Institutional Investors and Corporate Governance [Reprint 2010 ed.] 9783110893380, 9783110136432
The volume contains 23 articles by international experts, both scholars and practioners dealing with the development of
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English Pages 722 [724] Year 1993
List of Contributors
List of Abbreviations
Part One: Comparative and International Aspects
Chapter One: “Comparative Aspects of Institutional Investment and Corporate Governance”
Chapter Two: “Some Differences in Corporate Governance in Germany, Japan and America”
Chapter Three: “Corporate Governance by Institutional Investors? Some Problems from an International Perspective”
Part Two: United States
Chapter Four: “Public Pension Fund Activism in Corporate Governance Reconsidered”
Chapter Five: “Boards of Directors versus Institutional Investors”
Chapter Six: “CEO Performance, Board Types and Board Performance: A First Cut”
Chapter Seven: “Institutional Investors in the U.S. and the Repeal of Poison Pills: A Practitioner’s Perspective”
Chapter Eight: “Investment Companies as Guardian Shareholders: The Place of the MSIC in the Corporate Governance Debate”
Part Three: Europe
Chapter Nine: “Institutional Investors in the United Kingdom”
Chapter Ten: “Corporate Governance in Swedish Listed Companies”
Chapter Eleven: “Ownership of Equity and Corporate Governance - The Case of Sweden”
Chapter Twelve: “Institutional Investors and Corporate Governance in the Netherlands”
Chapter Thirteen: “Institutional Investors, Financial Groups and their Impact on Corporate Governance in Belgium”
Chapter Fourteen: “Les Investisseurs Institutionnels en Droit Français”
Chapter Fifteen: “Institutional Investors and Corporate Control in Spanish Perspective”
Chapter Sixteen: “Institutional Investors and Corporate Governance: The Austrian View”
Chapter Seventeen: “Institutional Investors in Switzerland”
Chapter Eighteen: “Duties of Banks in Voting Their Clients’ Stock”
Chapter Nineteen: “The Equity Market in Germany and its Dependency on the System of Old Age Provisions”
Chapter Twenty: “Institutional Investors and Corporate Governance: A German Perspective”
Part Four: Australia and Japan
Chapter Twenty-One: “Institutional Investors and Corporate Governance in Australia”
Chapter Twenty-Two: “Institutional Investors and Corporate Governance in Japanese Perspective”
Chapter Twenty-Three: “Institutional Investors and Corporate Governance in Japan”
Index
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Institutional Investors and Corporate Governance
Institutional Investors and Corporate Governance
Edited by
Theodor Baums, Richard M. Buxbaum, Klaus J. Hopt
W DE
G 1994 Walter de Gruyter · Berlin · New York
Printed on acid-free paper which falls within the guidelines of the ANSI to ensure permanence and durability.
Library of Congress Cataloging-in- Publication Data
Institutional investors and corporate governance / edited by Theodor Baums, Richard M. Buxbaum, Klaus J. Hopt. XXVIII, 696 p. 15,5 χ 23 cm. ISBN 3-11-013643-0 1. Corporate governance—Congresses. 2. Institutional investments —Congresses. 3. Directors of corporations—Congresses. 4. Corporations —Investor relations —Congresses. 5. Stockholders' voting —Congresses. 6. Comparative management—Congresses. 7. Corporation law—Congresses. 8. Comparative law—Congresses. I. Baums, Theodor. II. Buxbaum, Richard Μ. III. Hopt, Klaus J., 1940HD2741.I582 1993 658.4-dc20 93-21087 CIP
Die Deutsche Bibliothek — Cataloging-in-Publication Data
Institutional investors and corporate governance / ed. by Theodor Baums ... — Berlin ; New York : de Gruyter, 1993 ISBN 3-11-013643-0 NE: Baums, Theodor [Hrsg.]
© Copyright 1993 by Walter de Gruyter & Co., D-10785 Berlin All rights reserved, including those of translation into foreign languages. No part of this book may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopy, recording, or any information storage and retrieval system, without permission in writing from . the publisher. Printing: WB-Druck GmbH, Rieden Binding: Mikolai, Berlin Printed in Germany
Acknowledgments
The Conference on "Institutional Investors and Corporate Governance" at the Universität Osnabrück, Germany, from July 9-11, 1992 and this volume would not have been possible without the generous support of the following institutions and donors: Deutsche Forschungsgemeinschaft, Bonn-Bad Godesberg; Kommission der Europäischen Gemeinschaften, Brussels; Dr. Hans-Wolf Sievert, SIBO-Gruppe, Osnabrück; Kreissparkasse Osnabrück; Stadtsparkasse Osnabrück; Universitätsgesellschaft Osnabrück.
Preface
"Institutional Investors and Corporate Governance" has only recently emerged as a key topic of the corporate law reform agenda. This is somewhat astonishing since the legal and business communities have been acutely aware of both issues and have widely discussed them for a long time. The awareness of the corporate governance problem is usually traced back to Berle and Means who first analyzed the problem in terms of separation of ownership and control in 1932. In substance, however, the problem had already been grasped in the second half of the 19th century by visionary lawmakers and economists who discovered the merits of disclosure as a control mechanism as well as the advantages of utilizing a supervisory council in a two-tier board as a control organ. After the occurance of dreadful experiences in the 1930's certified public accountants were entrusted with independent professional control over stock corporations. Since then the number of corporate reform projects has proliferated. But despite all efforts a panacea was not found. Neither governmental control by state commissioners or regulatory agencies nor the labor codetermination movement, which was propelled forward most keenly in Germany by installing shareholder-labor parity on the supervisory boards of all major companies, lived up to the expectations. The corporate governance problem remains a perplexing fundamental problem of modern economy and society. The growth of the institutional investors has been dramatic in most industrialized countries. In the United States at the end of 1986, institutional investors held just under 50 per cent of the equities' value of the top 50 US corporations (almost 20 per cent of all US financial assets!), and it has been estimated that in the year 2000 approximately two thirds of the shares of all American corporations will be held by institutional shareholders. The same development has been witnessed in Great Britain where in 1990 financial institutions owned 61.3 per cent of the ordinary shares of listed UK companies. Even in countries in which the percentage of institutional shareholdings has not yet reached such proportions, it is still steadily increasing. This has not passed unnoticed, but has usually been regarded as a mere institutional and stock market phenomenon with little relevance to corporate law. Indeed institutional investors seem to refrain
from exercising their influence within the corporations. If they do not like a management and its performance, they simply sell out. Only in the past several years has the interrelationship between these two phenomena surfaced as a focal point of interest; with recognition first occuring in the USA and Great Britain. The initial survey on the American and international discussion was presented in Germany by Buxbaum in his article on "Institutional Ownership and the Restructuring of Corporations" in the Festschrift für Steindorff, Berlin 1990. Germany as well as some other countries in Europe have their own unique experiences with powerful banking institutions in an all purpose banking system (Universalbankensystem). These institutions possess a wide board room representation, block participations, depository votes and credit business. This manifold influence on the corporations and the resulting conflicts of interest have led to concern and proposals for reform. Additionally, the courts have begun to develop through case law a specific professional responsibility for banking institutions. The analysis of this interrelationship problem is still at a very elementary stage. At this juncture, even the notion of what constitutes an institutional investor is far from clear. For example, in Continental Europe, in countries such as Germany, institutional investors are for the most part banking institutions and insurance companies, and too a much lesser degree investment funds. Endowments and industrial foundations like the Carl-Zeiss-Stiftung exist, but are usually limited to holding shares in just one enterprise. This is distinguishable from the USA and other Anglo-American countries, where huge pension funds have emerged as the leading category of institutional investors, far outdistancing all other categories. Yet another variation is presented in Japan, where the monitoring of corporations is carried out via a kind of social web, whereby many fellow corporations form strategic alliances and hold interlocking shareholdings, even though small in size. This particular way of monitoring is a reflection of the Japanese spirit. The potential influence of the institutional is of consequence. If they have a potential role as guardians, the classical question intrudes: who guards the guardians; i. e. must the corporate governance problem in part be reformulated as an institutional investors governance problem? In an overall economic perspective two main models of control have emerged: systems of control which utilize the market as a monitor (for example the market of corporate control as particularly in the USA and Great Britain), and systems of control in which banks and fellow corporations function as monitors (as in Germany and Japan). Recent studies have been undertaken in order to understand and evaluate these differences, but they have not yet led to consistent results. The acute Western concern on short-termism is just one facet of this. The institutional investors movement runs across these divergent models and complicates the analysis further.
This book is a joint international and interdisciplinary effort aimed at understanding these new international developments. Therefore participants from many of the important industrialized countries were invited to present the experiences of their countries. Their reports evidenced the considerable differences that exist as to the kind of institutional investors as well as to their role in their respective economic and legal environments. Therefore the editors have refrained from espousing any generalized statements and purported solutions. However, it is their hope that a truly international dialogue is opened and that some facts and relevant analytical elements and tools for this dialogue can be discovered within the pages of this book. The contributions to this volume were presented before their finalization in a Colloquium held on 9 - 11 July 1992 at the University of Osnabrück, Germany, and organized there brilliantly by Professor Baums and his staff, especially Heike Konopatzki and Dr. Ruth Lüttmann. Uta Klawitter, Silke Podschull, Evelyn Ruttke and Johannes Stawowy assisted in the editing of this conference volume. Their support was invaluable. February 1993
Klaus J. Hopt, University of Munich
Table of Contents
List of Contributors List of Abbreviations
XV XVII
Part One: Comparative and International Aspects
1
Chapter One: "Comparative Aspects of Institutional Investment and Corporate Governance" Richard M. Buxbaum
3
Chapter Two: "Some Differences in Corporate Governance in Germany, Japan and America" Mark]. Roe
23
Chapter Three: "Corporate Governance by Institutional Investors? Some Problems from an International Perspective" Tom Hodden....................
89
Part Two: United States
103
Chapter Four: "Public Pension Fund Activism in Corporate Governance Reconsidered" Roberta Romano
105
Chapter Five: "Boards of Directors versus Institutional Investors" Leo Herzel
161
XII
Table of Contents
Chapter Six: "CEO Performance, Board Types and Board Performance: A First Cut" Kenneth E. Scott/Allan W. Kleidon
181
Chapter Seven: "Institutional Investors in the U.S. and the Repeal of Poison Pills: A Practitioner's Perspective" MarkR. Wingerson/ChristopherH. Dorn
201
Chapter Eight: "Investment Companies as Guardian Shareholders: The Place of the MSIC in the Corporate Governance Debate" Ronald J. Gilson/Reinier Kraakman
225
Part Three: Europe
255
Chapter Nine: "Institutional Investors in the United Kingdom" PaulDavies
257
Chapter Ten: "Corporate Governance in Swedish Listed Companies" Mats Isaksson/RolfSkog
287
Chapter Eleven: "Ownership of Equity and Corporate Governance The Case of Sweden" ErikBerglöf.
311
Chapter Twelve: "Institutional Investors and Corporate Governance in the Netherlands" WiekJ. Slagter
329
Chapter Thirteen: "Institutional Investors, Financial Groups and their Impact on Corporate Governance in Belgium" Eddy Wymeersch
347
Table of Contents
XIII
Chapter Fourteen: "Les Investisseurs Institutionnels en Droit Frangais" YvesGuyon
385
Chapter Fifteen: "Institutional Investors and Corporate Control in Spanish Perspective" AlbertoJ. TapiaHermida
399
Chapter Sixteen: "Institutional Investors and Corporate Governance: The Austrian View" Waldemar Jud
465
Chapter Seventeen: "Institutional Investors in Switzerland" Martin Anderson/Thierry Hertig
489
Chapter Eighteen: "Duties of Banks in Voting Their Clients' Stock" Johannes Köndgen
531
Chapter Nineteen: "The Equity Market in Germany and its Dependency on the System of Old Age Provisions" Michael Hauck
555
Chapter Twenty: "Institutional Investors and Corporate Governance: A German Perspective" Friedrich Kubier
565
Part Four: Australia and Japan
581
Chapter Twenty-One: "Institutional Investors and Corporate Governance in Australia" Jennifer Hill
583
Chapter Twenty-Two: "Institutional Investors and Corporate Governance in Japanese Perspective" Harald Baum/Ulrike Schaede
609
XIV
Table of Contents
Chapter Twenty-Three: "Institutional Investors and Corporate Governance in Japan" Zenichi Shishido
665
Index
689
List of Contributors
Anderson, Martin
Attorney-at-Law, Baker & McKenzie (Etienne Blum Stehlo Manfrini & Associos), Geneva
Baum, Harald
Max-Planck-Institut für Ausländisches und Internationales Privatrecht, Hamburg
Baums, Theodor
Professor, Director, Institut für Handels- und Wirtschaftsrecht, Universität Osnabrück
Berglöf, Erik
Associate Professor, European Centre for Advanced Research in Economics (ECARE), Brussels
Buxbaum, Richard M.
Jackson H. Ralston Professor of International Law, Director, Center for German and European Studies, School of Law (Boalt Hall), University of California at Berkeley
Davies, Paul L.
Fellow and Tutor in Law, Balliol College, University of Oxford
Dorn, Christopher H.
Associate, Shearman & Sterling, New York
Gilson, Ronald J.
Charles C. Meyers Professor of Law and Business, Stanford University
Guyon, Yves
Professor, Faculto de Droit, Universito de Paris I (Panth6on-Sorbonne)
Hadden, Tom
Professor, Queen's University of Belfast
Hauck, Michael
Hauck Bankiers, Frankfurt
Hertig, Thierry
Head of the Swiss research of Darier, Hentsch & Cie., Geneva
XVI
List of Contributors
Herzel, Leo
Senior Partner, Mayer, Brown & Platt, Chicago
Hill, Jennifer
Professor, Faculty of Law, University of Sydney
Hopt, Klaus J.
Professor, Director, Institut für Internationales Recht, Universität München
Isaksson, Mats
Ministry of Justice, Stockholm
Jud, Waldemar
Professor, Director, Institut für Handels- und Wertpapierrecht, Karl-Franzens-Universität, Graz
Kleidon, Allan W.
Lecturer, Graduate School of Business, Stanford University
Köndgen,Johannes
Professor, Rechtswissenschaftliche Abteilung, Hochschule St. Gallen
Kraakman, Reinier
Professor, Harvard Law School
Kubier, Friedrich
Professor, Director, Institut für Arbeits-, Wirtschafts- und Zivilrecht, Johann Wolfgang Goethe-Universität, Frankfurt
Roe, Mark J.
Professor, Columbia Law School
Romano, Roberta
Allen Duffy/Class of 1960 Professor of Law, Yale Law School
Schaede, Ulrike
Haas School of Business, University of California at Berkeley
Scott, Kenneth E.
Ralph M. Parsons Professor of Law and Business, Stanford Law School
Shishido, Zenichi
Professor, Faculty of Law, Seikei University, Tokio
Skog, Rolf
Ministry of Justice, Stockholm
Slagter, Wiek J.
Professor em., Erasmus University, Rotterdam; Advisor, Schaap & Partners, Rotterdam
List of Contributors
XVII
Tapia Hermida, Alberto J.
Professor, Universidad Complutense de Madrid; Partner, Estudio Juridico Sanchez Calero & Co.
Wingerson, Mark R.
Partner, Shearman & Sterling, Frankfurt
Wymeersch, Eddy
Professor, Director, Handels- en Ondernemingsrecht, Faculteit van de Rechtsgeleerdheid, Universiteit Gent
List of Abbreviations
AG-Report
Aktiengesellschaft-Report, Sonderteil der Zeitschrift Die Aktiengesellschaft (Germany)
ALRC
Australian Law Reform Commission
Am.Econ.Rev.
American Economic Review (USA)
Amer.B.Found.Res.J.
American Bar Foundation Research Journal (USA)
Am.J.Comp.L.
American Journal of Comparative Law (USA)
ANSA
Association Nationale des Sociotos par Actions
Art.
Article(s)
ASX
Australian Stock Exchange
Aust Bar Rev
Australian Bar Review (Australia)
BGB1
Bundesgesetzblatt (Austria/Germany)
BIS
Bank for International Settlements
BJIBFL
Butterworths Journal of International Banking and Financial Law (UK)
BNA
Bureau of National Affairs
BOJ
Bank of Japan
Bost.Coll.L.R.
Boston College Law Review (USA)
Brooklyn L.R.
Brooklyn Law Review (USA)
Buff.L.R.
Buffalo Law Review (USA)
Bus. Law.
The Business Lawyer (USA)
XX
List of Abbreviations
Bus. World
Business World (USA)
Bus.Wk.
Business Week (USA)
Calif.L.Rev.
California Law Review (USA)
CaMRI Rev.
Capital Markets Research Institute Review
CCH
Commerce Clearing House
CEO
Chief Executive Officer
CEPR
Center for Economic and Policy Research
cf.
confer
ch.
Chapter(s)
CNMV
Comision Nacional de Mercado de Valores (National Securities Market Commission, Spain)
Colum.Bus.L.Rev.
Columbia Business Law Review (USA)
Colum.J.Transnat'l L.
Columbia Journal of Transnational Law (USA)
Colum.L.Rev./Col.L.Rev.
Columbia Law Review (USA)
Colum.L.Sch.
Columbia Law School (USA)
Comm.
Commentaries
Cong.
Congress
CSAC
Companies and Securities Advisory (Australia)
CSLRC
Companies and Securities Law Review Committee (Australia)
D.A.O.R.
Le Droit des Affaires - Het Ondernemingsrecht
Doer.
D^crot
Diss.
Dissertation
DRGB1.
Reichsgesetzblatt (Germany)
List of Abbreviations
XXI
Duke L.J.
Duke Law Journal (USA)
EC
European Community/Communities
Econ. and Society
Economics and Society
ed(s).
Editor(s), Edition
EEC
European Economic Community
e.g.
exempli gratia
Emory L.J.
Emory Law Journal (USA)
et.al.
et alii
Fed.
Federal Reserve Board of Governors; Federal Reserve System
Fed.Res. Bank of N.Y.Q.Rev.
Federal Reserve Bank of New York Quarterly Review (USA)
Fed.Res.Bull.
Federal Reserve Bulletin (USA)
Fed.Res. BankS.F. Weekly Letter
Federal Reserve Bank of San Francisco Weekly Letter (USA)
Fed.Sec.L.Rep.
Federal Securities Law Report (USA)
ff.
following
Fin. Analysts J.
Financial Analysts Journal (USA)
FNMA
Federal National Mortgage Association
Fordham L.Rev.
Fordham Law Review (USA)
FTC
Federal Trade Commission
Geo.L.J.
Georgetown Law Journal (USA)
GesRZ
Zeitschrift für Gesellschaftsrecht (Austria)
GNP
Gross National Product
Harv.Bus.Rev.
Harvard Business Review (USA)
XXII
List of Abbreviations
Harv.L.Rev.
Harvard Law Review (USA)
Hastings Int'l & Comp.L.R.
Hastings International and Comparative Law Review (USA)
HC HCP
House of Commons House of Commons Paper (UK)
i.a.
inter alia
ibid.
ibidem
id.
idem
i.e.
id est
IMF
International Monetary Fund
Int. Bus. Law.
International Business Lawyer (UK)
Int'l Org.
International Organization
ISC
Insurance and Superannuation Commission (Austria); Institutional Shareholders' Committee (UK)
J.Acc. & Econ.
Journal of Accounting and Economics (USA)
J. Applied Corp.Fin.
Journal of Applied Corporate Finance (USA)
J. Banking & Fin./ J. of Bank, and Fin.
Journal of Banking and Finance (USA)
J.Bus.L.
Journal of Business Law (UK)
J Comp.Bus. & Cap.M.L.
Journal of Comparative Business and Capital Market Law (USA)
J.Comp.Corp.L. & Sec.Reg.
Journal of Comparative Corporate Law and Securities Regulation (USA)
J.Corp.L.
Journal of Corporation Law (USA)
J.Econ.Beh. & Org.
Journal of Economic Behavior and Organization (Netherlands)
List of Abbreviations
XXIII
J.Econ.Lit.
Journal of Economic Literature (USA)
J. Econ. Perspectives
Journal of Economic Perspectives (USA)
J.Fin.
Journal of Finance (USA)
J.Fin.Econ.
Journal of Financial Economics (USA)
J.Fin. Res.
Journal of Financial Research (USA)
J. Japanese Studies
Journal of Japanese Studies (USA)
J.L. & Econ./ J. Law & Econ.
Journal of Law and Economics (USA)
J.L.Econ. & Org.
Journal of Law, Economics and Organization (USA)
J.Pol.Econ.
Journal of Political Economy (USA)
J. Portfolio Mgmt.
Journal of Portfolio Management (USA)
J.T.
Journal de Tribunaux (Belgium)
Labor L.J.
Labor Law Journal (USA)
LBO
Leveraged Buy-Out
LGDJ
Librairie G^neYale de Droit et de Jurisprudence (France)
L.Q.Rev.
Law Quarterly Review (USA)
Mich.L.Rev.
Michigan Law Review (USA)
MIT
Massachusetts Institute of Technology
Modern L.Rev.
Modern Law Review (UK)
MOF
Ministry of Finance (Japan)
ms.
Manuscript
MSIC
Managerial Strategic Investment Company
n.
note(s)
XXIV
List of Abbreviations
N.C.L.Rev.
North Carolina Law Review (USA)
ΝΙΒΕ
Institute for Bank and Stock Trade (Netherlands)
No., nr.
Number(s)
NSW
New South Wales
NYSE
New York Stock Exchange
N.Y. Times
New York Times (USA)
N.Y.U.L.Rev.
New York University Law Review (USA)
OECD
Organisation for Economic Cooperation and Development
Ohio State L.J.
Ohio State Law Journal (USA)
Para.
Paragraph(s)
Publ.
Publication^)
PUF
Presses Universitaires de France
RabelsZ
Rabeis-Zeitschrift f r Ausl ndisches und Internationales Privatrecht (Germany)
Rand J.Econ.
Rand Journal of Economics (USA)
Rev.Banking & Fin.Ser.
Review of Banking and Financial Services (USA)
Rev. Banque
Revue de la Banque (Belgium)
Rev.dr. bancaire
Revue de Droit Bancaire (France)
Rev.Int. Droit Econ.
Revue Internationale de Droit Economique (Belgium)
Rev.jurisp.com.
Revue de Jurisprudence Commercial (France)
Rev.soc.
Revue des Sociotos (France)
Rev.trim.dr.civ.
Revue Trimestrielle de Droit Civil (France)
List of Abbreviations
XXV
Rev.trim.dr.com.
Revue Trimestrielle de Droit Commerciale (France)
RD
Royal Decree
RDBB
Revista de Derecho Bancario y Bursätil (Spain)
Riv. Societä
Rivista delle Societä (Italy)
RIW
Recht der Internationalen Wirtschaft/Außenwirtschaftsdienst des Betriebsberaters (Germany)
sc.
scilicet
S.Cal.L.Rev.
Southern California Law Review (USA)
SEAQ
Stock Exchange Automated Quotation System
Sec.
Section(s)
SEC
Securities Exchange Commission
Sec.Reg.L.Rep.
Securities Regulation Law Report (USA)
seq.
sequens
SESC
Securities and Exchange Surveillance Commission (Japan)
Sess.
Session
SGL
Superannuation Guarantee Levy (Australia)
SNS
Studieforbundet Näringsliv och Samhälle (Center for Business and Policy Studies, Stockholm, Sweden)
SOFREX
Swiss Options and Financial Future Exchange
SOU
Statens Offentliga Utredningar (Official Public Inquiries, Sweden)
SSIMC
State Superannuation Investment and Management Corporation (Australia)
Stan.L.Rev.
Stanford Law Review (USA)
XXVI
List of Abbreviations
Tulane L.Rev.
Tulane Law Review (USA)
TVVS
Tijdschrift voor Vennootschappen, Verenigingen en Stichtingen (Netherlands)
Ucits
Units for Collective Investment Securities
UCLA L.Rev.
University of California Los Angeles Law Review (USA)
U.Chi.L.Rev.
University of Chicago Law Review (USA)
U.Cin.L.Rev.
University of Cincinnati Law Review (USA)
U. Detroit L.Rev.
University of Detroit Law Review (USA)
U.Haw.L.Rev.
University of Hawaii Law Review (USA)
UK
United Kingdom
UN
United Nations
UNSWLJ
University of New South Wales Law Review (Australia)
U.Pa.L.Rev./ U.Penn.L.Rev.
University of Pennsylvania Law Review (USA)
v.
versus
Va.L.Rev.
Virginia Law Review (USA)
Vand.L.Rev.
Vanderbilt Law Review (USA)
Vers Rdsch
Die Versicherungsrundschau (Germany)
Vol.
Volume
Wall St.J.
Wall Street Journal (USA)
Wall St.J. Europe
Wall Street Journal Europe (UK)
W.D.
Western District
WM
Zeitschrift für Wirtschafts- und Bankrecht (Wertpapier-Mitteilungen; Germany)
List of Abbreviations
XXVII
WSI-Mitteilungen
Wirtschafts- und Sozial wissenschaftliches Institut. Deutscher Gewerkschaftsbund. Wirtschaftswissenschaftliche Mitteilungen (Germany)
Yale J.Reg.
Yale Journal on Regulation (USA)
Yale L.J.
Yale Law Journal (USA)
Yale L. & Pol. Rev.
Yale Law and Policy Review (USA)
ZHR
Zeitschrift für das Gesamte Handels- und Wirtschaftsrecht (Germany)
ZIP
Zeitschrift für Wirtschaftsrecht (Germany)
ZSR
Zeitschrift für das Schweizerische Recht (Switzerland)
Part One: Comparative and International Aspects
Chapter One Comparative Aspects of Institutional Investment and Corporate Governance Richard M. Buxbaum
Review and Agenda1 This presentation was prepared after I had the benefit of reading some of the papers submitted to this congress, and reflecting on the possibilities for comparative analysis they suggest (and to a considerable extent already engage in). They provide a framework for analysis not only for our sessions but for the future, analyses with professional and policy as well as more theoretical aims. I propose to begin with comments about each of the two elements of the meeting, corporate governance and institutional investment, discussing them separately and (primarily) from an United States perspective first, emphasizing the scholarly analysis of these two elements in the literature, before turning to their combined or entwined situation. I propose to discuss this, too, from the American perspective before turning to its comparative setting. There it should be possible to identify both empirical and theoretical elements of a comparative inquiry, proceeding from the former to the latter. We focus on the convergence of two phenomena, or developments institutional investment and corporate governance - each of which had a life of its own before their fates became entangled, and each of which will continue to have a life of its own, its own set of factual and normative problems to be dealt with; though, in the near future, it is their common relationships and entanglements that at least in the United States will dominate scholarly and perhaps public discussion.2 I shall first treat them separately, identifying what might be called the backward linkage of each of these phenomena, before discussing their relationship; and start with the older, or classic one of corporate governance. It 1
I have kept the discussion form of the original presentation for this publication, and held the citation apparatus to the minimum. 2 BUXBAUM, "Institutional Owners and Corporate Managers," 57 Brooklyn L. Rev. 1 (1991).
Richard M. Buxbaum comprises private and public elements (in the sense of the old and not everywhere respectable distinction of private law and public law). The former can be collectively characterized as the owner-manager, or in today's terms the principal-agent issues, and they are my starting point. I believe it is appropriate to place the phenomenon in the context of an earlier day's concerns, concerns with the problem or vision of "shareholder democracy." "Problem," because the atomization of ownership from the Gründerjahre or from the 1880s onward made its realization unlikely; "vision," because it could safely be prayed for, be publicly held out as an ideal to strive for, by managers as well as by owners, financiers, and politicians, so long as like the second coming - no one really thought it imminent.3 To be sure, this is an American statement. Were I to cheat on the structure of this discussion paper and move already now to the comparative aspects of this topic, we would be speaking here of the early, war-driven European or at least German acceptance of the corporatist vision of Rathenau and of the Unternehmen an sich.4 In any event, "shareholder democracy" encapsulates the debate over governance in the days before economic explanation of legal and institutional phenomena became prevalent. It had public as well as private implications, in the mentioned sense of private law and public law. For one thing, looking at the former, the concept both legitimated and limited the new federal role of securities regulation. As a legitimating concept, it supported not only the consumer-protection related new norms of investor protection associated with the issuance of securities, but more significantly it supported the formal framework of shareholder participation in corporate governance associated with the proxy machinery and with shareholder-meeting agenda setting. Given the reality of atomized ownership, of course, this formal framework, especially the second, agenda-setting component, was limited to a ritual role. Therefore it is the limitation inherent in the legitimation that next needs to be recalled. The legitimacy of the limitation of shareholder democracy lay and lies in the direct political analogy. The decisions of an informed electorate comprised of ideally autonomous subjects are what the political process accepts as correct, in the absence of an identity of underlying values that carries over to the detail of actual decisions. Thus, in the corporate polity, "full disclosure" is the goal, and more or less remains the limit, of structural implementation of shareholder democracy.5 Electoral reform responsive to - relatively speaking 3
See BUXBAUM, "Institutional Ownership and the Restructuring of Corporations," in Festschrift ßlr Steindorff, at 9, 26 (J. Baur, K. Hopt & K. P. Mailänder, eds., Berlin 1990). 4 For this provenance of Rathenau's formulation, see W. SCHMIDT-RIMPLER, "Wirtschaftsrecht," in Handwörterbuch der Sozialwissenschaften (Supplementary Volume, Munich 1966). 5 See J.H. CHOPER, J.C. COFFEE, JR. & C.R. MORRIS, JR., Cases and Materials on Corporations, at 543-545 (3rd. ed 1989).
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real issues of owner-manager relations, such as reform of the manager (director) nomination process, though recurrently propounded within the securities regulation framework (recall Mortimer Caplin's efforts in the early 1950s and the Carter Administration proposals of the late 1970s),6 has not breached this wall between disclosure and structure, just as electoral reform measures have not breached the First Amendment wall in the political sphere.7 Thus, I remain with the argument that "shareholder democracy," in its internal, principal-agent aspect, legitimated only its own objectively determined impotence. That in recent years the proxy-solicitation process has backfired against the efforts of large institutional investors to communicate with each other is only a bit of accidental icing on the cake of this limitation function of this legitimation role of shareholder democracy. Indeed, the legitimation claim is usually the louder, the stronger the bite of the limitation underlying it.8 When the post office proclaims that the customer is king, you know you had better duck. "Shareholder democracy" since its inception also has had a function or role going beyond the private, shareholder-manager or principal-agent relationship. Without going into the comparative elements of this issue now - and obviously they are even more salient in Europe and elsewhere than in the United States let me identify two American strands in what can best be called, in today's jargon, the discourse: the "moral shareholder" argument identified especially with Professor Bayne,9 and the vaguely populistic and idealistic notion, which one finds in the early if not the later Berle,10 that the more directly democratic the governance of the enterprise, the more the latter will be a good citizen in public-policy terms (expressed, for example, in labor relations or antitrust, today in environmental law and policy contexts). Unlike the private-relationship aspect of shareholder democracy, in which at least the securities regulation norms demonstrate some instrumental levels of implementation, no similar operational implementation seems available for its public-relationship aspect. Großfeld made a valiant effort to demonstrate a 6
CAPLIN, "Proxies, Annual Meetings and Corporate Democracy: The Lawyer's Role," 37 Va. L.Rev. 653, 682-85 (1951); SEC, Sec. Exch. Act Release No. 13901, Aug. 29, 1977, "Re-examination of the Rules Relating to Shareholder Communications, Shareholder Participation in the Electoral Process and Corporate Governance Generally," in 6 CCH, Sec. Reg. L.Rep. paragraph 81,296. 7 Buckley v. Valeo, 424 U.S. 1 (1976); First Nat'l Bank of Boston v. Belloti, 435 U.S. 765 (1978). 8 See BLACK & MONKS, "Disclosure not Censorship: The Case for Proxy Reform," 17 /. Corp. Law 49 (1991); BLACK, "The Value of Institutional Investor Monitoring: The Empirical Evidence," 39 UCLA L.Rev. 895, 896 (1992). 9 See especially BAYNE, "The Basic Rationale of the Proper Subject," 34 (/. Detroit L.J. 575, 579 (1957). 10 A. BERLE & G. MEANS, The Modern Corporation and Private Property (1932).
Richard M. Buxbaum correlation between shareholder governance and competition policy in his 1968 Habilitation,11 but it has not been hailed as a successful demonstration, and in any event little similar work of significance has followed it. In short, if you accept this historically derived shorthand correlation of corporate governance with shareholder democracy, there was little on the American scene to give the corporate governance concept operational salience before the twin efficiency-based pillars of the efficient capital market and the efficient market for corporate control arrived on the scene. The "backward linkage" of corporate governance, in other words, leads only to the concept that any given structure or element of governance can be measured by its implications for the welfare of firm owners as measured by a firm's share prices. In this limited sense, and of course I shall at once extend that limit, it has even within efficiency paradigms no prescriptive content,12 unless you choose to hear the subliminal prescriptive message that these two markets should exist in order that this type of measurement can be carried out. Corporate governance as a normative concept, were it based only on these two markets, not only would be severely limited but would face some inherent contradictions. Since these limits and contradictions have central implications for a comparative approach to our topic, I shall stop at least to identify them here, and return to their specific comparative impact later, after examining the other half of our session title, institutional investment, in similar "stand-alone" terms. First, however, an answer to the obvious charge that corporate governance is unfairly characterized if limited as above. Clearly, corporate governance is a central topic of concern to the new institutional economics, and that set of theories, which for present purposes includes finance theory, agency theory, and transaction-cost theory, is by no means abstract in the sense of abstracting from real and really imaginable societal - including political, legal, and cultural - contexts.13 As Fligstein puts it, all have in common an interest to specify how profit-maximizing social relations evolve to govern firms;14 thus, specifically in our context, the question of monitoring corporate managers is not limited to the role of efficient capital markets and efficient control markets. Agency and transaction-cost theories will consider, propose, and analyze other monitoring mechanisms when new shocks, such as the arrival of large and different institutional investors, unsettle old relationships and the theories based on them. Nevertheless, we had become so used to the primacy of capital and control markets as the standard monitors, and so used to the implicit assumption that they, at least, were not social-context 11
B. GROßFELD, Aktiengesellschaft, Unternehmenskonzentration und Kleinaktionär (Tübingen 1968). 12 FAMA & JENSEN, "Separation of Ownership and Control," 26 J. Law & Econ. 301,307(1983). 13 O. WILLIAMSON, The Economic Institutions of Capitalism, at 299ff (1987). 14 N. FLIGSTEIN, The Transformation of Corporate Control (1990).
Comparative Aspects specific and for that reason were superior species of monitors, that a recollection of why they, too, have their significant contingencies and deficiencies is critical to our comparative enterprise. A first limitation is the elimination of what I have labeled the public implication of the shareholder democracy version of corporate governance by the conversion of the latter to a capital- and control market-based vision of corporate governance. These particular versions of efficiency-calculating monitors rendered corporate governance concepts unavailable for guidance as to how to implement desired public values, and of course, paradoxically, rendered the concept mute and vulnerable to form-bending incursions from the political sector. If the state imposes labor representatives or bureaucrats on the firm's board of directors, then, while they can speak to those moves' implications for shareholder welfare as measured by their one yardstick, share prices, these markets-based definitions of good or bad corporate governance cannot speak to the implications of these moves for the private-firm sector's ability to provide goods and services effectively.15 Now to an American mainstream corporation law scholar of modern provenance, that is no real demonstration of the poverty of the current definition of corporate governance, and that for two reasons. First, the old, "shareholderdemocracy" based version, couldn't do much, at least not operationally, with this public-policy aspect of the concept either, as I have indeed just indicated. From my perspective, however, a discourse that tried, however feebly, to submit that shareholder democracy was good for society is better than a discourse that proclaims its abdication from the field. Bayne's strictures about the moral duties inherent in share ownership may have been both debatable and soft-focused, but they would have been of more use in, say, a confrontation with a corporatist version of a new National Recovery Administration's new General Johnson16 than would be the current form of corporate governance theory. Second, my objection to a one-legged concept of corporate governance would until recently have been deemed weak because its opponents would have assumed the non-contingent nature of the current situation.17 What in fact has itself been a contingent and historical American situation has not been recognized as such, resulting in what I can only call a poverty of imagined states of affairs. We've always done it this way - only shareholders elect directors, who direct only for the benefit of shareholders. Thus it would have been deemed irrelevant that the current discourse about corporate governance could 15
BUXBAUM, "Corporate Legitimacy, Economic Theory and Legal Doctrine," 45 Ohio State L.J. 515, 519f (1984). 16 See WHITMAN, "Corporatism, Fascism, and the First New Deal," 39 Am. J. Comp. L. 747 (1991). 17 GILSON & KRAAKMAN, "The Mechanisms of Market Efficiency," 70 Va. L. Rev. 549, 551 (1984).
Richard M. Buxbaum not well take account of other states of affairs. I pass by the obvious comparative point about these other, elsewhere all too real states of affairs, to remark only that simply within the American perspective, this one-legged concept of corporate governance only as a principal-agent issue left our theoretical frameworks unprepared when the political responses to the twin phenomena of institutional investment and hostile takeover activity created or threatened to create quite real alternative states of affairs even within the American system of corporate governance: when the shareholders don't necessarily elect directors who don't necessarily direct only for the benefit of shareholders.18 So much as to the limitation of the modern understanding of corporate governance as one that can speak only to the principal-agent relationship and only within the monitoring concept of the stock exchange. The modern concept of corporate governance also expresses some inherent contradictions even within that frame of reference; and it is these contradictions, more than the justreviewed limitation, that will later provide the bridge to my more explicitly comparative remarks. They are contradictions that arise from, or at least are a part of the problem of the awkward coexistence of neoclassical and neoinsitutional visions of markets and governance structures that I have already mentioned. To the extent that the stock market - for agency-cost reasons of rational apathy and other explanations familiar to us - needs the validation available from the market for corporate control, both markets thereby are rendered highly contingent and correspondingly questionable as expressors of the quality of corporate governance.19 The control market - that is, the takeover market - may have looked non-contingent and automatic, and thus congruent with the automaticity of the stock market, but that was only so long as it operated under facilitating rules set down in an earlier, relatively conflict-free day. In fact, as we now know, and as some of us believed fairly early on, it was no such thing. It was highly contingent, and turned out to be sharply vulnerable to political, including legal, restructuring. (Again, as obvious as the reference is at this point, I defer until later the comparative aspect.) With its transformation or reduction as a monitor, what remains of the uncorrected underlying monitor, the stock market? The very fact that it had to be buttressed by a control market at all demonstrates that the institutional realities of atomized ownership, resulting in the "rational apathy" and "collective action" problems associated with Mancur Olson,20 rendered the classic stock market, the bourse - the one institution that 18
F. EASTERBROOK & D. FISCHEL, The Economic Structure of Corporate Law, at88f(1991). 19 W.,at 113ff. 20 M. OLSON, The Logic of Collective Action: Public Goods and the Theory of Groups (1971).
Comparative Aspects American theorists deem an ideal type, unaffected by institutional realities - a weak monitor of agents' behavior and performance, and thus of the relative efficiency of firms. Not useless, but weak. If an automatic market has to be tied to a contingent market to be automatic, then it is not automatic. I do not mean that it is not a functioning market within the Efficient Capital Market Hypothesis; rather, that this price yardstick of efficiency, in this situation, is not an adequate monitor of the efficient behavior of agents. Of course, as I emphasize again, to characterize even the stock market, the bourse, as "automatic," in the sense I am using the term, is a specifically American exercise. One need only read, for example, studies of German stock minimarkets,21 or Schaede's recent study of the institutional framework of the Japanese stock market,22 to appreciate how highly contingent and institutionally specific even the stock markets of even such major economies in fact are. Neo-institutional economists know, by definition, that agents and transactions are institutionally - societally, legally, culturally - contingent constructs.23 Nevertheless, by tying corporate governance to capital and control markets as the former's monitors, we jumped over our own shadow, and, in giving a universal, non-contingent cast to these markets, implied rather too universal, non-contingent a cast to the diverse problems of the structure of corporate governance, the behavior of agents as lieutenant governors, and the performance of the thus-governed firms.24 Since it was the already mentioned arrival of 21
See, e.g., HANSEN, "Das Hochststimmrecht und seine Probleme," 35 AG-Report 166 (1990). 22 U. SCHAEDE, Der neue japanische Kapitalmarkt - Finanzfutures in Japan (Wiesbaden 1990); and, for a vivid recent illustration of the government/ investor/market culture, "Flickwerk von Brokern und Bürokraten," Die Zeit, March 12, 1993, at 416, and "Betting That The Fix Is In In Japan," N.Y. Times, March 28, 1993, Sec. 3, at 1. 23 See ROE, "Differences in Corporate Governance in Germany, Japan and America," 103 YaleL.J. (forthcoming, 1993). Still, it is not enough to acknowledge the "cultural variant" of the "other system," only then to "frame" that other sytem through the discourse established in one's own. Thus I find it problematical that one and the same paper can point to the Japanese "main-bank" system in confirmation of "the historical and political contingency of American arrangements," and then go on to confirm that the zaibatsu, which did exist, should exist - because "weak law enforcement or a reluctance to use the courts" should lead to "vertical integration, rather than contract, ... and [lo!] indeed there were large vertical organizations, the zaibatsu." GILSON & ROE, "Understanding the Japanese Keiretsu: Overlaps Between Corporate Governance and Industrial Organization," 103 Yale L.J. 871, 879, 899 (1993). My point is that this version of a "rational-actor discourse" subsumes culture (our common shorthand phrase) under the American analytical frame of reference and denies it its own frame of reference. 24 In a more general sense, these approaches also do insufficient justice to tensions on the American scene between the power of markets and the power of politics to
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institutional investment and of hostile takeovers that changed the scene, let me now shift gears and provide a briefer overview of that second element in the title of our session, institutional investment. The backward linkage has a narrower purpose in this case. We need to identify those characteristics of institutional investment that are salient to the interface with corporate governance.25 In my opinion that basically means to identify the sources and the dynamic properties of the flow of funds to institutional investors, the characteristics of their placement with firms seeking these savings as well as in secondary markets, and the nature of the financial intermediation and of the financial intermediaries that bring these funds to their destination. Since several of those present have worked on these issues, it will suffice if I summarize these salient characteristics. First is the reason for the existence of the particular institution that becomes an investor. On the whole, we can stay with pension-driven reasons, for most of these institutions are directly or at least indirectly associated with the second (firm-level) and third (individual) pillars of pension income. The actual flow of funds into these institutions of course will depend on the need for these two pillars, which in turn is to a great extent a function of the first pillar, social security,26 and to a lesser extent is influenced by public policies of taxation and subsidization of savings destined for these uses.27 It also is influenced by a factor often overlooked, and important both to this issue of generation of savings that flow to institutions and to the later, central issue of investment in firms; namely, whether the second pillar pension claims are capitalized through the collection and separate investment of premiums, or are more or less unsecured general claims against the firm promising the pension.28 That all of these characteristics are contingent on specific national policies and thus create a nationally quite variable range of issues relevant to corporate governance almost goes without saying. A second salient characteristic of institutional investment, even more variable across national borders because it is, at least in large part, a function of legal, institutional, and even cultural specifics, is the investment policy of institutional shape markets. In addition to Roe's work on this reality (see especially "A Political Theory of American Corporate Finance," 91 Colum. L. Rev. 10 (1991) and "Political and Legal Restraints on Ownership and Control of Public Companies," 27 J. Fin. Econ. 7 (1990)), see the historical record in J. HUGHES, Ihe Governmental Habit Redux: Economic Controls from Colonial Times to the Present (Princeton 1991). 25 See generally BUXBAUM, supra n. 2, and, of course, the country-specific comparative studies in this volume. 26 See, e.g., KÜBLER, "Institutional Owners and Corporate Managers: A Corporate Dilemma," 57 Brooklyn L. Rev. 97, lOOf (1991). 27 See WEISS, "Paternalistic Pension Policy: Psychological Evidence and Economic Theory," 58 U. Chi. L. Rev. 1275 (1991). 28 See BUXBAUM, supra n. 2, at 1 If.
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investors. It is, however, also in part a function of the availability of various types of financial assets in various markets, especially of equity shares, and in that sense has a separate relationship with financial markets as such, a relationship that is at least to some degree dependent on yet other contingent or national particularities. Again, the immediate relevance of this second set of characteristics to our comparative inquiry is obvious. The third characteristic I would like to highlight here is what might be called the style of financial intermediation. One example to illuminate this concept is the distinction between American mutual funds and American public-sector pension funds as institutional investors. The mutual fund is a creature of traditional financial intermediation structures and actors, and both its investment and (we shall come to this later) its governance behavior patterns reflect that provenance. The public pension fund is an autonomous creature that grew up outside the traditional structure and was not serviced by the latter's agents to anywhere near the same degree. That, too, should be, and we know it is, reflected in its investment and governance behavior patterns.29 This set of characteristics, unlike the first two, has not been fully recognized by legal and social scientists as nationally and culturally contingent, in part because the study of these investment considerations bring us back to considerations of efficient capital and control markets, which, as I have argued, to a considerable degree have been misperceived as automatic and independent of national and historically contingent determinants. I will leave this exercise in identifying relevant characteristics of institutional investors at this summary level, since many of the papers being presented here provide excellent and more specific coverage of these issues. In order now to comment on the relationship of institutional investors and corporate governance, however, let me add one increasingly important characteristic of the former, one that especially Romano's probing study emphasizes; namely, that of the governance structure of the institutional investor itself. This is to some degree an American issue, given the unique and uniquely powerful public-sector pension funds, whose "units," in collective-bargaining terms, number in the millions and whose political ambience gives them a cast quite different from that of voluntary associations like mutual funds. Nevertheless, to the degree these funds are driven by portfolio considerations to invest abroad, and by political considerations to play their shareholder roles with vigor, these considerations are relevant to comparative study of whether or not analogous non-US institutions can or will come to resemble them. It will be useful to suggest a typology of corporate governance issues raised by institutional investment, as an agenda on which comparative reflections might be based. 29
See ROMANO, "Public Pension Fund Activism in Corporate Governance Reconsidered," infra ch. 4.
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1) The arrival of institutions on a firm's book of owners. This aspect is in part preordained, as a function of the already mentioned inherent (though variant) attributes of institutions: their growth as engines of and collection agencies for often involuntary savings; and their function-driven need to invest, inter alia, in equity as well as in debt issues of firms. In any given national setting - both of institutions and of markets - the right of the institution to invest and the ability of the market to absorb the investment are important factors in bringing the institutional investor into the family of shareholders. That the addition of a foreign element provides a great deal of variety in the actual outcomes is an obvious complication, but we should also be interested in reflecting on local experience as it differs among nations and among markets. 2) The structural issues bearing on institutional shareholders' behavior as shareholders. The investment policy of institutions - active portfolio management with high turnover and index strategy with low turnover are polar examples - is the first element. The chosen or imposed style of management of the voting rights of a portfolio is the second. Examples of this set are whether the institution is commanded to manage this component carefully, and thus actively; and whether this is a part of the depositary function of the investment adviser, uncompensated, burdensome, and fraught with conflicts of interests. The external, typically legal constraints imposed on the exercise of the franchise is the third element. These may be standard forms of legal-organizational constraints, as illuminated in Slagter's review of the Dutch structure company,30 with its extreme layered separation of owner from manager. They may be charter limits voted into existence with the blessing of the law. All are framework conditions shaping the institutions' behavior as owners. Again, adding the foreign element fruitfully complicates the story, but is not, for comparative purpose, the whole story. 3) The corporate governance issue is of interest to institutional investors, with the hostile-takeover issue as a theoretical example. Institutional investors are not individual human subjects, but reified functions. Guided by a profit-maximizing mission imposed by the aggregation of their members' or beneficiaries' functional purpose in coming together, they are merely instrumental actors. Unless constrained by law or by their settlors' instructions, they "cannot do otherwise." Some looseness of detail may result from agency discretion within their own organizational structure, and some slack may be cut for them by playing with "long-term investment horizons" and similar evasions (we know these problems from the related use of these slogans in their corporate settings), but none of that gets us far away from the issue.31 Hemingway was wrong and 30
See SLAGTER, "Institutional Investors and Corporate Governance in The Netherlands," infra ch. 12. 31 See BUXBAUM, "Juridification and Legitimation Problems in American Enterprise Law," in Juridification of Social Spheres at 241, 262f (G. Teubner, ed., Berlin 1987).
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Lawrence was right: Institutional investors are not just richer than you or me, they are different. Thus, if institutional investors are to be constrained from killing the goose that lays the golden eggs by tendering into or even encouraging hostile takeovers - and I take it that some of the European and Japanese participants in this conference see it that way, even if most American participants persist in calling this a fairy tale - then the state and its law will have to stop them. But there is a more interesting question lurking here: Is there an exception to the instrumental-actor thesis because these particular investors invest to secure pensions, pensions expected by a workforce that depends on jobs, jobs that some believe certain forms of hostile takeovers, for example, jeopardize? It is, indeed, the central question, even if only as an abstraction - namely,whether pension-based institutional investors, and we realize most are just that, in fact are not condemned to be rational instrumental profit-maximizing actors, but for the mentioned reason may exercise this or other expressions of a moral or at least a redistributive impulse. If the interests of institutional investors indeed differ from our received view of investor interests, can they lead to a different substantive approach to or exercise of corporate governance rights and responsibilities?32 This is not to say that most mundane corporate governance issues will disappear, or that the current exercises in imagining a greater variety of forms of traditional, efficiency-based monitoring methods are unimportant. But it is to suggest that the separation of functions society accepts and expects from the private-firm sector, the acceptance of firms' profit maximization-based instrumentalization as the price for the efficient allocation of resources and the effective creation of wealth - that this differentiation will suffer not a global shift, but a change of nuance as the pension interest, and through it the possibly correlated job-maintenance interest of this group of owners is brought into sharper profile. With this admittedly vague comment let me leave this third element of the typology, and indeed close out the whole question of corporate governance issues raised by the specific role of institutional investment, and turn, finally, first to the practical and professional aspects of the comparative study of these issues and then briefly to more general questions about the comparative study of theory. The practical and professional aspects of the comparative study of institutional investment and corporate governance have, I hope, emerged in fairly clear fashion from the foregoing. More to the point, they emerge from many of the papers before us. These papers advance the comparative study of these linked issues further than many would have dared hope for when Baums first set these 32
Cf. LANGBEIN, "The Conundrum of Fiduciary Investing Under ERISA," in Proxy Voting of Pension Plan Equity Securities (D. McGill, ed., Homewood 1989).
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themes. I am convinced that this congress marks the maturation, not only the arrival, of rigorous comparative study of these new phenomena. We need to know how national institutional investors differ along the axes I have identified, and several of the papers provide that knowledge. We need to know how national markets receive local and foreign institutional investment, and again that knowledge is largely gained from these contributions. We are well on the way to understanding the general, legal and institutional framework of the relative roles of managers, directorates, and owners in the governance of firms. In short, from a descriptive and a policy-prescriptive point of view, much comparative knowledge is amassed here, and it is the more valuable for future comparative work because of the number of contributions that themselves already use comparative perspectives in order to frame their specifically national inquiries and reports.33 At the theoretical level - theory at various levels of abstraction - we are in a more ambiguous situation. In a recent paper on "Problemes et chances de l'analyse economique du droit en Europe," the British legal theorist Daintith describes, not uncritically, the manifold forms or "etements analytiques" of the principally American law and economics movement, only to ask, "pourquoi done si peu de juristes europoens la suivent?"34 The answer, as Stigler before him observed,35 cannot be given by economists, who rather are puzzled at the different appearance of elements of their discipline in different countries. We need not go so far as Albert, whose recent book derides economic analysis as an Anglo-American ideology,36 in order to observe that the legal treatment of similar phenomena differs sufficiently between otherwise similarly situated economies to be grounds for further study. Comparative Law, however, can only offer assistance if itself anchored in the social sciences and social theory, not only in legal theory.37 A good example of this intersection is provided, again, by the recent history of the hostile-takeover movement in the United States. The eruption of political will on the American scene in reaction to the unfettered sweep of that movement, and the legal blessing of the seizure of power over business organizations by their managements in reaction, quite simply called for more 33
The already cited papers by ROE and by GILSON and ROE (supra n. 23) belong here; as do COFFEE, "Liquidity Versus Control: The Institutional Investor as Corporate Monitor," 91 Colum. L. Rev. 1277 (1991) and GILSON, "The Political Ecology of Takeovers: Thoughts on Harmonizing the European Corporate Governance Environment," 61 Fordham L. Rev. 101 (1992). 34 [1991] Rev. Int. Droit Econ. 313, 317. 35 STIGLER in KITCH, ed., "The Fire of Truth: A Remembrance of Law and Economics at Chicago, 1932-1970," 267. L. & Econ. 163, 216 (1983). 36 G. ALBERT, Capitalisme centre capitalisme (1991). 37 See BUXBAUM, Rechtsvergleichung jenseits des Nationalstaats, (Fachbereich Rechtswissenschaften, Universität Osnabrück, ed., forthcoming, 1993).
