The Conundrum of Corporate Governance

Professor Cally Jordan

University of CambridgeOctober 25, 2005

The Truisms*

• Pressures of Capital Markets will Improve Governance of Corporations

• Improvements in Corporate Governance will Promote Development of Capital Markets

*A version of this presentation was presented at the Brooklyn Law School/New York Stock Exchange Breakfast Roundtable, New York City, October 2002.

The Conundrum

• High Quality Formal Legislation

- “an external supply of legal solutions”(Pistor 2001)

• Low Levels of Effectiveness

• “Simple convergence story does not do justice to the complexity of legal change” (Pistor 2001)

• More Questions than Answers

“International Standards”

• Not all Standards truly International: Origins in National Systems

• Promotion of International Standards:

- Proliferation of “transplanted” legal concepts

- Legal “transplants” do not always thrive

Theories of Effective Legal Rules for MarketsLegal Origins

• “Legal Origins” literature“…legal families appear to shape legal rules, which in turn influence financial markets”

(La Porta, et al. 2000)

• Measures of investor protection superior in common law countries and resulted in more developed financial markets

Political Structures

• Political Structures Matter

• “…one does not have to have the good fortune of being colonized by the British to be able to have vibrant financial markets…the main impediment we identify – the political structures within the country – can be as difficult to overcome as more structural impediments…”

(Rajan & Zingales 2001)

Convergence and Divergence

• Convergence: Economic Forces the Same all over the World – Supports use of International Standards

• Divergence: Institutional, Regulatory, Political Constraints– Legal systems are path dependent

Predictors of Effectiveness

• Manner of Introduction

- Voluntarily Embraced (Pistor 2001)• Dynamism and complexity

“…legal systems are the result of a layered complexity that stems from the accidents of legal history and from legal transplants” (Mattei 1997)

• Form and Substance

Interaction of Convergence and Divergence

• Relatively Modern Statutory Capital Markets Law (Sensitive to Forces of Convergence)

• Overlays Older (19th C) Corporate/Companies Law (Path Dependent)

• Corporate Law Itself Dependent on Even Older and More Path Dependent Basic Principles (Contract, Property, Status, Trust Law)

Dynamic Legal Rules: Public and Private

• Focus on Public Legal Rules

- ex ante: Legislation/Regulation

- ex post: Enforcement through Judicial Action

• Ineffective Public Rules Need for Greater Enforcement

• Is “Enforcement” the Answer• Too Narrow and Simplistic an Analysis

Observations from the Field

• Private Legal Rules and “Semi-Public” Legal Rules are Important

• Different Legal Traditions have Different Balances between Public and Private Rules

• Form is as Important as Substance when Transplanting Legal Rules

• “Semi-Public” Rules can be Effective for Market Driven Governance Initiatives

Interaction Between Private and Public Rules

• An Example: A Matrix of US Derivatives Regulation

• Trend to “Privatization” of Legal Rules likely to Continue (Partnoy 2002)

Private Public

Ex Ante Contract (ISDA)

Congress (CFMA)

Ex Post Arbitration (NASD)

Courts (SDNY)

Corporate Governance A Dynamic Continuum

Ex ante

Legal Sensibility

Standards of Behavior

Private Rules

Quasi-public rules

Public Rules

Moral

Obligation

Voluntary

Codes

Contract Listing Rules

Legislation

Ex Post

Moral Opprobrium

Reputational

ConsequenceArbitration

Specialized

Arbitration

Judicial

Action

Audit Committees: One Rule/Three Forms

Standard of Conduct Semi-Public Public

Cadbury Report/Combined

Code (1992/1998)

NYSE Listing Rules (1978)

Canada Business Corporations Act

(1975)

Different Legal Traditions Different Preferences for Effective Rules

• English Common Law System - Contract and the Judiciary- Aversion to “Written Law” (statutory law)- “No Right (or Wrong) without a Remedy”

• Continental European System- Primacy of “Written Law” (Codes/Statutes)- Little Emphasis on the Judiciary- “No Right without a Written Law”

US COMMON LAW

“The particular genius of US law…has been its constructive combination of elements of both civil and common law” (Glenn 2004)

– Great Importance given to Judiciary and “Procedural”

Rules

– No aversion to statutory law

US COMMON LAW

• “In many respects US law represents a deliberate rejection of common law principles, with preference being given to more affirmative ideas clearly derived from civil law. These were not somehow reinvented in the United States but taken over directly from civilian sources in a massive process of change in adherence to legal information in the nineteenth century” (Glenn 2004)

Market Driven Governance Mechanisms

• Anglo-American Debate

• Popular Mechanisms Reflect their Origins- “Voluntary” Codes (UK)- Cumulative Voting (US)- Class Actions (US)

• Prospects for Effectiveness as Transplants?

Class Actions• Effectiveness in Emerging and Transition Economies?

