CHAPTER 11

INTRODUCTION

The American corporate governance system is a market-based system. Corporations raise funds in public capital markets, and their managers are subject to the discipline of capital markets. Theoretically, a company is run in the best interests of its shareholders, whose interests are considered to be ‘‘above’’ those of the other stakeholders of the company. Banks provide debt capital but do not own shares of companies and deal with borrowers at arms length.

The two major alternatives to the American governance system are the German system and the Japanese system (the governance systems of other countries are variations on the American, German, or Japanese system). The German system is a bank-based system, often referred to as a universal banking system. The Japanese system is one of cross-ownership of firms and interlocking relationships called keiretsu. Both systems are also described as relationship-oriented systems.

THE GERMAN SYSTEM

The ownership of German corporations is far more concentrated than the ownership of U.S. corporations. Furthermore, as we showed in Figure 2-3, more than 40 percent of the shares in German companies are owned by other German companies. Individuals own very few shares of public corporations, and, for all practical purposes, no institutional investors (mutual funds, pension funds) exist. In short, Germany does not have a shareholder culture. The market capitalization of listed stocks in Germany is about 30 percent of gross national product, compared to 152 percent in the United Kingdom, 122 percent in the United States, and 103 percent in Sweden.

Another major difference between the American system and the German system is the role of banks. In the United States, banks make loans to corporations but do not take ownership positions in those firms (own shares of stock in the company). In Germany, though, banks can and do take ownership positions in the companies they lend to, and also place their representatives on the companies’ governing boards. Thus, there is a much closer and stronger relationship between German firms and German banks than there is between American firms and American banks. This relationship is buttressed by the fact that shares owned by Germans are usually deposited in banks for safekeeping and that the banks get to vote these shares, even though they don’t own them.

German Governing Boards

Unlike U.S. firms, German corporations have two governing boards: a supervisory board (Aufsichtsrat) and a management board (Vorstand). The management board is made up of five to fifteen full-time employees of the company and is responsible for the operations of the company. The management board is appointed by the supervisory board and reports to it. All major investment and financing decisions must be approved by the supervisory board.

The supervisory board consists of from nine to twenty-two members. Perhaps most importantly from a governance perspective, the supervisory board is required by law to have labor representatives as well as shareholder representatives. Labor representatives make up one-third of the supervisory boards of corporations with less than 2,000 employees and one-half of the supervisory boards of corporations with more than 2,000 employees. The other board members are elected by the shareholders. But, since over 50 percent of outstanding shares are controlled by other companies and banks with commercial relationships to the company, a conclusion that the boards of German companies represent public shareholders is unwarranted.

This subordination of shareholder interests to the interests of other stakeholders is reinforced by German law with respect to the responsibilities of supervisory board members. Supervisory board members are not liable for management decisions that are detrimental to shareholder interests, as they would be in the United States under the ‘‘duty of care’’ rules. In other words, whatever the supervisory board is, it is not a creature representing or charged with representing the primacy of shareholder interests.

Absence of Corporate Control Market

Along with the absence of a well-developed capital market, there is an absence of a corporate control market in Germany. Through 1995, there had been only three hostile bids since the end of World War II. Indeed, the whole idea of a corporate control market is near anathema to many Germans. This attitude is aptly captured in the public statements of Gerhard Schroeder, the German chancellor, during the eventually successful hostile takeover of Mannesmann by Vodafone Air Touch in 1999–2000. Schroeder noted that ‘‘hostile bids destroyed the culture of the target company … [and] hostile bidders in German companies underestimate the virtue of codetermination [worker representation on supervisory boards].’’ Schroeder, again in response to the Mannesmann takeover, also said that ‘‘hostile takeovers are never helpful.’’

With Germany’s Euro-MPs at the forefront of opposition, the European Parliament rejected a cross-border code for takeovers in July 2001. As reported in the Economist,

The failure is a blow for economic liberalisers, who saw it as a key part of their strategy for sharpening economic competition within the European Union. The thrust of the directive was to make it harder for European corporate bosses to ward off a hostile bid without first consulting shareholders. The idea was that shareholder rights would be strengthened, and managers forced to become more efficient.¹

German recalcitrance with respect to takeovers continued in 2002. In February 2002, Schroeder warned the European Commission to keep its hands off VW, a carmaker that is the country’s largest employer. He is quoted as saying, ‘‘Any efforts by the commission in Brussels to smash the VW culture will meet the resistance of the federal government as long as we are in power.’’²

So, do all of these governance differences matter? And why?

