Corporate governance is concerned with how a company is directed and controlled and, in particular, with the role of the directorate and the need for ensuring that there is an effective framework for accountability of directors to owners. Corporate governance and financial market liquidity are important topics in the finance liter- ature. But they have traditionally been addressed independently of each other. Here we attempt to link the two. The starting point of the corporate governance literature is the agency problem of capitalism. This concerns the credibility problem facing firms when they seek to convince outside investors to contribute funds. In its most extreme form, the agency problem is about how to ensure that management does not steal investors’ contributed resources or pay themselves undeserved handsome salaries and so on. The role of corporate governance is to ensure that resources are not dissipated but applied effectively into profitable investment opportunities. There are two generic approaches to the classic agency problem: either key investors are
44 Chapter 3. Corporate finance around the world
44 Chapter 3. Corporate finance around the world
given influence over strategic decisions in the firm (control-oriented finance) or man- agement finds ways of committing to efficient actions and shares in the proceeds from these actions (arm’s-length finance).
Under control-oriented finance, investor intervention is typically based on a con- trol block of equity or a position as exclusive or dominant creditor. Intervention may take many forms, from vetoing or blocking inefficient investment decisions to using a voting majority to oust incumbent management.
Under arm’s-length finance, investors do not intervene in the company, at least not as long as payment obligations are met. Intervention, if it occurs, typically involves some external mechanism such as renegotiation of corporate control, or a court in the case of bankruptcy. The firm attempts to commit to behave efficiently and to repay investors and, in the meantime, it may provide collateral in the form of con- tingent property rights to individual well-specified assets or cash flows.
The basic issue of these two approaches to the agency problems is the same – how to convince investors that they will be repaid in the future. The choice of ownership structure has important implications for the way in which the problem is addressed. In the case of control-oriented finance, control is concentrated from the outset, but in the arm’s-length case, we rely on the accumulation of controlling stakes – and this, in turn, presupposes the existence of a liquid market through which this is facilitated in the market place.
Systems where control-oriented finance dominates can be expected to be asso- ciated with more concentrated ownership structures at the level of the individual firm and with less liquid capital markets. Control-oriented financial systems breed control-oriented investors. The market for corporate control (takeovers) operates outside of the public stock exchanges in the form of occasional trades in large blocks. Arm’s-length systems have dispersed ownership of both debt and equity, and more liquid capital markets. Investors are oriented towards holding portfolios of securities and the market for corporate control operates over public stock markets and this is seen as an important mechanism for the correction of managerial failure. Table 3.9 summarizes hypothesized and observed contrasting characteristics of control-oriented and arm’s-length types of financial systems.
Although the link between corporate finance and governance, on the one hand, and corporate law and securities regulation, on the other, is still poorly understood, a recent survey of the corporate governance literature, by Shleifer and Vishny (1995), argues that concentration of ownership is an unavoidable outcome of shortcomings in the legal system. In the absence of well-functioning securities regulation, concen- tration of ownership is the only way to surmount the agency problem referred to above. Shleifer and Vishny imply that ownership and control patterns are ultimately determined by existing laws. On this front, it is not a coincidence that continental Europe has a legal system founded on codified Roman law whereas the legal systems of England and the United States are rooted in common law. This distinction is worth further comment.
Some countries have a legal system that relies upon a limited amount of statute law and a large amount of case law built up in the courts, supplementing the statutes. Such a common law system is the case in England. It is hence less abstract than codified law. A common law rule seeks to provide an answer to a specific case rather
than to formulate a general rule for the future. Although this common law system emanates from England, it is found in similar forms in many countries influenced by England. For example, the federal law of the United States, the laws of Ireland, India and Australia are, to a greater or lesser extent, modelled on English common law. Other counties have a system of law that is based on the Roman civil law as com- piled by Justinian in the sixth century and subsequently developed, at least in Europe, by continental European élites. Here, rules are linked to ideas of justice and morality and they become doctrine and codified in laws. The above distinction has important implications for company law or commercial codes. Table 3.10 illustrates the way in which developed countries’ legal systems fall into these two categories.
Nobes and Parker (2002) note the relevance of the above classification in terms of its impact for company accounting – they state that in Germany accounting is ‘to a large extent a branch of company law’. The fact that England and continental Europe fall in opposite camps in Table 3.10 may partially explain differences in cor- porate governance.
Table 3.10 Western legal systems
Common law Codified Roman law
England and Wales France Ireland Italy United States Germany Canada Spain Australia Netherlands New Zealand Portugal
Japan (commercial)
The laws of Scotland, Israel and South Africa, among others, tend to embody elements of both systems.
Table 3.9 Characteristics of control-oriented and arm’s-length financial systems
Type of financial system
Control-oriented Arm’s-length
Share of control-oriented finance
in capital markets High Low
Financial markets Small, less liquid Large, highly liquid Number of firms listed on exchanges Small Large
Ownership of debt and equity Concentrated Dispersed Investor orientation Control-oriented Portfolio-oriented Turnover of control blocks Very low Relatively high Dominant agency conflict Controlling v. minority Shareholders v.
shareholders management Influence of board of directors Less important Important Role of hostile takeovers Very limited Potentially
46 Chapter 3. Corporate finance around the world