Corporate Governance

CCCorporateCorporate Governance

Carsten Burhop Universität zu KKölnölnölnöln Marc Deloof University of Antwerp

1. General introduction

Since the late 1990s, a series of papers published in leading economics and finance journals contain evidence for a significant impact of institutions on financial and economic development (e.g., Acemoglu et al., 2001, 2005; La Porta, Lopez-de-Silanes, Shleifer, and Vishny – LLSV henceforth – 1997, 1998, 2000; La Porta, Lopez-de-Silanes, Shleifer – LLS henceforth – 1999, 2008). According to this literature, high-quality institutions cause financial development. In turn, financial development is a driving force behind economic growth. The historical legacy seems to play an important role in the relationship between the financial development of countries, their current institutions and their past institutions. Indeed, prominent contributions demonstrate a strong positive correlation between legal origins (common law is considered to be better than civil law) and three further elements: first, current indices of the rule of law (Acemoglu et al., 2001; Beck et al., 2003); second, financial development (LLSV 1997, 1998; Beck et al, 2003); and third, the dispersion of share ownership and the separation of ownership and control (LLS 1999). In general, shareholders are supposed to have the strongest protection in common-law countries, followed by German-style civil- law countries. Shareholder protection is the weakest in French style civil law countries. In contrast, secured creditors are supposed to be best protected in the German legal system. Consequently, common-law countries have relatively high numbers of listed firms and of initial public offerings and a relatively high ratio of stock market capitalisation to GDP. In contrast, bank finance traditionally dominates in Continental Europe. According to this point of view, the legal system determines the financial system and both determine the system of 1 corporate governance since the separation of ownership and control is more common in market-based financial systems.

In contrast to the popularity of the ‘legal origin hypothesis’ in the economics and finance literature, economic historians and legal scholars do not find much support for it. In 1910, for example, the protection of shareholders was equally weak in civil and common-law countries, while the protection of creditors was equally strong in all countries (Musacchio, 2010; Sgard, 2006). Musacchio (2008) finds no relation between creditor protection and the development of bond markets in Brazil over the 1885-2003 period. Moreover, legal scholars point out that the protection of shareholders was stronger in Germany than in the United States during the 1970s and 1980s, but weaker than in Britain (Siems, 2008). Thus, a general ranking of legal systems seems difficult. Consequently, it is important to track the development of each legal system over time.

Since the ‘legal origins hypothesis’ is not accepted by economic and legal historians, they stress factors like the demand for financing, the stability of the macroeconomic and political environment or extralegal institutions as more important in the long run for financial development and corporate governance than legal origins. Coffee (2001), for example, suggests that the enlightened self- regulation of the New York Stock Exchange in combination with efforts of investment banks to develop credible bonding mechanisms was the driving force behind financial development in the United States. For Germany, the interrelationship between banks and stock markets has also been highlighted. Fohlin (2007) demonstrates that the German civil-law tradition did not work against the development of active securities markets and she suggests that large universal banks positively affected security market development by assuring (potential) investors about the quality of listed securities. Thus, the separation of ownership and control is possible in all legal families and financial systems. Moreover, historical studies show the importance of extralegal institutions for financial development and corporate governance.

2 A better understanding of corporate governance and the political economy of corporate governance is essential since corporations are and were important for economic development. They allow locking-in financial capital beyond individual investors or entrepreneurs, they make investments into long-lived and specialised assets possible, they allow the build-up of specific information and control systems, and they make the emergence of organisational reputation possible (Blair, 2003). The corporate form of the joint-stock company therefore allowed the formation of large firms which build the backbone of the modern economy since the 19 th century. Moreover, the joint-stock company fostered the emergence and development of financial institutions since the shares of corporations are often traded at stock exchanges. However, the corporation not only has advantages. Corporate managers usually have substantial discretionary power and need not act in the interest of all shareholders, nor speak of all stakeholders of a corporation. Thus, shareholders and stakeholders are interested in setting up suitable institutions to monitor and influence managers. Only if investors and creditors are well protected by the rule of law or by extralegal institutions, they are willing to finance firms and they are willing to accept the separation of ownership and control.