UNIVERSAL BANKING: A GERMAN GOVERNANCE SOLUTION

Let’s start with what many people believe or believed to be the advantages of the German system compared to the American system. Most of the potential advantages are thought to arise out of a reduction in agency costs and conflicts of interest among the owners and creditors of German firms.

The essence of the German universal banking system is that German banks can own equity in the companies to which they lend money. Consequently, conflicts of interest between creditors and shareholders are reduced because the creditors and the shareholders are the same people. We encountered this idea earlier when we explained the connections between governance and financing decisions.

Advantages of Universal Banking

Conflicts of interests between creditors and shareholders are most likely to surface during periods of financial distress, when the borrower has insufficient cash to make principal and interest payments on debt obligations. Borrowers can play many games during periods of financial distress, such as changing the firm’s investment policies (to favor high-risk projects), borrowing additional funds to keep the firm afloat, paying cash dividends rather than paying down debt, not disclosing the financial difficulties to creditors, and restructuring the firm without gaining the approval of the creditors. Creditors are aware of these games and protect themselves by writing positive and negative covenants into loan agreements and by simply refusing to lend more money. Lenders can also force the firm to restructure itself voluntarily, force restructuring through the bankruptcy courts, or ask the courts to liquidate the company.

When banks also own equity in the borrower, the risks associated with the borrower’s playing games that transfer wealth from the creditor to the borrower are ameliorated; by owning an equity stake, the bank’s losses on its loans are offset by gains on its equity. In addition, lenders who also hold equity positions in a company are less likely than pure creditors to force a firm into bankruptcy when the firm encounters financial problems. Instead, the bank will work with the firm to seek a solution to the problems, since the bank stands to lose its equity position if it calls in the loan but could gain on its equity position if a turnaround can be worked out. The bank, in other words, is a ‘‘committed investor.’’

In theory, these reductions in potential agency, financial distress, and bankruptcy costs should translate into a lower cost of capital for German firms by permitting them to increase their financial leverage and substitute cheap debt financing for expensive debt financing. This potential reduction in cost of capital is reinforced because the banks have representatives on the borrower’s board of directors. These bank directors have access to inside information about the company and its financial situation, making it more difficult for the borrower to mislead the bank.

Having bankers on the board and having banks own equity may also reduce the potential costs of financial distress in terms of the company’s relationships with customers and suppliers. Customers and suppliers may be more willing to continue doing business with a firm that is in temporary difficulty if they know that a bank is involved and that, because it has an equity stake, it will be reluctant to call in the loan and bankrupt the firm.

Bank membership on borrowers’ boards and bank ownership of equity in their borrowers should also, in theory, affect dividend policy and investment policy. We noted that firms with no positive NPV projects should pay cash dividends. But we also noted that in the absence of a corporate control market or other mechanisms to discipline managers, managers might decide to grow the firm at the expense of the shareholders rather than distribute cash to the owners. In the absence of a German corporate control market, banks may be the mechanism that disciplines managers and stops them from making negative NPV investments—but we want to emphasize ‘‘may’’ here because it is not entirely clear whose interests the banks represent. This issue leads us into the disadvantages of the universal banking system.

Disadvantages of Universal Banking

Do German banks protect the interests of the public shareholders, or do German banks primarily protect their own interests in German companies? And, from a broader public policy perspective, what are the implications of the German universal banking system for supporting investments in new technologies and start-ups and for the emergence of public capital markets, especially an IPO market?

Banks May Care About Firm Survival, Not Share Price

Critics of universal banking point out that banks may be more interested in the survival of the firm and its continued existence as a borrower than in maximizing the wealth of public shareholders. Consequently, banks are likely to discourage firms from making risky but positive NPV investments, especially in projects with substantial intangible growth opportunities but no tangible assets. Instead, investment will be directed toward bricks-and-mortar projects, not projects where most of the funds go into human capital and firm-specific assets.

Critics also charge that banks will discourage firms from distributing cash dividends because this cash would leave the company, thus weakening the bank’s creditor position. In this regard, banks exacerbate conflicts of interest between the public shareholders and managers because the banks take the side of managers who want to retain control of free cash flow. Banks, in other words, act more like organizational stakeholders such as employees and managers than like public shareholders who discipline managers.

