to voters – corporate governance reforms in the direction of the Anglo-American
model provide a partial solution to the fiscal squeeze faced by all the countries in
this sample over the last decade. The state’s motives for supporting the Anglo-
American model include income from the privatization of previously state-
owned enterprises, moral hazard losses from poor governance (especially in the
financial sector), and the funding of state pension plans. The state was
transformed from being a passive agent by the fiscal costs that poor governance
imposed on national budgets – a hard budget constraint.

The data presented in Table 6 demonstrate that the state remains an important
controlling owner of listed companies, a public blockholder, in ten out of twelve
countries in the sample, even after fifteen years of privatization.

Public Blockholders’ Incentive Problems

It is important to point out that the “public purpose” that drives governance
reforms is not some altruistic sense of good government, but rather the urgent
desire of politicians to be re-elected and the equally intense affection of
bureaucrats for keeping their jobs. The state as blockholder exhibits a peculiar
owner’s incentive problem. Though ownership of a state-owned industrial
enterprise or bank is nominally held in the name of “the people,” as a practical
matter SOE’s are held by bureaucratic agencies, often multiple agencies, under
the ultimate control of politicians. Politicians have many objectives in addition to
maximizing the value of the state’s blockholding of an SOE, and thus the state’s
response to the FPI good governance deal reflects a mix of personal and public
policy motives. SOE’s provide politicians with patronage, excess employment
(for which they can take credit), and political contributions or outright bribes.
These are the equivalent of the private benefits of control, against which
politicians must weigh the appeal of the FPI good governance deal.

Predictions and Evidence
The public purpose model predicts that the rate of change in governance
institutions should be proportional to the intensity of the fiscal squeeze on the
government in each country, and that reforms which enhance minority investor
protections should follow rather than precede periods of fiscal adversity. These
governance reforms should be pioneered in the state-controlled sector, either by
SOE’s or among state-controlled banking institutions, rather than in the fully
private sector, and process-tracing of individual reforms should find the state
driving through these reforms in the face of opposition from private
blockholders and employee-managers alike.

Every country in this sample witnessed a program of corporatisation and partial
privatization of SOE’s, a program that began in the 1980’s and picked up speed
during the 1990’s. Partial privatization (perhaps “corporatisation” is a more
accurate description) was an attractive way out of this squeeze in every country,
not only because it reduced the drain on fiscal budgets that came from
subsidizing poorly-performing SOE’s, but also because it provided a fast way for
states to raise cash without raising taxes. For every country, the privatization
process preceded governance reforms pushed through by the state.

Table 9 compares the cumulative value of SOE share initial public offerings
(SIPO’s) for the twelve country sample between 1989 and 1999 to cumulative
government expenditure and fiscal deficits over the same period.

Table 9: Revenues from SOE Share Offerings16

                SIPO's IN STATE FINANCE, 1989-1999
                                  SIPO      SIPO/Exp    SIPO/Deficit
                    Country
                                 ($mn)         (%)          (%)
                Belgium               1,100        0.11           1.2
                China                 9,494        0.95          10.7
                France               41,999        0.78           7.9
                Germany              15,170        0.23           4.4
                Italy                59,457        1.51           6.4
                Japan                42,852        0.71           6.4
                Korea                 7,250        1.08          15.6
                Malaysia              3,773        2.09          57.5
                Netherlands           9,365        0.69            11
                Singapore             2,568        1.97         n/a
                Spain                37,085        2.94          16.3
                Taiwan                2,574        0.81         n/a




16
   Fiscal data from IMF Government Finance Statistic Yearbook, 2000; SIPO revenues from William
Megginson,      Appendix    Detailing     Public     Share   Offerings 1961-2000,   http://faculty-
staff.ou.edu/M/William.L.Megginson-1, author’s calculations.
         The states in this sample obtained a total of $231 billion in cumulative SIPO
         proceeds between 1989 and 1999. As a percentage of cumulative central
         government expenditure over this same period, SIPO revenue averaged a
         modest 1.2%, with a high of 2.94% (Spain) and a low of 0.11% (Belgium). SIPO
         revenues were a crucial “deficit reduction” measure, plugging on average 14% of
         the fiscal deficit for those governments who operated in the red during this
         period.

         Moreover, these data understate the importance of SIPO revenues to the state,
         since these SIPO’s freed the state from supplying capital funds to these
         corporatised SOE’s. After the state liquidated part of its holdings, these firms
         obtained additional capital themselves from secondary equity offerings, bond
         issues, and loan syndication’s, thereby reducing the cash-flow drain on the state
         budget and the state’s contingent liability as sovereign guarantor of their debts.

         As a result, the state in every country in this sample engaged in a partial sell-off
         of its blockholdings through SOE SIPO’s, a substantial block of which was
         acquired by FPI’s. In parallel, the state implemented a series of top-down
         governance reforms that enhanced minority shareholder protections to attract
         investors to these SIPO’s and maximize the state’s revenue stream from these
         offerings. Change in conformance levels has a .45 correlation with the ratio of
         SOE SIPO’s to state expenditure, as seen in the scatterplot below.




