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CHAPTER 4

CORPORATE GOVERNANCE IN THE ECE REGION

The recent financial scandals at major have highlighted the costs of failures and have put corporate governance reform firmly on the policy agenda. Within the ECE region, there are basically two established models of corporate governance, one prevalent in the Anglo-Saxon countries, the other in continental Europe. They differ from one another in several ways, including who exercises control, in the structure of the board and of ownership at large, in their focus on shareholder or stakeholder interests and in the degree of protection they offer to shareholder and creditor rights. However, neither system has proven demonstrably superior to the other. Powerful forces, such as the need to access foreign capital markets, the pressure of institutional investors and the drive to create a single European market in financial services, are creating considerable pressure for convergence of these systems. However, a system of corporate governance, like a society’s other important institutions, is not easily transplanted. Even more so than in mature market economies, the corporate governance systems in central and eastern Europe and in the CIS remain works in progress. While progress on the legal protection of shareholder and creditor rights has been quite impressive, considerable enforcement gaps persist, particularly in the CIS, constraining firms in their access to outside .

4.1 Introduction corporat e governance since the creat ion of the count ry’s securit ies regulation regime in the 1930s. Viewing the Corporate governance has become a subject of situation in the United States with alarm, European heightened import ance and attent ion in government countries, mindful of earlier financial scandals of their policy circles, academia and the popular press throughout own, are examining their own syst ems of corporate the ECE region. Various reasons explain the current governance in an effort to guard against similar abuses. prominence of what many persons might otherwise consider an arcane and t echnical topic. The recent Even before the recent scandals, significant effort s, financial scandals affect ing major American firms, such propelled to a certain extent by earlier financial abuses, had as Enron, WorldCom and Arthur Andersen, and the been underway since the early 1990s within the OECD,246 result ing loss of confidence by the investing public in the the European Commission247 and individual European have led to dramat ic declines in share prices countries248 to understand the economic consequences of and substantial financial losses to millions of individual investors. Both the public and the experts have identified failed corporate governance as a principal cause of these 246 Organisation for Economic Co-operation and Development, OECD scandals. Since half of all adults in the United States own Principles of Corporate Governance (endorsed by Ministers at the OECD stock either direct ly or indirect ly, corporate governance Council Meeting, 26-27 May 1999) (Paris), October 1999 [www.oecd.org]. In the wake of the financial scandals in the United States and the growing reform has become a highly charged polit ical issue. The international concern over corporate governance, the OECD Council at American Congress rapidly responded by passing the Ministerial at its meeting of 15-16 May 2002 launched a new initiative Sarbanes-Oxley Act of 2002,244 wh ich the New York to strengthen corporate governance. Its final communique stated: “… the St ock Exchange (NYSE) quickly followed by adopting OECD will survey developments in OECD countries on governance in the 245 corporate and financial sectors, with a view to identify ing lessons to be sweep in g new rules for list ed co rpo rat ion s, thereby learned and the implications for the assessment of the OECD Principles of effect in g the mo st sign ificant refo rm in Un ited St ates Corporate Governance as a bench mark” [www.oecd.org]. The assessment is to be completed by 2004.

247 Weil, Gotshal & Manges, LLP, on behalf of the European Commission, 244 Sarbanes-Oxley Abnct of 2002 (Senate), H.R. 3763, 107th Internal Market Directorate General, Comparative Study of Corporate Congress, July 2002. Governance Codes Relevant to the European Union and its Member States, January 2002 [www.europa.eu.int/comm/internal_market/en/index.htm]. 245 “Corporate governance rule proposals reflecting recommendations to the NYSE corporate and listing standards committee, as 248 In addition to numerous articles and studies, prestigious groups approved by the NYSE , 1 August 2002” and within individual countries have produced over 30 [www.nyse.com]. The new standards are subject to approval by the recommended codes of best practices in corporate governance over the United States Securities and Exchange Commission, which had not last decade. For a comprehensive listing of these codes and reports, see formally approved them as of 1 December 2002. Weil, Gotchal & Manges, op. cit., pp. 14-16. 104______Economic Survey of Europe, 2003 No. 1

corporat e governance and t o formulat e recommendat ions compet it ive market economies, effective systems of on appropriat e governance struct ures and pract ices. In corporate governance are seen as a key variable enabling emerging market economies in eastern Europe, countries to derive real economic benefit s from these experience over the last decade has clearly shown that fundament al economic changes. successful privatizations and the development of vibrant Corporate governance also has diverse international private sectors depend t o a significant extent on the 249 implications. that list their securities on existence of effective systems of corporate governance. foreign markets in order to gain access to new sources of For example, the ability of “oligarchs” in to capital subject themselves in varying degrees to the dominate and raid corporations and to engage in asset corporat e governance standards of the count ries where stripping and self-dealing at the expense of foreign and they are listed. In addit ion, one of the grounds upon domestic investors was clearly due to systems of which opponent s of “ globalizat ion” have challenged corporate governance that gave little or no protection to m ult inat ion al co rporat ion s, th e prim e m overs of investors who were not insiders. Following rapid globalization, is that flawed systems of governance allow privatization in the , which gave corporat e decisions to be made without taking account of insufficient att ention to the prot ect ion of shareholder the interests of all “stakeholders”, other than those of property rights, thousands of small investors sustained corporat e managers and shareowners. One recent st udy254 significant losses as “tunnelling” by insiders stripped has also concluded that important int ernational economic asset s from privat ized companies.250 disputes, such as those within the European Union over More generally, the ability of countries to attract the right of state-controlled public utilities to remain immune from takeovers, or the tensions between the foreign capital is affect ed by their syst ems of corporate Unit ed States and Japan over Japanese bank debts, arise governance and the degree to which corporate out of corporate governance problems. is compelled to respect the legal rights of lenders, bondholders and non-controlling shareowners.251 In view of the current concern with corporate Individual and institutional investors will refrain from governance and it s far reaching implications for providing capital or will demand a higher risk premium economic activity, financial strength and international for their capital from enterprises in countries without relat ions, this chapter considers the nat ure of corporate effect ive syst ems of corporate governance than from governance, the various models and forms that it takes in similar enterprises in count ries having strong corporate Europe and North America and the challenges that it governance standards.252 One can also say that because poses for economic and legal policy in the ECE region. of its role in capital format ion, corporat e governance has important consequences for economic efficiency and 4.2 Defining corporate governance growth.253 Effective corporat e governance imposes a The t erm “ corporate governance” appears t o have discipline on firm managers to maximize returns to the arisen and entered into prominent usage in the mid- to firm. With the movement throughout the world toward late 1970s in the United States in the wake of the the expansion of privat e sectors and the creat ion of more Wat ergate scandal and the discovery that major American corporat ions had engaged in secret polit ical contributions and corrupt payments abroad.255 Eventually it also gained 249 A. Dyck, “Privatization and corporate governance: principles, evidence and future challenges”, The World Bank Research Observer, currency in Europe as a concept distinct from corporate Vol. 16, No. 1, Spring 2001, pp. 59-84; S. Estrin, “Corporate governance management, law or corporate organizat ion. and privatization: lessons from transition economies”, Journal of African Economies, Vol. 11, February 2002 and “Competition and corporate Scholars and practit ioners of corporate governance governance in transition economies,” Journal of Economic Perspectives, give the term a wide variety of definit ions. Economists Vol. 16, No. 1, Winter 2002, pp. 101-124. and social scient ists tend to define it broadly as “the 250 M. Iskander and N. Chamlou, Corporate Governance: A in st it ution s th at influen ce ho w busin ess corpo rat ion s Framework for Implementation, The World Bank Group (Washington, allocate resources and returns”256 and “the organizat ions D.C.), 2000, p. 2. See generally, R. Frydman et al., Corporate Governance in Central Europe and Russia (two volumes), Central and rules that affect expect ations about the exercise of 257 European University (Budapest), 1996. control of resources in firms”. One noted economist 251 OECD Principles of Corporate Governance, “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 254 J. Shinn and P. Gourevitch, How Shareholder Reforms Can Pay credible and well understood across borders”, Preamble, p. 12, note 3. Foreign Policy Dividends (New York, Council on Foreign Relations, See also E. Rueda-Sabater, “Corporate governance and the bargaining 2002), pp. 5-6. power of developing countries to attract foreign investment”, Corporate Governance, Vol. 8, No. 2, April 2000, pp. 117-124. 255 E. Veasey, “The emergence of corporate governance as a new legal discipline”, The Lawyer, Vol. 48, 1993. 252 In a survey conducted in 2000, investors stated that all other things being equal they would be willing to pay more for a company that is well 256 M. O'Sullivan, “Corporate governance and globalization”, The governed as opposed to one less well governed. McKinsey & Company, Annals of the American Academy of Political and Social Science, Vol. Investor Opinion Survey on Corporate Governance, June 2000. 570, No. 1, July 2000, pp. 153-154. 253 OECD Principles of Corporate Governance, “One key element in 257 World Bank, Building Institu tions For Markets: World Bank improving economic efficiency is corporate governance …”, Preamble, p. 11. Development Report 2002 (Washington, D.C.), p. 68. Corporate Governance in the ECE Region ______105

