Jeffrey N. Gordon

Convergence and persistence in corporate governance

List of contributors Acknowledgments Introduction Jeffrey N. Gordon and Mark J. Roe Part I. System Issues: 1. The end of history for corporate law Henry Hansmann and Reinier Kraakman 2. A theory of path dependence in corporate ownership and governance Lucian A. Bebchuk and Mark J. Roe 3. Path dependence, corporate governance and complementarity Reinhard H. Schmidt and Gerald Spindler 4. Convergence of form or function Ronald Gilson Part II. Government Players: 5. The international relations wedge in corporate convergence Jeffrey N. Gordon 6. Property rights in firms Curtis Milhaupt 7. Modern politics and ownership separation Mark J. Roe Part III. Specific Institutions: 8. Norms and corporate convergence David Charny 9. Ungoverned production Charles Sabel 10. Substantive law and its enforcement Gerard Hertig 11. Cross-holding in the Japanese keiretsu J. Mark Ramseyer Index.

The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights

Equity ownership in the United States no longer reflects the dispersed share ownership of the canonical Berle-Means firm. Instead, we observe the reconcentration of ownership in the hands of institutional investment intermediaries, which gives rise to what we call “the agency costs of agency capitalism.” This ownership change has occurred because of (i) political decisions to privatize the provision of retirement savings and to require funding of such provision and (ii) capital market developments that favor investment intermediaries offering low cost diversified investment vehicles. A new set of agency costs arise because in addition to divergence between the interests of record owners and the firm’s managers, there is divergence between the interests of record owners – the institutional investors – and the beneficial owners of those institutional stakes. The business model of key investment intermediaries like mutual funds, which focus on increasing assets under management through superior relative performance, undermines their incentive and competence to engage in active monitoring of portfolio company performance. Such investors will be “rationally reticent” – willing to respond to governance proposals but not to propose them. We posit that shareholder activists should be seen as playing a specialized capital market role of setting up intervention proposals for resolution by institutional investors. The effect is to potentiate institutional investor voice, to increase the value of the vote, and thereby to reduce the agency costs we have identified. We therefore argue against recent proposed regulatory changes that would undercut shareholder activists’ economic incentives by making it harder to assemble a meaningful toe-hold position in a potential target.

Executive Compensation and Corporate Governance in Financial Firms: The Case for Convertible Equity-Based Pay

Unlike the failure of a non-financial firm, the failure of a systemically important financial firm will reduce the value of a diversified shareholder portfolio because of an increased level of systemic risk. Thus diversified shareholders of a financial firm generally internalize systemic risk whereas managerial shareholders and blockholders do not. This means that the governance model drawn from non-financial firms will not fit financial firms. Regulation that limits risk taking by financial firms can thus provide a benefit, rather than necessarily impose a cost, for the typical diversified public shareholder. Managerial shareholding also gives rise to particular problem of the CEO who, despite the increasing precariousness of the firm’s position, may be reluctant to pursue equity infusions or to sell the firm because of the consequent dilution of his ownership stake. This might be called the “Fuld problem.” To mitigate excessive risk-taking both in ordinary operations and as the firm approaches financial distress, the paper proposes a new compensation mechanism for senior managers, convertible equity-based pay. Upon certain external triggers, such as a downgrade into a high risk category by regulators or a stock price decline of a particular percentage, such stock-based compensation should convert into subordinated debt, at a valuation discount. This will give managers an incentive to curb excessive risk-taking and in particular to steer the firm away from financial distress.

Money Market Funds Run Risk: Will Floating Net Asset Value Fix the Problem?

The instability of money market mutual funds, a relatively new form of financial intermediary that connects short term debt issuers with funders that want daily liquidity, became manifest in the financial crisis of 2007-2009. The bankruptcy of Lehman Brothers, a major issuer of money market debt, led one large fund to “break the buck” (that is, violate the

Pathways to Corporate Convergence? Two Steps on the Road to Shareholder Capitalism in Germany: Deutsche Telekom and Daimler Chrysler

1 net asset valuation convention) and triggered a run on other funds that was staunched only by major interventions from the US Treasury and the Federal Reserve. One common reform proposal has been to substitute “floating NAV” for “fixed NAV,” on the view that MMF run risk was strongly affected by the potential to arbitrage between the “true” value of MMF assets and the

The Empty Call for Benefit-Cost Analysis in Financial Regulation

1 fixed NAV. It turns out that European MMFs are issued in two forms, “stable NAV” and “accumulating NAV,” which offer a reasonable proxy for the distinction between fixed and floating NAV. Thus the comparative run rate of these two MMF types during “Lehman week” offers a natural experiment of the effect of NAV “fixedness.” We find that the stable/accumulating distinction explains none of the cross-sectional variation in the run rate among these funds. Instead, two other variables are explanatory: yield in the period immediately prior to Lehman week, which we take as a proxy for the fund’s portfolio risk, and whether the fund’s sponsor is an investment bank, which we take as proxy for sponsor capacity to support the fund. We then argue that these findings indicate that other stability-enhancing reforms are necessary.

