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2003 G8 Pre-Summit Conference

Governing Globalization:
G8, Public and Corporate Governance

Tuesday, May 27, 2003
INSEAD, Fontainebleau, France

Hosted by the Research Group on Global Financial Governance, the Guido Carli Association, the G8 Research Group, the EnviReform Project, INSEAD, the Club of Athens-Global Governance Group, le Comité pour un Parlement Mondial, Futuribles and the Académie de la Paix

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Corporate Governance in the Twenty-First Century
Donald J.S. Brean, University of Toronto,
and Christopher Kobrak, ESCP-EAP, European School of Management
Draft of May 23, 2003


This paper addresses structural differences in corporate governance systems among industrial nations. Approaches to corporate governance are categorized as Insider- or Outsider-based control systems. Choices made by nations about which type of system to encourage reflect deeply held national priorities that have evolved over time. Quick international convergence to a common system seems unlikely on its own and ill-advised as policy. The evolution of idiosyncratic national systems involves path dependence and political accident along with economic and political structures that are difficult to reshape to fit external or "international" criteria. Moreover, each national system has strengths and weaknesses in terms of the governance that relate to industrial efficiency and corporate stability. Insofar as radical change comes at significant social cost, governments and society at large would be better off focusing on incremental adaptation of their own systems, building on existing strengths and drawing on minimal international standards of corporate administration and national principles of corporate ethos.


The institutions here envisaged call for analysis, not in terms of business enterprises but in terms of social organization. On the one hand, it involves a concentration of power in the economic field comparable to the concentration of religious power in the medieval church or political power in the nation state. On the other hand, it involves the interrelation of a wide diversity of economic interests, those of the ‘owners who supply capital, those of the workers who ‘create’, those of the consumers who give value to the products of enterprise and, above all, those in control who wield power.

Berle and Means, The Modern Corporation and Private Property (1932).


The idea that one system of corporate governance might serve as a model for the whole world is an idea that has not been a happy time of late. The past ten years have witnessed remarkable shifts in enthusiasm for and against alternative corporate governance systems. Early on the vogue was to chastise the economic and social contradictions of the American system while extolling and the advantages of the German or Japanese model. Attitudes changed with the subsequent collapse of the Japanese economy and the spectacle of a floundering Germany which contrasted with the boom of the US’ technology-based "new" economy. Meanwhile the Asian financial crises, Russia’s Volga virus, Mexico’s peso problems and in the US the embarrassment of Long Term Capital Management along with the seemingly endless series of corporate scandals created a sense of all systems out of control.

Advocates of market-based solutions found further reason for gloom as the world’s stock market bubble burst, vaporizing value and shaking the world’s faith in so-called market rationality and established mechanisms of corporate control.

Unfortunately for the purpose of constructive regulatory revision and structural change, the sensational cases such as Enron, Tyco and WorldCom get corporate governance into the headlines without the added value of clear understanding of root causes and systemic consequences. Overreaction and frantic policy response is typically the result.

A lesson of the past decade is that we have not yet found a panacea for proper governance of firms with limited liabilities in which the roles of ownership and control are split. In modern industry, shareholders and bondholders entrust the day-to-day decisions about investment in corporate assets to managers whose interest are not necessarily aligned with the shareholders and bondholders. Management’s behavior ought to be constrained by laws and customs along with the rewards and sanctions of owners or their representatives. In answer to the question, "Who manages the managers?", the practical answer is "No one.", but for the deeper issue of what shapes and constrains management behavior — and hence what determines the efficiency, performance and integrity of the industrial system — the answer is the more nebulous "corporate governance".

Like the blind Brahmins describing an elephant, definitions of corporate governance vary according to perspective. Oliver Hart (1995) for example, taking a legal approach, sees the thrust of corporate governance as dealing with matters that are not dealt with through contracts. The focus is on how the corporate system engenders responsible behaviour in areas that are not articulated explicitly. Shleifer and Vishny (1997), on the other hand, taking the narrower perspective of finance, suggest that corporate governance "deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment."

Most of the developed and developing world still struggles with determining the best way to foster the mix of explicit and implicit contracts that industry uses to manage the allocation of resources. Against this background, this paper outlines the basic institutional choices available to control companies. We argue that efforts to impose one set of legal controls over another inevitably misses certain key points about corporate governance. Those points are this:

In contrast to many analysts, we are skeptical about the likelihood and advisability of international convergence in corporate governance practices. Moreover, none of the approaches to corporate governance reform in individual nations call for structural changes in the basic mechanisms of control that differentiate national systems.

Although issues in corporate governance correspond to the potential for exploitative, self-serving behaviour that stems from the separation of ownership and control — what financial theorists call the "agency problem" — fundamentally different approaches have emerged to deal with them. German social designers, for example, reflecting their penchant for social harmony, lave long advocated a special sort of industrial organization for Germany, the so-called Sonderweg (special way) which contrasts sharply with America’s seemingly unmanaged economic system with its free-for-all social relationships. Karl Helfferich, the German banker and economist, praised banks as the linchpins of Germany’s system of corporate governance, as custodians of social values that "keep the proper balance between intensive capital employment and fundamental security" necessary for avoiding "the chaotic competition" and economic waste and tensions inherent to "unplanned" commercial endeavors. The Americans Berle and Means, in their 1932 seminal work on corporate governance, took as a starting point the division of ownership and control has broad social implications of corporate governance. Likewise, we acknowledge that the division of management and ownership underlies the need for corporate governance and we define corporate governance as the attitudes and institutions that national societies employ to determine the mission of firms while enabling firms to realize those ends. Consequently, corporate governance encompasses many aspects of business, law, and finance including but not limited to:

Despite the elusive consensus concerning the advantages and disadvantages of competing systems of corporate governance, the subject is of crucial importance for several reasons. First, sound corporate governance increases the willingness of investors to entrust managers with funds. Second, firms that maintain good corporate governance have a lower risk premium, a lower cost of capital and higher market values. Third, good corporate governance addresses the "allocation" problem of over- or under-investment by reflecting relatively undistorted investor preferences. Fourth, corporate governance is the primary tool of society to ensure that private contracts lead to social goods such as confidence in private enterprise. Finally, many overlapping social and economic goods, such as research, innovation, industrial stability and growth, appear to be highly dependent on good corporate governance.