has rather cryptically written that governance is “an first published in 1932.262 Berle and Means examined the in st it ut io nal fram ework in wh ich th e int egrit y of th e growing concentration of economic power in the modern transact ion is decided”.258 These definit ions focus not corporat ion and not ed the rise of professional managers only on the formal rules and institutions of corporate having operational control of large corporations but little governance, but also on the informal pract ices that or no ownership of the ent erprise. They also pointed to evolve in the absence or weakness of formal rules.259 the increasing dispersion of corporate shares among a Moreover, they encompass not only the internal growing number of persons, who, because they were st ruct ure of the corporat ion but also it s ext ernal numerous, widely scattered and had relat ively small environment , including capital and labour market s, interests, were not able to exercise control over the bankrupt cy syst ems and government compet it ion they owned. This divorce of ownership from policies. control in the modern American corporat ion posed a Corporate managers, investors, policy makers and challenge to the int erests of shareholders. Berle and lawyers, on the other hand, tend to employ a more narrow Means viewed corporate governance (a t erm that appears definit ion. For them, corporat e governance is the system nowhere in their book) as a classical agency problem: o f rules an d in st it ution s th at determ in e the co ntro l an d how could corporat e managers, as agent s of the direct ion of the corporat ion and that define relat ions shareholders, be induced to manage corporate asset s in among the corporat ion’s primary participant s. Thus, the the best interests of their principals? Unit ed Kingdom’s 1992 Report’s often quoted Some scholars have come to dispute the definit ion is: “Corporat e governance is the system by applicability to countries outside of the United States of which are directed and cont rolled”.260 As the Berle and Means model of the modern publicly traded applied in practice, this narrower definition focuses corporation. Finding that dispersed share ownership is almost exclusively on the internal structure and operation largely an American and Brit ish phenomenon, they have of the corporation’s decision-making processes. It has argued that because large publicly traded corporat ions in been this narrower definit ion that has been central to other count ries, for example in cont inental Europe, Lat in public policy discussions about corporate governance in America and Japan, are to a significant extent run by most count ries. For example, the OECD Principles of control groups with substantial interests in the Corporate Governance deals with only five topics: I. The firm, the basic problem of corporate governance in those Right s of Shareholders; II. The Equit able Treatment of countries is to protect minority shareholders from Shareholders; III. The Role of St akeholders in Corporate expropriat ion by controlling part ies.263 Share ownership Governance; IV. Disclosure and Transparency; and V. and therefore voting power in publicly traded The Responsibility of the Board.261 At the same time, as corporat ions is more concentrated in continent al Europe will be seen, countries within the ECE region have than it is in the Unit ed St ates and the Unit ed Kingdom. applied and elaborated upon these narrower definit ions in In addit ion, a larger percentage of the populat ion is different ways. This chapter will focus primarily on the shareowners in the Unit ed States than in European formal rules and inst it utions of corporat e governance in countries. For example, whereas one half of all ECE countries. American adult s direct ly or indirect ly own corporate 264 In the United Stat es, corporat e governance as a shares, only one in five Germans is a shareowner. public policy issue originates in The Modern Corporation The statistical patterns that emerge with respect to and Private Property, the classic work by Adolf Berle, the concentrat ion of corporate share ownership lead to the Jr., a law professor, and Gardiner Means, an economist, conclusion that within the countries of the ECE region there are basically two different types of publicly traded corporation: the “manager-dominated model,” which 258 O. Williamson, The Mechanisms of Governance (New York, prevails in the United St ates and the , Oxford University Press, 1996). and the “controlling shareholder-dominat ed model,” 259 A. Dyck, op. cit. which prevails in most of the European continent. While 260 Report of the Committee on the Financial Aspects of Corporate this difference in share ownership st ruct ure is real and has Governance (Cadbury Report), para. 2.5 [www.ecgn.org]. 261 The American Law Institute’s Principles of Corporate Governance: Analysis and Recommendations (St Paul, MN, American 262 Law Institute Publishers, 1994), takes a similarly restricted view of the A. Berle, Jr. and G. Means, The Modern Corporation and Private subject’s scope. The product of 15 years of study by America’s leading Property (New York, Macmillan, 1932). of lawyers, judges and law professors, it consists of over 800 263 For exam ple, R. La Porta, F. Lopez-de-Silanes and A. Shleifer, pages and purports to provide a comprehensive statement of corporate “Corporate ownership around the world”, Journal of Finance, Vol. 54, No. 2, governance in the United States. It consists of seven parts: I. Definitions; April 1999, pp. 471-517; F. Barca and M. Becht, The Control of Corporate II. The Objective and Conduct of the Corporation; III. Corporate Europe (Oxford, Oxford University Press, 2001); C. Mayer, Corporate Structure: Functions and Powers of Directors and Officers; Audit Cultures and Governance: Ownership, Control and Governance of European Committee in Large Publicly Held Corporations. III-A Recommendations and US Corporations, 31 March 2002, unpublished paper, conference draft of Corporate Practice Concerning the Board and the Principal Oversight [www.ksg.harvard.edu/cbg/Conferences/us-eu_relations/meyer_corporate_ Committees; IV. Duty of Care and ; V. Duty of culture_governance.pdf]. Fair Dealing; VI. Role of Directors and Shareholders in Transactions in 264 Control and Tender Offers; and VII. Remedies. New York Times, 29 September 2002, p. WK4. 106______Economic Survey of Europe, 2003 No. 1

a variety of implicat ions for corporate act ivity, a central governance problem essent ially as one of assuring that problem of corporate governance throughout the region the corporat ion is managed in the best interests of it s nonetheless arises out of the separation of ownership and shareowners.266 Indeed, since fund managers are control underscored by Berle and Means. That problem compensated by how well they maximize shareholder is how t o prot ect minority shareholders from those in value in relation to a stated “benchmark,” they have control, whether the controllers are professional powerful incent ives to do so. For them, the principal managers without substant ial ownership int erests who focus of corporate governance is to define the would manage the corporation largely in their own relat ion sh ip bet ween the th ree p rim ary participants in t he interests, or shareholders with a controlling interest who corporation: shareholders, the board of directors and would enrich themselves at the expense and in violat ion company management.267 of the rights of the minority. Many Europeans consider the tradit ional American The corporate governance problem identified by definit ion of corporate governance, wit h it s central Berle and Means 70 years ago has not diminished in the preoccupat ion of protecting shareholder rights and United States since the publication of their seminal work. interests, to be too narrow. For many persons on the Indeed, as the ownership of corporate shares by European cont inent , part icularly in and American households, both direct ly and through financial where share ownership is much less dispersed among the institutions, has increased and spread dramatically public than it is in the United States,268 the central throughout American society largely as a result of the preoccupat ion of corporate governance should not be t he privately funded nature of the United States retirement rights of shareholders in relat ion to managers, but rather system, the principal concern of investors, practitioners the rights of the community in relation to the corporation and scholars of corporate governance in the Unit ed States itself.269 For Americans, corporat e governance is about has been how to protect the legitimate right s and interests shareholders controlling managers for purposes of of shareholders when faced wit h managers who control shareholder profit (managerial responsibility); for many the corporat ion. The collapse of Enron and the financial Europeans it is about society cont rolling corporat ions for scandals at other large American corporations have purposes of social welfare (corporate social reignited public concern with the question of corporate responsibility). Thus, unlike Americans who have tended governance in the sense of how to devise systems, rules to separate issues of corporate governance from corporate and institutions that will induce corporate executives to social responsibility, Europeans have joined the two manage corporate assets in the interests of the themes in discussions about how corporations should be shareholders, rather than their own. The spectacle of managed and regulated. The difference in definit ion and certain Enron top managers emerging from their bankrupt perspect ive on the nat ure and purpose of corporate corporation with substantial financial gains while governance makes it essential that in any trans-Atlantic investors and employee shareholders sustained large dialogue on "corporate governance" the t wo sides losses has only served to highlight the problems posed by recognize that at times they may really be talking about the divorce of ownership from cont rol in large American two different things. corporations and to focus renewed attention on the need St rict ly speaking, corporate governance is a matter to reform corporat e governance. of vital concern for all corporations, large or small, Although the fundamental agency problem is still publicly traded or privately held. In practice, both in the same, what has changed since the t ime of Berle and North America and Europe, the policy discussion on M eans h as been th e r ise of in st it utio nal investo r s, propelled to a significant extent by the nat ure of the privately funded United St ates ret irement system and t he 266 Many institutional investors prefer the term “shareowner” to aging of the American population. The dispersion of “shareholder”. The California Public Employees Retirement System (CalPERS), the largest public pension fund in the United States with share ownership, which served to render shareholders assets of $143 billion and an active advocate of good corporate powerless, has been countered to some extent by the governance, has stated that “shareowner” is preferable because it “reflects growing concentrat ion of corporate shares265 in the hands our view that equity ownership carries with it active responsibilities and is not merely passive ‘holding’ shares”. CalPERS, Corporate Governance of mutual funds, pension funds and other institutional Core Principles & Guidelines 13 April 1998 [www.calpers.org]. investors who have shown increasing willingness to be 267 R. Monks and N. Minow, Corporate Governance, Vol. 1, 1995, strong act ive advocat es for shareholder int erests and good define corporate governance as the “relationship among various governance within the corporations whose shares they participants in determining the direction and performance of corporations. m anage. In st it ut ion al inv estors in th e Un ited Stat es an d The primary participants are 1) shareowners; 2) management (led by the ); and 3) the board of directors. See also CalPERS, the United Kingdom continue to view the corporate op. cit., which explicitly adopts this definition. 268 R. La Porta et al., op. cit. See also, J. Coffee, Jr., “The future as history: the prospects for global convergence in corporate governance and

265 its implications,” Northwestern University Law Review, Vol. 93, 1999, pp. It is estimated that out of the total market value of all publicly 641, 644-645. traded shares of $30 trillion in the United States at the end of 1999, $20 trillion was under some form of professional management. See website 269 M. Blair and M. Roe (eds.), Employees and Corporate of the Social Responsibility Investment Forum [www.socialinvest.org]. Governance (Washington, D. C., Brookings Institu tion, 1999). Corporate Governance in the ECE Region ______107

