9
Theoretically, the shareholders, through the use of their voting rights, have the power to select the
members of the board and to vote upon certain key issues facing the company. In practice, the
fragmentation of ownership has proven to be a serious impediment to the actual exercise of such control.
In the past, investors in outsider systems were not especially concerned with corporate governance
inasmuch as it was presumed that they could not and did not wish to exercise their governance rights. The
main means for investors to discipline management has been the buying and selling of company shares.
The capital market has provided the ultimate means for shareholders to discipline management. If the
company is poorly managed and/or if shareholder value is neglected, investors react by selling shares,
thereby depressing prices and exposing the company to hostile take-overs. Such a model presumes ample
disclosure of information, strict trading rules and liquid stock markets.
Much of the early thinking about corporate governance evolved in the context of the outsider model. It
was the separation between ownership and management that led analysts as long ago as the 1930s to
identify the potential agency problems when a dispersed group of shareholders were unable to monitor and
to control the behaviour of management.
7
Indeed, as recently as the late 1980s, many analysts had
concluded that the agency problems that characterised outsider systems might inevitably lead to poor
corporate performance.
8
Management was thought to have effectively shielded itself from accountability
while shareholders were thought to be focused on short-term results. Many analysts compared the market-
based system unfavourably with the insider systems in which corporate control was exercised by agents
having more permanent economic linkages to the company. In more recent years, the pendulum has swung
the other way, as companies in the US and the UK have managed to carry out sizeable restructuring and
show impressive gains in profitability. Thus, more recently observers have become much more positive
about the capacity of the capital markets to encourage efficient economic behaviour.
The insider model
In most other OECD countries and nearly all non-Members, ownership and control are relatively closely
held by identifiable and cohesive groups of "insiders" who have longer-term stable relationships with the
company.
9
Insider groups usually are relatively small, their members are known to each other and they
have some connection to the company other than their financial investment, such as banks or suppliers.
Groups of insiders typically include some combination of family interests, allied industrial concerns, banks
and holding companies. Frequently, the insiders can communicate among themselves with relative ease to
act in concert to monitor corporate management, which acts under their close control. Furthermore, the
legal and regulatory system is more tolerant of groups of insiders who act together to control management
while excluding minority investors. Hence, the agency problem, which characterises the outsider system,
is of much less importance.
Patterns of equity ownership differ significantly from "outsider" countries. One characteristic of countries
with insider systems is that they have generally experienced less institutionalisation of wealth than the
English-speaking countries. Until recently, no class of owners was found comparable to the pension funds,
mutual funds and insurance companies of the US and the UK who have emerged as the largest and most
active class of shareholders (see Table 2). Additionally, those institutions that do exist often face
regulatory limits on their ability to invest in equity.
10
7
See Berle and Means (1933), and Dodds (1932).
8
See Porter (1992).
9
La Porta et al (1998).
10
OECD (1997).
10
Insider systems have usually been bank-centred. Patterns of corporate finance often show a high
dependence upon banks and high debt/equity ratios. Instead of arm’s length lenders, banks tend to have
more complex and longer term relationships with corporate clients. Capital markets are in general less
developed than in outsider systems. In contrast to the market-based system, which insists upon public
disclosure of information, the insider system is more willing to accept selective exchanges of information
among insiders. This confidential sharing of information is typical of the way a bank interacts with
borrowers
11
. Reflecting the reliance on bank finance and the lack of sophisticated institutional investors,
the range of financial assets available to the public has been comparatively narrow and banks have
dominated financial intermediation. Regulatory policy often functions by prohibiting “speculative”
activity rather than by insisting on strong disclosure. The elaborate systems to regulate capital markets that
are found in market-based countries did not develop fully in bank-centred systems. For example, Germany
did not have a national securities markets regulator until very recently; securities market regulation was left
to the state (länder) governments or to the exchanges.
Insiders may control a company either by owning an outright majority of voting shares or by owning a
significant minority holding and using some combination of parallel devices to augment their control over
the company. Among the devices that are commonly used to redistribute control one can mention
corporate structures, shareholder agreements, discriminatory voting rights and procedures designed to
reduce the effective participation of minority investors. In general, the legal and regulatory system tends to
be relatively permissive of such mechanisms.
Some corporate structures, particularly “pyramid structures”, enable those with dominant positions in the
parent company to exercise control with only a small share of the total outstanding equity of the firm.
Other common ways of redistributing control are through issuance of multiple classes of shares with the
insider group having increased voting power. Capped voting is used to limit the number of votes that
investors may cast regardless of their equity ownership
12
.
In some governance systems, cross-shareholdings are used to create significant shareholder cores, which
are often used in combination with devices such as cross-guarantees and shareholder agreements to
diminish the influence of non-controlling investors on corporate policy. This potential may be increased if
the informal group has special linkages to other participants in the governance process (e.g. banks or
government) or to management.
Shareholder agreements are a common means for groups of shareholders, who individually hold relatively
small shares of the total equity, to act in concert so as to constitute an effective majority, or at least the
largest single block of shareholders. Shareholder agreements usually give those participating in the
agreements preferential rights to purchase shares if other parties in the agreement wish to sell and can also
contain provisions that require those accepting the agreement not to sell their shares for a specified time.
Shareholder agreements can cover issues such as how the board or the chairman will be selected and can
oblige those in the agreement to vote as a block.
13
In addition to outright redistribution of voting rights, some companies have voting procedures that place
practical obstacles in the way of shareholders who wish to vote. In the past, many companies had tended
to see the AGM as a formal exercise, which was tightly controlled by management. There may have been
some possibility for shareholders to be informed by management, but the capability of shareholders to
11
Reflecting the reliance of bank finance, Schmidt (1998) also notes that “accounting and disclosure in Germany is
not primarily aimed at...investors but...the protection of creditors...”.
12
Pinto and Visentini (1998) provide for a fairly thorough review of such arrangements in their country reviews.
13
See Fukao (1995).