When we recall that over 40 percent of the stock in German firms is owned by other corporations, which themselves are more likely to be interested in the survival of the firm so as to retain the benefits of interfirm commercial contacts, the prospects for protecting the interests of public shareholders in German firms are weak. Banks and other managers control publicly held German firms, with no German institutional investors holding substantial positions on behalf of public investors as in the United States.

Weak Investor Protection Laws

Relatively weak investor protection laws exacerbate the public investors’ situation, as does a financial reporting system that is geared more toward taxation issues than toward disclosure. Under German accounting regulations, companies can ‘‘smooth’’ earnings by bypassing the income statement and making transfers to retained earnings in good years and then putting these earnings back into the income statement in bad years.

Some observers have suggested that the reason for the highly concentrated ownership of German firms is weak investor protection. Only large block holders find it possible and worthwhile to monitor and control management, so concentrated ownership has emerged in Germany as an alternative to capital markets for disciplining management and reducing the agency costs associated with the separation of management and ownership.

Absence of an Equity Market Hinders Formation of New Firms

Lastly, the absence of a liquid and efficient equity market may discourage the formation of new firms, especially technology-based firms. Here, the argument turns on the absence of an exit strategy for the founders and venture capitalists. Those who supply capital to start-ups expect to get back their investment plus capital gains. They need what is called an exit strategy. They can exit either by selling the company to a trade buyer (another company) or by taking the company public through an IPO. IPOs require a well-functioning equity market. Without such a market, the only alternative to retaining an interest in the company is selling to another group of private investors or selling to another company. In the former case, the price would be less than with an IPO because this second group of private investors faces as illiquid a market for the company as did the original owners. In the second case, the price might also be less than what public investors would be willing to pay, especially if the buyer knows it is in a commanding market position.

Another problem is that the founders of the company may want to keep the company independent and retain control but don’t have enough cash to buy out the venture capitalists. If a well-functioning equity market existed, the founders could take the company public through an IPO and still retain control. But, in the absence of an equity market, the founders may have no alternative but to sell the firm to another company, thus losing the benefits of control.

In both cases, the motivation for starting new companies is diminished. The result is a truncation of investment in new industries and technologies and a brake on entrepreneurial activity.

WHAT’S THE EVIDENCE WITH RESPECT TO GERMANY?

Do the differences between the German and American governance systems generate differences in financial performance? Or, are the systems merely different ways of solving similar problems arising out of the separation of management and ownership, with no substantial differences in terms of overall performance? The evidence is mixed, often qualitative, and frequently controversial.

Although some researchers have found that bank-controlled German companies did not perform as well for their public shareholders as non-bank-controlled companies, others have not been able to show much difference in terms of profitability or share price performance. We do know that IPOs are far less common in Germany than in countries with market-based governance systems, but is the absence of IPOs hindering the economic performance of the overall economy? That is unclear.

Why German Firms Adopt an American Governance Structure

Perhaps the clearest insights into the question of German versus American governance structures can be gained from studying the reasons why a number of large German firms have chosen to move from a German-style governance culture to an American-style governance culture during the last decade. These companies, which coupled the transition with listing themselves on the NYSE, included Daimler-Benz (now DaimlerChrysler), SGL Carbon, Pfeiffer Vacuum, Fresenius Medical Care, Deutsche Telekom, Hoechst (now Aventis after a merger with Rhone-Poulenc), VEBA, and SAP.

Daimler was very explicit about the changes the company made and would make. Daimler adopted the notion of shareholder primacy and implemented stock option plans for its managers. When Juergen Schrempp took over as CEO in 1995, he noted that ‘‘those businesses which, after adjusting for risk, fail to earn a pre-tax return of 12% on capital will be dumped.’’ In 1996, Daimler withdrew from Fokker’s aircraft business, disposed of its energy systems technology business and its industrial automation business, and sold off other businesses as well.

SGL Carbon is a company that was spun off by Hoechst and listed on the NYSE. On its investor relations Web page in 1999, SGL Carbon stated, ‘‘If shareholder value is to be optimally implemented the first requirement is to firmly anchor the philosophy of shareholder value in the minds of management and convert an ‘employee-manager’ attitude to an ‘owner-manager’ mentality [through stock options and other incentive plans].’’ This philosophic statement reflects the shift from a German- to an American-style governance culture.