The remainder of this paper is divided into four sections. The next section offers an overview of the different modes of corporate governance, their mechanisms of control and their advantages and disadvantages. We then describe recent recommendations and regulations introduced in four important jurisdictions — the United States, Germany, France and the European Union. We then outline why institutional relationships cannot by themselves make for a sound system of corporate governance, noting that recent proposals for reform do not and cannot make structural changes. The last section establishes why a corporate culture of control is more important than institutional controls and includes some suggestions for how systems ought to develop.

Systems of Control: Insider versus Outsider Model

We will use the terms ‘insider’ and ‘outsider’ models to categorize corporate governance systems. Although the more common distinction between bank-based and market-based systems has much in common with ours, the insider:outsider distinction allows for broader grouping of countries and more analytic insight. The bank-dominated characterization, for example, becomes awkward when discussing Germany and France, whose system of corporate governance have much in common but within which banks play very different roles among firms of different sizes and industries. Moreover, the insider:outsider delineation goes right to the heart of the social and legal choices made by countries. In Germany, for example, banks are permitted, indeed encouraged, to maintain close contacts with and control their clients, because that country deplores impersonal capitalism. In France, on the other hand, banks until recently are mere organs of the state with intentionally ambiguous industrial purpose.

Most countries in the world fit into our insider category. Indeed, concentrating ownership and control into tightly paired and closely linked, identifiable and cohesive groups, even in Anglo-Saxon countries, was the mode until the middle of the 19th century. Insider groups tend to be relatively small. The members are generally known to one another and generally have a long-term relationship to the firm that goes beyond supplying capital. If they are investors, they are not passive participants in the company.

Insider systems have many different kinds of relationship to the firm. In Germany, they tend to be bankers (house bankers) and workers. The German system stresses a high degree of confidentiality between banks and their clients, which entails secrecy about strategic and operational matters. Banks are seen as a substitute for markets. The dual structure of German boards, with a relative strict delineation of the duties of the Aufsichtsrat (Supervisory Board) — with board membership in companies with more than 2,000 employees divided equally among shareholders and workers — and Vorstand (Management Board), made up of key internal managers. Shareholder representatives, due to the powerful role of banks, tend to be de facto bank representatives.

Some models seem to mix the two models. In Sweden, for example, which has highly liquid financial markets and many foreign investors, intermediary investment companies still play an important role in corporate affairs. Their role is amplified by the professional skills of their managers and Sweden’s system of multiple voting rights, which reinforces and concentrates the participation of active shareholders. In Sweden, 46 percent of the voting rights of the largest Swedish companies are controlled by the largest owner of companies (Nestor and Thompson, 1999). As is often the case, however, Swedish companies tend to move closer to the outsider model as they become more international. This phenomenon will be discussed in more detail later.

In France and Japan, firms — especially larger one - tend to have extensive interlocking ownership, such keiretsu. Keiretsu are essentially enterprise groups that are organized vertically — manufacturers and their suppliers — or horizontally — across different industries. Though Keiretsu are sometimes organized around one large company, there is no holding company. Member companies are held together by holding each other shares, which, in essence, allows them to pool risk and profit. In France, corporate ownership structure has been described either as a "bipolarity" between large financial concerns like AXA-UAP and Société Générale, which has stakes in 16 companies of the CAC 40, or a continuum of cross shareholdings among firms. Fifty-nine percent of the shares of French firms were held by non-financial companies.

The outsider model is typically associated with the industrial ownership structure in United States and England. Shareholding of public companies is dispersed with each of the many shareholders holding a relatively small percentage claim on the company. (In the United States, for example, 62 percent of American companies no single shareholder holds more than 15 percent of the company’s shares. In Germany, by contrast, 89 percent of listed companies had at least one shareholder with more than 15 percent of the companies shares.) Shareholder’s interests in the outsider model are paramount and are enshrined in company and securities laws. While shareholders collectively own companies, the wide dispersion of shares render shareholder influence largely ineffective on the part of individual shareholder. Representation and defense of shareholder’s collective interests is the responsibility of the board.

In the outsider model, laws, regulations and, above, all market forces are the principle means of limiting the moral hazard of managers using company assets to satisfy their own interests. Timely, objective and accurate public information in the form of accounting disclosures, backed up by audits, tough securities laws and accounting regulation form the backbone of the system. Although shareholders’ interests are ostensibly represented by the board, common practice allows top management to control board selection. The board’s first duty is to protect the interest of shareholders by evaluating the performance of senior management, link senior executive compensation to clear performance criteria, and review and evaluate strategic and operating plans.