corporat e governance has focused almost exclusively on In the United States, which has a system of federal publicly traded companies because it is in these law, each of the 50 states has it s own corporat ion code. In enterprises that failures of corporat e governance have the addit ion, judicial decisions by stat e courts have developed most serious and far reaching consequences for the important legal doctrines governing corporate behaviour, economies of the countries concerned. For this reason, such as “the business judgment rule” and the duties of care this paper will examine corporate governance exclusively and of loyalty of corporate officers and directors. within the context of corporations whose shares are American st ate corporat ion laws are very similar, but not publicly traded. ident ical. Indeed, the corporate laws of cert ain stat es may favour one interest group over another. Throughout the 4.3 The sources of corporate governance t wentieth ury, individual American states, seeking to maximize revenues from corporate franchise , Discussions of corporate governance demonstrate competed to become the st ate of for United t wo basic approaches to assuring managerial dedicat ion St ates companies. A winner in this competit ion, the small to the interests of the corporation and its shareholders: the state of Delaware is the legal home to about 60 per cent of regulatory approach and the non-regulatory approach. the Fortune 500 companies,272 Am erica's largest publicly The regulatory approach relies upon formal rules and traded corporat ions, because managers consider Delaware institutions backed by the coercive power of the state’s law to be favourable to their interests.273 As a result, the legal system. The non-regulatory approach, point ing to Delaware court s have been the sites of important corporate the cost s of regulat ion, emphasizes the market lit igat ion over the years, and their decisions have been mechanism and ual arrangement s, such as influent ial in shaping various doctrines of corporate corporat e control market s, incent ive compensat ion governance.274 Traditionally, Europe has not had a schemes involving stock and stock options, and efficient compet it ion for corporations among countries to the same capital markets, as means for inducing desired degree as American st ates, and European law has tended management behaviour.270 Both approaches are needed to inhibit the kind of corporate mobility experienced in to achieve optimal syst ems of corporate governance, but the United States.275 However, the creation of the single an important question for policy makers is what is the European market may be leading to increased freedom of appropriate balance. Until the recent financial scandals European firms to choose their count ry of incorporat ion and their negative impact on securities markets, the non- regardless of the place where they do business.276 regulatory approach had many advocat es and even A second important source of corporate governance seemed to be in the ascendancy. But the collapse of are national rules and regulations with respect to the sale, Enron has given new vitality to the regulatory approach distribution and trading of securit ies involving the public. as countries in North America and Europe focus renewed On e basic goal of securities regulation in virt ually all att ent ion on shaping appropriate rules and instit utions of corporate governance. This paper is devoted primarily to countries is to assure that investors receive adequate a study of those rules, regulations and instit utions. information about the corporation and its activities so that they may make investment decisions and exercise The rules and inst it utions of corporate governance shareholder rights appropriately. As with corporat ion laws come from a wide variety of sources, both public and and codes, the extent of protection afforded to shareholders private. A primary source is the company or corporation by securit ies legislation varies from country to country. law of the individual countries concerned. This legislation governs t he creat ion, basic struct ure and primary rules of operat ion of the company, corporation, protection in 49 countries and conclude that countries with the common law legal tradition (e.g. the United States and the United Kingdom) société anonyme, , or other corporate provide the best legal protection to shareholders and those with the legal form that a firm chooses to take. It also states some French civil law tradition (e.g. France, and ) provide the worst. of the basic rights of shareholders, including the right to 272 E. Veasey, “The defining tension in corporate governance in vote, to receive information about company matters, and Am erica”, The Business Lawyer, Vol. 52, 1997. to challenge management decisions in court. T he nat ure 273 Scholars do not agree as to whether Delaware law benefits shareholders of these right s varies significant ly from country to or managers. For a review of the literature on this question, see R. Daines, Does country. Some countries within the ECE region offer Delaware Law Improve Firm Value?, Columbia Law School, The Center for stronger protection to shareholders than others.271 Law and Economic Studies, Working Paper No. 159, November 1999 [www.law.columbia.edu/law-economicstudies/abstracts.html#159]. 274 Similarly, the state of Maryland is home to many mutual funds, 270 largely because mutual fund promoters consider that Maryland law R. Winter, Jr., “State law, shareholder protection, and the theory of facilitates the launching and management of mutual funds. the corporation”, Journal of Legal Studies, Vol. 6, 1977; M. Jensen and W. Meckling, “The theory of the firm: managerial behaviour, agency 275 J. Coffee, Jr., op. cit. pp. 641-651. costs and ownership structure”, Journal of Financial , Vol. 3, 276 1976; H. Manne, “Mergers and the market for corporate control,” Journal See, e.g. Centos, European Court of Justice, Judgment of 9 March of Political Economy, Vol. 73, 1965. 1999, in which the court concluded that the Danish government could not prevent a private formed in the United Kingdom by two 271 R. La Porta, F. Lopez-de-Silanes, A. Shleifer and R. Vishny, “Law Danish citizens for the purpose of avoiding Danish legal requirements on and finance”, Journal of Political Economy, Vol. 106, No. 6, December minimum paid-in capital from registering a branch to do business in 1998, in which the authors evaluate the effectiveness of shareholder legal . 108______Economic Survey of Europe, 2003 No. 1

Although the United States has no federal obligatory for corporations whose shares are traded on corporation law, federal securities laws, principally the the “Big Board”.278 In the wake of the Sarbanes-Oxley 1933 Securities Act and the 1934 Securities Exchange Act of 2002, the NYSE has adopted major rule changes Act, as well as the voluminous regulat ions issued by the on a wide range of corporate governance matters Unit ed States Securities and Exchange Commission, are a including audit committees, independence of directors central element of corporate governance for firms that and the composit ion of boards of directors.279 raise capital from the public or whose shares are publicly Account ing plays a vital role in corporate governance traded. While still subject to individual state laws on because it is fundamental to any disclosure regime many aspect s of int ernal governance, publicly traded concerning information about companies’ activities. A companies must at the same time respect the complex of strong disclosure regime is essent ial for the exercise of Federal rules on a wide range of governance matters from shareholder right s, for the monitoring of corporations and informing shareholders about corporate activity to for imposing discipline on management.280 But without conducting audit s of corporat e account s. The struct ure of effective and uniform account ing st andards and pract ices, federal law tends to give a high degree of uniformity to meaningful disclosure cannot t ake place. For example, the the systems of corporate governance of publicly traded lack of agreement within the American accounting corporat ions throughout the country. Federal legislat ion profession as to the need to t reat stock opt ion grant s to covering labour, ant i-trust and taxation also have execut ives as a current expense led to an overstatement of important consequences for American systems of the earnings of some corporations, thereby inflat ing t he corporat e governance. value of their stock on securities markets. As a result, the accounting rules and pract ices of professional The principal source of corporat e governance in organizations such as the Standards Europe is the legislation of the individual European Board (FASB) in the United States and the International country concerned. Although European Union legislat ion Account ing St andards Board in Europe (IASB) are yet does have an impact on cert ain aspect s of corporate another important source of corporate governance.281 governance, it has not unified corporate governance practice to the same extent that United States federal law An effective system of disclosure also requires the and regulat ions, together with stock exchange rules, have part icipation of organizat ions and individuals with tended to unify American practices. Thus, there is a sufficient expertise and a reputation for skill and honesty greater divergence on corporat e governance rules among to evaluate and verify the information that is disclosed. publicly traded European corporations than there is In making investment decisions, shareholders rely on among their American counterpart s. these “reputational intermediaries”, which include auditors, credit rating agencies, financial analysts and the In addit ion to the nat ure of the laws and regulat ions financial press, whose capital is the reputation that they on corporate governance, one must also consider the have developed for integrity. These individuals and quality of law enforcement in the countries concerned. organizat ions are considered the “ gat ekeepers” of the The effect iveness of corporate governance legislation and financial markets.282 While in most cases they are paid regulation depends of course on the competence, int egrity and forcefulness of the courts and regulatory agencies in the count ries concerned. On this issue, there are also 278 For the rules of the New York Stock Exchange applicable to listed significant variations among countries.277 For transition companies [www.nyse.com]. economies in Europe, the development of effective 279 “Corporate governance rule proposals reflecting recommendations securities regulation regimes poses a particular challenge to the NYSE corporate accounting and listing standards committee, as due to their lack of experience, supporting instit utions approved by the NYSE Board of Directors, 1 August 2002,” [www.nyse.com]. and trained personnel in this domain. Even in countries 280 with a well-developed regulatory capacity, such as the “The corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the Unit ed States, agencies regulat ing corporat e governance corporation, including the financial situation, performance, ownership and constant ly risk being influenced or “ capt ured” to the governance of the company”. OECD Principles of Corporate detriment of shareholders and the public by the very Governance, op. cit., Art. IV, p. 21. corporations they are to regulate or by the political class 281 All United States publicly traded corporations are subject to the that represents them. accounting and auditing standards set down by the FASB. At present, Europe has no single, agreed set of standards. As part of its efforts to The rules and decisions of certain private bodies, create a single European market in financial services, the European Commission has directed that by 2005 most EU listed companies should such as stock exchanges, professional account ing prepare their financial statements using in ternational accounting instit utions and industry organizations also influence standards, which are now being formulated by the IASB, a private group corporat e governance. Thus, the rules of the New York based in London. By 2007, all EU listed companies are to use common St ock Exchange, which are subject to approval by the international standards. D. Tweedie, “Tackling a crisis in financial reporting”, European Business Forum, Issue 11, Autumn 2002, pp. 19-21. United States Securities and Exchange Commission, are 282 J. Coffee, Jr., “Understanding Enron: ‘Its about the gatekeepers, stupid’”, The Business Lawyer, Vol. 57, 2002; S. Choi, “Market lessons for gatekeepers”, Northwestern University Law Review, Vol. 92, 1998; R. 277 See R. La Porta et al., “Law and finance”, op. cit., pp. 1141-1143, Kraakman, “ , strategies and the costs of legal controls”, evaluating the effectiveness of enforcement in 49 countries. Yale Law Journal, Vol. 93, 1984. Corporate Governance in the ECE Region ______109

by the very corporat ions they evaluate, the market which corporations should work, and to frame and assumes that they have less incent ive to misrepresent the influence discussion of corporate governance policies. facts than their clients since their reputations, their basic capital, is at stake. Nonetheless, corporate managers do 4.4 The objectives of the corporation seek to influence these intermediaries and, as in the case of Enron and Arthur Andersen, occasionally do so Any system of corporate governance must answer a successfully. As a result, systems of corporate fundament al quest ion: what is the object ive of t he governance also need to address the regulat ions and corporation and for whose benefit is it to be run? The incent ives affecting the gatekeepers. One important countries of the ECE region appear to offer t wo different dimension of the Sarbanes-Oxley Act of 2002 and the answers to this question. In the United States and the recent amendment s to stock exchange rules is to set down United Kingdom, the formal rules of corporate new regulat ions governing auditors. governance provide that the purpose of the corporat ion is Within the limits of law, regulations and the to bring profit to it s shareholders. Thus the American applicable rules of private bodies, corporations have Law Inst it ute (ALI), after considering various discret ion to shape their own int ernal mechanisms of formulations to accommodate social needs to corporate corporate governance, including the terms of managers’ purposes, finally concluded in its Principles of Corporate contract s, the composition of corporat e boards, and t he Governance: “… a corporation should have as its object ive the conduct of business activit ies with a view to internal structure of the corporation, to mention just a 285 few. The degree of discretion varies from country to enhancing corporate profit and shareholder gain”. In country. The traditional legal mobility of American other words, the purpose of the corporation under corporat ions from stat e to stat e and the broad discret ion American law is to make profit s and the beneficiaries of afforded corporat e organizers tend to reflect the basic those profit s are the shareholders. “enabling approach” (i.e. everything is permitted unless At the same time, following American judicial specifically prohibited) of American , as decisions on the point, the ALI’s Principles of Corporate compared wit h the great er restrict ions on mobility and Governance also st ates that a corporation 1) must obey discretion in Europe that reveal a more “mandatory” the law to the same extent as a natural person; 2) may approach (i.e. everything is prohibit ed unless specifically take into account ethical considerations that are permitted) that seems to characterize European corporate reasonably regarded as appropriate to the responsible law and pract ice. conduct of it s business; and 3) may, but is not required to, In order to influence the exercise of this discretion, devote a “reasonable amount of resources” to public industry groups and individual institutional investors have welfare, humanitarian, educational and philanthropic prepared codes, report s and statements of good corporate purposes, “ … even if corporate profit and shareholder gain are not thereby enhanced”286 (emphasis supplied). governance that they have presented to or pressed upon the Principles of Corporate Governance gives only general management of corporations. In the United States, the guidance for determining the reasonableness of resources Business Round Table, a leading organization of corporate devoted to such purposes. It assert s that one important ex ecutiv es an d in stit utional inv estors, such as the Californ ia factor is the strength of the nexus between the use of Public Employees’ Retirement System (CalPERS) and corporate resources and the corporation’s business, Teachers and Annuity Association College stat ing: “In general the greater the amount of corporate Retirement Equities Fund (TIAA-CREF), have been active resources that are expended, the stronger should be the participants in this movement. In Europe, during the 1990s nexus”.287 Despite periodic challenges to business in the various committees of eminent persons produced over 30 face of political and social event s at various t imes over recommended codes of best practices in corporate the years, t he formal system of corporate governance governance, including The Cadbury Report (United embodied in the laws of the United States has Kingdom, 1992), Viénot Report s I and II (France, 1995 unwaveringly and clearly stat ed that the objective of the and 1999), the Peters Report (, 1997) and the corporation is to maximize profits for shareholders. Mertzanis Report (, 1999).283 An important multilat eral effort to define best practices in corporate In the United Kingdom, the objective of the governance for both Europe and North America is the corporation is basically the same as it is in the United OECD Principles of Corporate Governance, adopted in St ates. English law makes it clear that the shareholders 1999.284 None of these codes and report s have mandatory are the owners of the company and that a company’s effect, but they have served to heighten awareness of board of directors is required to advance the interests of corporate governance issues, to est ablish goals toward