Pfeiffer Vacuum CEO Wolfgang Dondorf, in commenting on Pfeiffer’s decision to list its stock on the NYSE, stated that using American accounting principles (GAAP) prompted a change in the company’s business attitudes by providing more transparency to public investors—another key element of a market-based governance system. Dondorf went on to say that ‘‘Pfeiffer believes that its management should turn its attention to increasing the shareholder value of Pfeiffer and should receive remuneration corresponding to the degree to which they achieve this goal.’’

Deutsche Telekom, the German phone company, was privatized through a listing on the NYSE. Its chief financial officer said at the time that the company was being rationalized ‘‘with a view towards competition and shareholder value.’’ Again, the notion of shareholder primacy appears.

Hoechst listed its shares on the NYSE in 1997. Its CEO said, ‘‘The Hoechst share price will serve as the yardstick of our performance; in other words, we want the capital markets, specifically you, our shareholders, to be the judge of our efforts.’’³

VEBA switched to GAAP and listed itself on the NYSE in 1997. When it did so, management eliminated limitations on voting rights for shareholders and adopted a one-share-one-vote rule. The chairman also noted that ‘‘with our [NYSE listing] we are deliberately exposing ourselves to the critical appraisal of the world’s most important capital market and we hope to expand our access to U.S. institutional funds [investors].’’⁴

SAP, in adopting U.S. accounting rules, said that it did so because its competitors used GAAP and SAP needed to create a level playing field. It noted that ‘‘under German accounting rules, customers have had trouble comparing its financial strength with that of say Oracle—an important consideration in buying very expensive systems meant to last for years.’’⁵

Whether other German companies will follow these firms is an open question. But, note that the firms that have moved toward a market-based shareholder-primacy governance structure were competing in global markets and facing competition from American companies. Does this mean that a market-based governance structure is an advantage in such an environment? Or, are the reasons offered by the German companies simply rationalizations for paying managers higher salaries and improving their bargaining position within Germany with respect to workers and social welfare initiatives?

THE JAPANESE KEIRETSU

The keiretsu is a network of affiliated companies (industrial grouping) formed around a central company or bank and connected through cross-ownership and relational contracting. Examples, past and present, include the Toyota, Mitsubishi, and Mitsui keiretsu. The Mitsui Group, originally a producer and seller of soy sauce, is one of Japan’s largest keiretsu. The heart of the group is Mitsui & Co., the world’s largest sogo shosha (general trading company), with some 900 subsidiaries and associated firms worldwide. Other key members of the Mitsui Group include Mitsui Mutual Life Insurance, Mitsui O.S.K. Lines, and Sakura Bank, which has announced plans to merge with rival Sumitomo Bank. Other Mitsui operations include chemicals, construction, logistics, mining, petroleum, real estate, textiles, and retailing.

The Mitsubishi Group’s primary units are Mitsubishi Heavy Industries (Japan’s number one maker of heavy machinery), the Bank of Tokyo–Mitsubishi, and Mitsubishi Corporation, which provides organizational oversight. Mitsubishi Group’s more than forty companies make everything from steel and power plants to cameras, cars, chemicals, clothing, consumer electronics, and textiles.

The ‘‘members’’ of the keiretsu are connected in many ways. Often, the senior executives belong to a group that meets a number of times during the year to exchange opinions about the businesses in the industrial group and reinforce relational contracts. Suppliers of parts and services also belong to the keiretsu and meet to collect and disseminate information about one another and their relations to other group members (some might say like a club). In addition to sharing information, the members share management and own shares in one another.

Observers of Japanese corporate governance usually identify the following as key characteristics: (1) reciprocal and control-oriented share ownership and (2) relational contracting.

Reciprocal and Control-Oriented Share Ownership

In 1996, individuals (public shareholders) owned only 22 percent of the outstanding shares of common stock of Japanese companies, and this percentage had steadily declined from 70 percent in 1949. Instead, ownership is concentrated in the hands of what are called control-oriented shareholders.

As we noted, one of the key features of a keiretsu is member cross-ownership. Until recently, about 25 percent of the stock of keiretsu members was owned by other members. This ‘‘family’’ ownership is buttressed by considerable holdings of the stock of family members by companies that, while not part of the family, have very close ties to the keiretsu, including banks that have loaned money to the firms.