In the outsider model, corporate governance is buttressed by three markets: the market for managers of firms, the market for corporate control, and the product market. All three markets impose a sort of Darwinian selection process that ensures that the shareholder gets an appropriate return on invested capital. If the market for managers functions well, unproductive managers are dismissed while productive managers reap rewards within their company or in companies that hire them away. Incentives for managerial initiative and corporate performance are aligned. If this system breaks down, then the market for corporate control steps in. Raiders will wrest the company away from the existing managers and board, buying out old shareholders and re-positioning company assets to make it more profitable. Finally, if neither of these corrective mechanisms do the job, the product market will make a company’s products obsolete in terms of quality or price, forcing suppliers of credit or goods to go elsewhere with their resources.

Table 1: Insider & Outsider Models: Configuration of Control

Characteristics Outsider Insider

Board Make-up and Responsibilities

Little Shareholder Representation, Protect Interest of Shareholders, Business Judgment Rule, Boards Smaller, Mix of Managers and Outsiders

Shareholders and Other Stakeholders Sit on Board, Responsible to Society at Large and Company’s Interests

Role of Government and Legal Action

Securities Law and Other Regulations, Powerful Security Law Enforcement, Monetary Damages for Breach of Fiduciary Duties and Insider Trading

Active Participation in Ownership and Prioritization, No Civil Liability for Violating Trading Laws, Exchanges Main Regulators

Voice versus Exit — Market for Corporate Control

Investors’ Value Exit; Get Out of Investment Ultimate Control, New Investors Enter Easily, Shareholders have not Delegated Representation to Board

Relationship Built on Trust and Loyalty, Key Participants Know Each Other

Variable Based Compensation

Large Percentage of Management Compensation, Managers Viewed as Having Interests that Conflict with Shareholders, Economic Interest must be Conjoined

Rarely Employed, Duty Rather than Self-Interest, Both Managers and Shareholders Accept Social Responsibility to the Firm and Society at Large




Public Accountants Relied on For Audits and Accounting Information; Agents of Shareholders,

Transparency & Value Creation Key

Insiders Play Audit Function, Accounting Disclosure Generally Weak, Insiders Perform Function, Fewer Substantial Disclosures, Safety First




LBOs and MBOs used to Focus Management; Bankruptcy is Part of Portfolio of Corporate Strategies

Long-term Investors Tend to Hold Mix of Debt and Equity, Bankruptcy Considered Cardinal Sin


Rights of Shareholders

Dispersed, Few Large Shareholders, Shareholders Have Legal Right to Decide A Lot, Rarely Used

Shares Concentrated in the Hands of a Few Investors, Whose Relationship Goes Beyond that of Investor

Stakeholder Participation and Rights

Protected Classes and Social Interests, but Rarely Stakeholders Serve on Boards, Limited Protection of Interest

Most Countries Institutionalized Participation of Key Stakeholders, Protection of Considered One of Chief Aims of Governance

Table 2: Insider & Outsider Models: Advantages and Disadvantages

Criteria Outsider Insider

Long-term Investment

Public Debate, Exit is the Ultimate Control, Public Disclosure Impedes Strategic Closed-door Cooperation Among Stakeholders

Shareholders & Other Stakeholders Part of the Company; Change Debated Inside of Company Privately

Conflict of Interests and Cost of Services

Control by Management of Board Board Beholden to Management Competitive Bidding for Services

Board Members Tend to Represent Interest of their Institutions
Cost of Borrowing and Other Services Higher


Easy to Sell, Larger Capital Markets, More Equity Investment
Lower Transaction Costs

Large Blocks
Hard to Sell


Occurs Often

Few Social Constraints on Significant Change

Blocked by Large Shareholders Embedded Stakeholders Resist Change

Mission of Firm

Clear Goals
Shareholder Wealth Maximization

Balance Stakeholder Interests Further Interests of the Firm,

Agency Costs

Free Rider Problem
Not Economically Attractive to Invest in Control for Each Investor

Larger Equity Interest and Other Economic Ties Makes Investment in Control More Economically Feasible

Worker and Other Stakeholder Protection, Stability

Few Legal Constraints on Companies

Many Constraints on Shifting Relationships;
Premium on Stability

Protection of Minority Shareholders, International Capital Flows

Easier to Integrate New Investors

Requires High Degree of Trust in Intermediaries; New Investors Harder to Integrate; Insiders Obliged to Take Responsibility

Stock Market Capitalization and Returns

Higher, US and UK 2xGDP
Get Profitability Numbers

Japan & France: 1xGDP
Germany : 0.7 GDP

III System Evolution: Recent Reforms in the United States and Europe

In this section we provide a brief overview of the reform of corporate governance in the United States, two countries — Germany and France — and the Europe Union. The choice of these three countries and the EU itself provides substantial diversity in industrial structure, political evolution, cultural traditions and social priorities. They also represent the areas in which the debate has been most intense. Despite the intensity, we observe that recent reforms in the both the United States and Europe reveal no inclination to tamper with prevailing structures of corporate governance.

United States

The American approach to corporate governance is the archetypal "outsider" system. Although board membership comes from a relatively wide circle of corporate connections, US law and tradition make concentrated shareholding and stakeholder representation on boards relatively rare. Seventy-six percent of American shares are owned by households directly or through mutual funds and pension funds compared to 24 percent in France and Germany. Investors collectively rely on impersonal market forces — the market for managers, the market for corporate control, the product market — as well as confidence in securities regulation to ensure the integrity of their investments and, in the process, to control managers. Although the American shift from an "insider" to an "outsider" system is less than a century old, the US was ahead of most countries in developing an independent accounting profession which undertakes mandatory audits and is responsible for accurate, objective financial reporting to inform investors. This foundation of corporate governance, of course, has been rocked recently by highly publicized failure.