                           2.94                                    Spain




                                                                  Malaysia
                                                     Singapore

SOE Proceeds/State Expenditure
                                                                    Italy



                                                                               Korea
                                            China
                                                      France      Taiwan
                                            Japan   Netherlands



                                                     Germany
                            .11   Belgium

                                  0                                              5
                                                        Change in Governance
For example, Spain began an aggressive program of partial privatization of
SOE’s in the period 1989-99, to offset yawning deficits during the 1990’s and in
the face of the 3% deficit caps imposed by the Maastricht Agreement on the Euro.
The Spanish state raised $37 billion – 3% of the total government budget,
plugging 16% of the fiscal gap - from share offerings of state firms, particularly
utilities such as Telefónica, GESA (Gas y Electricidad de España), Endesa, Repsol,
and Tabaclera, as well as the state-controlled banks. The Ministry of Finance
imposed tougher new audit requirements for listed firms and delegated
accounting standards setting to the quasi-independent Instituto de Contabilidad y
Auditoria de Cuentas (ICAC). With state encouragement, SOE’s pioneered the use
of GAAP or International Accounting Standards (IAS) and Big Five auditors in
these SIPO’s, while pioneering the use of options for managers of privatized
SOE’s, first widely-used by Telefónica.

In Malaysia the state raised 2% of its revenue and plugged 58% of its budget gap
with SIPO’s totaling $3.7 billion over the same period. Malaysia’s SIPO’s began
with the sale of a 30% share in Malaysian Airlines in 1985, followed by larger
transactions in Telekom Malaysia in 1990 and 1992, Tenaga National in 1992,
Petronas in 1995, and Malaysia Airports in 1999. In parallel with these offerings,
the state imposed a series of reforms in information, oversight, and management
practices that gave Malaysia one of the highest conformance rankings in the
twelve country sample.17

In Italy, governance reforms were also imposed by the state, particularly the
Ministry of Finance and the Commissione Nazionale per le società e la Borsa
(CONSOB).18 The Italian government was under intense pressure to meet the
Maastricht guidelines for fiscal deficit caps during the 1990’s, and Italy’s pattern
of SIPO’s corresponds closely to the state’s program of plugging the budget gap
with SIPO revenues, raising $59 billion between 1989-99, the largest amount in
the sample, equal to 1.5% of the entire central government budget for that
decade.


17
   The Companies Act mandates third-party audit, a requirement backstopped by the Kuala Lumpur Stock
Exchange (KLSE). Ninety percent of listed companies have at least two NED’s, and the Malaysian Code of
Corporate Governance has set a minimum of 30% independent NEDs on boards. Malaysia’s legal system
imposes strong standards of fiduciary duty to minority shareholders, and the courts entertain derivative
suits for breach of this duty, although class-action suits are not possible. The obligations of directors are
monitored by the Government Minority Shareholder Watchdog Committee, which along with the Securities
Commission and the KLSE enforces the one-share-one-vote rule.
18
   The Ministry of Finance and a bloc of reform politicians altered the legal foundations of Italian publicly-
traded corporations, or società per azioni, invigorated the Commissione Nazionale per le società e la Borsa
(CONSOB), and privatized the stock exchanges. As a result, information institutions have gradually come
into conformance with international standards of accounting systems, standards setting, and audit. The
1998 changes reduced the ownership threshold by which minority shareholders can bring derivative suits
against the management or blockholders of a publicly traded firm.
The Chinese government began its strategy of corporatisation of SOE’s to raise
revenue for the central government in Beijing, which was perpetually tax-
starved, and to shift the continuing losses of the SOE’s out of the state-owned
banking system by imposing a hard budget constraint, as SOE losses were
estimated at 4-5% of GDP. As a result of a string of SIPO’s during this decade,
many SOE’s were removed from the central government’s books and brought in
revenues equal to 1% of the central budget – thereby plugging 10% of the budget
gap. In order to promote the growth of domestic stock markets and to tap
international equity investors, particularly in Hong Kong, the state engaged in
gradual series of top-down reforms in information institutions that have slowly
begun to bear fruit.19

As in Italy, the French government was under intense pressure to reduce its
fiscal deficits to meet the Maastricht caps in order to qualify for the Euro, a high
priority for the French government for several reasons. SIPO proceeds were a
major factor in the success of the state in shrinking its deficit rate from above 5%
in 1993-94 down to 2.9% in 1998. Ironically, the French state imposed most of the
institutional changes that brought France into conformance with FPI
expectations, even while decrying the growing presence of foreign investors and
the threat they posed to French efforts at industrial structure policy and dirigisme
in general. The changes in information institutions, and to a lesser degree in
oversight and managerial compensation practices, are associated with France’s
systematic program of SOE corporatisation.20

The German state was squeezed by the enormous costs of German unification in
the first half of the 1990’s and by the Maastricht deficit cap in the second half of
the decade. The fiscal deficit in Germany hit –3.3% in 1995 and –3.4% in 1996 -
not as tight a squeeze as France, but still an incentive to liquidate SOE holdings
of $15 billion over this period, equal to 4.4% of the budget. The biggest deal took
place in three steps, between 1996 and 2000, when the state raised a total of $25
billion from the sale of 41% of the equity of Deutsche Telekom. The Deutsche
19
   The China Securities Regulatory Commission (CSRC mandates that listed firms use a third-party auditor
to verify financial statements. In 1993 the MOF issued a regulation on “Professional Qualifications of CPA
Firms,” which began establishing professional standards under the aegis of the China Institute of Certified
Public Accountants (CICPA) and formal licensing by the MOF. All Chinese firms listing on the Hong
Kong and New York exchanges now use a Big Five auditor. China Securities and Regulatory Commission,
Information Disclosure and Corporate Governance in China, paper for the OECD Conference on
Corporate Governance, Hong Kong, pages 8-10; Martin Foley, “Accounting Adjustment,” The China
Business Review, July-August 1998, page 23.
20
   French listed firms, particularly SOE’s, were rapid adopters of IAS for domestic as well as international
reporting: 40% of French public firms use IAS, including over one third of the CAC40 top firms. Third
party audit is mandatory, and widespread, with the Big Five holding the dominant market share and a
reputation for high professional competence. The state also pioneered the use of stock options for managers
in corporatised SOE’s, a practice highlighted in “l’affaire Jaffré”, a scandal in which Philippe Jaffré, the
head of Elf Acquitaine (an SOE), pocketed $56 million in options when Elf was acquired by Total Fina
(another SOE) in 1999.
Telekom transaction was listed on the New York Stock Exchange (NYSE) using
Generally Accepted Accounting Principles (GAAP), triggering rapid adoption of
the GAAP or IAS by leading German firms immediately thereafter and helping
push two sets of financial reform legislation through the Bundestag, the KapAEG
and the KonTraG.21

Moral Hazard Melt-Down’s

The second event motivating these states to push governance reforms was the
mounting price-tag of moral hazard losses in the financial sector during the
1990’s in most of these countries. Corporate governance failures in the financial
sector were one of the root causes of these losses, which were ultimately picked
up by the state.

