CORPORATE GOVERNANCE: EFFECTS ON FIRM PERFORMANCE AND ECONOMIC GROWTH by Maria Maher and Thomas Andersson ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT © OECD 1999 CORPORATE GOVERNANCE: EFFECTS ON FIRM PERFORMANCE AND ECONOMIC GROWTH TABLE OF CONTENTS SUMMARY.................................................................................................................................................... 3 I. Introduction.......................................................................................................................................... 4 II. Analytical Framework: The Shareholder and Stakeholders Models of Governance........................... 5 II.1 The Shareholder Model ................................................................................................................ 6 II.2 The Stakeholder Model ................................................................................................................ 8 II.3 The Interaction of Corporate Governance with the Institutional and Economic Framework..... 10 III. Corporate Governance in OECD Countries: Strengths, Weaknesses, and Economic Implications12 III.1 Outsider Systems of Corporate Governance .............................................................................. 17 III.2 Insider Systems of Corporate Governance ................................................................................. 24 III.3 A Convergence in Systems?....................................................................................................... 30 IV. Corporate Governance and Performance: The Empirical Evidence............................................... 31 IV.1 Ownership concentration and firm performance ........................................................................ 31 IV.2 Dominant shareholders and the expropriation of minority shareholders.................................... 34 IV.3 The market for corporate control and firm performance............................................................ 37 IV.4 Managerial compensation and firm performance....................................................................... 41 V. Conclusions........................................................................................................................................ 44 BIBLIOGRAPHY......................................................................................................................................... 46 2 CORPORATE GOVERNANCE: EFFECTS ON FIRM PERFORMANCE AND ECONOMIC GROWTH1 SUMMARY 1. This document addresses corporate governance and its effect on corporate performance and economic performance. It first recapitulates and builds on previous work undertaken by DSTI, for example, it gives a more explicit exposition of the shareholder and stakeholder models of corporate governance. It then goes on to address some of the underlying factors that promote efficient corporate governance, and examines some of the strengths, weaknesses, and economic implications associated with various corporate governance systems. In addition to providing data not presented in the previous work, it also provides newly available information on ownership concentration and voting rights in a number of OECD countries. The document also provides a survey of empirical evidence on the link between corporate governance, firm performance and economic growth. Finally, several policy implications are identified. 2. One of the most striking differences between countries’ corporate governance systems is the difference in the ownership and control of firms that exist across countries. Systems of corporate governance can be distinguished according to the degree of ownership and control and the identity of controlling shareholders. While some systems are characterised by wide dispersed ownership (outsider systems), others tend to be characterised by concentrated ownership or control (insider systems). In outsider systems of corporate governance (notably the US and UK) the basic conflict of interest is between strong managers and widely-dispersed weak shareholders. In insider systems (notably Germany and Japan), on the other hand, the basic conflict is between controlling shareholders (or blockholders) and weak minority shareholders. 3. This document shows how the corporate governance framework can impinge upon the development of equity markets, R&D and innovative activity, entreprenuership, and the development of an active SME sector, and thus impinge upon economic growth. However, there is no single model of corporate governance and each country has through time developed a wide variety of mechanisms to overcome the agency problems arising from the separation of ownership and control. The document looks at the various mechanisms employed in different systems (e.g. concentrated ownership, executive remuneration schemes, the market for takeovers, cross-shareholdings amongst firms, etc.) and examines the evidence on whether or not they are achieving what they were intended to do. For example, one of the benefits of concentrated ownership is that it brings more effective monitoring of management and helps overcome the agency problems arising from the separation of ownership and control. Some of the costs, however, are low liquidity and reduced possibilities for risk diversification. While dispersed ownership brings higher liquidity it may not provide the right incentives to encourage long-term relationships that are required for certain types of investment. Therefore, one of the challenges facing policy makers is how to develop a good corporate governance framework which can secure the benefits associated with controlling shareholders acting as direct monitors, while at the same time ensuring that they do not impinge upon the development of equity markets by expropriating excessive rents. 1. This paper was written by Maria Maher and Thomas Andersson of the OECD Secretariat. A modified version was presented at the Tilburg University Law and Economics Conference on “Convergence and Diversity in Corporate Governance Regimes and Capital Markets”, Eindhoven, the Netherlands, 4-5 November 1999. The opinions expressed in the paper are the responsibility of the author(s) and do not necessarily reflect those of the OECD or of the governments of its Member countries. 3 I. Introduction 4. At the 1998 Industry Ministerial, a new direction for industrial policy was stressed and Ministers agreed on a number of priority areas for future work, including corporate governance. The OECD Council, meeting at Ministerial level in April 1998, also stressed the importance of corporate governance and called upon the OECD to develop a set of corporate governance standards and guidelines. In order to fulfil this Ministerial mandate, the OECD established an Ad Hoc Task Force on Corporate Governance, consisting of representatives from national governments, other relevant international organisations and the private sector. DSTI also participated in the Secretariat team serving the Task Force and contributed substantive input into the development of the OECD Principles on Corporate Governance, see OECD (1999a). OECD Ministers, meeting in May 1999, endorsed the Principles developed by the Task Force and also agreed that the Principles be assessed in due course, possibly in two years time. The OECD Council, therefore, also requested continuing analytical work in this area, see OECD (1999b). 5. The May 1999 Council Ministerial also called upon the OECD to study the causes of growth disparities (e.g. technological innovation, framework conditions for firm creation and growth, SMEs, etc.), and identify the factors and policies which could strengthen long-term growth performance. While macroeconomic factors certainly play a major part in the economic performances of OECD countries, governments have increasingly come to recognise that there are strong complementarities between sound macroeconomic policies and sound microeconomic foundations. As the last decade has seen a convergence on what constitutes good macroeconomic policy the OECD countries have increasingly come to recognise that weakness in microstructures can have profound impacts on a macro level. For example, the 1997 financial crisis in Asia was thought to be due, in part, to weaknesses in the banking sector and in corporate governance. Countries are therefore looking towards microeconomic foundations and structures in order to enhance their economic performance. The OECD reports on Regulatory Reform, the Jobs Study and the Principles for Corporate Governance are good examples of this new approach. This approach is also in line with the new direction of work for the Industry Committee as set out by Industry Ministers at their 1998 OECD Ministerial meeting. 6. One key element of improving microeconomic efficiency is corporate governance. Corporate governance affects the development and functioning of capital markets and exerts a strong influence on resource allocation. It impacts upon the behaviour and performance of firms, innovative activity, entrepreneurship, and the development of an active SME sector. In an era of increasing capital mobility and globalisation, corporate governance has become an important framework condition affecting the industrial competitiveness of OECD countries. Meanwhile, in transition economies, privatisation has raised questions about the way in which private enterprises should be governed. It is thought that poor corporate governance mechanisms in these countries have proved, in part, to