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theoretical resources than neo-classical economic analysis of law and its use of the automatic monitors of stock markets and control markets alone could provide. To the degree that facts, transactions, and structures shifted, to that degree comparisons with settings in which some analogies to these shifts already existed became relevant and fashionable. But recent acquaintance with these settings is only the beginning; much more rewarding is the critical grappling with the social theories current in these other settings. It is true that economic analysis of law is available, as a semantic, for focus on any setting, not only on one that had provided the structures and processes leading social theorists to think theory. That is the comparative advantage of neo-institutionalist forms of analysis with their emphasis on agency and transaction-level work.38 Even within frames of reference that had this affinity to legal, social, and cultural variations, however, there remains a strong implication that efforts to insulate economic actors from markets and the efficiency derived there from would fail, especially when the polity that permitted this effort was not in control of the competitive universe within which this deviation would be tested. The notion that economic actors, private or public, could through political acts of will shape the markets that defined efficiency with impunity is foreign to this way of thinking.39 And it is this "foreignness" that now is the subject of comparative inquiry. This new comparative inquiry, however, can only be meaningful (i.e., can only help one understand the fate of one's own economic structures in their new legal frame of reference), if the theoretical component of the foreign legal order is a major part of that inquiry. A more detailed example: Simply to describe the foreign legal rules governing the behavior of corporate managers towards the firm's owners is of little assistance in the effort to understand and predict that fate at home. It is not even of much assistance in the effort to understand that foreign economic structure on its own terms. Only a discourse between theoretical constructions and explanations of the respective rules makes the comparative inquiry truly instructive. The availability of a theoretical explanation of the foreign rule in that rule's home setting, however, is itself a matter for comparative inquiry, as Daintith's question clearly implies. And with that, we come full circle. An exploration of the reasons for the absence of a discourse between theories of similar provenance is a challenge of special pertinence for legal theory,40 informed by 38
This is well illustrated by GILSON & ROE, supra n. 23. See also FLIGSTEIN, supra n. 14. 40 See ROE, and GILSON & ROE, supra n. 23, though "knowing" this role of comparative theory and dealing with it on a comparative basis are two different matters. For example, as much as I appreciate the sophisticated effort by a legal theorist like Roe, conversant with political economy, to get inside another system in order to understand its own contingent and historically specific characteristics, I do not find it helpful to learn that "culture" explains a variation between the normal (sc. 39
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but not colonized by social-science, especially economic theories.41 The role of meeting that challenge is well suited for comparative legal theory because our enterprise, after all, is the comparative study of legal norms, norms that are expressions of state and societal power.42 An interesting argument in this direction stems from Kahn-Freund. In his 1974 Oxford inaugural lecture, he made a point that ties in well with his earlier thesis43 that there was a remarkable distinction between the increasing uniformity of economic and social structures and the continuing differentiation of political structures. "[U]nder similar social, economic, cultural pressures in similar societies the law is apt to change by means of sometimes radically different legal techniques. The ends are determined by society, the means by legal tradition."44 It is true I claim more for comparative law than this, in that I claim both its right and duty to incorporate economic and other social-science theories into its processes. But if we concur in this quoted observation, we can also claim an important leadership role for legal scholarship, and especially for a comparative law, in a form that incorporates but is not merely coexistent with the economic analysis of law. Since we are interested primarily in the European theories available to address the new phenomena we are investigating, we should also pay some attention to the changes in the underlying real situation in Europe and its comparability with the existing American scene. Two aspects of this theme need elucidation. The first aspect is the role of comparative law as a guide to the transition from a national state to a polity, like the European Community, beyond the nationstate; the second is the role of comparative law when one or more of the legal regimes whose norms are the subject of comparison already are large polities that extend beyond the nation-state. The comparativist's role in the transformation process is a more urgent form of instrumentalism, indeed a major exercise in what Roscoe Pound, who also American) rational behavior of a financial intermediary and the observably different behavior of a Japanese intermediary in a similar situation. Again, this is the problem of avoiding the "framing" of the "other's" theoretical construct only by means of one's own. I am reminded of Galtung's ebulliently malicious characterizations of different national-cultural styles of scientific argument; see J. GALTUNG, The Bases of Scientific Discourse (New York 1983). 41 See to this now J. HABERMAS, Faktizität und Geltung (Frankfurt 1992). 42 See BUXBAUM, supra n. 37. While it appeared after this paper was presented, and I thus could not use it to buttress this argument, J. HABERMAS, Faktizität und Geltung, supra n. 41, provides theoretical support for this view of the role of law and legal theory. 43 "Comparative Law as an Academic Subject," 82 L. Q. Rev.· 40 (1966), reprinted in O. Kahn-Freund, Selected Writings, at 275 (1978). 44 "The Uses and Misuses of Comparative Law," 37 Modern L. Rev. 1, 16 (1974), reprinted in O. Kahn-Freund, supra n. 43 at 294.
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spoke of the "modern complexity" of comparative law,45 labeled "social engineering."46 With a timetable, whether inexorable or contingent, dictated by economic forces (relatively inexorable) and political events (relatively contingent), comparativists, as it were, have been drafted, or at least commissioned, to produce results. This effort to create legal norms and even legal systems that adequately honor the legal norms and legal systems being amalgamated into this tertium quid needs sophisticated theoretical foundations in both the "legal-cultural" and the inherently instrumental strand of the comparative law tradition. Those foundations range from relatively abstract social-theoretical frames of reference to socio-political theories and research findings about the cultural expressions of power and money, and to economic theories and findings about the "rules" of economic transactions carried out through specific market structures. Indeed, even comparative experience with the crafting of amalgamations as such are important; let me simply mention the origin of the Uniform Commercial Code in the United States. This last aspect of the comparative experience also and legitimately explains the deserved popularity of comparative studies of European and American federalism among both legal and social scientists.47 The second aspect of moving beyond the nation-state involves not the transformation process but the end result. The European Community as an economic region is larger than the nation-state as an economic region. If size (in its spatial, population, and resource sense) is a determinant of economic and social processes and structures, then a new culture - in all its societal, political, economic, and legal dimensions - may evolve there as a result of the new dimensions of the region-state. These new dimensions may produce new objective realities, and it is a major task of comparative law to participate in the evolution of social as well as legal theories congruent with these new realities. Many American economic and legal theories about efficient markets and their objective impact on market-insulation efforts rest, knowingly or unwittingly, on this brute reality of size, on its determination of economic structures and processes, and on the latters' determination of social and political and economic behavior and its legal expression. Much European theory, similarly, rests on the corresponding European nation-state reality and its determining consequences. 45
POUND, "The Revival of Comparative Law," 5 Tulane L. Rev. 1, 15 (1930). R. POUND, Justice According to Law, at 30 ( New Haven 1951): "Let us think of Jurisprudence for a moment as a science of social engineering, having to do with that part of the whole field which may be achieved by the ordering of human relations through the action of politically organized society." (Reprinted in Interpretations of Legal History, at 152 (P. Smith, ed., New York 1967)). 47 See particularly the EUROPEAN UNIVERSITY INSTITUTE (FLORENCE) SERIES, Integration Through Law, especially 1:1, "Methods, Tools and Institutions: A Political, Legal and Economic Overview" (M. Cappelletti, M. Seccombe & J. Weiler, eds., Berlin 1986). 46
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As the latter nation-states merge into a larger entity, will the relative power of political will over economic force remain the same, or is an increase in size likely to lead to the kind of "American reality" that determined that nation's theories as well as laws? That these questions are no empty exercises in logic the current debates over both American and European responses to the mentioned merger movements and hostile takeover phenomena amply prove.48 A particularly interesting aspect of this reflection on reality and theory is revealed in the tension in Europe today between efforts to liberalize financial markets and their institutional players' freedom of action and countering efforts to insulate European firms from the winds of those markets and those market participants. I have neither the time today nor the competence to describe this situation in any detail, but since we are focusing on the principal methods of societal monitoring of firms' behavior and performance, and on European analogues to the two American markets for stock and for control, we necessarily have to focus also on the relationship of the corporate sector on the one hand and the financial sector on the other. The French state-controlled banking sector, the Japanese keiretsu arrangement of banks and firms, the German Grossbank and Hausbank mechanism - all display an intimate, social web of networks that seems leagues away from the robust and impersonal American style of business-society-state interaction to which at least some practitioners of economic analysis of law grant primacy. The principal test of the durability or at least adaptability of present European forms of monitoring the performance of firms probably will be found in the durability or at least adaptability of those networks to pending financial market liberalization. Therefore, a brief look at the future of that financial sector is essential, for it is that sector's structure, and that sector's part in this enterprisesociety-state relationship, that will be the crucial determinant of the European version of our enterprise future. Not surprisingly, it is on this terrain that proponents of the English or Anglo-American form of modern capitalism, are trying to force through Brussels and the European Community those liberal directives and regulations, like the long-pending Thirteenth Draft Directive on Takeovers,49 and it is on this terrain that the individual member states and their firms are still successfully resisting. The great anomaly is the difference between these nationally bound product and (traditional) service markets, and the global nature of the most important modern service market, the financial market. I have argued that private firm actors and public governmental actors have the will and the power to maintain corporate structures in a mutually desired, typically national economic setting, 48
See, e.g., Öffentliche Übernahmeangebote (K. Kreuzer, ed., Baden-Baden 1992), a volume of comparative studies of this phenomenon based on a session of the Deutsche Gesellschaft für Rechtsvergleichung. 49 See generally and most recently to this story R. LÜTTMANN, Kontrollwechsel in Kapitalgesellschaften (Baden-Baden 1992).
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and that the evidence suggests current success in doing so despite the movement towards the larger European regional market identified with "Europe 1992. "50 But financial markets - and in American terms that includes capital markets if not markets in corporate control - not only are already regional, they are now global. The new fund transfer technologies mock national boundaries, and the new institutional investors have the means and certainly the appetite to graze abroad almost as readily as at home. It hardly seems that a nationally specific form of corporate organization can withstand the levelling power of international financial flows through international financial intermediaries. But the premise on which that anomaly is founded may be wrong, or at least eroding. The national financial firms of Europe, when compared with those of the United States, are much fewer in number, much more oligopolistically organized, and, paradoxically, because of the prevalence of universal banking and its merger of investment and commercial banking functions, much less exposed to so-called outsider competition.51 Indeed, my economist colleague Albert Fishlow has suggested that one of the more important consequences, and therefore perhaps intentions, of the Cook Committee and the Basle Accord's setting of stringent and uniform standards of capitalization for the banking sector world-wide is the maintenance of traditional discipline among banks as they continue or at most carefully adapt their traditional governance relations with the private firm sector. Of course, the jury is still out on the success of this effort to hold the financial sector to the same minimal structural conditions necessary to permit firm-state interaction to function as continue to hold in the corporate sector. Not all major banks are maintaining this discipline, a feature particularly noticeable in the case of some of the smaller East Asian countries' banking sectors. Furthermore, it is doubtful whether the totally different American commercial and investment banking sector, still more or less internally segregated despite the erosion of the Glass-Steagall barrier, will evolve to a similar structural situation. The inevitable merger wave now consolidating the US financial sector has a long way to go before it can possibly fit the minimum conditions for the imposition of that kind of discipline, even assuming our cultural and historical conditions would generate the mindset that would readily entertain such a seachange in habits and practices. And some barely noticed European developments may also militate against the capture of the new financial world by the old. For example, the modern German economy's amazing ability to operate with only a fraction of its firms exposed to modern capital markets - a special feature of its niche economy - may be in jeopardy as the first generation of heirs with much wealth excessively concentrated in their family founders' firms pushes for greater 50
See also FLIGSTEIN & MARA-DRITA, How to Make a Market: Reflections on the Attempt to Create a Single Unitary Market in the European Community (ms. 1992). 51 See T. BAUMS, Verbindungen von Banken und Unternehmen im amerikanischen Wirtschafisrecht (Tübingen 1992).
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liquidity and diversification. But all in all, the possibility certainly exists for European business organizations to weather current liberalization and globalization tendencies, and to maintain the kind of symbiotic state-private sector relationship that marks Albert's "Rhenish capitalism." Finally, we have noted that the single most critical variable in this story is the degree of separation between the directions and rates of change of corporate sectors and of financial sectors. The reason why that is important is not that one type of financial sector would monitor corporations and another would not, but because changes in the financial sector's organizational patterns may disrupt older forms of relationships between corporations and their financial (and monitoring) institutions. It is this last that makes the role of institutional investment in this story so important and so fascinating. As I have pointed out elsewhere, the portfolio ownership of firms by institutional investors as such is not new. What is new is the further transfer of ownership from traditional intermediaries like banks directly to the beneficiaries or ultimate owners of these financial assets, or if not to these ultimate beneficiaries then to other types of intermediaries whose relationships with the corporations whose shares they hold in their portfolios are less symbiotic and less intimate than these traditional relationships.52 From the perspective of this discussion, then, we need to ask whether this major, indeed predominating new form of portfolio investment in equities (and for that matter in debt securities, given their potential use in corporate governance situations) may be a major influence on the corporate sector's current efforts to create a new equilibrium in the relation of firms and of firm management with firm owners and with society. So we come to what I believe is the critical issue: Can we reconcile American and European social-science and legal theories that bear on the inevitable and understandable efforts of governmental and private economic actors to reestablish stability and control over this newly perturbed external environment? My guess, and it is a guess, is that the corporate sector, just as it has triumphed over or at least reached a favorable acccommodation with America's traditional investment and commercial banking sectors, will reach an accomodation with the new institutional investment sector. If this is so, it would support the more political rather than the more economic end of the spectrum of theories we are reviewing here. Our mutual search for theory and for theoretical congruence is compelled by developments in Europe and Asia as well as by developments in the United States, and thus will surely benefit from comparative analyses of these comparative developments. If the closer business-state relationships of European and Asian societies makes them more suitable to the kind of economic structure the new international environment and the new international economy require, 52
BUXBAUM, supra n. 2, at 1.
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then our own search for a new structure, which in any event is tending towards these more symbiotic relationships, is bound to be influenced by that success.
Chapter Two
Some Differences in Corporate Governance in Germany, Japan and America* Mark J. Roe*
I. Abstract Authority at the top of the German and Japanese large firm differs sharply from that at the top of the American large public firm. In America powerful managers sit on top of a hierarchy and face scattered shareholders with limited power. In nations whose politics permitted powerful financial intermediaries, authority at the top neither shifted from owners to managers, as occurred in America, nor shifted from managers to bankers, as is frequently asserted about Germany and Japan. Rather the structure of authority flattened. We do not know enough about the foreign corporate governance systems. We have scant data on whether they are more functional, whether they arose to resolve industrial organization problems, labor relations problems, financing problems, or corporate governance problems, or whether they depend on (or arose out of) government directive or government inaction. Most basically, we do not have a good understanding of what the differences in corporate structure and governance really are. In this article I try to better understand what the differences are.
* Reprinted, in substantially edited form, by permission of The Yale Law Journal Company and Fred B. Rothman & Company from The Yale Law Journal, Vol. 102, Issue 8. ** Theodor Baums, Victor Brudney, Ronald Gilson, Hideki Kanda, Fritz Kubier and J. Mark Ramseyer offered useful comments. Douglas Cardwell, Megumiko Ishida, Marco Geromin, Burkard Gopfert, Steven Lorenz, Hans-Gert Vogel, and Jean-Claude Zerey assembled data and researched and translated German and Japanese materials. The Bradley Foundation supported this research.
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The German and Japanese firms have common elements: 1. Multiple intermediaries wield big blocks of stock; rarely does a single one dominate management. 2. Stockholders are personified in governance meetings. Foreign CEOs relate to stockholders whom the CEOs see as people; the American CEO owes fiduciary duties to an anonymous stock market of distant holders. 3. Structured interaction forces foreign CEOs to deal with large stockholding institutions, which often review managers' results, but usually only intervene in crisis and to pick new managers. 4. The structures help the flow of proprietary and soft information from the managers to the stockholding institutions, mitigating tendencies of a securities market to shorter investment horizons. 5. Both the German and Japanese structures would be quite illegal in America. The existence and persistence of the foreign structures casts great doubt on the usual American evolutionary story, that securities markets are the best and highest form of financial development and ownership thus far, combining liquidity, diversification, and ownership rights in just the right proportion of trade-offs. Germany and Japan are seen to be behind America, but rapidly securitizing to catch up to America 's better developed financial markets. But the persistence of the foreign ownership structures, and the kind of forces threatening them, show that there is more than one evolutionary path, that recent American institutional investor activity is probably the delayed result of America suppressing strong intermediaries, and that pieces of German and Japanese corporate governance are as likely to be America's future as America's securities markets are likely to be theirs.
Π. Introduction Ownership and governance of the large public corporation in Germany and Japan differ markedly from that in America. Here, senior managers hold the reins of power; stock historically has been fragmented, owned by scattered individuals and institutions. American financial intermediaries have not yet projected power into corporate boardrooms; they are usually weak, dispersed, and uninterested. Only recently have institutional stockholders even made efforts in corporate governance. In the Japanese and German large firm, in contrast, senior managers already face active intermediaries wielding the votes of large blocks of stock. Managers and intermediaries must share power, making large firm foreign corporate governance resemble American political governance more than American corporate governance: power is shared and dispersed and
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there are checks, balances, and accountability. This comparison casts doubt on conventional explanations for the BerleMeans corporation. True, to reach economies of scale firms had to tap vast pools of capital, and with shareholders diversifying, scattered ownership shifted power to managers. This is the dominant paradigm but it omits a critical step: Shareholders could have diversified through intermediaries; functions could have further specialized, with intermediaries sharing governance functions with managers. That happened in Germany and Japan, not in America. Earlier I argued that another paradigm better explains the American results: America's politics of financial fragmentation, dominated by federalism, populism and interest group pressures, pulverized American financial institutions, contributing heavily to the rise of the Berle-Means corporation.1 Today, the structure of American intermediaries and their role in corporate governance are in upheaval. Some intermediaries seek new roles. The Department of Treasury had vast plans, which stalled in Congress, to mix banking and commerce in ways alien to American history; the SEC reduced some restrictions on institutions' governance role. Regulators wonder if ties between finance and industry help propel German and Japanese economic performance.2 All this is a discovery of the San Andreas fault in American corporate governance. How we organize our financial institutions deeply determines key elements of large firm corporate governance. But in America, a deep gap separates finance and industry. In this article, I show how in Germany and 1
MARK ROE, "A Political Theory of American Corporate Finance," 91 Colwn. L. Rev. 10 (1991); MARK ROE, "Political and Legal Restraints on Ownership and Control of the Public Companies," 27 J. Fin. Econ. 7 (1990). For related discussions, see BERNARD BLACK, "Shareholder Passivity Reexamined," 89 Mich. L. Rev. 520 (1990); RONALD GILSON & REINIER KRAAKMAN, "Reinventing the Outside Director: An Agenda for Institutional Investors," 43 Stan. L. Rev. 863, 873 (1991); Joseph Grundfest, Subordination of American Capital, 27 J. Fin. Econ. 89 (1990); MICHAEL JENSEN, "Eclipse of the Public Corporation," Harv. Bus. Rev., Sept.-Oct. 1989, at 61, 65; WILLIAM OUCHI, Ttu- M-Form Society, at 82, 89 (1984); LESTER THUROW, The Zero Sum Solution, at 164 (1985). 2 Report of the Subcomm. on Financial Institutions Supervision, Regulation and Insurance, Task Force on the International Competitiveness of U.S. Financial Institutions of the [House] Comm. on Banking, Finance and Urban Affairs, Comm. Print 101-7, 101st Cong., 2d Sess. 7-8, 66, 189-90, 193-94, 286 (1990) ["HOUSE BANK REPORT"] (in "the EC ... the emergence of numerous strategic alliances are creating megafirms capable of offering a full array of financial services, including banking, securities and insurance"; and Japanese "cross-shareholding arrangements [between banks and industry] create real advantages"; "the 'keiretsu' [is] a very effective system designed to maintain Japanese business competitiveness."); CORRIGAN, "The Banking-Commerce Controversy Revisited," Federal Reserve Bank of New York Quarterly Review, Spring 1991, at 1, 11 (congressional testimony).
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Japan such a fault line does not yet separate intermediaries from managers. While finance there is "stronger" than here, no single financial institution can usually control. Several institutions have influence. I speculate why this pattern may be economically stable. Each foreign structure would be illegal here. The Japanese firm's five largest stockholders own a fifth of its stock; five German bankers vote nearly half of the largest firms' stock. Banks there are large compared to the largest firms in their nations. In America, financial institutions are relatively smaller; an American intermediary trying to control 5% or 10% of the largest industrial firm's stock would be akin to a pup trying to grab a lion. The foreign banks have a national scope that would violate America's McFadden Act, accounting for the size disparity. The Bank Holding Company Act is interpreted to require passivity. The foreign banks are, however, not passive. In Germany, banks enter boardrooms by combining votes from stock they own directly, stock in bank-controlled investment companies, and stock they hold as brokers but vote. Were American intermediaries to try to combine banks, brokers, and mutual funds in this way, they would violate the Bank Holding Company Act of 1956, the Glass-Steagall Act, the Investment Company Act of 1940, and the Securities Exchange Act of 1934. If German bankers had to operate under American laws they would run their banks from jail. Americans, inured to bankers as lenders, would expect bank power to come from credit allocation. In both nations bank power did grow out of their control over credit. But in Germany, bank boardroom power no longer depends on controlling credit but on controlling stock; the banks control the German proxy system in ways similar to how American managers control the American proxy system. American intermediaries other than banks could do the same. As in America, politics in Germany and Japan influences corporate structure, but the ways and degrees differ. In Japan, transforming credit-based financial power — which is weakening — to stock-based boardroom power will be hard, because laws left by the post-World War II American occupation preclude transformation, and the resulting interest groups — bankers versus brokers — want to maintain the status quo. To transform themselves, the Japanese must dismantle the American framework. They are beginning to do so, but may fail. In Germany, persistent popular pressure to reduce banker power induces parliamentary proposals to reduce banker power over industrial stock. These pressures have had an effect. In America's political history strong popular pressure and interest group infighting fragmented finance. Germany has strong popular pressure, but weak interest group infighting; Japan has weak popular pressure but bloody interest group infighting. The extent of the foregoing restrictions are parallel: Germany has some (mostly informal, other than codetermination and due to popular pressure) and Japan has more (from the legacy of the American occupation), but neither have the complete set that the United States has. Corporate differences
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arise from variations in political results as much as differing firm problems. Finally I consider normative implications. Is foreign corporate governance a source of competitive advantage? If so, I suspect product market competition in an internationalized economy is the best self-corrective. Whatever is the source of recent success of foreign firms ~ and I suspect corporate governance is not primary ~ competition induces American firms to perform better. True, better corporate governance at the top might speed adaptation. But we have so little data about the foreign firms that we cannot tell which governance feature is key and which is an evolutionary curiosity. In this article I hope to provide a first effort to develop hypotheses about where the important differences might lie, by triangulating the three corporate governance systems. But even now, without rigorous testing, a minimalist preliminary but important point appears: Large firms can function with intermediaries participating in corporate governance. Without good data, there's no reason yet for America to emulate the foreign systems in gross or in detail; but alternatives are plausible and America could experiment with institutions to check managerial agency costs or to reduce short-run strategies due to an atomized securities market. We could not emulate the foreign systems explicitly, even if we wanted to. Any big gains from corporate governance would be for large firms, which would require heavy stock ownership by the largest intermediaries. But America's largest are too small and weak to be useful in the near-term. The foreign systems cannot be a blueprint, because they depend on banks. Second, history counts. Paths once open eventually close off. American institutions would have to fight their way into the boardrooms, both politically and transactionally. But private gains from shared authority are probably modest, making a costly fight not worthwhile. Power-sharing might come through evolution, as it did in Germany and Japan. Managers there prefer institutional white squires to takeovers. But American managers have defeated takeovers for now, and need not concede institutional power. Thus, one weak conclusion and two strong ones emerge. The weak one is normative. Evidence of superiority is scant; we can only say that non-American governance systems are plausible, at least in the foreign environment. The foreign results do not yet tell us we should change; it tells us we could change. The first strong conclusion is that corporate governance in America is quite dissimilar to that in Japan and Germany, where senior managers share power with financiers. In America we can see authority in the large firm as a hierarchy with the CEO at the pinnacle; in Germany and Japan, the authority structure is flatter, with power shared with intermediaries. The second strong conclusion is that American law would prohibit either foreign system here. This comparison poses big problems for prevailing academic theories. The economic model says many corporate structures arise due to economics of scale, wide capital-gathering, and the resulting divergence of managerial goals from
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stockholder goals. Managerial incentive compensation, proxy fights, the conglomerate, takeovers, and a board of independent outsiders are all partial solutions to (or reflections of) managerial agency problems. But if the economic model were universal, it would predict that other nations with similar economies would have similar structures. There is a best way to make steel, and presumably there is a best way to organize large steel firms. But the flatter authority structure abroad poses a challenge. At a minimum, there is more than one way to deal with these economic problems. And, the differences suggest that differing histories, cultures and paths of economic development better explain the differing structures than economic theory alone. The economic model must be down-sized, and thought of as only a special case in an American setting of fragmented intermediaries and powerful managers. This is the article's organization: Part I shows the role of finance in governance in Germany and Japan. Large firms have a few focused intermediaries with the means to affect the firm. In Part II we see how the foreign systems would clash with American law. In Part III we find common elements in the German and Japanese structural pattern and look for theoretical explanations. In Part IV, we reject the view that Germany and Japan are "behind" us and are evolving without political pressure to the American system. They too are subject to political influences on corporate governance. And as many trends here point to diluted forms of their systems as our future as trends there point to our system as their future. In Part V, we look at what can be done here. "Unleashing" American banks would not today have a positive effect. For banks, America's options are limited by its path-dependent history, because American banks are now ill-equipped for governance tasks. Weak banks and strong stockholding pensions make quick transformation impossible. Quick change in large firm governance will not come from reforming American banking regulation.
ΙΠ. German and Japanese Financial Influence Through Stockholding German and Japanese large firms have voting blocks of 20% to 40% of the firms' stock; in America the largest five owners rarely control as much as 5 % of a large firm's stock. Despite large legal differences between Germany and Japan, firms in both nations have an ownership structure of shared power. No institution or person has complete control. In contrast, the American governance structure focuses power in management, and especially in the CEO. A. Germany In Germany, a supervisory board appoints a managerial board and reviews the firm's and managers' performance, typically two to four times a year. The
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supervisory board has labor representatives who take half of the supervisory seats; stockholders elect the other half. The typical large German firm's stock is in big voting blocks held by three or so banks. Bankers, or their nominees, sit on the boards, influencing policy and personnel with authority that, while hardly dictatorial, is unmatched in America. The CEO reports to the supervisory board, to which the CEO may not belong, much less dominate.3 1. Structure, Source, and Mass The ten largest German companies have 16 institutional voting blocks of 10% or more of the company's stock; the American top 10 have none. The top three voting blocks have half of most of the top companies' stock.4 The American equivalent is, not just under half, but only 5%. 5 German voting blocks are much stronger than the American. The German bankers voting power comes from directly owning stock, from controlling investment companies, and from voting custodial stock owned by the bank's brokerage customers and deposited with the bank. Each — direct ownership and voting custodial stock — has been impermissible in America. These votes get them into the supervisory boardrooms of 96 of the 100 largest German corporations; in 14 cases the banker chaired the board.6 Whether or not lending is central, stock is. German banks' direct ownership is not big, but they deploy it in concentrated blocks, as Table II in the Appendix shows: In the 100 largest German industrial enterprises, the banks have nineteen positions greater than 5 %. Bank-sponsored investment companies put another one or two percent of stock and big blocks of bonds under the control of the large banks.7 Brokerage stock yields the largest pool of votes. Individuals leave stock with 3
ERNST GESSLER, WOLFGANG HEFERMEHL, ULRICH ECKHARDT & BRUNO KROPFF, Aktiengesetz, Vol. II, 138-39 (1974). "CEO" overstates the authority of the managerial board's (Vorstand's) leader, or "speaker", who is really a first among equals. All on the management board report to the supervisory bord, legally and, I understand, factually. 4 See Appendix, Table I. 5 See Appendix, Tables XIIa-d. 6 Hauptgutachten der MONOPOLKOMMISSION, in 11 Deutscher Bundestag, Drucksache, 7582, at 203-06, 216 (July 16, 1990) (Parliamentary investigative report); see THEODOR BAUMS, Banks and Corporate Control, at 29-30 (1991) (Berkeley Law and Economics Working Paper No. 91-1). A management board handles internal day-to-day decisions; the supervisory board names the management board and approves key strategic decisions. 7 ARNO GOTTSCHALK, "Der Stimmrechtseinfluß der Banken in den Aktionärsversammlungen von Großunternehmen," WSI-Mitteilungen, May 1988, at 294.
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their bank, which then votes it, unless the individual gives the bank contrary instructions. A single bank's custodial holdings often exceed 10% of a single large company.8 The large German banks are proportionately much bigger than American banks. The largest automaker's assets in both nations are 3% of GNP. The largest three American banks have assets equal to 7% of American GNP, the German have assets equal to 36% of its GNP, making them five times "stronger" than American banks.9 2. The Scope and Scale of the German Banks To an American observer the big difference with American structures is the banks' voting blocks.10 In 42 of the 100 largest German companies, three banks' combined average voting strength is 45%.n No small American financial group has the size, scope, votes and legal power that the large German banks wield. For most firms, no single bank controls the industrial firm. Together three banks can dominate. (Deutsche Bank is the biggest. But Commerzbank and Dresdner together have about the same votes.) 3. Control over the Proxy Machinery In Germany, management does not control the proxy machinery. German managers must filter proxy solicitations through their bankers. Indeed, it's doubtful that German managers can lawfully solicit proxies,12 a solicitation that managers dominate in America. The bankers vote directly-held stock as they think fit and recommend to brokerage customers how to vote. Rational apathy would lead most shareholders to ignore the solicitation, but their stock would not be silent. The bank would vote it, although not always with shareholders' 8
See generally DETLEV VAGTS, "Reforming the "Modern" Corporation: Perspectives from the German," 80 Harv. L. Rev. 23, 55-58 (1966); HERMANN KALLFASS, "The American Corporation and the Institutional Investor: Are There Lessons From Abroad?," 3 Colum. Bus. L. Rev. 775, 782-83 (1988). 9 See Appendix, Tables Ilia and IV. 10 True, German bankers sit on boards where they lack votes, as do American bankers. The difference with American structures is not there, but in the many firms where the German banker votes 15% or more of the stock of a firm whose board a bank employee sits on. American institutions that controlled such big blocks would also sit on the Board and be taken seriously by senior managers. 11 See Appendix, Table I. 12 ALFRED CONARD, "The Supervision of Corporate Management: A Comparison of Developments in European Community and United States Law," 82 Mich. L. Rev. 1448, 1470 (1984).
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interests in mind. Obviously, managers will deal with the bankers before soliciting proxies. Through this combination of concentrated stock deposits, as shown in Appendix I, and a proxy system that gives the banks the first-mover advantage, banks can elect shareholders' representatives to the supervisory board. Through the formalities of the proxy system and the realities of concentrated deposits of stock with the largest banks, these banks and their nominees have a very large voice on the supervisory board. German firms do not rely on a single stockvoting bank for credit, but use multiple lenders. Bank loans helped create the close relationship, but then faded.13 Banks control the proxy system, not the sources of lending. Concentrated stock deposits with banks, stockholders' rational apathy, and banks' noticeable but not overwhelming directly-owned stock all combine to yield the bank the voting power to elect the stockholding side of many supervisory boards. It would, however, be easy to exaggerate the power of the German supervisory board. First, translation of the German board's name — Aufsichtsrat ~ as supervisory board, while linguistically correct, does not quite reflect its authority, which is less than that of a supervisor, a position one would ordinarily suspect would yield the authority to supervise. In fact, a better translation might be Advisory Board, with advisory used as more than just a gratuitious consultant, but used in the sense of the U.S. Senate's power to advise and consent to treaties and appointments. That advisory power is usually to be used to ratify, but ratification means consultation and influence, although not supervisory control. The supervisory board, for example, cannot remove the managerial board, which has a five-year term, at will. Second, the managerial board can co-opt and name some members of the supervisory board, in a manner similar to, but weaker than, the American CEO's ability to name the board by suggesting names to the supervisory board when a vacancy opens.l4 Third, codetermination induces shareholder representatives to make the supervisory board supervise less than it might otherwise be. Banker-shareholders prefer that the supervisory board not become the central governance organ of the firm, because doing so would enhance the authority of labor's representatives. The banker-shareholders prefer to take their chances, most of the time, with the managerial board. True, if push came to shove, bankershareholders could defeat labor on the supervisory board due to two corporate features: the chair of the supervisory board always comes from the shareholding side and can cast a deciding vote in a tie, and shareholders can, with a supermajority vote, send directions directly to the managerial board, by-passing the
13
See BAUMS, supra n. 6, at 9. PAUL WINDOLF, "Codetermination and the market for corporate control in the European Community," 22 Econ. and Society 137, 140-41 (1993). 14
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supervisory board.15 Nevertheless, the total effect gives the shareholding side influence without control. Managers still have the upper hand, but the tilt is not easily as pro-managerial as it has historically been in the United States. B. Japan Japanese firms typically have an inside board, formally elected by stockholders, but usually appointed by the CEO, perhaps with the advise and consent of large stockholders. Stockholders are usually not on boards unless a crisis arises. Corporate governance, if it occurs in ways similar to that which occurs here, occurs either in crisis or in regular meetings between senior managers and large stockholders. 1. The keiretsu and the Presidents' Council Large Japanese firms belong to a keiretsu, a group of firms and intermediaries that cross-own one another's stock. A "main" bank owns 5% of the common stock of the keiretsu's industrial firms, which in turn own some stock of the "main" bank. Typically four other banks and insurers own 4-5% blocks, creating a latent coalition with 20% of the stock. Table IX in the Appendix shows a persistent pattern for all large firms for the past 25 years: In Japan, five holders own 20% of the stock of the largest firms; in America the five largest holders rarely own as much as 5 %. American owners of a big block would be on the board. The Japanese owners are not; although the few outsiders on the board are from the blockholders, Japanese boards draw from insiders. Yet leaders of the intermediaries and industrials do interact, in monthly keiretsu "Presidents' Council" meetings, which, although not formal governance structures, resemble a second board, analogous to the German supervisory board. Votes are not taken; no single firm can direct another. Presidents feel constrained from ignoring a consensus opinion of the council; council members collectively control much of the company's stock. The bank may be a first among equals, potentially speaking with the authority of a 20% block of stock, or if the firm's proposed projects require bank financing. Council members are consulted when a CEO chooses his or her successor.16 The authority distribution differs from that in America, where senior managers are central and intermediaries rarely own big blocks of 15 16
W.,at 143.
W. CARL KESTER, Japanese Takeovers: The Global Conquest for Corporate Control, at 69 (1991); CHARLES A. ANDERSON, "Corporate Directors in Japan," Harv. Bus. Rev., May-June 1984, at 30, 32 (insider board does not choose a new CEO; the incumbent consults with the big institutional owners of the firm's stock and debt).
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stock.17 Our knowledge about monthly Presidents' Council meetings is vague and I hesitate from calling what follows fact as opposed to "model", based on some reported facts. Minutes are not kept and leaked; action agendas are not printed in the press. Some reports say business is discussed. Others say the meetings are purely social,18 but pave the way for doing business later. I'll take the President's Council to be both the meetings and the information and decisionmaking channels the meetings open up. No one can dictate, and no one can incur the ire of a coalition of the others. Monitoring, if it occurs, is a collegial monitoring of equals. "These meetings are not organs of decision making in the sense that a majority vote would carry the day, but they are manifestations of the very dynamic process of consensus. Views are exchanged, opinions heard, and actions reciprocally adjusted, more on an ad hoc basis than in terms of binding policy.19 It may be wrong to project American goals onto the Japanese structure. We still do not know what the Japanese firm is maximizing. Quite possibly, they maximize size, not profits.20 This is consistent with the nature of who these cross-owning stockholders are: About one-third of the cross-holdings are not held by financial institutions, but are held by industrial firms, often in a supplier-customer relationship. Plausibly, Presidents' Council meetings are part of a governance system that tends to increase sales, size, growth and employment, or resolve supplier-customer relational problems, with profits — the prime American stockholders' goal — only secondary. 2. Size and Scope of Japanese Banks The largest banks in Japan, a country with a GNP about 60% that of America, are three times as large as America's. Yet their largest industrial firms are 17
See C. BRANCATO, P. GAUGHAN, M. DEBLOIS & K. RODGERS, Institutional Investors and Capital Markets: 1991 Update, at 18 (1991) (mimeo of Columbia Institutional Investor Project, from the Center for Law and Economic Studies at Columbia Law School). 18 MICHAEL L. GERLACH, "Twilight of the Keiretsu? - A Critical Assessment," 18 J. Japanese Stud. 79, 81 (1991), citing RYUTARO KOMIYA, The Japanese Economy: Trade, Industry and Government (1990). 19 ROBERT BALLON & IWAO ΤΟΜΓΓΑ, The Financial Behavior of Japanese Corporations, at 68 (1988) (Kodansha International); MICHAEL GERLACH, Alliance Capitalism (1992); ANDERSON, supra n. 16 (corporate governance "take[s] place behind the scenes between the senior corporate official and the major institutional shareowners"). 20 ALAN S. BLINDER, "Profit Maximization and International Competition," in 5 Finance and the International Economy - The AMEX Bank Review Prize Essays, at 37 (Richard O'Brien ed. 1991).
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smaller than America's.21 American intermediaries are too weak to take a large block of stock in GM or Exxon or IBM. In Japan, intermediaries' mass makes it plausible. The largest financial is eight times the size of the largest industrial; in America the largest financial is no larger than the largest industrial. Ownership is concentrated in Japan. The 20% ownership by the five large shareholders in the 25 largest Japanese firms is more concentrated than that here, where there are no 20% blocks — and few 5% as well — in the 25 largest American firms. Moreover, as one increases the American sample size to include smaller firms, which are easier for institutions to take bigger blocks of, the stock ownership still fails to exceed the concentration in the very largest firms.22 In GM, Exxon, and IBM, the largest 25 shareholders vote less stock than the largest five stockholders in Japan's largest firms.23 3. Political Parallels Japanese cross-ownership arose partly to thwart takeovers. Its effects are partially unintended. If you own 5% of the company in which I am CEO, and I own 5% of your company, we each have a stake justifying interest in mutual well-being, giving each an incentive to be informed about one another's problems, to protect our stock investments and customer-supplier relationship. Since five others have similar investments, questioning a project or results will be paid attention to. A group of five stockholders with 20% of another's stock probably has the firm's interests at heart and, although the group might not overrule a decision, it has the potential to do so. This has political parallels in the structure of American democracy. James Madison designed a constitution to disperse power; individuals in each different 21
These relationships are outlined in Tables IV and VII of the Appendix. Compare Appendix, Tables VIII and IX with P. CLYDE, The Institutional Shareholder as a Monitor of Management, (April 1991) (Table II) (unpublished manuscript) (for panel of 376 American companies, the top five financial institutions owned only 18.4% of the stock of a sample of 511 companies); DEMSETZ & LEHN, "The Structure of Corporate Ownership: Causes and Consequences," 93 /. Pol. Econ. 1155 (1985) (for only 37% of 511 large American companies, the top five stockholders control 20% of the stock). As we get to smaller firms, one would expect more concentrated ownership, because investors can take a big percentage of stock and still diversify. Yet the bigger Japanese firms are more concentrated than all of America's Fortune 500. 23 Tables VIII and IX of the Appendix show a five-bank ownership level in Japan of about 20%; Tables XIIa-d show a twenty-five institutional investor ownership level of 11.47% (Exxon), 13.54% (IBM), 12.89% (GE) and 19.39% (GM). These numbers for Exxon and GM are typical of the largest American industrials. See BRANCATO, supra n. 17. 22
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branch of government would be elected or appointed through different means and occupy their office for different time spans. With power dispersed through the branches, a stable, nondictatorial government should arise. Similarly, Japanese firms do not seem to have authority solely in the hands of the CEO. Internally, the Japanese CEO can dominate a board made up by managers.24 But outside financiers and suppliers, not dependent on the CEO, have historically shared authority with those inside the firm.25 But, contrary to common misconceptions that the banks are dominant and can and do easily dictate to the managers,26 the structure of authority is flat. Dispersal of power can lead to paralysis, rent-seeking, or mutual selfprotection. This criticism of Madison's system points to potential weaknesses in the foreign systems. Perhaps they function adequately so far because the dispersal is not so severe as to induce paralysis; the "power" centers are management, labor (through understandings in Japan, codetermination in Germany), stockholding institutions, and sometimes stockholding suppliers, not hundreds of congressional committees, dozens of assistant cabinet secretaries and thousands of interest groups. The Madisonian framework flattened political power here, and also fragmented it. The foreign corporate systems flattened it without fragmenting it. In Part III, I speculate how flattening without fragmentation might enhance corporate performance. But speculation is not proof: the underside of the political parallel is that we may have a difference in authority distribution that has nothing to do with differences in performance. 4. Influence, not Control What mechanisms yield stockholder influence in Japan? Because bank control over credit has been overwhelming, we do not know if inquiries in the President's Council from stockholders have an effect, because the banks are 24
KANABAYASHI, "Japanese Scandals Underline the Lack of Enough Corporate Checks, Balances," Wall St. J., Jan. 6, 1992, at A9. 25 In America, reform efforts focus on structuring the board of directors to have outsiders with incentives to monitor. See VICTOR BRUDNEY, "The Independent Director - Heavenly City or Potemkin Village?," 95 Harv. L. Rev. 597 (1982); GILSON & KRAAKMAN, supra n. 1. Arguably the Japanese Presidents' Council (but not the internal board) helps achieve this American goal. 26 This hierarchical image was more real when Japanese firms were expanding and depended on the bank as lender for increasing infusions of capital, which the bank monitored carefully. This form of bank power eroded, but did not disappear, in the 1980's and according to some may strengthen during economic adversity. The erosion was due to successful firms generating enough cash internally so as not to need the bank as lender of new funds. See W. CARL KESTER, Japanese Takeovers: The Global Market for Corporate Control, at 197 (1991). However, the bank's role as stockholder continued.
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both creditor and stockholder. No one needs to know the precise source of authority. Presumably the bank's leverage as creditor has been enough: the banks were expected to finance new projects and could kill them by refusing to. They did not have to assert power as stockholders. Individual stockholders are probably powerless; institutional stockholders probably are not. Credit institutions are major stockholders; they had little reason to assert stock-based influence; cutting off credit was enough. But a group with 20% of the stock could also tell managers that they want board seats. Managers bend. New data shows that Japanese bankers become board directors when the firm's performance weakens.27 Moreover, large stockholders need not always seek board seats in conflict to have influence. Formality is consistent: shareholders may remove directors without cause at any time.28 Maybe shareholders raised their voice and managers desisted; nuclear deterrence shaped American and Soviet behavior, without any missile launching. Japanese greenmail — 22 in the 1980's — and a successful hostile takeover,29 suggests some power does come from voting stock. But to confirm I would like to see more instances of directorial deterrence, attempted or successful. Second, stockholding institutions unhappy with managers could threaten to sell their stock and leave managers at risk of takeover; this is the means of influence Japanese commentators see.30 Influence via sales threats fits with the cross-holdings origin as partial antitakeover mechanisms. Unhappy large institutions have threatened to sell stock if managers did not change policy.31 Recent financial studies see a big role for stockholder power and institutional monitoring in Japan. One divides Japanese firms into two groups: one, with high financial institution stock ownership, the other with high corporate ownership. The average profits of each group are the same, as one would expect in a competitive economy. But the shape of the profit distributions differ radically: the finance-dominated firms have the lower (and upper) ends of the 27
STEVEN N. KAPLAN & BERNADETTE ALCAMO MINTON, "Outside" Intervention in Japanese Companies: Its Determinants and Its Implications for Managers (Working Paper Sept. 1992). A scandal in a large department store chain implicated the CEO, who uncharacteristically refused to resign. The Mitsui Presidents' Council decided he had to go; the banker on the store's board engineered the coup de grace. GERLACH, supra n. 17, at 150-52. Moreover, large stockholders need not always get board seats in conflict to have influence. 28 AOKI, supra n. 18 at 10 (citing Japanese Commercial Code, Article 278). 29 KESTER, supra n. 26, at 17, 247-48. 30 KUNIO ITO, "M&A to Kabushiki Mochiai no Honshitsu," Kinyu Journal, Dec. 1989, at 11. 31 Insurance companies have in recent years been unhappy with dividend payouts and have threatened to dump stock of companies that failed to increase their payout. The observed threats are the tip of a private iceberg ~ of uncertain size — of private influence.
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profit tail cut-off, but the corporate cross-holding firms do not. The difference is explained by financial institutions intervening when their firms have bad results.32 5. Other keiretsu Features Cross-ownership yields partial vertical integration; suppliers and customers get information and constrain one another's opportunism.33 Such hybrids between market and hierarchy may be stronger than market or hierarchy alone. In this light, the bank is just another supplier — but of capital, not goods or services ~ sitting in governance meetings and cross-owning part of the others. Financial institutions have two-thirds of the cross-holdings; but industrials have one-third. Some of those at the flattened top are bound together as colleagues in production. Institutional voice is embedded in multiple financial and industrial cross-holdings. Isolating power sharing with financial stockholders from other features is not easy. We can tell with certainty that keiretsu ownership structure and distribution of power differ radically from ownership and power distribution in the American firm. This supports a claim that structure and authority in the American firm were influenced, perhaps determined, by the politics of financial fragmentation, as much as by natural economic evolution. We have much more trouble assessing the Japanese structure's normative significance. First, the multiple relationships — lender and stockholder, supplier and stockholder — could reinforce tendencies to maximize not profits but growth. Second, the supplier-stockholder relations could be a form of industrial organization, designed to facilitate relational investing in production, not profit maximization directly. Third, labor policies may determine success; keiretsu structure might be secondary or irrelevant. Fourth, success may arise from noncorporate features — education levels, worker motivation, good government policies ~ making corporate structure's contribution impossible to separate and evaluate.
32
FRANK LICHTENBERG & GEORGE PUSHNER, Ownership Structure and Corporate Performance in Japan (Columbia University unpublished manuscript) (November 6, 1991). Studies will have to show why explanations alternative to monitoring should be rejected: the banks choose low risk investments ex ante, the banks "insure" their companies by forgiving loans when bad results occur, the financedominated firms are at the top of the keiretsu and pass their problems off onto the corporate-dominated firms (which are their quasi-subsidiaries) when bad times hit. See also STEPHEN D. PROWSE, "The Structure of Corporate Ownership in Japan," 47 J. Fin. 1121 (1992) (stockholder power). 33 I explore this with Ron Gilson in RONALD J. GILSON & MARK J. ROE, "Understanding the Japanese Keiretsu: Overlaps Between Corporate Governance and Industrial Organization," 102 YaleL.J. 871 (1993).
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C. Summary Below we begin to assess the normative significance of the foreign structures. But although we do not yet know exactly how it all works and the data is thin, we must not miss the main point here, that they differ greatly from what now dominates in America. German and Japanese senior managers share power with financial intermediaries, which own and vote large blocks of stock and are active in governance, formally through boards in Germany, and informally through Presidents' Councils in Japan. Firms there have flat authority structures at the top. Their survival for several decades suggests that modern agency theory must be reinterpreted as a special American case; firms can prosper with different structures at the top. This foreign flat distribution of authority is uncommon here. It is also, as we next see, illegal.
IV. American Banking Regulation A. American Law and Structure Law has historically kept American banks small and weak. In Germany eight banks have half the banking assets; in Japan, thirteen have half. To reach half of America's banking assets, requires the assets of the largest 100 American banks.34 Large American banks have a scale 1/5 that in Germany and Japan. Historically they have been banned from entering commerce, operating nationally, affiliating with investment banks, equity mutual funds, or insurers, or coordinating stockholdings with these other intermediaries. Some nations have some restrictions; only America has had them all. The National Bank Act of 1863 confined national banks to a single location; the McFadden Act of 1927 allowed them to branch as permitted under state law, but no more. After World War II, bank chains avoided McFadden through multi-state holding companies. The Bank Holding Company Act of 1956 restricts bank chaining. Today, regional banking pacts allow some interstate branching and the Treasury proposes nation-wide branching,35 a feature common in other nations, including Japan and Germany. America still lacks a true national banking system. 34
HOUSE BANKING REPORT, supra n. 2, at 93, 95. (The report has just German commercial banks in the denominator, not German building societies, which like American savings and loan associations have large aggregate assets and are individually small and fragmented.) Do the bank numbers merely reflect that Germany and Japan have weaker securities markets, thereby leading banks to hold financial assets that individuals and other intermediaries would hold in America? Only partly. See Appendix, Tables III and V. 35 Treasury Proposal, supra n. 2.
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American banks face product limits. Glass-Steagall has denied them a securities business, tight affiliation with an investment bank or mutual fund, and ownership of stocks.36 The Bank Holding Company Act prohibits affiliation with insurers and fine-tuned Glass-Steagall, prohibiting bank affiliation with a nonbank, other than passive ownership of up to 5% of a nonbank's stock.37 Geographic, product, and activity restrictions account for American banks' smaller size and power. Two dominant themes explain these laws: American public opinion, which mistrusted private large accumulations of power, and interest group politics. Small country banks wanted to shackle large ones. Allied with farmers and small business, and armed with a middle-brow ideology that securities speculation drew off credit from real business activity, small banks got Congress to ban banks from the securities business.38 The small banks got deposit insurance to prevent deposit run-offs from them to larger banks. Investment bankers later sought to thwart commercial bankers' effort to enter the securities' business.39 Public interest rationales were invoked, but cannot explain the results fully. Foreign banks have done well without Glass-Steagall (Germany, for example), without branching limits (most of the world), and without America's deep deposit insurance (until recently, Germany and Japan had none; even now it is narrower). These are the obstacles that German and Japanese banks would face. Neither foreign banking system could survive under American law.
36
To be sure, some of these American restrictions are slowly eroding, particularly those that confine banks, geographically and to the narrow business of commercial banking. The historical restrictions still have big effects, because it will take decades for banks to evolve out of their prior restraints. 37 The 1956 Act kept multi-bank holding companies out of nonbanking businesses. Later amendments apply to single bank holding companies. 38 DONALD LANGEVOORT, "Statutory Obsolescence and the Judicial Process: The Revisionist Role of the Courts in Federal Banking Regulation," 85 Mich. L. Rev. 672, 694 (1987). Other interest groups could have been in play. See JONATHAN MACEY, "Special Interest Group Legislation and the Judicial Function: The Dilemma of Glass-Steagall," 33 Emory. L.J. 1 (1984); FERGUSON, "From Normalcy to New Deal: Industrial Structure, Party Competition, and American Public Policy in the Great Depression," 38 Int'l Org. 41, 70-72 (1984). Some money center banks wanted a securities business; the ban binds them in ways that it didn't bind small country banks. At the moment the Glass-Steagall Act was passed, the money center banks had limited interest in the then-profitless securities business. They were willing to concede the small banks a Glass-Steagall separation in hope of heading of the small banks' deposit insurance goal. 39 Cf. JONATHAN MACEY, supra n. 34; Investment Co. Institute v. Camp, 401 U.S. 617 (1971); Securities Industry Ass'n v. Federal Reserve Board, 807 F.2d 1052 (1986).
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B. German Universal Banks in the United States? Five German banks often vote half of a large firm's stock and sit on its board. They get these votes from directly-held stock, brokerage stock, and stock in affiliated mutual funds. The German banks would smash into nearly every American financial regulation. 1. Size McFadden's restrictions on interstate banking would splinter them. Unlike American banks, they have a national scope and are bigger than the largest German industrial firms. Nor should one mistakenly focus only on bank direct stock ownership of stock, and certainly not on average German bank ownership of stock; for the large industrial firms, the banks take big blocks, or nothing at all. Eighteen positions in the top 100 German firms exceed the 5% permitted to passive American banks under Glass-Steagall and the Bank Holding Company Act. 2. Scope German banks control the proxy system. The largest are also the largest German brokerage houses, and they vote the stock they hold in "street name." Unlike American banks, the German banks can also be brokers. Unlike American brokers, who cannot vote their customers' stock on anything important,40 the German banks can vote their customers' stock on anything at all.41 And they do.42 German banks advise equity mutual funds, and vote that stock as well.43 Under the Glass-Steagall Act, an American bank could not control open-end equity mutual funds.44 Even if it could, under the Investment Company Act, the bank could not combine the mutual fund's stock with the bank's and broker's to assert influence.45 40
New York Stock Exchange, Listed Company Manual 1402.06(D) (1990), analyzed in BERNARD BLACK, supra n. 1, at 520, 560-61 (1990), and CONARD, supra n. 1, at 1469-70. 41 German AktG [Corporations Code], § 135(2) (authorizing revocable general proxy to bank). 42 GOTTSCHALK, supra n. 7; "Sprachlose Eigentümer, Aktionäre nehmen viel zu selten ihre Rechte als Inhaber von Unternehmen wahr," Die Zeit, June 7, 1991. 43 W. 44 Investment Company Institute v. Camp, 401 U.S. 617 (1971); 12 C.F.R. § 225.25(b)(4) (1991). Open-end investment companies allow shareholders to redeem their shares; they are the most common type of investment company. Banks are now interpreting court decisions as allowing them to sponsor open-end equity funds. 45 17 C.F.R. § 270.17d-l (1991); MARK ROE, "Political Elements in the Creation
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The German banks are not passive. Banker-stockholders are in the boardrooms of German industry, where they expect to be active and be heard. Under the Bank Holding Company Act, such banker activity would be illegal.46 American banks cannot combine the little stockholding authority they do have. American banks do run trust accounts. If the trust made concentrated stock investments and combined trust votes with a 5% holding company position, they might have enough combined votes to assert boardroom influence. But if the trust fund gave a proxy to the holding company, the holding company would impermissibly "control" voting stock.47 If the holding company gave its proxy to the bank, the bank would violate Glass-Steagall.48 Even bank trusts asserting authority would face problems. Practitioners warned banks in the I960's not to use trust fund stock to build a control block.49 Congress held hearings, castigating banker power through the mere ownership of lots of stock, threatening banks not to use their stock to assert influence.50 Moreover, trust law induces even otherwise unshackled trustees to hyperfragment their portfolios.51 In sum, German bankers are also brokers, a violation of Glass-Steagall. They vote brokerage stock on everything, a violation of American stock exchange rules. They sponsor mutual funds, a violation of Glass-Steagall, and use the mutual fund votes in ways that would violate the Investment Company Act. They operate nationally, a violation of McFadden. They take big blocks of stock, a violation of the BHC Act. And they affiliate with insurers, another violation of the BHC Act. German bankers, if forced to operate under American law would have to operate from jail. of a Mutual Fund Industry," 139 U. Pa. L. Rev. 1469 (1991). German portfolio regulation is somewhat similar to the American, with a 10% ceiling on shares of a portfolio firm. Gesetz über Kapitalanlagegesellschaften, § 8(a)(3) (1986). 46 4 F.R.R.S. 4-338.2 (Jan. 22, 1986); 12 C.F.R. § 225.137 (1990). 47 Section 4(c) of the BHC Act. 48 Conscious parallelism might work. But realistic exertions of power would require coordinated voting, which until recently would have met regulatory hostility. Similarly, a bank with a "revocable" proxy could argue, perhaps convincingly, that it did not "control" the stock in questions, because the proxy could be revoked at will. 49 RAYMOND A. ENSTAM & HARRY P. KAMEN, "Control and the institutional investor," Bus. Law. 289, 291 n. 14 (1968); A.A. SOMMER, JR., Who's in Control?, 21 Bus. Law. 559, 570 (1960). 50 Staff of Subcomm. on Domestic Finance, House Comm. on Banking and Commerce, 89th Cong. 2d Sess. Bank Stock Ownership and Control 10 (Comm. Print 1966). 51 See MARK ROE, Institutional Fiduciaries in the Boardroom, in Institutional Investing, at 292 (Arnold Sametz and James Bicksler, eds., 1991); MARK J. ROE, The Modern Corporation and Private Pensions (Colum. L. Sch. Working Paper Sept. 1992); BLACK, supra n. 1; JEFFREY GORDON, "The Puzzling Persistence of the Constrained Prudent Man Rule," N.Y.U. L. Rev. 52, 96-98 (1987).
