15
quoted. Private equity, venture capital and other forms of “patient” capital have adapted to this type of
ownership and control arrangements. The willingness to accept “close” control arrangements has not been
limited to private, closely-held corporations. Exchanges that specialise in newer and more innovative
firms, notably NASDAQ, are often accommodating to closely controlled companies, mainly by
recognising multiple voting structures and different classes of common stock.
Management
The corporate governance discussion started along the lines of the Berle and Means paradigm of large
corporations with their share ownership dispersed among millions of small shareholders, and effectively
run by their management. Management is seen to wield enormous power because of the high monitoring
costs and pervasive free rider problems encountered by the shareholders/principals. Effective control by
managers allows them to pursue their own opportunistic goals instead of maximising the present value of
the firm to its shareholders.
When management succeeds in de-linking its welfare from the interests of the shareholders, the only real
means of enforcing accountability to shareholders is through the take-over mechanism. But transparency,
technology and institutional ownership are rapidly changing the assumption about exit being the only way
for shareholders to deal with a badly-managed, broadly-held corporation (see next section). As for
transparency, increasing disclosure on how firms generate and use their cash flow as well as various forms
of non-financial disclosure have rendered managerial intentions and strategy more accessible to
shareholder scrutiny. Direct disclosure of executive compensation and a widespread effort to align
managerial pay schemes with shareholder interests have also contributed to higher constraints on
managerial opportunism. Exchanges in the UK and Australia have put forth self-regulatory codes of
conduct on executive compensation. Most of these codes provide for a compensation committee headed
by independent (i.e. non-insider) board members and accountable directly to shareholders.
Transparency would be both expensive and meaningless without adequate technology. The amount of
disclosure that a firm can easily provide today by using sophisticated computer systems would have been
prohibitively expensive but to the largest of firms only a decade ago. On the other hand, the information
currently generated by publicly-quoted firms would be largely meaningless if the corresponding software
models for processing it were not available. The possibility to understand managerial behaviour through
the available information and to offer to shareholders the possibility to vote or otherwise sanction
management relatively cheaply is a key driver of the current trend to exercise shareholder “voice” rather
than “exit".
Again, convergence is not only happening at one end of the spectrum. “Insider” countries used to
experience low levels of managerial opportunism, due to concentrated ownership patterns. However,
managers would be more attuned to blockholder interests rather than those of the shareholders as a whole.
But recent trends in many European economies and in Japan to enhance performance-based pay might be
about to change all that. Managers are increasingly becoming residual claimants. Consequently, their
interests are more and more aligned to those of shareholders in seeking to maximise the present value of
the firm.
Financial institutions
Market developments are obliging many financial institutions to adapt their governance-related strategies.
With deregulation and growing international competition, the financial services industry confronts the
prospect of consolidation and a requirement to generate profits. In pursuit of this goal, financial institutions
16
are trying to find their optimal size and product mix. In this process of refocusing, corporate governance
activities are seen more and more as distracting banks from their primary mission of financial
intermediation and credit selection while creating conflicts of interest. Banks increasingly find that they
have been expending considerable energies in exercising governance rights over companies. In
recognition of this new reality, the two largest German banks have separated their long-term equity
holdings into separate companies; this is possibly a first step to divestiture. Similarly, in Japan the
traditional ties of banks to industrial companies are loosening, as companies go directly to the international
capital market for financing while the main banks have been seeking to disentangle themselves from non-
financial affiliates in the recent banking restructuring.
21
In many European bank privatisations, the share
issue has been accompanied or preceded by the sale of bank equity positions and a tightening of bank
balance sheets.
Perhaps the most radical change of all can be found among the institutional investors. In those countries
where institutional investors have not been significant, there is a considerable growth, especially in the
mutual fund industry. With pension reform, a considerable growth in pension funds is also likely to occur,
especially in countries that have up to now relied on pay-as-you-go, state pension systems.
22
In countries
where institutional investors are already important, they tried to pursue “arms-length” relationships with
companies in which they invested and, to defend their interests by selling shares when performance failed
to live up to expectations. They could be characterised as “buy and sell” investors or active portfolio
managers. A significant part of the institutional investor community, especially the pension funds, now
finds this strategy unrealistic. This is because most of the pension fund assets are in portfolios that track
indexes, thus limiting the possibilities of exit as regards individual firm shares.
In order to address limited exit possibilities, funds have found it useful to engage in “relationship
investing.”
23
In the US, the private pension funds have also faced the legal obligation to vote their shares
and to make efforts to cast informed votes, thus requiring a certain amount of investor activism. Many
public pension funds embarked on investor activism by targeting under-performing companies and seeking
to induce the management of these companies to change their behaviour. In the UK, the legal requirements
to become active have been less, but the concentration in the funds management industry has been even
greater, meaning that exit is now a less realistic strategy than in the past. Additionally, the insurance
industry in the UK has adopted an activist position.
A significant share of the institutional investor community has in effect altered its traditional “outsider”
approach to investment. In a stylised manner, one could say that in the past fragmented investors each
studied carefully the reports issued by companies and occasionally voted at annual general meetings while
contact with management was to be scrupulously avoided since it carried the risk of conferring insider
status, the main defence being to sell the shares of under-performing companies. Today, by contrast,
investors have a far wider range of weapons in their arsenal. They have formed associations to share
information, communicate with management and occasionally urge management to change its behaviour
radically. An entire industry has emerged to support the activist investor community, by producing and
sharing company information and by forming groups to advocate changes in law and regulation, to define
and to advocate better corporate governance practices and to highlight needed changes in practice on the
part of corporations.
24
21
See Yasui (2000).
22
See OECD (1998b).
23
For a description of what a large institution wants to see in a company in which it invests and the kind of
relationship it wants to develop with it over time, see Clapman (1998), who describes the corporate governance
policy of the largest US pension fund, TIAA-CREF.
24
See Latham (1998) and Gilson-Kraakman (1993).