285 American Law Institute (ALI), Principles of Corporate Governance, (St. Paul, MN), 1994, sect. 2.01(a). 283 Weil, Gotshal & Manges, op. cit., pp. 14-16. 286 ALI, Principles of Corporate Governance, op. cit., sect. 2.01(b). 284 OECD Principles of Corporate Governance, op. cit. 287 ALI, Principles of Corporate Governance, Vol. 1, op. cit., p. 65. 110______Economic Survey of Europe, 2003 No. 1

the shareholders as a whole.288 Because of the centrality models undermine the not ion of private property, of shareholders’ interests to corporate purposes, the enhance the power of executives by diminishing the prevailing model in both countries, which of course share power of shareholders to control them, and make the common law tradition, is often referred to as the corporate managers less accountable to shareholders. “ shareholder model of corporate governance”. Professor Milton Friedman, a Nobel laureate in economics, condemned t he idea 40 years ago: “ … few Elsewhere in Europe, both law and policy recognize trends would so thoroughly undermine the very to varying degrees, that corporations also have the foundations of our free society as the acceptance by object ive of advancing t he int erests of other persons and corporate officials of a social responsibility other than to groups beyond the narrow category of shareholders. make as much for their shareholders as possible. This is Such persons and groups, who may include employees, a fundamentally subversive doctrine”.293 suppliers, creditors, civic organizations and the community at large, are usually referred to as St akeholder advocates, on the other hand, argue that “stakeholders.”289 As a result, these countries are said to the corporat ion, deriving special benefits and privileges have a “stakeholder model” of corporate governance. from the community, for example of Their prevailing legal tradition is that of the civil law. shareholders, legal personality, perpetual existence and access to public capital, must as a result take account of Germany, with it s system of codeterminat ion comm un ity int erest s in its decision s. As the Am erican grant ing employees a formal role in corporate scholars Berle and Means wrote 70 years ago: governance, is often cited as the prime example of the stakeholder model. Generally, such a model of corporate It is conceivable – indeed it seems almost essential governance gives stakeholders a “voice” in firm if the corporate system is to survive – that the management and seeks to accommodate their diverse “control” [i.e. management ] of the great interests in deciding upon corporat e act ion.290 Another corporations should develop into a purely neutral manifestation of the stakeholder model in European and t echnocracy, balancing a variety of claims by Japanese firms is the “relat ional board struct ure”, which various groups in the community and assigning to includes representatives of key constituencies, such as each a port ion of the income stream on the basis of labour, lenders and major customers or suppliers, whose public policy rather than private cupidity.294 posit ions on the board are a funct ion of the corporation’s special relationships with those constituencies and are It is also argued that the stakeholder model unrelated to any shares they may hold in the firm.291 facilitates the kind of long-term corporate strategy necessary for the welfare of the firm, rather than the Debate about the relative merits of the shareholder short-term opport unistic corporate act ions taken to sat isfy and stakeholder models is long standing. Both have shareholders in response to swings in volatile stock strong advocat es and resolute opponent s.292 Shareholder market s. In addition, the stakeholder model encourages model proponent s argue that the corporat ion is best able beneficial investment s in human capital by employees, to create the goods and services that society needs if it suppliers and others to create value in the long run for the focuses on it s primary funct ion, which is to maximize firm, investments that employees and suppliers would be gains to its shareholders. To force managers to deal with reluctant to make in firms following the shareholder social considerations is to divert them from this task with corporat e model. On the other hand, it must be a deterioration of result s. They argue that stakeholder recognized that stakeholders do at t imes exploit their posit ions to pursue their individual interests to t he detriment of t he firm. For example, the bankruptcy in 288 Weil, Gotshal & Manges, op. cit., p. 36. lat e 2002 of United Airlines, the second largest airline in 289 For example, the Recommendations of the Norby Commission in the United States, was due in part to the fact that it had Denmark states that corporate governance comprises “the goals, according the highest labour costs in the industry, a result to which a company is managed, and the major principles and frameworks attributable to a certain extent to worker representatives which regulate the interaction between the company’s managerial bodies, the owners, as well as other parties who are directly influenced by the holding three seats on it s board of directors. Europe has company’s dispositions and business (in this context jointly referred to as also had it s share of corporat e scandals and failures. A the company’s stakeholders). Stakeholders include employees, creditors, stakeholder model is no guarant ee of effect ive corporate suppliers, customers and the local community”. The Norby Commission, Recommendation for Good Corporate Governance in Denmark, governance. Introduction, 6 December 2001 [www.corporategovernance.dk]. Although the debat e bet ween advocat es of the two 290 S. Vitols, “Varieties of corporate governance: comparing Germany systems has gone on for several years, it has gained and the U.K.”, in P. Hall and D. Soskice (eds.), Varieties of Capitalism: renewed vigour in the wake of the American financial the Institutional Foundations of Comparative Advantage (Oxford, Oxford University Press, 1999). scandals of 2002. Europe’s tendency to emphasize 291 A. Dyck, op. cit., pp. 59-60. 292 See, e.g. G. Vinten, “Shareholder versus stakeholder – is there a 293 M. Friedman, Capitalism and Freedom (Chicago, The University governance dilemma?”, Corporate Governance, Vol. 9, No. 1, January of Chicago Press, 1962), p. 133. 2001, pp. 36-45; E. Sternberg, “The defects of stakeholder theory,” 294 Corporate Governance, Vol. 5, No. 1, January 1997, pp. 3-10. A. Berle, Jr. and G. Means, op. cit., p. 356. Corporate Governance in the ECE Region ______111

stakeholder interests may have allowed European substantial profits. It also leads to short-term corporations to avoid the headlong pursuit of perspectives on earnings at the expense of longer maximization of shareholder value, the proclaimed goal strategies that might yield great er benefits to of United Stat es corporations in the 1990s, which many shareholders. Equally important for managerial interests, persons think led to or at least facilitated the excesses of stock has become the currency of corporate acquisit ions Enron, WorldCom and other American corporations. and mergers. Thus a high stock price, presumably achieved to maximize shareholder value, also allows The preference for the shareholder as opposed to the managers t o substantially enlarge the corporate empires stakeholder model of corporat e governance appears to over which they preside and from which they derive have some basis in the cult ure and public attit udes of the subst antial benefit s.299 countries concerned.295 One survey of 15,000 managers and employees in 12 countries asked respondent s to European and Japanese lack of enthusiasm for the choose whether: 1) the only real goal of a corporat ion is shareholder model, as opposed to the stakeholder model making profit ; or 2) a company, besides making profit, of corporate governance, is clearly reflect ed in the survey has the goal of attaining the well being of various mentioned above. Compared to the 40 per cent of stakeholders, such as employees, customers, etc. The two American respondent s who believed that the sole goal of groups wit h the largest percentage of managers and the corporat ion was to make a profit, only 28 per cent of employees selecting profit as “the only goal” were It alians, 27 per cent of Swedes, 26 per cent of Dutch, 25 Americans (40 per cent) and British (33 per cent).296 One per cent of Belgians, 24 per cent of Germans, 16 per cent may therefore conclude that among indust rialized of French and just 8 per cent of Japanese had the same countries, national culture in America and the United preference.300 Kingdom are closest to the ideal of shareholder value maximization as a corporate goal. On the other hand, it The difference between the Anglo-American and should be noted, of course, that despite the large continental European positions on corporate purposes percent age in relation to other countries, 60 per cent of may be explained to some ext ent by the great er the Americans surveyed nonetheless considered that a emphasis placed by the former on the individual and by corporation had other goals in addition to making a profit. the latter on the community. In an extensive survey of Consequently, it would seem that the prevailing cultural individualism in 53 countries, one study found values in the United States might not be completely in Americans to be the most individualistic, achieving an 301 accord with the United States system’s stated goal of individualism rat ing of 91 out of a possible 100. The corporat e governance. cultural value of individualism, which accords the individual a central role in the scheme of things, is In order to align the interests of managers to the manifest throughout the American system with it s goal of shareholder value maximizat ion, United St ates emphasis on individual rights and the availability of corporations have increasingly compensat ed their individual legal remedies to enforce those right s. executives with stock and stock opt ions, now a widespread American law and att it udes towards individual property phenomenon throughout American corporate life. As a right s and freedom of contract strongly reflect the result , management contract s and compensat ion schemes American cultural preference for individualism. have become important instrument s of governance in the Transferred to the corporate arena, the law considers the modern American corporation. According to one study, individual shareholders as the “owners” of the the typical American corporation now allocates 1.4 per corporation. As such they are legally entitled to all its cent of it s equity each year to executives and other 297 fruit s. The United Kingdom, sharing a common employees. In 2000, the value of options granted by language, history, and legal tradit ion with the Unit ed America’s 325 largest corporations nearly equalled 20 298 St at es, also favours t he shareholder model of the per cent of their pre- profit s. In certain companies corporat ion. It had an individualism score of 89, stock opt ions have given an incentive to management to ranking it third behind the United States and . manipulat e earnings through questionable accounting and other pract ices so as to raise their companies’ share prices The European cont inent t ends to emphasize the role long enough to sell their stock and thereby make and import ance of the community more than does the Unit ed Stat es. Europe’s emphasis on “ social solidarity,” its scepticism about the merits of unfettered competition, 295 See generally, J. Salacuse, “Corporate governance, culture and and the formal inclusion of labour in corporate convergence: corporations American style or with a European touch?”, management in some European countries all reflect the Law and Business Review of the Americas, Issue 4, Fall 2002. 296 C. Hampden-Turner and A. Trompenaars, The Seven Cultures of Capitalism: Value Systems For Creating Wealth in the United States, Japan, Germany, France, Britain, and the Netherlands (New 299 M. O'Sullivan, op. cit., pp. 153, 168-169. York, Doubleday, 1993), p. 32. 300 C. Hampden-Turner and A. Trompenaars, op. cit, p. 32. 297 Financial Times, 12 August 2000. 301 G. Hofstede, Cultures and Organizations: Software of the Mind, 298 New York Times, 23 March 2002. (New York, McGraw-Hill, 1997), p. 53. 112______Economic Survey of Europe, 2003 No. 1