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C. Main Banks in the United States? Japanese bank and insurer groups hold 20% of large firms; a banker meets monthly with industrial firms at the "President's Council" where, according to some, they all reach consensus on operations and direction. Main banks keep their distance from day-to-day detail, but, it is said, discuss the big picture and intervene in crisis. Could the main bank system work under American law, as some commentators assert, because Japan has Glass-Steagall and prohibits banks from 5%+ ownership? Can American bank holding companies do what they want, as long as they keep stock ownership under 5%?52 1. Stunted Size and Passivity Promulgations American main banks would suffer from the "background" fact that geographic and product limits make them puny (compared to Japanese banks). A look at Table IVb in the Appendix shows the assets of the ten largest Japanese banks as over $3 billion; the ten largest American banks do not reach $1 billion, in an economy larger than the Japanese. No American bank has the financial muscle to take 5% of GM or make huge loans to GM without heavy syndication; grabbing a big piece of GM's capitalization would subject its capital and assets to untoward risks; a much bigger Japanese bank could take 5% of Toyota without the same risks.53 This law-induced size disparity is key.54 And the Bank Holding Company Act requires banker passivity in wielding stock, beginning with a flat prohibition: Except as otherwise provided in this chapter, no bank holding company shall (1) after May 9, 1956, acquire direct or indirect ownership or control of any voting share of any company which is not a bank.55 The law prohibits not just control of a firm, but control of any voting stock. It deters taking proxies, voting trusts, parking, and owning through nonbank subsidiaries. Everything, anywhere. If Citicorp accepts an "active" proxy to 52
JOHN C. COFFEE, "Liquidity Versus Control: The Institutional Investor as Corporate Monitor," 91 Colum. L. Rev. 1277 (1991). Coffee in particular stresses that the common 5% limit on ownership indicates the relative unimportance of law here. 53 See Appendix, Table Vllb. 54 Moreover, America's largest firms are larger than foreign firms. American antitrust and financial structures encouraged growth in size. The current large firms in America, Germany and Japan grew out of the firms dominant in each nation in the early part of this century. Then, only America could foster industrial size with a continent-wide economy. 55 Bank Holding Company Act of 1956, § 4(a), 15 U.S.C. §1843(a) (1988) (emphasis supplied). To be precise, the American bank cannot own any stock; what little can be done can only occur at the holding company level. This probably raises the cost of some action, but I assume not by a lot.
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vote a share of GM stock, it violates Section 4(a). Then the Act excepts "shares of any company which do not include more than 5 per centum of the outstanding voting shares of such company[.]"56 A bank owning 5% and taking proxies for another 15% would "acquire indirect control of voting share[s] of any company which is not a bank" over the 5% exemption and violate the Act. Moreover, regulators say the Act requires bank passivity with the stock they own. Imagine five banks and insurers coordinating through a main bank, which takes the others' 5% proxies and votes them to get seats on the industrial firm's board.57 A group of American bank holding companies sought Federal Reserve approval of ownership in a nonbanking company, with the BHC's actively owning 5% each. But, the Fed said: [Investments made in reliance on § 4(c)(6) [the 5% permission] must be essentially passive. [Section] 4(c)(6) is not an unqualified grant of permission for a BHC to acquire or retain a 5% voting interest in any company. It is the Board's view that the prohibition against BHC's engaging in nonbanking activities extends to joint ventures or concerted action by a group of BHCs in a nonbanking activity as entrepreneurs.58 Congress did not with the 5 % rule unleash banks to do whatever they want with the stock, but allowed a holding that usually has low influence. When 5% ownership yields control or influence, the Board prohibits it,59 deterring an American "main bank" system. (Indeed, for a time the BHC Act reached the foreign operations of a foreign bank operating here, even if their American operations had no connections with American commerce. This called into question Japanese keiretsu operations in Japan. Although the Fed never enforced this extraterritorial reach of the BHC Act,60 saying it was meant to deal with 56
Bank Holding Company Act of 1956, § 4(c)(6), 15 U.S.C. §1843(c)(6) (1988). The Japanese system is more complex. Influence is informal, through "Presidents' Council", where the banks are active, but the role of their stockholding unclear. 58 4 F.R.R.S. 4-338.2 (Jan. 22, 1986). See also 12 C.F.R. §225.137 (1990) ("The Board believes that section 4(c)(6) should properly be interpreted as creating an exemption from the general prohibitions . . . on ownership of stock . . . . only for passive investments amounting to not more than 5 percent. . . ."); PAULINE HELLER, Federal Bank Holding Company Law § 4.03[2][a], at 4-60.9 (1992). 59 Because the statute does not explicitly require passivity for the 5% blockholder and does not explicitly cover the informal relationships in Japan, where the formal proxies aren't given, a reading of the words of the statute is ambiguous. Scalia might interpret the statute differently than the Fed. In the Fed's interpretation, if the main bank isn't passive, it violates the Act. 60 In re The Dai-Ichi Kangyo Bank, Ltd., Tokyo, Japan, 58 Fed. Res. Bull. 49 (1972) (cross-ownership could prohibit foreign bank acquisition of an American bank, but cross-control in Japan was unimportant "[i]n light of the [Act's] purpose . . . to maintain separation of banking from commerce in the United States."). Cross-control would violate the Act (and was found not present); if the Fed concluded cross-influence 57
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connections with American commerce, it felt constrained to ask Congress to amend the Act when many foreign banks entered America in the 1970's,61 which Congress did.62) The passivity rules are redundant, because small American banks lack the muscle for activity. And a "main bank" group raise Section 16 risks of liability for trading profits.63 Interbank communications could be a proxy solicitation, which would have to be publicly filed with the SEC.64 Under state antitakeover law, the group votes would be sterilized, trigger a poison pill or violate "control share" statutes.65 These passivity rules could break down. Some arise from Fed interpretation of the BHC Act; a change in Fed opinion could yield new authority, as it has for bank securities powers. Certainly, the Treasury's banking reforms would have ended many passivity inducements, including the McFadden-induced lid bank size.66 But the proposals are stalled in Congress. 2. Potential Control The Act would deter American main banks even if it allowed day-to-day influence, because large investors want the option to control. When Berkshire Hathaway takes a big block of stock and a board seat, it wants not day-to-day control, but the freedom to take control, to put in a new CEO in a crisis, as it did in the recent Salomon crisis. Short of crisis, their control potential yields were enough to violate, the Fed would have had to abandon its passivity rules. 61 International Banking Act of 1978, S. Rep. No. 1073, 95th Cong., 2d Sess. 1 (1978). Actually, the Fed sought exemption even before 1972. International Banking Act of 1976, Hearing Before the Subcomm. on Financial Institutions of the Sen. Comm. on Banking, Housing and Urban Affairs, 94th Cong., 2d Sess. 21, 30 (statement of Fed Vice Chairman Gardner) (quoting 1970 Senate testimony of Chairman Burns, requesting exemption). 62 International Banking Act of 1978, § 8(e), Pub. L. 95-369, Sept. 17, 1978, 92 Stat. 623, codified at 12 U.S.C. § 1841(h)(2) (1988). Parallels occur today. European banks affiliate with insurers, each with an American subsidiary. This indirect affiliation between the American bank and insurer runs afoul of the Act. American banks and insurers could not affiliate, but the Fed does not yet bar the European subsidiaries from America. It gave temporary relief and asked Congress to amend the Act again. 63 Since Japanese banks do not trade heavily, and since American banks seeking long-term relationships wouldn't trade, Section 16 is surmountable. Moreover, the notion of what is a group for Section 16 purposes is unclear. 64 BLACK, supra n. 1. New rules, adopted on October 15, 1992, reduce but do not eliminate this possibility. 65 Cullen v. Milligan, 61 Ohio St. 3d 352 (Aug. 14, 1991); Atlantis Group, Inc. v. Alizac Partners, slip op. (W.D. Mich. Aug. 27, 1991). 66 Interstate banking pacts are slowly eroding the McFadden lid. The pacts allow reciprocal branching between two (or more) states' banks.
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influence. CEOs listen less intently to crippled 5% stockholders than to 5% stockholders that could control. Since crisis intervention is a key function of Japan's modern main bank system,67 the passivity rules are enough to deter such a system here. Tret's say a bank is lender and 5% stockholder. In crisis, the bank takes control. Control as lender would not violate the BHC Act, but is it clear that the alliance of 5 % blocks is not the source of control? The bank displaces the old board with stock votes faster than with debt covenants and bankruptcy. The precise source of power will be unclear — as it is unclear in Japan. American creditor-stockholders might hesitate to exert control, fearful that control might be seen as arising from the stockholdings, which would violate the Act. When Japanese banks control an industrial company, they do so as stockholders.68 American banks have reason to stay away from large stockholdings, which could undermine their authority as creditor.69 3. Suppression of a securities market The Japanese Glass-Steagall Act is frequently misunderstood here. True, it severs investment banks from commercial banks, like the American law. But modern Japanese regulation skewed finance into banks, by (1) suppressing a bond market, through collateralization and issuance standards,70 (2) holding down deposit interest rates, and (3) suppressing competing financing sources, such as equity issuance, thereby channeling savings into banks.71 After a bond failure in the 19th century, the Ministry of Finance concentrated banking.72 In pre-war Japan, politics subsidized larger banks,73 in contrast to here where 67
See sources cited infra n. 86. W. CARL KESTER, "Governance, Contracting, and Investment Time Horizons: A Look at Japan and Germany," J. Applied Corp. Fin., Summer 1992, at 83. 69 And equitable subordination and lender liability risks also deter bank authority. These are analyzed in J. MARK RAMSEYER, Japanese Main Banks as a Regulatory Artifact: The Legal Framework (1991) (unpublished manuscript). 70 FRANCES ROSENBLUTH, Financial Politics in Contemporary Japan, at 157-65 (1988). 71 RAMSEYER, supra n. 69; ROBERT ZIELINSKI & NIGEL HOLLOW AY, Unequal Equities-Power and Risk in Japan's Stock Market, at 156 (1991); MIKUNI & CO., Banking, at 5, 6-7 (Occasional Paper No. 2) (Dec. 1987). 72 1 Nihon ginko hyakunen shi (A Hundred Year History of the Bank of Japan (1982), as cited in GARY SAXONHOUSE, "Mechanism for Technology Transfer in Japanese Economic History," 12 Managerial and Decision Economics 83, 85 (1991). Indeed, even today, when firms place debt securities, they need banks as their bond trustees. MASAHIKO AOKI, The Japanese Firm as a System of Attributes: A Survey and Research Agenda (Stanford Center for Econ. Pol. Res. Pub. No. 288) (May 1992). 73 FRANCES ROSENBLUTH, Bank Consolidation in Prewar Japan: The Market for Regulation under a Non-sovereign Diet (March 1991) (unpublished manuscript). 68
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politics subsidized smaller banks. Regulatory impediments stymied the rise of investment companies.74 Properly seen, post-war Japan had two offsetting regulatory sets. One set segmented finance, but not as severely as in America; banks could be large and active, but could not have securities, insurance or very large blockholding activities. But another set channeled finance through banks: depositors had few options other than banks, and large corporate borrowers had few non-bank financing sources,75 encouraging powerful intermediaries. Japan "repealed" the American-imposed Glass-Steagall separation, not by allowing commercial banking to mix with investment banking, but by stymieing a securities market and forcing savings into the banking system.76 Channeling into banks now is weakening, due to regulatory change and competition. Weak channeling makes important the old segmenting regulation (which keeps banks out of the securities channels). The combination ~ weak channeling and preexisting segmenting — now makes Japanese banks weaker than they would otherwise be. But in previous decades, channeling effectively made Glass-Steagall much less important there than it was here. German and Japanese ownership structures do not fit well, or at all, with American banking rules. Banks there control big blocks of stock in ways not now accommodated under American law. Here, banks lack the financial strength to play that role. To have influence, banks need huge assets that come from national operation, which McFadden prohibits. They need to be active in corporate governance, which the Bank Holding Company Act prohibits or makes difficult. They must network stock, which securities laws and state antitakeover law prohibit. The Federal Reserve rulings may seem to be minutiae, but are not when one understands the policy behind the Bank Holding Company Act: to put a huge fault line between banking and industry. Closer bank-industry relations abroad flatten authority in the firm, allowing power-sharing with intermediaries that are banks. Next we try to assess normative significance.
74
HIDEKI KANDA, Politics, Formalism, and the Elusive Goal of Investor Protection: Regulation of Structured Investment Funds in Japan (August 1991) (University of Tokyo: unpublished manuscript). 75 Cf. RAMSEYER, supra n. 69. 76 See BRUCE KASMAN & ANTHONY RODRIGUES, "Financial Liberalization and Monetary Control in Japan," Fed. Res. Bank ofN.Y. Q. Rev., Autumn 1991, at 28, 29. Determining which is the "natural" base — American securities markets or Japanese banks — is difficult. We could see the natural baseline to be nationwide banking, which America killed, thereby killing otherwise healthy non-securities alternatives for large firms, and thereby facilitating a securities market. Large American banks — if they existed — might have made huge loans and stock investments that in the United States must flow through the securities market.
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V. The Structure of Corporate Governance To begin to assess whether the foreign structures yield a competitive advantage, we must know what those structures are and develop hypotheses as to how they might be functional. My goal in this Part is first to triangulate the three nations, to find common elements in Japanese and German corporate governance that differ from American governance. Triangulation then should yield us hypotheses for future investigation. Most basically, triangulation casts doubt on the current economic models as fully explaining most key features of the modern American firm. If agency theory were universal, we should expect structures similar to the American to have arisen in Japan and Germany. But we do not. As we see then in Part VI.b, politics and history may better explain the foreign structures than does agency theory. Triangulation helps us deal with a key problem in the American agency cost inquiry: Increasing institutional power could reduce managerial agency problems, but at the cost of increasing institutional agency problems. How can one decrease without the other increasing? Why doesn't a shift in power from managers to banks in Germany and Japan just make the bankers the problem, substituting for the American managerial problem? The normative story has three general lines of inquiry: problems with managers, problems with securities markets, and problems with relational contracting. Contrary to conventional wisdom, foreign bank ownership does not shift control from managers to banks. Rather, senior managers share authority with outside intermediaries. In neither nation are the intermediaries usually dominant. They "balance" power with the managers. Stockholders appear to the senior managers as people, not abstractions to whom fiduciary duties are owed. Personification might matter. In both nations several intermediaries usually have big blocks of stock in the large firm, no one intermediary dominates. Coalitions to affect managers might only occur when there is near unanimity among different institutions. Agency problems may not be ameliorated day-to-day. Institutions may do nothing, except in crises. The problem resolved abroad may not be managerial agency costs, but the inability of a stock market of traders to assess soft, proprietary, long-term information well. Big institutional holdings may deal less with managerial agency costs77 than with a dysfunctional, fragmented securities market. Also, cross-ownership, particularly in Japan, may not be primarily about stock investments, but about relational productive investments. Close cross-ownership may facilitate these, and as an ancillary matter improve performance of the firms' CEOs and other top managers.
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this.
The common hypothesis that Japanese firms maximize size not profits supports
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A. Shared Authority and Personification The foreign CEO must meet with agents of big stockholders who do not owe their position to the CEO, but to their home institution, and who do not depend psychologically, socially, or financially on the CEO, a dependence that afflicts American directors.78 In Germany, managers interact with institutional stockholders in regular, formal meetings of the supervisory board of directors. (An internal, manager-dominated board handles day-to-day matters. The managerial boards reports to the supervisory board. The managers neither dominate nor even become members of the supervisory board.) In Japan, managers interact with big stockholders in regular, informal Presidents' Council meetings (a managerial-dominated board handles day-to-day matters).79 Managers dominate an internal board, but not the supervisory board or council. American corporate governance is in a single board that the CEO dominates. The German and American boardroom should be different. A financier there often chairs the board.80 German bank directors are not there due to friendship with the CEO or a reputation for proven passivity, but because their institutions have votes. The German CEO reports to the supervisory board. In Japan, council meetings force CEOs to interact with big shareholders. An American CEO rarely sees shareholders personified by the president of a 5 % owner with whom the CEO has breakfast monthly, because there typically is no 5% shareholder. Japanese managers attend to stockholders not due to fiduciary duties: "[T]he top managers of Japanese companies tend to think little of the benefits of general stockholders other than those who are cross-holders."81 American directors owe fiduciary duties to an abstraction, a faceless stock market. In Germany and Japan, the abstraction is personified in the bank director (on the German board) or the bank president (at the council meeting). The foreign CEO should think not just of abstract fiduciary duties to an anonymous market, but of betrayal of, or cooperation with, people from a stockholding institution. Sociologists found few American soldiers fought "for 78
VICTOR BRUDNEY, supra n. 25; JAY LORSCH & ELIZABETH MACIVER, Pawns or Potentates: The Reality of America's Corporate Boards (1989). 79 Moreover, in both nations labor plays a bigger governance role than in America, in Germany through codetermination, in Japan through norms of deference to employees. This further flattens authority. 80 A non-CEO chair for the board is frequently proposed for American large firms, but rarely accomplished. MARTIN LIPTON & JAY LORSCH, "A Modest Proposal for Improved Corporate Governance," Bus. Law, Nov. 1992, at 59; JUDITH DOBRZYNSKI, "Chairman and CEO: One Hat Too Many," Bus. Wk., Nov. 18, 1991, at 124. 81 See FOUNDATION FOR ADVANCED INFORMATION AND RESEARCH, Japan, A Perspective on Japanese Merger & Acquisition from International Viewpoint, at 24 (Sept. 1990).
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freedom", "for the American way", or "against aggression"; motivation came from loyalty to buddies in the platoon, not to abstract ideals.82 While it's a leap to project this onto CEO's, loyalty to personified shareholders might motivate more than abstract fiduciary duties to an abstract, anonymous market. Constant interaction with individuals representing stockholding institutions could increase peer pressure, guilt about shirking, empathy among co-workers (I can hurt an anonymous stockholder, but not one of my cohorts) and CEO camaraderie, all of which should improve performance.83 In both foreign nations, rarely does a single dominant bank own a controlblock. Groups hold the stock. Neither foreign meeting structure facilitates detailed ongoing review of senior managers; German supervisory boards meet a few times per year and Japanese monthly President's Council meetings involve enough firms that no single one can command the agenda; their meetings are said not to have a detailed business agenda and to often be social events. The structures are fit for crisis management and big picture ongoing review. Managerial authority does not shift to the banks. Both contrast starkly with the large American firm, where no shareholder votes enough stock for the CEO to pay serious attention, Board membership is by invitation of the CEO, senior managers and financiers meet infrequently, rarely in a structured governance context, and information exchange is constrained. American stockholding institutions do not go inside the boardroom: the total holdings of an average board of directors amounted to no more than 3.6% of the firm's stock.84 The primary controls on managers are the hostile takeover, now rare, and product competition. Managers see shareholders not as friendly institutions, expecting a profit, but as anonymous traders with little loyalty to the firm.85
82
JOHN KEEGAN, The Face of Battle, at 50-51, 71-72 (1976). EUGENE KANDEL AND EDWARD P. LAZEAR, "Peer Pressure and Partnerships," 1007. Pol. Econ. 801 (1992). 84 LORSCH & MACIVER, supra n. 18. 85 Perhaps power sharing is worse than American centralization. Bankers and managers might collude, bankers might be uninformed. We do not know precisely what goals foreign bankers pursue. The firm may be paralyzed by indecision. Perhaps other features make the foreign system work. A catalyst could be competition arising from the export-driven economy: paralysis will lead to quick decline. German firms that need to export much of their production cannot accept paralysis. Cf. Gilson and Roe, supra n. 33 (risk of inaction afflicts the Japanese structure and that Japanese domestic competition may help avoid the inert results). Yet the flatter structure of authority may avoid internal dysfunction better than does the American structure. 83
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B. Between Market and Hierarchy The separation of ownership from control yields scattered shareholders lacking the incentive to fully monitor managers. But foreign intermediaries are also large Berle-Means firms, with too many scattered shareholders to give their agents the proper incentives. Why should reducing managerial agency costs at the firm just displace the conflict up one level, into the financial intermediary? 1. The Bench This problem may well make the normative inquiry a dead-end. But pieces of data from the foreign systems suggest we should not stop the inquiry so quickly. First, as the previous section argued, there's no complete power shift from managers to bankers abroad. Rather power is shared, suggesting that a shared power model could improve performance over a managerial-dominated or a banker-dominated system. In the previous section I offered personification as one hypothesis for investigation. A second hypothesis is that the foreign institutions do little day-to-day, but intervene only when the incumbent managers fail. Consider the "bench" for sports teams. Having passable players on the bench could be key to a team's success. Eventually injury, exhaustion or slump weakens the first-line team. Teams that only have the first-line players will underperform those with a "bench." The first-line team is better than the bench (i.e., industrial managers are better than financial managers). But the bench still has value. If institutions do little when managers succeed, and only intervene when they do not, defects of the intermediary should not compound managerial problems. Recent scholarship sees the main bank as crisis epicenter, making managerial, strategic and financial changes when the first-line team fails.86 Japanese firms with large institutional blocks have few disasters, consistent with the crisis monitoring hypothesis. Productivity in the institutionally-powerful firms is higher than outside, suggesting slack develops there more slowly.87 An American analogue is Berkshire Hathaway's investment in Salomon Brothers, which justified putting two of its senior executives on the Salomon board. When crisis hit, it justified Berkshire Hathaway sending an executive full-time to help Salomon mitigate the crisis. A medium stake justifies the time 86
MASAHIKO AOKI, Ex Post Monitoring by the Main Bank (1992); MASAHIKO AOKI AND PAUL SHEARD, The Role of the Japanese Main Bank in the Corporate Governance Structure in Japan (1991), papers presented at a conference on Corporate Governance: New Problems and New Solutions, Center for Economic Policy Research, Stanford University, April 16-17, 1992; ROBERT REICH & JOHN DONAHUE, New Deals: The Chrysler Revival and the American System, at 81-85 (1985) (Mazda rescue). 87 LICHTENBERG & PUSHNER, supra n. 32. The result is also consistent with the banks just choosing low-risk investments.
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and attention that make a good board of directors — or a good President's Council meeting — and not more. A crisis manager, like Buffett or the main bank, can have good effects without ever intervening: The large block of stock ready to become active in crisis motivates managers to avoid that crisis. Involvement of the large stockholder with the firm — through President's Council meetings or through Buffett's boardroom presence — means the crisis manager does not need time to move up from the bottom of the learning curve. 2. Financial Institutions as Berle-Means Corporations: Between Market and Hierarchy Contrasting market with hierarchy fails to capture the complex links of foreign finance with industry; control is not the right word, interlock, or Escher-like overlap, might be the phrase.88 An Escher hand reaches out from the bank to control industry, but then an Escher-like hand reaches out from industry to control the bank. Or, we trace the authority of, say, the Japanese banks on top and see that in their heyday they had substantial control via credit allocation over industry. They monitored, reviewed budgets, affected management; they owned stock in these industrial firms. Then we look at the assets of the firms they monitored and see corporate stock, including stock of their bank monitor. We aggregate the stock in the industrials in the keiretsu and find a big block of bank stock (although rarely as concentrated as the blocks the banks hold in the industrials). The bank's stockholders affect the bank; the bank owns stock in its stockholders and affects them. Escher-like mutuality also describes Germany, but less starkly: Managers from important industrial firms are on the banks' boards and the banks have national advisory boards of senior managers in industry;89 managers direct employees, some of whom sit on the supervisory board and direct managers. We go down an Escher-like staircase: while always walking downstairs, we wind up on top of the staircase from which we started. Organizational theory suggests why partial vertical integration could be functional. Information is dispersed; no individual or staff has all the information and perspective needed to evaluate complex projects. A decisionmaker's biases are often invisible to the decision-maker. Networks of decisionmaking can reduce error. The keiretsu and the German banks reduce the CEO's authority, but do not, like the American conglomerate, replace it with a new centralized authority.90 Rather, centralized authority is dispersed, with powers 88
M.C. Escher was a Dutch graphics artist, whose work most readers will be familiar with: they show realistic renditions of staircases that descend to the top their own ascent, of walls that abut ceiling and floor at the same joining point. 89 FRITZ KÜBLER, "Institutional Owners and Corporate Managers: A German Dilemma," 57 Brooklyn L. Rev. 97, 109 (1991). 90 The most prominent exception is Deutsche Bank's control block in Daimler-Benz; the bank effectively usurps the authority of the CEO rather than shares authority. It
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separated, checked, and balanced.91 Markets have costs; sometimes command and hierarchy are the best way to organize economic activity. When hierarchy is better than atomized markets, firms arise.92 The keiretsu could be a hybrid that provides a web of Escher-like relationships without a vertical hierarchy, trading off some benefits of markets for some benefits of organization. New organization theories point to Americanstyle command-and-control hierarchies as poorly adapted to today's persistent technological change and informational shifts.93 The point of the Escher analogy is that the structures should be seen as a series of non-hierarchical coalitions. Banks own pieces of industrial firms; industrial firms own small pieces of banks. Managers rule inside the firm. But managers must interact with groups of large stockholders. Persistent failure ~ and now we are hypothesizing a model for testing, not relaying a confirmed fact — should yield a coalition of stockholders that motivates managers to improve. No single institution can command the CEO; only a coalition can. And such coalitions only form, we hypothesize, when error is clear. Moreover, coalitions against an opportunistic bank can also form. This model comports with the Japanese structure in two ways: no single bank dominates stock ownership; only groups can dominate. And groups of firms own some influential blocks of stock in the banks. A shifting coalition of CEO "partners" exists. This model comports with the German structure well only on one level: No single bank usually dominates an industrial firm; a dominant voting block requires a coalition. But most of the banks themselves are BerleMeans firms with scattered shareholders.94 3. Government and Banks This half of the German "model" leads us to consider a simple tri-Ievel hierarchical monitoring model: industry is at the bottom, institutions in the middle and government regulators on top. Intermediaries monitor industry. Who monitors the intermediaries? No one, day-to-day. Leveraged intermediaries have one monitor, the government, which shuts them down when their equity becomes the problem, not a power-sharing solution. 91 RAAJ KUMAR SAH, "Fallibility in Human Organizations and Political Systems,11 5 J. Econ. Perspectives 67 (1991). 92 RONALD COASE, "The Nature of the Firm," 4 Economica 386 (1937); see also GUIDO CALABRESI, "The Pointlessness of Pareto: Carrying Coase Further," 100 YaleLJ. 1211, 1212(1991). 93 PETER F. DRUCKER, "The Coming of the New Organization," Harv. Bus. Rev., Jan. -Feb. 1988, at 45, 53. 94 The bank stock is disproportionately deposited with and voted by the bank itself, after the bank gets a detailed proxy from its depositing customers. Appendix I; GESSLER et al., supra n. 3, at 327-28.
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declines toward zero. Regulators need only a signal of near insolvency. Short of insolvency, regulators make inquiries, weakening the autonomy of the bank managers. This cousin to the American cash flow model shifts the locus of leverage from industry to banks. Leverage, it is said, induces firms that tend to retain excess cash to pump it out. Leverage substitutes for monitoring. In the variation I'm using here, banks' weakness — highly leveraged firms with thin equity — become their strength, if properly regulated. Leveraging and regulation cause the senior bank managers to avoid disasters and get good returns to avoid a further thinning of their equity and regulatory intervention. This model highlights American defects, where regulators have been ineffective at such tasks, due to America's anti-government ethos and to political feedback: the regulated ~ the intermediaries and industry ~ cripple the regulators, as they did in the savings and loan crisis. C. Multiple Monitors and Opportunism A bank controlling a firm could charge an above-market interest rate, or compel the firm to do fee-generating deals. It could opportunistically divert value to itself or its agents, or gather all authority unto itself and pursue its own empirebuilding agenda.95 Foreign firms do not rely on a single bank; they use competing financing sources. German loan rates are said not to reflect banker control.96 Japanese firms sometimes end the relationship with the main bank and seek another bank.97 And multiple lending sources now arise. Moreover, in both nations strong regulators are in the background. And fear of political retaliation could keep the bankers at bay. And multiple big blocks might mitigate opportunism. Absolute control — like Deutsche Bank's control of Daimler-Benz — is rare. The Japanese main bank cannot influence easily if the other banks and insurers defect. And the German bank cannot easily influence if the other banks defect. If the lead bank seeks above-market rates on its loans, managers can appeal to the other bankers or 95
See STUART ROSENSTEIN & DAVID RUSH, "The Stock Performance of Corporations That Are Partially Owned by Other Corporations," 13 J. Fin. Res. 39 (1990). 96 JOHN R. CABLE, "Capital Market Information and Industrial Performance: The Role of West German Banks," 95 The Economic Journal 118 (1985); ECKSTEIN, supra n. 147, at 478 (reporting results of German Parliamentary investigation). 97 J. MARK RAMSEYER, "Legal Rules in Repeated Deals: Banking in the Shadow of Defection in Japan," 20 J. Legal Stud. 91 (1991); TOSHIAKI TACHIBANAKI & ATSUHIRO TAKI, "Shareholding and Lending Activity of Financial Institutions in Japan," Bank of Japan Monetary & Econ. Stud. 23, 24, 31 (1991) (quarter of firms switch main bank in four year period).
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insurers to defect from their coalition. A counter-coalition can form, because the industrial firms and other banks usually own a big piece of the bank.98 Perhaps, knowing that opportunism will not work easily (unless bankers collude), it is kept at manageable levels." Multiple monitors helps us understand why American intermediaries do not go to the limits of the law. Bank holding companies can own up to 5% of the stock of an industrial company, yet rarely do. Large insurers can put 2% of their assets in a single firm, yet rarely do. Why? Aside from legal impediments (e.g., banks are too small and must be passive), a small isolated block is unstable. Size has costs, but 5% fails to assure influence; managers have the upper hand if there's conflict. A 5% leader needs a critical mass of other votes, which they lack in America but have in Germany and Japan. Some "unleashed" American institutions refuse to take large blocks; in crisis they would usually need a critical mass of other large blockholders, which they do not have. D. Is Corporate Governance Involved, Or Are the keiretsu Otherwise Explained? Keiretsu cross-ownership facilitates trade, as a hostage exchange or "credible commitment," needed when weak, informal law debilitates long-term contracts.100 Multiple cross-ownership deters opportunism, which when it occurs could activate the group to punish the wrong-doer. One-third of the crossownership in Japan is between suppliers and customers.101 Credible commitment analysis helps explain cross-ownership in Japan. A supplier needs protection before buying machinery to be used only for a specific customer. A detailed contract might protect, but too many sticking points are 98
Mutual life insurers are big financial players, with about half the gross stock ownership of banks. They are not cross-owned. RYUTARO KOMIYA, The Japanese Economy: Trade, Industry, and Government, at 233-35. 99 Even this cannot be a complete explanation. Coalitions of institutions might form. Banker A agrees with Banker B that A will exploit company X while B exploits company Y. Such coalitions like cartels are often hard to construct and enforce. In Germany, the owner of brokerage stock can withdraw it, or vote it directly. This will not stymie small thefts, because the small owner has little incentive to be informed. But gross, media-publicized theft could lead to mass withdrawal. See HANS-JACOB KRÜMMEL, "German Universal Banking Scrutinized," 4 J. Banking & Fin. 4, 13-15 (1980). 100 Cf. ANTHONY T. KRONMAN, "Contract Law and the State of Nature," 1 J.L. Econ. & Org. 12, 12-15 (1985); Oliver E. Williamson, Using Hostages to Support Exchange, 73 Am. Econ. Rev. 519 (1983). 101 Yusaku Futatsugi, What Share Cross-Holdings Mean for Corporate Management, Economic Eye, Spring 1990, at 17, 18. Holding companies are illegal, but vertical integration is not, perhaps explaining supplier-customer cross-holdings.
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unforeseeable. But relational contracts could be enforced with multiple exchanges of stock. If one party tries to mulct the other, a coalition of the others will intervene to stop the opportunism. Bank investment in long-term loans102 is similar to the supplier's investment in complex machinery for a specific customer. The borrower may renege by increasing risk; the lender may renege by refusing to roll-over the loan at a critical juncture. In America, such problems are solved, or at least mitigated, by the 100-page bond indenture. Perhaps, I hypothesize, facilitating trade of capital is a part of the opportunism cross-ownership mitigates, by substituting for and extending enforcement of fiduciary duties.103 Supply problems and corporate governance may overlap in two key ways. First, multiple relations — supplier and stockholder, creditors and stockholder — double up (1) the sources of information, (2) the incentives to intervene, and (3) the means of intervention, exit and voice. This doubling up could improve corporate governance and contractual relations simultaneously. Even the 5% stockholder lacks the incentive to provide an "optimal" amount of monitoring, because among all stockholders monitoring is a public good. But the 5% stockholder that is also a creditor, or also a supplier, will monitor to protect a stock position and to protect the loan or supply source. Similarly, the cost of monitoring — whether it be of a supplier or portfolio firm — decreases if multiple information sources open up. E. Institutions, Not Managers, as the Problem Any advantages of the structures probably arise from close relations between inside managers and outside stockholders. The close structure should improve information flow to big stockholders, helping to deter the stock market's shortterm propensities.104 To do this here, managers would have to reveal the complex, proprietary information to the stock market, and derivatively to competitors.105 Evaluating technical information, even if not proprietary, may need constant close interaction, which the foreign structures have, but the 102
Which may in form be short-term, but if rolled over regularly are effectively long-term. 103 This is more complicated. Japan may "need" cross-ownership if fiduciary duties are weaker and more difficult to enforce than in the U.S. The Japanese may bear the costs —whatever they may be — of cross-ownership, because they lack other mechanisms of contract and fiduciary duty enforcement. 104 I first argued this possibility in ROE, "A Political Theory of American Corporate Finance," supra n. 1, at 55-56. 105 Bruce Atwater, the savvy CEO of General Mills, says he tries to learn of competitors' activities from analysts. Bruce Atwater, The Governance System Is Sound, Directors and Boards, Spring 1991, at 17, 19. Presumably CEOs severely reduce the proprietary competitive information they release to analysts.
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American does not. Japanese firms operating in noisy, difficult-to-evaluate environments tend to have large institutional stockholders.106 F. Just a Better Board? Perhaps we are over-analyzing differences. A simple hypothesis is that the foreign structures motivate a better board and do little more. Instead of a Board created by the CEO, key members of the German board (and the informal Presidents' Council) have reason not to blindly follow the CEO. "True" independence may be the key contrast with America. The other incentives may just make poor firm results more embarrassing for the foreign actor than professional pride would alone. Let us review the additional incentives. Neither nation, nor any particular board has them all. But they occur widely abroad, and rarely here. The German banker comes from an institution often owning a big block of stock; the Japanese banker's home always owns a big block. The German banker does not want to induce a run-off of brokerage stock or political inquiry. The Japanese banker will be embarrassed if firm failure leads to criticism from a customer of the firm, with which the bank also does business. G. Complex Intermediaries I cannot avoid setting down complexity after simplicity. We can see what comes next as helping to understand why a foreign director will simply be embarrassed by poor firm performance, or as helping to understand the complex web of incentives and means the foreign banks have to affect their firms. Consider the German banker. Do bankers bother to monitor for the brokerage stock? Perhaps not. Perhaps they spend to support directly owned stock, which is enough to send an executive into the boardroom, enough to divert modest research resources inside the bank, but not more. It's enough to motivate a good board, no more. The bank charges custodial fees;107 high expenses for directly-owned stock drive German stock into institutions. These fees are, however, not tied to
106
TAKEO HOSHI, ANKI KASHYAP & DAVID SCHARFSTEIN, Corporate Structure, Liquidity, and Investment: Evidence from Japanese Panel Data, in Asymmetric Information, Corporate Finance and Investment (R. Glenn Hubbard ed. 1990); STEPHEN PROWSE, "Institutional Investment Patterns and Corporate Financial Behavior in the United States and Japan," 27 J. Fin. Econ. 43 (1990). I'm aware of no similar tests with German data; anecdote claims a few banker-dominated firms have the short-term affliction. MICHAEL J. PIORE & CHARLES F. SÄBEL, The Second Industrial Divide - Possibilities for Prosperity, at 285 (1984). 107 See BAUMS, supra n. 6.
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performance.108 Brokerage stock's role might not be to bear expense, but for voting influence. A 5% position is precarious. Management can outmaneuver, isolate, and destroy the small blockholder.109 The foreign structures give the blockholder backup votes, in Germany from controlled mutual funds and custodial stock, and in Japan from the other 5% blocks. The directly-owned stock motivates and the backup stock bulks up the voting power.110 Securitized, liquid debt, and concentrated voting blocks of stock may fit with financial theory. The least risky layer —debt — in the enterprise is the least useful vantage point for monitoring;111 large financial institutions disproportionately deal in debt. Lower ranking layers are most affected by changing value. It is there where monitoring should emerge. But the riskiest layer has incentives to diversify into small, uninfluential blocks of stock. Monitoring and enhanced information flow impel equity cohesion, but diversification and liquidity tear it apart. This tension cannot easily be resolved in the American securities markets. Even if simple intermediaries could legally hold big blocks, they are pressed to diversify. The tensions can be resolved, if at all, only through large, complex intermediaries: The institution must gather not just deposits or insurance funds, but a mutual fund or brokerage stock, where the ultimate holders have diversification and liquidity, but the institution has concentrated voting power. But if the ultimate holders have the beneficial interest, the incentives decline for the intermediary to do the work. The risks are borne by the ultimate holders. The ultimate holders must compensate the intermediary. But if they bear an extra expense, ultimate holders withdraw and free ride, forcing remaining holders to bear the full expense. To overcome free-riding, the mass holding might enjoy some economy of scale, or the intermediary must hold some of the stock for its own account and then motivate its own employees to protect that directly-held block. To hold enough, the intermediary must have mass, financial strength, a collective vehicle for shareholders, and legal authority. 108
The bank could also be paid via conflicts of interest. Cable, supra n. 96, at 11924 (arguing that they do not in fact). 109 Large stock positions in large American firms are rare. One rare one was H. Ross Perot's 6% of GM. He got into the Boardroom, but when GM managers found that they had a feisty critic on their hands, managers threw him out. Perot could not ally with other large stockholders, because there weren't any. See Appendix, Table Xlld. When Carl Icahn got 13% of USX, he also lacked big block allies; managers outmaneuvered him. 110 Political pressure on German banks leads them to reduce supervisory board positions and directly-held stock. See infra text accompanying n.s 131 ff. Reducing the directly-held stock would leave the German banks with power — through brokerage stock —but without the incentive to act responsibly. 111 ALAN SCHWARTZ, "The Continuing Puzzle of Secured Debt," 37 Vand. L. Rev. 1051 (1984).
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But this complexity requires a large, variegated intermediary, which thus far is illegal in America, and difficult enough even if permitted. H. Implications for American Structure Foreign governance has common elements: (1) Senior managers share authority with outside intermediaries. (2) A handful of institutions split the vote; power does not shift to a single intermediary, nor does it shift to a formed, focused coalition. (3) Rarely does a single institution own as much as 5 % outside of a coalition. The Japanese main bank owns 5% but has another 20% behind it, in allies. The German universal bank owns 10%, but also controls a big block of brokerage and mutual fund stock; another universal bank or two also has stock. (4) Stockholders are personified. (5) Close interaction facilitates flow of soft, proprietary, long-term information. This flow could enhance relational contracting. It could also protect managers from the ravages of a stock market of traders unable to evaluate (or receive) this information. My primary goal here is to show that the foreign corporate structures differ from America's, that would be illegal in America, and that alternatives to the American organizational form are plausible. In this part I developed some of the possible advantages of the foreign forms. But the foreign forms have some obvious weaknesses. Cross-ownership is afflicted with conflicts of interest, which could detoriate into mutual self-protection, and is not likely to yield the entrepreneurial leadership that is necessary to function successfully in fast changing environments. Concentrated owners may be passive and ineffective. My goal in this part was not to show that the foreign systems have an overall superiority, but to show that there are some advantages that may offset their obvious costs. Japanese, and perhaps German, firms, quite possibly maximize size, not profits. Roughly one-third of the cross-holdings in Japan are held not by financial institutions but by industrial firms, often involving supplier-customer relationships. President's Council meetings may be part of a governance system that tends to increase size, sales, employment, and growth, or to resolve problems in supplier-customer relationships, with profits a secondary concern. German codetermination is not likely to make belt-tightening and down-sizing easy. If so, the systems may work well when economic determinants impel expansion and perform poorly when expansion is no longer warranted. American corporate governance may, when the pluses and minuses are added up, be superior. It's unclear which system, the foreign or the American, is more adaptable. American managers own more stock, and that pay-for-performance (bad as it is in America) may provide greater motivation than in America than abroad. The primary basis for asserting the superiority of the foreign structures — very large blocks of institutional stock with regular interaction -- may prove to be only a slight difference as
Corporate Governance in Germany, Japan and America American intermediary holdings become intermediaries more active.
more concentrated
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VI. Financial Evolution in Germany and Japan? The foreign structures contradict academic theories that say the large firm's features are primarily due to economic problems. The theory must be rejected or seriously modified as explaining only a special American case. That is, the economic model would predict similar boards of directors in similar firms in Germany, Japan and America. But we do not observe them as really similar, at least yet. But the way a nation moves savings into large firms largely determines corporate structure. And there is more than one way to move savings to industry; the American way — via a securities market with weak intermediaries — is not the only one. Intermediaries abroad are stronger and share authority with managers. The relative strength of intermediaries is the product of history, politics and culture, all of which better explain the different structures than does agency theory alone. One major way remains for the dominant academic theory to explain Japan and Germany. We examine this major argument in this part. A. The Evolutionary Argument Is different governance in Japan and Germany due to their lagging behind America's financial evolution? In time, the argument runs, finance liquefies and disintermediates. Powerful intermediaries wither, due to securitization and globalization. Stock disperses to individuals and small institutions in small blocks. Debt securitizes into commercial paper and bonds, eroding bank power as creditor. Universal problems of financial organization eventually force dispersed ownership agency problems, and structures that mitigate those agency problems. Thus, powerful institutions in Germany and Japan are temporary; Anglo-Saxon financial institutions are the highest form of financial development; in time Japan and Germany will reach our level. I question this view. True, the Japanese main bank system is under severe stress: securitization in Japan, internationalization of financial markets, Bank of International Settlements capital standards that penalize stock ownership, and a sinking Japanese stock market. But the data show one brute fact that belie fragmentation predictions: Despite stress, bank ownership of the large firms in Japan has been rock-solid at about 20% for the past twenty-five years. Moreover, critical forces threatening the Japanese main banks (and the German universal banks) are weak forms of the political forces that fragmented American banking. If there is an evolution going on, political forces play at least some, and perhaps a major, role.
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B. Problems With the Evolutionary Argument Why have the ownership levels persisted thus far despite the stress? Globalization and securitization are indisputable facts. Their effects are what is in doubt. The Club of Rome predicted dwindling resources and western industrial collapse. By extrapolating only one trend — increasingly scarce critical resources -- and ignoring others -- rising resource prices were forcing technological substitutions — the Club of Rome's predictions have proven ridiculous. Predicting that securitization and globalization will debilitate foreign finance, while more plausible, runs the same risks. After World War II, Japanese stock has relentlessly concentrated into intermediaries. Uncomfortable as it may be to many of us, the German and Japanese structures may — warped to correct for different laws, cultures, and histories — be our crude corporate future; and our structures may not be their future. 1. Securitization German and Japanese banks' muscle comes, it is said, only from credit. As bank finance withers, institutional influence will wither too. Because everywhere debt is securitizing,112 banks' power in governance in Germany and Japan will wither and die. But, as the Appendix, in Tables VIII and IX, shows, bank ownership of large firm stock was stable in the 1980's.113 The number of
112
That is, banks are a conduit, an intermediary. A depositor places money in a bank; the bank then lends those funds, but is obligated to repay that deposit even if the bank's loan goes bad. These functions are increasingly going through the securities markets: The depositor who used to deposit in the bank now lends to the corporation without using the bank intermediary. The provider of funds buys commercial paper from the industrial corporation if the loan is short-term, and bonds if the loan is longterm. 113 The latest comprehensive data collection argues that keiretsu fragmentation is more discussed than real. GERLACH, supra n. 16, at 94-118. A modest 1% sell-off started in 1977, when Japan lowered the maximum bank holding from 10% to 5%, effective in stages through 1987. The sell-off stabilized in 1985. This 1% sell-off represents exactly the bank-owned stock above 5% in 1977, as the Appendix, in Tables X and XI, shows. Law and Japanese politics, not securitization, best explains it. Japanese FTC, The Actual Conditions of the Six Major Corporate Groups, at 2 (Aug. 1, 1989). Now that stock prices are low, a sell-off is predicted (although not observed). When stock prices were high, a sell-off was also predicted. LARRY ZOGLIN, "Stable cross-holding of shares likely to withstand pressures," The Japan Econ. J., June 21, 1986, at 7. The Appendix shows it did not happen. Sell-off when high seems more plausible than when low. When high, insiders get a bargain by selling; when low, insiders take a loss.
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large blocks in the largest German firms apear to be rising, not declining.114 Perhaps predictors of fragmentation conflated an inevitable weakening of fractional reserve banking with a weakening of large stockholding institutions. The first is likely; the second may not be. Influence can survive securitization. Stock and debt can disintermediate from bank direct ownership, but reappear in the complex intermediaries grouping, say, mutual funds, brokerage stock, and pensions.115 A common misconception is that German bank influence comes only from credit; Americans are so inured to bank separation from commerce that credit seems the only means of bank influence. But German banks' power over credit has already withered for the large firm;116 yet their control over the proxy system has not.117 114
JÜRGEN BÖHM, Der Einfluß der Banken auf Großunternehmen, at 236 (1992). Incentives change; the stock is held for another's, not the bank's, direct benefit. But influence persists. Deutsche Bank controls Daimler-Benz, not as lender, but as stockholder. Data show a slight shift from debt-based to stock-based power in Japan. PROWSE, supra n. 106, at 1139. 116 MICHAEL H. BEST & JANE HUMPHRIES, "The City and Industrial Decline," in The Decline of the British Economy, at 223, 224 (B. Elbaum and. W. Lazonick eds. 1986). After 1970, German bank loans are only 12% of net firm financing, less than bank loans in Britain and Canada, and about that in America; retained earnings are 84% of new financing, about that in America. CLAUDIO BORIO, Leverage and Financing of Non-Financial Companies: An International Perspective, Bank for International Settlements Economic Papers, No. 27, May 1990, at 15. For Britain, credit institutions provided 14% of new flows, the Canadian percentage 15%. Others confirm that bank finance accounts for 40% of gross finance in France, Italy and Japan, but only 20% in Britain, the United States, and Germany. MAYER, Financial Systems, Corporate Finance, and Economic Development, in Asymmetric Information, Corporate Finance, and Investment, at 307 (R. Hubbard ed. 1990). (The gross number is the percentage of capital from banks; the net number is the source for new financing.) Debt disappeared as a source of net new German inflows in the early 1980's. Monetary and Economic Department, Bank for International Settlements, Faxed materials 7 (Sept. 16, 1991). Of the (small) amount that is externally financed (i.e., after excluding retained earnings), 70% comes from banks in Germany, 25% in the U.S. RANDALL POZDENA, "Commerce and Banking: The German Case," Fed. Res. Bank S.F. Weekly Letter, Dec. 18, 1987; J.S.S. EDWARDS & KLAUS FISCHER, Banks, Finance and Investment in West Germany Since 1970, Centre for Economic Policy Research Discussion Paper Series No. 497 (6 Duke of York Street, London SW1Y 6LA) (German stock corporations internally financed, "rel[ying] hardly at all on bank borrowing as a source of finance for investment over the period 1971-85, and instead were largely internally financed."). 117 Id.; A. KNIGHT, Deutsche Bank and Industry Post-1945: Interpreting the Evidence, at 1 (1988): "By the early twentieth century, industrial development had led German firms to depend more on retained earnings and less on external capital. Nevertheless, the powerful German credit banks retained a close interest in industrial 115
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Bank financing is higher in Japan; banks' influence can only go down as providers of credit. Substitutes arise. Banks now dispatch more directors to industry, not less,118 and insurers are becoming more assertive;119 as bank influence via credit slackens, other governance structures strengthen. Some evidence says bank monitoring goes dormant when the firm does well, but increases if the firm is mismanaged. If so, those seeing evolutionary decay may be mistakenly seeing a long-term shift when the 1980s' changes were only cyclical.120 Moreover, disintegration depends on Japan's Glass-Steagall Act and the absence of another intermediary. Without Glass-Steagall, banks might sponsor mutual funds or become brokers.121 But evolution to other intermediaries is budding in Japan, as the Ministry of Finance proposes to allow banks to buy, sell, trade, and form mutual funds for commercial paper and bonds; investment companies and funded pensions are predicted to flourish.122 Change in Glass-Steagall could have "disintermediated" debt and stock reappear in mutual funds and brokers affiliated with the bank, allowing Japanese banks to resemble the German.123 performance, as they continued to sit on boards of large industrial concerns and underwrote financial issues, often holding a proportion on their own account and retaining the proxy rights of outside shareholders." 118 Japan FTC, supra n. 113, at 2. 119 KESTER, supra n. 24, at 216. 120 STEVEN N. KAPLAN & BERNADETTE ALCAMO MINTON, "Outside" Intervention in Japanese Companies: Its Determinants and Its Implications for Managers, at 20 (U. Chi. Working Paper Sept. 1992); MASAHIKO AOKI & PAUL SHEARD, supra n. 86 . 121 And if bank debt is replaced with bond debt and significant chunks of that debt end up in financial institutions affiliated with holders of equity, then elements of the main bank system are recreated, although in muted form. Indeed the Japanese banks have moved into the debt securities market, as the Japanese Glass-Steagall Act has been slightly rolled back. MASAHIKO AOKI, Information, incentives and bargaining in the Japanese economy, at 141 (1988). Some bank weakness in recent years was taken up by the insurance companies, which increased their stock ownership. But insurers are now reaching the limits of their legal (and perhaps financial) ability to hold stock. JACK MCDONALD, Origins and Implications of Cross-Holdings in Japanese Companies, at 9 (Stanford Business School Technical Note 79) (July 1991). 122 KANDA, supra n. 74, at 1; ROSENBLUTH, supra n. 70. 123 The evolutionary theorists mistakenly offer this syllogism: (1) Banks are the intermediaries with governance influence in Germany and Japan. (2) Banks' core function is to lend money. (3) Securitization and retained earnings marginalize banks' credit. (4) Therefore, as Securitization reduces bankers control over credit, financial institutions must disappear from the boardrooms. Statements (1), (2), and (3) are true, but (4) is not, due to substitutes and stockbased power.
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Even if a sell-off occurs, someone is going to own the stock that banks now own: It could be fragmented individuals (unlikely), it could be small institutions (possibly), or it could concentrate in new institutions (such as mutual funds or banker-broker networks, as in Germany, or expanded customer-supplier crossownership), or it could stay with the banks, especially if Japan abandons its Glass-Steagall segmentation. The result may partly depend on the nature of Japanese business, whose rapidly changing product cycles and managerial styles favored today's ownership structure. If product cycles change, the old structures may become less useful.124 A plausible prediction is that some firms — say those whose business is easily understood by a securities market — will securitize and that others will not. If powerful stockholding intermediaries in America's past were displaced by a superior securities market,125 we might predict a single path for financial evolution. But we don't find powerful stockholding intermediaries in American history. Large blocks arise in America if permitted, undercutting dispersal as "natural."126 Rather than view finance as a unified evolution — everybody moves to diversified portfolios and weak intermediaries — we should view financial evolution as path dependent, with political differences as large determinants of that path. 2. Evolution and Autonomy Managers may share power, if they fear the alternative. When Japanese firms feared American domination, they chose cross-holding for protection. And German managers have been inconsistent toward banker control of the proxy system. Many German companies have capped voting of outsiders, but not bankers, as an antitakeover device.127 In America, the closest analogues to foreign intermediary influence are Berkshire Hathaway's positions in Salomon, Coca-Cola, Capital Cities, and Gillette. Managers invited Berkshire Hathaway 124
Cf. MASAHIKO AOKI, "Toward an Economic Model of the Japanese Firm," 28 J. Econ. Lit. 1 (1990). 125 The only American intermediary that could fit is the Morgan firm, whose power came as a securities underwriter, not as a commercial bank, insurer, mutual fund, or pension fund. Its power to control insurers (and their substantial investment assets) was reduced by the Armstrong investigation (and laws) of 1905-1906 and its power to affiliate with commercial banks (and their substantial deposit assets) was ended by Glass-Steagall. And it never could control a nationwide network of banks, because nationwide branching has always been illegal. Japanese firms in the past resembled modern American firms and then changed, according to AOKI, supra n. 72, at 35. 126 DEMSETZ & LEHN, supra n. 22; MELV1N EISENBERG, The Structure of the Corporation, at 49-50 (1976). 127 BAUMS, supra n. 6.