Until the 1930s, US banks held large blocks of shares and sat on boards, representing their own interests and the interests of their key clients, not unlike German universal banks do today. Economic and political factors since the 1930s have pushed the United States away from the insider model. First, anti-trust legislation in the Unites States favoured the formation of large companies rather than the association of smaller ones which tend to keep a more concentrated (often family) shareholding and close relations with key stakeholders. Second, the conviction that the Great Depression was caused by unscrupulous economic agents whose control of companies and markets robbed small investors to line their own pockets, seemed plausible to Americans who distrusted concentrations of power. It grew as part of American folklore. This led to a whole series of banking and tax laws that precluded banks from owning shares in one another and limited the size of mutual and pension fund shareholdings in individual companies. Third, the post-World War II unprecedented wealth and willingness of many Americans to invest in the stock market directly or through mutual funds created ample equity funds which did not have to be channeled through big banks. Reforms in the United States since the 1930s like those of the Depression Era, therefore, have been directed at protecting citizens and institutions by adequate disclosure and by limits on how much any institution can invest in any one company.

American regulations and American federalism help preserve the dispersed share ownership that is really the economic context for an outsider system. Insurance companies, regulated by state law, are discouraged by many states from owning equity. Mutual funds and pension funds are obliged to diversify their portfolios, which keeps their ownership in individual companies small. Moreover, in the United States, only a small amount of equity, approximately 5 percent, is owned by financial institutions, compared with an average of 29 percent in other countries. Individual ownership, usually small holdings, is much higher in the United States than in most other industrial countries. Also, there are regulatory restrictions on non-financial companies holding large blocks of other companies’ shares. In most other industrial nations, banks can hold equity in amounts that are limited only in relation to the banks’ overall capital.

Unlike earlier developments in corporate governance in America, recent reforms propose no radical shift in accounting rules, regulatory institutions or ownership structures. Even the recent reaction to corporate scandals tends merely to add a dimension of personalization to responsibility, an approach with some resemblance to the insider model. The Sarbanes-Oxley bill, for example, threatens severe retribution for wrong-doing while providing little guidance as to what constitutes right-doing.

Regulatory reaction to the collapse of Enron, WorldCom and Tyco attributes the breakdowns to human error in applying basically sound principles. Moreover, the views about the sorts of errors committed and harm done are consistent with America’s value system about corporate governance. Enron executives and investment analysts were less vilified for "cooking" the books than profiting personally from their "insider" information to the determinate of workers not so much as workers but as investors through their pension plans. The correction has been to increase the personal responsibilities of executives by dint of punishment and to reduce potential conflicts of interests among auditors and managers.

Recent reform proposals are also designed to address weaknesses in America’s accounting profession and board structure. The latter has long been criticized for the dominance of company managers over hand picked, poorly informed outside managers. While details of enforcement have not been laid out by the Securities and Exchange Commission (SEC), the Sarbanes-Oxley Act calls for creation of a public accounting oversight body, restrictions on consulting services of accounting firms, the naming of independent financial experts to company board audit committees and signing off on companies’ annual statements by company chief executives and financial officers — with loss of bonuses in case of misstatement. The New York Stock Exchange has already added that companies must have a majority of directors without previous close links to firms, regular meetings of non-executive members, compensation and nominating committees composed entirely of outside directors, and the publication of corporate-governance guidelines. None of the proposals address the qualifications and training of outside directors, and the separation of the board chairman and president functions. Most importantly, recent reforms in the United States emphasize the process of preparing accurate, audited financial statements without questioning the decentralized system’s competence, commitment and willingness to act on the information in the context of democratic capitalism.

Reforms in the United States must be seen against the background of the growth of institutional investors and the corresponding decline in bank lending, bank deposits and higher degree of equity financing, a process in which the United States has led the way. Although for some analysts, channeling investments from individual shareholders into companies via large institutional investors offers a hope of overcoming the principal agent problem by combining the interests of those shareholders into blocks larger enough to justify more investor participation in management, this ignores some fundamental aspects of institutional investing. Not only are many institutional investors forbidden by law to invest large blocks in any single company, much of their investment strategy is based on defining optimal portfolios that efficiently removes unique risk. That is not to say that they do not do fundamental analysis of the companies in which they invest, but they do so with an optic towards picking stocks that are undervalued and that will, therefore, yield higher gains. Institutional investors’ reliance on large diversified portfolios is in essence outsider control. Direct control of unique risk is not something that fits into their cost benefit calculations. Although it is possible for institutional investors to take an active role in decision-making or negotiate with management, despite a few examples to the contrary and legal pressure to take shareholder responsibilities such as voting proxies more seriously, institutional investors still follow the "Wall Street Rule": Selling or threatening to sell shares, which can only indirectly force change or CEO turnover, remains their principal form of applying pressure. Much of shareholder activism among institutional investments involves analyzing and encouraging companies to adopt international norms of good corporate governance.


For many years, Germans prided themselves on the efficiency of their industrial system which, with the strong role played by banks and the integration of workers onto supervisory boards, seemed to guarantee unparalleled prosperity through a balance of economic, social and political goals.

Corporate governance has emerged as a controversial issue in Germany over the last decade. In its internal or national dimension, German corporate governance is anchored in state preference for industrial stability combined with cohesive social policy. However, as Germany began to lag behind other countries in developing a culture of equity investment, many German companies have turned to equity capital via listings on foreign stock exchanges, exposing firms to new demands for corporate governance.