These owners are the control-oriented owners. Their primary concerns are their commercial relationships with the business firms in which they hold stock. Thus, their objective is maximizing the relationship values and the financial/economic performance of the keiretsu as a whole, not maximizing the market value of any one company.

This objective of protecting the keiretsu as an entity or family causes control ownership to be stable over time and protects individual firms from hostile takeovers. Keiretsu members will not vote their shares in favor of a takeover group simply because the group has offered a very high price for the target company. Instead, the members will protect the existing management of the company in order to protect relationships within the industrial group and to ensure continued sales to group members. Consequently, no effective arms-length corporate control market for monitoring and controlling managers has existed in Japan.

This absence of arms-length monitoring and control of management is exacerbated by the fact that the boards of Japanese firms consist entirely of the company managers. The board of a Japanese company consists of up to twenty-five people, typically men over fifty and most likely past employees of the company. Japanese boards have no outside directors and few women, academics, or minority representatives. Diversity is not an attribute of Japanese corporate governance. So, who monitors and controls company management?

Monitoring and controlling is done by the other control owners themselves. The term selective intervention is used to describe this process—control owners selectively intervene when a company faces financial or other problems.

If a company is in financial distress, the company’s lead bank may intervene and take effective control of the company for the keiretsu as a whole. The bank, which is itself an equity holder in the company, may pay off the debts the firm owes to non-keiretsu banks or companies, with other keiretsu members sharing the loss. Along the way, the directors of the troubled company are augmented or replaced by directors of the bank and other group members—an outcome that would be virtually impossible in the United States, where such actions would cause the bank’s loans to be declared equity capital and not recoverable in bankruptcy.

Selective intervention is also a mechanism for restructuring keiretsu members—but again this is done by executives and board members of the other companies. So, no really effective outside discipline exists, other than the eventual failure of the keiretsu itself or the intervention of the government.

Relational Contracting

The term relational contracting is best understood as an alternative to the written legal contracts used in the United States as a means of specifying what is to be done, by whom, and how. In a broader sense, the term covers the favored status that members of a keiretsu possess relative to nonmembers for business transactions.

Japan’s automotive industry is a good example of relational contracting at work. Toyota, for example, will sign long-term supply agreements with parts suppliers within the Toyota group. However, these agreements are primarily indications of a joint willingness to work together over an extended period of time, including agreements to cooperate in business ventures. Unlike the situation in the United States, where such agreements would be much more detailed with respect to the rights and responsibilities of the signers, the Japanese signers rely on trust and mutual respect for enforcement, with the expectation being that disputes will not be settled through the legal system.

One of the ways in which this trust is established and maintained, or at least was in the past, is through the lifetime employment policies of Japanese firms. Contracts or agreements would be made ‘‘in principle’’ between the managers of firms (individuals), each of whom would expect the other to honor any implicit as well as explicit terms of the agreement and not seek to take advantage of the other party. Such arrangements work in part because each manager knows that he will be with the firm indefinitely, as will his counterpart at the other firm, and that dishonoring any terms of the agreement would have severe consequences in terms of the individual’s reputation. Again, think of the arrangements as ones between members of an extended family, with all the consequences that follow from family disloyalty.

This relational contracting is reinforced through cross-ownership of shares within the keiretsu and through implicit agreements to buy goods, parts, and services from other members even if the price is higher than that available from nonmembers. Such practices obviously compromise the public shareholders’ interests in the individual firm, but, from a family group perspective, such non-arms-length transactions merely reallocate profits within the group, leaving total group profits about the same. After all, the member who may be paying a higher-than-market price for one item may be receiving a higher-than-market price for what it sells to others.

Relational contracting, along with cross-ownership of shares, is a way of solving the problems associated with having parts suppliers make investments in the specific machinery and technologies needed to produce the parts and locate their production facilities where the automotive assemblers need them—a problem that American companies coped with through vertical integration. The essence of the problem is how to get a parts supplier to make investments in the machinery needed to supply parts to, say, Krafft Motor Company, and also to build the parts manufacturing facility near a Krafft assembly plant. Once the investment has been made and the plant has been built, what is to prevent Krafft from trying to lower the price it is willing to pay for the parts because the supplier, having made the investments, is in a very weak bargaining position? One answer would be cross-ownership of shares by Krafft in the parts supplier and relational contracting. Another answer would be to have Krafft buy the parts supplier and make it part of the company.