Prudential regulators wrestled with the peculiar corporate governance problem
of financial institutions, especially banks, in all of these countries. Each flavor of
insider governance poses its own risk to the state as lender-of-last-resort. Private
blockholders are prone to use banks as a private piggy-bank to fund their other
enterprises: this occurred in Belgium, Italy, Korea, Malaysia, Spain, and Taiwan.
The state blockholder does such a poor job supervising managers (due to the
owner’s incentive problem) that risk management fails and loan losses mount:
this occurred in China, France, Korea, Malaysia, Singapore, and Taiwan. Banks
controlled by employee-managers who are unaccountable to stockholders or an
independent board also perform badly at risk management: this happened in
Germany, Japan, and the Netherlands.

Central bankers, prudential regulators, and finance ministerial officials in all of
these countries realized during the 1990’s that outsider governance combined
with prudential regulation (to counter related party lending by private
blockholders) could substitute market discipline for failed insider governance.
This motivated the state to undertake many of the reforms that boosted the
compliance rankings in Table 4.

For example, process-tracing of the burst of reforms in Korean corporate
governance institutions in 1998 indicates that these reforms were rammed
through by the newly-elected Kim Dae-jung government with a thin veneer of
consultation with the blockholders, but essentially unilaterally by the state,

21
  Germany’s company law (the Aktiengesetz) was modified by two comprehensive legal reforms, the Law
on Facilitating Raising Capital (Kapitalaufnahmeerleichterungsgesetz, or KapAEG) and the Law on
Control and Transparency of Corporations (Gesetz zur Kontrolle und Transparenz im
Unternehmensbereich, or KonTraG), both passed by the Bundestag in early 1998. The KapAEG permits
German firms to use IAS for their consolidated financial reporting rather than the rules set by the old
Handelsgesetzbuch (HGB, or Commercial Code), thereby avoiding the cost of maintaining two sets of
accounting records.
under pressure from moral hazard losses during the Korean Financial Crisis.22 In
a short period of time, the Korean government changed accounting to reflect the
IAS, required third party audit (and increased the liability of accounting firms),
enhanced disclosure requirements, and imposed the rule for a majority of
independent directors on the boards of big firms, including the largest chaebol.23

Similarly, close examination of events in Japan suggests that moral hazard
pressure was the prime mover behind Japan’s limited reforms in information
institutions. The Ministry of Finance began to lose control over Japan’s monetary
policy in the mid-90’s because of mounting concern over swelling bad debts in
the banking system. As early as 1992, mid-level officials in the Ministry began to
debate the need to tighten up the accounting system in response to mounting
evidence of the moral hazard losses incurred during the excesses of Japan’s
bubble asset inflation. In 1994, slack reserve accounting for potential loan losses
allowed Japanese banks to report good profits and pay dividends even as their
loan portfolios were deteriorating and both the real estate and stock markets
continued to implode.24

A threshold was crossed in the last quarter of 1997, when a series of defaults by
Sanyo Securities, Hokkaido Takushoku Bank, and Yamaichi Securities caused
Tokyo’s interbank market to freeze up, as the magnitude of the hidden losses
from securities trading and the unreliability of reported financial figures became
clear to market participants.25 The Bank of Japan was forced to inject large


22
   Non-bank financial intermediaries (or NBFI’s) controlled by the chaebol accumulated huge unhedged
external liabilities during the 1990’s, liabilities incurred as they borrowed on foreign markets and re-lent to
other members of the chaebol group, thereby demonstrating the risk of private blockholder insider
governance of banks. These unhedged borrowings were one of the major causes of the 1997-98 Korean
Financial Crisis.
23
   In 1998 Korea’s newly launched Financial Supervisory Commission (FSC) overhauled Korean Financial
Accounting Standards (KFAS), to bring them in line with the IAS, and external auditors were made
mandatory for use by listed firms. New regulations also require detailed disclosure of financial transactions
between chaebol blockholders and public firms, as well as independent, outsider boards of directors, in
contrast to the former pro forma boards that rubber-stamped the orders of the founding blockholders.
Chaebol were required to obtain 50% of their directors from outside, with a strict definition of
“independence”. The legal obstacles to filing a derivative suit against a firm were reduced, from 1% to
.01% of the stockholding, which made it much easier for small shareholders to bring such suits
Regulations that limited hostile takeovers by capping such acquisitions at 10% of the target firm were
removed, and voting procedures and tendering rules were changed to enhance the protection of minority
shareholders. Il-Sup Kim, “Financial Crisis and its Impact on the Accounting System in Korea,” Korea
Accounting Standards Board, KASB manuscript, January 2000; Bonchun Koo, "Corporate Restructuring
and Financial Reform in Korea”, Korea Development Institute Working Paper No. 9807, 1998; People’s
Solidarity for Participatory Democracy, “Shareholder Activism in Korea”, www.pec.pspd.org.
24
    Takahashi Yoiichi, “The Truth behind Japanese Financial Crisis,” Princeton University manuscript,
December 6, 1999.
25
   This was made abundantly clear by third-party analysts, who rapidly downgraded the ratings of leading
Japanese financial institutions and lead to a stinging “Japan premium” that these firms were required to pay
in the international money markets.
amounts of liquidity to keep the financial system functioning.26 MOF officials
agreed that it was time to bite the accounting bullet; in any case economic
recovery was stalled, and there was no end in sight for the banking crises. The
MOF arranged for the Business Accounting Discussion Council (BADC) or Kigyô
Kaikei Shingikai, to rapidly approve a series of GAAP principles for valuation and
accounting, with special attention paid to accounting principles for financial
institutions.