The increase in foreign shareholders, especially large institutional shareholders, whose holdings in German equities have doubled as a percentage of GNP in the past ten years, have helped stimulated many reforms. The public debate about the topic is cited as part of the reform movement. With scandals like Enron in the United States and IG Metalgesellschaft in Germany, and haunted by fears that Germany AG is kaputt, as one author put it, "The concept "corporate governance" is, therefore, on everyone’s lips." Concrete measures include the creation of Corporate Governance Codes of Conduct, regular reports by several groups on how well companies adapt the codes, rating companies against corporate governance precepts such as the incorporation of control responsibilities in corporate by-laws, protection of shareholders, transparency, the strength of management and supervisory boards, and audit requirements. Nevertheless, the greater concern in Germany is not the underperformance of companies, but rather the risk of bankruptcy. The bankruptcies of Holtzman and IG Metal tend to weigh more heavily on Germans than the sub-optimal performance of DaimlerChrsyler.

Germany’s state-sponsored commission on corporate governance, Kodex, came out with a series of recommendations in 2002 that have guided reforms in German corporate law including standards designed to reform boards in line with "international norms." They call for structural improvements in the knowledge of board members, age limits, and minimum supervisory board sizes (eight members). In addition to reinforcing the Aufsichtsrat’s earlier role of advising and electing the management board, the new legislation clarifies the role of the supervisory board vis-à-vis the management board with the delegation of such specific new direct responsibilities as creating management information systems, training of management, management control systems, setting the agenda and organization of shareholder meetings, insuring clarity and breadth of auditors’ reports to the supervisory board, and regularly evaluating of the quality of its own supervisory activities. Moreover, it makes personal demands on supervisory board members by stressing their independence — criticizing specifically the practice of appointing former Vorstand members to the Aufsichtsrat — and limits on other activities, such as the total number of boards on which they serve.

None of the recent reform proposals have called into question mainstays of Germany’s system: the two-tier board structure, the mission of the board, and the role of banks and workers on the supervisory board. Although some recent studies and criticisms from the 1920s have pointed to some deficiencies in the two-board system and bankers’ role in it, German reforms have addressed issues like the appointment of former managers to the supervisory board. The chairmen of many supervisory boards are former heads of the company’s management board. Although no one may serve on both boards simultaneously, the continuity between management and supervisory boards has the advantage of keeping knowledge in the company. Nevertheless, the arrangement enables supervisory boards to protect current managers from criticism of decisions that the former managers helped put into place with the new management which the former leaders helped select. A second criticism is that the big banks have no effective overseers on themselves. Since private investors deposit shares with banks along with their proxy votes, banks control much of the vote at annual meetings. The only recent "threat" to bankers’ control of corporation and the large interlocking ownership structure of many large German companies has come with recent tax reform which slashed the capital gains tax on sales of shares held by financial institutions. This "unlocks" capital and unties ownership that would otherwise stay within the financial institutions — mostly banks — to avoid the capital gains tax. While this reform has had some impact already on share held by German banks, it is not clear that it will lead to a major shift in the governance of German companies. Finally, the mid- and small-size companies in Germany (the so-called Mittelstand) that make up a substantial portion of German industry were not addressed by the Kodex Commission, compromising the extent to which the Kodex reforms will affect the broader landscape of German corporate governance.


France’s system of corporate governance reflects two long-standing elements of its social and political structure: a tightly-knit elite and a large, direct role for the state. Recent reforms have done little to change this.

Corporate governance in France has often been described as an uncomfortable mixture of the American and German models, although it clearly fits better into the Insider model. Company presidents (président directeur-générale, PDG) have held near dictatorial control over their boards and companies, leading to justified criticism about the ineffectiveness of control mechanisms. France’s interlocking shareholdings (albeit with less bank supervision than in Germany), a strong government role in the running of companies, significant worker involvement in company decisions and board representation held by important stakeholders puts France into the category of an Insider system.

Although French companies have the choice between the single- and dual-board systems, most choose the single.

With the increase of private companies, the opening of markets to international investors, and a shortage of equity financing — but no shortage of control scandals such as Credit Lyonnais - France has engaged in a vigorous debate about corporate governance over the past decade. Michel Albert’s Capitalisme contre Capitalisme (1992) lays the foundation for the French debate by arguing that any system of corporate control is tied to social values. According to Albert, France has basically to choose between the Rhine Model (Germany) and America’s free-wheeling liberal system. He concludes, not unsurprisingly, that France’s social and economic system is better suited to the German model. Implementing the German system in France would require few structural or attitudinal changes. The basic "social commitment" is there, along with the existence of large shareholdings and an active government. Adding a requirement for a two board structure with the active participation of bankers and other large shareholders or their representatives with expanded representation of workers are relatively minor structural adjustments.

Since Albert’s book, France has taken concrete steps to strengthen its corporate governance system by adapting to international and European norms of best practice. Both major undertakings took as their starting point that good corporate governance required a clear understanding of the mission of the firm and that French traditions were much closer to Germany’s view of a more socially responsible capitalism set against the "Anglo-Saxon" variety. The Viénot Report, based on the work of the Conseil National du Patronat Français (CNPF) and the Association Française des Enterprises Privée (AFEP) focused on the objectives, powers, and organization of boards of listed companies with the aim of increasing investor confidence. It contained many widely-accepted aspects of good corporate governance among its recommendations, including:

The Viénot Report also called for government legislation to reinforce the already-existing pressures on companies from investors to reform their corporate governance. Like German law and in contrast to the Anglo-Saxon shareholder focus, the Report calls for company boards to pursue the interests of companies, not just its shareholders, workers, creditors, suppliers, government, and other stakeholders. Unfortunately, some observers found that few of the recommendations had been implemented among CAC 40 companies and this orientation toward "the company’s interest" too vague, or perhaps even, dangerous, as a justification for a "new type of company despotism." A government committee was formed to create a framework for new legislation and produced a report (The Marini Report) with a broader agenda than that of the Viénot Report. It set the stage for Law for New Economic Regulations (Loi Nouvelles Régulations Economiques, May 2001), which mandates among other things a distinction between supervisory and executive power in unitary board structures (Chairman and CEO), a limit on the number of boards on which directors can serve (five public companies), and increased power for employees and minority shareholders, especially with issues involving tender offers.