One central problem of corporate governance is the existence of different aims by different groups involved. Moral hazard of managers, for example, comes in many forms: low effort, private benefits, inefficient investment, accounting value manipulation, market value manipulation or self-dealing. In principle, shareholders can take two roads to alleviate managerial moral hazard: incentive schemes and monitoring. Incentive schemes connect the managers’ income to a performance target set by the shareholders. However, one should note that shareholders are a heterogeneous group and that managerial contracts are usually signed by shareholder delegates, e.g., members of the supervisory board. Consequently, managerial working contracts may align the targets of the manager and of only some influential shareholders. Another way to align shareholders’ and managers’ targets is compulsory shareholding of managers. If managers receive a substantial fraction of their income from stock returns, they are more likely to act in the best interest of all shareholders. 3

Monitoring of corporations can be performed by a variety of parties, e.g., the supervisory board, auditors, large shareholders, large creditors, banks, labour representatives, and government agencies. On the one hand, monitoring can be active and forward-looking, e.g., the influence on investment decisions taken by large shareholders or bankers sitting on the supervisory board. On the other hand, monitoring can be passive and backward-looking, e.g., the auditing of accounts by external auditors. Monitoring institutions can be set up by the shareholders – for example in the corporate charter or corporate by-laws – or by the government. The traditional monitoring institution of a joint-stock company is a supervisory board or non-executive board, both often composed of shareholders. A supervisory board can closely monitor the managers in the best interest of all shareholders. In practice, however, supervisory board members may represent their own interests, which are not necessarily identical to the interests of all other shareholders. Furthermore, supervisory board members may be handpicked by the managers, they may be former managers or they may have a large number of supervisory board positions, leaving little time to monitor a given firm. Consequently, monitoring is often incomplete.

This view of corporate governance takes the existence of corporations and the legal environment for granted. In fact, corporate governance institutions are set up, among others, by national governments or by private actors. In some cases, the interaction of government and private actors is necessary. For example, the fundament of joint-stock companies builds the corporate law enacted by the government. Private actors incorporate a certain joint-stock company and design its corporate governance within the legal limits. In turn, incorporators, investors or managers may push the government to enact specific rules.

Typically, corporate governance research in economics focus on the optimal design of contracts between suppliers of finance and managers or the optimal design of corporate governance within a given legal-institutional framework. However, the corporations’ ability to commit to return funds to their investors depends on a policy environment that is exogenous to individual firms: laws and 4 regulations that govern contracts and contract enforcement, taxes, labour law, macroeconomic policy and so on. Tirole (2006: 55) points out that the legal and contracting institutions are endogenous. They are made by political coalitions. As a consequence of this insight, the political economy of corporate governance has been in the focus of recent research. Evidence has been put forward showing that the legal rules of corporate governance depend on the legal tradition of a country (e.g., civil-law versus common-law countries) and the political system of a country (e.g., centralist versus federalist; majoritarian versus proportional electoral system).

2. The historical empirical evidence in context

2.1. The political economy of corporate governance systems.

The openness of economies, the distribution of wealth within national economies, the distribution of political power within countries and the political system shaped the political economy of corporate governance systems during the 20th century. In a seminal paper, Rajan and Zingales (2003) describe the great reversal of financial development over the 20 th century. During the early and late 20 th century, highly developed financial markets existed, whereas the period between World War I and the early 1970s was shaped by less developed financial markets. Rajan and Zingales (2003) relate the relative decline of financial markets to major disruptions in the global economic system. They suggest that trade and cross-border capital flows weaken incumbent interest groups within countries. During the interwar and early post-war period, trade and cross-border capital flows were restricted in many countries. Thereby, national champions became politically more influential and they had an interest to inhibit the emergence of competitors. One way to restrict newcomers is to restrict access to finance. Thus, incumbents’ pressure groups in closed economies favour legal actions to limit financial development. One way to limit financial development is to weaken corporate governance.

5 Perotti and von Thadden (2006a, 2006b) propose another explanation for the decline of financial development after World War I. They hypothesize a close relation between the political system, the concentration of wealth in a society, and the rules of corporate governance. A strong concentration of wealth implies that most voters rely on labour income as the major source of earnings. Thus, most voters have a strong preference for redistribution of capital income – i.e., high corporate taxes – and a preference for low corporate risk-taking since this increases job security. Thus major changes in wealth concentration should affect the legal rules underlying corporate governance. In particular, Perotti and von Thadden (2006a, 2006b) highlight the destruction of financial wealth during the hyperinflation of the post-World-War-I period.