greater importance that European cult ure attaches to the goal of seeking profit s for shareholders without regard community. American doctrines of “employment at will” to other stakeholders, various groups are protesting and “freedom of contract”, both reflections of strong against corporations that refuse to accommodate other individualistic values, contrast with German concept s of stakeholder interests. A further point of friction may “labour rights” and “good faith” in contract ing,302 wh ich arise as a result of American institutional investors using reveal strong communitarian values. This difference is their holdings in European and Japanese companies to also found in att itudes toward competition. For example, press American not ions of good corporat e governance on in one survey whereas nearly 70 per cent of American European and Japanese managers. In November 2001, managers believed that increased competition as opposed for example, the California P ublic Employees Ret irement to increased cooperat ion among business would lead to System (CalPERS), America’s largest public pension greater benefit s for society, only 41 per cent of German fund, allocated $1.7 billion of its investments specifically managers, 45 per cent of French managers, 39 per cent of to pursue “ act ive corporate governance strategies” in 307 Swedish managers and 24 per cent of Japanese managers European and Japanese markets. Good governance for had the same view.303 In the individualism survey Unit ed St ates in stit ut ion al inv estors m ean s th e p rimacy of mentioned above, France and Sweden ranked 10 with shareholder interests. Many multinational corporations scores of 71, Germany ranked 15 with an index of 67 and are sensitive to cultural differences between the Spain ranked 20 wit h an index of 51. (Japan ranked 23 American and European views on corporat e goals. For with an index of 46.)304 example during the 1990s, the mantra of “ building shareholder value” was a proclaimed objective of many The greater importance of communit arian values in American corporat ions and was prominent in both their Europe would quite naturally lead to the belief that the internal and external communicat ions in the United corporation, as part of the community and benefiting St ates. These same corporations were much more from its p osit ion in the comm un ity , n eeds to t ake acco unt circumspect in Europe, fearing that explicit statement s in o f comm un ity interest s, not just sh ar eho lder interest s, in favour of maximizing shareholder value would conducting it s operat ions and distributing it s benefit s. antagonize European government s and labour unions that The relative lack of dispersed share ownership among the strongly believe that corporations should advance the public in most European countries, as compared with t he interests of all its stakeholders.308 United States and the United Kingdom, may reinforce this view. On the other hand, there is evidence that the While the differences bet ween the st akeholder and stakeho lder mo del, an d p art icularly co det erm in atio n, shareholder models are real, care should be taken not to makes it harder for shareholders to cont rol management overemphasize them for several reasons. First, in and that European managers manipulate the stakeholder countries with a shareholder model, the management and model by playing off one set of stakeholders against board of directors of the corporat ion are required to obey another in order to advance managerial interests.305 For the law, and numerous laws (for example labour and example, one st udy of corporat e governance and the role environment al legislat ion) exist to prot ect persons from of banks suggests that affiliations bet ween banks and adverse corporat e actions, even though such persons are their principal corporate borrowers in Germany and Japan not t echnically designat ed as “ stakeholders” and even often encourage excessive lending and deferred though such legislat ion does not fit within the rubric of restructuring.306 “corporate governance”. Second, as will be seen, among the countries said to have a stakeholder model of The differing cultural views as to the objective of corporat e governance, there is wide variation in the the corporation may account for some of the public extent to which such stakeholders act ually part icipate in protests against “globalization” that American corporat e governance. Thus, for example, in , corporations have encountered in Europe and elsewhere. Denmark, Germany, and Sweden, the law Seeing the globalization movement led by American gives employees, a key stakeholder group, in companies corporations whose declared governance system has the of a specified size, the right to elect some members of the company’s . In , on the other hand, company articles may grant employees that right. 302 S. Casper, “The legal framework for corporate governance: the In France when employee shareholding reaches 3 per influence of contract law on companies strategies in Germany and the cent , they may nominat e one or more directors, with United States”, in P. Hall and D. Soskice (eds.), Varieties of Capitalism: …, certain except ions. But in all other European Union op. cit., pp. 387-388. 303 C. Hampden-Turner and A. Trompenaars, op. cit, p. 71. 304 G. Hofstede, op. cit., p. 53. 305 K. Pistor, “Codetermination: a sociopolitical model with governance 307 “CalPERS turns up corporate governance heat – plan calls for externalities”, in M. Blair and M. Roe (eds.), Employees and Corporate efforts to target Japanese and continental Europe”, Press Release, 15 Governance (Washington, D.C., Brookings Institution, 1999), p. 190. November 2001 [www.calpers.org/whatsnew/press/2001/]. 306 D. Weinstein and Y. Yafeh, “On the costs of a bank-centered 308 P. Hasplespleigh, T. Nada and F. Boulos, “Managing for value: it’s financial system: evidence from the changing main bank relations in not just about numbers”, Harvard Business Review, July-August 2001, Japan”, Journal of Finance, Vol. 53, No. 2, April 1998, pp. 635-672. pp. 67-68. Corporate Governance in the ECE Region ______113

member states, again with certain conditions, only The instit ut ions of corporate governance include shareholders elect members of the company’s board. both those that are external and those that are internal to Third, there appears to be some convergence in the corporat ion. The external inst itut ions include corporate practice between the two models as a result of government regulatory agencies, stock market s on which globalization and the listing by large corporations of their corporat ions list their shares, and the court s that enforce shares on the exchanges of other countries in order to remedies for violations of corporate governance rules. widen their access to capital. The OECD, whose member Thus, both the United States Securities and Exchange countries include proponent s of both shareholder and Commission and the European Commission are in a real stakeholder models, faces this issue in its Principles of sense institutions of corporate governance. The internal Corporate Governance.309 The Principles seek t o bridge institutions are the mechanisms within the corporation the gap bet ween the shareholder and st akeholder models that determine how it is run. The external and internal of corporat e governance by stat ing in Art icles I and II organizat ions are linked since the internal mechanisms that corporate governance should protect shareholders’ are to a large extent defined and determined by the rights and should ensure the equit able treatment of all external institutions. For example, law and governmental shareholders, but also stating in Article III that “[t]he regulations specify the powers of boards of directors and corporate governance framework should recognize the supervisory boards, the rights of shareholders, and the rights of stakeholders as established by law …”. 310 The obligations of managers. Thus, the participants in a implication of this provision is that if a given stakeholder corporate enterprise, particularly one that solicits capital does not have right s established by law, the corporate from the public, are not free to organize themselves any management is not required to take account of them in it s way they like, but must follow rules set down by decisions. legislative bodies, regulatory agencies and stock exchanges. At the same time, all external systems of Although American systems of corporate corporat e governance leave certain governance matters to governance permit but do not require corporate boards the discretion of the corporat e part icipant s themselves. and management to t ake account of social welfare issues A fundamental and pract ical governance question in their decisions, various internal and external factors, for corporate managers, directors and lawyers is such as pressure from labour unions, environmental therefore: what matters of corporat e governance are groups and non-government al organizations, have determined by external rules and what matters are left to induced corporat ions in individual cases to int egrate the discretion of the internal participants? The scope of social considerations in their decisions; however, this internal corporate discret ion varies from count ry to tendency by no means implies the kind of dilution of country. For example, while Germany requires certain shareholder rights ent ailed by the extreme stakeholder members of a corporat ion’s supervisory board to be model. Of part icular not e in this regard is the emergence representat ives of labour, American legislat ion has no of “socially responsible investing”, by which investors such requirement, thus giving Unit ed States corporat ions instruct institutions managing their funds to take account broader discret ion in the selection of directors. of certain social criteria in making investment decisions. It is claimed that $2 trillion of United States investments Governance is about power, and the purpose of any in 2001 were subject to social responsibility crit eria.311 system of governance is to determine how power is To some extent, this trend may represent a slight allocated and exercised. Within any publicly traded convergence of the differing American and European corporation in Europe or North America, there are views on the purpose of the corporation. On the other pot entially three instit utional centres of power: 1) the h an d, th e gro win g influen ce of in stit ut ion al sh areho lders board of directors or supervisory board; 2) the managers; and their increased assertiveness towards European and 3) the shareholders. These power centres are managers may also represent a force for convergence and examined in turn. increased shareholder right s in Europe.312 (ii) The board of directors and supervisory board 4.5 The institutions of corporate governance In all corporate governance systems in the ECE region, a board, select ed by shareholders and act ing (i) In general collect ively, exists to make key corporate decisions and to supervise management. It is a cent ral instit ution of corporat e governance. Yet import ant differences in board struct ure, composit ion and powers exist among countries. One significant struct ural element to be not ed at the 309 OECD Principles of Corporate Governance, op. cit., p. 20. outset is that whereas the United States and the United Kingdom’s laws provide for a single board of directors, 310 Ibid. certain European countries, notably Austria, Denmark, 311 See the website of the Social Responsibility Investment Forum Germany and t he Netherlands, and require corporat ions [www.socialinvest.org]. of a certain size to have a two-tiered system consisting of 312 M. O’Sullivan, op. cit., p. 153. 114______Economic Survey of Europe, 2003 No. 1

a management board composed primarily of executives responsible for monitoring managerial performance and of the corporation and a supervisory board composed of achieving adequate ret urn for shareholders, while non- execut ives elected by the shareholders and in some prevent ing conflict s of interest and balancing compet ing cases by the employees. The supervisory board selects demands on the corporation”.316 Although the board has the members of the management board and assures their certain key managerial tasks, such as selecting and account ability to corporat e goals and governance removing the company’s chief execut ive officer and regulations. In the other 11 EU countries, the unit ary approving important transact ions, the fundament al t ask of board prevails; however in 5 out of the 11, a t wo-tiered the board in a publicly traded corporation is oversight of sy stem is opt ion al.313 For example, French law provides the corporation’s managers. In the words of one for such an option, but only about 20 per cent of the Paris authority, the board’s primary duty is “overseeing Stock Exchange CAC 40 and less than 4 per cent of all management’s dedicat ion to the polestar of profit French sociétés anonymes have chosen to create one.314 maximization …”317 Those that have opted for the t wo-tiered struct ure are primarily multin ation al corpo rations who se shares are Efforts in recent years to reform corporate listed on foreign markets and which raise capital from governance have focused primarily on struct ural means to foreign sources. They apparent ly believe that the existence strengthen the board’s oversight role. In general, the of a t wo-t iered struct ure gives their system of corporate challenge in designing syst ems of corporat e governance governance increased credibility with foreign investors. has been to allow managers flexibility to conduct management operations in an efficient way but at the What the two-tiered system does is to separate the same time to establish processes that ensure managerial managerial and supervisory funct ions, usually combined accountability to shareholders for accomplishing the within the unitary board system, into two distinct organs. stat ed corporate object ive of profit maximization.318 The existence of a separate supervisory board serves to increase the independence of non-executive directors and If the board is truly to hold corporat e managers to give them additional power in acting as an oversight accountable to shareholder interests, the members of the body over corporate managers. In evaluating the board must genuinely represent shareholders rather than advantages and disadvantages of the two systems, one management. Directors, of course, are elected by st udy concluded: shareholders, but that process has traditionally resembled an elect ion in a one-party state: management cont rols the The one-tier system may result in a closer relation vot ing process and chooses a single slat e of nominees, and better information flow bet ween the supervisory most of whom are managers or have close relations with and managerial bodies; the two-tier system them. In recent years, good corporate pract ice has encompasses a clearer formal separation between stressed measures to give corporat e boards great er the supervisory body and those being supervised. independence from management in the hope that the However, with the influence of the corporate board would, as a result, represent shareholder interests governance best practice movement , the distinct more vigorously. Rather than enact legislat ion on these benefits traditionally attributed to each system measures, the approach in the United States has been to