The European Union

For Europe, corporate governance is a particularly perplexing issue. Between 1992 and 1998, in ambitious privatization programs, European governments sold over USD 200 billion in previously state-owned assets such as Renault and Rhone-Poulenc in France and DeutscheTelecom in Germany. Despite this enormous public:private conversion, the European Union is pressuring member states towards even greater liberalization of industry. Many Europeans view capital market integration as a crucial source of financial scale economies necessary to propel privatization and private industrial development to a new plateau. The prospect of attracting large amounts of equity investment, especially from institutional investors tapping sophisticated continental equity markets, was a compelling argument for the launch of the Euro. Tempering this enthusiasm, the recent collapse of the NASDAQ-like Neuer Markt points to European problems in creating the financial milieu for innovative, risky projects. This suggests that Europe is wobbly in its early steps of institutional transition from an insider:bank-based system to an outsider:markets-based one. With this in mind, European regulators recognize that companies relying on capital markets require more complete accounting information and greater public disclosure than those dependent on banks.

In contrast to America, Europe seems willing to forgo the advantages of national competition in corporate governance systems. In the US power is shifting to individual states so as shore up deficiencies in the American system by competition within the federal system. Nevertheless, most recognize that key aspects of America’s efforts to great a uniform economic system were created before economic structures were imbedded or in periods of severe crisis. To uproot the role played by banks in German corporate governance, as was done in the United States in the early 1930s, seventy years later without the debilitating crisis of the Depression, is not only unrealistic, it is almost unthinkable.

Moreover, as many economists have recognized since the 1950s, international competition not only for capital, but for labor, goods and services, is in itself, a check on management excesses and a means of insuring good corporate governance. With the degree of choices that investors, workers and other stakeholders have, especially if the European Union functions as intended, managers will have increasing difficulty hiding behind national borders to protect themselves against imprudent investment and poor cooperation with key stakeholders. As a consequence, most of European efforts to harmonize corporate governance standards deal with accounting information.

The evolution of modern Europe involves not only the establishment of the internal market — the free movement goods, capital and labour - but also the unification of competition policy, fiscal rules and corporate laws. The latter includes the harmonization of accounting standards for which the EU has taken several steps en route to a unified set of standards. The Fourth and Seventh Directives, which deal exclusively with accounting issues and standards, must be incorporated into the national law of member countries. The EU has a established an Accounting Advisory Forum, composed of preparers and users of financial information, to consult the European Commission on how best to harmonize European accounting principles with those of other standard setting bodies, especially the International Accounting Standards Committee, to which the European Union belongs. Adopted in 1978 but implemented in 1991, the EU Fourth Directive contains comprehensive accounting rules covering the contents of financial statements, methods of presentation, valuation methods, and disclosure information. The Directive is meant to contain minimum standards and implementation differs among member countries. The Seventh Directive, adopted in 1983, addresses consolidated financial statements, but offers member states many choices in how to incorporate its provisions into company law.

Despite the unifying efforts of the European Union, most member-states retain their particular capital market, accounting and disclosure conventions. Brussels has little direct authority over stock exchanges, for example. In a domain in which Brussels does have authority, however, the failed efforts to gain acceptance of a common takeover policy is indicative of troublesome inertia at the level of the member-states.

In comparison with the Anglo-Saxon world, continental Europe maintains institutional resistance to rapid and radical change in corporate structure. The institutional barriers include concentrated shareholdings that allow a few shareholders to hold the balance of voting power and legal obstacles to removing boards as well as the vested power of boards to ward off takeover bids.

In 2001, after twelve years of negotiation, the European Parliament rejected the proposed European Takeover Directive. Though aimed at setting minimum country standards not harmonization, and though vague about the timing and methods of implementation, the proposed directive ran into stiff opposition, especially from German legislators who feared that company boards would no longer be able to stymie unwanted takeover attempts. The legislation modestly called for equal treatment of shareholders, sufficient time for boards to distribute information to shareholders about a bid, and that shareholders be allowed to decide on the merits of bids. Sufficient consensus seems unlikely to emerge to address the concerns of shareholders who see exit through acquisition as a viable control and payout mechanism.

European domestic institutional investors have taken a leading role in shareholder activism and in corporate governance reform. Some institutional investors have voiced doubts about the adequacy of individual company’s corporate governance, including the likes of Royal Philips Electronics, Vivendi and DaimlerChrysler. The chairman of AXA, a major European institutional investor, recently called for compulsory shareholder voting. Most shareholder activism has been aimed at developing and enforcing codes of conduct for boards and CEOs while defining their liabilities. These efforts have led to increased independence and competence of boards and CEOs as well as several shareholder suits, notably those against the management of Deutsche Telekom and Telecom Italia.

IV Ownership Structures and Social Values

Corporate governance structures reflect complex interaction between social and economic interests, a point argued effectively by Mark Roe in 2000. Using a theoretical argument that differs from his landmark history of American corporate governance development, Strong Managers, Weak Shareholders, Roe contends that social democracies tend to have concentrated ownership with insider corporate control. Strong social democratic traditions allow industry insiders to exercise powerful counter pressure to shareholders’ push for greater returns. The insiders’ power often results in lost value to shareholders and other stakeholders including workers. Old shareholders, mostly founding families, find that they have diminished market for sale of their shares. The status quo becomes their only option, essentially captive capital. Roe’s first book, while stressing the political compromises that gave birth to America corporate governance, also discusses American attitudes to powerful economic interests.