Moral hazard pressure also accounts for the motivation of the German state to
push for reforms of information and oversight institutions. A string of
spectacular failures during the 1990’s (such as Metallgesellschaft) and the
exposure of tampering with corporate balance sheets to gloss over financial
problems (as in the case of Bremer Vulkan) demonstrated the need for increased
transparency and monitoring of corporate accounts. 27 These bailouts had been
expensive for the state; many of the write-offs were borne by Lander-owned
banking institutions.

As a result of these financial scandals and bank problems, all three political
parties and Chancellor Helmut Kohl himself were increasingly suspicious of the
oversight failings of the Big Three Banks. Reflecting this consensus, the KapAEG
and KonTraG were passed with remarkably broad political support.28 This led to
tightened financial reporting and accounting standards, a change in Germany’s
oversight institutions, a limitation on the number of boards on which bankers
could sit, and restrictions on banks’ right to vote proxies at their own discretion.

Malaysia suffered moral hazard losses in the wake of the Asian Financial Crisis
and the Malaysian state began its own program of top-down reform, pointing
the finger at the governance sins of private blockholders. This top-down reform
project began with a High Level Finance Committee on Governance established
by the MOF in March ’98, which unleashed a series of regulatory changes
through the Securities Commission, the Kuala Lumpur Stock Exchange (KLSE),
and the Registrar of Companies.29 These changes led to the creation of a
Malaysian Corporate Governance Code, the Malaysian Institute of Corporate
Governance, and the Minority Shareholder Watchdog Group, whose power
stemmed in part from equity holdings by government controlled funds.30
26
    “Japanese financial markets clearly experienced a kind of credit crunch because of a rash of failures,
declining asset prices, and growing mistrust of financial statements and regulators….That resulted in a
further contraction of credit in what became a vicious cycle. In other words, unreliable financial statements
had proved a serious impediment to the functioning of a market economy.” Mitsuhiro Fukao, Financial
Crisis in Japan, October 26, 1999, Keio University manuscript, page 12.
27
   “Arbeitsplätze     durch      attractive  deutsche      Kapitalmärkte,”      December       12,      1999.
www.cducsu.bundestag.de/texte/bericht.
28
    “Intime Einblicke,” Der Spiegel, March 31, 1997.
29
    “Crusade for Better Governance,” New Straits Times, 5/04/99, page 13.
30
     “Minority Shareholders Watchdog Group looking for a Suitable Model”, Bernama News Agency,
The Pension Funding Black Hole

The third event motivating states to reform corporate governance practices was
the yawning gap in the net present value of social security and pension schemes.
Except for Malaysia and Singapore, the social security systems of the twelve
countries in this sample are in the hole, with insufficient assets to cover future
claims (payments to current beneficiaries are being covered by receipts from
current workers).


Table 10: The Public Pension Hole31

Country         Net Present Value (% of 1994 GDP)
Belgium         -153
France          -102
Germany         -62
Japan           -70
Italy           -60
Netherlands     -53
Spain           -109

Table 10 shows estimates of the magnitude of this negative net present value of
pension systems for seven of the countries in this sample. (China’s state pension
system, like the banking system, is widely-considered to be insolvent, as are the
pension systems in Korea and Taiwan.) Political leaders in these states all face
the unpleasant choice of reducing benefits or hiking social security taxes,
increasing the return on state pension assets, or replacing the bankrupt state
pension system with a funded private pension system. Choosing either of the
latter two options places the state on the side of FPI’s with regard to demanding
minority investor protections.

For example, the public pension systems in Malaysia and Singapore are fully
funded, the legacy of an enforced provident savings scheme. As noted earlier,
state-controlled pension plans served as a potent tool for implementing the top-
down corporate governance reforms in those two countries and help account for
the high conformance levels.32 Singapore’s large net external asset pool in effect

8/16/99.
31
    Roseveare, Liebfritz, Fore, and Wurzel, Aging Populations, Pension Systems and Government Budgets:
Simulations for 20 OECD Countries, OECD Working Paper No. 168, 1996, Table 1.
32
   Singapore’s Finance Ministry launched a three-pronged effort to modify Singapore’s governance
institutions by setting up a Committee on Company Legislation to reform the company law and control
issues, a Committee on Disclosure and Accounting Standards to review information institutions, and a
Committee on Corporate Governance to focus on oversight, plus a new Singapore Institute of Directors -
transformed the state into a large FPI, with similar preferences for improved
minority investor protections around the world. State-controlled pension funds
are the largest single investor in the Singapore stock exchange, with Temasek
holding an estimated 25% of the total equity market capitalization, and the state
holds an estimated $100 billion in offshore assets, including a large block of
equity.

The decision by the Netherlands government to privatize and fully-fund its
pension plans provided one of the few counterweights to resistance against
improved governance from Netherlands managers in league with labor unions.
With a record of conservative fiscal management and an average fiscal deficit
among the lowest in the European Union (EU), the Netherlands state did not
come under the sort of budget pressure for privatization of the state sector that
occurred elsewhere in Europe. Nor did the Netherlands experience the moral
hazard losses that troubled other governments. As it entered the 1990’s, however,
the state faced a severe pension crunch due to unfavorable demographics and the
richness of its retirement benefits.