A CRITIQUE OF THE KEIRETSU

Until recently, the keiretsu was probably even more insulated from capital market discipline than German corporations. No arms-length corporate control market existed, and many transactions among firms were based on relationships rather than prices. But, for the system to have survived and Japan to have prospered under it in the post-World War II era, the system must have been solving a variety of problems associated with promoting economic growth and efficiency.

Advantages of the Keiretsu

Perhaps the most often cited advantage of the Japanese system is the development of long-term relationships that would not be possible in an arms-length market governance system. These relationships make it relatively easier for Japanese firms to restructure agreements in the event of financial difficulties or if outcomes are very different from those that were expected. For example, suppose the development costs incurred by a parts manufacturer for producing a new part for a new vehicle line turn out to be much higher than anticipated. The likelihood that the parts manufacturer will be able to renegotiate the original agreement and ‘‘share’’ the losses with the keiretsu buyer is much greater in Japan than in the United States, at least historically. Hence, a Japanese manufacturer was more likely to undertake the development project initially and make the necessary investment as the project unfolded without seeking prior contractual guarantees from the purchaser. Both parties would know that if something went wrong (or much better than expected), both would be obligated to share the unexpected consequences.

At the larger firms in Japan, this long-term relationship carried over to workers as well in the form of lifetime employment (this was not usually the case for small firms). Although Japanese workers do not have formal board representation as workers in Germany do, they are considered important stakeholders whose needs matter a great deal. When Nippon Steel planned to diversify into some nonsteel areas in which the company had no experience, it decided to retain steelworkers even though they were not needed. Workers came to expect these outcomes, and the result was a labor force that was committed to the company.

Disadvantages of the Keiretsu

The major criticism of the keiretsu from an economic growth and efficiency perspective seems to be that the system makes structural change difficult. Without market forces at work, companies tend to do what they always have done, and rather than shutting down negative NPV operations (restructuring), they keep them going so as to maintain the status quo. Critics of the system charge that these policies are reinforced by the government, which also wants to maintain high employment levels and reduce the political costs typically associated with structural changes.

It is impossible to quantify the benefits and costs of the Japanese keiretsu, just as it is impossible to do so for German universal banking or the American market governance system. Historical and cultural forces are as important as ‘‘scientific’’ economic efficiency factors, if not more important. But we can look at what is happening in Japan just as we did with Germany. What we find is a gradual erosion of the traditional keiretsu system—an erosion that arguably dates from the deregulation of Japanese financial markets (dubbed the Big Bang) and the country’s banking crisis.

Japanese Reforms

In 1996, Japan’s finance minister promised a ‘‘big bang’’ that would match the deregulation of London’s financial system in 1986. The objective was to liberalize and internationalize Japan’s financial industry. The proposed reforms included removal of restrictions that prevented banks, insurance companies, and investment houses from competing with one another. Financial reforms were to be coupled with reforms in other areas, including the way goods were distributed from producer to consumer and rules governing employment practices. The motivation for the reforms, according to many Japanese officials, was to make Japanese industries competitive in a global economy.

The Big Bang officially started on April 11, 1998, with the elimination of fixed brokerage commissions and the partial liberalization of foreign exchange dealings and cross-border capital transactions. Additional reforms were scheduled through 2001. Among these were giving individuals greater choice over where to place their money, such as mutual funds, thereby moving funds out of banks and into pension funds and other intermediaries that would be more attuned to the needs of public investors and less to the survival of the keiretsu.

This 1998 Big Bang coincided with a major banking crisis. Estimates of bad loans in the banking industry ran as high as a trillion dollars, or about one-fifth of total bank assets. Many analysts, especially Western analysts, attributed these bad loans to the clubby arrangements and relationship (non-arms-length) transacting within keiretsu, which were supported by the government. Instead of effectively monitoring management and stopping the flow of credit to failing firms within the group, the banks continued to pour money into them. The result, according to critics, was a set of bloated and inefficient industries, rising unemployment, and falling stock prices. These industries, protected by government restrictions on trade, were able to charge the Japanese prices that were far above world market prices, and any group member that tried to compete on price was ostracized. For example, the construction industry promised not to buy cement from firms that sold at prices below the cement industry association price. When one company tried to buy low-cost Korean cement, Japanese longshoremen refused to unload it.