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to beat back a takeover threat. LBOs bring financiers into corporate governance, flattening authority at the top.128 Everywhere managers seek autonomy. Because managers defeated takeovers with antitakeover laws, they have no reason to share power with the institutions. These forces are at work in the rise of German "keiretsu". The prospect of American-style takeovers arose;129 then, last summer, Dresdner Bank, Allianz Insurance Company, and Hoechst, a chemical firm, announced major crossshareholdings among themselves and a group of German industrial companies. This German "keiretsu" also contradicts evolutionary decay.130 3. Evolutionary Summary Evolutionary fragmentation faces four problems: First, neither Japan nor German public firms have done so yet. Predictions are not facts. Institutions still have large blocks of stock. Second, securitization of debt in Japan may undermine bank influence as creditor, (i) but it hasn't yet on the equity side and (ii) Japanese proposals to amend their Glass-Steagall may mean more powerful intermediaries. Third, large Japanese firms outside the old-line keiretsu built new keiretsu and German firms now form keiretsu-style relationships. Fourth, many American trends are toward enhanced institutional voice and more concentrated institutional investments, rather than maintenance of fragmented ownership. The foreign structures my be dimly-lit versions of the American future. Moreover, some of the pressure for institutional reticence in corporate governance arises from political pressures, which we examine next. 128
See CAROL J. LOOMIS, "The New J.P. Morgans," Time, Feb. 29, 1988, at 44 (listing LBOs with financiers on board). Many LBOs dealt with free cash flow problems, as managers misdirected extra cash to empire-building; Japanese firms are only now facing this problem. The point is that LBOs flatten authority, with financiers in the boardroom, calling into question economic evolution as meaning Japan and Germany will catch up to us as soon as they learn how to. 129 The most prominent was Pirelli's multi-year siege of Continental, the large German tire manufacturer. See ANDREW JONCUS, "Continental AG Shareholders Deliver Pirelli Another Blow," Wall St. J. Europe, July 6, 1992, at 4, col. 1. 130 EGLAU, "Allianz/Dresdner Bank-Vermachtet und Verschachtelt [Powerful and With Interlocks]," Die Zeit, Aug. 16, 1991, at 19. Dresdner is Germany's second largest bank, Allianz its largest insurer, and Hoechst the sixth largest industrial. Lufthansa and Bayer are expected to join. News reports show an Allianz-Dresdner octopus, gobbling up German industry, suggesting popular reproach to the concentration of private economic power. Id. Banks are hubs of new industrial networks elsewhere in Germany, with cross-representation of network members on boards. KIRSTEN S. WEVER & CHRISTOPHER S. ALLEN, "Is Germany a Model for Managers?," Harv. Bus. Rev., Sept.-Oct. 1992, at 36, 42.
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C. Political Evolution in Germany and Japan 1. Germany Deutsche Bank might not allow employees to chair an industrial firm's board and German banks sold some directly-held stock. In America, politics disables powerful intermediaries. And in Germany now, the German banks are under intense political pressure.131 Banker power is unpopular; politicians say it clashes with the German "social order."132 Parliamentary reports attack the banks. Politicians want to cut "the percentage of equity a bank could maintain in a nonbank enterprise and cut the number of supervisory board positions a bank executive could hold"133 and look to the American Bank Holding Company Act for guidance.134 Managers prefer to get bankers out, although are shy to say so publicly.135 The banks bow to the political pressure.136 Second, German politicians provoked a storm of political protest in the region where a bankpropelled takeover target operated, resembling state-by-state American 131
PROTZMAN, "Mighty German Banks Face Curb," N.Y. Times, Nov. 9, 1989, at Dl, col. 9; JOHN DORNBERG, "The Spreading Might of Deutsche Bank," N.Y. Times, Sept. 2, 1990, at 23, 60, col. 3 (Bus. World) ("Social Democrats and the staunchly market-oriented Free Democrats, the junior [partner] in Chancellor Kohl's coalition government, want to clip the banks' wings"); TERENCE ROTH, "West German Banks Face Threat of Reduced Influence in Industry: Bonn Will Consider Rules to Curb Their Holdings and Seats in Boardrooms," Wall St. J., July 18, 1989, at A20, col. 5. 132 KRÜMMEL, "German Universal Banking Scrutinized: Some Remarks Concerning the Gessler Report," 4 J. Banking & Finance 33, 35 (1980). See also JÖRG HUFFSCHMID, "Demokratische Alternativen der Bankpolitik," Verbraucherpolitische Hefte, Dec. 1987; HORST GREIFFENBERG, "Die Macht der Banken," Verbraucherpolitische Hefte, Dec. 1987; "Der Herr des Geldes," Der Spiegel, Mär. 13, 1989; "Zwischen Bonn und Banken: Finanzdiplomat Hermann Abs," Der Spiegel, Nov. 3, 1965; "Die Geheimräte der Nation," Industriemagazin, Apr. 1987. 133 DORNBERG, supra n. 131, at 60. 134 ECKSTEIN, supra n. 147, at 480. See also "Gegen wachsende Bankenmacht und für mehr Wettbewerb im Kreditgewerbe," Anhörung des Bundestags-Ausschusses für Wirtschaft, May 16, 1990 (German parliamentary hearings about bank proxy voting in 1990, discussed in JOHANNES KÖNDGEN, "Duties of Banks in Voting Their Clients' Stock" (at 531 ff. below). 135 OTTO LAMBSDORFF, "Das Machtgeflecht der Banken lichten," Frankfurter Allgemeine Zeitung, Aug. 22, 1989, at 10 (leading German politician says senior managers privately tell him that they'd like banker power reduced). When takeovers became a real possibility, German managers had second thoughts. 136 KRÜMMEL, supra n. 132, at 43: "They thus continue with their traditional tendency to elude public controversy by a flexible attitude and not to rise against die Zeitgeist, even if they are convinced they have the better arguments."
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antitakeover moves in the 1980's.137 To dampen political protest, the bankers lowered their public profile. Third, Deutsche Bank, Germany's largest, says that the political heat is too high to maintain high visibility in corporate governance - either as owner or as director.138 Bankers may think managers could tap popular discontent about banker power, and get American-style restrictions. So the bankers keep a low profile and publicly announce that they would not fight a political requirement that they give up proxy voting.139 Politics, not efficiency, accounts for some of the laxness some observe in German banker assertiveness. These public sentiments would in America combine with powerful interest groups — the small bankers or managers, for example — to produce laws restricting the large banks, giving deposit insurance to the small banks, and protecting managers from takeovers. The German restraints are informal and self-imposed, to head off formal restrictions. Why don't formal restrictions appear anyway? German political structure dilutes the political effect of anti-bigbank opinion united with small bankers and managers with an axe to grind. Germans vote for a party, which gets a proportion of seats in Parliament based on the vote;140 local bankers (and managers) and their campaign contributions are less important than in an American congressional elections.141 Codetermination is a critical part of German corporate governance. Employees get half of the supervisory board, with blue collar, white collar, and national labor unions represented, balancing institutional power on the supervisory board.142 The German Parliament wanted labor in the boardroom as a counterweight to capital, a balance that seems like comicbook politics in its simplicity. The historical origin of codetermination is rooted in the aftermath of 137
"Once the [target's] employees protested the proposed] deal, the politicians in southern Germany, where [the target] is based, began to send up a hue and cry [which affected Deutsche Bank.] JACKEY GOLD, "M&A Continental Style," Financial World, March 5, 1991, at 36. 138 Report of the Subcomm. on Financial Institutions Supervision, Regulation and Insurance of the [House] Comm. on Banking, Finances and Urban Affairs, Comm. Print 101-7, 101st Cong., 2d Sess. 164-65 (1990). 139 FRITZ KÜBLER, supra n. 86. 140 LEWIS EDINGER, West German Politics, at 119-20, 149, 172 & n.6 (1983). Half of parliament comes from the party lists; the other half is elected from a local constituency. 141 See id. at 148 (power of political parties "discouragfes] interest associations from supporting independent deputies and [strengthens] cohesion within the parliamentary parties. The leaders . . . can use the threat of expulsion to keep dissidents in line[.]"). 142 Labor presence reduces the attractiveness of takeovers that would disrupt employment at the target. Codetermination's implications for other takeovers is more obscure. For one type of German large corporation, the GmbH, the impact of codetermination is reduced, because the shareholders can bypass the board of directors and give directions to managers. FRITZ KÜBLER, Gesellschaftsrecht, at 405 (3d ed. 1990).
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the German revolution of 1918 when politicians sought to co-opt potential revolutionary forces. They thereafter expanded it, most recently in 1976, when parliament sought to pacify unions after a wave of strikes in the 1970s.143 While I am unaware of a probing political analysis of Germany's expansion of codetermination in 1976, I doubt that either popular opinion concerning the banks nor the interest group influence of the Germen unions was irrelevant. America fragmented capital and labor; Germany brought both into the boardroom to deal with one another. Codetermination is the German political cousin to American fragmentation of finance, not a product of natural economic development without political action.144 Codetermination has two large effects on corporate governance. First, codetermination should be seen as the German political cousin to America's fragmentation of finance and antitakeover wave of the late 1980s. It makes powerful intermediaries more politically palatable than they have been in America, because the employees are in the boardroom. Employee presence also impedes the ability of powerful intermediaries to bring about rapid organizational change, if that change would disrupt employment. Second, codetermination affects and changes corporate governance. As I just noted, employees' voice in the boardroom impedes changes that would disrupt employment. My understanding, based on discussions with those familiar with the German scene, say this has led bankers to want to weaken the supervisory board, the arena where the employees are. If key decisions are brought into the supervisory board, the employees would have more authority. Recognizing this, the bankers have, I understand, preferred to downplay the supervisory board, hoping for an effective managerial board.145 The rhetoric of banker boardroom withdrawal should be considered with codetermination in mind. What if banks feared that the governance task ahead is to tighten the belts and salary levels of highly paid workers? They might plausibly conclude that the German political climate wouldn't allow them the luxury of visibly firing employees or lowering their salaries. Better to move to the sidelines and let a codetermination board do the best it can. I lack the institutional feel for German structures to be sure how much of the 143
ALAN HYDE, "A Theory of Labor Legislation," 389 Buff. L. Rev. 383, 411-12 (1990). 144 In Japan, neither are heavily represented in the boardroom. But while the financiers have influence, through the Presidents' Council, lifetime employment protects labor. 145 The bankers have a trump. If push comes to shove in the supervisory board, and the employee directors and stockholder directors deadlock, the stockholders cast the deciding vote, although I understand this rarely if ever, happens. Nevertheless, the banker-stockholders may think they are better off downplaying the supervisory board, where they usually tie with employee directors if there is conflict, and hope that their informal influence will be great enough outside of the supervisory board.
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banker withdrawal is minor, how much is due to financial evolution, and how much is due to political pressures. But whatever the right mixture is, it seems that German politics plays a not small role. 2. Paths to the Present: Germany When Bismarck unified Germany, he sought to develop German industry, by creating great banks as engines of development. The great banks naturally expected to follow the money they lent and monitor its proper deployment. Happenstance is the other key historical explanation. Germany taxed securities transfers at the end of the 19th century. Banks held customer stock in the bank's name, issuing receipts to the retail owners. When a customer sold stock to another customer, the banks argued that no taxable transfer occurred, because the bank continued as the record owner. The taxing authorities agreed. Thereafter stock owners preferred to deposit stock with bigger banks, because the bigger bank could better match customers' sales and purchases.146 The explanations are reconcilable. Government could have fostered banks as engines of development, but been indifferent to banker control over proxies, which could have devolved upon the large banks due to happenstance. Today, even German governmental authorities suspicious of bank power believe that destroying bank control of the proxy system would just shift their conflicts to managers; banker conflicts are seen as the lesser of the two evils.l47 3. Japan Before World War II, large Japanese firms were the zaibatsu, which resembled American 1960's conglomerates, but with family ownership at the top. Little could better show law determining structure than the law a military dictatorship imposes ~ such as the 1943 Japanese military order to firms to choose a main bank to facilitate wartime production148 — or the law an occupying military power imposes, such as the laws imposed in 1948 by the Supreme Command, Allied Powers, to break up the zaibatsu, distribute their stock, and prohibit bank ownership of big blocks of stock149 due to the "American belief that [democracy] not only required free elections, free speech, and due process but
146
JACOB RIESSER, Die deutschen Großbanken und ihre Konzentration im Zusammenhang mit der Entwicklung der Gesamtwirtschaft in Deutschland (3d ed. 1910). 147 WOLFRAM ECKSTEIN, "The Role of the Banks in Corporate Concentration in West Germany," 136 Zeitschrift für die gesamte Staatswissenschaft (ZgS) 465, 476 (1980) (Eckstein was Secretary General of the Monopoly Commission). 148 AOKI, supra n. 72, at 37. 149 J. MARK RAMSEYER, supra n. 97, at 99-100.
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also the Glass-Steagall Act."150 Foreshadowing the American Bank Holding Company Act of 1956, SCAP, the Supreme Command, Allied Powers, prohibited Japanese banks from owning more than 5% of another firm's stock. But international politics — communism in China and war in Korea - changed SCAP's primary goal from pacifying a defeated enemy to building a stable economic ally; SCAP loosened its grip, fragmentation ended. Japan fostered close relations between finance and industry. In the next decades, stock relentlessly moved from individuals to banks and insurers; and Japanese authorities did not require banker passivity, as did the American. Cross-ownership bound finance and industry together, without one able to control the other day-to-day, which would violate the holding company prohibition. Politics should be seen as affecting the structure of the Japanese firm, through an amalgam of political directives, just as politics determined key features of the American firm by fragmenting finance. American rules giving Japan a GlassSteagall Act were designed not for efficient operation of financial markets and sound corporate governance; they were designed to inculcate democracy.151 American fragmentation of Wall Street arose partly from belief that democratic political stability depended on financial fragmentation; that belief reappears in the Japanese occupation; weaknesses in Japanese intermediaries partly result from American democratic ideology.152 In the 1960's cross-ownership accelerated, due partly to fears that partnership with American firms would yield American control. Cross-ownership accelerated to thwart takeovers153 and maybe to improve supplier-customer relations, not to improve governance or to share power. Only with subtlety could the Japanese overcome the rules: by not adopting the American passivity rules, by keeping the banks big, and by channeling much 150
DAVID LITT, JONATHAN MACEY, GEOFFREY MILLER & EDWARD RUBIN, "Politics, Bureaucracies, and Financial Markets: Bank Entry into Commercial Paper Underwriting in the United States and Japan," 139 U. Pa. L. Rev. 369, 380 (1990). 151 Coffee astutely points this out. COFFEE, supra n. 52. 152 The post-war occupation forces also tried to splinter the German banks through a proto-McFadden Act, splintering the big three into 30 small banks. By 1956, they had reemerged. ROLF ZIEGLER, DONALD BENDER & HERMANN BIEHLER, "Industry and Banking in the German Corporate Network," in Networks of Corporate Power, at 91, 106 (Frans Stokman, Rolf Ziegler and John Scott eds. 1985). 153 "The cross-holding of shares was started as a defensive countermeasure against cornering or buying up stocks that had been activated by the postwar breakup of Japanese financial cliques. Since then the custom has prevailed. Especially after the liberation of capital transactions in the 1960s, cross-holding of shares has been used as a defense against takeover attempts by foreign capital." FOUNDATION FOR ADVANCED INFORMATION AND RESEARCH, Japan, supra n. 81, at 16.
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post-war credit through the banking system. This they did, but right now banks do all the heavy lifting, and the system is under pressure.154 Restructuring the intermediaries could allow concentrated ownership, but interest group fights so far stymie a restructuring of Japanese finance that could preserve concentrated ownership while relieving the banks.155 Securities firms want banks held back from underwriting securities of companies in which the bank is influential, either as creditor and or as stockholder.156 The commercial bankers see no danger in this relationship.157 [T]he walls that have divided various types of financial institutions since World War II still stand, because of the tenacity of entrenched interests. City banks, for example, will be barred from making long-term loans in the Euroyen market until the long-term credit banks and trust banks receive suitable compensation, such as expanded securities powers. It is the political power of these various groups rather than economic rationale that protects them.158 But managers like cross-holding and want a substitute if the banks cannot continue their heavy lifting: "Any hard-landing approach which restricts . . . cross-holding . . . riskfs] demolishing the base of [the] Japanese management systems, and will never be accepted by a national consensus and must be avoided by all means."159 154
The Bank of International Settlements capital standards makes stockholding more difficult. Japanese savers and corporate borrowers have access now to non-bank alternatives. Government depressed interest rates are reaching market levels. The American Structural Impediments Initiative seeks to fray the equity ties inside the keiretsu. 155 See LITT, MACEY, MILLER & RUBIN, supra n. 150, at 452 (commercial paper market); JAMES STERNGOLD, "A Japanese-Style Old Boy' Network," N.Y. Times, June 7, 1991, at Dl, col. 3 (conflict between brokers and bankers in Ministry of Finance about allowing banks into the securities business); ROBERT ZIELINSKI & NIGEL HOLLOW AY, supra n. 71, at 70 (post-retirement - at 55 - jobs keep some Ministry of Finance officials attuned to interests of banks, others to that of brokers); ELLIOT GEWIRTZ & CLARK TABER, "Fundamental Issues in Japanese Financial System Reform," 7 Rev. Banking & Fin. Serv. 135, 141 (1991). 156 THE [JAPANESE] SECURITIES AND EXCHANGE COUNCIL, How Basic System Regarding Capital Market Ought to be Reformed, at 18 (June 21, 1991). 157 FINANCIAL SYSTEM RESEARCH COUNCIL, On a New Japanese Finance System (June 25, 1991). 158 FRANCES ROSENBLUTH, supra n. 70, at 94-95. 159 FOUNDATION FOR ADVANCED INFORMATION AND RESEARCH, Japan, supra n. 78, at 23. See also GERLACH, supra n. 16, at 117 (Japanese executives opposed to stopping cross-holding); KOMIYA, supra n. 94 at 255-56 (some managers look to insurers for protection). Changes in Japan's pension funds may create a huge emerging pool of capital. FRANCES ROSENBLUTH, supra n. 70, at 75. How and who controls these funds — managers or intermediaries — may determine the future
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I make no claim to a deep understanding of Japanese and German political history. Others will have to deepen, and correct, this history. The point here is that even a superficial review shows the Japanese and German evolutionary path is now being shaped -- partly and only weakly — by forces similar to those that deeply shaped the American evolution. A populist, antibank ethos so far seems absent in Japan.160 But consider the current economic turmoil there, where firms in mature product markets have free cash flow, loosening bank lender control. Two tests loom. First, will stockholding banks keep the stock and induce portfolio firms to better use the cash? Second, if they succeed in a way that makes managers and workers unhappy, say by ending lifetime employment, then a major test of the political theory looms. In America damaged groups would appeal to the legislature to redo the result. While in Japan the appeal might fail, politics there is not so different that we should expect disgruntled silence from those affected. We shall see. D. Or Are the Foreign Structures the Dinily-Lit American Corporate Future? Commentators assert Japan and Germany will get American-style diffuse ownership. Unnoticed is the prospect that American firms will evolve — weakly and oddly — toward German and Japanese style ownership. Functions move persistently into American intermediaries. The next natural "stage" in American corporate finance might be of intermediaries in the boardroom,161 or of intermediaries electing directors whose loyalty runs to the intermediaries, not managers. The one American intermediary vaguely like the main bank and universal bank is Berkshire Hathaway, an insurer whose big blocks — and legal authority to take them — are recent acquisitions. Institutions owned only 8% of the stock of America's largest firms in 1950. Now they own half, but in small, unconcentrated blocks.162 The five largest holders rarely own much more than 5% of the largest American firms, only a few approach Japanese concentration.
of Japanese corporate governance. 160 T.S. BISSON, Zaibatsu Dissolution in Japan, at 29 (1954), quoting U.S. DEPARTMENT OF STATE, Report of the Mission on Japanese Combines, Publ. No. 2628, Far Eastern Series 14, 21 (1946): "Since the [Meiji] restoration ... [t]here has never been any movement in Japan strong enough to produce a Sherman Act, ... a Money Trust Investigation, a Federal Trade Commission, or a Securities and Exchange Commission such as developed in the United States...." 161 Cf. ROBERT CLARK, "The Four Stages of Capitalism," 94 Harv. L. Rev. 561 (1981). 162 BRANCATO et al., supra n. 17.
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The rarities are mainly the large blocks held by Berkshire Hathaway.163 Even with their weaker holdings, some institutions have been active, seeking to elect directors, making shareholder proposals, petitioning the SEC to loosen restraints on their activity. If these trends continue, we may some day approach the German and Japanese numbers.
VI. The Paradox of International Competition: Solution and Problem Corporate managers are situated in several markets and several organizational webs. Product markets, and labor markets are constraints. Responsibility to employees and a board of directors makes managers responsive to internal voices insisting on good performance. Differences in corporate structures may have only a marginal impact on corporate performance because of these other constraints. International competition induces reconsideration of American corporate governance. Successful foreign structures pressure American finance, industry, and government to change. In a mechanism that mimics Tiebout's model of state competition to provide efficient regulation,164 international competition is not just between firms and people, but between forms of organization. The existence, persistence, and (thus far) success of rival forms makes us question whether the American forms are as superior as Americans have thought. A political rallying cry of change to meet the foreign competition would have credibility. But product competition partly substitutes for corporate governance. Badly governed firms will feel pressure to change when competing with better governed firms. Competition has two cross-cutting effects. First, it shows deficiencies in America's system of business governance. But, second, product competition instigates the badly-managed businesses to improve, making a change in governance form less important. Which effect is more significant is hard to say. Response from the stimulus of enhanced international competition might end the governance problem, without changing the internal structure. Intense domestic competition helps make the Japanese industrial cross-ownership functional.165 Other responses are possible. In industries with long-lived capital resources, the poorly-governed firms may stagger along, using up the fixed assets, without 163
Coca-Cola had a five-shareholder concentration level of 20%, due not surprisingly to legal anomalies: holdings by Berkshire Hathaway, an insurance holding company operating outside the norm and by a bank exempt from the general provisions of the Bank Holding Company Act. 164 CHARLES TIEBOUT, "A Pure Theory of Local Expenditures," 64 J. Pol. Econ. 416 (1956). 165 GILSON & ROE, supra n. 33.
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73
improving the enterprise, as some American heavy industries, like steel and cars, have failed to improve. And the affected firms may compete by political action: quotas and tariffs reduce competition and several American industries, like steel and cars, have sought quotas and tariffs.
ΥΠ. Conclusion The American-style large firm, with managers at the pinnacle holding most power, is not inevitable. Managers could share authority with intermediaries voting large blocks of stock; in Germany and Japan they do. The foreign institutions control large blocks but do not dominate. Usually several intermediaries have blocks. The flat foreign structures more resemble each other than they do the American hierarchy with the CEO at the top. The dominant paradigm explaining the evolution of the large American public firm begins with economies of scale requiring large inputs of capital from thousands of far-flung investors demanding diversification. As the investorshareholding level fragmented, power inside the firm shifted from shareholders to managers. I argued before that this shift depended on American politics. If permitted, powerful intermediaries could have gathered the funds and invested them. Germany and Japan do not have as extensive fragmenting laws; they have powerful financial intermediaries that would be highly illegal in America. I examine Germany and Japan not so much to argue that they are better and should be mimicked, but to show that vastly different systems of governance are possible, that the American-style public firm with fragmented shareholder power is not inevitable, that managers can share power with intermediaries without the corporate world falling apart, that perhaps America could, if it wanted, change the American pattern. Banks are central in Germany and Japan, but other intermediaries could be; indeed, the German banks have a stock-based role far from what we think of as commercial bank functions in America. Weak American banks mean reform ought not make banks central. Deposit insurance — a product of small banks' political power — makes unleashing banks now unwise. Accommodating banks in corporate governance should be subject to high capital requirements, making "permission" aspirational for the time being. And while banks will continue to have the bulk of financial assets for some time, their declining share makes reconstruction for corporate governance purposes more difficult; it would have been easier to allocate growth to governance, but growth is not in the cards. American reform with bite would not be for banks. America could imitate the German banker role here by reconstructing insurers (to look like Berkshire Hathaway) or mutual fund complexes. Right now managers command private
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pension funds, not the other way around.166 Pensions and mutual funds are the growing financial institutions. They lack banks' difficult-to-undo path dependent weaknesses. We should experiment by ending subchapter M's and the Investment Company Act of 1940's portfolio restrictions, facilitating pension fund activity in corporate governance, and ending securities law strictures on shareholder activity. Finance and industry relate similarly in Germany and Japan, through Escherlike overlaps without hierarchy. Despite different cultures and histories, and American occupation efforts to fragment foreign intermediaries, both nations constructed ownership structures that more resemble the other than either resemble America's. Full treatment of foreign governance must attend to labor relations, government guidance and the big blocks' role in industrial organization, but what we know so far is that the differences between the American and the foreign are today vast. Politics influences the structure of the large public firm. Firms in nations that tolerate large pools of private economic power evolve differently than firms do in nations that repeatedly fragment financial institutions, their portfolios and their ability to network blocks of stock. The comparison reveals a profound irony: America has the world's longestlived democracy, founded on a premise of checks and balances, dividing power among the branches of government, constructed by the theorist Madison who recognized that "Ambition must be made to counteract ambition," and "[i]f [people] were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls on government would be necessary." This democracy founded on a fragmentation of governmental power produced corporate governance by centralization of power in senior managers. In Japan and Germany, countries with a weaker democratic past and a differing parliamentary present, politics encouraged powerful financial intermediaries that facilitated a system of "checks and balances" between managers and financiers: senior managers in those countries must, like America's politicians but not its CEO's, share authority.
166
Federalist No. 51
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Appendix Table I Aggregate Voting Blocks of the Largest Three German Banks (1986) Percentage Voting holdings of: Commerz of shares Deutsche Dresdner Rank of Company voted at bank Bank Bank meet i nq 1 . Si emens 60.64 4.14 17.64 10.74 2. Daimler Benz 1.07 81.02 41.80 18.78 Mercedes Hold 12.24 67.20 11.85 13.66 3. Volkswagen 1.33 50.13 2.94 3.70 4. Bayer 6.77 53.18 30.82 16.91 5. BASF 6.18 55.40 28.07 17.43 6. Hoechst 31.60 57.73 14.97 16.92 9 VEBA 50.24 5.85 23.08 19.99 11. Thyssen 11.93 68.48 9.24 11.45 4.04 12. Deutsche Bank 55.10 47.17 9.15 13. Mannesmann 9.71 50.63 20.49 20.33 18. M . A . N . (GHH) 13.72 64.10 6.97 9.48 3.57 21 . Dresdner Bank 56.79 13.39 47.08 27. A l l i a n z - H o l d i n g 11.14 2.35 66.20 9.91 28. Karstadt 77.60 33.02 37.03 8.81 29. Hoesch 45.39 16.73 15.31 15.63 34. Commerzbank 34.58 50.50 16.30 9.92 35. Kaufhof 37.18 66.70 6.29 13.33 3.55 36. Kloeckner-Werke 69.13 17.30 3.78 1.50 37. KHD 72.40 44.22 3.82 41. M e t a l l g ' s c h a f t 90.55 0.35 16.42 48.85 44. Preussag 69.58 2.59 5.60 11.5 1.89 51. Degussa 70.94 6.86 33.03 3.59 52. Bayr. Vereinsbank 62.40 11.42 2.71 56. Continental 6.04 35.29 22.77 9.99 1.20 57. Bayr. Hypobank 67.90 5.86 7.05 59. Deutsche Babcock 67.13 5.29 9.67 7.58 67. Schering 46.60 10.17 23.86 17.46 68. Linde 52.99 21.36 22.76 15.73 73. Ph. Holzmann 82.18 55.42 6.49 0.91 94. Strabag 1.37 83.02 6.80 19.15 96. Bergmann 99.12 36.89 98. Haoaq- Lloyd 84.50 0.39 48.15 47.82 On Average 64.49 9.05 21.09 15.30
All Big Banks 32.52 61.66 37.75 7.98 54.50 51.68 63.48 47.92 32.62 60.36 50.53 30.17 64.04 23.41 78.86 47.67 60.81 56.80 24.63 49.54 65.62 19.34 41.79 17.72 38.81 14.11 22.54 51.50 59.87 62.82 27.32 36.89 96.36 45.44
Source: Arno G o t t s c h a l k , Der S t i m m r e c h t s e i n f l u s s der Banken in den AktionärsVersammlungen der Grossunternehmen, 5 W S I - M i ttei lungen 294-404 (1988). Although Gottschalk's data -- from 1986 -- is not real time, it is the most recent a v a i l a b l e according to recent German commentary. See Baums, supra.
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Mark J. Roe Table Π
Percentage of stock of largest German corporations held DIRECTLY by German banks (not held through mutual funds and not held as custodian) (top 100 companies, 1988) Company rank 1
Company Daimler Benz
Bank Deutsche Bank Dresdner Bank Commerzbank DG Bank Bayerische Landesbank
Percentage of stock 28.2% 1 .6% 1.6% .3% 1.6%
10
Thyssen AG
Commerzbank
14
BMW
Dresdner Bank
5%
16
Deutsche Lufthansa
Bayerische Landesbank
5%
21
MAN AG
Commerzbank
4.94%
23
Messerschmitt Boelkow-Blohm GmbH
Dresdner Bank Bayers i sehe Vereinsbank
5%
25
Karl Stadt AG
Deutsche Bank Coirrnerzbank
over 25% over 25%
35
Kaufhof
Dresdner Bank Commerzbank
9% [1986] 3% [1986]
40
Vereinigte E l e k t r i z i taets-uerke Westfalen
Deutsche Bank Westdeutsche Landesbank
6.3%
Metallgesellschaft AG
Deutsche Bank Dresdner Bank Westdeutsche Landesbank
10.72% 23.1%
10% 10%
42
4.94%
5%
over 7.2%
48.8%
57
Linde AG
Deutsche Bank Commerzbank
58
Kloechner Werke
Deutsche Bank
19.6%
67
Hochtief AG
Commerzbank
12.5%
71
Klockner-Humboldt Deut z AG
Deutsche Bank
41.4%
75
P h i l i p p Holzmann AG
Deutsche Bank Commerzbank
35.4% 5.0%
90
PWA Papierwerke Waldhof Aschaffenburg
Bayerische Hypotheken und Wechsel -Bank 25.0%
92
Bergmann-ElektricitatsWerke AG
Deutsche Bank 36.5% Bayerische Vereinsbank 25.4%
Source: Hauptgutachten der Monopolkomnission, in 11 Deutscher Bundestag, Drucksache, 7582, at 203-06 et
seq.
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Corporate Governance in Germany, Japan and America
Table ffla Summary of Bank Size in Germany and the United States (1)
(2)
(3)
(4)
(6)
C5)
(7)
Assets of 3 Assets of 3 German American Relative size Relative size German size/ of American American size biggest biggest GNP GNP of German German banks American banks [(1)/(3)] banks C(2V(4)] U5)/^h^'^'c3>h*tri CMCMCMCMCMCMCMCMCMCMCM OJ CM CM
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Corporate Governance in Germany, Japan and America
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Table X: The Total Percentage Held By Banks Owning More Than 5 % The Industrials *1
O O O O O O O O O O O O O O O O O O O O O O O O O O
3
o o o o o o o o o o o o o o o o d d d d d o o o o d
ί
1 Ϊ
ooof^coir)ir)'-oSource: Sven-Ivan Sundqvist, Ägarna och makten i Sveriges Börsföretag 1992 (Owners and Power in Sweden's Listed Companies, 1992) (Stockholm 1992). This survey leads to a number of observations. Firstly, the largest companies seem to include two groups. On the one hand, there is a group of companies in which a controlling owner can be singled out, often in the form of an investment company. On the other hand, there is a somewhat smaller group of companies that lack any controlling owner, due either to restrictions on the right to vote at a shareholders' meeting specified in the company by-laws or to cross-ownership with other companies. Secondly, we may also observe that none of the top 25 companies has a family as its controlling owner. Institutions are totally dominant among the largest single owners of the largest companies. But the survey also reveals interesting differences among these institutions. It is clear that several of the owner categories with large percentages of the stock market capitalization at the aggregate level are absent as major shareholders in individual companies. It is especially remarkable that this seems to be a consistent feature of those institutions that have increased - or at least not decreased - their portion of the overall market value in recent years, for example mutual funds, pension funds and insurance companies. The absence of certain owner categories as controlling owners of individual companies can be largely explained by rational investment behavior. A mutual fund, to take one example, aims at a diversified portfolio and gives priority to the possibility of divesting holdings that do not yield a satisfactory return. Furthermore, several institutional investors are also prohibited by law to acquire large equity stakes in individual firms. A mutual fund may not hold shares representing more than 5 percent of the total number of votes in an individual
Corporate Governance in Swedish Listed Companies
293
representing more than 5 percent of the total number of votes in an individual company, a national pension fund no more than 10 percent and an insurance company no more than 5 percent. Though Swedish legislation has encouraged the formation and growth of these type of institutions, it has nevertheless deprived them of the opportunity to become major owners of shares in individual companies. The legislators have never discussed how this situation affects the owners monitoring function. Having noted who the shareholders in Swedish listed companies are, and which of them have (or do not have) the prerequisites to become controlling owners of individual companies, let us now focus on the size of their holdings. The concentration in the structure of ownership in individual companies will be described by employing a "concentration ratio" that shows the cumulated percentage of votes held by the largest owners of individual companies.3 The Swedish Companies Act allows corporations to issue different classes of shares with different voting rights. An owner's percentage of the total number of votes in a company may thus differ substantially from his percentage of the company's equity. A discussion of ownership concentration in Swedish companies must therefore begin with a survey of the prevalence of voting right differentials. According to the current Swedish Companies Act, no share may confer a vote which carries more than ten times the weight of another share in the company.4 However, a handful of very large Swedish companies have managed to retain voting right differences of 1 to 100 and even 1 to 1,000 through grandfathering, and may continue to issue shares with these voting rights.5 Shares with differentiated voting rights are very common among publicly traded companies in Sweden. In January 1992, unequal voting rights existed in nearly 90 percent of the companies on the Stockholm Stock Exchange. See Table 3. Unlike the situation in countries such as Britain, Swedish investors show no reluctance to buy low-vote shares. On the contrary, market trading in the shares of most companies is especially heavy for these particular shares, which are obviously priced in accordance with their limited voting rights.
3
A more comprehensive way of measuring concentration, but one that is not especially suitable in the present context, is the Herfindahl index. The conclusion from using either of the two concentration indicies are, however, identical. 4 Swedish Companies Act (1975:1385), chapter 3, sec.l. 5 Act (1975:1386) On the Implementation of the Companies Act, sec. 8.
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Mats Isaksson/Rolf Skog
Table 3: Voting right differentials between classes of shares in Swedish listed companies. January 1992. Voting right differential
Number of companies
1:1,000 1:100 1:10 1:5 No differential
3 1 165 6 27 202
=>Source: Sundqvist, 1992. Partly because of the widespread use of shares with superior voting rights, the ownership structure of Swedish listed companies is very concentrated. Today the largest single owner of a listed company has an average voting power of 49 percent, and the five largest owners have a combined voting power of 74 percent. Obviously it is worth pointing out once again that the listed companies vary greatly in size, and that almost by definition, ownership concentration is high in small family-controlled companies in which the family has retained high vote shares while selling shares with limited voting rights to the general public. Can these companies explain the high average concentration figures? The answer is no. In 62 listed companies with a market capitalization of 1 billion Swedish kroner or more at year-end 1991, the largest single owner averaged 46 percent of the total number of votes, the five largest owners a total of 72 percent. See Chart 1 below. In other words, grouping the companies into categories of different size does not change the picture of high ownership concentration in individual firms.
Corporate Governance in Swedish Listed Companies
295
Chart 1: Cumulative percentage of the voting rights held by the largest owners in Swedish listed companies. January 1992. 100- Percentage of voting stock 908070605040302010-
Largest owners
As for changes in ownership concentration over time, it is apparent that there has been a substantial increase in the level of concentration in listed companies over the past few decades. The voting power of the largest single owner now averages roughly 15 percentage points more than in the late 1970s. Excluding the effects of the many small, often family-controlled companies introduced on the stock market over the past few years, the average voting power of the largest single owner in 30 companies with continuous stock exchange listings since the late 1970s has risen from 31 percent to 38 percent. The importance of voting right differentials in the concentration of company ownership may be illustrated by comparing the voting power of the largest single owners with their percentage of company's equity. The comparison indicates that these owners have a far higher portion of the total voting rights than of the capital stock. Examining the shareholdings of the largest single owner in the 165 companies with voting right differentials of 1 to 10, we find that the largest owner's voting power averages 18 percentage points higher than his capital ownership: 53 percent compared with 35 percent. Given this high degree of ownership concentration, it is possible in most Swedish listed companies to single out a controlling owner, i.e. an owner who either holds a majority of the voting rights or has such a large percentage of the voting rights in relation to other shareholders that he can be said to exercise effective control. As a consequence of this, in most listed companies we can
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speak of an "owner majority" on the board of directors. The board is elected by the shareholders' meeting and reflects the majority structure of this meeting.6 The debate in many countries on ways of increasing shareholder representation on company boards is thus of limited interest in Sweden. Since the board, in turn, appoints the management of the company, in practice the controlling owner also has a major influence on the choice of management.7 This is illustrated clearly by a strong correlation between changes in corporate control and changes of management in Swedish listed companies during the 1980s. See Section 2. As mentioned above, however, there is also a group of very large publicly traded firms in which no controlling owner can be identified among the shareholders. In most cases, this is explained by the fact that the by-laws impose very tight restrictions on the right to vote at a shareholders' meeting, or that the company is part of a network of cross-ownership with other companies. We will return to this topic in Section 2.
Π. Mergers, Acquisitions and Defensive Measures The distribution of share ownership by owner categories and the concentration of ownership in individual firms provide some idea of the ability and willingness of owners to exercise their monitoring function at the shareholders' meetings and on the board of directors. But the monitoring role of owners is not limited to vote their shares. Another important aspect of the monitoring role is their trade in the companies shares. Until the 1980s the Swedish stock market, like that of many countries in Continental Europe, was relatively calm. Daily share trading volume was not particularly heavy, and merger and acquisition activity was very limited. From 1945 until the end of the 1950s, roughly one corporate acquisition per year took place in the Swedish stock market. During the 1960s there were 29 acquisitions, and during the 1970s there were 40. Not until the 1980s did a major wave of acquisitions hit the Swedish stock market. No fewer than 137 acquisitions occurred during the 1980s. In 1988 alone, there were nearly as many 6
The board of directors shall be elected by the general meeting of shareholders, unless the articles of association provide that one or more directors shall be appointed in another way, Swedish Companies Act, chapter 8 sec. 1. In an election the candidate who has received the largest number of votes shall be considered elected, chapter 9 sec. 13. 7 In a company where the share capital amounts to at least 1 million Swedish kronor, the board of directors shall appoint a managing director. In other companies the board of directors may appoint a managing director, Swedish Companies Act, chapter 8, sec. 3. The managing director does not have to be a member of the board although he very often is.
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acquisitions as during the entire preceding decade. Chart 2 illustrates the number of acquisitions and the value of the acquired companies during the 1980s. Chart 2: Corporate acquisitions in the Swedish stock market during the 1980s. Number of companies acquired and their aggregate market value. Total martwt
Total market value
Numbers of / acquisitions/ -
1980
1981
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1984
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1986
\
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*
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In three-quarters of all acquisitions during the 1980s, the buyer was another publicly traded company. The remaining acquisitions were carried out mainly by private companies. Unlike the case in Britain and many other countries, the Swedish stock market has no rule requiring a shareholder who reaches a certain level of voting rights in a listed company to make an offer to the other shareholders. For this reason, many bidders already have substantial holdings in the target companies. Of the 137 acquisitions in the Swedish stock market during the 1980s, 72 were initiated by purchasers that held no shares at all in the target company on the date of the offer. In the other 65 acquisitions, when the
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offer was made public the offerer already held an average of 25 percent of the target company's shares. The changes in the merger and acqusition activity during the 1980s were not merely of a quantitative nature, however. Whereas previous corporate acquisitions usually involved a buyer who negotiated with the target company's management and major shareholders, reached an agreement with them, and then approached other shareholders with an offer to buy the remaining shares, early in the 1980s the "takeover" concept was introduced in Sweden. Public offers were presented in the absence of any prior negotiations with target company shareholders or management. In most cases the offers were accepted without discussion. In others, however, they encountered substantial opposition and were referred to in the media by the misleading term "hostile" offers. About one-tenth of all public offers in the Swedish stock market during the 1980s are usually classified as "hostile". In connection with these offers, the board of the target company or one of its major shareholders publicly declared their intention to refuse the offer and in some cases recommended that other shareholders follow suit. In some cases, more active defensive measures were also taken to prevent the transaction. In most cases such opposition was successful. Only four of the "hostile" bids were completed. Corporate acquisitions almost always lead to major changes in the operations and organizational structure of the acquired company. The new owner often appoints a new management immediately after the purchase. According to a preliminary review, half of the 137 acquisitions in the Swedish stock market during the 1980s led to an immediate change of management in the target company. Given this background, it is not at all surprising that during the 1980s we also witnessed a greater eagerness and inclination among management to take defensive measures aimed at preventing undesired ownership changes in Swedish companies. Legislation allows a relatively large scope for such measures, as long as an offer has not yet been presented - that is, "preventive" defensive measures. Once an offer has been made public, however, the target company's arsenal of weapons is considerably more limited. Shares with unequal voting rights are usually included in the category of preventive defensive measures. In our opinion, this is not a correct interpretation. If a company's shares carry different voting rights, the company usually also has a controlling owner that a potential buyer is forced to negotiate with concerning the price of controlling the company, i.e. the price of shares with superior voting rights.8 Unequal voting rights do not protect a management without shares of its own in the company against a takeover. 8
The experience of the 1980s also shows that in nearly one-third of the buyouts, the owners of high vote shares received a substantially higher price than the owners of low vote shares.
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The situation is different in those companies that have restrictions on the right to vote written into their by-laws. These restrictions specify that at a shareholders' meeting, a shareholder may only cast votes for a certain percentage of all shares or all votes in the company, or for a certain percentage of all shares or votes represented at that meeting. The Swedish Companies Act stipulates that no one may cast a vote for more than one fifth of all shares represented at a shareholders' meeting, but this provision is optional, and in most companies it has been set aside in the bylaws.9 A review of the by-laws of all 202 publicly traded companies reveals that 181 of them allow the shareholders to vote all shares they represent at a shareholders' meeting. These companies thus have no restrictions whatsoever. However, the by-laws of 21 companies contain voting restrictions ranging from a ban on any single shareholder voting more than one fourth of all shares in the company to a graded voting scale where no one can represent more than 30 votes at a shareholders' meeting. See Table 4. Table 4: Restrictions in the by-laws of Swedish listed companies concerning shareholders' right to vote at a general meeting. January 1992. Restriction Number of companies Graded voting scale, maximum 30 votes 1/20 of number of votes represented I/10 of number of votes represented 1/10 of number of high vote shares represented and 1/100 of low vote shares represented 1/10 of number of shares represented 1/5 of number of shares represented 1/5 of number of high vote shares represented and 1/5 of number of low vote shares represented 1/50 of total number of shares 1/5 of total number of shares 1/4 of total number of shares No restrictions Total
1 1 1 1 3 10 1 1 1 1 181 202
=>Source: Company Register, Swedish Patent and Registration Office.
9
Swedish Companies Act, chapter 9, sec. 3.
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Restrictions in the by-laws concerning the right to vote at a shareholders' meeting are common in banks and insurance companies, but very rare in other companies. One possible reason for this is that these industries have been very strictly regulated for many years, and consequently there has been little scope for an active ownership function. The most far-reaching restrictions are found in Sweden's largest insurance company, Skandia. Since 1855 no one has been permitted to exercise more than 30 votes at a Skandia shareholders' meeting, regardless of how many shares he owns. A holding of 1-375 shares entitles the owner to 1 vote, 376-750 shares are worth 2 votes, and so on up to 29 votes for 28,501-30,000 shares. A holding of more than 30,000 shares entitles the owner to 30 votes. With a total of 75 million shares in the company, it is easy to understand why Skandia has no controlling owner. In recent years the restrictions on voting has protected Skandia's management from several takeover attempts. One of the most outstanding examples of how incumbent management in Swedish companies have sought to protect themselves against undesired changes in the structure of ownership is the cross-ownership arrangements that surround some of the largest non-financial companies in the Swedish stock market. The Swedish Companies Act does not allow a company to buy back its own shares or a subsidiary to buy shares in its parent company.10 As a general rule, however, a parent-subsidiary relationship only exists if Company A holds a majority of the voting rights in Company B.11 In cases where Company A holds shares representing less than 50 percent of the voting rights in Company B, in practice B can buy shares in A and exercise its voting rights for these shares. Cross-ownership refers to a situation where two companies hold shares in each other. In other words, these firms indirectly own some of their own shares. If Company A holds such a large portion of the shares in Company B that it can influence the decision-making process in that company, the cross-ownership arrangement enables A, via B, to influence decision-making at its own shareholders' meeting, for example in electing the board. The extent of this influence is determined by the percentage of votes cast at the meeting which is at the disposal of Company B. If Company A has a controlling owner, he can strengthen his position vis-avis other shareholders through the cross-ownership arrangement, without having to bear the entire cost himself. The funds invested in the cross-ownership are taken out of the company. If the company has no controlling owner, crossownership can be used by management as a device to fend off undesired attempts by existing or potential owners to influence the use of company resources.
10 11
Swedish Companies Act, chapter 7, sec. 1. Swedish Companies Act, chapter 1, sec. 2.
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Circular ownership is a situation comparable with cross-ownership where three or more companies own shares in each other in such a way that the last company in the chain, in turn, owns shares in the first. As with cross-ownership between two companies, this situation may also give one or more of the companies involved the opportunity to influence its own shareholders' meeting. Figure 1: Cross-ownership between two companies and circular ownership among three companies.
Company A
Company B
In the spring of 1988, there were 26 cases of cross-ownership among Swedish listed companies in which the companies involved held at least 2 percent of each other's equity or voting stock. Their voting strength varied from 2 percent to almost 50 percent, with an average of 14 percent. In addition, there were numerous cases of circular ownership complementing the cross-ownership arrangements. The companies involved in cross- and circular ownership varied in size, but included some of Sweden's largest listed companies. In Figure 2 this is illustrated with the cross-ownership relations involving the construction company Skanska and the automotive manufacturer Volvo in the spring of 1988. Throughout the 1980s both these companies were, in practice, managementcontrolled. Cross-and circular ownership gave management a very strong position vis-ä-vis the widely dispersed shareholders, in practice making it impossible to carry out any kind of takeover constituting a threat to incumbent management.n 12
For further discussion, see SKOG, R., ömsesidigt aktieägande och aktiebolagslagens regier om förvärv och innehav egna aktier, (Cross-ownership of Shares and the Rules in the Swedish Companies Act on Acquisitions and Holdings of a Company's Own Shares), SOU 1988:38, Bilaga 1 (Appendix 1 to the main report, Stock Ownership and Efficiency Commission).
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Figure 2: Cross- and circular ownership involving the companies Skanska and Volvo hi the spring of 1988. Percentage of voting rights. 2.2
14.3
Swedish companies have a far better chance to undertake preventive defensive measures than to implement emergency measures once a bid has already been presented. The actions of the target company during the bid period are regulated by a takeover code devised by Swedish business organizations, based on the British Takeover Code.13 This code forces the target company to assume a relatively passive role. One important difference between the Swedish and British codes, as indicated above, is that the Swedish code has no rule on mandatory offers. It is thus entirely possible to gradually build up a controlling stake of, e.g., 40 percent in a Swedish listed company without being required to bid on the remaining shares. It is not unusual for 30 or 40 percent blocks of shares to change hands without the company in question becoming the object of a complete takeover. For years, the Swedish Shareholders' Association has been calling for a "mandatory bid rule" in the Swedish stock market, but so far this demand has won very little support. For the sake of completeness, however, we should mention the upper limit set by the Swedish Companies Act in this regard. If a single shareholder in a Swedish corporation has built up a holding that represents 90 percent of capital and voting stock, he is entitled to redeem the remaining shares, and the owners 13
Recommendations issued by the Swedish Industry and Commerce Stock Exchange Committee 1988.
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of these shares have a corresponding right to have their shares redeemed by this shareholder.14
ΙΠ. Ownership and Corporate Performance The ownership structure of Swedish listed companies underwent substantial changes during the 1980s. The changes can be summarized in four points: 1. 2. 3. 4.
continued institutionalization of share ownership increased concentration in the ownership structure of individual companies the emergence of a market for corporate control increased use of defensive measures by company management.
This section will supplement our empirical findings with a brief survey of studies concerning the possible impact of such changes on corporate governance and corporate performance. The survey will give some idea of the correlations that have been assumed possible, and the extent to which these assumptions have gained empirical support. A. Studies of Concentration and Categories The aspect of corporate ownership that was first linked with corporate performance was concentration of ownership. During the early decades of the 20th century, the ownership of major American corporations became widely dispersed. This led to a number of studies on management possibilities to deviate from the profit-maximization objectives of the shareholders. By far the most influential of these studies was the book by Eerie and Means published in 1932, which argued that control over major American corporations had passed from shareholders to the managing directors, who rarely owned shares in the companies that employed them. Using a preset minimum shareholding that was assumed to constitute owner control - 5 percent of voting rights - the authors showed that nearly half of America's 200 largest corporations had no controlling owner; they were "management-controlled".15 Similar studies were conducted by, among others, Gordon in the mid-1940s16 and Florence in the early 1960s.17 14
Swedish Companies Act, chapter 14, sec. 9. A. BERLE & G. MEANS, The Modern Corporation and Private Property (New York 1932). 16 R.P. GORDON, Business Leadership in the Large Corporation (Washington D.C. 1945). 15
17
P.S. FLORENCE, Ownership and Success of Large Companies (London 1961).
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On the basis of Berle and Means' as well as subsequent, purely descriptive studies, in the 1960s a number of economists developed mathematical models to show how the management of a company with a widely dispersed ownership structure attempted to achieve goals that were entirely different from maximizing shareholders' wealth. Baumöl showed how management gave priority to maximizing sales.18 Morris emphasized management's desire for growth19 and Williamson pointed to management's desire to pursue a number of more personal objectives.20 Since the late 1960s, numerous studies have also tested, empirically, whether the division of power between shareholders and management had any impact on corporate performance. These studies are designed in somewhat different ways but share a number of common features. Typically, the independent variable, as in the Berle and Means study, is a schematic and mainly arbitrary classification of companies into owner- and management-controlled, respectively. A dependent variable is linked with this, often profitability but in some cases also growth and risk-taking. The correlation between these variables is then tested using regression or other multivariate analysis. The findings of these studies are not uniform: Some of them find a positive correlation between concentration of ownership and performance, others find no correlation at all. As a rule, the findings are also very sensitive to variations in the independent variable.21 Using similar theoretical assumptions and methods, a 1988 study examined the correlation between concentration of ownership and corporate performance in Swedish listed companies.22 The independent variable, concentration of ownership, was defined in terms of the percentage of voting rights held by the largest single owner as well as in terms of the Herfindahl index. As dependent variables, the author used the valuation ratio between a company's market capitalization and its net asset value, as well as return on equity. This study admittedly shows a statistically significant correlation between concentration of ownership and the performance yardsticks employed, but a number of objections
18
W.J. BAUMÖL, Business Behavior, Value and Growth (New York 1967). R. MARRIS, The Economic Theory of Managerial Capitalism (Glencoe 1964). 20 O. WILLIAMSON, The Economics of Discretionary Behavior: Management Objectives in a Theory of the Firm (Englewood Cliffs, N.J. 1964). 21 For a survey of 15 different studies published between 1967 and 1982, see E. BERGLÖF, Ägarna och Kontrollen over företaget (Ownership and Control of Companies), SOU 1988:38, Bilaga 12 (Appendix 12 to the main report, Stock Ownership and Efficiency Commission). For a survey of 23 different studies between 1968 and 1987, see KAULMANN, T., "Managerialism versus the Property Rights Theory of the Firm", in Agency Theory, Information and Incentives (G. Bamberg & K. Spremann, eds., 1989). Seven studies appear in both of the surveys. 22 P.O. BJUGGREN, Ownership and Efficiency in Companies Listed on the Stockholm Stock Exchange (SNS Occasional Paper 1988). 19
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to the design of the study may be raised. In our opinion, this study cannot be used as the basis for far-reaching conclusions. The trend toward growing institutionalization of corporate ownership has attracted considerable interest in public discourse but has not received nearly as much attention among economic researchers as has the trend toward concentration of ownership. The few studies that have been conducted have assumed that due to differences in investment horizon, willingness to take risks and level of competence, different categories of shareholders behave differently when carrying out their ownership functions. The composition of corporate ownership by shareholder categories therefore might have an impact on company performance. On the basis of such an assumption, a few British and American studies have tested whether a high level of institutional ownership, for instance by pension funds, forces companies into short-term behaviour. These studies have found no evidence that this is the case.23 A Swedish study from the mid-1980s classified the 100 largest institutional investors in the Swedish stock market on the basis of Hirschman 's terms "exit" and "voice."24 In this study, the exit concept meant that an owner who was displeased with a company's performance mainly relied on the opportunity to sell his shares, whereas voice referred to owners seeking to influence company performance primarily by voting at shareholders' meetings.25 Pension funds and mutual funds were cited as examples of exit-inclined owner categories, while certain investment companies and family-related foundations and a number of non-financial companies were cited as examples of shareholders whose behavior was more voice-oriented. This study was entirely descriptive, and contained no empirical attempts to establish connection between various owner categories and company performance. Such a connection was made, however, in a 1988 study by Bjuggren.26 By using a multiple regression analysis it examined the correlation between the owner category to which the single largest shareholder belonged and company performance. The study did not reveal any general, unequivocal correlation
23
The Office of the Chief Economist, Securities and Exchange Commission, "Institutional Ownership, Tender Offers and Long Term Investments" (1985), "Management of UK Equity Portfolios," 27 Bank of England Quarterly Bulletin, 253 (1987) and J. JONES, K. LEHN & J.H. MULHERIN, "Institutional Ownership of Equity: Effects on Stock Market Liquidity and Corporate Long-Term Investments" in Institutional Investing (A.W. Samets, ed., 1991). 24 G. HEDLUND, I. HÄGG, E. HÖRNELL & B. RYDEN, Institutioner som aktieagare (Institutions as Shareholders) (Stockholm 1985). 25 A. HIRSCHMAN, Exit, Voice and Loyalty (Stanford 1970). 26 P-O. BJUGGREN, Agarkate'gorier och effektivitet i svenska bOrsnoterade fdretag 1985 (Owner Categories and Efficiency in Swedish Listed Companies in 1985), unpublished paper (1988). On file with the authors.