Aware that its social security taxes were among the highest in Europe, and facing
resistance from Labor on trimming of benefits, the Netherlands state chose to
privatize its state pension scheme in 1990, seeking higher returns from the large
pool of pension assets that had hitherto earned low returns under state
management. It also removed the caps on equity exposure and international
exposure from these funds. The improvement in the return on these assets is one
of the reasons why The Netherlands now has a relatively low pension deficit
ratio among EC countries, 53% of GDP.

As a result of these pension reforms Netherlands pension funds rapidly
transformed into return-sensitive investors similar to those in the U.S. and the
U.K. They banded together to confront poorly-performing Netherlands
companies at Annual Meetings, in an informal Association of Pension Funds,
and collectively hired Déminor, a third-party governance consultant, to subject
large Netherlands companies to close scrutiny. They challenged the structuur-
regime on several fronts, although on this point the former state pension funds
were more aggressive than the corporate pension funds, which were reluctant to
criticize their parent firms.

By the same token, attempts by the French state to improve its pension system
strengthened the hand of the Association Française de la Gestion Financière
(AFG-ASFFI), the association of money management and pension firms, which
became a vocal critic of entrenched managers and inefficient SOE’s. AFG-ASFFI

staffed by officers from GLC firms. “Move to improve corporate governance”, Business Times Singapore,
12/99, page 2.
urged the government to reform France’s pay-as-you-go pension scheme with a
fully-funded quasi-private system, even as it took the lead in pressing French
firms for improved corporate governance, including improved disclosure, more
NED’s, and removal of unequal voting rights.33 AFG-ASFFI issued its own
governance code and funded third-party scrutiny of French firms on a
collaborative basis through France’s two leading third-party fee-based analysis
firms, Déminor and Proxinvest.34

The German state has been slowly coming to grips with its pension funding hole,
but, as in France, with resistance by organized labor unions and by employee-
managers. Again, the most vocal proponents of a fully-funded private system -
and enthusiastic supporters of governance reforms - were money management
and pension firms, financial analysts, and the shareholder’s association. For
example, the German guild of financial analysts, the Deutsche Vereinigung für
Finanzanalyse und Asset Management, which represents one thousand
professionals in four hundred investment banks and asset management firms in
Germany, issued a set of formal guidelines that “scorecard” the accounting,
auditing, and disclosure practices of listed firms, thereby reinforcing the
assignment of a corporate governance premium and generating more pressure
for reform.35

Japan’s mixed public/private pension system is also in a deep hole; private
Japanese firms have a huge unfunded pension liability to their employees,
estimated at somewhere between 60 and 80 trillion yen.36 The portfolio returns of
the mixed private-state pension system, as well as the plans managed by
Japanese insurance and trust banks (shintaku ginko) have been dismal, with a
current yield of about 2.5%, 3% below the return needed to meet the actuarial
commitment to pension beneficiaries. The Ministry of Health and Welfare, which
supervises these pension plans, issued a series of administrative regulations that
tighten the fiduciary obligations of pension trustees and require them to
maximize asset return (rather than other stakeholder values) and to focus on,
inter alia, good corporate governance of the firms in which they invest.37




33
    Alain Leclair, “The French Experience: An Activist Corporate Governance Strategy”, paper for the
International Corporate Governance Network, Tokyo, July 2001.
34
   “Deminor rates 300 European Companies based on Corporate Governance Standards”,
www.deminor.com.
35
   Deutsche Vereinigung für Finanzanalyse und Asset Management, “Scorecard for German Corporate
Governance,” July 2000, www.dvfa.de.
36
    Goldman Sachs Japan, Portfolio Strategy: Tsunami Alert, October 16, 1998.
37
    Kôseisho, Nenkin shikin unyô bunkakai, “kôsei nenkin hoken oyobi kokuminnenkin no tsumetatekin no
unyô ni kansuru kihonhôshin ni tsuite”, February 2001; Tomomi Yano, “Nenkinshikin unyô kara mita
corporate governance”, paper for International Corporate Governance Forum, Tokyo, July 2001.
Since revised accounting principles require firms to disclose their unfunded
liability, an exodus began (estimated at thirty trillion yen out of a total of fifty
trillion yen) away from the mixed public/private pension system into privately
managed funds.38 As a result, the market share of foreign investment advisory
firms (who behave exactly like FPI’s) has grown from zero to 10% of Japan’s
pension market in the last ten years.

Preserving the Public Benefits of Control

Overall, the pattern of change in institutions in this sample reflects the
governance preferences of politicians to preserve the public benefits of control
while striving to manage the fiscal consequences of privatization, moral hazard
losses, and pension underfunding. The state could reap SOE SIPO’s on the basis
of improved accounting and audit practices, with nominal changes in oversight,
but without relinquishing control of these firms to value-maximizing outside
directors. The employee-managers and directors of these firms (bureaucrats or
political appointees) were compensated with stock options – pioneering the use
of stock options in many of these countries. Hostile takeovers by a value-
maximizing acquirer were blocked by anti-takeover and voting rule obstacles.

In all twelve countries (except China) SOE SIPO’s were accompanied by careful
consultation with labor unions. This is consistent with the empirical literature on
privatization, which indicates that post-privatization lay-off’s are limited to
either “transition” or lower-income developing countries.39 Nor is there much
evidence that agency or expropriation costs declined after SIPO’s.40 Though the
literature suggests that there are substantial performance improvements in post-
SIPO SOE’s, including greater output per employee and reduce leverage, it is not
clear that this is due to lower expropriation costs by the state blockholder. In
every country example, the state adopted changes in information institutions, in
part to obtain the revenues from SOE SIPO’s, but drew the line at changes in
oversight practices or control institutions that would open these “privatized”
firms to the discipline of a market for control.