As the banking crisis worsened and the Japanese economy continued to stagnate, what some might call seismic changes began to occur. In 1999, the French automotive company, Renault, acquired a 36.8 percent stake in Nissan, part of a keiretsu that was in a weak financial position. Along with the stake came an announcement that 21,000 jobs would be eliminated and five factories closed. Then, in November 1999, NTT, Japan’s leading telecommunications operator, said that it would cut 21,000 jobs by March 2003. And reports in the press in March 2000 tell about Japanese companies selling the shares they hold in one another (cross-holdings) at a faster rate than ever. The industries in which the cross-holdings are falling the fastest are airlines, railways, steel, and banking—generally identified as the poorest-performing industries. So, relationships seem to be unraveling and arms-length transactions seem to be becoming more important as the deregulation of Japan’s economy continues.

CONVERGENCE OR DIVERSITY?

Will corporate governance systems around the world converge to a single model, or will a diversity of systems continue to exist? And, if convergence is the answer, will it be the Anglo-American market system that dominates, or will it be some other system?

An informative context for evaluating these questions is that of the globalization of product and financial markets. By globalization, we mean the removal of barriers to capital and trade flows, so that national markets are open to all comers and domestic firms do not receive special legal treatment. In this world, firms compete on price and quality, with the winners being those firms that can offer the best quality at the lowest price. Even more important, perhaps, the winners are those firms than can quickly adjust to changing market conditions, innovate, and respond to technological change—let’s call this dynamic competition. So, the underlying economic question is: Does a particular governance system give a competitive advantage to those firms that adopt it? If so, all firms would be likely to adopt that system in order to remain dynamically competitive and survive.

However, suppose that the differences we have identified among market, banking, and relationship-based systems don’t really affect the firm’s competitive position or cost of capital, but simply represent different ways of solving similar problems—the old adage about there being many ways to skin a cat. If this is the case, then diversity among systems is likely to remain, with the differences being driven by cultural, political, and philosophical differences rather than economic efficiency factors. Economists have a name for this process: path dependence.

Path dependence means that the governance systems we observe around the world reflect the unique legal, political, and cultural conditions in a given country at a given time. Legal systems that did not protect the individual investor led to concentrated ownership structures. Political concerns about concentration of wealth and size led to systems that looked to markets and public ownership of corporations to solve economic efficiency and growth problems. Once in place, these governance systems evolved into their current form, as did the country’s other institutions. The result is simply a different constellation of rules, regulations, and institutions designed to solve the problem of organizing and monitoring the modern corporation.

We find the idea of path dependence appealing, especially because it is rooted in the political economy of a country and the country’s culture and traditions. Still, the evidence does suggest that governance systems that require government protection from competition or that hinder the firm’s ability to compete dynamically in world markets are likely to disappear. And, we are inclined to the view that a market-based governance system is better able to respond to the changing dynamics of the marketplace than a relationship-based system designed to protect the weakest members of its group. Only time will tell; after all, it was only a dozen years ago that many observers had declared the market-based system obsolete.

OECD PRINCIPLES OF CORPORATE GOVERNANCE

In May 1999, the Organization for Economic Cooperation and Development (OECD) put out a set of corporate governance standards developed in conjunction with national governments and international agencies such as the World Bank and the International Monetary Fund as well as the private sector. The principles are intended to assist governments in their efforts to evaluate and improve the legal, institutional, and regulatory framework for corporate governance in their countries, and to provide guidance and suggestions for stock exchanges, investors, corporations, and other parties that have a role in the process of developing good corporate governance.

The motivation behind the OECD initiative was partly its recognition that the overall health of a country’s economy, its prospects for economic growth, and its economic efficiency were directly related to the corporate governance issues we have addressed in this book. The OECD notes in its OECD Principles of Corporate Governance that:

good corporate governance enables companies to access financing from a much larger pool of investors and that if countries are to reap the full benefits of the global capital market, and if they are to attract long-term ‘‘patient’’ capital, corporate governance arrangements must be credible and well understood across borders. Even if corporations do not rely primarily on foreign sources of capital, adherence to good corporate governance practices will help improve the confidence of domestic investors, may reduce the cost of capital, and ultimately induce more stable sources of financing.

The principles are divided into five areas: the rights of shareholders, the equitable treatment of shareholders, the role of stakeholders, disclosure and transparency, and the responsibilities of the board. You can get a full listing and explanation of these principles at www.oecd.org. The principles effectively summarize the issues and points we have made throughout this book.