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between owner category and performance. Nor have later studies by the same author empirically clarified this correlation.27 B. Studies of Takeovers and Defensive Measures Studies on the correlation between corporate ownership and corporate performance reveal contradictory findings. They do not support the hypothesis that any particular ownership structure promotes corporate performance to a greater extent than any other structure. This does not mean that concentration of ownership or owner categories are entirely unimportant in this context. But the empirical evidence can simply not provide us with the basis for any generalizations. This is not surprising. At any given time, the business sector exhibits a broad spectrum of companies in different industries and in different stages of development. It seems reasonable to assume that such a range of variation calls for flexibility and variation in the structure of ownership as well. This conclusion makes it natural to focus our attention on economic models that views corporate development from a dynamic perspective and discuss the role of individual actors in this process. One common element of these models is that economic agents are constantly attempting to achieve competitive advantages.28 The technical and organizational innovations that lead to such advantages emerge continuously, even though the search for them involves costs and an uncertain outcome. This search can basically be regarded as production - the production of knowledge - and as a rule it requires some form of input or investment. Yet investments in such production, like in all other production, can be expected to continue only on the condition that the investor can benefit from its economic value. There is a chance of benefitting from this value because of the inertia existing in the economy when it comes to diffusion of such knowledge. As a result, temporary monopolies and monopoly rents continuously arise. But in an economy with functioning competition, a temporary monopolist is soon attacked by competitors. In this way, the business sector develops through constant confrontations between forces that disturb and restore equilibrium. Shareholders play an important part in this process, since the potential profits that thus arise create an incentive to seek information on business opportunities. Shareholders can benefit from the economic value of such information by influencing company operations through shareholders' meetings. Since the company's shares are freely transferable, this incentive exists both for existing 27
P-O. BJUGGREN, Ägarstruktur och effektivifet i svenska storßretag 1950-1985 (Ownership Structure and Efficiency in Major Swedish Corporations, 1950-1985), unpublished paper (1990). On file with the authors. 28 K. ARROW, "Economic Welfare and the Allocation of Resources for Invention" in The Economics of Technological Change (N. Rosenberg ed., 1971).
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and potential owners. Consequently, not only existing but also potential owners participate in a continuous re-valuation and monitoring of a company's operations. Different investors nevertheless have varying abilities and ambitions when it comes to investing in information and producing unique knowledge concerning the optimal utilization of company resources. As a result, knowledge about the potential value of resources is asymmetrically distributed among different owners, as well as between owners and management, which in turn is ground for disagreement on how to run the company. When such disagreement exist, only an owner who can control the decision-making process at the shareholders' meeting can be certain of benefiting from the economic value of the knowledge that he has built up. This picture of the motivating forces behind business development and the role of shareholders in this process presupposes that the shareholders' interests coincides with that of management. If this is not the case, management has an incentive to protect itself against shareholders' monitoring. If management is successful, the shareholders' business intentions cannot be realized and as a consequence incentives to seek new knowledge of business opportunities will be reduced. The economic theories that adhere most closely to this approach are the ones that have discussed correlations between corporate performance and the potential for change in ownership structure. There have been numerous theoretical as well as empirical works along these lines, especially in the United States. One fundamental assumption in these studies is that a transfer of shares takes place only if a gap exists between the buyer's and the seller's evaluation of a company's resources. Such a gap may be based, for example, on the fact that information about the best alternative use of the company's assets is asymmetrically distributed. In this context, the task of the stock market is to minimize the cost of transferring decision-making rights in the company to those who assign them the highest value. In this perspective, the stock market can be regarded as a market for corporate control, which like other markets may function smoothly or otherwise. If it functions smoothly, the possibility of a change of controlling owner stimulates the search for new information, and companies receive this information at the lowest possible cost. The stock market has thereby fulfilled an important function in terms of resource allocation in the economy. Empirical tests of how a change of controlling owner affects resource allocation are commonly based on information about how the stock market reacts to events related to a change of control in a company— for example, a takeover bid or the imposition of defensive measures against a takeover. This "event study method" estimates changes in the financial return on a company's shares in relation to an event. The method assumes that all available information on the company is reflected in its share price, which is thus assumed to be
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equivalent to the net present value of the company's expected future dividends. Among other things, this implies that when the market receives information about an organizational change that increases a company's efficiency in terms of potential financial return, there will be an immediate raise in the price of the company's shares. Such an approach assumes that the value of the efficiency gains expected to result from a change of controlling owner is reflected in the price a buyer is willing to pay for control. If the share price correctly reflects the discounted value of the company's future dividends, the improvements in efficiency are equivalent in value terms to the difference in market value before and after the bid was made public. Numerous American studies indicate that changes of controlling owner by means of public tender offers are generally accompanied by an increase in share price, whereas events that reduce the probability of a change in ownership structure cause the market value of the company to fall.29 Similar findings have emerged from Swedish studies. A study covering all public bids on the Swedish stock market between 1980 and 1988 revealed that takeovers paid shareholders in the target company an average return on investment more than 17 percent above normal, while the owners of the purchasing company averaged a 2.5 percent increase in their return. In 80 percent of a total of 80 acquisitions during this period, the net effect of the acquisitions was positive, averaging 5.6 percent of the combined market capitalization of the two companies.30
IV. Concluding Remarks Efficient resource utilization in the business sector is of vital importance to economic growth and prosperity. It requires a continuous reallocation and a constant monitoring of the way in which company resources are being used. During the 1980s, the increased awareness that these two functions to a large extent are carried out by the shareholders stimulated an interest in the rapid changes of corporate ownership. In 1985 the Swedish Government assigned a Parliamentary Commission to study corporate ownership in Swedish industry. The Commission noted a 29
It is highly probable that mergers, acqusitions and defensive measures are one of the most-studied economic phenomena of the entire 20th century. We abstain from listing the innumerable references in this field, but instead refer the reader to the extensive review in F.H. EASTERBROOK & D.R. FISCHEL, The Economic Structure of Corporate Law, at 162 ff., (Cambridge, Ma. 1991). 30 C. BERGSTRÖM, H. MATTSDOTTER, K. RYDQVIST & F. UHRSTRÖM, "Corporate Takeovers. Who Gains and Who Loses?," 1 Skandinaviska Enskilda Banken Quarterly Review 10 (1989).
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number of significant trends, among them an increased concentration of ownership in individual companies and a growing level of institutional ownership. Beyond the importance that was attached to this survey, the Government's instructions to the Commission reflected an ambition to find a correlation between ownership structure and efficiency in the business sector. The Government apparently harbored the illusion that with the help of the Commission, it would be able to identify one kind of ownership structure that presumably benefited corporate performance more than others. Five years of research in close cooperation with leading experts in the field nevertheless showed that it is not possible to find any general correlation between a given ownership structure and corporate performance. A survey of numerous studies led the Commission to the conclusion that neither concentration of ownership nor the type of owner categories can be linked generally to company performance. The Commission attached greater importance to smoothly operating mechanisms for changes in corporate ownership through the stock market and company legislation that enables shareholders to carry out their monitoring functions. A well-functioning stock market includes a market for corporate control and limited opportunities for management to thwart owner influence and ownership changes. If changes in corporate control are rendered more difficult, the likelihood of inefficient resource utilization increases. As far as Sweden is concerned, this implies a restrictive attitude toward such phenomena as the increased incidence of cross-ownership between corporations. The Commission therefore urged the Government to consider legislation against this type of ownership arrangements. A smoothly operating market for corporate control is an important, but not always sufficient, prerequisite for ensuring the monitoring function of owners. In addition, it is also necessary to have a company law that enables shareholders to carry out their monitoring functions within the companies. Shareholders must have the final word on the composition of the board of directors as well as on crucial decisions concerning the future of the company. In our view this implies a restrictive attitude towards the possibility for companies to buy back their own shares and other devices that may increase the cost of monitoring corporate management. This perspective should be kept in mind by the Swedish Company Law Committee that is presently preparing a revision of the Swedish Companies Act. In Sweden, as in many other countries, share ownership is becoming increasingly institutionalized. Individuals and families among company owners are being replaced by institutions with diversified investment portfolios. In large part, this trend is probably an inevitable result of the fact that the capital requirements of companies have grown so large that they can only be met by
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institutional owners. Unlike most countries, however, in Sweden this trend has been thwarted by the existence of shares with differentiated voting rights. The system of differentiated voting rights has, quite simply, made it possible to retain clearer ownership functions in companies than would otherwise have been the case. This experience from the Swedish industry may be useful in countries where the possibility to issue shares with unequal voting rights is now on the agenda.
Chapter Eleven
Ownership of Equity and Corporate Governance - The Case of Sweden Erik Berglöf I. Introduction The financial system plays an important role in monitoring and motivating managers. Through institutional evolution and design, intricate mechanisms for corporate governance have been created. Casual observation, and a number of in-depth studies,1 indicate that these mechanisms differ considerably across countries. Corporate governance also changes over time; in particular, recent transformations in financial systems following innovation in financial technology and internationalisation of financial flows have influenced how corporations are governed. Furthermore, changes in general economic conditions and regulatory frameworks affect the functioning of the financial system. For example, the fragility of the Japanese banking system is perceived by many observers as having weakened the banks' ability to monitor corporations. Similarly, legislation and a number of court rulings in the United States have dramatically increased the costs of corporate takeovers and made it exceedingly difficult to replace managers. The comparative study of financial systems promises to provide important insights into how to fill such perceived vacuums in corporate governance. This article discusses the role of equityholders in corporate governance and how this role is affected by changes in the rest of the financial system. The discussion takes as its starting point the case of Sweden, and in particular the report from the Commission on Ownership and Influence in Swedish Industry.2 The study makes use of internationally unique statistics on equity ownership. However, while the data pertain to Sweden, the discussion is of general 1
See, for example, C. MAYER, "Financial Systems, Corporate Finance, and Economic Development," in Asymmetric Information, Corporate Finance, and Investment (Hubbard ed., Chicago 1990), at 307-332. 2
Ägande och inflytande i svenskt näringsliv (Stockholm 1988).
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interest. Like Sweden, many financial systems underwent considerable change during the 1980's. The magnitude, and even direction, of change may differ from one country to another, but the framework for understanding the consequences for corporate governance should be the same. By placing equity ownership in the context of the entire corporate capital structure and the larger financial system, we hope to contribute to the understanding of the interrelationship between the various dimensions of corporate governance. The Swedish data on equity ownership show a very high, and rising, level of concentration in listed firms, in particular when related owners are combined; on average the largest owner, or group of owners, holds more than half of the outstanding shares. Institutional shareholders play an important, and increasingly vital, role in monitoring how funds are used. In particular, intercorporate holdings are widespread, often in the form crossholdings of equity. The closed-end investment companies affiliated with major commercial banks are also important owners. The high concentration of ownership and the bank-centered corporate groupings stand out as the most striking characteristics of corporate governance in Sweden. However, our theoretical discussion suggests that focusing solely on equity ownership at best provides a partial, and at worst a misleading, picture of corporate governance and changes in such governance. The firm's capital structure defines the scope of external control exercised by different classes of investors; the degree of self-finance and the relative importance of equity in the capital structure determine the role of equityholders. In addition, a focus solely on equity ownership overlooks important linkages between the distribution of equity and that of debt, and the effects of changes in the larger financial system on corporate governance. When the holdings of debt in the Swedish corporate sector are also considered, ownership appears to be even more concentrated, and institutions more significant in corporate governance, than when the focus is solely on equity ownership. In particular, within the bank-centered corporate groups combinations of extensive lending and large indirect equityholdings through intermediaries play an important role in governance. In addition, despite the apparent stability in the patterns of equity ownership with an increase in concentration of holdings during the period, a number of developments in the Swedish financial system may have fundamentally altered corporate governance, and the role of equityholders in such governance. The strong liquidity of Swedish corporations during the 1980s reduced the extent of external governance. Securitization and financial disintermediation may also have weakened the effectiveness of monitoring institutions. Furthermore, an increase in the number of corporate takeovers, and a more frequent turnover in major ownership positions, suggest that the Swedish system has entered into a different mode of corporate governance. However, hostile takeovers are still very rare, and the defensive arrangements in the form of crossholding arrangements and voting restrictions were strengthened during the 1980s.
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An interesting issue is whether the apparent change in the governance mode during the period reflected a fundamental transformation from one financial system to another, or merely an adjustment of the same financial system to the general business cycle; the observed emancipation of corporate managements could have been made possible primarily by temporary improvements in liquidity. If the system is indeed fundamentally changing towards a system with more active market governance, it may in the transition face a serious "stuckin-the-middle"-problem; new institutions replacing bank monitoring do not emerge over night. In the meantime, managers may have considerable latitude in pursuing their own goals. However, the renewed importance of creditor monitoring triggered by the recent recession lends some support to the view that despite important changes the financial system has remained fundamentally the same. Such a conclusion, in turn, would also raise serious concerns for corporate governance, given the present fragile state of the Swedish banking sector. Thus, independent of which conclusion one reaches, the Swedish financial system appears to face a governance vacuum similar to that of Japan; no alternative corporate governance mechanism has emerged to replace bank monitoring. The article is intended as a general commentary on studies discussing the efficiency implications of different corporate governance arrangements based on data on equity ownership alone. The report provided by the Commission on Ownership and Control, with its high-quality data and complete coverage of major listed companies, is a particularly interesting example of such a study. In Section 2 the main findings of the Commission are briefly summarized. The third section steps back to provide a theoretical framework for discussing the effects of choice of capital structure for agency costs, the issue which originally motivated the appointment of a commission. Section 4 makes use of this framework to reinterpret and qualify some of the findings of the Commission. Finally, Section 5 is devoted to some implications for the study of corporate governance and for policy.
Π. Equity Ownership and Control in Swedish Industry In 1988, the Commission on Ownership and Control in Swedish Industry presented one of the most extensive studies of corporate ownership patterns ever undertaken in an individual country.3 The report is particularly interesting because of the unique quality of the underlying data on ownership in Swedish
3
For a much more complete summary of the findings of the Commission, see ISAKSSON & SKOG, ch. 10 supra.
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industry.4 This section briefly summarizes the Commission's main observations and provides some additional data with an emphasis on the changes in ownership in individual corporations during the 1980s. Shares in listed companies are primarily, and increasingly, held by institutional owners. In January 1992 non-financial corporations held 20 per cent of outstanding shares, insurance companies 15 per cent and closed-end investment companies 10 per cent.5 National pension insurance funds (including employee investment funds) and mutual funds accounted for 6 and 9 per cent, respectively. Private individuals directly held a dwindling 16 per cent of listed shares (down from 25 per cent in 1985 and 70 per cent in 1960). Non-financial corporations and investment companies often, and to an increasing extent, hold large controlling block in corporations, in particular in large companies. In January 1992, out of the 25 largest corporations (by market value), 9 were controlled by investment companies, and 4 by nonfinancial corporations.6 The shares of investment companies were dispersed but in most cases a controlling owner, or group of owners, could be identified. In particular, the large commercial banks, SE Bank and Handelsbanken, which are prevented from holding shares, have used their affiliated investment companies as important vehicles for control over corporations. Insurance companies have been subject to restrictions of shareholdings preventing them from exercising control over non-financial corporations. Other institutions generally play little or no role in corporate governance even though they often are represented on the board of directors. The level of ownership concentration in individual firms is high by international standards. In 1978, the largest single owner accounted for 20 per cent on average of equity in listed firms; by 1985 this share had increased to 29 per cent. The five largest shareholders together held 41 per cent of equity in 1978 and 56 per cent in 1985. In terms of voting power, the share of the largest owner had increased from 27 to 39 per cent, and for the five largest shareholders from 48 to 66 per cent. Today the corresponding proportions are 49 and 74 per cent.7 The difference between the shares of equity and those of voting power stems from the use of shares with differentiated voting power, a practise which increased in importance during the 1980s. 4
Ownership of listed shares are registered by Värdepapperscentralen (VPC). A number of data bases have been set up using the VPC data. These data bases compute portfolios of individual owners and the ownership structure of individual firms. In addition, combined holdings of related shareholders can be obtained. The Commission partly developed its own data base and partly used existing computations. The accuracy of the data underlying its analysis must be regarded as extraordinarily high by international standards. 5 M. ISAKSSON & R. SKOG, supra n. 3, Table 1. 6
Id. Table 2.
7
Id. at 7-8.
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If holdings of related owners, e.g., two shareholding intermediaries with the same final owner, are combined, the level of concentration becomes even more conspicuous. In 1978, the share of the largest grouped holdings was 34 per cent; by 1985 this share had increased to a startling 47 per cent. In nearly half of the companies surveyed by the Commission, the largest owner configuration held a majority of the voting stock. The increase in concentration of listed firms stems from both a change in the composition of firms and more concentrated ownership in remaining firms. The increased concentration reflects a tendency for institutional investors, primarily non-financial corporations and investment companies, to increase the size of their control blocks in individual firms, while those of private individuals are decreasing. However, there is also a group of large listed companies with dispersed shareholdings without an apparent controlling owner. Four out of the 25 largest corporations in January 1992 lacked such an owner because of extensive crossholdings of shares, and another five companies, primarily banks and insurance companies, lacked it because of voting restrictions.8 In many of these companies corporate governance by equityholders played virtually no role. The 1980s also saw an increase in takeover activity; during the decade a total of 137 takeovers took place as compared to only 40 in the 1970s.9 However, only four out of the 137 completed takeovers were hostile in the sense that they were carried out against the desire of the incumbent controlling owner. About 10 per cent of all attempted takeover bids were considered hostile. Out of the 90 major companies listed on the Stockholm Stock Exchange in 1978, 40 were acquired during the 1980s. In 29 of these 40 a change in control took place; in the 50 remaining companies only 10 experienced a change in control. The virtual absence of hostile takeovers reflects the high concentration of control (when more than 50 per cent of the shares are held by the incumbent, a hostile takeover cannot, by definition, take place). Furthermore, the existence of considerable defensive arrangements, in particular elaborate crossholdings of shares and voting restrictions in the corporate charters, made hostile takeovers of many companies impossible. In 1988, there were 26 cases of crossownership where the involved corporations held at least 2 per cent of each other's equity capital or voting stock.10 In some cases these arrangements came close to 50 per cent of the voting strength. Crossholdings are complemented by circular ownership, as when, Company A hold shares in Company B, which own shares in Company C, which, in turn, has shareholdings in Company A. These arrangements could be used either by a controlling owner to strengthen his control, or by management in a firm without a controlling owner to entrench 8
Id. at Table 2. Id. at 10. 10 ISAKSSON & SKOG, "Ownership and Control in the Swedish Business Sector," The Institutional Investor Project, Columbia University School of Law (1989), at 19. 9
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itself vis-a-vis equityholders. The use of crossholdings and other defensive mechanisms increased substantially during the 1980s.
ΠΙ. An Agency Theory of Capital Structure The Commission on Ownership and Control collected its data under the assumption of a causal relationship between equity ownership and efficiency. Explicitly, and implicitly, the Commission relied on the principal-agent theory for its theoretical underpinning; increased separation of ownership and control, measured as a decrease in the concentration of equity ownership, was assumed to raise agency costs. However, equity is only one of the financial instruments issued by corporations, and other investors than equityholders may play a role in motivating and monitoring management. To understand the implications of the Commission's findings we need an agency theory of capital structure. The Commission is concerned with the agency problem of moral hazard because actions of corporate management are not freely observable, or not contractable. Such ex post opportunism may take the form of underinvestment because management has to share the benefits of investments with outside investors, or overinvestment, e.g., in overly risky projects, when management does not carry the full costs of the investment. Another form of moral hazard which has received much attention in the recent literature is that of ex post renegotiation; management may renege on its initial promises, e.g., by saying that it cannot meet its payment obligations even though it has the cash flows to do so (so-called strategic default). Both these agency problems are anticipated by investors and affect the terms at which they are willing to contribute funds. However, agency costs depend on the design of the firm's capital structure, i.e., the allocation of revenue streams and control rights among investors. A useful way to start thinking about the determination of capital structure is to assume that the firm faces a competitive capital market with a large number of basically identical (risk-neutral) investors. The simultaneous decision problem facing the firm is how many investors to have and what type of rights, i.e., what financial instruments, to issue to these investors. Recent research has used this approach to explain, among other things, why firms have more than one investor and issue both debt and equity. One such explanation suggests that a firm's capital structure is designed to provide incentives both to insiders and to outsiders; managers are induced to maximize firm value, whereas outsiders are given incentives to intervene when managerial incentive schemes fail, e.g., because of limited liability.11 Through the return schedule associated with debt, this instrument provides incentives to 11
M. DEWATRIPONT & J. TIROLE, A Theory of Debt and Equity - Diversity of Securities and Management-Shareholder Congruence, mimeo (1992).
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discourage ex post renegotiation. Equity, on the other hand, has a bias in favor of management. A similar ex post conflict can be created by allowing investors to specialize in long-term and short-term claims, and by giving short-term claimants liquidation rights and adverse incentives.12 Both these explanations generate a capital structure with multiple investors who specialize in either debt or equity. Holders of (short-term) debt are "hard" in ex post renegotiations, while equityholders are "soft", with interests close to those of management; threats to liquidate assets, or to otherwise hurt the business, are more credible when they come from an investor who does not have a long-term interest in the firm. These theories rationalize the existence of both equityholders and debtholders, and of short-term and long-term debt. However, they are silent on whether there should be one or more investors of each type, i.e., whether holdings of these instruments should be concentrated or dispersed. A recent article suggests that the choice between one or more short-term creditors, and the allocation of liquidation rights among these investors, is determined by their effects on the ex post bargaining game;13 empirical findings also show that the number and heterogeneity of participating creditors influence the costs of bargaining.14 By making its capital structure complicated the firm can increase bargaining costs and strengthen its commitment not to default strategically, at the expense of more costly liquidation of assets when it actually cannot pay. However, increased dispersion of holdings may also lead to more free-riding in monitoring; only when a single investor holds a significant share of outstanding claims does she have incentives to invest in monitoring. Of course, monitoring, and free-riding in monitoring, are not confined to shareholders; creditors, in particular banks, also monitor managers. For debt, as a "hard" claim, there may be a tradeoff between reducing free-riding in monitoring and discouraging renegotiation. However, due to its "soft" features, considerations of incentives to renegotiate should be less important for equity, and a more concentrated ownership structure should improve monitoring. Weak empirical evidence suggests that large shareholders do indeed contribute value to the corporation.15 Studies of concentrated debtholdings provide strong support for 12
E. BERGLÖF & E.-L. VON THADDEN, Short Term versus Long Term Interests: A Model of Capital Structure with Multiple Investors, Centre for Economic Policy Research (London 1993). 13 P. BOLTON & D. SCHARFSTEIN, A Theory of Debt Structure, mimeo (1992). 14 S. GILSON, K. JOHN & L. LANG, "Troubled Debt Restructurings: An Empirical Study of Private Reorganization of Firms in Default," J. of Fin. Econ. (1990); and P. ASQUITH, R. GERTNER & D. SCHARFSTEIN, The Anatomy of Financial Distress, mimeo (1992). 15 A. SHLEIFER & R. VISHNY, "Large Shareholders and Corporate Control," J. of Pol. Econ. 94 (1986), at 46M88; H. DEMSETZ & K. LEHN, "The Structure of
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the claim that lenders, in particular banks, can provide important monitoring services.16 An individual investor with large holdings in individual firms, whether in the form of equity or debt, also incurs the opportunity cost of diversification gains foregone.17 A useful distinction could be made between a control-oriented owner who keeps a narrow portfolio with large block in individual corporations, and a portfolio-oriented owner who diversifies his portfolio and avoids excessive exposure in any one firm. Our understanding of why certain owners are control-oriented and others portfolio-oriented, and why ownership patterns in particular industries (countries) have a stronger control-orientation than in other industries (countries), is still very incomplete. Capital structure is determined within the framework of the rest of the financial system, which provides a number of complementary institutional arrangements motivating and monitoring managers. The market for corporate control, where large blocks of shares are traded and where takeover bids are launched, serves an important function in this regard. However, the role of takeovers in corporate governance is also affected by the choice of capital structure. For example, a hostile bid is only possible if the shares of the corporation are widely held, i.e., if the controlling owner has less than 50 per cent. Furthermore, the decision whether to go public or stay private (or go private if the corporation is public) influences how corporate governance is best organised; while a private firm does not incur the costs of public listing, it cannot make use of the potential monitoring services and commitment possibilities provided by the markets for equity and debt. In addition, board of directors and managerial labor markets may play important roles in motivating and monitoring managers. Despite considerable international variations, markets, institutions and regulatory frameworks seem to appear in certain patterns. Attempts have been made to understand these patterns by classifying existing financial systems into broad categories such as bank-oriented and market-oriented, or market-based
Corporate Ownership: Causes and Consequences," J. of Pol. Econ. 93 (1985), at 1199-1177; and R. ZECKHAUSER & J. POUND, "Are Large Shareholders Effective Monitors? An Investigation of Share Ownership and Corporate Performance," in Asymmetric Information, Corporate Finance, and Investment (Hubbard ed., Chicago 1990), at 149-180. 16 T. HOSHI, A. KASHYAP & D. SCHARFSTEIN, "The Role of Banks in Reducing the Costs of Financial Distress in Japan," J. of Fin. Econ., (1990) at 67-88. 17 J. ROMER, Would Economic Democracy Decrease the Amount of Public Bads, mimeo (1991), suggests that there may be an optimal level of ownership concentration determined by the tradeoff between the gains from reduced free-riding in monitoring and the "public bads" (e.g., pollution) arising from increasing concentration in wealth.
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and credit-based.18 Table 1 shows one such, necessarily simplistic, classification. This scheme certainly does not claim to exhaust the universe of possible systems or the dimensions along which such systems can be characterized, and no country perfectly matches the archetypes. In addition, a financial system may change operating mode over the business cycle. For example, the role of banks, and creditors in general, increases in times when many firms simultaneously experience liquidity constraints.19 The distinction, nevertheless, has proven to be a helpful tool in understanding international variations in financial systems. In particular, the empirically supported clustering of properties indicates that the different dimensions of the financial system are interconnected. For example, the classification scheme of Table 1 suggests that a strong role for banks in corporate governance is associated with more concentrated ownership of equity and less takeover activity in the market for corporate control. Unfortunately, the research attempting to understand these interrelationships between different aspects of economic systems is still at an embryonic stage.20 This theoretical discussion has implications for our interpretation of equity ownership and its role in corporate governance. A first lesson is that the agency problem should be studied in its entirety. All external sources of funds, both debt and equity, are associated with agency costs; and agency costs give rise to conflicts not only between insiders and outsiders, such as managers and shareholders, but also among outside investors (e.g., between shareholders and creditors, and between old and new investors). Equally important, the financing decision itself may be subject to agency problems. For example, managerial preference for retained earnings may reflect self-interest; an increase in liquidity gives managers more latitude in pursuing their own goals. Another insight is that while both creditors and shareholders may play a role in motivating and monitoring managers, their incentives are qualitatively different. The "soft" nature of equity and its close alignment with management gives it a radically different role from debt with its "hard" features averse to both management and shareholders. Obviously, the forms of governance exercised by these two types of instruments may complement each other. 18
These two dichotomies are used by, for example, T. RYBSZCINSKI, "Industrial Finance System in Europe, United States and Japan," J. of Econ. Beh. and Org., 5 (1984), at 277-280; and J. ZYSMAN, Governments, Markets, and Growth (Ithaca 1985), respectively. 19 A. SHLEIFER & R. VISHNY, Liquidation Values and Debt Capacity: A Market Equilibrium Approach, mimeo (1991), have analysed how the ex post bargaining game is affected when liquidity shocks within an industry are correlated or affected by the general business cycle. They show that such correlation lowers liquidation values thus increasing the deadweight loss from financial distress. 20 M. AOKI, "The Japanese Firm as a System: Survey and Research Agenda," in The Japanese Firm: The Sources of Competitive Strength, (Oxford 1993).
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However, it is more doubtful whether they can serve as substitutes, e.g., whether more active shareholder monitoring can substitute for increased passivity of debtholders. Similarly, the governance features of short-term and long-term debt differ from, and cannot directly replace, each other. Two interesting, and largely unresolved, issues are why we observe that investors sometimes hold both debt and equity, and why firms issue financial instruments which are convertible from debt to equity, or vice versa.21
21
There is a considerable literature explaining informational reasons for why firms issue convertible instruments (for a survey, see C. LEWIS, "Convertible Debt: Valuation and conversion in complex capital structures," J. of Bank, and Fin. 15 (1991), at 665-682. However, the role of convertible debt in ex post bargaining has to the knowledge of this author not been explored.
Ownership of Equity and Corporate Governance in Sweden Table 1. Financial Systems and Capital Structure General characteristics of financial markets and financial institutions
Depth and width of financial markets (i.e. the opportunities for diversification) Ratio of financial assets held by banks to total assets held by financial institutions
Type of financial system Bank-oriented
Market-oriented
Low
High
High
Low
Low
High
High
Low
High
Low
Low
High
High Low
Low High
High Significant
Low Insignificant
Widespread Slow
Less common Faster
Overall capital structure Degree of internal finance Debt/equity ratios Creditor structure Ratio of bank credits to total liabilities Importance of bond financing Degree of concentration Turnover Shareholder structure Degree of concentration Commercial bank shareholdings Interfirm shareholdings Turnover of controlling blocs
321
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A final important conclusion from this literature is that equity ownership should ultimately be understood in the wider context of the entire financial system. Changes in this larger system could have important repercussions for corporate governance and for the roles of holders of equity and debt in such governance.
IV. Reinterpreting Corporate Governance in Sweden Our theoretical framework suggests that a focus only on equity ownership may be misleading when understanding corporate governance and the agency problem. This section evaluates the findings of the Commission in the context of the entire corporate capital structure and the financial system in Sweden. While the Commission spent several years developing high-quality statistics on equity ownership, the discussion here is based on casual observation and official statistics of a much less precise nature. The conclusions must therefore be treated with considerable caution. The purpose is merely to suggest that a broader analysis may affect the results and throw additional light on the basic issues addressed in the Commission's report. During the 1980s the Swedish financial system underwent considerable change. At the end of the 1970s, Sweden most closely resembled a bankoriented system (see Table 2). While the financial markets were developing rapidly, they were still not comparable to their counterparts in, for example, the United States in terms of depth and width. The ratio of bank credits to domestic financial assets were higher than in United States and United Kingdom, but lower than in France, Germany and Japan.22 The capital structure patterns in the Swedish corporate sector also resembled those of a bank-oriented system.23 While international comparisons of debt/equity ratios should be interpreted with particular caution, the data suggest that debt levels were high by international standards; net debt/equity ratios were on par with those in France, and substantially higher than in United States and United Kingdom, but lower than in Japan. The structure of debt holdings was clearly that of a bank-oriented system with a high degree of concentration and low turnover of lenders. The share of bank credits in total loans to the corporate sector was lower than in Japan but higher than in France which in turn had a significantly higher ratio than United States and United Kingdom. The role of bond markets in corporate finance was minuscule.
22
R. GOLDSMITH, National Balance Sheets for 20 Countries, (New Haven 1985). 23 See E. BERGLÖF, Ägarna och kontrollen over företaget - enjämförande Studie flnansiella system, (Stockholm 1988), at 170-174, for a discussion of the classification of the Swedish system.
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In addition, the shareholding patterns found by the Commission corresponded well to those of a bank-oriented system. Ownership was highly concentrated with wide-spread interfirm shareholdings and a limited turnover of controlling owners. Due to regulation banks are not allowed to hold shares, but the major commercial banks exercised considerable control over many, if not most, large corporations through their affiliated investment companies. By the end of the 1980s the picture had become more complex. While the major commercial banks still played an important role in Swedish industry, increased retentions, lower debt/equity ratios and the emergence of corporate bond markets diminished bank influence. The role of bank credits in total loans had fallen, and the creditor structure had become more dispersed. Corporations also showed an increased propensity to have more than one bank relationship and to change main bank.24 While patterns of equity ownership remained largely unchanged, there was an increase in interfirm shareholdings, including crossholdings, and more frequent turnover of controlling blocks. In addition, corporate takeovers had become a feature of the stock market. Financial innovation associated with securitization and disintermediation also affected the operation of the Swedish financial system. This process started in 1980 with the introduction of certificats of deposits (bankcertifikat) and commercial papers (foretagscertifikat) in 1982. However, after rapid early growth, activity in these markets slowed down considerably towards the end of the decade.
24
H. SJÖGREN, Industrins kapitalstrutour och finansiella kontrakt under hög- och lagkonjunktur 1984-1991, mimeo (1992).
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Table 2. Financial System and Capital Structure in Sweden General characteristics of financial markets and financial institutions
Year 1979
1989
Depth and width of financial markets (i.e. the opportunities for diversification) Ratio of financial assets held by banks to total assets held by financial institutions
LOW
Higher
High
N.A.
Low
High
High
Lower
High
Lower
Low
Higher
High Low
Lower Higher
Overall capital structure Degree of internal finance
Debt/equity ratios Creditor structure Ratio of bank credits to total liabilities Importance of bond financing Degree of concentration Turnover Shareholder structure Degree of concentration Commercial bank shareholdings
Interfirm shareholdings Turnover of controlling blocs
High Higher Significant Significant (if holdings through investment companies included) Widespread Increasing Slow Faster
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While caution is warranted when classifying systems in terms of the simplistic dichotomy of bank versus market orientation, there certainly had been a movement along several dimensions towards increased market orientation during the period studied by the Commission. (Some authors have suggested that the financial systems of United States and United Kingdom showed signs of increased bank orientation during the same period.25) Despite this qualitative change the Swedish financial system was by most measures (e.g., ratio of bank credits to total financial assets in the economy and the ratio of bank credits to total loans to corporations) closer to France and Germany than to United States and United Kingdom.26 This conclusion has been reinforced by recent events, as Sweden has entered a severe recession with far-reaching involvement by the commercial banks. In many cases, bank obligations have become so large that the government has had to step in with loan guarantees and depositor protection. If we interpret the findings of the Commission in the context of the larger financial system and changes in this system, a few things stand out. First, if the entire capital structure is taken into account, ownership and control are more concentrated, and institutional ownership is more important, than suggested by the data provided by the Commission. In a substantial number of large corporations the major commercial banks both control large blocks of shares through their affiliated investment companies and hold a considerable part of outstanding debt. Second, and more importantly, the observed increase in the concentration of equity control during the studied period does not necessarily imply that agency costs are lower; the increased reliance on internal funds, in fact, suggests less rather than more external governance. The improved liquidity in most large corporations increased the latitude of managers, with a potential increase in agency costs arising from the financial decisions themselves. For example, the expansion of crossholdings of shares, and the wave of corporate takeovers, may have been made possible by managerial insulation from investor monitoring. Third, while external governance appeared to have been weakened, the falling debt/equity ratios indicate a shift in emphasis from creditor to shareholder monitoring. There were also signs of shareholders becoming more control-oriented, and creditors growing increasingly portfolio-oriented as firms diversified their bank relations. Since equity governance is an imperfect substitute for governance exercised by holders of debt, it is not clear what replaced bank monitoring. Recent examinations of bank portfolios indicate that monitoring during the period may have been insufficient.
25
See, e.g., M. JENSEN, "The Eclipse of the Public Corporation," Harv. Bus. Rev., (Sept-Oct 1989), at 61-74. 26 BERGLÖF, supra n. 20, at 170-174.
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Fourth, a focus on the distribution of equity ignores other important changes in the financial system influencing aggregate agency costs such as financial disintermediation and securitization. These developments could potentially have had a significant impact on the total production of monitoring services in the financial system. As a result, gains from improvements in allocative efficiency and diversification of risk may have been reduced, or even cancelled out, by a deterioration in the incentives for monitoring. Indeed, evidence from Japan indicates that firms which increased their reliance on bond markets at the expense of main bank finance were more sensitive to liquidity shocks and had higher costs of financial distress. 27 If the Swedish financial system did experience a shift in the direction of market-orientation in important dimensions, there may be a serious "stuck-inthe-middle" problem. In other words, a vacuum in corporate governance of the type suggested for Japan and United States may have been created as the system changed from one mode to another. For example, the monitoring exercised by banks may not immediately be replaced by well-functioning institutions protecting bondholders, such as bond rating institutes and lobby organization. Similarly, the extensive regulatory framework supporting marketoriented systems typically emerges only gradually. In the meantime there may be significant increases in agency costs from corporate governance failures. Another possible interpretation is that the changes in corporate governance in Sweden during the 1980s also partly reflected a natural adjustment in the operating mode reflecting the business cycle rather than a fundamental transformation of the financial system. During most of the period the Swedish corporate sector experienced sustained high profits and liquidity with managerial emancipation, in particular from creditor monitoring. From such a perspective, the observed wave of takeovers may have resulted from increased managerial latitude, or investors seeing opportunities to improve inefficiencies arising from such managerial excesses. The recent return of the banks in corporate governance in the recession lends some credence to this latter interpretation.
V. Concluding Remarks The discussion of the Swedish study on equity ownership may provide some guidance for future studies with similar objectives. The interconnection between various forms of finance, and between observed corporate capital structures and the rest of the financial system, should be taken into account when evaluating observations of changes in patterns of equity ownership.
27
HOSHI et al., supra n. 16.
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In addition, such interconnectedness has wider implications for interpretations of comparisons across countries. If institutional arrangements are interrelated in the way suggested, comparing individual nodes in a complicated web may be deceptive. For example, an international comparison of equity ownership in industry that fails to take into account the extent of corporate leverage and the distribution of debt holdings may give us an incomplete and possibly misleading picture of corporate governance. An investigative strategy which takes interconnectedness seriously should be directed at understanding the underlying principles determining the observed patterns within a particular financial system. The discussion also has implications for future theoretical work. Despite substantial changes in the relative costs of different financial instruments and in the underlying financial structure, and in the activity level of the market for corporate control, basic patterns in the ownership of equity in Sweden have remained largely unchanged. This suggests that control constitutes an overriding constraint on financial decisions, a constraint rarely taken into account in the traditional literature on capital structure. Interconnectedness also has important ramifications for policy. For example, harmonization of legal and institutional frameworks may be much more difficult and potentially costlier than generally believed. More knowledge is needed to determine when harmonization is beneficial and when the costs exceed the benefits. In addition, interconnectedness raises issues regarding the scope for economic integration and the effects of increasing interdependence in international trade and capital flows. For governments involved in institutional design, to the extent such design is feasible, interconnectedness may imply the emulation of complex packages of interrelated institutions rather than of individual features from several existing financial systems.
Chapter Twelve
Institutional Investors and Corporate Governance in The Netherlands Wiek J. Slagter
I. Problem Formulation The question whether institutional investors among other stakeholders in the company should take a special position and whether their presence should be taken into consideration by the management in making policy, has been hardly raised in The Netherlands. This is especially remarkable since the relationship between institutional investors and private investors is continuously changing in favor of institutional investors. With institutional investors are meant in particular insurance companies, pension funds, investment companies, participation companies, and banks. Dutch institutional investors have investments worth DFL 550 billion in The Netherlands and abroad. The total value of all Dutch funds listed at the Amsterdam Stock Exchange stood at approximately DFL 292 billion in October 1991. Excluding investment and holding companies, this sum amounts to approximately DFL 225 billion. If the stock value of Royal Dutch Shell and Unilever is deducted from this amount of DFL 225 billion, a sum of DFL 113 billion is left. Dutch pension funds usually invest not more than 20% of the financial resources administered by them in stocks. In other countries this percentage can be higher, and possibly this percentage might rise too in The Netherlands as a result of sharpening competition between pension funds to show a good performance. If only 4% of this DFL 550 billion of total institutional investments were invested in Dutch companies listed at the stock exchange, institutional investors would already own 20% of the assets of all these companies1. The extent to which institutional investors like ING (Internationale Nederlanden Groep, 1
These figures have been taken from a lecture of Mr. P.S. Zwart during Shareholders' Day in Amsterdam on October 31, 1991.
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Wiek J. Slagter
formed in 1990 as a result of a merger between Nationale Nederlanden, an insurance company, the NMB Bank, and the Postbank)2, ABP (Algemeen Burgerlijk Pensioenfonds, which administers the pensions of all Dutch government employees employed by the central government or lower public institutions, like provinces and municipalities), and Robeco (Rotterdams Beleggings Consortium) already own large portions of shares in Dutch companies, has become only recently clear as a result of the enactment of the Shareholding Notification Act. The Shareholding Notification Act implements the directive of the European Community dated December 12, 1988, no. 88/627/EEG. The Act was enacted as of February 1, 1992, and obliges holders of shares in companies listed at the Amsterdam Stock Exchange to notify these companies when shares or voting rights exceed or fall below 5, 10, 25, 50 or 66 2/3 % of the total3. This information had to be notified before March 2, 1992. Although share blocks thus registered were already partly known, implementation of the Shareholding Notification Act has still contributed much to clarifying capital relationships in The Netherlands. For one, it partly belies the theory, put forth in the Report of the Minister of Finance (Ned. Stcrt. 5 February 1991) regarding protection clauses4, that The Netherlands is justified to legal protection clauses to realize a "level playing field", as The Netherlands supposedly would have institutional protection (shares held permanently by institutional investors or "les grandes families") to a much lesser extent than some other countries. Do institutional investors have only quantitative, or also qualitative significance for corporate governance? Put differently: does an institutional investor distinguish himself from other shareholders only by the size of his block of shares, or should the presence of an institutional investor prompt the management to take this into consideration in ways other than voting at shareholders' meetings? Should it make a difference whether the company concerned has shares listed at the stock exchange (the Shareholding Notification Act only concerns these)? In which respect does an institutional investor distinguish himself from other holders of large blocks of shares, like raiders, family foundations, and institutions, like associations, which are committed to obtain proxies of shareholders enabling them to cast their votes at shareholders' meetings representing a large block of shares? 2
H.G. BARKEMA, S.W. DOUMA & B.T.M. STEINS BISSCHOP, Analyse van een fusie, Strategische, flnancieel-economische en juridische aspecten van de fusie
tussen Nationate-Nederlanden en de NMB Postbankgroep, Serie Bedrijfskündige Signalementen, uitg. Academic Service, Schoonhoven, 1992. 3
Regarding this Act, see also S. PERRICK, "De Wet melding zeggenschap is in werking getreden," TWS 1992, 35-40. 4 See also W.J. SLAGTER, TWS 1991, 126-129.
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Π. Different Company Forms in The Netherlands Before addressing these questions, an explanation of the different forms of companies in The Netherlands is required. First, like in other EC countries, a distinction is made between the public company (N.V.) and the private company (B.V.). The public company (N.V.) can issue both bearer shares and registered shares, while the private company (B.V.) can issue registered shares only. Many public companies have shares listed at the stock exchange, while private companies can never have such shares, as only bearer shares and other stocks are admitted to listing at the Amsterdam Stock Exchange, since registered shares are more difficult to transfer. In January 1993 in The Netherlands a law has come into force, requiring a notarial act for transfer of registered shares, to be entered into the shareholders' register, partly for fiscal considerations, partly to prevent abuse of the private company5. It can be preferable to issue registered shares, if a blocking clause and/or regulation requiring certain qualities to be possessed by shareholder are stipulated in the statutes. Free transfer of shares is thus restricted. With a public company, such a blocking clause is possible; for a private company, it is mandatory. A private company cannot issue depository receipts. Shareholdership in such a company can only be proven by an extract from the shareholders' register, which in itself is a non-transferable document of value. In fact, one can describe the situation by saying that as of February 1, 1992, The Netherlands has 276.537 private and 7.049 public companies, that the large companies generally have the public company form, and that small companies (family-owned companies, one-man companies) as well as almost all (sometimes very large) subsidiaries of large concerns have the private company form. In the second place, in The Netherlands a distinction should be made between companies (regardless of whether these have the public or private company form) which are subject to the structure regime, and companies which are not. As a rule, it can be said that companies are subject to the structure regime if they own equity (capital plus reserves) worth at least DFL 25 million, employ at least 100 persons (including 50 percent or more subsidiaries) and the company (or a subsidiary) has a works council. One of the purposes of the structure regime is to realise employees' codetermination. All companies employing more than 35 employees are obliged to establish a works council, resulting in employees' participation at the basis. Implementation of the structure regime meeting the cumulative criteria mentioned above - also results in an indirect employee's participation at the top, as the members of the supervisory board only can be appointed when the works council don't object or when their veto is overruled by the Chamber of Enterprises of the Court of Appeal at Amsterdam. 5
See about this bill W.J. SLAGTER, Maandblad De NV 1989, 196-204; G.M. TER HUURNE, TWS 1991, 314-318 & H.P.J. OPHOF, 1WS 1991, 277-280.
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The full structure regime has the effect that there is a mandatory supervisory board (for a normal public or private company not subject to the structure regime a supervisory board is optional), which is appointed with participation of works council (or central works council) through a system of controlled cooptation, in which the works council and the general shareholders' meeting have equal powers to make proposals or raise objections. This means that the supervisory board replenishes itself following proposals of the shareholders' meeting and the works council, and that both organs can raise objections against a member of the supervisory board to be proposed, based on three limitatively mentioned grounds. If necessary, the Chamber for Enterprises of the Court of Justice in Amsterdam can lay down a verdict in this matter. The supervisory board thus composed has extra powers in addition of the normal powers of a supervisory board with a non-structure-company (supervision on the board of managing directors, advice, representation of the company in case of conflicting interests or absence of the managing directors): to appoint and dismiss managing directors, to adopt the annual accounts, and to give its consent to some important economic decisions of the board. Another form is the mitigated structure regime in particular important to (large) Dutch companies with shares held for 50 percent or more by foreign companies. In this case two important powers return to the shareholders' meeting (read: the foreign mother company), being to appoint and dismiss managing directors, and to adopt the annual accounts. Hence if a company is subject to the mitigated structure regime, the effect is only that the supervisory board is composed according to the system of controlled cooptation described above, while this board receives only one extra power, that is to give (or withhold) consent to important economic decisions, like large restructuring operations. The above can be summarised as follows:
N.V.
B.V.
non-structure full structure mitigated structure
ΙΠ. Position of Shareholders in Different Companies This short explanation on different forms of Dutch companies was necessary to determine the position of shareholders, and consequently also of institutional investors. For it makes clear that the position of shareholders in a company
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subject to the structure regime is much weaker than with an ordinary company. In the first place, shareholders have much less influence on the composition of the supervisory board; they always have to consider the possibility that, for example, the works council raises objections against a candidate proposed by the shareholders (or the large institutional investors), and that these objections are ruled legitimate by the Chamber of Enterprises of the Court of Appeal in Amsterdam. This has happened repeatedly in recent years, especially on the grounds that with the appointment of a proposed candidate the supervisory board has no member who is familiar with social relations in The Netherlands. The supervisory board of a Dutch structure company, whose shares are, for example, wholly or largely held by an American holding, is not composed appropriately, if it consists exclusively of persons from the financial-economic sector, coming from the American parent company6. In the second place, the influence of shareholders on a structure company is less, because under the full structure regime important powers are taken from the shareholders' meeting, and transferred to the supervisory board: to appoint and dismiss managing directors, to adopt the annual accounts (with the shareholders only retaining the power to approve or disapprove the annual accounts thus adopted, without power to amend), and to give (or withhold) consent to important economic decisions. In the case of a company under the mitigated structure regime, the transfer of powers from the shareholders to the supervisory board is limited to the last-mentioned power. It is a nice example of a thesis which I have defended in my farewell lecture "Scarce Rights", partly with a view to law and economics7: rights can only be conferred upon A by withdrawing them from B, or by imposing an obligation on B. Not only commodities are scarce in an economic sense, rights are also scarce, as also with distribution of rights choices have to be made continuously. Thus rights can only be conferred upon the works council by withdrawing them from the shareholders. This thesis of scarce rights is applicable to numerous areas: more rights for employees means less rights or more obligations for employers; more rights for consumers means less rights or more obligations for producers; more rights to employment or allocation of houses to ethnic minorities, women or disabled persons, means automatically less rights for own subjects, males, and non-disabled persons. Although the structure regime was in particular aimed at 6
SER cone. Standard Electric, see De NV, 1979, SER cone. Mobil, see De NV, 1983, at 56; SER cone. Cyanamid, see De NV, 1983, at 233; OK cone. Kodak Nederland BV dated Febr. 1989, see NJ, 1990, 86. Concerning these decisions of the SER (Social and Economic Council), which dealt with these issues before jurisdiction was transferred to OK (Chamber of Enterprises of the Court of Appeal at Amsterdam), see P. VAN SCHILFGAARDE, Van de B.V. en de N.V. ("About the private economy and the public company"), (9th edition, 1992), § 141. 7 W.J. SLAGTER, Schaarse rechten ("Scarce rights"), farewell lecture at Erasmus University Rotterdam, (ed. Kluwer, Deventer, 1989), at 30-31.
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strengthening employees' participation, it has unintentionally also the effect of a protection clause by withdrawing powers from the shareholders' meeting (which at an ordinary company also has the power to appoint the supervisory board and managing directors, and adopt the annual accounts): the less powers the shareholders have, the less a company intending a hostile take-over will be inclined to strive for participation in a structure company through purchase of or bid for shares. This leads to two paradoxical conclusions. In the first place, labour organisations and employers' organisations, who often have opposite interests, now have a common interest in maintaining the Dutch structure regime, which is unique within the EC and whose future is still uncertain, in view of the ongoing discussions on a draft for the fifth EC-directive for harmonisation of company law. The effect is a mutual hypocrisy. In the second place, the mandatory transition from normal regime to structure regime, when a company meets the three criteria for a big company mentioned above, means that the successful large shareholder, who is simultaneously also managing director of a company, which under his management has grown into a large company, is penalised by having his powers as shareholder reduced.
FV. The Position of Institutional Investors vis-a-vis the Management of the Company I have now arrived at the basis for answering the questions raised in par. 1. The relationship between the management of the company and institutional investors is in the first place determined by the legal framework, within which companies based in The Netherlands (that is, according to Dutch law, and with by-laws drawn up before a notary with residence in The Netherlands) must operate. The question whether institutional investors should be granted a qualitatively special position differing from ordinary investors, raises five questions in particular8. In putting these five questions I emphasize that monitoring of an institutional investor towards a company in advance is more relevant than monitoring after the decision. Preventing damage is more effective than firing a C.E.O.: 1. is it permissible that the management consults with the institutional investors, without informing the shareholders' meeting, in particular with regard to strategic matters? 2. is it permissible that the management informs institutional investors more extensively or earlier than other shareholders? 8
Regarding distinctions between different kinds of shareholders from the point of view of law and economics, see W.J. SLAGTER, Macht en onmacht van de aandeelhouder ("Power and weakness of the shareholder"), lecture on the occasion of
the 75th anniversary of the Erasmus University Rotterdam, (ed. Kluwer, Deventer, 1988), at 24-28.
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3. is it permissible that institutional investors be granted special powers beyond the normal powers of every shareholder? 4. can institutional investors be granted powers to appoint or propose one or more members of the supervisory board? 5. are votes of an institutional investor subject to special rules or special vigilance? These five questions have to be answered within the framework of the following conditions: a. Art. 2:92 section 2 BW stipulates: "The public company must treat shareholders, respectively holders of depository receipts in the same position, similarly". b. Art. 2:140 section 2 BW, applicable both to members of the supervisory board of an ordinary company and of a structure company, stipulates: "The supervisory board is responsible for monitoring the management of managing directors and the general state of affairs in the company and the enterprise. It assists the management with advice. In fulfilling its duties, the supervisory board shall consider the interests of the company and the enterprise" (and not give priority to the special interests of an institutional investor). c. The rules governing co-determination in force in The Netherlands do not only compel the management to take into consideration the decisions of the works council in exercising its right of advice (again with appeal to the Chamber of Enterprises of the Court of Appeal in Amsterdam) and its right of co-decision-making, and cause the management of a structure company to be faced with a supervisory board composed with due regard to the right of the works council to propose and raise objections, but also require the management and supervisory board of every company be led by the interests of the company and her enterprises, which means a continuous balancing of interests in the short and long run of shareholders, employees, and other stakeholders, like creditors.
Adi The first question can be answered affirmatively. The management can consult with advisors or any person, hence also with institutional investors, who have a large financial interest in the company, who provide risk-bearing equity and who have the fiduciary task to invest the financial means trusted in their care (e.g. pension premiums) as profitably as possible. Such consultations can in the first place concern strategic questions, like new investments, new acquisitions, mergers, discontinuation of non-core-business, strategic alliances, and joint ventures. Other matters for discussion can include management of financial assets, management of foreign exchange (in particular, if that institutional investor happens to be a bank). I would value the correcting influence of such consultations with institutional investors higher than the correction of failing
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management by a hostile take-over. Buxbaum9 points out that the Chicago School of law and economics "characterises the hostile take-over as an efficiency-promoting check on suboptimally performing management". When the monitoring of an institutional investor turns out badly, the board remains responsible for following this bad advice, in the same way as the board remains responsible for the consequences of a bad advice of a management consultant, such as McKinsey. A golden handshake for a failing managing director, recommended in such a correcting consultative discussion with an institutional investor, can in the end prove to be a much more economical and better solution than damage by continuing mismanagement by a wrongfully not dismissed C.E.O. or a hostile take-over. Yet such consultations should not result in disclosing stock-price sensitive information to the counterpart, which should only be supplied to all shareholders simultaneously. If it is necessary to disclose sensitive information in such consultative discussion, e.g. regarding plans in an advanced stage of execution, then this should be done confidentially and under the obligation not to make any stock transactions until the information is made public. This solution is contrary to the theory, set out here, but is in practice inevitable. Ad 2 The question whether it is permissible that the management informs institutional investors more extensively or earlier than other shareholders should be answered in principle negatively. This follows from the article 2:92 section 2 BW quoted above concerning equal treatment of shareholders. Yet this regulation is not in conflict with the actual situation that the institutional investor possesses much more information than a private shareholder. An institutional investor has a team of analysts which can draw much more information from published annual accounts, in combination with previous annual accounts of the same company, with annual accounts of other companies, and with macro-economic data supplied by CBS (Central Office of Statistics) and CPB (Central Planning Agency), added with data from the sector concerned, than an ordinary shareholder. In the second place, listed companies in general hold so-called "roadshows", at which the management provides more in-depth information and addresses more searching questions. Although such road-shows are open to any 9
RICHARD M. BUXBAUM, Institutional ownership and the restructuring of corporations (with special reference to take-overs), Festschrift fur E. Steindorff, (1990), at 7-29, especially at 18. See also FRIEDRICH K. KUEBLER, "Institutional owners and corporate managers: a German dilemma," Brooklyn Law Review, Vol. 57, Spring 1991, at 97-111, who considers an unfriendly take-over as a real market for corporate control. An ESOP (Employee Stock Option Plan) can be considered as a new form of institutional investment, but also as a protection clause. On ESOPs, see BUXBAUM, o.e., at 20, and J. VAN WULFFTEN PALTHE, "Medezeggenschap ä rAmericaine" (American co-determination), TWS 1990, 143-148.