Roe (2003) explains differences in corporate governance with the conflict between capital and labour, since rents had to be distributed among (minority and majority) owners of firms, other financers, management and labour. Politically influential groups can change the national corporate governance system to increase its share of the rents. Moreover, he suggests that major political disruptions explain different governance systems in civil-law versus common-law countries, since mainly civil-law countries collapsed under war, military invasion, or occupation during the 20 th century.

The three aforementioned lines of research highlight different interest groups: incumbent firms, investors, managers, workers, voters and labour representatives. These interest groups do not write the legal rules themselves, but they can influence politicians making the rules. The ways to influence political decisions makers strongly depends on the political system. Major differences can be expected to exist between political decision-making in late 20 th - century democracies on the one hand and political decision making in mid-19 th - century monarchies on the other hand. So far, only the divergence of corporate governance during the late 20 th century has been linked to differences in electoral systems in democratic states (Pagano and Volpin, 2005). Countries with a proportional electoral system favour low investor protection and high labour protection, whereas the outcome can be converse in countries with a majoritarian 6 electoral system. Moreover, within a given political system, financial development can be path dependent. Pagano and Volpin (2006) demonstrate for a panel of countries for the 1990s that better investor protection induces companies to issue more equity, leading to a broader stock market. In turn, equity issuance expands the shareholder base and increases political support for shareholder protection.

2.2. The ownership structure of corporations.

The principal-agent problem in joint-stock companies depends on the separation of ownership and control. Faccio and Lang (2002) show that the typical European firm is nowadays widely held or family controlled. Widely held firms are more important in Britain, whereas family controlled firms are dominant in continental Europe. Taking a global perspective, LLS (1999) show that today’s firms are typically controlled by families or the state and the controlling shareholders have more governance than cash-flow rights. Widely held ownership is – by and large – restricted to the United States and Britain.

The ownership structure affects firm performance. An important study employing firm-level data about the ownership structure of Asian firms shows that the stock market valuation of firms increases when they have a large shareholder, as long as the cash flow share of the dominant shareholder does not exceed his ownership share (Claessens et al., 2002). LLSV (2002) take an internationally comparative look into the issue and they combine data about national corporate governance regulation and firm-level data. They provide evidence that firms have a higher stock market valuation when they come from countries with better protection of minority shareholders and when they have a controlling shareholder with a high cash-flow share.

Historical studies about the ownership structure of corporations are in short supply. Hannah (2007) provides some evidence that the relatively weak rights of minority owners were a reason for the relatively high ownership concentration in the United States around 1900. In contrast, minority shareholders were 7 relatively well protected in Europe at the time, making dispersed ownership possible. European minority shareholders were often protected by graduated voting scales in corporate charters, whereas American firms usually employed a one-share-one-vote rule. Thus, cash-flow rights of large shareholders were weaker than their governance rights. For a sample of British firms incorporated around 1900, Franks et al. (2008) find that their ownership was rapidly dispersed in the first half of the twentieth century, in the absence of strong investor protection. This finding suggests that the differences in ownership concentration between the United Kingdom and continental European countries are not a recent phenomenom and are not caused by investor protection. With respect to Germany, the most extensive empirical study, which has been published by Franks et al. (2006), is based on ownership data for less than 20 firms and presents data for some benchmark years starting in the late 19 th century. In contrast to Hannah’s (2007) hypothesis, it turns out that most firms had a dominant shareholder.