There is little evidence that post-SIPO SOE’s have boards composed of
independent outsiders; perusal of a random sample of SOE share offering
memoranda reveals boards filled with serving or retired government officials,
politicians, and labor union representatives, with a small sprinkling of managers
of large firms. More important, in this sample the state retained, on average, at
least 50% of the voting rights in SOE’s after the SIPO’s and several rounds of

38
   At an exchange rate of ¥110/$1, 30 trillion yen equals approximately $270 billion.
39
   William Megginson, “From State to Market: A Survey of Empirical Studies on Privatisation”, Journal of
Economic Literature (forthcoming), pages 32-34.
40
   Megginson, op. cit.
secondary offerings. This commanding blockholding, combined with various
“golden share” and formal veto rights, effectively buffers these firms from any
chance of a successful contest for control.

Process-Tracing Proof for the Public Purpose Model

In sum, process tracing of actual regulatory changes points to the state as the
prime mover of governance changes, and lends credence to the public purpose
model of governance change. Once these state-imposed reforms are in place,
such as better accounting, auditing, and disclosure, they serve to reduce the
private benefits of control extracted by private blockholders, by making it more
difficult to extract those benefits – increasing the cost of stealing, and imposing,
as it were, a “tax on blockholders”. Entrepreneurs or private blockholders who
are strapped for cash and thus must access equity markets for capital, tend to
became “early adopters” of good governance, thereby increasing the competitive
pressure, over time, on incumbent blockholders and entrenched employee-
managers to adopt similar reforms. There is some evidence that the parallel
stock exchanges for entrepreneurial companies that were established in several
countries in this sample, including the Neuermarkt in Germany and the
KOSDAQ in Seoul, had slightly better corporate governance practices than the
major stock markets (although this impression did not often survive the collapse
of the high-tech bubble).

Thus the endpoint of the public purpose model is the same as the private
markets model, but by different pathways, with different actors in the vanguard.
The FPI good governance premium offered a direct price incentive to the state
with regard to the governance practices of SOE’s, and also set in motion an
indirect premium for better governance by means of domestic pension funds.
The causal connection between FPI and moral hazard losses is more attenuated,
and the costs of poor governance were largely endogenous to each country,
although international capital markets persisted in highlighting these costs,
much to the discomfort of finance bureaucrats and politicians alike.

Implications of the Public Purpose Model

The public purpose model of governance convergence, if accurate, has several
implications for theory of political economy as well as public policy.

Governance change in any given country depends primarily on how badly the
state is squeezed by the three fiscal pressures, how quickly private blockholder
“early adopters” forgo private benefits, and how much resistance to governance
reforms the state must overcome from private blockholders and employee-
managers. This predicts country-specific path dependence in the sequence and
rate of change. Instead of uniform convergence, it suggests the pattern of
governance change will persistently vary between countries, as the fiscal
pressures can present themselves in different combinations and intensities over
time.

The public purpose model confirms the suspicion of some governance
economists that private benefits of control are stubbornly resistant to change.
There are steep obstacles to the process by which private blockholders trade their
private benefits of control in exchange for higher stock valuation. By the same
token, politicians and bureaucratic elites who control the state may find it as
difficult to relinquish the private benefits of control of state-owned firms as do
private blockholders.

The pivotal role played by the benefits of control suggests that the scholarly
debate over whether there are one, or many, versions of capitalism may be
clarified by viewing institutional formation through the more parsimonious lens
of ownership type. Ownership determines where the potential income cleavages
run in response to international inducements and pressures, and the shifting
terms of state ownership are a key determinant. In order to predict how these
cleavages affect policy outcomes, political science and international relations
theorists may have better results using the ownership hypothesis when
examining the effect of exogenous forces on domestic choices.41

A great deal of ink has been spilled in the political economy literature creating
elaborate taxonomies of “stakeholder versus shareholder capitalism”, “producer
versus consumer capitalism”, and even “Nippo-Rhenish versus Anglo-American
capitalism” in order to explain contrasting institutions and policy outcomes.
However, these findings suggest a mundane question of “who gets the money?”
may provide a more parsimonious explanation.42 In an early study of how
external economics affects domestic institutions, Zysman focused on the
structure of the banking system as the key explanatory variable, arguing that “by
knowing the financial system one can predict the nature of the process of
adjustment.”43 These twelve cases suggest the paraphrase “by knowing the
ownership type one can predict the nature of the process of adjustment.”44
41
   See Robert Putnam, “Diplomacy and Domestic Politics,” International Organization 42 (1988), 427-60
and Helen Milner, Interests, Institutions, and Information: Domestic Politics and International Relations,
1997.
42
   See Berger and Dore, National Diversity and Global Capitalism, 1996; Hollingsworth and Boyer,
Contemporary Capitalism: the Embedded ness of Institutions, 1997; and Michel Albert, Capitalism vs.
Capitalism, 1993, all of which speculate on institutional divergence or convergence as a function of many
variables, including the type of state, but not as a function of ownership.
43
   John Zysman, Governments, Markets and Growth: Financial Systems and the Politics of Industrial
Change, 1983, page 91.
44
   Traditional political science terms such as Business and Labor are poor predictors of who wins and who
loses in response to exogenous influences such as FPI. As demonstrated by these twelve cases, “Business”
As for the debate on whether non-state actors matter in policy outcomes, the
corporate governance example proves unambiguously that they do: the state’s
mediation of financial inducements offered by FPI determine the shifting pattern
of corporate governance around the world. As a result of the FPI tidal wave and
higher ratios of stock market valuation to GDP in all of these countries, the state
and foreign investors are locked in an uneasy embrace that either party would
find expensive to relinquish.45

The corporate governance example suggests that convergence to a global
standard of governance is not a “race to the bottom,” in which the state that
deregulates fastest wins by attracting the most capital at the lowest cost. 46 On the
contrary, the state with the most impartial, efficient protection of minority
shareholder rights is the one that wins by attracting the most capital at the lowest
cost.