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shareholder, in general only institutional investors and their advisors make use of this facility. The lead in information of institutional investors thus obtained is therefore only a result of the fact that private shareholders due to lack of time, knowledge and willingness to obtain extra information in this manner, leave much information unused. In the third place, managing directors of listed companies often receive very frequently (not seldom twice a day) officials of institutional investors (mostly attractive but very keen, intelligent and ambitious young women), who pose more searching questions based on prior analysis, which could also have been raised at a shareholders' meeting if such were to have taken place. Based on such discussions, an institutional investor can, for example, receive confirmation that the expectations expressed at the shareholders' meeting for the current year are still valid. A private shareholder lacks this certainty, but must conclude from the absence of publication of adjusted expectations that expectations expressed previously are still valid. In this case the institutional investor does not possess more information but more certainty about available information. What if the management should answer such a question negatively? In that case, it concerns stock-price sensitive information, to which the same rule as mentioned in the answer to question 1 applies. Ad 3 Dutch legislation allows the possibility of issuing priority shares. Such shares in general have a low nominal value, while the stock-price per definition is always 100 percent of the nominal value. Holders of priority shares are granted extra powers. Priority shares were initially instituted to strengthen the power of the management vis ä vis the shareholders. Nowadays priority shares are issued mostly as a protection clause. These extra powers can include the right to make (binding) proposals for the appointment of managing directors and members of the supervisory board (not permitted with structure companies) or to make, or give consent to, certain proposals (e.g. for amendment of statutes or issuing of new shares). If an institutional investor is provided with one or more priority shares, extra powers can thus be granted (depending on the relations within the meeting of holders of priority shares). Hence institutional investors do not derive their extra powers from their status as such, but from the fact that they are also holders of priority shares. If a new institutional investor wishes to obtain priority shares it should first be examined whether the by-laws allow the possibility of issuing priority shares, and if so, whether current holders of priority shares are willing to cede one or more priority shares to the newcomer. If not, the plenary shareholders' meeting should first decide on issuing priority shares to the (new) institutional investor, if necessary after prior amendment of the by-laws. Disagreeing with the position put forward in the report "The role and duties of directors - A statement of best practice", drafted by the (British) Institutional
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Shareholders Committee of April 18th, 1991, I am of the opinion that institutional investors have no special responsibility to determine directors' emoluments and other compensation payments. Perhaps in Great Britain extra vigilance is required, but in The Netherlands these emoluments are generally not disproportionately high, leaving the influence of these emoluments on profits negligible. Ad 4 Members of the supervisory board at an ordinary company are appointed by the general shareholders' meeting, and at a structure company by the supervisory board itself (controlled cooptation). This means that a member of the supervisory board can never be appointed by part of the shareholders. Yet at an ordinary company the same result can be attained in two ways. In the first place, different kinds of shares A, B and C can be issued. If, for example, to an institutional investor are issued shares C, a stipulation can be included in the bylaws to the effect that one or more members of the supervisory board are appointed at binding proposal of holders of shares C. In the second place, all shareholders can reach a voting agreement obliging all shareholders in the case of appointment of one or more members of the supervisory board to cast their votes each time in favour of candidates proposed by the institutional investor. Such a voting agreement is valid under Dutch law. However, such solutions are not possible with a structure company. Such a statutory stipulation would be in conflict with the compulsory law of the structure regime. The same applies to a voting agreement, to which can be added that a mutual agreement between shareholders can never infringe upon the legal powers of the works council and the Chamber of Enterprises of the Court of Appeal. At most an agreement can be reached between institutional investors, other shareholders (together forming a majority) and the management, by which parties commit themselves to merely promoting that a candidate proposed by the institutional investor is appointed to the supervisory board10. If a member of the supervisory board is appointed at the recommendation of an institutional investor, he is restricted by art. 2: 240 section 2 BW quoted in the beginning of this paragraph. Thus that member of the supervisory board cannot be appointed on behalf of the institutional investor, and in exercising his duties he must not allow himself to be guided by the interests of the institutional investor, but only by those of the company and the enterprise liaised with her. The ultimate aim of that company - continuity in the long run - can run counter to the interests of the institutional investor in the short run (profitability). The board member thus appointed should realise that he is not just faced with a conflict of interests (for the interests of the institutional investor should under 10
See H.W. WERTHEIMER, TWS 1975, at 293-299, concerning HVAWestertoren-Socfin, HR March 19th, 1975, NJ, 1976, at 267.
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any circumstance yield to those of the company) but with something even less agreeable: something which he could feel as betrayal towards the institutional investor, to whom he owes more or less his appointment, and who has placed in him a (misplaced) trust. If, conversely, such a board member would forsake his legal duties and would allow the interests of the institutional investor to take prevalence over those of the company, he would not be eligible for reappointment. To demand compliance with the voting agreement under these circumstances would be in conflict with the requirements of fairness and reasonableness (cf. art. 2:8 BW). In the case of a structure company, the right to object could be exercised successfully, both by the general shareholders' meeting (in which the institutional investor forms a minority) and by the works council. In general, the supervisory board is bound by an obligation of confidentiality. It is the responsibility of the chairman of the supervisory board to make public announcements. If a board member feels the need for consultation with a third person (for example, a board member appointed at the recommendation of the works council receives a request for a meeting from the works council), he should consult in advance with the chairman of the board. Resolutions to this effect can often be found in the rules for a supervisory board. Even without such an internal code of conduct, the same conclusion would in general be reached on the basis of rules of conduct, partly based on the principles of fairness and reasonableness11. This means that a board member, appointed at the recommendation or proposal of an institutional investor, is not free to disclose confidential information to that institutional investor. Appointment of such a board member therefore in principle does not entail the danger of abuse of advance knowledge or insider information. Yet it is conceivable that the equal position of shareholders is eroded, if a person who simultaneously occupies a high position with an institutional investor is appointed member of the supervisory board, as this position would enable him to take decisions in favour of that institutional investor using information obtained in capacity of board member, without informing others in contravention of his obligation of confidentiality. Ad 5 Votes of an institutional investor are not subject to special rules. For fiscal reasons it is attractive to have a participation of at least 5%. Except for a deviation in the by-laws (art. 2:118/228 BW) the law attributes proportional voting rights to the shareholders, depending from the number of their shares. Votes of an institutional investor might be subject to special vigilance in case of 11
J.R. GLASZ, De commissaris, Aanbevolen gedragsregels ("Recommended code of conduct for members of a supervisory board"), rule 16.2.8, in Praktijkboek commissarissen ("Practical guide for members of a supervisory board"), (ed. Kluwer, Deventer, and Series Recht en praktijk, nr. 44, ed. Kluwer, 2°,1992).
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conflicting interests or too close relations between the institutional investor and the board of the company. Special attention deserves the case of a bank as an institutional investor or in the case of cross-shareholding. This can be demonstrated by this scheme of the worst case: bank dumping of an unsuccessful issue of shares: participants in ' investment fund financially damaged institutional the investor
credit
cross-shareholding
investment fund of 'bank no independent votes, but instructed by the bank, who cares for the credit
company
V. The Institutional Investor and Other Large Shareholders To what extent does an institutional investor distinguish himself from other large shareholders, and to what extent are the five answers given above also applicable to those other large shareholders? First a word about the bank, which in some countries can play a double role: as institutional investor in its own right; and as proxy of shareholders who have deposited their shares with a bank12. Unlike Germany, where the "Depotstimmrecht" is very common, banks in The Netherlands do not automatically obtain a proxy every year from the shareholders who have deposited their shares with the bank on the occasion of the annual shareholders' meeting. In exercising all its voting rights, the bank usually supports the management, unless there are important reasons to deviate from this rule. In general, the shareholders authorise the bank to cast its votes as it sees fit and useful. The option to give authorisation in the opposite sense is seldom exercised. Due to this double system the management is protected by the bank, which plays three roles simultaneously: as institutional investor, as proxy for her client shareholders, and as credit supplying bank. The danger exists that 12
THEODOR BAUMS, "Corporate Governance in Germany: The Role of the Banks," 40 Am.J.Comp.L. 503 (1992).
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the three roles conflict with each other, and that managing directors who should be criticised profit from the situation unjustly. The proxy system13 is much less developed in The Netherlands. If it is used, it is mostly done by the VEB (Shareholders' Association). A combination between an insurance company and a bank, like ING, raises in The Netherlands the prospect that a bank develops into an institutional investor, a "banque d'affaires". This is already partly the case through participation companies, while banks are sometimes compelled to act as institutional investor, e.g. with remnants of share issuings and at financial restructuring operations of clients, with loans being converted into share capital (DAF, HCS, Breevast, Vilenzo and HSS). The Nederlandsche Bank (Netherlands Central Bank) does not encourage such a development. Cumulation of possession of shares and credit lending could result in credit lending being continued longer with problematic debtors at the expense of other creditors than a bank would have done without share participation14· If a bank director is appointed to the supervisory board of a company, in whose capital the bank participates, the same answers to the five questions raised in par. 4 apply. With regard to the fourth question: such a bank managing director could use advance insider knowledge obtained as member of the supervisory board without violating his obligation of confidentiality by terminating bank credit. This again underlines the ambiguity of such a dual capacity. In principle it makes no difference for the answers to the five questions raised in par. 4 whether the company has shares listed at the stock exchange or not. Institutional investors, like the Nederlandse Participatie Maatschappij, are often involved in smaller companies (usually in private company form). In such cases 13
J.J. VAN DE VIJVER, "Proxy solicitation," in Jurist in bedrijf ("Lawyer in action"), Opstellen van bedrijfsjuristen bij het 50-jarig bestaan van het Nederlands Genootschap van Bedrijfsjuristen ('Essays of corporate lawyers at the occasion of the 50-year anniversary of the Netherlands Association of Corporate Lawyers'), (ed. Kluwer, Deventer, 1980), at 213-235 and W.J. SLAGTER, "Gebundelde action" ("Combined actions of shareholders"), in Goed en trouw (Goodness and loyalty), Opstellen aangeboden aan Prof. Mr W.C.L. VAN DER GRINTEN ('Essays dedicated to Prof. Mr W.C.L. van der Grinten'), (ed. W.E.J. TJEENK WILLINK, Zwolle, 1984), at 235-253. 14 Paper of L.D. DE BIEVRE, Nederlands Instituut voor het Bank- en Effectenbedrijf' ("Netherlands Institute for Bank and Stock Trade"), in ΝΙΒΕ, 1991, who mentions as examples of "banques d'affaires" the (German) Deutsche Bank, the (French) banks Suez and Paribas, and the (Belgian) Soci^te" Ginorale, with her minority daughter Socie"t£ Gonorale de Banque. Supervision by De Nederlandsche Bank (Netherlands Central Bank) will, however, in the case of combinations between insurance companies and banks, prompt erecting Chinese walls inside such a group of companies.
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the institutional investors often demand an appointment to the supervisory board for their willingness to participate in share capital. From the perspective of the management it is attractive if shareholders consist of on the one hand quiet, permanent, and knowledgeable institutional investors, and on the other hand more or less inexpert, but hence also harmless, scattered private investors, who remain silent at meetings or sell their shares when they are dissatisfied. Uniting shareholders' interests, like at the Vereniging Aegon (resulting from a merger between AGO and Ennia) and the Vereniging Nederlandse Heidemaatschappij, is less attractive from this perspective, but neither is it threatening. From the same perspective, it is unattractive if shareholders include a company which prepares a hostile take-over, or a "raider". So far, the presence of such undesired shareholders in the supervisory board has been successfully prevented in the Netherlands through protection clauses. However, it can be anticipated that such protection clauses will partly be no longer permitted after passing of the 13th EC directive concerning harmonisation of company law. In this connection, I would like to express the hope that at least that part of the draft of the 13th EC directive compelling 30 percent-shareholders to bid for the remaining 70 percent of shares will not be passed. Institutional investments over 30 percent would thus be made impossible. Regarding the need to reduce protection clauses, different opinions are voiced in The Netherlands. In general, institutional investors will not be affected by it (they do not have hostile intentions), unless it would result in diluting share capital by more than 10 percent (code of conduct between institutional investors and the VEB of april 1992; see Exhibit), or in lower stock pricing. For companies listed at the Amsterdam Stock Exchange, the permissibility of protection clauses will be limited earlier due to amendment of supplement X of the Fund Code of Rules, on which agreement was reached in april 1992 by the Association for Stock Trading (Vereniging voor de Effectenhandel), and the Association of Shareissuing Companies (Vereniging van Effecten Uitgevende Ondernemingen)15. With reduction of protection clauses, this difference in appreciation for the institutional investor and some other large shareholders can surface, if the company refuses its cooperation to one or more of the instruments mentioned above (voting agreement, amendment of by-laws, issuing or allotment of priority shares, appointment of a member of the supervisory board). If a family is a large shareholder and this family, due to either inexpertise or high claims for dividend (Vendex), causes more harm to the company than it contributes expertise, it can be recommendable to encourage that the family converts its shares into depository receipts, which are issued by a Foundation Trust Office, and that in the board of trustees of this foundation administering the shares the 15
D.C. BUIJS, "De beursregeling van beschermingsconstructies herzien," TWS 1992,247-251.
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family only forms a minority. In The Netherlands, institutional investors often failed to appear in a shareholders' meeting. Questions and wishes they may have had were brought to attention in a separate discussion with managing directors. Yet one can notice an increasing willingness on the part of institutional investors to use their voting rights at meetings, sometimes through proxy to the VEB. This development merits encouragement. Replacing such separate and uncontrollable discussions by expert, possibly critical, contributions during the meeting will benefit the general level of a shareholders' meeting. Much commotion has been caused last fall by an attempt of Mr Hagen, through his investment company Marine Investments, for 17.2 (or 27?) percent shareholder and with the help of 22 percent supporting shareholders in NV NedLloyd, the largest Dutch shipping company, to gain a seat on the supervisory board. At first, the management and supervisory board were not in favour of this appointment, arguing that the interests of a large shareholder could conflict with those of the company. While conceivable, it was in this case less probable, as Mr Hagen has given some correct advice in his capacity of large shareholder (like with regard to desinvestment of non-core business), which was followed by the management with some delay. It is more probable that the management and supervisory board were concerned that the homogenity of the supervisory board would be lost by taking in Mr Hagen. After refusal of the shareholders' meeting to approve the annual accounts over 1990 to express its dissatisfaction with the failure of the management and the supervisory board to propose Mr Hagen for an existing vacancy on the supervisory board, and after establishment of a committee of shareholders proposing Mr Hagen to the supervisory board, the management and supervisory board relinquished their opposition, but only after they had made Mr Hagen make a statement of "good conduct", the permissibility of which is, in my opinion, not beyond doubt. After this obstacle had been removed following numerous meetings, Mr Hagen found a second obstacle on his way to the supervisory board: the central works council exercised its right of objection at this structure company, compelling the supervisory board (if it is not a frame-up) of NV NedLloyd to bring this case before the Chamber of Enterprises of the Court of Appeal16. This affair has caused observers in other countries to suppose that it is hardly possible to gain participation in decision-making by investing in a Dutch structure company, and that the Dutch structure regime is, from a perspective of European law, objectionable. From a Dutch perspective, this is regrettable, since the structure regime, instituted at the time as an ingenious compromise between employers and employees17 and therefore received with scepsis by both sides, after 20 16
W.J. SLAGTER, TWS, 1991, 184-185. See about the final act in this tragedy W.J. SLAGTER, "Lessen voor Hagen en voor NedLloyd," TWS 1993, 39-40. 17 G.H.A. SCHUT, "Met wonder van Den Haag" ("The miracle of The Hague"), in
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Wiek J. Slagter
years of experience is generally appreciated as a workable institution to reconcile wishes with regard to efficient management and co-determination. Institutional investors striving for a permanent relation with the company in which they participate, will be more inclined to appreciate the need and desirability to realise co-determination in an economy based on consultation like the Dutch economy, than companies preparing a hostile take-over or "raiders" intending to proceed to "asset-stripping". This is also an aspect of continuity of the company in the long run. To institutional investors aiming for profit maximization in the short run, the gate should remain closed as much as possible.
Minimum Code of Conduct of Dutch Institutional Investors In future, the links between companies and their long-term shareholders will become stronger. Institutional investors will, as long-term investors, adopt a more active approach. This will be reflected in the following areas: 1. Provision of Information It is of prime importance that they have a good understanding of the objectives of the company's management. Management must continually strive for as open a dialogue as possible. This will also keep management better informed of shareholders' expectations. 2. Shareholders' Influence (Voting Rights) As far as the exercise of voting rights at shareholders' meetings are concerned, institutional investors will in principle support management unless there are good reasons for not so doing. Such reasons could concern the extent of the company's defences. Companies in the Netherlands are often too highly protected. This means shareholders' power to influence policy is lacking, and as longterm investors, institutional investors consider that undesirable. The general opinion among institutional investors is that the maximum number of preference shares should be set at 50 % of the number of ordinary shares outstanding. If prefs are issued, they should remain in force for no longer than two years. As long-term shareholders, institutional investors also feel it undesirable to have no voting rights whatsoever. This is the case in the event of certification (the issue of non-voting share certificates), the more so because the possibility of con-
Uit het recht, Rechtsgeleerde Opstellen aangeboden aan Mr P.J. Verdam, (ed. Kluwer 1971), at 307-319.
Institutionais and Corporate Governance in The Netherlands
345
verting the certificates into ordinary shares is often restricted to 1 % and generally limited to natural persons. 3. Dilution Institutional investors value their priority application rights in the event of new issues. They are prepared should the occasion arise to accept a limited dilution of their stakes. Dilution by more than 10 % is too much. This explains their wish to see management's authority to issue new shares restricted to a maximum of 10 %. They would like to restrict to 18 months the period of the mandate to management that authorises it to issue new shares. 4. Formation of an Interest Group Institutional investors are increasingly contacting each other on the way in which they handle their interests. Where necessary and useful, institutional investors can cooperate with national and international shareholders' pressure groups.
Chapter Thirteen
Institutional Investors, Financial Groups and their Impact on Corporate Governance in Belgium Eddy Wymeersch
I. Historical Background 1. The current characteristics of Belgium's financial and economic structure cannot be correctly described without first recalling some elements of the historical background. The history of several of today's largest businesses goes back to the early days of Belgium's first industrialization during the first half of the 19th Century. Industrialization initiatives were due to the governing monarchs, the Dutch King and the Belgian Kings Leopold I and II. Special mention should be made of Dutch King Willem I, who reigned in Belgium between the Treaty of Vienna (1815) and the 1830 declaration of independence, and who in 1822 stood at the cradle of the Sociot G6n6rale de Belgique, "founded for the promotion and industrialization of the southern provinces", at that moment considered less developed than their Northern equivalents.1 After the declaration of independence it became the 8οάέΙέ Generale de Belgique, and the shares were bought back by Belgian investors. Support from Leopold II also is reported to have played an important role in the success of other present day groups such as Solvay (° 1863) and many of the now dissolved businesses that were active in the Belgian Congo, such as Union Miniere, the mining subsidiary of the Socioto Gen6rale.2 Belgian entrepreneurs and engineers contributed significantly to industrialization, especially by the
1
The King himself subscribed a large part (about 40%) of the shares of the new company. See about the history of this company, the Memorial of the Socioti ge'ne'rale de Belgique, published at its 150th anniversary in 1972. During the early years of existence it also had a monetary function: see V. JANSSENS, De Belgische frank, (Standaard, Antwerp, 1975). 2 Founded 1906, at the instigation of King Leopold II.: see i.a. B. EMERSON, Leopold II, le royaume et l' empire, at 188 ff. (1980).
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building of factories and the construction of railways in Southern Russia, large parts of Eastern Europe, Egypt, Argentina, and even China.3 It would seem that early Belgian capitalism, although not amounting to Colbertism, was tributary to state support and mainly relied on strong family ties. The latter feature, although in a somewhat modified form, still is predominant. 2. A major policy change intervened in 1934, as a consequence of the near collapse of the banking system. Up to then, most industrial groups had been functioning as universal banks i.e., both taking deposits from the public and investing in company shares and bonds of and loans to industrial businesses that most of the time belonged to the same group. By Royal Decree n° 2 of 22 August 1934, it was decided that both functions be separated.4 The dividing of the pre-1934 universal banking entities could have taken place in several ways. Obviously not very much to the taste of the political world, the business leaders decided to put their banking business in a wholly-owned subsidiary rather than dividing the company vertically; i.e. into an industrial and a financial entity. Here lies the origin of the still-existing ties between the financial holding companies and the major Belgian banks. The banks were subject to "control"5, later called "prudential supervision", while several techniques were developed to allow the banks to unload their frozen assets.6 A separate body, almost a mortuary for deceased enterprises,was set up for the orderly liquidation of failed companies.7 During the first years of implementation of the new banking act, the Banking Commission urged the financial holding companies to divest themselves of their shares in the commercial banks. This policy proved technically unachievable 3
See for a large overview: H. PIRENNE, Histoire de Belgique, (Lamertin, Bruxelles, 1922-32); E.J. HOBSBAWM, The age of revolution, (1789-1848) and The age of capital, (1848-1875). 4 See about this important policy decision and its backround: BANKCOMMISSIE, Memorial, at 34 ff., (1935-1960); more critical: H. VAN DER WEE & K. TA VERNIER, De Nationale Bank van Belgie en net monetaire geheuren tussen de twee Wereldoorlogen, at 298 ff. (Nationale Bank van Belgie, 1975); BANKCOMMISSIE, Memorial, at 33 ff.; (1935-1960); Memorial E.G. DE BARSY, In bono et aequitate perseverans, (Brussels, Bruylant, 1985). 5 It was a popular slogan during the 1930 crisis to call for "control on the banks"; hence the 1935 Decree expressly called for "le contröle des banques". 6 E.g. the still functioning Institut de riescompte et de garantie R.D. nr. 175 of 13 June 1935 and the Office central de creclit hypothecate RD. nr. 225 of 7 January 1936; also the Office central de la petite ^pargne. L.7 December 1934, bodies in charge of the refinancing of the frozen assets. 7 See E.G. DE BARSY, "Les interventions de crise: vie et mort d'un office d'Etat," in Memorial E.G. de Barsy, In bono et aequitate perseverans, at 41 ff., (Bruylant Brussels, 1985,).
Institutional Investors and Financial Groups in Belgium
349
and harmful in terms of prudential supervision. It was abandoned in the Sixties, the Commission deciding that the shareholdings could be maintained on a permanent basis, provided the holding company signed a so-called "protocol on banking autonomy". The holding company agreed not to dominate the bank, especially as to its daily operations.8 This protocol regime continues to function today although it has come under serious strain due to the increasingly competitive environment and the increased interpenetration of banking and insurance business.9 3. The holding companies subsisting after the implementation of the 1934 reform mainly consisted of a share portfolio in a large variety of enterprises. Many of these investees were stock exchange-listed or traded companies, the holding company owning only a minority stake, though one sufficient to dominate the normal functioning of its investees. Joint and cross shareholdings among financial groups were frequent, resulting in agreements to share influence or, more rarely, in border fights.10 In 1967, in order to encourage these holding companies to invest more actively in Belgian industry, the Government enacted a decree11 obliging these holding companies to take part in the economic planning that was than being developed by the State Planning Bureau, and to subject themselves to supervision by the Banking Commission. This supervision is mainly aimed at transparency and disclosure of intragroup dealings, and left freedom of management untouched. The first steps undertaken consisted of identifying the assets controlled by these larger holding companies. After some hesitation, both so-called financial and industrial groups were considered subject to the regulation.12 The financial groups are mainly conglomerates based on minority 8
See for the text of the protocol: COMMISSION BANCAIRE, Annual report 19731974, at 242 and for the latest version: 1990-1991, at 32 ff. Also see A. BRUYNEEL, "La Commission bancaire beige," Banque (Fr) 1972, nr. 303, 12 ff., nr. 304, 125 ff.; nr. 305, 247 ff.; PH. DEMAIN, "L'autonomie de la function bancaire en Belgique," Refl. Persp., 1976, 3 ff.; R. HENRION, "La concertation et l'autonomie bancaire," JT., 1972, 293; R. WITTERWULGHE, "Le protocole bancaire, un mode de comportement," Reflets et Perspectives, 1978, 354. 9
See in/τα at 379 ff.
10
One of these still famous battles relates to the 1964 attempt to aggressively take over Sofma: see for details G. SCHRANS, "L'offre publique d'achat," Rev. Banque, (B), 1965, 495. 11 Royal Decree nr. 64 of 10 November 1967 "relating to the portfolio companies and their association with economic programming". Art. 10 of that decree, later modified by L. 1978, called for "the association of these companies in the planning of investment programmes within the framework of the general economic programming". This side of the regulation has de facto been abandonned. 12 See BANKING COMMISSION, Annual Report 1968-1969, at 191.
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shareholdings in a wide variety of other enterprises.13 The industrial groups are businesses active in one specific line of economic activity, but organized mostly by way of 100%-owned subsidiaries.14 As of June 30, 1991, there were 9215 businesses registered as "portfolio or holding companies", most of which are stock-exchange listed.16 The market capitalization of these holding companies stand for 83 % of total Belgian sharemarket capitalization of the Brussels Stock Exchange. The remaining 17% has been issued by 72 companies. 4. The development towards conglomerate-type financial holding companies has not been the only pattern of group formation. Roughly speaking, the said type could be said to be dominant for the businesses established in the 19th Century, while most of the businesses started in the 20th Century do better correspond to the industrial type of holding company, although in the latter as in the former family shareholdings would be prevalent and generally insure a working majority. The "industrial group" phenomenon might be said to be more visible in the Northern part of the country, where economic take-off took place in the 20th, rather than in the Southern, already heavily industrialized before the end of 19th Century. In the meantime, this distinction between the two types of holding companies is not a rigid one and differs from case to case. Also the distinction is getting somewhat blurred again, as industrial groups tend to diversify especially into the financial services field, while formerly highly diversified groups are streamlining their operations and limiting themselves to a number of specific lines of production.17
Π. The Role of Institutional Investors in Belgian Stock Exchange-Listed Companies Although the financial holding companies referred to have sometimes been compared to investment funds of a special type offering to investors a wide
13
Examples would be Sociiti Ginorale de Belgique, Groupe Bruxelles Lambert, Cobepa, and as a purely financial conglomerate, Almanij. Each of the groups will be described infra at 362 ff. 14 Examples would be: Solvay, UCB, Bekaert, Petrofma. 15 According to the Banting Commission's Annual Report 1990-1991, at 211. There were at that moment 164 companies listed. 16 Only 2 or 3 are not stock exchange listed. 17 See e.g. the acquisition of an insurance company by Petrofma, as opposed to the streamlining that took place in the GBL group, and more recently in the Socie"t6 ge'ne'rale group.
Institutional Investors and Financial Groups in Belgium
351
diversification of risks, one should clearly distinguish them from institutional investors properly.
the
A. Description of the Belgian Institutional Investors 1. It is difficult to precisely determine the position of the institutional investors in the Belgian financial system. Very little research has been done on their role, mainly due to the fact that no detailed information is available, but also because of the widespread perception that most institutional investors are linked to financial groups and hence would not be able to act independently. However, one could assess the presence of institutional investors in listed companies as follows.
in billion BEF
BEF
%
date
source
insurance enterprises
143
9.13
1990
OCA
UCITS
131
8.37
1991
CBF
50.3
3.21
1990
Bull.Gon. Banque
20
1.28
1991
344.3
21.99
1566
100
Pension
funds
Credit institutions
total institutional investors
Stock exchange capitalization(18)
18
However, one should take into account that only a few listed enterprises do not have the majority of their shares in firm hands (issued shares, convertibles and
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Eddy Wymeersch
In terms of market capitalization, institutional investors held about 22% of all Belgian shares, insurance companies accounting for 9%, Ucits for 8.5%, pension funds for 3%, and credit institutions for 1.3 %. These figures are unfortunately not very reliable, as little detailed public information is available. Also, one should take into account the Belgian bank-managed Luxembourg funds, about which no figures have been found. On the other hand, most institutional investors belong to (or are managed by management teams belonging to) banks, or to the financial groups that dominate the Belgian economic scene. Full independence of action or judgment therefore will only occur on extreme occasions19. Monitoring action thereby can be presumed to be limited although not totally absent. Recently, one has seen Ucits suing the purchaser of a controlling block for not extending a mandatory bid to all shareholders.20 In some listed companies the employees own significant stakes (e.g. Petrofma, BBL), but this is not a prevalent phenomenon. Belgium has no tradition nor systems for codetermination, and one rarely if ever finds labour representatives on the board. The State or its agencies21 seldom own shares in listed companies, except their controlling interests in companies which they had to come to rescue (FN, Barco) or which have been transformed from the former State-run business (airline, railways, telecommunication, postal office). In a few rare cases, investee enterprises were later brought to the market22. In other closely-held corporations, these agencies would normally take a minority interest.23 2. Alongside the holding companies mentioned supra, institutional investors play a certain, although not important role in Belgian stock exchange-listed companies. Institutional investors that are "located" in Belgium have relatively small shareholdings in Belgian companies. Our recent studies estimated that the warrants included), while the percentage of the shares effectively circulating on the market will often not exceed 20 to 30%. 19 For an analysis of the questions raised by the UCITs' links to the financial groups, see e.g. E. WYMEERSCH & M. KRUITHOF, Belangentegenstellingen bij het beheer van gemeenschappelijke beleggingsfondsen, Bank- en Financiewezen, nr. 5, 303-321. 20 See Brussels, 6 August 1992, D.A.O.R., 1992, nr. 25, 63, (appeal pending) and Trib. Comm. Brussels, 3 September 1992, D.A.O.R., 1992, nr. 25, 93 in the so-called "Wagon lits"-case (cassation review pending). 21 These are the so-called Public Investment Companies, L. 2 April 1962, of which there are four, one national (SNI-sociito nationale d'investissement) and three regional ones (GIMV, SRIW, SRIB). 22 See e.g. De Witte Lietaer, in which the NIM/SNI held a 1,9% stake. 23 See i.a. the prevailing financing technique using in implementation of the Textile reorganization plan: RD. n° 20 of 23 March 1982 and RD. 7 May 1985.
Institutional Investors and Financial Groups in Belgium
353
total shareholdings of institutional investors, including investment funds, investment companies, insurance companies, pension funds, etc., represent about 22 % of market capitalization. However, it has proved impossible to determine how many of these shares held by pension funds are listed shares. Another approach could therefore be based on the declared24 holding. If one only takes into account the shares owned by banks, investment funds and insurance companies that have been reported, the amount of shares so owned represent about 10% of market capitalization. Hence, the ownership of listed shares could be situated somewhere in between 18% and 22% of market capitalization. This lack of interest by institutionals for investment in shares was criticized, i.a. by the Governor of the central bank25, who implicitly seems to have expected that these investors could been drawn upon to avoid Belgian industry from being even more massively taken over by "foreign" interests.26 In addition to Belgian institutional investors, one should also mention Luxembourg-based investment vehicles, as many of these collect savings funds originating in Belgium (for tax purposes), while their management often is in hands of subsidiaries of Belgian banks, or of Belgian financial groups. No breakdown is available as to the importance of these shareholdings. Finally, foreign institutional investors are also active on the market. Here again, it is impossible to obtain any reliable data as to the importance of these holdings. One therefore can only attempt to sketch the situation from some elements of occasional evidence.27 3. Interest in Belgian shares by institutional investors that operate internationally generally seems to be relatively limited. Robeco, the giant Dutch investment company, holds only 0.54% % in Belgian shares, to be compared to 1.77% in
24
Reporting takes place only for holdings exceeding 5% owned by one or several persons, acting in concert (L.2 march 1989). Some of the institutional investors obviously declared their holdings as acting in concert with other shareholders, i.a. holding companies. 25 The same figure of 12% was cited by the Central Bank Governor VERPLAETSE in FET17 June 1992, Belgische financiele sector belegt te weinig in aandelen. 26 On this issue see further at 361-369. 27 Only one foreign institutional investor has been reported on the basis of the 1989 law; i.e., the Merchant Navy Officers' Pension Fund (3,5% stake in the BBL bank) a UK pension fund, held a significant shareholding and was even represented on the board of directors. Recently, due to the ongoing changes of the bank 's shareholder structure (see infra p. 379), the fund sold its shares to the bank 's principal shareholder, GBL, implementing an agreement of first refusal that these "stable" or controlling shareholders had entered into. CALPERS and other American institutional investors are reported to own some stakes in Belgian companies.
354
Eddy Wymeersch
Swiss, 1.46 % in Italian or 2.21% in Spanish shares.28 This lack of interest seems to be due to several factors, among which is insufficient market depth. Indeed, with the majority of the shares in firm hands, and a not very smoothly functioning market, one cannot expect institutional investors to be overconfident in this market segment. One could also refer to rather weak disclosure policies, and the belief in the prevalence of insider trading, at least before the recent legislation was enacted.29 In 1991, effective legislation against aggressive takeovers was put into place, mainly by reinforcing the position of the controlling shareholders.30 B. Regulations Applicable to Institutional Investors' Conduct Under this heading attention should be called to the rules and regulations that govern the position of the Belgian institutional investor vis ä vis the investee companies. These regulations relate to three topics: limitation of the volume of their investments, exercise of voting rights and conflicts of interests. 1. Limitation of the Volume of the Investments Most institutional investors are subject to regulations restraining, with a view of risk spreading, the range of eligible investments while limiting the volume of investment in one single company. Investments in unlisted shares are either forbidden or strictly limited; investments in individual companies are limited to a percentage of the investor's total portfolio; while the percentage of shares owned in an investee company may be limited to a percentage of the investee1 s 28
If related to 1991 GNP of the countries mentioned, these investments represented of 0,014% of GNP of Belgium; 0,039% of GNP of Switzerland; 0,007% of GNP of Italy; 0,011 % of GNP of Spain. 29 It should be mentioned here that the holding companies have been exempted from the insider dealing rules as far as these relate to information received as part of the role the holding company plays in the management of the companies in which they hold shares and provided the information is not of the kind that has to be disclosed pursuant to legal or regulatory obligations (art. 181, al. 2, L. 4 December 1990). It is debatable whether this exemption is compatible with the EC directive 89/592 of 13 November 1989. Holding companies actively trade shares of their investee companies, on some occasions even disclosing in their annual reports important buy and sell volumes for the same shares during the same accounting period (e.g. Sociito g£n£rale buying and selling Union miniere shares). No criminal charges for insider dealing nor manipulation have yet been brought, although several cases - not relating to holding companies - have been reported, probably because the public prosecutors have other more urgent matters at hand. 30 By the L. 18 July 1991. The position of management remained unchanged, i.e., very much dependent on the decisions made by the shareholders.
Institutional Investors and Financial Groups in Belgium
355
issued shares. Especially the latter rule influences the investor's influence on the investee. Insurance companies enjoy a widely framed franchise: Up to 25% of their total reserves may be invested in shares31, although not more than 5% in the shares of one single enterprise. In practice, only about 12% of the reserves are used for share investment.32 One will notice that insurance companies are not prevented from acquiring controlling blocks in investee companies, nor from exceeding the said percentages for the investment of funds, other than their insurance reserves. Ucits33 qualifying under the specific rules imposed by virtue of the 1985 harmonization directive would enjoy free circulation in the EC. Two restrictions are imposed: Not more than 5% of the portfolio is to be invested in shares of one single issuer, while the amount of shares owned in one investee company is limited to 10% of the latter's shares.34 Similar rules are applicable to ucits that would not qualify for freedom of circulation according to the directive. Pension funds of the second pillar are organized as not-for-profit associations.35 Investment in the securities of one single issuer is limited to 5% of the reserves of the fund. However, this limit is raised to 15% if the investment relates to securities issued by the employer company owing the pension benefits.36 Investment in shares of an unlisted enterprise may not exceed 3% of the reserves, but may in the aggregate amount to 30% for all investment in unlisted shares. As voting rights are not restricted, pension funds could play an important role in defending the issuer in case of a takeover bid. Third pillar investment funds are included in the Ucits1 figures. 2. Voting Rights There are no rules on voting rights exercised by insurance companies, nor by pension funds. These investors would, it seems, not be considered subject to specific fiduciary obligations towards the policy holders or towards the pensioners. Several insurance companies own substantial, even controlling shares in other enterprises, such as holding companies, banks, and others. From 31
Whether Belgian or foreign: however, an additional authorization would be required for foreign unlisted shares. 32 See annual reports of the Insurance control office indicating that share investments amounted to 11.7%, 13.6%, 9.6%, 12.1% and 12.2% of the insurance companies' portfolio for the years 1986 to 1991. 33 Units for collective investment in securities, according to the Directive 85/611 of 20 December 1985. 34 Art. 42, § 2, R.D. 4 March 1991. As to investment in unlisted shares, it may not exceed 10% of the Ucits portfolio. 35 R.D. 15 May 1985. 36 No breakdown of these figures has been available.
356
Eddy Wymeersch
the declared shareholdings, it appears that, in some financial groups at least, insurance companies own substantial amounts of shares and that these holdings are considered part of group strategy. One could question whether the use of insurance funds for group strategy reasons is compatible with the purpose of these funds. Due to the lack of precise information and research in this field, no definite answer can be given. Under the former legislation on mutual funds, it was generally admitted that Belgian funds could not exercise voting rights, securities being held in common ownership. A proxy of all certificate holders would have been necessary. Since the L. 4 December 1990, all Ucits37 are entitled to exercise voting rights relating to portfolio shares, provided this voting has been allowed in the fund's bylaws.38 Due to the expressly stated fiduciary relationships voting rights can only be exercised in the interest of the certificate holders.39 Implementing the Ucits directive of 198540 the Belgian legislator forbids investment institutions to acquire shares which, taking into account all shares under the same investment management are likely to influence the management, of the investee company. Agreements limiting the funds management freedom of decision are forbidden41, as are voting agreements including proxies, waivers of preemptive rights or agreements to refrain from selling. First refusal clauses would remain valid42; in addition, proxies to other parties attending the general meeting would be permitted.
37
"Units for collective investment in securities", as the standard EC terminology now designates investment vehicles, organized whether as undivided property, as incorporated bodies or as unit trusts. 38 Art. 112, L. 4 December 1990; voting by investment companies had always been admitted. 39 Art. 108 of the L. 4 December 1990. 40 Art. 25 of the Council directive 85/61 I/EEC of 20 December 1985 states that Ucits "may not acquire any shares carrying voting rights which would enable it to exercise significant influence over the management of an issuing body". The rule is applicable per fund, or per series of funds under the same management. 41 Art. 126 L. 4 December 1990. 42 See for the different instruments used in Belgian practice: P. VAN OMMESLAGHE, Les conventions d' actionnaires en droit beige, Revue pratique des sociitSs, at 289, (1989); J.M. NELISSEN-GRADE, "De la validiti et de Γ execution de la convention de vote dans les socie"tes commerciales," Revue Critique de Jurisprudence Beige, 1991, 214 ff.; and since the L. 18 July 1991; R. NIEUWDORP, "Overeenkomsten tussen aandeelhouders," in Het gewijzigde vennootschapsrecht at 255 ff. (Braeckmans & Wymeersch, eds., 1991); J.M. NELISSEN-GRADE, de Goedkeurings- en voorkoopdausules in de naamloze vennootschap - Overeenkomsten betreffende uitoefening van het stemrecht, De NV en de B VBA na de wet van 18 juli 1991,Biblo, 1992, at 55 ff.
Institutional Investors and Financial Groups in Belgium
357
3. Conflicts of Interests The regulations on insurance companies and on pension funds allow a wide discretion with respect to the management of their reserves. No explicit rules on conflicts of interests are imposed. Therefore, pension funds may invest in the shares of the company owing the pensions, up to the limits indicated above. The Ucits regulation contains several rules with respect to this topic. As far as voting is concerned, if the Ucits vote is liable to have been inspired by a conflict of interests, the annual report of the Ucits will have to mention it, indicating the direction in which the voting rights have been exercised, or have not been exercised.43 The investment policy should be implemented exclusively taking into account the rights of the certificate holders.44 Therefore, transactions have to be executed on the markets, and not directly with the investment manager, the custodian or its personnel.45 The exception is, however, more important than the rule: It allows the banks to place the securities they have underwritten in the funds they manage, provided this is done at the market price. Also the cash and other assets of the firm can be managed by the bank.46 Investment in the shares of issuers related to the investment manager or the financial group to which it belongs is not regulated, except as far as the voting rights are concerned. C. The Influence of Institutional Investors on Corporate Conduct 1. It is very hard to measure the actual impact of the institutional investors on the conduct of companies in Belgium. No research has been undertaken on this topic, and the abovementioned changes to the law are still too recent to allow for reliable information. The illiquidity of the markets in Belgian shares prevents institutional investors from actively applying the "Wall Street rule". One would therefore expect a certain level of "institutional investor activism". This obviously is not the case. Although impossible to prove at present, this influence on company management is generally considered weak to non-existent. The institutional investors' mildness is due to their embedding in the overall financial network. Belgium-located investment funds are - de jure or de facto managed by investment management companies belonging to or dependent on either banks or holding companies. Although in practice it sometimes is difficult to identify which group a certain investment institution is dependent on, it would seem that most investment institutions are, in one way or another, related to one of the five or six financial groups. One should make a reservation for a 43
Art. 21 § 2, A.R. du 4 mars 1991. Art. 108, L. 4 December 1990. 45 Art. 20, R.D. 4 March 1991. 46 Art. 20, R.D. 4 March 1991. 44
358
Eddy Wymeersch
few funds managed by stock-exchange member firms. Therefore, one should not be surprised that the independent monitoring exercised by these institutional investor is minimal, if existent at all. Rather it would appear that on some occasions these institutional investors have acted alongside the financial group to which they "belong". 2. Some evidence of the investment funds' embedding in the overall action of the financial groups can be found in the declaration of significant shareholdings to which all 5% or more shareholders in stock exchange-listed companies have to proceed. With respect to several companies one finds declarations by controlling shareholders relating to shares held in the portfolio of investment funds, although these shares do not exceed the 5% threshold.47 Obviously, these shares are reported as being held by parties "acting in concert"48, anomalous, as this may seem. Therefore, rather than studying the limited role of the institutional investor, it seems more important to explain the functioning of the holding companies in relationship to their investee companies (see § 3). 3. Institutional shareholder activism is relatively unknown on the Belgian scene. Partly this may be due to the fact that institutional investors de facto had no voting rights until the change of the law in 1990.49 New to Belgian habits was the abrasive stand taken by American institutional investors at the general meeting of two of the principal Belgian holding companies. In the first case the protests of three investment funds were addressed against the waiver of preferential subscription rights which the shareholders, on the board's proposal, were called to ratify50. In the second case, the principal shareholder of a major bank, the Belgian holding company, owner of about 39% of the bank's shares, subscribed to share warrants to secure full legal control in order to protect the bank in case of an hostile takeover. The press covered the meeting and adequately informed the public opinion about the action taken by these institutional investors. 4. Belgian institutional investors have not undertaken comparable action. From anecdotical evidence it appears that they usually vote for the board's proposals.
47
A survey established by D1 HAENE, at the University of Gent, found at the end of 1990 a higher frequency of investment fund holdings than has been found in November 1992. 48 It should be mentioned that the declarations on the basis of concert action are not published. 49 Art. 112, al. 3, L. 4 December 1990. 50 See i.a. Finandeel Economisch Tijd, 27-28 May 1992, at 8. Trends, 11 June 1992, at 39-42.
Institutional Investors and Financial Groups in Belgium
359
Cases involving conflicts of interest or derivative liability actions have not been reported.51 However, in the recent case involving the sale of a controlling block of Wagons-Lits shares by the Belgian Societo ge"n6rale to the French Accor, investors alleged that a mandatory takeover bid should have been made by Accor, since it purportedly had acquired control.52 Here the institutional investors sued not on behalf of all investors, or to influence the acquirer's conduct, but to obtain for themselves the benefit of the mandatory bid at the high price paid by Accor to Sociote" g6n6rale.53 Strikingly, some investment funds belonging to the General Bank group hesitated to join the pack; they were severely criticized in the press, and later sued on independent grounds. This single case does not constitute evidence of the investment funds' biased decision making. In the case of the 1988 de Benedetti takeover of 8οαέΙέ gonorale de Belgique, several of the investment funds of the latter group held shares of Sociite gonorale. As at a certain moment the battle raged about even the smallest percentages, the importance of these holdings is not to be underestimated. It seems that these funds did not hold their shares at the group management's command, but sold at the moment they deemed to be most profitable, which was under the highest price on the market. No evidence of breach of trust has been found, nor alleged. With respect to the more general issue of conflicts of interests between these funds and the financial group they belong, there are several occasions on which funds were used for purposes mainly related to the group's interest, such as the "dumping" of unsold underwritten securities in the funds portfolios.54 Also, front-running case have been alleged in the press.
ΙΠ. The Role of the Financial Holding Companies A. The Significance of the Holding Companies 1. In contrast to the rather discreet influence exercised by the institutional investors on stock exchange-listed and other enterprises, the financial holding 51
In case of a conflict of interests the Ucits would have to report on it in its annual report (art. 21 § 2, R.D. March 1991). The minority suit for directors' liability was introduced only in 1991. 52 See about the decisions, supra n. 20. 53 However, attempts are still under way to secure the full offer price to all shareholders. 54 See for further details: WYMEERSCH & KRUITHOF, supra n. 19.
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companies have an undeniable significant influence on decision-making within most of the larger enterprises. As some of these holding companies are conglomerates of a specific type, in certain respects not very different from investment portfolios held by institutional investors, their monitoring role has sometimes been compared to the role played by institutional investors in Anglo-Saxon enterprises.55 2. Belgian holding companies seem to be of a rather specific type and obviously are not met within any other part of Europe, the closest equivalents being found in France and in Italy. Therefore a short description and analysis will be useful.56 Belgian law contains a registration requirement for holding companies (soci6t6s portefeuille) that are either listed on the exchange or are parent to a company listed on the exchange, provided they own a share portfolio worth at least half a billion BEF (+ 15m.$)57. As this threshold has not been raised since 1967, inflation has caused many enterprises to be subject to this type of supervision. Although there still are holding companies that are entirely privately held and hence not registered, most important decision centres are situated in one of these large holding companies, several of which also are heading the main financial groups. As of June 30, 1991, 92 companies were registered, standing for 83% of the market capitalization of the 164 Belgian stock exchange listed companies. Only a few non-listed enterprises are registered as holding companies.58 Behind these holding companies one mostly finds other holding companies, dominated by either foreign interests (mostly French), of family or personal interests, traceable to individual persons or entities. The owners of these entities play an important role in the management of the holding company, but also in its investees. Therefore, one finds the same persons as directors in most of the 55
Fortune Magazine published a review of Socie^e" gonirale and compared it to a mutal fund (1968). 56 For further analysis one could refer to: H. DAEMS, The holding Company, at 68 (Leuven, 1975) F. NEDEE, "Holdings vandaag en morgen," Rev. Banque, 1979, 549564; ANON, "Les holdings en Belgique," Reflets et Perspectives, 1981, 209-273; L. CUYVERS & W. MEEUSEN, "The structure of personal influence of the Belgian Holding Companies, A quantitative analysis," European Economic Review, 1976, 5169; VINCENT & LENTZEN, "Les socie^s portefeuille, Role et moyens d'action," Courier Crisp, 17 October 1982, 2-28; ANNE VINCENT, Les groupes d'entreprises en Belgique, Le domaine des principaux groupes ρηνέζ, CRISP, (Bruxelles, November 1990); A. VINCENT & J.P. MARTENS, L'europe des groupes, Presences et strategies en Belgique, CRISP, at 407 (1991); Also: BBL, Aandeelhouderschap van grote Belgische beursgenoteerde vennootschappen, (2 ed., Oct. 1990). 57 The definition used in art. 1 R.D. nr. 64 of 10 November 1967 is more complex. 58 As of December 1st, 1992.
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Belgian enterprises.59 Ultimately, it also means that to a certain extent this personal interest may constitute a important driving force behind strategic decisions taken at the level of the management of the investee companies. Anecdotal evidence supports this proposition. The proposition would also underline the significance of the conflict of interests between the management of the holding company and the personal interest of its ultimate controlling shareholders.60 Some of the more prominent holding companies will be discussed in more detail in order to illustrate and document the influence they exercise on the investee companies. Account should be taken that power is exercised not only vertically, but also horizontally, as the result either of cross shareholdings61 between holding companies or of agreements of "good neighbourhood" between independent companies. Indeed, as the number of decision making centres is limited, several of the majors being present in the capital of several other companies, power sharing or "empire-division agreements" are the consequence. Also, one sees more and more "chain" shareholdings, in which a chain of companies hold minority shares in the other, establishing systems of friendship and allegiance, often across a large part of Southern Europe. 3. Whether these Belgian-incorporated and domiciled holding companies in fact also are "Belgian" is an issue that keeps the public authorities busy.62 Several of the mentioned holding companies are subsidiaries of foreign groups63 while important, sometimes controlling stakes are held by Belgian companies, although dominated by non-Belgian interests.64 Therefore, the identification of a holding company according to "nationality" of the decision making centre is an haphazard undertaking. 59
See for an analysis of the personal links existing between the Belgian enterprises: "DAVIGNON en FRERE zijn de big linkers in fmancieel economisch Belgie", FET, 19.11.1992 referring to research undertaken by F. VANDENBROEKE. In 45 of the largest Belgian enterprises, 419 persons occupied 571 board seats. Sixteen persons, all belonging to the holding companies, occupied 4 or more seats. 60 See about this issue infra at 377 ff. 61 These may be contrary to company law, if a subsidiary is holding shares in the parent for more than 10% or if two independent companies mutually hold shares exceeding the 10% limit (art. 52 quinquies and sexies). Violation of these rules merely result in freezing voting rights. 62 See the recent report of the KONING BOUDEWUNSTICHTING: Onze Welvaart: zelf beslissen, mee beslissen? The opposite position was taken by the KREDIETBANK, in its Bulletin, 4 December 1992 nr. 37. 63 Societe ge'ne'rale de Belgique is a subsidiary of the French Compagnie de Suez, Cobepa is a subsidiary of the French Paribas group. 64 See the Wagon-Lits shares, held by a Belgian intermediary company, in which a controlling stake has been transferred to French Accor.
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B. Descriptive Analysis The major groups involved should be described in brief, giving particulars about both shareholdings and portfolio composition. In both cases, information will be drawn from official publications and from annual reports. 1. Financial Holding Companies These are the typical Belgian financial conglomerate type of holding companies, based on minority stakes and engaged in a wide variety of business. A descripion of the four main examples follows. a) Sociiti G£ne>ale de Belgique (a) Ownership 60,97% of the shares are directly or indirectly owned by Compagnie de Suez, 11,77% by Assurances Gonorales (AG) a Belgian insurance group. Acting in concert is a Luxembourg group, owning 2,8%. (b) Portfolio Composition65 1) Acec-Union Miniere (Non-ferro) 81,57% 2) AG (Insurance)66 19,58% 3) Arbed (Steel) 25,60% 4) CBR (Cement) 42,58% 5) Gechem (Chemical) 58,51% 6) General Bank (Financial services) 19,19% 7) Tractebel (Electric Power - engineering) 34,57% 8) Accor (Hotel) 12,77% Each of these companies holds shares in several other companies, many of which were also stock exchange listed. However, one could consider that the directional influence would mainly be exercised starting from the Socioto gondrale itself, and upstream by Compagnie de Suez.
65 66
Based on the 1991 annual report. Cross shareholding, to be unwound.
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(c) Consolidation Policy In its 1991 annual accounts Socidto gonorale has fully integrated : 1) Acec-Union Miniere (81,57%), holding shares in 42 other fully consolidated companies, and including 11 according to the equity method; some of these companies are exchange listed 2) CBR (42,58%) 3)Gechem(58,51%) 4) Finoutremer (53,97%) The equity method was applied to: 5) Arbed (25,60%) 6) Tractebel (34,57%) - change from full integration in 1991 7) General bank (19,19%) 8) AG Group (19,58%) b) Group Bruxelles Lambert (a) Ownership (Shares and Warrants) Pargesa Netherlands Group UAP Group Royale Beige Belcofi Pension Fund GBL
41,1% 8,8% 6,34% 7,79% 0,08%
(b) Portfolio Composition - Main Lines of Holdings67 Electrafina Petrofina Tractebel Bank Brussels Lambert Royale beige Parfinance Audiofina Bemheim - Comofi 67
41,4% 20,2% 20,7% 11,0% 12,5% 21,6% 52,2% 40,0%
(49,4%) (20,5%) (24,4%) (23,2%) (68) (22,3%) (55,1%) (60,2%)
Direct holding by GBL or its consolidated subsidiaries. In addition, shares are held by affiliated companies that are included in the GBL accounts according to the equity method. All the companies mentioned are stock exchange listed companies. 68 Plus 50% in joint control with UAP through the 25,1% holding in Royal Vendome.