The German two-board system — Aufsichtsrat (Supervisory Board) and Vorstand (Management Board), which is the standard in Austria and Scandanavia as well as Germany — had its historic roots not in the protection of shareholders, but society at large. The creation of the two-board system was a function of the 1870 compromise (Aufsichtsratfrage) in which the German states gave up their direct overseeing and chartering responsibility for the promise that independent "watchdogs" would insure that society’s interests were upheld. As the direct successor of the state oversight, supervisory boards naturally created by legislators to protect society’s interest in, or perhaps better put against, the company, not merely those of shareholders. As one author put it, "The ‘modern’ observation that the supervisory board does not live up to its control function and, indeed, that it does not act only many be not even primarily in the interest of dispersed shareholders is, historically speaking, a truism."

Moreover, the eventual role played by banks in Aufsichträter was condoned as a means of avoiding the twin anathemas of capitalism in the German view: speculation and impersonal exchange. As entrepreneurs who had forged wealth creation were replaced by speculators with no concern for anything but making of money, banks stepped into a vacuum in the German capitalist system. Their influence increased as capital market and tax legislation gave them special advantages with small investors and with companies with large investments in fixed assets. Nevertheless, as far back as the 19th century concerns arose about the conflicts of interest posed by the house bank’s role on supervisory boards. Personal relationships, favored by Germans for the supervision of companies, were subject to potential abuses of personal networks, viz., Germany’s cartel system of cartels, bank ownership inter-locking directorships with all its advantages and disadvantages. Banks still play a much greater role on German boards than in the United States.

Although co-determination (Mitbestimmung) did not come into existence in its present form until after World War II, its implementation has had a long history in Germany that reflects fundamental values about capitalism. In German political-economic literature the social concept of a firm’s responsibility for its workforce and labour co-determination in industrial activity dates back to 1835. As early as 1891, German law encouraged the establishment of workers councils. Formal boardroom representation arose in the aftermath of both World Wars as labor cooperation and consensus became crucial to Germany’s recovery. During the Weimar Republic, companies were required to have two worker representatives on company Aufsichträter, a measure initially suppressed by the Nazis and later re-instituted in a more threatening fashion as part of the government’s control of labor activities and pressure on management to enforce party policies. The Nazi-drafted Stock Corporation Act of 1937 included a provision making management responsible for workers’ welfare and societal advancement whereas the 1965 version omitted such clauses following legislative debate that concluded that they were "self-evident" in the mission of a firm.

By 1976, half the Aufsichtsrat of German companies with more than 2,000 employees were elected by employees, two-thirds by employee representatives, one-third by unions. The Chairman of the Aufsichtsrat is elected by the shareholders and has one vote in case of a tie in Supervisory Board decisions. Although all representatives are required to act in the interest of the company as a whole, this is very vague and the deputy Chairman is elected by workers, giving that labor maintains a substantial role in board decisions. In 1996, 740 German companies had boards with 50 percent worker representation. Although labor representation may weaken the control function of the supervisory board by forcing a disproportionate amount of attention to the issues of interest to labor, the reforms currently discussed in Germany doo not contemplate any revision to Mitbestimmung. Even among shareholders, the view is that Germany’s consensus management has economic and social justification.

German values and experience with corporate governance contrasts greatly with America’s. While accident and political compromise are responsible fro many features of American corporate governance, ideology and economics played important roles in the process. In the 1920s and 30s, America turned away from the insider model as US dependence on foreign capital declined and as smaller shareholders, afraid of the control exercised by big-moneyed interests, entered capital markets. John D. Rockefeller, Sr. and J. P. Morgan, quintessential insiders, maintained close relationship with their firms and were committed to the public good a la German capitalism. American history has not treated them kindly. They were the most hated men of their day, maligned as overseers of a network that reduced the economic opportunity that gives everyman his chance.

Proposals emanating out of recent scandals do not call for changing insurance, pension, and banking law in the United States so as to allow greater concentration of ownership which is essential to the insider model. Indeed, the proposal to limit 400k contributions to one’s own company stock investment would reduce worker shareholding in their companies. Indeed the risk to workers of becoming too tied to their own companies’ financial fortunes — for better or worse - leads to worker representation on boards and a means of improving corporate governance.

To this day, U.S. rules prevail against using insider information and they enforce the board’s responsibility to shareholders. The rules impose fiduciary responsibility, assume sound business judgment and demand accounting disclosure to indicate performance, risk and consequences of managerial action. The famous Ford Motor case illustrates much about American views of corporate control and established the legal predominance of the interests of shareholders. Henry Ford, certainly no great liberal, wanted to hold back dividends from "his" company to do more for his workers. Small shareholders took him to court and forced him to disgorge larger dividends.

U.S. corporate law takes as its starting point that investors, managers, and board members are rational, moral persons who need no institutional oversight on what they can do. Clear, objective information is the public good that demands public support. One sees this in the evolution of the business judgment rule. While the interest of the shareholder is the aim of the firm, directors of boards are not held accountable for their mistakes. Only bad faith or irrationality make directors or financial analysts culpable and subject to legal damages. Contrast this to the German system in which shareholders, financiers and workers sit together on boards that watch what managers do.