appear to be lessening as pract ices converge.315 develop codes of best pract ices and then, through In varying degrees, all syst ems of corporate pressure by instit utional investors, industry groups and governance of publicly t raded companies give the board a stock exchanges to induce corporat ions to adopt them. In central position of responsibility. Article V of the OECD countries that require a separate supervisory board, Principles of Corporate Governance, states: “ The legislation requires that it members should not be corporat e governance framework should ensure the managers. strategic guidance of the company, the effective One principle that has found widespread adopt ion in monitoring of management by the board, and the board’s practice, although not in law,319 is that a majority of the accountability to the company and its shareholders.” The board of publicly traded corporat ions should consist of commentary to this principle elaborates: “Together with guiding corporate strat egy, the board is chiefly 316 OECD Principles of Corporate Governance, op. cit., p. 42. 317 I. Millstein, “The responsible board”, The Business Lawyer, Vol. 52, 1997, pp. 407-409. 313 Weil, Gotshal & Manges, op. cit, p. 43. 318 ALI, Principles of Corporate Governance, Vol. 1, op. cit., p. 77. 314 Franco British Law Society , “The director’s liability under French 319 law”, Franco British Law Society Lecture (Edinburgh), 19 November United States state corporation laws do not set requirements for 2001 [www.law.ed.ac.uk/legalconnexion/research/societes.htm]. Law No. persons to serve on the board. The Investment Company Act, the law 66-537 of 24 July 1966, as amended, on commercial companies, gives governing mutual funds, however, required that no more than 60 per cent French companies the option to create a two-tiered system consisting of a of the board be “interested persons”. An interested person has specified management board (directoire) and a supervisory board (conseil de relationships with the managers of the fund. In 2002, the required surveillance). A few large, internationally listed companies, such as percentage of “disinterested directors” was increased to a majority. Stock Peugeot, AXA and TotalFina have adopted the two-tier system. exchange rules also provide for a minimum number of non-executive outside directors for listed corporations. For the text of the Standard 315 Weil, Gotshal & Manges, op. cit, p. 43. [www.nyse.com]. Corporate Governance in the ECE Region ______115

persons who are not themselves managers of t he corporat e affairs independent ly, in part icular, from corporat ion. In 2001, for example, on the average board management”. To implement this norm, it recommends of Standard & Poor 500 companies, 82 per cent of it s that: “boards should consider assigning a sufficient directors were non-employees. As part of the post-Enron number of non-executive board members, capable of corporat e government reforms, the New York Stock exercising independent judgement , to t asks [such as Exchange in August 2002 adopted a new rule,320 subject financial reporting and executive compensation] where to SEC approval, requiring that independent directors there is a potential for conflict of interest”.325 comprise a majority of the board of directors of all listed The collapse of the Enron Corporation, a majority companies other than those in which a shareholder or of whose board members were neither executives nor group of shareholders possess vot ing control. In Europe employees of the corporation, raises the question of also, there appears be a growing trend to include non- whether still other mechanisms are needed to assure employees in corporate board membership and many of director independence. The failure of Enron directors to the European codes of best practice stress the importance act as “independent watchdogs” may have been of a board’s “independence” from management. In 2001, influenced by their social, political and personal 50 per cent of the members of an average board of a connect ions to Enron management. German DAX 30, 92 per cent of the members of the average board of a French CAC 40, 99 per cent of the Other struct ural devices that have been int roduced Netherlands Top 21 boards, and 57 per cent of the United to strengthen the board’s oversight funct ion include the Kingdom’s average FT SE 100 board consisted of non- establishment of specialized committees to conduct employees.321 certain key funct ions. For example, as a result of the Sarbanes-Oxley Act of 2002, all publicly traded Not being an employee of a corporat ion is no companies are to have an consisting of guarantee that a director will be truly independent of independent directors. However, Enron had a specialized management. A variety of other factors, such as family audit committee of independent directors but it connect ions, financial relat ionships, and links to nonetheless failed to detect and correct accounting controlling shareholders can limit the ability of directors irregularit ies. Pract ice is also evolving whereby most to act independently – to be, in the words of the United companies have separate nominat ing and compensat ion States Supreme Court, “independent watchdogs”.322 committees. The basic thrust behind this movement is Independence is a subjective matter. In order to provide the belief that a specialized committee, known to the some objectivity to the process, one organization323 has shareholders and particularly if composed of independent developed a set of criteria to weigh board member’s directors, is more able to perform these tasks effectively independence from management. T hey include: 1) not than if they are ent rusted t o the board as a whole, having worked at the company for at least the last three part icularly, if that board includes represent atives of years; 2) not having personal financial relationships with management. the company; 3) not having familial relat ionships with management; and 4) not having a connect ion to major or (iii) The managers of the corporation controlling shareholders. When these crit eria are applied, the percent age of boards with independent directors falls If the select ion of corporat e directors resembles an dramatically in the United States to 69 per cent, in elect ion in a one-party state, the posit ion of the chief Germany to 50 per cent, in the United Kingdom to 39 per executive officer (CEO) in the modern American cent, in France to 25 per cent and in the Netherlands to 7 corporat ion is like that of an aut ocrat. Indeed, like per cent.324 political systems dominated by the “cult of the leadership p erson ality”, it is not un fair t o say that most Am erican Ambivalence with respect to the independence of corporations manifest “a cult of the CEO”. It is almost an directors in the countries of the ECE region is also article of faith of American business that the CEO, and reflected in the OECD Principles of Corporate the CEO alone, is responsible for the rise or fall of the Governance. Rather than set a firm rule that the board corporat ion’s fort unes.326 must consist of a majority of persons independent from management, it merely states in Article VE that: “The In recognition of this role, American CEOs are paid board should be able to exercise objective judgment on extravagantly. The average CEO of a major American corporation received a record breaking $17 million in compensat ion in 2000. According to Business Week, the 320 For the text of the Standard [www.nyse.com]. 321 Davis Global Advisors, Leading Corporate Governance Indicator 325 OECD Principles of Corporate Governance, op. cit., Art. V, p. 22-23. 2001 (Newton, MA), 2001, p. 31 [www.davisglobal.com]. 326 322 Popular and managerial opinion in the United States considers that Supreme Court of the United States, Burks v. Lasker, 441 U. S. Lou Gerstner single handedly turned around IBM, that Jack Welch built 471, 484, 1979. GE into a modern force all by himself, and that Sandy Weill alone created 323 Davis Global Advisors, op. cit. Citigroup. CEOs not only manage. They write books. They appear regularly on television. They are the superstars of American corporate 324 Ibid., p. 35. culture. 116______Economic Survey of Europe, 2003 No. 1

average American CEO made 42 times the average blue- for combining both offices is no doubt strongly collar worker’s pay in 1980, 85 times in 1990 and 531 in fluenced by it s cult ural faith in t he h ero ic in div idual, t imes in 2000.327 While it is true that almost two thirds of as well as claims of efficiency made on behalf of this a CEO’s pay takes the form of stock options, it is also type of leadership. Perhaps influenced by their own true that the average American CEO earns almost t wice belief in the cult of the CEO and their own cultural as much as his or her counterpart in other OECD preference for individualism, American advocates of countries. corporat e governance have not pressed as hard for this structural division as they have for other corporate Despit e effective performance on t he part of governance devices. individual CEOs, the American emphasis on the role and importance of the CEO may be attributed, at least to (i v) Sharehol de rs some extent , t o it s cult ural value of individualism. Americans believe t hat organizational achievement is The very struct ure of shareholder ownership can disproport ionat ely att ribut able t o t he act ions of the serve to facilitate or render more difficult the task of individual leader, rather than to the efforts of the group. controlling managerial behaviour. The existence of In countries with a more communitarian culture, such as large shareholders, often with seats on the board, a Germany and Japan, corporat e management tends to be charact erist ic of European corporat ions, makes it harder more of a group effort than in the United States, a factor for managers to manipulate the machinery of corporate that influences CEO compensation in relation to that of governance in their interest s, for example by cont rolling other executives and employees. Moreover, European the nomination of outside directors or dominating the and Japanese cultures with their emphasis on int ernal audit ing process, than in corporat ions, such as community values and their large number of family those in the United St at es, where shareholdings are companies seem to give the European and Japanese widely dispersed and directors, although nominally CEO the status of a patriarch or father figure within the independent , do not have subst ant ial share holdings in corporation, rather than the heroic standing that the corporation and may have social or financial American culture gives to its own CEOs. connect ions to management. Moreover, as long-term investors, large shareholders in corporation are in a In view of the overwhelmingly dominant posit ion position to check the tendency of managers to act given t he CEO in American corporat ions, it is curious opport unistically to raise the share price long enough to that both the formal and informal instrument s of sell their holdings. The differing shareholder struct ure corporate governance have little to say about the CEO between the United States and Europe may explain in or other senior executives. Corporat e codes and laws part why Europe in the last few years seems to have hardly mention them. The OECD Principles of avoided the kind of failures of corporat e governance Corporate Governance, while devot ing specific art icles experienced recently in the United States. On the other to the board and shareholders, contains no comparable hand, Europe has had it s share of corporat e governance provisions with respect to the obligations of corporate failures in the past, and the role of large shareholders has managers. Informal stat ement s of pract ice limit not always been benign. As indicated earlier in this themselves to trying to create structures that will chapt er, one of the goals of effective corporate prevent or inhibit the CEO from dominating the board, governance is to protect minority shareholders from whose basic function, after all, is to hold the CEO abuse, whether from managers with little ownership accountable. Thus, for example, one emerging tenet of interest or controlling shareholders who dominate good corporate governance practice, advocated by management. certain groups, is that the CEO should not also serve as Some scholars have found that the reason for company chairman. Indeed, many advocat es of good concentrated ownership of shares in many countries is the governance also favour a chairman who is an out sider, poor investor prot ect ion that those count ries provide to rather than a current or recent corporate executive. It is share owners. Aware of poor legal prot ect ion, investors interesting to note that while the concept of the separate know that they must take a large equity position to be chairman and CEO is prevalent in many European able to monitor management and thus protect their co unt ries, it is not comm on in t he Un it ed St ates. For investment . Small investors, also knowing they have example, in 2001 only 19 per cent of S&P 500 limited protection, are only willing to buy shares at a low companies had this type of arrangement, while 100 per price, a fact that makes issuance of shares to the public cent of Germany’s DAX 30, 90 per cent of the Unit ed unattractive to the corporations.329 The difference in Kingdom’s FT SE 100 and 100 per cent of the ret irement syst ems bet ween t he United St ates and Netherlands’s Top 21 did.328 The American preference continental Europe is also an important factor in explaining differing share ownership structure. The privately funded pension system in the United States 327 For more detailed information on the compensation of CEOs of American companies [www.aflcio.org/paywatch/index.htm]. 328 Davis Global Advisors, op. cit., p. 38. 329 R. La Porta et al., “Law and finance”, op. cit., pp. 1113-1142. Corporate Governance in the ECE Region ______117