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(c) Consolidation Policy The Group reported holdings in 49 companies, 16 of which were fully consolidated69, 11 included according to the equity method70, one according to the proportional method71, while 21 were omitted as non-material or as a consequence of the group's limited interest of the group. c) Almanjj This holding company presents a different structure: mainly invested in the financial services sector, its shareholdings constitute outspoken majority positions. (a) Ownership The majority (52,4%) of the shares and convertibles is in the hands of major shareholders, that reputedly are linked by a shareholder agreement. The four main groups of shareholders are: 1) ABB 2) Gevaert 3) Other legal bodies 4) Physical persons
10,8% 10,3% 19,6% 11,7%
This ownership structure was reinforced in 1991 by placing shares with a certain number of institutional and other investors, none of which, however, exceeded the 5% notification threshold.72
Ob) Portfolio Composition Three segments are distinguished: domestic banking, international banking, financial services, including insurance a.o. financial services (leasing, factoring, investment advise, venture capital) 1. Kredietbank 2. Kredietbank Luxembourg: 69
39,75 %73 46,69%
Electrafina and several other subholdings. Bernheim-Comofi, holding the shares of Royale beige in joint control with UAP. 71 Royal Vendome, holding the shares of Royale beige in joint control with UAP. 72 See infra at 373. 73 In 1992, the Almanij group reinforced its control position in the bank by issuinglS warrants, each entitling to the subscription of 10.000 shares, FET, 5 June 1992. 70
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3. Financial services: Kredietcorp 100% However, these segments stand for (1) 71,19% (2) 12,05% and (3) 16,76% of the group's assets. (c) Consolidation Policy Each of the segments proceed to a subconsolidation, fully consolidating majority-owned companies, applying proportional consolidation to joint ventures, and the equity method to minority stakes. However, as the main companies in the segments one and two are only minority-owned, equity accounting is used at the level of their integration in the holding company's annual accounts. d) Cobepa Cobepa is the main Belgian holding company belonging to the French Paribas group. (a) Ownership As of the end of 1991, 69,47% of the shares had been notified as belonging, directly or indirectly, to the French Parisbas group. (b) Portfolio Composition Cobepa holds majority shares in a number of subholdings that on their turn hold smaller holdings in a wide variety of industrial or financial enterprises. Among its main direct or indirect holdings one could mention: - GIB 13% -Gevaert35,2% - Pargesa 15,1 % or 20,7% of the voting rights - Uco 34,9%
(c) Consolidation Policy Full consolidation for majority holdings in the fields of holding companies, banking insurance, real estate management. Equity method for all other shareholding between 20 and 50%. Shareholdings of 15,9 % in Parisbas Bank and of 16,3% in Power Corp were included according to the equity method, taking into account the special relationship with Cobepa.
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3. Industrial Holding Companies These companies present a different structure: The group is engaged in one or two lines of business. Although split up into many, usually 100% or majorityowned subsidiaries, the latter are engaged in the same business as the parent or have a supporting function. Ownership of the industrial company is sometimes rooted in - although not controlled by - the financial holding companies. Three typical examples will be detailed, but many others could be given. a) Petrofina (a) Ownership The shares of Petrofina, listed in Brussels and on several other European Stock Exchanges, represent about 10% of the Brussels stock market capitalization. As of the end of 1991, 39,7% of its shares were reported to be in the firm hands of a group of shareholders, declaring to act "in concert", probably referring to agreements about the transfers of the shares.74 Among these shareholdings, special mention is to be made of GBL and affiliated enterprises (20,20%) and of a number of companies dominated by Mr. A. Frere (6,55%), GBL's major indirect shareholder. Another large block was held by the Soci6t6 g n ale and its affiliates (11,33%). In addition, it would seem that more than 10% of the shares are owned by members of the personnel, the company having systematically pursued personnel ownership plans. The company further mentions that of the 22 million shares, 4,8% are in registered form, the others being bearer shares. The board of directors is composed of 21 effective members, 7 of whom are officers of the Company, 7 belong to the GBL group and 4 to the Soci6t6 gen6rale group. Three members could be designated as "independent directors", not being affiliated to any of the major shareholders. (b) Portfolio Composition and Consolidation Policy Petrofina is organized as a vertical group of enterprises, composed of 22 Belgian and 22 foreign subsidiaries, fully consolidated in the accounts. Most of these are fully owned subsidiaries, with 4 joint ventures. The equity method was mainly applied to minority stakes (20-50%). Excluded were subsidiaries in smaller entities and subsidiaries located in economically unstable countries.
74
During 1992, additional shares were acquired raising this percentages to 41,40%.
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b) Solvay sa (a) Ownership - Solvac sa 25,01% and an additional potential 22,46% as a consequence of the exercise of warrants, held by the Deutsche Bank, Creclit suisse, Sofina; warrants, exercisable at Solvay's request - bearer/ registered shares: 41,19% v. 58,80%. Transfer of registered shares to bodies corporate is subject to board approval. (b) Portfolio Composition The group owns a very large number of direct and indirect subsidiaries, organized either as a socioto anonyme, partnership, or limited partnership.75 All subsidiaries are engaged in the group's chemical business and ancillary activities. (c) Consolidation Policy 147 subsidiaries, mostly 100% owned have been fully consolidated; 33 minority owned companies including joint ventures were included according to the equity method. c) Bekaert nv. (a) Ownership: 62,93% of the shares notified. Bekaert Administratiekantoor 21,40% Physical person 12,64% (b) Portfolio Composition 55 fully controlled subsidiaries 14 joint ventures 5 affiliated enterprises (minority holding) All subsidiaries are engaged in the group's main steel wire and cable activity (c) Consolidation Policy - 51 subsidiaries are fully consolidated - 14 enterprises joint ventures (50,49,45 or 40% holdings) dealt with according to the proportional consolidation method - 5 included according to the equity method. 75
Soci6t£ en nom collectif or sociote" en commandite simple.
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IV. Assessing the Role of the Holding Companies From the foregoing description, one cannot but recognize a wide variety of individual situations and even relationships: Each of the main holding companies has its own policy, its own philosophy, as to the way it conceives its influence towards its investee companies, and this influence may vary from company to company, and change over time. In trying to seize the essence of the monitoring function attributed to or actually exercised by each of these holding companies, one runs the risk of entering into a description of individual cases. Moreover, neither description nor analysis can be based on evidence of actual decision making, as most of it remains unknown. However, it will be tried, on the basis of historical research and of recent policy statements, to situate their action vis- -vis the investees. The analysis does not relate to the industrial holding companies, as management there takes place on an integrated basis throughout the group. A. Changes Over Time 1. Differences in the exercise of controlling power are sometimes more clearly apparent when they occur over time and are due to specific events. The clear example - and historically the best documented - is the "Sociote" g6ne"rale de Belgique" case. Before the contested take-over by Italian de Benedetti, Socie*t6 gonorale was a large industrial empire, dominating Belgian business to the extent that its influence is reported to have been felt in one-third of all Belgian businesses of importance. Societe generale had invested in a wide variety of sectors: banking, steel, non-ferro metals, electrical construction, mining (including for diamonds), cement, defense equipment, shipping, etc. The number of its subsidiaries reportedly exceeded 1200, 58 of which were themselves stock-exchange listed. For each of these main business lines one board member was ultimately responsible. The Socie"t6 generale therefore served as the meeting place for the heads of the business lines, who coordinated their action at board level, but without centrally integrated management.76 Some 76
For a description, see M. DE VROEY, Ρτορηέίέ et pouvoir, CRISP, Brussels 1973, 141. "Dans de nombreux cas, la politique du groupe a consists acquorir une possibilite* de contr le aussi dtendue que possible, plut t qu' exercer re"ellement le controle. ... Ce que la Ginirale attend de ses filiales est d'abord qu'elles rapportent un dividende... La notion exprime (ogalement) la contribution d'une filiale dans le chiffre d'affaires des autres filiales. L'attente du groupe est en effet que les socie*tes affilioes s'approvisionnent et livrent par pr6f6rence aux autres sociotis du groupe ("partnership multilatoraT) .... Les socie^s du groupe sont soud6es entre elles par des conventions tacites et des liaisons de personnes plut t que par Γ integration dans une structure organisationnelle explicite. L'e"tat-major qui les chapeaute est tres r&luit et s'appuie sur une administration centrale des plus legeres. " This structure was reinforced during the
Institutional Investors and Financial Groups in Belgium
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critics described it as more a business club than a centre of strong decisionmaking.77 Also, shareholders were largely absent from the board: Board members were nominated by the subsidiaries from which they originated, not by the holders of shares, only 20% of which were in firms hands even as late as September 1987; that is, three months before the de Benedetti takeover attempt.78 This situation changed quite radically after the Suez take-over, following the failed de Benedetti attempt.79 The board's composition was almost entirely modified while the staff, however limited, was fully renewed. Suez appointed the principal members of the board, although great efforts were made to avoid the appearance that the company had entirely gone French. Since the takeover the group has been thoroughly streamlined, Suez closing down or selling its "thousands of subsidiaries" and focusing its attention on the eight principal business sectors.80 The role of the group is described, in the latest annual report, as that of "continuous monitoring of the management of each of the subsidiaries, in order to be able to take account of all changing circumstances. Medium-term strategy is fixed in concert with the subsidiaries, while financial support, both in terms of means and of management, is actively put to work" .81 The relationship with Suez, the majority shareholder, is based on a long-term strategy, leaving to the board of the Belgian company freedom to manage, but within the framework of the financial objectives fixed by the French parent. To what extent the French parent intervenes in decision making in the Belgian holding company, or downstream, in the latter's subsidiaries, is difficult to assess, but can be designated as not insignificant at least as far as major matters are concerned. On the other hand, the continuous presence of a Belgian shareholder (the insurance group AG) is declared to serve the purpose of embedding the company in the Belgian community (so-called "ancrage beige"), 1980's. One will reread the analysis made by E.G. DE BARSY, president of the Banking Commission, in "Boodschap aan de Socioto g£n£rale de Belgique," in Memorial De Barsy, supra n. 7., at 250 ff. also reprinted in the Memorial published by the company at its 150th anniversary. 77 See for analysis before the takeover: M. VANDENDRIESSCHE, Poker d'enfer, ΟΡΑ sur la Genlrale de Belgique, at 42 (Fayard, 1988). 78 A technical and legal description of the transaction has been published by A. BENOIT-MOURY, Cerus-de Benedetti centre la Χοαέίέ gέnέrale de Belgique, and the decisions reprinted in Journal des Tribunaux, at 217-240, (1988). 79 Suez and a number of Belgian shareholders acquired more than 50% of the shares. Suez1 share later increased to its present level of 61 %. 80 I.e. four industrial Acec-Union Miniere (non-ferro and diamond), CBR (cement) and Arbed (Steel), Gechem (chemical); four in the services industry Tractebel (energy and engineering), banking (General Bank), Insurance (AG) and tourism (Accor, sold in the meantime). 81 Annual report 1991, Address to the shareholders, at 5.
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although here again it would seem that influence on decision-making by the latter partner is limited. 2. Another clear example of a change in the exercise of control can be found in the supermarket stores "GIB".82 Due to the decease of one of the main family members, Cobepa, one of its 14% stake holders put itself at the helm of the board and developed a restructure plan aimed at avoiding the further loss of market share GIB had experienced these last years. This change in influence was interpreted in the press as a board coup, as family influence was reported to have been curtailed. Daily management, however, remained in the hands of the former managers' members. The new strategy seems to have been successful. 3. Within one single group, there also will be considerable differences as to controlling powers. These differences may be due not only to the importance of the shareholding; personal motives, historical situations or even the priorities set at the group level may contribute to this diversity. From the outside, these differences are however very difficult to assess. B. The Banking Case 1. Most financial holding companies still own a large percentage of the shares in the banks they were obliged to spin off due to the 1934 measures mentioned above. The following table gives an overview of holding companies ownership of these banks: Bank General Bank83 Bank Brüssel Lambert Kredietbank85 Paribas Bank
82
Holding Company Socioto ge"n6rale de Belgique Groupe Bruxelles Lambert84 Almanij Cobepa Paribas International
% direct + indirect 18,08 % 23,16 % 39,75 % 16,3 % 63,1%
Former "Grand Bazar-Innovation-Bon Marchi". Increased to 20,96% as of November 1992. AG insurance group is owning another 14,30%. The 1991 annual report mentioned in intermediate figure. 84 GBL owned 11 % and through subsidiaries accounted for under the equity method, another 12,2%. Agreements between shareholders assured GBL control of about 39% of the shares. 85 However, in June 1992 warrants were issued to secure Almanij's full control on the bank; see supra, n. 73. 83
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One of the flaws to which the 1933-1934 banking crisis had, rightly or wrongly, been attributed was the financing of subsidiaries by the group's main entity, at that time still a "Universalbank". The group provided both equity capital and loans, often on soft terms. The compulsory divestiture of the bank to a separate subsidiary was not sufficient, and the Banking Commission developed an elaborate instrument, the already mentioned "banking autonomy protocol", that would ensure banking decisions to be taken on an independent basis, taking into account exclusively the interests of the bank. However, this policy was changed at the end of 1991; due to the pressures exercised by the holding companies, their influence was allowed to increase. Management, it was alleged, being immune from outside criticism, had performed too weakly and hence had not enabled the bank to meet the Cooke Committee's prudential ratios. Hence the main shareholders had to step in again, justifying their claim for more power. In at least one bank this drive led to a considerable increase in the number of board members representing the holding company, while other members that one could have identified as independent directors were removed from the board. Similar shifts occured in other Belgian banks, indicating a stronger influence of the holding company. Simultaneously, due to the Second Banking Directive, the discussion about banks holding shares in non-financial enterprises has much increased. The originally proposed 5% ratio is considered by many as insufficient, while the higher 15% ratio is invoked as allowing a firmer Belgian rooting of enterprises.86 Others argue that raising the limit will only serve the purposes of the holding company, which will order the bank to invest in sectors or enterprises in which the holding company has strategic interests.87 C. Defining the Role of the Holding Company 1. In trying to assess the monitoring function exercised by the holding companies on the individual investee enterprises, one should be aware of the fluctuating nature of the subject, the difficulty of obtaining reliable information due to the absence of easily verifiable information and the somewhat embellished nature of the statements delivered by the holding companies themselves. Taking into account this triple precautionary statement, one may try to identify some management strategies as developed by some of the above mentioned financial groups. First of all, the four main holding companies present individual differences. Up to the 1970's, the Sociote gone" rale and the holding companies belonging to 86
Comp. Association beige des banques, Annual report 1992, at 31, where no mention of this argument was made. 87 See H. VERWILST, "Aandelenbezit door banken," Rev. Banque, 1992, 367-371.
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the group that later led to the Group Bruxelles Lambert presented a somewhat comparable picture, being mainly centers of coordination of the individual affiliated companies' activities.88 The role of the holding company was described as the provision of risk capital without direct intervention at the management level, thereby contributing to the stabilization of the company's shareholder base and acting as the equilibrating factor against other shareholders' influence. Finally, the holding company provides financial and fiscal expertise, along with its financial contribution, provides management services and allows to draw upon a pool of qualified managers.89 The last characteristic was highlighted for the Cobepa group, describing itself as the catalyst of industrial initiatives by combining capital and knowhow and developing "synergies". The latter group usually had smaller stakes in its investees and more heavily relied on its financial expertise. 2. The foregoing picture has changed in several respects. The Socioto gonerale has become a majority-owned subsidiary of Compagnie de Suez, Group Brussels Lambert has become one of the most powerful decision centers, and Cobepa has stepped up its shareholding in many of its investees. Therefore, if one looks at the descriptions given in the latest annual reports as published by these financial holding companies, the following picture will appear. Cobepa1 s annual reports90 are undoubtedly the most explicit on this subject, as a continuous reflection is going on with respect to its function as a financial holding company, to its role vis ä vis investee companies, and to the added value it creates for its shareholders' wealth.91 Although a subsidiary of the French Paribas group, Cobepa has an outspoken Belgian signature. Its portfolio contains controlling blocks in several listed subholdings.92 Recently it undertook interesting studies to better express the value of the underlying assets held through these subholdings. Cobepa and its principal subholdings act as institutional or reference shareholders, not merely as a financially interested investor. Its shareholding serves as the basis for management assistance aimed at maximizing the value of its portfolio. The role of these "responsible" shareholders is described as "serving the purpose, not only of providing the necessary capital, but also giving management financial and technical assistance, supporting the investee's 88
See the description in Socioto geneiale de Belgique, 1822-1972 at 259 it is "le coeur d'un groupe de sociites industrielles et de services, ancries ä eile par le lien de la participation financiere". 89 See the analysis of the Group Bruxelles Lambert by BARON LAMBERT in 1973, as quoted by NEDEE, supra n. 56, at 553. 90 E.g. the 1991 one from which quotations will follow. 91 See further with respect to price differences, infra at 383. 92 Such as Mosane (65%), Ibel (59,1%), Gevaert (35,2%). Unlisted is P.P.L.(75%).
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strategic decisions, and striving at a lasting structure supporting the investee's autonomy by putting into place efficient, stimulating management procedures and systems".93 Assistance for the development of efficient, including tax efficient, management techniques would be usual. Centralized financial management of the investees also seems part of the strategy. In the past this group often saw its role as a transitory one comparable to that of a merchant bank. Share investments are acquired in order to contribute to the surplus value generated by the investee. Therefore, investments were often sold off once they had reached maturity. It would seem that Cobepa has somewhat scaled down this approach, choosing what it calls the "federative concept" of Cobepa within the Paribas group, implying a longer-term perspective. 3. Almanij n.v. is a holding company, born out of the 1934 banking reorganization, that led to the creation of Kredietbank n.v., the third most important bank in Belgium. It is a rather specific case as its investments are almost entirely situated in the financial services field. The function of Almanij, developed in part out of family shareholdings, could best be described as that of group coordinator. The group consists of three rather unequal segments to a certain extent competing with each other.94 As the Belgian Kredietbank is the heavyweight group asset, the holding company's intervention aims at coordinating development of the overall group and at avoiding that one segment leader hampers development of other segment companies. Cross-financing is an element of the group strategy, although several of the subsidiaries tap specific sections of the savings market. Present policy of this group is geared on the one hand towards assuring the groups' independence as a major regional bank (the Belgian "ancrage"), on the other towards the creation of a medium-size group of financial enterprises, present in selectively chosen financial centres and linked to financial enterprises in specific areas or regions. The latter linkage is based not only on agreements, but on limited shareholdings, sometimes reciprocal holdings, not, however, exceeding the 5% declaration threshold. The importance of these business and commercial links that are based on the mentioned reciprocal shareholdings is still difficult to access. One could perhaps compare them with the analogous "keiretsu" practice. Hence one sees an increasing number of small shareholdings being notified.95 4. The Group Brussels Lambert or GBL's policy is more difficult to situate. Previously holding a rather large variety of shareholdings, it now focuses its 93
Cobepa 1991 annual report. See supra at 364 for further details. 95 Fortyseven parties notified holdings each of less than 2%. 94
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attention on fewer lines of business.96 According to its latest report, GBL prefers industry to finance, invests in enterprises in the (French speaking) region (Belgian, Luxembourg, France) and strives to obtain a significant although not dominant influence in the investees. 5. Could the monitoring function assumed by the Belgian holding companies be compared to the monitoring ascribed in the literature to institutional investors? The function of the holding company has been described as that of "monitoring" on behalf of the shareholders.97 As the larger institutional investors the holding company will closely supervise the investee's developments, mainly through the presence of one or several directors at the investee's board. This supervision will at least relate to the investee's financial situation and performance, but would most of the time include business strategies, restructuring decisions, M&A activity, and so on. Daily management will, however, be left to the investee's own directors. Major decisions, such as the merger of the investee, the flotation of additional shares or other decisions affecting the shareholder's rights, will not be undertaken except with the approval of the holding company that more generally will decide on all issues relating to shareholder relations, including the entry of new partners in the capital, the transfer of control blocks to third parties, and the business strategies resulting from these transactions. In these matters the board, including the management committee, would normally follow the ideas formulated by the representatives of the holding company, or at least not decide against their wishes. Whether this type of monitoring is comparable to the monitoring undertaken by the institutional investors seems debatable. There are certain resemblances, especially at the level of supervising the management and of drawing a just balance between the company's interests and those of its shareholders. In that sense, the holdings described themselves as defenders of the absentee shareholder. There are, however, several differences. In terms of investment and risks the stakes most of the time are larger, often affording working control. The function of the monitor is not only to supervise, but also to stimulate and offer services. The holding companies often underline the importance of their support and service rendering, relating to financing, top management personnel, and financial engineering. Most importantly, the action of the holding companies is geared towards developing horizontal synergies between the investee companies, in order to present to the market a more all-round package of goods and 96
Mainly: petrochemical (Petrofina, Electrafina, Transcor); electrical power and engineering (Tractebel) and television and audio (Audiofina-CLT). Shareholdings in the insurance (Royale beige) and banking sector (BBL) may be due to be sold. 97 NEDEE, supra n. 56 describes it as the "begeleidingsrunctie", at 557.
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services. The latter function has tended to become more important in recent years. The comparison with the institutional investors' role as monitor, therefore, is imperfect. The participation in actual management, their sometimes heavy representation at the board level and the actual weight of their influence, and the tendency towards a stricter integration of management all point to a more thorough involvement of the holding companies. 6. A more ready resemblance could be found with some of the proposals that have been formulated i.a. by Jensen98, and by Gilson and Kraakman", as the "LBO association", in which an LBO partnership would take over control along with minority investors. Being heavily engaged in the investee, the managers would be strongly motivated to perform, thereby creating a parallelism between the managers' and investors' interests. One of most obvious divergences between the two schemes seems to be the fact that the holding company has a long-term interest defined in terms not of one single investee company, but very often of the entire group of enterprises it controls. Hence the very frequently found statements about the "synergies" between the different companies belonging to the same or to different groups in which shares are held. Therefore the drive to maximize performance in one single investee company - a definite strength in the proposed LBO scheme - may not be unequivocally present in the case of the holding company, as it is diverted by conflicting objectives in the group's other investees. The large interest the Banking Commission's practice has paid to intragroup transactions explains this feature of group conduct. Also, as Gilson and Kraakman observed, the proposed LBO structure suffers from a lack of available capital. Although for a variety of different reasons, the same could be said for the Belgian holding companies. D. Regulation of Holding Companies 1. In 1967 the Government enacted regulation directly aimed at the major Belgian holding companies.100 The purpose of this regulation was to ensure that these enterprises contribute more effectively to the development of the Belgian economy and to support the Government's policy of economic expansion. At the 98
M. JENSEN, "Eclipse of the public corporation," 67 Harvard Business Review, 61 (1989). 99 R. J. GILSON & R. KRAAKMAN, "Institutional Investors, Portfolio performance and corporate governance: A brief for professional directors," in Institutional Investing, 185, at 195 (A. Sametz, ed.). 100 R.D. n° 64 of 10 November 1967. Their portfolio should exceed 0,5 bill. BEF. This figure has not been raised since 1967. Also subsidiaries of non-Belgian enterprises could be subject.
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same time, the regulation organized a supervisory apparatus, entrusting the Banking Commission the monitoring function for part of the corporate behavior of these entities. The economic policy function - it was reorganized in 1978 seems to have been abandoned. The latter is still in force, although these last years the supervisor seems to have taken a more relaxed attitude.101 The regulation of these holding companies is geared towards disclosure102; the Banking Commission cannot impose or forbid any specific transaction but only require disclosure. If the Commission deems the annual accounts, or reports to shareholders "incomplete or imprecise", especially with respect to transactions or relationships within the group, it could invite the company to change its report, and could disclose its remarks if the company refuses to do so. Apart from disclosure, there are no really biting remedies attached to violations of the regulation or of the Commission's orders. 2. The regulation and supervision of these holding companies has proved rather difficult, and all in all achievements are not very impressive. In the early years, the action of the Banking Commission focused on identifying the groups, their - up to then largely unknown - holdings and subsidiaries, and their main transactions. A later step dealt mainly with the specific issue of consolidation of annual accounts. Consolidation methods and recommendations were developed by the Commission.103 Simultaneously, it became more and more apparent that special attention should be devoted to shareholder protection, especially as non-group shareholders often appeared to be harmed by intra-group deals. Hence the Commission focused on major intragroup transactions and gradually developed a system of rules and practices that could be defined as law relating to groups of enterprises.104 The Belgian legal framework could therefore be seen as a rather specific attempt of State-led monitoring of major business enterprises, most of which are 101
It is argued that this type of supervision duplicates supervision on stock exchange listed companies and should therefore be abandoned. Duplication depends very much on how the supervisor is exercising its powers. The present analysis also clarifies the need for specific supervision on the conflicts of interests issue. 102 One should not omit to mention the obligation for holding companies to appoint professional auditors, as in 1967 this was not obligatory for Belgian companies. 103 See its annual reports for the period 1974 to now. Also: CENTER FOR THE STUDY OF GROUPS OF ENTERPRISES (ed.), Legal aspects of consolidated accounts, (1980). 104 STUDY CENTER ON GROUPS OF ENTERPRISES, Droits et devoirs des societes mires et de leurs flliales - Rechten en plichten van moeder- en dochtervennootschappen (Parent and subsidiaries: rights and duties), (Kluwer Rechtswetenschappen, Antwerp, 1986). The group law aspects have specifically been dealt with in WYMEERSCH, De handing van de Bankcommissie tegenover het groepsverschijnsel, at 393 (La Commission bancaire beige et le droit des groupes de sociotes, also in Riv. Societa, 1986, 207 ff.).
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stock exchange-listed. Building on its experience in the field of public issuance of securities, the Commission further refined its philosophies, mainly geared to the "correct information of the shareholders and the public about group structures and about the links existing between affiliated companies".105 It was stressed that the business judgment itself was not part of the action of the Commission; therefore, this monitoring function does not relate to the functioning of the business, only to the functioning of the company.106 E. Managing Conflicts of Interest 1. One of the essential issues involved in the monitoring action by holding companies relates to the conflicts of interests that may arise within the holding company's own interests, with the interests of other group members, or more generally with the overall group strategy. These issues are in part dealt with in present company law, but mainly are left to the slowly emerging rules on groups of companies, as these are being developed by the Banking Commission or by the courts. In the Belgian perception, the law of groups focuses on these frequently arising conflicts. This issue could be dealt with at two levels: conflicts arise at the board level, and at the level of the general meeting of the shareholders. The present law, as recently revised, contains rules and procedures relating to the conflicts at the board level. Fundamental conflicts of interest are met at the level of the general meeting, which is the one through which the holding company is usually dealing. Here no specific company law procedures are applicable. The Banking Commission's supervision has significantly contributed to clarifying some of the issues and to offering answers, some of which have recently been introduced in the law. Although legally directors are chosen by the general meeting and represent the company, they usually owe allegiance to the shareholder that has proposed their appointment to the general meeting and would be able to dismiss him without notice or compensation. The Belgian legislation relating to conflicts of interests has recently been revised, leading to quite unexpected results in the field of holding company monitoring of subsidiaries' decisions.107 One should mention that Belgian company tradition does not know "independent directors", at least as these are understood in Anglo-American literature. 105
See BANKING COMMISSION, Annual Report 1967, at 222. In this sense expressly in the Report to the King accompanying the R.D. n° 64, Official Journal, 14 November 1967, p. 11820 ("II ne s'agit la d'aucune maniere, d'un controle de la gestion portant sur I'opportuniti et les conditions des decisions et operations de la soci£t y los < >", Revista Crftica de Derecho Inmobiliario, n. 592 (1989), at 643 ff. regarding the abandonment of management by the owners in the investment funds. >» See BROSETA PONT, supra n. 17, at 225.
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Finally, in the same manner as the securities issued by institutional investors (the shares of the SIMs or SIMCAVs or the participations of FIMs) represent quotas of which part is composed mainly of securities from other companies (what originates phenomenon denominated as "transubstantiation"20); this very phenomenon is produced - as what the control of company is concerned - in many relationships of established control in the core of institutional investors, representing quotas which are part of the total control relationships that those investors exercise over companies in whose shares are their assets invested. So, the internal control relationships of institutional investors are reflected in and determine the external control of these investors. In this sense, there may be a conflict of interests between the interests of institutional investors' shareholders or participants and the interests of the shareholders of the companies in whose shares those investors invest; a conflict that has been resolved by the managers of institutional investors in favor of their shareholders or participants. In Spanish law, the managers of the institutional investors have fiduciary duties set out in the specific legislation (for example, art.29 of the LIIC and art.22 of the LPFP) that are stronger than the duty of abstention in their role as shareholders21.
20
See J.F. DUQUE DOMINGUEZ, "Participaciones y certificados en los Fondos de Inversion Mobiliaria", in supra n. 17, at 328, regarding the general characteristics of the units ("participaciones") and GARCIA-VAQUERO, supra n. 8, at 38. 21 See UPTON & LORSCH, supra n. 3, at 61, "Institutional investors may face real conflicts of interest between their fiduciary responsibility to beneficiaries and any role as active owner" and WEIGMAN, supra n. 8, at 1104, says that, with regard to American institutional investors, their managers prefer the interests of their participants to the interests of the shareholders of the companies whose shares are acquired by the institutional investors. In the Spanish literature, regarding the shareholder's duty of abstention in the exercise of his right to vote in case of conflict of his particular interest with the interest of the company, see ALBORCH, supra n. 12, at 237 ff. See also J.F. DUQUE, Tutela de la minoria. Impugnacion de acuerdos lesivos (Art. 67 L.S.A.), at 110 ff., (Valladolid 1957). Regarding the duty of loyalty of the shareholders, see GIRON TENA, supra n. 12 ("Derecho de Sociedades Anonimas"), at 110 ff. In the field of the institutional investors, we can compare with other situations of conflict of interest, e.g., with regard to the FPs. See, J.L. CASEY, "ERISA and die Investment Management and Brokerage Industries: Five Years Later", The Business Lawyer, Vol.35 (November 1979), at 276 "Mutual funds pose some special problems, particularly in plans covering employees of the fund or employees of the fund's investment adviser or principal underwriter. To avoid conflicts in investment advice, many investment advisers prefer to invest assets of their own plan in shares of the mutual funds for which they consult".
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3. Corporate Rights Derived from Shares and Their Exercise by Institutional Investors a) Corporate Rights in General Traditionally, the rights of shareholders have been divided into economic and corporate rights22. The latter are those which represent the control value of their shares. Spanish law has set out a list of corporate rights in the Regulations of the takeover bids. Royal Decree 1197/1991, of July 26, on the regulation on takeover bids, in art.40, considers the following to be corporate rights: the right to attend and vote at general meetings, regulated in arts.48.2.c) and 104 ff. of the LSA; the right to information, regulated in arts.48.2.d) and 112 LSA; the right to preemptive subscription, regulated in arts.48.2.b), 158 and 159 LSA; the right to form part of the boards of the company, which is a consequence of the right to vote and follows from art. 123 LSA; the right to oppose corporate resolutions, regulated in arts.48.2.c) and 115 ff. LSA; and, generally, all those rights not having exclusively economic content. Institutional investors, through the exercise of these inherent corporate rights for shares, which belong to their portfolios, will participate in the control of SAs. From among such rights, we must emphasize the right to information, given its extraordinary importance as an instrument for the protection of the investors. Particularly, "institutional investors are in a position to keep in touch with the boards of the companies in which they have invested, in a way which is not feasible for the individual shareholder"23. 22
See GIRON TENA, supra n. 12 ("Derecho de Sociedades Anonimas"), at 178 ff. and TAPIA HERMIDA, supra n. 12, at 739. " See the COMMITTEE ON FINANCIAL ASPECTS OF CORPORATE GOVERNANCE, supra n. 10, at 36, which adds: "A second issue which arises over communications between institutional investors and companies is the danger of imparting inside information". Generally, the decisive role of the right to information in the improvement of corporate control has been pointed out in the "Draft Report" of this COMMITTEE, at 34, "The formal relationship between the shareholders and the board of directors is that the shareholders elect the directors, the directors report on their stewardship to the shareholders and the shareholders appoint the auditors to provide an external check on the directors' financial statement". Regarding the relationship amongst the gap between risk and power in large corporations, the absentism of the shareholders, the needs for information and the effective control of the management in corporations see, in the Spanish literature, J. GARRIGUES, "Una vez mäs en torno al tema del derecho de informacion del accionista en la sociedad anonima", in Estudios de Derecho Mercantil en homenaje a Rodrigo Uria, at 169 ff., (Madrid 1978); R. URIA, La Informacion del accionista en el Derecho Espanol, at 63, (Madrid 1975); POLO, supra n. 14, at 209 ff.; SANCHEZ CALERO, supra n. 12, at 22 ff. and J.M. EMBID IRUJO, Grupos de sociedades y accionistas minoritarios. La tutela de la minoria en situaciones de dependencia societaria y grupo, at 94 ff.,
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b) Special Reference to the Right to Vote aa) Correlation Between Right to Vote and Control When the LSA of 1951 was in force, the right to vote was an essential attribute of shares. After the authorization of non-voting shares in the new text of the LSA of 1989, the right to vote is a natural attribute of shares which constitutes their principal corporate asset and the basic element for corporate control24. This is emphasized by art.60 of LMV and art.40 of the Royal Decree 1197/1991, punishing the non-compliance with the duty to make a takeover bid with suspension of the inherent corporate rights of shares so acquired. Although LSA does not contemplate the creation of shares that, in a direct or indirect way, alter the relation between the nominal value of share and the right to vote or the right to preemptive subscription (art.50.2); there are a series of legal situations which can alter that initial equation between the number of shares held and the right of control: (a) The first and most important alteration comes from the issuance of nonvoting shares, recently authorized by the 1989 LSA (arts.90 to 92)25. (b) The second exception comes from possible limitations of the right to attendance and vote in by-laws, limitations which have to respect limits established in article 105 of LSA26. (Madrid 1987). In Portuguese law, the right to information is regulated in arts.288 ff. of the "Codigo das Sociedades Comerciafs". 24 Regarding the right to vote in the 1951 LSA see ALBORCH, supra n. 12, at 49 ff. See also GIRON TENA, supra n. 12 ("Las reformas ..."), at 5 regarding the right to vote as a condition of the market for corporate control, and PAZ-ARES, supra n. 15, at 574 ff. In the Portuguese law, the right to vote is regulated in arts.384 ff. of the "Codigo das Sociedades Comerciafs". 25 See F. VICENT CHULIA, Compendia Critico de Derecho Mercantil, T.I, vol.2., at 531 ff., (Barcelona 1991) and PAZ-ARES, supra n. 15, at 571 ff. For a comparative analysis, see recently in Spanish literature, L.J. PORFIRIO CARPIO, "Las acciones sin voto en Bilgica, Holanda, Portugal y Suiza", Revista de Derecho Mercantil, n. 199-200 (January-June 1991) at 91. For a comparison with the American experience, see R.C. CLARK, "Contracts, elites, and traditions in the making of corporate law", 89 Columbia Law Review, n. 7, at 1708, (1989), "Within the last few years, a relatively large number of publicly held corporations have attempted to create capital structures with dual classes of common stock: a class with superior voting rights (to be held mostly by management) an a class with no or limited voting rights (to be held by ordinary investors). A major impetus to form such structures is the fact that they make hostile takeover bids virtually impossible. In order to get effective voting control, a bidder has to buy the superior voting shares held by the incumbent management". 26 In the Spanish literature see, GIRON TENA, supra n. 12 ("Derecho de Sociedades Anonimas"), at 208 ff.; ALBORCH, supra n. 12, at 193 ff.; J. SANCHEZCALERO GUILARTE, "La limitacion del numero mäximo de votos correspondientes a
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bb) The Right to Vote in Company Law and in Securities Market Law The right to vote is regulated in two legal fields: a) In company law, the right to vote is a minimum right of shareholders (art.48.2.c LSA) that is regulated from an internal and static perspective, that is, it is a means of control which operates inwards and is held by a shareholder. b) On the other hand, when the Securities Market Law refers to shares with voting rights, it does so from a dynamic perspective, that is, as a control element which is acquired and transmitted together with the shares. This occurs, for example, in the system for significant shareholder communications, in which a holder of shares is considered -in cases of usufruct, pledge or coproperty of the same- to be the person who is entitled to exercise the voting rights, who is considered a purchaser and therefore will be required to carry out the communication (arts.2.2 and 2.3 of Royal Decree 377/1991). An analogous phenomenon occurs in the takeover bid's law (arts. 1.1 and 2.3 of the Royal Decree 1197/1991). cc) The Exercise of the Right to Vote by Institutional Investors Insofar as institutional investors are concerned: (a) Possession of voting rights requires investment in equities with right to vote, in the form of actual capital (i.e. shares) or potential capital (i.e. warrants or convertible bonds). Spanish institutional investors have recently started an "escape from listed equities" which will lead to a reduction of corporate control27. (b) Although the institutional investors share with investors in general, a preference for the value of stock as economic investment that make them un mismo accionista con especial referenda a los Bancos Privados y al Mercado de Valores", RDBB n. 42 (1991) at 271. In the comparative literature, see BUXBAUM, supra n. 3, at 11 stating that "the clear acceptance of maximum voting limitations under German Law (...) contrasts with the mentioned novelty and fragility of their American treatment". These limitations can have negative effects on the improvement of mechanisms of corporate control because, generally, according to the COMMITTEE ON THE FINANCIAL ASPECTS OF CORPORATE GOVERNANCE, supra n. 10, at 34, "the Annual General Meeting gives every shareholder, whatever the size of their shareholding, direct and public access to their boards" and "if too many Annual General meetings are at present an apportunity missed, this is either because shareholders do not make the most of them or because boards do nor encourage them to do so". 27 This escape may be a consequence of the "prudent man rule" that guides the activity of all the institutional investors. Regarding this principle see, in the Spanish literature on Investment Funds, VERDERA, supra n. 18, at 65. Generally, regarding the role of institutional investors, see ARRUNADA, supra n. 15, at 63.
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appreciate fundamentally the economic rights they hold; the complementary role that corporate rights develop28, stimulates them not to abstain completely from exercising the same. (c) Exercise of voting rights inherent to shares integrated in their portfolio will be carried out by the boards of directors of the institutional investors with a typical company structure (i.e. the board of directors of a SIM or insurance company) or to the management firms of institutional investors with a contractual structure (i.e. the SGIIC of FIM or the EG of the FP). The degree of discretion in the exercise of such rights will depend on the specific regulation to which each type of institutional investor is subject29. (d) Exercise of voting rights by the SGIIC in the case of FIM or by the EG of FP is an exception to the general limitations to the proxy rules at the General Meetings of the S AS, established in the articles 106 and 107 of the LSA30.
B. The Notion of Corporate Control and the Market for Corporate Control in Spanish Law 1. Exercise and Transmission of Corporate Control The notion of "corporate control" have several meanings with very diverse projections31. We can define it as the ability, generally stable, of one 28
Regarding the complementary role of the corporate rights with respect to the economic rights see URIA, supra n. 12, at 69. In the field of pension funds, see CASEY AND OTHERS, supra n. 21, at 293 where they say: "Voting rights on stock are an important attribute of a security and, as such, constitute plan assets". In the American literature, see also R.M. PHILIPS, "Deregulation under the Investment Company Act - A Reevaluation of the Corporate Paraphernalia of Shareholder Voting and Boards of Directors", The Business Lawyer, Vol.37 (April 1982) at 903. 29 In the comparative experience, see BUXBAUM, supra n. 3, at 19 where he refers to the "Proxy Voting Guidelines" promulgated by Wells Fargo Investment Advisors. 30 See, in the Spanish literature, with regard to art.60 of the previous 1951 LSA and the management firms of the investment funds, BROSETA, supra n. 17, at 235 and A. SANCHEZ ANDRES, "Los derechos de suscripcion en los Fondos de Inversion Mobiliaria", supra n. 17, at 572. Regarding the "Corporate Proxy Machinery (CPM)" see PAZ ARES, supra n. 15, at 575 ff., who compiles the EISENBERG Theory. 3 > According to the COMMITTEE ON THE FINANCIAL ASPECTS OF CORPORATE GOVERNANCE, supra n. 10, at 7, "corporate governance is the system by which companies are run. At the centre of the system is the board of directors whose actions are subject to law, regulations and the shareholders in general meeting". From a different perspective, BAUMS, supra n. 12, at 3 begins by pointing out: " < < Control > > can be necessary means especially for partners who stand in a long-term contractual relationship, such as a labor or credit relationship". In the Spanish literature see ARRUNADA, supra n. 15, at 13 ff. regarding the "economic
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shareholder or of a group of shareholders to influence the most important decisions taken by a company. This notion appears as the result of the exercise of corporate rights and, specially, of the exercise of the right to vote and the right to information32. The phenomenon of corporate control has two facets: a) Firstly, control is exercised within companies fundamentally through exercise of the right to vote. b) Secondly, control is transmitted to the outside of companies controlled through transmission of shares which incorporate corporate rights and, particularly, the right to vote. Corporate control, like voting shares, is a species of property33. The field of exercise of control is regulated by Company Law, whereas the external market of control is regulated by Securities Market Law. These fields are not watertight compartments but are connected, as shown in recent interventions of the SEC in USA regarding proxy statements34. In this sense, the analysis of corporate control". In the EC Law, Regulations of December, 21, 1989 (4064/1989) defines the term "control" for its purposes in the art.3.3. About this notion see M. SIRAGUSA. & R. SUBIOTTO, "Le controle des operations de concentration entre enterprises au niveau europien: une premiere analyse pratique", Revue Trimestrielle de Droit Europaen, n. 1, (janvier-mars 1992) at 53 and L. GYSELEN, "Le R6glement du Conseil des Communautes Europienes relatif au controle des operations de concentration entre enterprises", Revue Trimestrielle de Droit Commercial, n. 1, (janvier-mars 1992) at 8. 32 In the Spanish literature, see ARRUNADA, supra n. 15, at 15 ff. regarding "the control of the Stock Company". See also in the comparative literature see ALLEGRI, "II fondo comune come azionista: 1'esercizio del diritto di voto", Revista delle Societa, 1988, at 790 ff. 33 See H.W. BALLANTINE, Ballantine on Corporations, at 433, (Chicago 1946) regarding "corporate control as a species of property". L.A. BEBCHUK, "Limiting contractual freedom in corporate law: the desirable constraints on charter amendments", Harvard Law Review, n. 8, at 1843 (1989), "The market for corporate control increasingly has become viewed as exerting significant disciplinary force over managers. When share value goes down, the company becomes more vulnerable to a takeover. Because the takeover might wrest from the managers the control that is valuable to them, the prospect of a takeover might well make them more concerned about share value". In the Spanish literature, see GIRON TENA, supra n. 12 ("Las reformas ..."), at 6 regarding the market for corporate control and the selective management role of the takeover bid; J.M. EMBID IRUJO, "Medidas de defensa de una sociedad mercantil frente a una accion exterior de obtencion de su control. Las clausulas anti-OPA", RDBB n. 39 (1990) at 535 and ARRUNADA, supra n. 15, at 25 ff. 34 See KRIPKE, supra n. 14, at 173 where he says: "It is clear that Congress has not, deliberately or consciously, given the Commission power over corporate governance, except in so far as Congress in section 14(a) through (c) of the Securities Exchange Act of 1934 authorized the Commission to adopt rules regulating proxy
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CNMV in Spain enjoys an extraordinary legitimacy to impugn company agreements adopted with the participation of votes derived from shares acquired with the elusion of a takeover bid (art.60 LMV and 40.5 Royal Decree 1197/1991). The success of the notion of a market for corporate control follows two successive confirmations35: a) Firstly, it is possible to acquire the control of a company without the acquisition of all its shares, but through acquisition of control of their boards of directors, with the saving of costs. b) Secondly, the corporate control situations, as well as depending on the property of voting shares, can be the object of transmission through the transmission of such shares. c) A third observation can be added to those two in case consistent institutional investors because the control of an institutional investor can permit indirect control of several other companies with lower economic cost than that demanded by an immediate control. Granting that the market for corporate control is considered to have positive effects for the economic system in general, it must try be protected from artificial interferences coming from manager's interests. To this end, in the Regulation of takeover bids, Spanish and EC Law impose on affected company managers a duty of abstention. Nevertheless, in Spain there is not a real market for corporate control as a consequence of oligopoly trends that impede the establishment of the basic principles of openness, integrity and accountability in the relationships between shareholders (including institutional investors) and boards of directors36.
solicitations". See, in the Spanish literature, C.J. HENDEL, "El movimiento de reforma de la estructura de la empresa y la actividad de los accionistas institucionales en Estados Unidos: sus orfgenes, objetivos y consecuencias en las relaciones con los inversores", Revista de Derecho Mercantil, n.s.203-204 (1992), at 277 ff. 35 See L. RABINOWITZ, Weinberg and Blank on Take-overs and Mergers, at 1015, (5th ed., London 1989) regarding "the meaning and clasification of control" and at 1017 regarding "the advantages of control of a company". 36 These are the principles of the "Code of best practice" that has been elaborated by the COMMITTEE ON THE FINANCIAL ASPECTS OF CORPORATE GOVERNANCE, see supra n. 10, at 9. See also FINCH, supra n. 10, at 582 ff. Regarding the Spanish situation, see ARRUNADA, supra n. 16, at 321 ff. In EC Law, limitations on the actions of the board of the offeree company are imposed by art.8 of the Proposal of Directive on takeover bids. In Spanish Law, such limitations has been imposed by the art. 14 of the Royal Decree 1197/1991. In the American literature, see M. LIPTON, "Takeover Bids in the Target's Boardroom: An Update after Oner Year", The Business Lawyer Vol.36 (April 1981) at 1017 and H.S. WANDER & A.G. LECOQUE, "Boardroom Jitters: Corporate Control Transactions and Today's Business Judgment Rule", The Business Lawyer, Vol.42, (November 1986) at 29.
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2. Types of Corporate Control In view of the different control situations and especially bearing in mind the greater or lesser dispersion of controlled companies, various degrees of control have been distinguished37: a) Absolute control, which is achieved through ownership of all voting shares of a controlled company. This first level of control does not appeal to institutional investors. Besides the excessive cost, the standards of diversification of investments which dominate their legal obligations and are advised by prudent regulations deter them. b) Majority (or voting) control can be reached by holding a majority of voting shares. This type of control does not seems adequate to meet the demands for diversification of institutional investors, as a means of reducing risks. c) Minority (or effective) control can be exercised through holding a block of shares, taking into consideration the dispersion of the remaining shares among a large number of shareholders38. This is an interesting type of control for institutional investors, even when in some cases, as in IICs, the concentration level which permits them (5%) can seem excessively small39. d) Control measures can be exercised, not by large investments in equities of the controlled company, but by controlling proxy system (i.e. the banks as custodians of shares of their customers). 3. Corporate Control by Institutional Investors In a broad sense, institutional investors can develop a dual type of corporate control: a) A direct and internal control in their role as shareholders which is exercised by entitlement of securities in which a right to actual (i.e. voting shares) or
37
See RABINOWITZ, supra n. 35, at 1015 regarding the types of control exercised by the existing controllers of a company. In the Spanish literature, see R. UR1A, "Teorfa de la concentration de empresas", Revista de Derecho Mercantil, n. 24 (1949) at 318 regarding the types of concentrations; J. GARRIGUES, "Formas sociales de uniones de empresas", Revista de Derecho Mercantil, n. 7 (1947) at 66 about the problems of corporate dominance; M. SACRISTAN REPRESA, "El grupo de estructura paritaria: Caracterizacion y problemas", Revista de Derecho Mercantil, at 375, (1982) and EMBID, supra n. 23, at 107. 38 Regarding the acquisition of a minority participation in the context of the EC Regulations of December 21, 1989, see SIRAGUSA & SUBIOTTO, supra n. 31, at 55. 39 With regard to the minority control by institutional investors see WEIGMAN, supra n. 8, at 1092 dealing with the factual share control definition of art.2359 of the Italian Civil Code.
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potential (i.e. convertible debentures) vote is incorporated40. b) An indirect and external control in their role of creditors, who can own securities (i.e. simple debentures or voteless shares) or not (i.e. housebank relationships)41. In the Spanish securities market, quantitative growth of institutional investors has not yet been accompanied by a qualitative increase in their role in controlling companies, which has had decisive influence in other developed securities markets, as in the US movement to reform the organisational structure of corporations42. In this sense, it is not established firmly in Spain the culture 40
See DELANNEY, supra n. 1, at 383, who distinguishes three types of relationships of the institutional investors: with the public whose assets they administer, with the companies in whose shares they invest and with the Stock Exchanges where they trade. In the specific field of the Pension Funds, see CASEY & OTHERS, supra n. 21, at 222, stating: "The ownership of securities carries with it a number of rights. One of them is the power to vote portfolio securities. This power is obviously important in the case of a closely-held corporation. Even for a public held corporation, this power can be nonministerial and nonroutine. Proxies, in recent years, have dealt not only with election of directors but also with recapitalizations to prevent takeover, age and gender limits for directors and numerous corporate responsability and «good citizen» issues". In this field, R.R. PENNINGTON, Pennington's Company Law, at 730, (London 1990), dealing with the English situation, says: "The final way in which a company may become another's subsidiary is by the other investing its cash resources in the shares of the subsidiary simply because it considers them to be a sound investment. Here the relationship of parent or holding company and subsidiary is not created for some ulterior purpose, but results from the parent or holding company acquiring sufficient shares in the subsidiary to control the voting power exercisable at its general meetings. In practice, this rarely happens. Although institutional investors subscribe for and purchase ordinary shares in industrial and commercial companies on an extensive scale, they deliberately refrain from acquiring controlling interest and even though they may excepcionally acquire as much as 20 per cent of a company's ordinary shares, they do not attempt to influence routine management decisions made by its board, nor do they usually interfere on major policy questions within its directors' competence although they do maintain a general supervision in order to protect their investments in the company". We can also recall the words of BUXBAUM, supra n. 4, at 34 when he deals with "the inappropriate application of the problematic < < controlling person> > concept of the traditional securities regulation regime to this new group of institutional investors". 41 We can remember BAUMS, supra n. 12, at 5 where he deals with the "banks as creditors" and their influence in corporate control. See also along these lines M.W. McDANIEL, "Bondholders and Corporate Governance", The Business Lawyer Vol.41 (February 1986) at 413. 42 See BUXBAUM, supra n. 4, at 1 regarding the remarkable increase in institutional ownership of United States equities from 7.6% in 1900 to over 20% in 1950, at 23 discussing "the ownership position of institutional investors" and at 37 regarding the institutional-investor participation in corporate governance and its
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of competitive management of corporations. It would be neccesary to adopt several measures by the institutional investors. For example, they should encourage regular, systematic contact at senior executive level with the companies in order to exchange views and information on strategy, performance, board membership and quality of management; they should make positive use of their voting rights and they should take a positive interest in the composition of boards of directors, with particular reference to concentrations of decision-making power not formally constrained by appropriate checks and balances, etc.43. C. Notions of Group of Companies or Entities in Spanish Law As a consequence of the control relationships described, several concepts of groups of companies or entities exist in Spanish law44 that apply to institutional investors and determining limits on their investment. 1. Groups of Companies in Company Law Article 2 of Act 19/1989, of July 25, reformed the Title III of the First Book of the Code of commerce, with regard to the company accounting. The Third Section, dealing with the presentation of accounts for goups of companies opens with art. 42, where there is a notion of group based on the right to vote which manifests itself directly, through holding of majority votes, or indirectly, proceeding from a liberal, market-oriented economic premise. See also R.C. FERRARA, "Current Issues Between Corporations and Shareholders: Federal Intervention into Corporate Governance", The Business Lawyer Vol.36 (March 1981) at 759 and J.S. LETTS, "Corporate Governance: A Different Slant", The Business Lawyer Vol.35 (July 1980) at 1505. See also INSTITUTE ON DYNAMICS OF CORPORATE CONTROL, The Business Lawyer, Vol.39, n. 4, at 1461. 43 See COMMITTEE ON THE FINANCIAL ASPECTS OF CORPORATE GOVERNANCE, supra n. 10, at 35. In the Spanish literature see J.M. GONDRA ROMERO & A. SANCHEZ ANDRES, "La viabilidad juridica de la OPA formulada por el Banco de Bilbao a los accionistas del Banco Espanol de Cr&Iito", in La ΟΡΑ del Banco de Bilbao. Documentos y dictamenes jurtdicos, at 100, (Banco de Bilbao, ed., Madrid, December 1987) and A. SANCHEZ ANDRES, "Sobre la caracterizacion y re*gimen de las llamadas OPAs simult neas", La Ley, May 28, 1990, at 1. 44 See J.F. DUQUE DOMINGUEZ, "Concepto y significado institucional de los grupos de empresas" in Libra homenaje a Ramon M. Roca Sastre, Vol.Ill, at 525 ff., (Madrid 1977); SANCHEZ CALERO, supra n. 12, at 23 ff.; F. VICENT CHULIA, Concentration y union de empresas ante el Derecho espanol, at 378 ff., (Madrid 1969); J.M. EMBID IRUJO, "Regulacion mercantil de los grupos de sociedades", La Ley, February, 3, 1989, at 1 ff. Regarding the relationships between the group of companies and the right to vote in EISENBERG see, in Spain, PAZ-ARES, supra n. 15, at 581 ff.
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through the right to designate the members of board of directors45. By virtue of this notion, a dominant company is one which, being a member of another dominated company, holds the majority of the voting rights or which can avail of the majority by virtue of agreements with other members or has the power to designate or dismiss the majority of the board of directors, or has designated such a majority with its votes. Furthermore, the voting rights of the dominated company can be added together with those of other people who act in their own name but for the account of the dominating company46. This notion of group of companies is characterized by its exhaustiveness, being different from that of art.4 LMV (as is seen below) because a relationship of dominance only exists if certain legal tests are passed. This notion of group of companies not only has an accounting effect (to determine when consolidated accounts are required) but is also utilised to fix the concept of dominant company in relation to companies dealing in their own shares (art. 87 LSA). 2. Groups of Entities in the Securities Market Law Art.4 of the LMV - which has recently been modified by Act 13/1992, of June 1 (art.4) - says that a group of entities exists when a unified decision-making occurs because any of them have or can have, directly or indirectly, the control of others or when the control corresponds to one or several persons who act in concert. The new art.4 LMV considers that control exists in the cases of art.42 of the Code of Commerce or when top managers of the dominated entity are top managers of the dominating entity47. This notion of group of entities is broader than that of art.42 of the Code of Commerce. It is so for subjective reasons as it deals with a group of "entities" and not merely "companies", and for objective reasons, as it is an open concept, which enumerates a series of control relationships "ad exemplum" in a non-exhaustive manner. To our interest, this notion is not only relevant because it applies to principal techniques of 45
Regarding the general concept of group of companies, see J.F. DUQUE, "El Derecho de las empresas vinculadas en la legislation espanola. Especialmente en la Ley de reforma parcial y adaptation a las Directivas comunitarias en materia de sociedades y en la Ley del Mercado de Valores", RDBB n. 35 (1989) at 466; F. SANCHEZ CALERO, Instituciones de Derecho Mercantil, at 357, (Madrid 1992); M. BROSETA PONT, Manual de Derecho Mercantil, at 343 ff., (Madrid 1990) and VICENT CHULIA, supra n. 25, at 964 ff. With regard to groups of listed companies, see SANCHEZ CALERO, supra n. 10, at 935. In the Portuguese law, see arts.481 and ff. of the "Codigo das Sociedades Comerciais". 46 Regarding the dependence situation see EMBID IRUJO, supra n. 23, at 73. On the consolidation of annual accounts see DUQUE, supra n. 45, at 498. 47 See F. SANCHEZ CALERO, "Grupos de sociedades y Mercado de valores", Boletin Financiero. Bolsa de Barcelona, n. 69 (1979), at 38 ff. and DUQUE, supra n. 46, at 490.
