Corporate Governance and Enforcement

1
Corporate Governance and Enforcement

• By
• Stijn Claessens
• World Bank and University of Amsterdam
• International Conference on
• Corporate Governance in China and Asia
• Shanghai, China, March 11-13

2
Overview of presentation

• What is the enforcement problem?
• What are alternative enforcement mechanisms? What
  mechanisms work?
• What is the enforcement problem in corporate
  governance? What follows?
• What are corporate governance mechanisms that can
  work in weak contracting environments?
• What are the policy and new research issues?

3
Enforcement and development

• Problem of enforcing agreements is a
  long-standing part of development agenda. North
  (1991) how effectively agreements are enforced
  is the single most important determinant of
  economic performance
• Enforcement particularly affects firms external
  financing
• Recent research enforcement more important than
  laws
• Laws effectiveness versus law, transition
  economies
• Insider trading rules adoption versus
  prosecution
• LLSV simple correlations suggestive

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Income, Antidirector Rights and Rule of Law
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What enforcement mechanisms? Continuum of
alternative tools

• Private ordering
• Exception rather than norm
• Unilateral, bilateral and multilateral, with
  multilateral mechanisms especially often used in
  finance
• Private law enforcement
• Litigation most important tool
• Public law/regulation enforcement
• Traditional view of enforcement
• State-ownership/control
• Has many problems, but may be considered

6
Private ordering

• Unilateral mechanisms
• Create valuable assets, most common reputation,
  involving sunk costs, e.g., advertising, or
  investments
• Needs repeated dealings for it to work
• Bilateral mechanisms
• Use reputation, others enforcement, e.g.,
  auditors
• Self-enforcing agreements, e.g., split of
  functions, delegating of actions joint
  investments, such as in JVs, vertical
  integration hostages with firm-specific assets
• Shareholder agreements can be more specific
  have covenants of hostage nature and rely on
  other courts

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Private ordering

• Multilateral mechanisms
• Financial intermediaries, e.g., banks, investment
  banks, rating agencies, clearing houses
• Self-regulatory associations, e.g., industry
  organizations, codes of conduct/punishments
  (expel), minority shareholders associations
• Self-regulatory organizations, e.g., stock
  exchanges, with listing standards and penalties
• Arbitration, e.g., as in JVs, possibly backed up
  internationally, e.g., through NY convention

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Private ordering evidence

• Unilateral and bilateral mechanisms
• Can work, e.g., voluntary adoption of CG, FDI
• Up to a limit, however, as effectiveness depends
  on the overall institutional environment
• Multilateral mechanisms
• Can depend on size/number of market, scope for
  entrenchment, degree of competition, multiple
  equilibriums. Many practical issues, e.g.,
  arbitration when to arbitrate and whom to use
  which law?
• Private ordering can be the basis for public law
• Most need some form of public enforcement

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Private laws enforcement

• Either the government creates the rules, but
  delegates the enforcement to others
• Delegation of public enforcement to SRO/SRAs
  (e.g., stock exchanges) can be more efficient if
  more information, better tools/incentives
• Or initiation of enforcement lies with private
  parties, with litigation the most important
• The norm in securities markets (LSV, 2005)
• Depends on standards set in the law, e.g., bright
  lines
• Depends on legal system and institutional setup,
  e.g., class action suits, role of stock exchanges
  depends on competition, etc. especially with many
  constituencies

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Public law/regulation enforcement

• SEC, other regulator type of approach, with
  courts
• Seems less effective than private enforcement in
  securities markets, especially when institutional
  environment is weak
• Public law enforcement depends on
• Extensiveness and effectiveness of law some laws
  are easier enforced than others, affects scope
  for enforcement and scope for misuse (bright
  line)
• Independence (financially, politically, tenure)
  of the regulators and the checks and balances in
  the system
• Efficiency of the court system, since backup is
  needed

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Extensiveness of laws and origins