encourages wide share ownership among the public, important of all, the ext ent of directors’ and officers’ while the publicly funded system on the European fiduciary duty and duty of care to the corporat ion and the continent does not have the same effect. shareholders. Some studies have concluded that the With respect to the legal rights of shareholders, in common law legal tradition, which prevails in the United both the Unit ed States and Europe, direct part icipation of States and the United Kingdom, affords stronger legal protection to minority shareholders than does the civil shareholders in corporate governance is limited to: 1) 331 elect ing directors or members of the supervisory board, law. For example, the regulation of self-dealing by and 2) approving certain it ems that require shareholder officers and directors is more stringent in the Anglo- approval. In addit ion, there are legal right s accorded to American system of corporate governance than it is on shareholders to act against corporate officers and directors. the European continent, a specific illustration of the relative value placed on minority shareholder rights in the With respect to the first, a major difference between the 332 United St ates and Europe concerns those count ries, such t wo sy stem s. as Austria, Denmark, Germany, Luxembourg and The legal right s of shareholders and the legal Sweden, in which employees elect some members of the dut ies of officers and directors would have litt le effect board. The effect of this concession to stakeholder on corporate behaviour without the existence of participation is to reduce the influence of shareholders effect ive enforcement mechanisms. Governmental in t he governance of the corporat ion in which they own agencies have varying degrees of power to pursue shares. enforcement against corporations, officers and directors, and they invoke them with varying degree of vigour. With respect to it ems of corporate act ion subject to But in addit ion, there is another powerful mechanism shareholder approval, there do not appear to be significant th at pro bably t akes it s m o st v igo ro us fo rm in th e Un it ed differences bet ween Unit ed States and European St at es and has no exact replica in Europe: the private corporations.330 Within the United States, individual state right of action. The American system permits laws grant shareholders, as owners of the corporation, shareholders to sue directors and officers for injuries the right to make decisions direct ly about certain key that t hey have sustained either directly by corporate matters, such as mergers, affect ing t he fundamental act ion or derivat ively, on behalf of the corporat ion, for int erests of the corporat ion. T he ext ent of these injuries done to the corporat ion because of wrongful shareholder right s can vary from stat e to st at e and actions by its officers or directors. To facilitate such indeed from company to company by virt ue of differing law suits, specialized law firms have arisen that carry corporate articles and by-laws. The importance of these forward the suit while assuming the financial risks right s is seen in proxy fight s for corporate cont rol, most entailed by litigation. Their incentive is to recover recent ly in 2002 in the batt le bet ween management and “attorney’s fees”, a portion of the settlement that the dissident shareholders of Hewlett Packard Corporat ion corporat ion is judged ent itled to. over approval of a $12 billion merger between Hewlett For many investors, the basic remedy and sanct ion Packard and Compaq, a batt le that resembled a polit ical for bad governance is to sell the stock of the offending campaign in the use of the media to influence corporat ion or not to buy it at all. Nonetheless, shareholder votes. Corporat e governance advocat es are particularly in the United States where corporate increasingly pressing corporat ions to grant shareholders lit igat ion is frequent, the existence of a legal remedy the right to approve a variety of fundamental issues serves as one more factor, along with others, to exert affecting the corporation, including stock options plans, discipline on corporate behaviour. If the American style and to have easy access to the proxy process. Once of corporate governance is to spread to Europe by reason again the thrust is to involve shareholders in certain of the pressure of capital markets and institutional fundament al corporat e decisions as a check on investors, it must be asked whether shareholder litigat ion management action. These efforts represent a further will be far behind. But without a culture that tends to attempt to affirm the role of shareholders as “owners”, not favour private actions by aggrieved individuals, including merely stakeholders, of the corporat ion. shareholders, it is unclear whether private act ions would Various legal rules may affect the ability of evolve as effective deterrents to corporate misconduct in shareholders to take action against the decisions of certain European count ries. corporat e officers and directors with which they disagree. It has been argued that dispersed share ownership in These include the ability to vot e by proxy, whether or not the United States and the United Kingdom is a product of cumulative voting (which increases minority shareholders effect ive legal protection that encourages investors to ability to elect directors) is permitted, the right to challenge corporate actions in court, the right to call an extraordinary meeting of shareholders and, perhaps most 331 R. La Porta et al., “Law and finance”, op. cit. 332 L. Enriques, “The law on company directors’ self-dealing: a comparative analysis”, International and Comparative Corporate Law 330 Weil, Gotshal & Manges, op. cit., p. 38. Journal, Vol. 2, 2000, pp. 297-331. 118______Economic Survey of Europe, 2003 No. 1

become minority shareholders.333 If true, then this legal single European market in financial services may tend to protection for minority shareholders is itself, at least to a foster a certain convergence among corporate governance certain extent, the product of a cultural preference by sy stem s in the region . But sy stem s o f cor por ate Unit ed States and United Kingdom court s and governance are not simply forms that can be replaced legislat ures for the values of individualism.334 with ease.335 Systems of corporat e governance, like a It may be difficult to transplant the United States society’s other import ant instit utions, contain it s cult ural shareholder right s model to western Europe, where a values, values that it has come to believe, rightly or tradit ion of equity holding by corporat ions from the wrongly, are essent ial for social survival. For example, same country and with ties to the CEO may stifle one cannot assume that American values of individualism attempts by shareholders to curtail managerial decisions will easily replace European attachment to community that they perceive as threatening shareholder wealth values. maximization. Cont inually stressing the dichotomy bet ween the Anglo-American shareholder corporat e model and the 4.6 Conclusion European stakeholder model, however, may exaggerate the differences bet ween the t wo syst ems of governance Corporate governance plays a vital role in the and overlook the impact of forces making for sett ing of corporate st rat egy, in efficient ly allocat ing and convergence, such as the activities of United States managing a firm’s resources, in det ermining the in st it ution al in vestors in Europe an d th e list in g of conditions at which it has access to capit al and, European corporations on American stock exchanges. ultimately, whether the corporation is successful or not. While a sharp distinction between the two models may For this reason, a sound system of corporate governance satisfy those with a penchant for dialectic thinking, it may is essential for long-term economic growth and is an also lead to a neglect of opport unities to bridge the important asset for countries compet ing for foreign differences and fail to notice the extent to which capital. This consideration has become increasingly convergence may already be taking place. For one thing, important in the recent past because the growing cross-border mergers, such as the one bet ween Daimler integration of global capital markets has intensified the and Chrysler, are paving the way for internal governance mechanisms to be transplanted across borders. Anglo-American model European model Compensation patterns are one prominent example. In a similar vein, hostile takeovers, which used to be a Management dominated Controlling shareholder dominated corporate governance tool almost exclusively confined to Shareholder focused Stakeholder focused the Anglo-Saxon system, are making inroads in continental Wide public share ownership Narrower public share ownership Europe. Moreover, European companies have increasingly Strong shareholder rights Weaker shareholder rights Unitary board structure Two-level board structure been seeking a listing on a United States stock market, and Single powerful leader Consensus or divided leadership as a prerequisite have moved – for better or worse – Shareholder litigation culture Weaker litigation culture towards United States accounting practices. Conversely, recent changes to legislation regulat ing the United States financial industry have created the condit ions for banks compet it ion for mobile capit al. and other financial intermediaries to take more active Within the ECE region, there are two basic models ownership roles in that country. Similarly, some of corporate governance, the Anglo-American model and in st it ution al investo rs in the Un ited Stat es hav e lon g the cont inental European model. The t wo models are moved to a more act ive corporat e governance role. different iated by several important factors discussed Moreover, efforts to make management, whether earlier. In very general terms, and while acknowledging American or European, more responsive to other part ies exceptions to the pattern in individual countries, the two outside of management it self can only serve as salutary models of corporat e governance can be summarized as discipline on managers. The movement throughout the follows: ECE region toward more independent directors is also a Models, of course, are merely intellectual step forward, whether the goal of the corporation is seen as construct s. They do not capt ure reality in all it s shareholder profit or stakeholder benefit s. The effort, now complexity. Nonetheless, the seven elements indicated well advanced in Europe, to separate the positions of above represent important issues that differentiate and chairman and CEO, would probably be seen as beneficial influence the various approaches to corporate governance by the shareholders of most American corporations. And within the ECE region. Significant and powerful forces, finally a middle ground, a point of convergence bet ween such as the need to access foreign capital markets, the the stark shareholder model advanced by Americans and pressure of instit utional investors and the drive to creat e a the extreme stakeholder model advocated by Europeans, may reside in the not ion of “ socially responsible corporate

333 J. Coffee, Jr., “The future as history …”, op. cit., p. 644. 334 J. Salacuse, op. cit. 335 J. Coffee, Jr., “The future as history …”, op. cit., p. 646. Corporate Governance in the ECE Region ______119

governance”, a concept that seeks to bring together t wo important themes that really have not been joined thus far: corporate good governance and corporate social responsibility. Current discussions of corporate governance are taking place largely within the context of the developed economies of North America and western Europe. But the subject of corporate governance is also of vital concern for transit ion economies. It should be an important element in their strategies for growth, financial strength and productive privat e sectors, as they have learned from a variety of painful experiences, including failed privatizations during the 1990s. For the most part, the systems of corporate governance in transit ion economies remain works in progress (see box 4.6.1). As the count ries 120______Economic Survey of Europe, 2003 No. 1