2.3. Corporate governance differences among firms within countries.

Corporate governance differs among firms within countries. Corporate by-laws and corporate charters often contain specific rules protecting shareholders and creditors of a specific firm. A substantial variation of shareholder rights has been documented for modern U.S. corporations. Moreover, a correlation between the quality of firm-level corporate governance and firm performance has been established (Gompers et al., 2003). In a historical context, Burhop (2009) has shown that firms having a one-share-one-vote provision in their corporate charter or a banker at the top of the supervisory board paid lower bonuses to executives. In addition, governance standards of German banks during the early 1870s varied substantially and were on average below the legal minimum standards. Moreover, Burhop (2009) presents evidence for a positive impact of corporate governance on firm performance for large banks. In addition, large banks having their charter audited by the government had better corporate governance. Beyond Germany, Hickson and Turner (2005) show for a sample of Irish banks for the early 19 th century that weak legal protection of shareholders was 8 substituted by substantial shareholder protection in corporate charters. Campbell and Turner (2011) find for a sample of publicly traded British firms at the beginning of the 1880s that larger boards and requirements upon directors to own shares were positively correlated with corporate value. Other studies are available for 19 th century Britain and the U.S., but firm-level studies about the quality of corporate governance for the period between c. 1915 and c. 1975 are not available.

2.4. Banks and bankers.

Banks and bankers play an important role in corporate governance. In modern Germany, for example, bank monitoring is a solution to the control problem in joint-stock companies (Chirinko and Elston, 2006) and it is correlated with lower executive compensation (Elston and Goldberg, 2003). In a historical context, Bayer and Burhop (2009a) have shown that bank monitoring reduced the level of executive compensation in Imperial Germany. The results of Becht and Ramirez (2003) suggest that universal banks in pre-World War I Germany reduced financing constraints for companies in the steal and coal-mining industries. However, their results are contradicted by the finding of Fohlin (1998) that in the period considered, investments of German companies affiliated with a universal bank were actually more sensitive to cash-flow.

For the U.S., Ramirez (1995) finds that at the turn of the twentieth century U.S. companies with a J.P. Morgan director on their board were less liquidity constrained. Furthermore, De Long (1991) finds that U.S. companies with a Morgan partner on their board added between 6 and 30 percent to common stock equity value and about 15 percent to the total market value. Similarly, Simon (1998) finds that the withdrawal of a Morgan director from a company’s board depressed company value about 7 percent.

An influence of bankers on corporate governance has also been reported for 19 th - century Belgium. Van Overfelt et al. (2010) show that Belgian firms connected to a bank had better financial reporting and that high dividend pay-out ratios were 9 a substitute for detailed reporting of corporate accounts to the shareholders 1. Deloof et al. (2010) demonstrate that firms with one bank director on their board paid higher dividends, whereas companies with several bank directors on their board and companies in which banks owned an equity stake paid lower dividends. Moreover, Van Overfelt et al. (2009) present evidence that Belgian industrial firms having a banker in the corporate board had a higher market-to- book ratio and higher return on assets. Firms affiliated with a bank also displayed lower stock price volatility and better Sharpe ratios.

Most current studies do not use data from the period circa 1914-1970 and it is thus not clear if the impact of banks on governance was stable over the 20 th century, or if the governance role of banks was similar during the early and late 20 th century, but different in between. In a recent study, Braggion and Ongena (2011) investigate the relationships between firms and banks between 1896 and 1986 in Britain, and find a remarkable shift from single to multiple firm-bank relationships in the second half of the Twentieth century. They find that especially larger, global and transparent firms with a greater need for bank credit and specialized services switched to multiple firm-bank relationships.

2.5. Takeovers

Takeovers may play an important role in corporate governance. Especially in the U.S., they are widely seen as a critical corporate governance mechanism to control managerial discretion (e.g., Shleifer and Vishny, 1997). Takeover targets are often poorly performing firms of which the managers are removed once the takeover succeeds. However, while takeovers typically increase the combined value of the target and acquiring firm, most studies find non-positive wealth

1 Another study which considers financial reporting as a tool to reduce agency problems is Barton and Waymire (2004). Using a sample of stocks traded on the New York Stock Exchange in October 1929, they find that the quality of financial reporting increased with incentives of managers to supply higher quality financial information demanded by investors. Furthermore, firms with higher quality financial reporting before October 1929 experienced smaller stock price declines during the market crash. 10 effects for acquiring firms. Why would managers undertake takeovers if these destroys shareholder value? One explanation could be managerial empire building or hubris: managers engage in takeovers in order to maximize their own utility at the expense of shareholders. Braggion et al. (2010) investigate bank mergers and acquisitions in Britain from 1885 to 1925. Contrary to most contemporary studies, they not only find positive wealth effects for target banks but also for bidding banks. This result suggests that the role of managerial empire building or hubris in takeovers may be overstated, since bank directors faced few constraints on their actions in Britain during the period considered.