- Dead on Arrival

- Wrong Form of Rule for Continental European Based Legal Systems

- No Procedural Rules or Institutions to Support them

Experienced Judiciary Extensive Network of other Procedural

Rules Active Body of Litigation Professionals Populace with Litigious Bent

Cumulative Voting

• Originated in voting practices- Overrides “Majority Rule” Voting for

Directors • Passed to Public Rule: Corporate Statutes

- Minority Shareholder Protection- Mandatory

• Slipped Back to “Semi-Public” Rule- Optional: Charter/By Laws could

Override

Cumulative Voting

• Cumbersome/Procedural

• Not used for shareholder protection in publicly traded companies in US

• “[A]pplication to shareholder voting is a path-dependent historical oddity” (Gordon 1994)

Cumulative Voting in Korea

• Introduced in Aftermath of 1997 Asian Financial Crisis at Suggestion of International Advisors

• Signaling Effect to International Markets

• “Weak” or Semi-Public Variety

Cumulative Voting in Korean

• Korean Legal Tradition: Strongly German Source

• Preference for Written Law – Public Legal Rules

• Statutory Right to Board Representation by Certain Constituencies Well Established in German Law

Effectiveness of Cumulative Voting in Korea

• Introduced by Statute but Korean Corporations Moved Quickly to Neutralize by Charter Amendment

• Wrong Rule

• Wrong Form

• Degree of “Imposition” (Pistor)

Cumulative Voting in Korea

• “As of 1998, cumulative voting has become an option for companies. Unfortunately, from a policy standpoint, it has remained largely ineffective” (Jang & Kim 2001)

“Voluntary” Codes of Corporate Governance

• Immediate Origin: Cadbury Report (1992) (London Stock Exchange/Society of Accountants)

• “Combined Code” not Written Law; a Standard of Behavior (not even Binding Force of Contract)

• “Set of Written Rules on any Subject, esp. the Prevalent Morality of a Society or Class; an Individual’s Standard of Moral Behaviour” (OED)

Effectiveness of Voluntary Codes

• In UK, Reasonably Effective

- Aversion to Written Law- Tradition of Reliance on

“Convention” or Custom- Moral Suasion as Regulatory

Technique

Effectiveness of Voluntary Codes

• Why this Form: Usual Virtues of Private Legal Rules

- Flexibility, Responsiveness, Sensitivity to Industry Specific Concerns

- “Fiduciary Duties” of Directors

Originate in Courts of Equity

Suffused with Moral Righteousness

Effectiveness of Voluntary Codes Elsewhere

• Can They be Transplanted

• “Voluntary” Code an Oxymoron in Continental Europe

• “Written Body of Laws so Arranged as to Avoid Inconsistency and Overlap” (OED); ie a very Strong Form of Public Legal Rule, Higher than Statute, Second only to the Constitution

• Russian Code: Is it Law or is it not?

German Voluntary Code of Corporate Governance

• “The German government yesterday announced broad voluntary guidelines for publicly traded companies on the management of their businesses, citing the collapse of the US company Enron as a warning sign….Herta Daubler-Gmelin, justice minister, argued that while the code contained no sanctions for non-compliance, ‘the capital market will provide very effective sanctions’ for those that chose to ignore it”

  (Financial Times, February 27, 2002, 2)

German Voluntary Code of Corporate Governance

• “Common rules for corporate takeovers have become a test for Europe’s capacity to reform itself. Thanks to the conservatism of German business and the refusal of the Berlin government to look beyond narrow political interests, it is one that Europe is likely to fail. Despite the eye-catching call for greater disclosure of executive pay, Germany’s new voluntary code, published yesterday, does little to nudge German corporate governance towards a more investor-friendly model.”

(Financial Times, February 27, 2002, 12)

German Voluntary Code of Corporate Governance

• “A group of 21 Social Democrat members of the German parliament will today table a draft bill… The bill, drafted in consultation with corporate governance expert Theodor Baums, comes in response to what the legislators see as the failure of a three-year-old voluntary code…” (Financial Times, January 19, 2005)

Effectiveness of Popular Governance Mechanisms

• Anglo-American Spill-over can be Ineffective Domestically - Incompatible with Underlying Legal System (Fiduciary Duties)

- Contradiction with Civil or Commercial Codes (Trumped in the Legislative

Hierarchy)

- Takes the Wrong Form to be Recognized and Effective in that Legal System

Popular Governance Mechanisms and International Markets

• Signaling Effect

• Greater the Interest in Signaling, Greater the Interest in Internationally Recognized Mechanisms

• Perverse Effect: Internationally Recognized, but Domestically Ineffective, Mechanism

- Potential to Disrupt Political/Corporate Status Quo Limited

Lessons from Latin America

• Markets are Idiosyncratic - indigenization

• Signaling is Significant

• Governance Mechanisms in Multiple Guises along a Continuum of Public and Private Legal Rules

SOX and Europe

• SOX – more symptom than solution

• European models appearing

• Rise of legal sensibilities in the board room