Box 4.6.1 Corpor ate governance in easter n Eur ope and the CIS For the economies of eastern Europe and the CIS, corporate governance reform is of great importance. First, corporate governance systems had to be created from scratch during the transition, because the mechanisms used to control enterpri s es under state ownership and central planning were not suited to a market environment. Doing so requires major reforms not only in the legal and regulatory environment, but also in the internal organization of firms. Second, corporate governance is most important in large firms. Deficient corporate governance might therefore be a secondary concern in an economy where the bulk of economic activity takes place in small, owner-controlled firms. However, in comparison with mature market economies, the economies of eastern Europe and the CIS started out with a size structure heavily skewed towards large firms. As a result, corporate governance issues loomed particularly large for transition economies from the outset. Third, corporate governance is particularly critical in these economies because many of the constraints which the economic environment puts on the potentially inefficient behavior of firms in mature market economies cannot yet be taken for granted in the formerly centrally planned economies. In particular, competitive pressure in the product markets of mature market economies is an important determinant of enterpri s e performance. 1 T he formerly centrally-planned economies, in contrast, mostly started the transition as relatively closed economies with highly concentrated domestic market structures and hence faced the challenge of creating a competitive environment. The challenge has been particularly daunting for the CIS countries for historical reasons (see chapter 5.4(ii)). Achievements in creating a competitive environment have been uneven across the region so far, with the Central European and Baltic countries leading the way (table 5.3.4). But even in the most advanced economies, gaps in the enforcement of competition policy persist, and some barriers to entry in key industries remain.2 In a similar vein, mature market economies have established broadly effective bankruptcy and procedures in order to facilitate the restructuring or the market exit of enterprises that fail to compete successfully. Again, the economies of eastern Europe and the CIS did not possess effective bankruptcy procedures at the outset. Creating them has been imperative as a prerequisite for hardening budget co ns t rai nt s an d fo r product market competition to lead to increased efficiency through restructuring. Several recent studies have analyzed the extent and effectiveness of creditor rights vis-à-vis debtor firms. 3 Based on existing laws, any countries have established levels of creditor rights protection comparable or even superior to those prevailing in mature market economies, although the CIS countries are lagging behind most other economies in the region. A similar picture emerges from a broader index of , which in addition to creditor rights includes an evaluation of civil and commercial codes, collateral law and company law. 4 However, effective enforcement is essential. 5 There is a considerable gap between the extensiveness of commercial law and its actual effectiveness in terms of enforcement and implementation. 6 These limitations in the economic environment, which are particular to formerly centrally-planned economies, have a number of consequences for corporate governance. On the one hand, the pressure on corporate governance to deliver efficient enterprise performance is all the greater in environments where other checks and balances, such as competitive pressure and bankruptcy threats, are weaker. On the other hand, corporate governance solutions, which have proven relatively effective in the presence of these checks and balances, may prove less effective under the special circumstances prevailing in the economies of eastern Europe and the CIS. Own ersh ip an d control Both the methods used and the progress made with the privatization of large enterprises have been uneven across the region.7 Initial ownership structures have been shaped by the various privatization strategies. Subsequently, policies towards securities markets and financial intermediaries as well as shareholder rights legislation and its enforcement have played a key ro l e i n determining the evolution of ownership structures and the exercise of corporate control. and in particular have relied on direct sales of enterprises to strategic foreign investors as the primary method of privatization. , the Czech Republic, and have used both mass privatization and sales to strategic investors. Other countries, notably Russia, have chosen primarily management and employee buyouts and various forms of mass privatization. While sales to strategic investors obviously establish concentrated ownership, both mass privatization and employee buy-outs typically lead at first to dispersed ownership. In the former case, the challenge for corporate governance lies primarily in making sure that controlling investors respect the interests of minority shareholders. In the latter case, the challenge li es i n making sure that management acts in the interest of dispersed shareholders. Before discussing how these challenges have been met, it should be noted that initial ownership structures are not necessarily cast in stone. Indeed, privatization programmes have sometimes been created in the expectation that initial ownership patterns would matter less for efficiency than for reasons of fairness, as market forces would quickly assert themselves to create efficient ownership structures.

Corporate Governance in the ECE Region ______121

Box 4.6.1 (concluded) Corpor ate governance in easter n Eur ope and the CIS In some countries, financial intermediaries have been created to provide a means of concentrating share ownership during or after mass privatization. In other countries, the secondary trading of shares has led to an increase in ownership concentration in the hands of enterpri s e m an agement (chapter 5.4(i)). However, secondary trading has not always led to more efficient ownership structures due to a lack of effective regulation of stock markets and financial intermediaries. A substantial gap exists on this count between the central European and Baltic countries on the one hand, and the south European countries and successor states of the Soviet Union on the other. But ownership per se is not all that matters for corporate governance. The existence and enforcement of shareholder rights is critical. Indeed, as far as the legislation in place is concerned, the protection of shareholder rights in 1998 was already comparable to the situation prevailing in the European Union. However, enforcement has been a problem in many east European and CIS countries.8 Performance Sound corporate governance facilitates access to outside finance and creates incentives for enterprise restructuring. The deficiencies discussed above are reflected in the fact that most firms in the economies of eastern Europe and the CIS are still limited in their access to outside finance relative to their counterparts in mature market economies. 9 The quality and enforcement of the legislation underpinning corporate governance are also reflected in the effects of privatization. Different types of owners emerging fro m th e privatization process have very different effects on enterprise restructuring and performance (chapter 5.4(i)). Given the deficiencies in the protection of minority shareholders and in the regulation of securities markets, concentrated outside ownership appears to have the strongest positive impact. However, the effects are again not uniform across regions. For instance, in Russia there has been no particular correlation between ownership and performance.10 This is attributed to the fact that ownership structures are not generally reflected in the composition of company boards and hence in corporate control. As a result, management often retains control even in companies where it does not hold a controlling ownership stake. As a final point, the empirical evidence suggests that there are significant complementarities between elements of the corporate governance system, such as the ownership structure on the one hand, and the broader economic environment, most notably competitive pressures in the product market, on the other.11

1 S. Nickell, “Competition and corporate performance”, Journal of Political Economy, Vol. 104, Issue 4, 1996, pp.724-746. 2 EBRD, Transition Report 2002 – Agriculture and Rural Transition (London), 2002. 3 R. La Porta, F. Lopez-de-Silanes, A. Shleifer and R. Vishny, "Legal determinants of external finance", Journal of Finance, Vol. 52, No. 3, 1997, pp. 1131-1150; K. Pistor, M. Raiser and S. Gelfer, Law and Finance in Transition Economies, EBRD Working Paper, No. 48 (London), February 2000. 4 EBRD, op. cit. 5 K. Pistor et al., op. cit. 6 EBRD, op. cit. However, the gap has been narrowing over the past two years. 7 See chap. 5.4(i) and table 5.3.3 of this Survey. For a comprehensive survey of the literature on ownership, control and performance in transition economies see S. Djankov and P. Murrell, Enterprise Restructuring in Transition: A Quantitative Survey, CEPR Discussion Paper, No. 3319 (London), April 2002. For recent evidence on Russia see M. Angelucci, A. Bevan, S. Estrin, J. Fennema, B. Kuznetsov, G. Mangiarotti and M. Schaffer, The Determinants of Privatized Enterprise Performance in Russia, CEPR Discussion Paper, No. 3193 (London), February 2002. For recent evidence on the Czech Republic, Hungary and Poland see R. Frydman, C. Gray, M. Hessel and A. Rapaczyski, “When does privatization work? The impact of private ownership on corporate performance in transition economies”, Quarterly Journal of Economics, Vol. 114, No. 4, 1999, pp.1153-1191. 8 Inter alia, corruption has been a serious problem, notably in the CIS (chap. 5.6(iv)), to the point of allowing well-connected insiders to effectively bypass the law both during privatization and in the corporate governance of privatized firms. 9 K. Pistor et al., op. cit. 10 M. Angelucci et al., op. cit. 11 Chap. 5 of this Survey, as well as M. Angelucci et al., op. cit., S. Djankov and P. Murrell, op. cit., S. Estrin, “Competition and corporate governance in transition”, Journal of Economic Perspectives, Vol. 16, No. 1, Winter 2002, pp. 101-124. in central and east ern Europe construct their own adopt ion by transition economies of “best pract ices” in corporat e governance systems, they should examine corporate governance, best practices that have invariably carefully and critically the entire experience of both originated in their own home countries. Those best North America and west ern Europe. Rather than leap to practices were of course the product of specific national a shareholder or stakeholder model or hastily choose a experiences and cultures, factors that may make their unitary or t wo-level board struct ure, each transit ion state adopt ion by a given transition economy inappropriate or needs to determine the system of corporate governance at least difficult without significant adaptation. In most appropriate to its own individual needs and evaluating foreign models of corporate governance, circumstances. Organizations and individuals from policy makers in transit ion economies would do well to west ern dev elop ed co untries in evit ably press for the remember that to a large ext ent western corporate 122______Economic Survey of Europe, 2003 No. 1

governance systems have evolved over time as a response stock markets and of those financial intermediaries to periodic, specific financial crises in individual (such as investment funds and their sponsoring banks) countries. While recognizing that those crises have come that may be count ed upon to act as delegate monit ors for and gone, they should also remember that others, leading dispersed shareholders. Given the limited capacit ies in to st ill further corporat e governance reforms, are some transit ion count ries for regulat ion and probably yet to come. enforcement, and given the need of small open Apart from corporate governance proper, policies transit ion economies to (further) integrate into which further promot e competit ion in product markets, as int ernat ional capit al market s, considerat ion should also well as policies which improve expeditious and equit able be given to “importing” good corporate governance bankruptcy procedures would go a long way towards from abroad. This could involve local firms seeking making sure that companies are run efficient ly, and that list ings at and complying with t he corporat e governance inefficiencies are corrected. These policies are rules of foreign stock exchanges, local firms having indispensable complements of any corporate governance their books audited by international firms to system. With respect to the latter, transition economies int ernat ional standards, (further) opening up domestic should recognize both the interdependencies bet ween t he markets for foreign financial intermediaries operating different element s of a sound corporat e governance under the regulat ion and supervision of their home system and the priorities that emerge from decisions authorities, as well as policies conducive to attracting already taken. In particular, privatization policies which further foreign direct investment . Finally, for the have led t o the emergence of controlling strategic countries set to enter the European Union, an important shareholders need to be complement ed first and consideration in developing their corporate governance foremost with policies that protect the rights of minority systems ought to be to make them compat ible wit h EU shareholders. In countries where privatization has practice in order to minimize the adjustment costs faced instead led to more widely dispersed share ownership, by domestic firms and investors upon entering the priority needs to be assigned to the proper regulat ion of Common Market.