2.6. Executive compensation.

Executive compensation is one of the most active fields of debate since the 1990s. For example, Core et al. (1999) show for a cross-section of American corporations that firms with weak corporate governance have greater agency problems and therefore CEOs receive larger compensation packages. In a similar vein, Burhop (2004) and Bayer and Burhop (2009a, 2009b) have shown an effect of varying firm-level corporate governance and of legal minimum standards of corporate governance on the agency conflict between shareholders and managers in late 19 th - and early 20 th -century Germany. The stricter legal minimum standards enacted in the 1884 corporate law reform resulted into a significantly lower pay- performance sensitivity of executive compensation and a stronger correlation between executive turnover and short-run firm performance. In contrast to the relatively strong relation between pay and performance in 19 th -century Germany, evidence for modern Germany suggests at best a weak correlation between them (Edwards et al., 2009). Furthermore, the co-determination law enacted in Germany in 1976 weakened the pay-performance sensitivity, since labour representatives in corporate boards favour a redistribution of rents. More specifically, firms with a strong influence of labour representatives have longer payrolls and lower stock market value. This suggests that co-determination legislation redistributes rents from capital income towards labour income (Gorton and Schmid, 2004). However, it has not yet been investigated whether the higher

11 influence of labour representatives after World War I affected executive compensation and the distribution of income between labour and capital.

One should note that most executive compensation studies use data from the very recent period, whereas historical studies using data from the pre-1970 period are in very short supply. One exception is Frydman and Saks (2010), who investigate the compensation of executives of large firms in the United States from 1936 to 2005. They find that executive compensation was remarkably flat from the end of World War II to the mid-1970s, even though firm grew considerably in this period. In the 1980-2005 period, executive pay and firms expanded at almost the same rate. The sensitivity of changes in executive wealth to performance was similar from the 1930s to the 1980s and strengthened considerably after that. They also find that the correlations of firm characteristics with pay-to-performance have not much changed over time.

2.7. Dividends

When shareholder protection is weak, firms may pay higher dividends as dividends may be a substitute for investor protection. By paying dividends, firms can establish a reputation for moderation in expropriating outside investors, i.e. stealing company assets at the expense of these investors. This reputation makes it possible for the company to raise external funds on attractive terms (LLSV 2000). A reputation of good treatment of shareholders is especially valuable in an environment with information problems and weak shareholders protection as shareholders have little else to rely on. Cheffins (2006) argues that in the U.K. during the 20th century, dividends mimicked the role that the ‘law matters’ literature attributes to corporate and securities laws: high and stable dividends constrained corporate insiders, and provided investors with information about the companies. However, this argument is not confirmed by the results of Braggion and Moore (2010). In a study of dividend policies of 475 British firms listed on the London Stock Exchange between 1895 and 1905, they find little support for the argument that dividend policies are used to reduce agency conflicts. Campbell and Turner (2011) on the other hand find a positive relation 12 between dividend payouts and Tobin’s Q for a sample of publicly traded British firms at the beginning of the 1880s, which suggests that investor put a higher value to stocks which paid higher dividends.

3. Conclusion

Historical research provides valuable new insights into the role of corporate governance. For example, some studies have raised serious doubts about the ‘legal origins hypothesis’ of LLSV, although LLS (2008) dispute that the historical evidence undermines their legal origins hypothesis. Nevertheless, corporate governance research with historical data is scarce. While some topics have been receiving some attention in recent years (e.g., the role of banks) other topics have been scarcely touched at all (e.g., executive compensation, the value of takeovers). Furthermore, the existing research has focused on a limited set of countries (primarily the U.S., the U.K., and Germany), which makes it difficult to draw general conclusions from the results, especially since studies for different countries often find seemingly contradicting results (e.g., on the role of banks). To the best of our knowledge, there have not yet been any historical studies that take a multi-country perspective on corporate governance. This therefore seems a very fruitful avenue for further research.

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