• What needs to be codified in the first place?
• How does codification vary with level of
  development, social and economic features? How
  does codification interacts with various
  enforcement mechanisms?
• Extensiveness of law affects enforcement problem
• With imprecise laws, private ordering and private
  enforcement may be costly or uncertain, and the
  benefits for parties to deviate may be too big
• But, broader laws allow for more evolution
• Transplanting of laws/systems leads to less
  effective formal institutions, higher legality
  with voluntary adoption

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State control

• State ownership
• Can be justified to deal with market failures,
  externalities, public goods, coordination issues,
  etc
• Golden share
• A more targeted approach to certain concerns
• Regulations covering various areas have also
  corporate governance functions, especially with
  other stakeholders
• Full control, through ownership or centrally
  planned economy/lack of market economy

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Choice of enforcement technologies

• Overall environment
• Social and other norms, civic capital, general
  political
• Costs and benefits of each technology/issues
• Outside options vary Multistage issues, need
  several technologies Public to back up
• Path dependence, certain technology can stick
• Technological progress can change choices
• Mix of technologies will always be used
• Vary by country, issue to be enforced
• Rules and political economy
• Tollbooth view rules can create rent-seeking

14
Corporate governance and enforcement

• CG and enforcement intimately linked
• Firms nexus of contracts require enforcement
• Corporate governance is about firms ability to
  commit towards their stakeholders, in particular
  towards external investors (shareholders and
  creditors)
• The enforcement environment can help with
  commitment problem, i.e., lower cost, overcome
  time-inconsistency
• But corporate governance is also about balancing
  multiple stakeholders interests, so perfect
  enforcement of every contract is not necessarily
  always first best

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Corporate governance mechanisms

• Facilitate collective action of dispersed
  investors
• Concentrated shareholdings
• Hostile takeovers
• Proxy fights
• Board activity
• Executive compensation schemes
• Litigation through courts
• Bank monitoring
• Public opinion and media
• Other stakeholders
• Vary in their need for enforcement and use of
  enforcement tools, e.g, exit, collateral,
  bankruptcy, etc.

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With weak enforcement

• In many developing and transition countries,
  general enforcement environment is weak and few
  traditional corporate governance mechanisms are
  effective
• Predominant form of corporate governance is then
  large blockholders and high ownership/control
  concentration
• But this mechanism has important costs
• Main corporate governance conflict for public
  firms controlling owners vs. minority
  shareholders
• But also corporate governance weaknesses impact
  SMEs ability to raise financing and to grow
• Overall adverse impact on corporate governance
  environment, institutional development

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Large blockholders dominate, with costs though
and limited scope for policy
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What is scope for other corporate governance
mechanisms?

• Most mechanisms need some enforcement technology
  and tools, e.g, exit, collateral, bankruptcy,
  etc. Will not work well. Ownership concentration
  the outcome, yet has costs.
• What to do in weak contracting environment? What
  to expect from private ordering, private law
  enforcement, public enforcement? What is their
  relative importance in developing/transition
  countries, for which mechanisms?
• What policy interventions can help reduce costs
  and reinforce specific mechanisms?

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Scope for policy interventions for other
corporate governance mechanisms
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Scope for policy interventions for other
corporate governance mechanisms
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Have to consider the political economy of
enforcement

• Laws and enforcement evolve in response to
  economic and other pressures
• Can be vested clear interests blocking progress
• Wealth concentration hinders reform
• Capacity building is a difficult investment
• Long-term payoffs, many bodies, subject to many
  parties, low political payoff
• Enforcement is a public good, with few champions
• Can be indirect effects of financial sector
  development, changes in ownership structures,
  real sector reform on desires for enforcement and
  institutional reform

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Possible research topics on enforcement

• Balance between private enforcement of public
  standards and public enforcement in corporate
  governance
• Tradeoffs between the extensiveness of the law
  and its effectiveness in different contexts
• Effectiveness of self-regulatory agencies and
  organizations in encouraging better standards and
  greater enforcement
• Role of competition in improving the environment
  for enforcement
• Both case studies and cross-country research can
  help clarify what is best suited to needs of
  different countries