V Ethics, Corporate Control and the Future

The events and circumstances of the past two decades illustrate that neither of the systems that we have outlined for corporate governance is without flaws. The failures of the "systems" point to an issue seldom addressed in the corporate governance debate, namely that the functioning of any system requires responsible, well-informed individuals who understand the strengths, limits and objectives of the system. As Mark Roe has argued recently, there are practical limits to legal approaches to effective corporate control. Corporate law can never be so comprehensive as to eliminate the risk of costly management mistakes or misalignments with the interests of shareholders.

Our guidance to the future of corporate governance begins with this proposition. There is no call for radical change in national corporate law, ownership structures or social objectives. Without pursuing convergence by design, we can draw on the strengths of both systems — insider and outsider - while adding constructive new elements. With this in mind, the following interrelated points frame public policy and corporate strategy:

First is the need to view corporate governance in broad terms, both conceptually and organizationally. Effective corporate governance does not simply constrain managers from stealing from shareholders of to prevent myriad other wealth transfers. Effective, socially optimal corporate governance promotes innovation and economic growth. It is part of a dynamic process in which companies define and re-define their missions to meet new competitive challenges. It encourages them to be flexible, strategic, Schumpeterian and to counter corporate sclerosis, all of which harks back to Coase’s view of why firms exist.

Second, certain aspects of the corporate governance must be raised from the national arena and placed it in an international setting. While corporate governance has profound political implications within nations, in an international setting industrial conduct is a facet of trade, cross-border investment and globalization generally. Clashes in corporate governance can be a destructive as trade disputes.

Failure to establish international standards of corporate governance will inhibit capital movements. The risk is greater for emerging markets whose fragile political circumstances make agreement and enforcement of corporate governance standards difficult. International norms dealing with accounting standards, insider trading, board functions and responsibilities and the legal responsibilities of auditors are reasonable targets for consensus. Basic standards of corporate conduct and governance need not touch deep-seeded national social values or economic structures. Nations could in a sense compete with one another for investors based on the international norms and how well their own individual institutions implemented the internationally accepted norms. Germany might use its bank-dominated structure and worker-consensus model for producing strong social and economic values to woe investors.

Lastly, society at large and corporations in particular must place greater emphasis on an ethos of corporate conduct and governance that promotes social and economic values. Politicians and theorists often live with the delusion that one can achieve good corporate governance with a particular set of institutions. One of the clear messages of the past decade is that no institutional framework can protect companies and societies from those who maliciously or ignorantly misapply the rules of the system. Recent failures emanated out a collective failure of auditors to apply the standards of their profession, managers to ignore their fiduciary responsibilities, investment analysts to serve their clients, board members to commit themselves in a desultory fashion, and investors critically examine their own expectations. Recent settlements in New York between the Attorney General and brokerage firms recognize the problem of investor education, but the problem goes deeper. Many graduates of even highly-ranked business school approach investing and managing without an historical perspective, which might help modify expectations. As both managers and investors, they lack the tools to help them distinguish what is reasonable in economic returns and what is not. Along these lines, few business organizations outline the objectives of the firm and how each individual can play a role in achieving them. To be sure, the effects of this lack of ethos may be more apparent in outsider systems, but no amount of control of what investors can do and substitution of small elites for defused market control can eliminate the problem. Indeed, it just shifts it to those who design the controls or to the education of the elite with another set of political and social issues. As business school teachers we have a special responsibility in creating this culture, this ethic framework for approaching business, without which all systems of corporate governance are doomed to failure.

While this comment is addressed at some of the excesses of the recent stock market bubble, it is no panacea for human craziness and a willingness to believe on faith. Our suggestion is based on an insight that like auditors have long understood in a somewhat different domain, namely that a corporation with a culture of control presents fewer risks for auditors. If control is taken seriously by those running and those working in a company, the likelihood that rules will be enforced is greater than in companies where they are not. Our suggestion is that companies develop a culture or ethos of corporate governance. This would entail a clear mission for the firm (the aim of governance), clear principles of how that mission will be implemented and better knowledge at all levels of organizations how people fit into that corporate governance mission. The implementation steps would entail training for board members, senior and junior managers in their responsibility to shareholders and other stakeholders, regular audits of the organizational awareness and commitment, and a system of rewards based on contributions to corporate governance.

Those who studied internal control have known for many years that there is no substitute for reliance on what might be called a "culture of control." As it is impossible or at least economically undesirable to verify all transactions, especially in large companies, one of the first steps in any audit was an evaluation of a company’s system of internal control. For decades, the authors of audit manuals strongly implored their colleagues to begin with an evaluation of how well internal control was embedded in company organizations, how seriously it was taken by senior managers. Public accountants were encouraged to evaluate circumstantial information, like the qualifications and training of internal auditors, their independence and procedures, access to important transactions and to senior management, and their future career paths within the organization as well as certain attitudinal, subjective criteria such as the degree of evidence of complacency about or conversely commitment to good control throughout the company. By analogy, this auditing approach might be extended to the broader concept of good corporate governance. Investors, national regulators, business school teachers, and corporate executives have neglected the importance of corporate culture and its evaluation as an aspect of good corporate governance.

To try to put more "ethics" in business misses the point about ethics as well as business. Ethical behavior is done not out of self-interest but rather as commitment to higher level social objectives. A modest notion of ethics would suit the purpose — a code of conduct designed to reduce transaction costs by creating a climate of trust among the corporation’s key stakeholders for dealing with the problem of incomplete contracts. Unlike most professions, businessmen unfortunately have no professional body that defines the norms to which they should adhere. Professional norms are also no panacea —witness some of the problems of the medical, legal, and accounting professions — they create a transparent guide for behavior, which can be used to train managers and for investors to evaluate.

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