Agency Capitalism: Further Implications of Equity Intermediation

Perhaps the key question in the corporate convergence debate is the extent to which parties will settle on a shareholder capitalism model, in which managerial accountability will be measured against a public shareholder wealth maximization criterion. The paper evaluates two particular events for the impact on German corporate governance: the privatization of Deutsche Telekom and the cross-border merger between Daimler Benz and Chrysler Corp. The Deutsche Telekom transaction had symbolic impact, because it made many Germans shareholders for the first time, but the terms of the transaction substantially protected these shareholders against risk and deprived them of governance rights. The Daimler Chrysler merger, on the other hand, is a major event in governance convergence because it should inject a substantial element of US-style shareholder activism into the governance of a major German corporation. The paper identifies several elements, including: the change in the shareholder body through a dilution of traditional German holders and the addition of U.S. institutional investors, the pioneering of a template for subsequent cross-border mergers involving German firms, the flexibility of German corporate law to shareholder initiatives, and the likely rippling impact of governance changes at Daimler Chrysler on other major German corporations.

The Micro, Macro and International Design of Financial Regulation

The call for benefit-cost analysis (BCA) in financial regulation misunderstands the origins and utility of BCA as a guide to administrative rule making. Benefit-cost analysis imagines an omniscient social planner who can calculate costs and benefits from a natural system that generates prices (costs and benefits) that do not change (or change much) no matter what the central planner does. For example, the toxicity of chemicals, the health hazards of emissions, the statistical value of life—these do not change in response to health-and-safety regulation. For the financial sector, however, the system that generates costs and benefits is constructed by financial regulation itself and the subsequent processes of adaptation and regulatory arbitrage. An important new rule will change the system beyond our calculative powers. Instead of weighing costs and benefits, financial regulation necessarily is based on a series of trade-offs of normatively derived values, which may entail principles of pragmatic design.

Convergence and Persistence in Corporate Governance: Frontmatter

This chapter continues our examination of the corporate law and governance implications of the fundamental shift in ownership structure of U.S. public corporations from the Berle-Means pattern of widely distributed shareholders to one of Agency Capitalism – the reconcentration of ownership in intermediary institutional investors as record holders for their beneficial owners. A Berle-Means ownership distribution provided the foundation for the agency cost orientation of modern corporate law and governance – the goal was to bridge the gap between the interests of managers and shareholders that dispersed shareholders could not do for themselves. The equity intermediation of the last 30 years gives us Agency Capitalism, characterized by sophisticated but reticent institutional shareholders who require market actors to invoke their sophistication. We examine here three implications of this shift in ownership distribution. The first addresses a proposal to turn back the clock in the regulation of ownership disclosure under the Williams Act to a time when shareholders were small and dispersed rather than large and concentrated as they are today. The next two share a common theme: that the allocation of responsibility between directors, shareholders and courts can no longer be premised on a paternalism grounded in an anachronistic belief concerning the distribution and sophistication of shareholders. We show that the Chancery Court has recognized that Agency Capitalism counsels different rules concerning the roles of shareholders and the court in policing freezeouts. And we argue that the Supreme Court will come to realize what the Chancery Court has recognized for some time – that the doctrine of substantive coercion as a basis for takeover defense must give way as Delaware corporate law adapts to the very different shareholder distribution the capital market has now given us.

Convergence and Persistence in Corporate Governance: Specific institutions

Regulation that is designed to enhance the stability of individual financial institutions, micro-prudential regulation, can create and exacerbate systemic instability. This is particularly true of detailed prescriptive rules about corporate governance which are prone to incorrect specification and the imposition of unwarranted homogeneity on the conduct of firms. They can create externalities where none previously existed. Harmonization of micro-prudential regulation across countries elevates this problem to a global level of financial instability and can be a source of, rather than, a cure for global financial crises. Regulation required to protect the financial system as a whole, macro-prudential regulation, is fundamentally different in nature from micro-prudential regulation. It seeks to identify, immunize, isolate and intervene in financial failures and, in contrast to micro-prudential regulation, it requires international harmonization across countries. The focus of harmonization to date has therefore been precisely the opposite of what is required to protect the financial system.In a systemic context, capital is of fundamental significance and the tax system should be employed to encourage banks to hold appropriate levels of capital. The capital provisions of individual institutions should be supplemented by reserves of central banks, the amounts being dependent on the systemically important banks under the central banks’ authority. Bail-ins of convertible debt should be triggered by systemic not individual institutional failures. Costs of intervention and moral hazard should be minimized by writing down debt and equity in failing institutions, and equity but not debt in second round institutions threatened by first round failures. Harmonization of macro-prudential regulation should be overseen by a global committee of central banks which ensures the correct designations of banks, adequate holdings of central bank reserves, and coordinated interventions organized around lead central banks.