The spread of Anglo-American style corporate governance is not equivalent to
deregulation, for capital markets are embedded in a set of sophisticated formal
and informal institutions: in many respects the market-ordering Anglo-American
model requires more institutional support than private-ordering or state-
ordering models.47 Nor is it a simple process of re-regulation, whereby the state
uses a different set of tools to pursue the same objectives, as interventionist
bureaucrats attempt to harness equity markets to their existing developmental
model.48 Instead, it results in para-regulation, with a shift of authority to investors




can represent any one of three different ownership groups – private blockholders, state blockholders, or
employee-managers – with radically different institutional preferences.
45
   The state cannot sit down with FPI’s and “hammer out a deal” regarding the terms and conditions of
corporate governance. This contrasts to bank debt markets, in which the MOF can sit down with a dozen or
so big banks and work out an agreement on, say, debt swaps in a crisis. It is also unlike FDI markets, in
which the state can summon the investor and negotiate (from a position of considerable strength) the terms
of the deal. FPI’s face the inverse problem of collective action in responding to the state. There are many of
them, with heterogeneous preferences. They are limited in their ability to flee from a given country: rapid
exit incurs high transactions costs, especially during a financial crisis, and they are increasingly constrained
in exit by the practice of portfolio indexing: for example, the top 25 U.S. institutional investors use
indexing to manage 60% of their equity portfolio. Once committed to such an index, for example, investors
are predisposed to leave a given percentage of their portfolio in a given country market: if they don’t like
the corporate governance standards, they must work to improve them.
46
   Dani Rodrik, Has Globalization Gone Too Far? 1997.
47
   The complexity of the Anglo-American governance model should give pause to the conventional wisdom
assumption that the Anglo-American model is easier to imitate than Japanese or German models, which
require “idiosyncratic” governance institutions. See Bernard Black, “Creating Strong Stock Markets by
Protecting Outside Shareholders,” paper for the OECD Conference on Corporate Governance in Asia,
March 3-5, 1999, pages 6-7.
48
   Steven Vogel, Freer Markets, More Rules: Regulatory Reform in Advanced Industrial Countries, 1996.
above the level of the state, combined with a greater shift of authority to
independent statutory regulatory agencies below the state level. 49

Explanations of institutional changes in response to global markets do not
require the invocation of “American hegemony” that frequently pops up in
discussions of financial globalization.50 The spread of the Anglo-American model
of corporate governance has little or nothing to do with policy goals of the
United States government; FPI markets and sovereign states abroad are the key
actors in bringing about governance changes, at least in this twelve country
sample. Any influence acquired by the state in Washington or London as a result
has been obtained the same way that Britain acquired its global Empire, “in a fit
of absentmindedness” rather than by design.51

From a policy standpoint, “reforms” to corporate governance institutions,
particularly in emerging markets, must be careful to deal with agency and
expropriation costs in balance. Governance institutions ex ante the introduction of
FPI are complementary, and they rely on each other to mitigate, if not eliminate,
both expropriation and agency costs.52 Changing just one institution at a time,
without examining the question of complementarity, may have undesirable
effects.

For example, efforts to reduce expropriation costs by improvements in NED
oversight, which in effect levy a heavy “tax on entrepreneurs”, may blunt the
ability of private blockholders to discipline managers. The unintended
consequences of these reforms can be soaring agency costs – with entrenched
employee-managers now free to manage badly. Indeed, in the corporate
governance debate in some countries, calls to “professionalize” managers are
often a code phrase for “reduce the influence of blockholders.” Conversely,
efforts to reduce agency costs - changes that open the door to free-for-all
takeover contests - may result in high expropriation costs, as blockholders
emerge to discipline (or expropriate) employee-managers and, in the process,




49
   The Anglo-American model is based on securities regulation by quasi-independent agencies such as the
SEC, accounting rules by semi-private bodies such as the FASB, and enforcement of minority rights and
fiduciary responsibility by independent common-law courts, rather than by Ministries of Finance or
Ministries of Justice.
50
   See for example Robert Gilpin, The Political Economy of International Relations, 1987, and The
Challenge of Global Capitalism, 2000, or Loriaux, op.cit.
51
   "We [the English] seem, as it were, to have conquered and peopled half the world in a fit of absence of
mind." Sir John Seeley, The Expansion of England, 1883.
52
   Heinrich,Ralph. 1999. "Complementarities in Corporate Governance: A Survey of the Literature with
Special Emphasis on Japan," Kiel Working Paper No. 947, Kiel Institute of World Economics, Kiel,
Germany.
compensate themselves for these efforts at the expense of minority
shareholders.53

In terms of industrial organization, convergence may halt at shallow equilibrium,
with potentially unpleasant consequences for product/market competition.
States are extremely sensitive to the potential fall-out from hostile takeovers.
Even if states gradually adopt a para-regulatory approach to supervising
corporate governance, this will not necessarily change the political disincentives
associated with market-based contests for control, or make these states more
willing to expose corporatised SOE’s to such contests. As noted earlier, the
pattern of conformance has stopped well short of accepting market-based
contests for control in ten out of twelve of these cases. 54

States’ distaste for such contests, particularly for the corporatised SOE’s that now
account for such a large weight of their stock market capitalization, suggests that
one result of the SOE corporatisation trend in the late 1980’s and 1990’s may be
higher agency costs. Because of remaining state majority control, or because of
voting restrictions or “golden shares” imposed by Ministries of Finance, the
managers of these firms are likely to become more entrenched and less
disciplined by the threat of hostile takeover’s, while strengthening their
“stakeholder” common cause with the rest of the SOE workforce – especially if
that workforce is unionized and politically mobilized.55 They may also engage in
classic empire-building by acquiring other firms at above-market prices, while
being protected from such take-overs themselves by the state, and insulated from
the financial market discipline that otherwise makes such acquisitions dangerous
to the employee-managers.56

53
   Blockholders can expropriate employees by breaking implicit contracts on the sharing of the firm’s
“quasi-rents” or simply by looting their pension funds (as in the Robert Maxwell scandal). See Margaret
Blair, Ownership and Control: Rethinking Corporate Governance for the Twenty-First Century, 1995.
54
   The two frequently-invoked examples of hostile takeover in Europe, the Vodafone-Mannessmann
transaction in Germany and the Olivetti-STET transaction in Italy, may be an aberration and not indicate a
fundamental change in those two countries.
55
    The “grabbing hand” model developed by Shleifer and Vishny suggests that in many cases politicians
can extract as many private benefits from SOE’s that are partially or even fully privatized as long as they
can retain control over the profits of the firm through discretionary regulations. Depending on the degree to
which corruption is tolerated, they will take these private benefits in cash or in terms of excess employment
for favored unions or regions. Shleifer and Vishny, The Grabbing Hand, pages 176-78.
56
    “Golden shares prevent that bad bidders become good targets. In an unconstrained control market an
acquirer that failed to achieve synergy would run into difficulties and would become a prey of other
companies. Golden shares protect potential bad bidders. Partial public ownership also protects potentially
bad acquirers, since governments may value control of the company for political reasons more than cash
flows derived from selling ownership rights. There seems to be an asymmetry in that some firms still
controlled by the public sector (through partial ownership or golden shares) are active acquirers abroad
while their governments keep important restrictions at home. The Spanish government vetoed the merger
between KPN and Telefónica and the Italian government vetoed the merger between Telecom Italia and
Deutsche Telekom.” Francesc Trillas, Mergers, Acquisitions, and Control of Telecommunications Firms in
Europe, paper for the Regulation Initiative, August 2000, www.london.edu/ri, page 7.
The minority shareholders of these firms, domestic and foreign alike, are
unlikely to be cheerleaders for continued deregulation, if it poses a threat to the
earnings (rents) of the largest stocks by value. This may lead to a new “shallow
equilibrium”, with states and FPI’s aligned with entrenched employee-managers
- all three of whom now resist further deregulation and competition, and jointly
collect respective portions of the rents.57 In this way, an unintended consequence
of SIPO’s and increasing FPI may be a roadblock erected in the path of continued
product-market deregulation, while encouraging inefficient acquisitions and
cross-border mergers.

This process could quickly become politically contentious, not just domestically,
but across borders as well. There is already considerable political fallout within
Europe as corporatised SOE’s spar with each other in attempts at cross-border
acquisition and consolidation. The process of consolidation among “national
champions” is even more delicate in Asia, as witnessed by the squabbles
between Singapore Telecom, Malaysia’s Time Telecom, and Hong Kong
Telecom. In both regions, hostile cross-border contests can rapidly escalate into
high politics. At that point, states may realize that they have adopted, more or
less by default (if not in a “fit of absentmindedness”) a set of market-driven
Anglo-American corporate governance institutions without having forged the
domestic political consensus to deal with the consequences.

However, demographics and increased competition in financial markets will
keep the process moving forward, albeit in fits and starts. As states begin to fund
their pension systems, and as households and firms assert more control over
their pension assets, this places more pressure on pension fund managers to seek
higher returns domestically and abroad. These changes in pension plans will
mobilize a huge amount of previously passive savings into active equity
investment, especially in Japan and continental Europe. Active equity investment
leads to a more systematic use of the governance discount (or premium). This
suggests that regulations regarding the structure and function of pension plans
are a central issue of public policy, with enormous long term consequences for
equity markets generally and for corporate governance specifically. Pension plan
reforms may turn out to be the tail that wags the corporate governance dog.



57
   A shift on either the supply or demand side of this equation could upset equilibrium at shallow
convergence. On the supply side, FPI’s could tire of swelling agency costs at corporatised SOE’s, driving
the stock price of these firms to embarrassing lows. On the demand side, fiscal pressure on the state could
force it to liquidate the balance of its equity holdings in these firms. Either factor could lead to a contest for
control of these SOE’s, whereby private blockholders buy out the state’s interest in private transactions,
gobbling up bits and pieces of the former “national champions” and natural monopolies, or engaging in
nasty public contests for control.
Retrospectively, the explosive growth of assets managed by institutional
investors in the United States and the United Kingdom during the three decades
between 1970 and 2000 caused Anglo-American investors to became serious
players in international equity markets during the 1990’s, thereby providing the
price incentives for adopting the Anglo-American model of corporate
governance.58 Looking forward, as states increasingly permit domestic savings to
freely enter the FPI pool, these minority shareholder protections will lose their
“Anglo-American” appellation, the para-regulatory practices that support these
protections will spread, and countries may be impelled from shallow to full
convergence.


                                                                                       James Shinn
                                                                                        Jshinn@cfr.org
                                                                                 October 15, 2001
                                                                                 Discussion Paper




58
  This growth was driven by tax changes (such as 401-k plans) and rules regarding private pension plans
such as the ERISA statutes.

				
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