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transparency and also acquisition and transfer of corporate control foreseen by LMV; but also because it is applied in the diversification rules for IICs (art.4 LIIC and RIIC). 3. Groups of Companies in the Legislation on Pension Funds The LPFP - for the purpose of diversification of FPs investments - establishes a notion of group of companies based on the existence of unified decision-making because any of them controls the others directly or indirectly. This control exists when the dominant ones hold the majority of votes in the dominated, when the dominant ones have the rights to designation or dismissal of members of boards of directors of the dominated ones or when the dominant ones have a percentage of participation in the capital of the dominated ones which lets them submit the dominated ones to them control (arts. 16.5 LPFP y 34.6 RPFP). 4. Groups of Companies in Insurance Law In the regulation of insurance companies (limitations in investments of technical provisions), they are considered to belong to the same group of companies if they possess unified decision-making by controlling others directly or indirectly (art.70.3 ROSP)48. 5. Groups of Credit Entities Article 8 of Law 13/1985, May 25, regarding coefficients of investments, resources and duties of disclosure - which has just been modified by Law 13/1992, of June 1 (art.l) - imposes consolidation on credit entities that are in a situation described in art.4 of the LMV49. Recently, the need to extend the principle of self-sufficiency of resources on a consolidated basis to all groups of entities that carry out activities of a financial nature according to EC Law in the banking field has motivated the new Act 13/1992. To achieve this aim, there is an evident need to homogenise the notion of a group of financial entities and this Act has done this in the fields of banking law, securities market law, insurance companies law, etc.
48 49
See DUQUE, supra n. 45, at 490. See DUQUE, supra n. 45, at 487.
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. The Institutional Investors and their Active Role in Corporate Control A. The Notion of Institutional Investors in Spanish Law 1. The Generic Notion of Investor and its Qualification as Institutional Investor a) Company Law Although the generic notion of investor means broadly any consumer of securities; in the field of corporate control relationships we can identify it with shareholder owning voting shares. So situated, investors are visualized as minority shareholders in large SAs who, conscious of their insignificance as regards the control of the company in whose shares they invest, adopt a politically inactive position and absent themselves from the "well-acted comedy" that constitutes the General Meeting50. However, together with that individual investor, isolated and devoid of power of control, there is the figure of the 50
This image was introduced by SCHMOLLER ("eine schlecht besuchte, aber geschickt gespielte Komödie"), cited in the Spanish literature by ESTEBAN VELASCO, supra n. 12, at 528. Regarding the absentism of shareholders see A. MENENDEZ, "Absentismo de los accionistas y desequilibrio de poder en la sociedad anonima", in Estudios homenaje a F. De Castro, T.II, at 273 ff., (Madrid 1976) and J.F. DUQUE, "Absentismo del accionista y acciones sin voto", in Homenaje a J. B. Vallet de Goyüsolo, Vol.11, at 148 ff., (Madrid 1988). Regarding the individual investor see, generally, GIRON TENA, supra n. 12 ("Las reformas..."), at 3; M. WEBER, La Bolsa. Introduction al sistema bursatil (Spanish translation of "Die Börse)", at 49, (Barcelona 1987); DUQUE, supra n. 21, at 4 ff. and ALBORCH, supra n. 12, at 66 ff.. See also GARRIGUES, supra n. 12 ("La reforma..."), at 522 and IDEM, supra n. 12 ("Hacia..."), at 57 ff. where he n.d the classification of investors made by JOSE DE LA VEGA, in his book, Confusion de confusiones published in Amsterdam in 1688. This author said that there were in the Amsterdam Stock Exchange, diree types of "bolsistas" that were "prfncipes, mercaderes y jugadores" (princes, merchants and gamblers). The present concept of investor corresponds with the notion of "principes de la renta" (income princes). Regarding this classification see also J.A. TORRENTE FORTUNO, La Bolsa en Jose de la Vega. Confusion de confusiones. Amsterdam, 1688, at 115, (Madrid 1980). In the American literature, see BUSINESS ROUNDTABLE, supra n. 12, at 244 regarding "shareholders and stakeholders", stating: "Corporations are chartered to serve their shareholders and society as a whole. The interests of shareholders are primarly measured in terms of economic return over time. The interests of others in society (other stakeholders) are defined by their relationships to the corporation". In Portuguese law, the duties and rights of members of companies generally are regulated by arts.20 ff. of the "Codigo das Sociedades Comerciais", whereas the duties and rights of shareholders in stock companies are regulated in arts.285 ff.
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institutional investor which, on channelling big investments, regains awareness of the role of control that its investments in shares permits. In particular, institutional investors can improve corporate control mechanisms, improving the communications between the boards of directors and the shareholders51. The institutional investor appears, then, as an intermediate category between control shareholders and absentee shareholders, a "tertium genus" that is in the middle of the line that goes from active shareholder behaviour and the inactive shareholders. Institutional investors often choose a widely spread control over companies in which they invest, that is, on the other hand, the only one permited by them own limits on investment (i.e. diversification of IICs). This intermediate role goes with the fact that institutional investors are, above all, interested in economic value of their investment in shares; but, at the same time, the number of shares held makes their political value non-negligible, and hence makes them more active as regards investments made for the medium or long term. b) Securities Market Law The generic notion of investor is implicit in the text of the LMV. It has several manifestations. First and most important is that which entrusts to the CNMV, among others, the task of investor protection (art. 13 LMV). The notion of investor appears again in LMV in relation to the composition of the Consultant Committee of CNMV (art.22 LMV and Royal Decree 344/1989), to the wellfounded view which investors should be able to reach regarding an investment based on its prospectus of the issues of securities (art.28 LMV), to the fundamentation of the CNMV decision to suspend trading (art.33 LMV), etc.52. 51
Along these lines, see the COMMITTEE ON THE FINANCIAL ASPECTS OF CORPORATE GOVERNANCE, supra n. 10, at 36. See also RABINOWITZ, supra n. 35, at 1016 and 1027, "The current range of shareholders in listed companies (excluding controlling shareholders) would appear to fall largely into two classes: (a) The impersonal investor, who tends to be even less wealthy on average and to take even less direct interest in the affairs of the company (...) (b) The institutional investor: insurance companies, pension funds, investment trusts and unit trusts, investing a very large and ever-increasing stream of public savings, generally by means of wellinformed investment departments. (...) While it is generally the policy of the institutions not to interfere in the management of a company so long as the management is not acting against the interest of shareholders, there are some signs that this attitude is starting to change. The role of independent institutional shareholders is also supplemented by the activities of the institutional Investment Protection Committee". See also BUXBAUM, supra n. 4, at 40 "The old legitimating ideology -the myth of shareholder supremacy- had to be abandoned once institutional shareholdership threatened to make it real". 52 Besides, the LMV of 1988 contains other notions, i.e., "customer" in the field of the Rules of Conduct (art.79) or "public" with regard to the disclosure aspects (arts.82,
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The recent regulations issued under the LMV include an enumeration of the entities that are "institutional investors", an category that includes the IICs, FPs and insurance companies (art.7.1.a Royal Decree 291/1992). 2. Differences Between Individual Investors and Institutional Investors a) Differences in the Spanish Legal System The LMV, when it refers to "investors" in order to protect them, uses the word in a generic sense without distinguishing between individual investors or institutional investors, and they are entitled in principle to the same level of external public protection, fundamentally by CNMV53. However, in the Spanish primary securities market, a different treatment has been established for institutional and individual investors. If an issue is going to be placed among institutional investors, there is a partial exception to the common requirements for any issue of negotiable securities. In this case, the issuer need not present to CNMV the audit reports for the two preceding years nor the propectus (art.T.l.a Royal Decree 291/1992). Institutional investors are considered capable of investigating the situation of the issuer, the characteristics of the securities issued, etc.54. 92, 93, etc.). We can remember the activity of attention to the public which is made by the CNMV. See, CNMV, supra n. I , at 203. In the same Report, we can appreciate the role of the CNMV protecting not only investors but also customers when it says, in at 166: "The CNMV's role in supervising market intermediaries is much broader, as is aimed at ensuring their solvency and protecting the interests of their clients". Compare with the distinction between "private customers" and "professional customers" that, in the field of Stock Exchange Conduct of Business Rules, in Great Brittain, THE SECURITIES ASSOCIATION LIMITED has made. See "Proposed Core Rules on Conduct of Business (Board Notice, n. 205-30 th. July 1990. Consultation Document. SIB's Consultative Paper 42)". In Portuguese law, art. 3 n. l.i) of the "Codigo do Mercado de Valores Mobiliarios" (Decreto-Lei n. 142-A/91) contains the legal notion of "investor". This Code has other near notions, e.g., "public" with regard to disclosure aspects (art.97), "customer", in the rules of conduct for brokers (art. 184 and 638), etc. 53 Regarding the protection of investors see A. BERCOVITZ, "La proteccion juridica del inversor en valores mobiliarios", at 199, (Valencia 1977) and, IDEM, "El Derecho del Mercado de Capitales", RDBB n. 29 (1988) at 102. Regarding the necessity of special protection of the minoritary shareholders see J. GARRIGUES, "La proteccion de las minor fas en el Derecho espanol", Revista de Derecho Mercantil, n. 72 (1959), at 249 ff. and EMBID IRUJO, supra n. 23, at 30. In Portuguese law, regarding the principle of investors' protection, see arts.4.f) and 5.a) of the "Codigo do Mercado de Valores Mobiliarios". 54 Cf. arts.2.1.a) and 2.1.b) of EC Directive 89/298. In Portuguese law, see art.l31.1.d) of the "Codigo do Mercado de Valores Mobiliarios".
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It is important to note that this reduction in certain aspects of protection for institutional investors is deemed compensated by protective measures for individual investors who acquire the securities issued by institutional investors. Otherwise, by virtue of the "transitive" property, the weakeness in institutional investor's protection would affect the protection of individual investors who invest in them55. b) Behaviour Differences In principle, the individual investor has a greater amount of liberty in his investment decision than the institutional investor. However, as regards corporate control, the institutional investor has a greater capacity of reaction than the individual one. Indeed, whereas the individual investor disagreeing with the company management has only the option of "voting with his feet", making use of the liquidity of his shares; the institutional investor, owing to the volume of its investment and its technical capability, have several options: a) Selling out. b) Improving its monitoring role. c) Using the corporate rights in its shares to replace the board of directors56. 55
Recall, e.g., the measures of information protection for investors enacted by the LIIC (art.8.4) and developed by the RIIC (art. 10). Regarding this articles, see A.J. TAPIA HERMIDA, "El nuevo Reglamento de las Instituciones de Inversion Colectiva", Derecho de los Negocios n. 4 (January 1991) at 3; GARCIA-VAQUERO, supra n. 8, at 39 ff. and J.M. POMARON BAGÜES, "El nuevo rogimen de las Instituciones de Inversion Colectiva en Espana", La Ley, at 2, (June, 28, 1991). Regarding the participants' right to information in the earlier regulations see DUQUE DOMINGUEZ, supra n. 20, at 370. Regarding disclosure requirements for investment funds see VERDERA, supra n. 18, at 117 where he said, citing from LARCIER, that investment funds have to be "glass houses" for their participants. See also BROSETA PONT, supra n. 17, at 233 who concluded his paper recommending the establishment of collective means in order to protect participants. 56 The second solution is the preferred by the COMMITTEE ON THE FINANCIAL ASPECTS OF CORPORATE GOVERNANCE, supra n. 10, at 35: "Given the weight of their votes, the way in which institutional shareholders use their powwer to influence the standards of corporate governance is of fundamental importance. Their readiness to do this turns on the degree to which they see it as their responsability as owners, and in the interest of those whose money they are investing, to bring about changes in companies when neccesary, rather than selling their shares". See LIPTON & LORSCH, supra n. 3, at 61: "Certain institutional investors actively are seeking ways to communicate more easily with each other and jointly to elect directors. To be successful in a meaningful way, such efforts, however, would require changes in the Securities and Exchange Commission (SEC) regulations beyond the changes recently adopted by tbe SEC". According to the Spanish LSA, holders of 5% -that is the
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B. Classification of Institutional Investors From the point of view of corporate control, a dual classification of institutional investors may be made57.
concentration permitted to the IICs- of the capital can ask the managers to hold a general meeting (art. 100.2) or initiate suits against managers for violations of the duties owed to the company (art. 134.4). Regarding the differences in the behaviour of individual investors and institutional investors see, in the Spanish literature, M. POOCUE, Comportamiento del mercado de valores 1965-1974. Impacto de la inversion colectiva. Analisis del alia., at 101 ff., (Madrid 1980). In this sense, WEIGMAN, supra n. 8, at 1107 cited from EISENBERG the paragraph of the SEC paper about "Investment Trust and Investment Companies" that began saying: "Investment companies may serve the useful role of representatives of the great number of inarticulate and ineffective individual investors in industrial corporations in wich investment companies are also interested. (...) These investment companies can perform the function of sophisticated investors, dissociated from the management of their portfolio companies. They can appraise the activities of the management critically and expertly, and in the manner not only serve their own interests but the interest of the other public stockholders". 57 See BUXBAUM, supra n. 4, at 9, stating: "Institutional investment vehicles generally are grouped in five categories: foundations and endowments; bank (nonpension) trusts; insurance companies; investment companies; private and public pension funds. Motives for the investment of private households surplus savings in corporate securities are not so clearly categorizable, but making provision for retirement income in a large one" and BAUMS, supra n. 12, at 1 who includes among the institutional investors, "investment and insurance companies, trust departments of commercial banks and especially all institutions which administer pension funds". In Spanish literature, see J.R. CANO RICO, "Mediation, fe publica mercantil y Derecho bursatil", at 214 ff., (Madrid 1982). The classification of institutional investors has to be flexible because the different categories of institutional investors are related. We can see this relation, e.g., in the Italian Literature: M. POGLIANI, "Fondi d'investimento ed assicurazione vita come strumenti di risparmio e di previdenza", in Asssicurazzioni, at 406 ff., (1984), I; G. VOLPE PUTZOLU, "Assicurazione sulla vita, fondi assicurativi e fondi communi di investimento", in Giurisprudenza Commerciale, at 227 ff., (1984); N. NESI, "Assicurazione vita e prodotti fmanziari", in Assicurazzioni, at 495 ff., (1985), I; A. LONGO, "Considerazioni riassuntive sul rapporto tra assicurazione vita e intermediazione finanziaria", in Assicurazzioni, at 505 ff., (1985), I and G. FANELLI, "Assicurazione sulla vita e intermediazione finanziaria", in Assicurazzioni, at 215 ff., (1986), I.
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1. Purpose Criterion a) Institutional Investors of the First Degree We call institutional investors of the first degree those whose sole purpose is investing in financial assets. In Spanish law, belong to this first category the IICs58. This sole purpose, which seems to permit them more freedom in their investment policy, leads to the imposition of the more stringent rules as to corporate control. b) Institutional Investors of the Second Degree These are those institutional investors who have other main objectives besides the investment. For them, investment in securities is not an end in itself but as means to fulfil those main purposes. In this second category, we can include FPs whose priority purpose is social security59 and insurance companies, whose sole objective is carrying out insurance operations60. 2. Legal Struture Criterion From the point of view of corporate control by institutional investors, the legal structure is of fundamental importance inasmuch as it will determine their internal and external control relationships61. This second criterion is superimposed -as we shall see- on the first. a) Institutional Investors with Company Structure The IICs, which take the form of special SAs (SIMs and SIMCAVs) and the insurance companies, which can adopt SAs forms, be cooperative companies, etc.; will establish their internal structure of control according to specific legal models based on the common structure of company contract.
58
As to the exclusive object of this type of institutional investor, see arts. 1 LIIC and 1 RIIC. See FERNANDEZ DEL ΡΟΖΟ, supra n. 18, at 630 ff. 59 See J.M. MICHAVILA NUNEZ, "Principios institucionales de los Planes y Fondos de Pensiones. Estudio sobre las disposiciones generales de la Ley 8/87 de Planes y Fondos de Pensiones," RDBB n. 34 (1989) at 344 and 346 where he discusses the difference between the FIMs/FIAMMs and the FPs with regard to their objective. 60 See art.2 LOSP. 61 See BUXBAUM, supra n. 3, at 23 regarding the "legal framework of institutional investment", and at 24 regarding the influence of the Employee Retirement and Income Security Act of 1974 (ERISA) on the behaviour of the pension funds in USA.
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b) Institutional Investors with Foundational or Contractual Structure The IICs, which adopt a contractual form (FIM y FIAMM), together with FPs, constitute this second category which presents, as common feature, the development of internal relationships of control according to trust structures62. Even though both types of institutional investors share a similar structure, between them there are, however, notable differences (e.g., the existence in the FPs of a Control Commission of the Pension Funds) which allow more management freedom to the SGIICs of FIMs than to EGs of FPs63. C. DCs
1. The Concept a) The Evolution of the Legislation on IICs The IICs have, in Spanish law, financial and tax aspects. Both aspects are seen in the legislation regarding this type of institutional investors, which has gone through three fundamental stages: a) A first stage of "disperse formation", which began in the Act of July 15, 1952, and was characterised by its tax objectives and by the separate regulation of two fundamental categories of IICs, investment companies and investment funds. b) A second stage of "integrating consolidation" of the formerly scattered regulations, characterised by its financial-tax aims, by the imperative nature of its norms and by the all-embracing aim of Act 46/1984 and of its Regulations, contained in the Royal Decree 1346/1985. 62
Regarding the structure of investment funds see BROSETA PONT, supra n. 17, 233; DUQUE, supra n. 20, at 353 and 359 and FERNANDEZ DEL ΡΟΖΟ, supra n. 18, at 628 ff. 63 Regarding the comparative relationship between the concepts of investment funds and pension funds in Spanish law, see J.F. DUQUE DOMINGUEZ, "Notas delimitadoras y naturaleza juridica de los Fondos de Pensiones," in Rlgimen juridico de los Planes y Fondos de Pensiones, at 54, (Sanchez Calero & others, eds., Madrid 1988). In particular, M. VERGEZ, "Los contratos de gestion y deposito de los Fondos de Pensiones," also in Sanchez Calero & others, supra, at 119, compares the management of FIMs/FIAMMs by the SGIICs (a discretionary and dynamic management) with the management of FPs by the EGs (a limited and controlled management). See also more recently, FERNANDEZ DEL ΡΟΖΟ, supra n. 18, at 639 ff. Regarding the limited role of the EGs in the management of FPs, see M. RABADAN FORNIES, "Comentarios a la Ley y al Reglamento de Planes y Fondos de Pensiones," in Estudios sobre Planes y Fondos de Pensiones, at 41, (Martinez Lafuente & others, eds., Barcelona 1989).
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c) A third stage of integration of IIC in the new scheme of Securities Market established by LMV and harmonization of its system to EC Directive 85/611, modified by EC Directive 88/22064. b) The Legal Concept of IIC The concept of IIC is defined in the Spanish law through three logical operations (arts.l LUCand 1 RIIC): a) On the first place, there is an enumeration of the IICs that are legally typified (SIM, SIMCAV, FIM, FIAMM). b) Secondly, a generic concept of IIC is offered, characterised by the management of funds from the public, as the yield of investor always establishes in the function of collective results. c) Lastly, public firms, entities of credit, insurance firms, etc. are excluded65. 64
The CNMV, supra n. 5, at 17 says: "The sixth addendum to the Securities Market Law brought modifications to the Collective Investment Institutions Regulatory Law, which made it necessary to adapt to the new norms". In particular, see at 121 regarding the new rules on the marketing in Spain of EC and non-EC OICVM/UCITS and marketing of Spanish IICs in EC Menber States. Regarding the new regulations for the IICs in 1991 -which have affected securities lending, investment in high liquidity securities and the tax system- see CNMV "Annual Report 1991", at 160. Regarding the evolution of the IIC legislation in Spanish law, see VERDERA, supra n. 18, at 28; TAPIA HERMIDA, supra n. 55, at 1; MICHAVILA, supra n. 59, at 347; A. TORRECILLA FRADEJAS, "Las instituciones del mercado fmanciero: la inversion colectiva", Chapter XXXI of the collective book Curso de Introduction a Bolsa, at 841, (Madrid 1987); CANO RICO, supra n. 57, at 229 ff.; POMARON, supra n. 55, at 1 ff and DIRECCION GENERAL DEL TESORO POLITICA FINANCIERA, "Aspectos bäsicos del nuevo Reglamento de la Ley de Instituciones de Inversion Colectiva", in Information comertial espafiola, (12-18, November, 1990), at 4144 ff. The IICs regulation is contained in A.J. TAPIA HERMIDA, Legislation de las Instituciones de Inversion Colectiva (Madrid 1991). Regarding the Comparative legislation, see PREDA, S. (ed.), Funds and Portfolio Management Institutions. An International Survey (Amsterdam 1991); E. PIETRA, "La disciplina giuridica dei fondi comuni d'investimento mobiliare in alcuni paesi europei", in Banco, Borsa e Titoli di Credito, at 534 ff., (1983), I, and B. ELSNER, Das Recht der Wertpapierinvestmentunternehmen in den Ländern der Europäischen Gemeinschaften (Köln 1980). In Portuguese law, the legal framework of the IICs is comprised "Decreto-Lei" n. 77/86, May 2, of Investment Companies ("Sociedades de Investimento"); "DecretoLei" n. 229-C/91, of July 4, of Investment Funds ("Fundos de Investimento") and "Decreto-Lei" n. 234/91, of June 27, reprinted in Codigo comertial. Codigo das sociedades comer dais. Legislacao complementar, at 471 ff., 707 ff. and 730 ff., (A. Caeiro & M. Nogueira, eds., Coimbra 1992). 65 Regarding this concept, see SANCHEZ CALERO, supra n. 45, at 363 ff. and F. RODRIGUEZ ARTIGAS, "Instituciones de Inversion Colectiva (Sociedades y Fondos de Inversion)", RDBB n. 35 (1989) at 531. See also, A. CUERVO & L. RODRIGUEZ
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2. Typology The LIIC has a double diversifying aim because it tries to offer a heterogeneous "menu" of IICs66; and an all-embracing aim because it tries to regulate all types of IICs. Therefore, the LIIC contemplates two fundamental categories of IICs. Financial IICs which invest and manage financial assets, and non-financial IICs, which invest in other types of assets (see arts. 1.2 LIIC and 1.3 and 2 RIIC)67. The latter have been recently regulated by the Act 19/1992, July, 768. As regard the financial IICs, the LIIC contemplates two categories, typified and non-typified (arts.30 LIIC and 59 RIIC). Only the first have a real existence in the Spanish financial market, and they are divided into two kinds, in accordance with their legal structure, the company type (SIMs and SIMCAVs) and the contractual type (FIMs and FIAMMs) (art.2 RIIC). The two types have different minimum capital69 and different rules on the composition of their assets, which gives them different capacity for corporate control. Within the SAIZ & L.A. PAREJO, Manual de slstema finandero. Instituciones, mercados y medios en Espana, at 367 ff., (Barcelona 1988). We can compare this with the EC Directive 85/611 which establishes a positive criterion in its art. 1.2 and a negative criterion in its art.2. Compare with the definition of investment company as an issuer that "holds itself out as bearing primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities" in the section 3(a)(l) of the American Investment Company Act of 1940. See it in G.T. LINS & J.B. GOULD, "Unit Investment Trusts: Structure and Regulation Under The Federal Securities Law", The Business Lawyer Vol.43 (August 1988) at 1178. 66 See, along these lines, the third paragraph of the Exposition of Motives of the LIIC and the fifth paragraph of the Preamble of the RIIC. 67 Regarding the types of IICs, see RODRIGUEZ ARTIGAS, supra n. 65, at 533 ff. and P. FERNANDEZ RANADA, "Las Sociedades y Fondos de Inversion Mobiliaria. Las Instituciones de Inversion Colectiva", in Papeles de Economia Espaflola. Suplementos sobre el Sisiema Finandero. Institutiones de Inversion Colectiva, at 9 ff., (Madrid 1985). 68 For background, see A.J. TAPIA HERMIDA, "I fondi immobiliari nell'ordinamento spagnolo e portoghese", in I fondi comuni immobiliari. Esperienze europee e prospettive italiane, at 69 ff., (D. Velo & D. Fruscio, eds., Milan 1989); IDEM, "Los Fondos de Inversion Inmobiliaria en el Derecho Espanol y en el Derecho Portugues", RDBB n. 32 (1988) at 783 ff.; IDEM, "El Proyecto de Ley de Sociedades y Fondos de Inversion Inmobiliaria", RDBB n. 44 (1991) at 1188 ff. and PIETRA & OTHERS, "Fondos colectivos de inversion inmobiliaria", Revista Espanola de Finandadon de la Vivienda, n. 13 (1990), at 9 ff. In Portuguese law, see the "Decreto-Lei" n. 135/91, April 4 on Real Estate Investment and Managing Firms ("Sociedades de Gestao e Investmente Imobiliario"), reprinted in CAEIRO, supra n. 64, at 518 ff. 69 Art. 12 RIIC establishes the minimum capital and asset requirements as follows: SIM and SIMCAV, 400 mn. pesetas; FIM, 500 mn. pesetas and FIAMM, 1.500 mn. pesetas.
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investment fund category (FIMs and FIAMMs), there are subtypes of great importance in the recent Spanish financial panorama, which are the "Investment Funds in Public Debt" ("FONDTESOROS"), born under the protection of a Ministerial Order of 7, June, 1990. Moreover, the LIIC regulates the portfolio management firms ("Sociedades Gestoras de Carteras"). They are not IICs, but they operate as institutional investors in the financial market70. 3. IICs Management The way in which IICs exercise corporate control is directly related to their own management structure, which depends on wether they are of the company or contractual type71. a) The Management of SEVIs and SIMCAVs Since SIMs and SIMCAVs are special SAs, the generically rules of the LSA are applicable to their management, supplemented by some specific norms (arts. 12.2 and 15 LIIC and 22.1 RIIC). Among these, we point out the requirements of experience and honorability for their Board of Directors (arts. 8 LIIC and 9 RIIC), the existence of a Commission on Management and Auditing Control (arts. 13 LIIC and 23-25 RIIC) and the possible delegation of management to a portfolio management firm (arts. 12.4 LIIC and 22 RIIC)72. b) The Management of the FIMs and FIAMMs For investment funds (FIMs and FIAMMs), a triangular structure of property, management and deposit is established, based on the existence of a community
70
The "FONDTESOROS" represent 7% of the total assets of investment funds in Spain according to "Cinco Dias", May 23, 1992, at V. Regarding them see CNMV, supra n. 5, at 99; GARRIDO, I., "Las cuentas directas y los fondos de inversion Fondtesoro en la polftica de la Deuda del Estado", in Papeles de Economia Espafiola. Suplementos sobre el Sistema Finandero, n. 35 (1991), at 15 and GARCIA VAQUERO, supra n. 8, at 38. See also A.J. TAPIA HERMIDA, "Las Sociedades Gestoras de Patrimonio en la Ley Reguladora de las Instituciones de Inversion Colectiva de 26 de diciembre de 1984", RDBB n. 18 (1985), at 289 ff. 71 Compare with section III of EC Directive 85/611 regarding the structure of the investment funds and section IV the structure of the investment companies. 72 See RODRIGUEZ ARTIGAS, supra n. 65, at 550 and 552. In particular, we can compare this Comission on Management and Auditing Control with the solutions recomended by the COMMITTEE ON THE FINANCIAL ASPECTS OF CORPORATE GOVERNANCE, supra n. 10, at 48, regarding the establishment of an Audit Committee in listed companies.
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of owners and two "auxiliary firms" (see arts. 19 LIIC and 40 RIIC, with regard to FIMs)73. The management of funds is governed by the established Management Rules74 and has to devolve necessarily in an SGIIC75. These are special SAs registered with the CNMV, whose capital has to be at least 50 mn. ptas. Their sole corporate purpose is IICs administration and representation. They may not delegate investment decisions, although they can employ, previous authorisation from CNMV, the management of foreign assets for foreign firms (arts.27.1 and 2 LIIC and 53 RIIC)76. These SGIICs play a central role in corporate control because they, among other powers, exercise all rights inherent to securities integrated in the fund, for the exclusive benefit of their members (art.54.b RIIC); and because they select the securities that integrate the fund in accordance with their Rules and because they order the depository to carry out purchases and sales of securities (art.54.h RIIC)77. The SGIIC receive commissions for their management services freely negotiated, within maximum percentages established by Regulations (art. 22 LIIC) and which may be different for FIMs (art.45.1 y 2 RIIC) and or FIAMMs (art.52.1 RIIC)78. Together with SGIIC works the depository, which carry out, besides the custody, other functions which are susceptible to influence corporate control by the fund (e.g. vigilance and supervision of management by SGIIC, art.56.b 73
Regarding the triangular relationship see M. OLIVENCIA RUIZ & G.J. JIMENEZ SANCHEZ, "El Depositario", supra n. 17, at 258. See also J.A. CALLE OLIVA, "Las relaciones jurfdicas en el fondo de inversion mobiliaria", Moneda y Cridito, n. 99 (1966), at 51 ff.; FERNANDEZ DEL ΡΟΖΟ, supra n. 18, at 646 ff. and GARCIA VAQUERO, supra n. 8, at 36 ff. 74 See VERDERA, supra n. 18, at 63 and 87 and F. RODRIGUEZ ARTIGAS, "Procedimiento de modification del Reglamento de los Fondos de Inversion Mobiliaria" supra n. 17, at 539. 75 The new Regulations of 1990 had "the intention to lend content of this IIC Portfolio Managament Firms to their functional specialisation, stressing the fact that they may not delegate investment or divestment operations" according to the CNMV, supra n. 5, at 121. 76 Regarding the purpose of the SGIICs, see BROSETA PONT, supra n. 17, at 223. These SGIIC have a general duty of diligent management which was synthesized by the same author, supra n. 17, at 234. This is a best effort obligation, as stated SANCHEZ ANDRES, supra n. 30, at 576. 77 In general terms, see WEIGMAN, supra n. 8, at 1097 regarding the reasons for restricting the right to vote of the management companies of investment funds. In particular, regarding the exercise of corporation rigths by the SGIIC in Spanish Literature, see VERDERA, supra n. 18, at 147; BROSETA PONT, supra n. 17, at 235 and SANCHEZ ANDRES, supra n. 30, at 572 stating that the power of the management company was, at the same time, a "right" and a "duty" (called "rightfunction"). 78 See VERDERA, supra n. 18, at 136 and BROSETA PONT, supra n. 17, at 236.
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RIIC; carrying out the purchase and sale operations and collect interest and dividends, art.56.h RIIC)79. Banks, savings-banks, brokerage firms and cooperative banks can be depositories (arts.27.3 LIIC and 55.1 RIIC). Commissions cannot exceed a maximum percentage set by Regulations, which may be different for FIMs (art.45.5 RIIC) and FIAMMs (art.52.3 RIIC). It is very important to note, as regards corporate control, that the SGIICs and depositories must act in the members interest regarding investments and resources which they administer or take charge of; being liable for all financial losses which they cause and being required to demand from each other payment of that liability on the investors behalf (arts.29 LIIC and 58 RIIC)80. Precisely, to ensure proper functioning of that system of reciprocal vigilance in favor of investors, not only are SGIICs and depositories not allowed to be the same firm (arts.27.4 LIIC and 55.6 RIIC) but, they are also not allowed to belong to the same group, except when they fulfil the conditions of separation set by the regulations (arts.27.3 LIIC and 55.2 RIIC). In Spanish practice the SGIICs are SAs branches of the banking groups that administer FIMs or FIAMMs, deposited in the head offices of the credit firms of such groups, complying with the separation rules. It is invested, in fact, the balance of theoretical powers, so that investments decisions -which can affect the acquisition or cessation the corporate control- emanate from the head offices of credit firms81. 4. Investments and Operations of IICs IICs1 ability to exercise control over other companies is defined -as is that of other institutional investors- by the norms applicable to their investments and operations on securities82. 79
Recently, a Ministerial Order was enacted on July 30, 1992 regarding the functions and duties of the depositories. See OLIVENCIA RUIZ & JIMENEZ SANCHEZ, supra n. 73, at 249 regarding the active side of the legal role of the "Depositario" and at 269 regarding its role with regard to the securities management. 80 See RODRIGUEZ ARTIGAS, supra n. 65, at 567 and BROSETA PONT, supra n. 17, at 218. With respect to the liability see OLIVENCIA RUIZ/JIMENEZ SANCHEZ, supra n. 73, at 270 and 275 and SANCHEZ ANDRES, supra n. 30, at 577. 81 Regarding the predominant role of the banks in the field of investment funds see OLIVENCIA RUIZ & JIMENEZ SANCHEZ, supra n. 73, at 252. See C. CONTRERAS, "Las entidades de cr6dito ante la popularizacion de la inversion colectiva", Papeles de Economfa Espafiola. Suplementos sobre el Sistema Financiero, n. 35 (1991) at 30. 82 As to the notion of "healthy investment policy" in investment funds see VERDERA, supra n. 18, at 118. From the economic point of view in the Spanish literature, see I. GARCIA DIEZ, Los fondos de inversion en el mercado financiero (Madrid 1970); J. PETIT FONSERE, "Los fondos de inversion y la financiacion del
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a) Diversification of Investments The LIIC, as well as the RIIC (both in their arts.4), establish "general norms regarding investments", which are characterised by their general ambit and for their common objective, consistent in diversifying the portfolios of IIC, reducing their risks by means of a behaviour characteristic of "investment trusts"83. In order to achieve this objective there are two mechanisms which act in a joint and complementary manner: aa) Diversification Regarding IIC Resources In the first place and in order to guarantee the operation of IICs in conformity with the "investment trust" model, a series of norms are established that require diversification in relation to assets and resources of the IIC itself (arts.4.1 LIIC and 4.1 RIIC). In turn, these norms refer to three types of securities according to their issuers: 1. Securities issued by others IICs. No IIC can have more than 5% of its assets invested in securities issued by other IIC and no IIC can invest in securities of another IIC in the same group84. 2. Private securities issued by other companies individually or by group. No IIC can invested more than 5 % of its assets in securities issued or endorsed by the same firm, limit that rises up to 10%, provided that the excess of concentration does not exceed 40% of the IIC assets. For securities issued by firms belonging to the same group, the limit is up to 15% of the IIC assets85.
desarrollo industrial en Espana", Hacienda Publica Espanola n. 12, at 47 ff., (1971); J. SAN ΡΙΟ SIERRA, "El impacto de los fondos de inversion en el sistema economico y financiero", Hacienda Publica Espafiola n. 12, at 21 ff., (1971) and GARCIA VAQUERO, supra n. 8. 83 These norms of general investment are the result of the adaption to the minimum harmonisation requirements required by the relevant EC Directive (Section V). In this sense see A.J. TAPIA HERMIDA & SANCHEZ-CALERO GUILARTE, "La adaptacion del Derecho espanol del mercado de valores al Derecho comunitario", RDBB n. 44, (1991) at 1005. Regarding the Spanish rules see RODRIGUEZ ARTIG AS, supra n. 66, at 536. See also VERDERA, supra n. 18, at 64 and 66 where he compares the holding companies with investment trusts and J.A. GOMEZ SEGADE, "El patrimonio del Fondo", in the collective book supra n. 17, at 310. Regarding the adaptation of "trust" in die Spanish law, see J. GARRIGUES, Negocios fiduciaries en el Derecho Mercantil, at 89 ff., (Madrid 1978). 84 Compare with GOMEZ SEGADE, supra n. 83, at 312. 85 Compare with GOMEZ SEGADE, supra n. 83, at 306.
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3. Public securities. An IIC can invest up to 35% of its assets in securities issued by the State, "Comunidades Autonomas", or International Bodies. This limit can rise to 100% if the investments are diversified in six different issues without any of them representing more than 30% of IIC assets. bb) Diversification with Regard to the Capital of Companies which Issue the Securities in which IICs Invest
In second place and in order to avoid the operation of IICs as "holding companies", a series of rules which require diversification in relation to the capital of other companies were established (arts.4.2 LIIC and 4.2 RIIC)86. Under these rules, an IIC cannot invest more than 5 % of the total securities in circulation issued or endorsed by the same firm. This percentage rises up to 15% when they belong to a group. Although these rules are guided by the goal of diversifying risks, they have a direct influence on corporate control87. Moreover, it must be remembered that the establishment of percentages (5 % or 15%) is not a definitive method to determine the capacity for corporate control, as this will depend on the size and distribution of power within the company. Thus, whereas in a large S A the ownership of 5% of its capital with voting right can allow control, in others with concentrated capital that same percentage can be irrelevant. This is the criterion which seems to inspire art.4.4 of LIIC when it says that the Government can establish other maximum percentages depending on the volume of the issuers88. b) Securities in which IICs Can Invest
The LIIC and the RIIC establish the categories of securities in which IICs can invest, always respecting the diversification norms mentioned in the preceding paragraph: aa) General Rules The financial and defined types of IICs (SIM, SIMCAV, FIM, FIAMM) must have, at least, 90% of their assets (the 80% for FIMs) invested in national or
86
The goals of corporate control have been outside of the legal framework of Spanish regulatoty system of investment funds. In this sense, see VERDERA, supra n. 18, at 62 and GOMEZ SEGADE, supra n. 83, at 309. 87 Compare with art. 25 of EC Directive 85/611. 88 In this sense see VERDERA, supra n. 18, at 67 and BROSETA, supra n. 17, at 235.
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foreign securities belonging to the following categories (arts. 10.1 LIIC and 17.1,2and3RIIC) 89 : 1. National securities. Securities which are already traded in the stock exchanges ("Bolsas de Valores"), in the market for public debt ("Mercado de Deuda Publica en Anotaciones") or in other Spanish securities market, organised, functioning regularly, recognized and open to the public. 2. Foreign securities. Securities listed for trading in a stock exchange or in a market for public debt situated in a member State of the OECD are treated like those listed on Spanish stock exchange. Investment is also allowed in securities traded in other organized markets within the OECD if the CNMV verifies that those markets are functioning regularly, are recognized and open to the public. The CNMV can also authorize investment in non-OECD securities90. bb) Specific Rules for Each Type of IIC SIMs and SIMCAVs must have al least 90% of their assets invested in the securities listed in the previous paragraph (art.26.1 RIIC). On the other hand, 80% of the assets of a FIM must be invested in the securities listed in the previous paragraph. The rest of their assets can be invested in any securities that enjoy high liquidity as defined in art. 49 of RIIC (arts. 18 LIIC and 37 RIIC). The criteria for investment and the rules for selection of securities have to be embraced in the management rules (art.35.1.e RIIC)91. With regard to FIAMMs, the fact that they cannot invest in shares or convertible debentures (arts.25 LIIC and 49 RIIC) keep them from playing a significant role in corporate control.
89
A Ministerial Order was enacted on July 6, 1992 regarding the operations of the IIC in financial options and futures. Compare with GOMEZ SEGADE, supra n. 83, at 300. 90 Compare with GOMEZ SEGADE, supra n. 83, at 304. 91 According to the CNMV, supra n. 5, at 103: "The FIM can be classified in accordance with many different criteria. A simple way is by investment preferences, which can be determined by looking at each porfolio. By this yardstick we can distinguish four types of FIM, each with a different proportion of fixed-interest investment. Hence Pure Fixed-Interst FIM are those which hold nothing but fixedinterest investments. Mixed Fixed-Interest FIM are those with more than 75% of fixedinterest holdings. Mixed-Equity FIM hold between 25% and 75% of fixed-interest investments. Equity FIM are those whose portfolios contain less than 25% fixedinterest investments". For other classifications, see GARCIA-VAQUERO, supra n. 8, at 37 ff.
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cc) Reflections on IIC Investments in Spanish Practice and Their Repercussions on Corporate Control In the previous paragraphs we have described the securities which, according to Spanish law, IICs can invest in. Now is the time to observe how, in Spanish practice, IICs actually invest their assets. As regards the SIMs and the SIMCAVs, their real importance is limited inasmuch as the SIMs have established mechanisms for important family resources to obtain an advantageous tax treatment. Their minimum required capital (400 mn. ptas. according to art. 12.1 RIIC) as well as their behaviour do not allow considering its effective incidence on control of large SAs92. The situation for FIMs is very different inasmuch as the recorded spectacular increase in 1991 and 1992 would permit to cherish on its importance in corporate control. However, as we have had the opportunity to emphasize above, their concentration on fixed-interest bonds and, in particular, in public debt, has kept them from playing such a role93. 92
See CNMV, supra n. 5, at 115 regarding SIMs and SIMCAVs in 1990. According to the CNMV, Informe sobre Instituciones de Inversion Colectiva. Cuarto trimestre 1991, there were 272 SIMs on 31.12.1990 and 270 on 31.12.1991. On the other hand, there were 10 SIMCAVs on 31.12.1990 and 19 on 31.12.1991 (Cuadro 1, at 9). The SIMs and SIMCAVs had a 37.73% of their portfolio invested in domestic equities and 2.86% in foreign equities (Table 5, at 12). The CNMV, supra n. 1, at 152 says: "During 1991, investment companies continued in the low-keyed, somewhat lethargic role which has been characterising their activity for the past several years. In fact, the net number of SIM declined as a result of the mere handful of new firms which applied for registration versus the larger number of firms which seased operations". About the evolution of the figures in the past decades see, POO CUE, supra n. 56, at 384 ff. and G. SOLE VILLALONGA, El mercado espanol de valores: analisis economico, at 173 ff., (Madrid 1978). 93 According with the CNMV, Informe sobre Instituciones de Inversion Colectiva. Cuarto trimestre 1991, there were 206 FIMs on 31.12.1990 and 286 on 31.12.1991 (Table 1, at 9). The FIMs had on 31.12.1991 a 1,30% of their portfolio invested in domestic equities and a 0,18% in foreign equities (Cuadro 3, at 10). The CNMV, supra n. 1, at 134 explains "the changing weight of equities in FIM portfolios" and the investment strategy followed by these institutions. The CNMV says: "As a general rule, the predominant trend has been the shift to the fixed-interest category". This strategy can be considered as a demand of the prudent man rule. Regarding this last rule see B. LONSGTRETH, (Reviewed by L. Nicholas), "Modern Investment Management and the Prudent Man Rule", The Business Lawyer, Vol.43 (February 1988) at 779. We can compare with the American practice discussed in G.T. LINS & J.B. GOULD, supra n. 65, at 1177: "In recent years, the number and variety of investments products offered to the general public has dramatically increased. In particular, mutual funds and other collective structures has grown exponentially". Regarding the evolution of the figures in recent decades in Spain see POO CUE, supra n. 56, at 356 ff.; SOLE VILLALONGA, supra n. 92, at 183 ff.; CANO RICO, supra
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c) System of Operations of IICs In general, IICs must realise their operations through normal mechanisms established in the secondary markets in which the securities held by them are traded. Exceptionally, they carry out operations through special mechanisms, provided that favourable conditions are arranged for IICs (arts.7 LIIC and 8 RIIC)94. This order is specifically ratified for the SIMs (art.28 RIIC) and for the FIMs (art.39 RIIC)95. It may be added that securities and financial assets forming part of the assets of IICs cannot be used as any sort of guarantee. Moreover, such securities will have to be in the custody of an registered depository (arts. 10.3 LIIC and 18 RIIC). This requirement is ratified for SIMs (art.27 RIIC), and for FIMs as well (art.38 RIIC)96. D. Pension Funds 1. Pension Plans and Pension Funds The legal regulation of the complementary social security established in Spain in 1987 by the LPFP (and developed in 1988 by the RPFP) is based on two fundamental and complementary concepts, PP and FP97.
n. 57, at 240 ff. and GARCIA-VAQUERO, supra n. 8, at 41 ff. See also R. MINGUEZ PRIETO & G. HERNANDEZ GARCIA, "Caracterfsticas y evolucion reciente de las Instituciones de Inversion Colectiva", Information Comercial Espanola, 4-10, February, 1991, at 309 ff. 94 Regarding the legal framework of the special operations in the Spanish Stock Exchange see A.J. TAPIA HERMIDA, "El desarrollo reglamentario del rogimen de las operaciones bursätiles", RDBB n. 44 (1991) at 1143. 95 Regarding the strategic performance of FIMs in the Stock Exchange in 1990, see CNMV, supra n. 5, at 103. For 1991, see CNMV, supra n. 1, at 135. 96 Compare with GOMEZ SEGADE, supra n. 83, at 314. 97 See M1CHAVILA, supra n. 59, at 343; L. ANGULO RODRIGUEZ, "Planes y Fondos de Pensiones y la Ley de Contrato de Seguro y la demäs normativa aseguradora", in SANCHEZ CALERO & OTHERS, supra n. 63, at 35; E. ANGULO RODRIGUEZ, "Constitucion y regimen de los Fondos de Pensiones", in MARTINEZ LAFUENTE & OTHERS, supra n. 63, at 69; J.L. MONEREO, "Instrumentacion jurfdica e institucional de los Planes y Fondos de Pensiones", Revista Civitas de Derecho del Trabajo n. 2 (1989), at 587 ff. and L.J. PORFIRIO, "Los Fondos de Pensiones en Espana. Estudio de la Ley de 8 de junio de 1987, de Regulacion de los Planes y Fondos de Pensiones", Revista Espanola de Seguros, n. 52 (1987), at 13 ff. The Spanish Act of 1987 was based on the United States ERISA. Regarding this Act see CASEY & OTHERS, supra n. 21, at 193 ff.
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a) Pension Plans PPs establish the contractual conditions of pension-saving (Preamble of the LPFP) and are considered to be collective contracts for social security (arts.l LPFP and 1 RPFP)98. The PPs can be viewed as the "ends" and Fps as "means", since FPs invest in order to ensure the existence of financial flows to satisfy the obligations undertaken by PPs. In this latter sense, we can emphasize two basic principles governing PPs: The principle of capitalization and the principle of obligatory integration in an FP (arts.S.l.b and e of the LPFP and 4.1.b n d e of the RPFP)99. b) Pension Funds FPs are investment instruments for pension-saving arising from an integrated PP or PPs (Preamble of the LPFP). They are legally defined as separate and independent patrimonies from the enterprises or entities that promote them. They lack juridical personality and are composed of resources to meet the income goals of PP or PPs integrated in them (arts.2 LPFP and 25 RPFP)100. FPs are institutional investors101 of second degree in the sense that their primary 98
See F. SANCHEZ CALERO, "Delimitacion y notas caracterfsticas de los Planes de Pensiones", in Sanchez Calero & Others, supra n. 63, at 23. See also J.M. MICHAVILA NUNEZ, "Naturaleza y tipologia de los Planes de Pensiones", in Martinez Lafuente & Others, supra n. 63, at 59. 99 This integration is carried out by means of a position account ("cuenta de posicion") which is regulated in the arts. 10 LPFP and 11 RPFP. See RABADAN FORNIES, supra n. 63, at 42. 100 See DUQUE DOMINGUEZ, supra n. 63, at 54 and 67; VERGEZ, supra n. 63, at 111; MICHAVILA, supra n. 59, at 361; J. BOLAS ALFONSO, "Constitucion de los Fondos de Pensiones: Especial referenda a la escritura de constitucion", in Martinez Laftiente & Others, supra n. 63, at 100 and FERNANDEZ DEL ΡΟΖΟ, supra n. 18, at 631 ff. See also F. GOMEZ GALLIGO, "Titularidades fiduciarias", Actualidad Civil, n. 33 (1992), at 555. 101 See J.C. URETA DOMINGO, "Las operaciones burs tiles de los Fondos de Pensiones", in Martinez Lafuente & Others, supra n. 63, at 189 where he makes reference to May Day (1.5.1975) on the NYSE and the Big Bang (27.10.1986) on the London Stock Exchange and the relationship of these events with institutional investors. In comparative literature, see BUXBAUM, supra n. 3, at 16, "A third major institutional inverstor is the pension fund to which the saver, now in the capacity of employee, makes involuntary contributions, at least in the sense that the voluntary employment decision brings with it a collectively (via union) or unilaterally (via employer)". See also CASEY & OTHERS, supra n. 21, at 222 who, regarding the "incidents of ownership of investments" of the pension funds say: "In light of the increasing comlexity and importance of the decisions presented in voting portfolio securities, it would seem that making voting decisions can involve exercising "authority
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purpose is social and their role in the financial market is a consequence of that purpose. The social dimension of the FPs includes their complementary social security aspect as well as their goal of giving access workers to the management of SAs. In this sense, we can distinguish the scheme of direct access from the scheme of indirect access through acquisition of shares or through FPs102. To conclude, the FPs exhibit two profiles in an instrumental relationship. To achieve the social security objective, these entities place the worker's savings in long term investments leading to a direct influence on the corporate control103. 2. The Management of Pension Funds FPs have a trilateral management structure because they are being managed by an EG, with the assistance of depository and under the supervision of the FP Control Commission (arts. 13 LPFP and 29 RPFP)104.
or control respecting management" of plan assets, and make the holder of this power a fiduciary". 102 See BUXBAUM, supra n. 4, at 58 where he compares the American situation with the German context. See in Spanish literature, about the participation of workers in the corporate control, ESTEBAN VELASCO, supra n. 12, at 189 and IDEM, "Participacion de los trabajadores en la empresa y reforma de las sociedades anonimas" (Madrid 1980). See also, G. LEJARRIAGA, "El acceso a la propiedad de la empresa por los empleados", in Manual de fusiones y adquisiciones de empresas, at 195 ff., (Mascarenas & others, Madrid 1992). 103 See J.A. HERCE SAN MIGUEL, "Planes y Fondos de Pensiones. Primera Parte: Consideraciones generales", Papeles de Economfa Espanola, Suplementos sobre el Sistema Financiero, n. 26 (1989) at 14. In the comparative literature, see BUXBAUM, supra n. 4, at 9 and 13. 104 See, from the legal point of view, A.J. TAPIA HERMIDA, "La gestion de los fondos de pensiones. Un anälisis jurfdico", RDBB n. 30 (1988) at 383 and, from the economic point of view, see SAENZ DE JUBERA ALVAREZ, Aspectos economicos de los Planes y Fondos de Pensiones. Una especial referenda a la normativa espanola, at 238 (Madrid 1991) and S. ANFOSSO BORREL, Initiation a los Fondos de Pensiones, at 65 (Bilbao 1988). See also W. STERN, "Nuevas orientaciones en la gestion de los fondos de pensiones," at 103 and G. DENNINS, "Nuevos aspectos de la administration de los fondos de pensiones," at 107, both in Papeles de Economia Espanola. Suplementos sobre el Sistema Financiero. Analisis financiero: Nuevos productos y mercados (Madrid 1980). We must recall die Proposal of Directive on the freedom of management and investment of Pension Funds, presented by the EC Commission on October 21, 1991 and published in the Journal of the EC n. 312, 3.12.91. Finally, we must refer to the internal relationship between pension governance and corporate control as discussed by the COMMITTEE ON THE FINANCIAL ASPECTS OF CORPORATE GOVERNANCE, supra n. 10, at 23.
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a) The FP Control Commission (CCFP) Since PP's assets are owned by its participants and beneficiaries (art.8.4 LPFP) and as such assets are integrated in an FP, FP assets belong to communities of owners. Therefore, the CCFP -eventually made up for several PP Control Commissions- represents the FP owners and have duties of representation of FP and supervision of PP fulfilment, etc. (arts. 14 LPFP and 30 RPFP). There is, in this respect, an important difference between FIMs (or FIAMMs) and FPs because in the investment funds the participants exist separately without any internal body that exercises their collective rights. This difference is very important for the internal control relationships of the two types of institutional investors and, thus, for the corporate control decisions adopted by the two types of institutional investors. b) The Management Firms (EGs) From the point of view of the corporate control which FPs can improve, the fundamental role will have to correspond to the EG, because the brden of the management falls on it105. Two types of EGs exist: a) Exclusive EGs are those special SAs which meet the legal requirements regarding capital, net worth, purpose and domiciles and are registered in the corresponding administrative register (arts.20.1 LPFP and 40.1 and 2 RPFP). b) Secondly, insurance firms authorised to operate in Spain in life insurance, which meet requirements regarding capital, domicile and registration pointed out before (arts.20.2 LPFP and 40.3 RPFP)106. These EGs are legally assigned two types of tasks: a) Firstly, some minimum tasks relative to accounting, to the determination of balance accounts of the position of the PPs in the FP, etc. (art.40.6 RPFP).
105
See URETA DOMINGO, supra n. 101, at 189 and 196. See S. ALBELLA AMIGO, "Aspectos del regimen jurfdico de las Entidades gestoras de Fondos de Pensiones", in Martinez Laftiente & Others, supra n. 63, at 122 and 134. In the comparative literature see G. VOLPE PUTZOLU, "La gestione dei fondi pensione da parte delle imprese di assicurazione vita," in Assicurazzioni, I, at 15 ff., (1988). 106
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b) Secondly, some potential tasks which they will undertake as the CCFP decides and with the limitations that the CCFP deems appropriate. Among these tasks functions are the ones most relevant for corporate control (e.g. the exercise of the rights derived from securities and integrating goods of the FP, choice of investments to be realised by the FP, etc.) (art.40.7 RPFP). From this distinction between their own tasks and delegated ones, it may be deduced that the corporate control that such EGs can exercise comes strongly intercessed by the control over them that CCFP can exercise107. By carrying out these indicated tasks, EGs will earn a management commission which cannot exceed 2% of the net worth of the FP and which can never depend on the outcomes (art.43.1 RPFP), unlike what happens with the SGIICs. c) The Depository Entities The custody of securities and other assets integrated in the FP will correspond to an entity, which has to be a Deposit Entity domiciled in Spain (arts.21.1 LPFP and 41.1 RPFP). It is interesting to emphasize that these entities, together with that custody, monitor EGs on behalf of promoters, members and beneficiaries (arts.21.2 LPFP and 41.2 RPFP). Together with these generic tasks, the Depository will carry out other tasks, among which we can emphasize the execution of buying and selling operations, the charge of profits of investments and materialization of other income and several operations derived from their own deposit of securities, etc. (art.41.6 RPFP). Depository will receive, as remuneration of its services, a freely negotiated payment, but not more than 0.6% of annual nominal value of the net assets in its care (art.43.2 RPFP). d) Common Rules for Management Firms and Depositories The function of monitoring the management carried out by the EG which trusts the depository makes it necessary that both functions fall on different entities, except in exceptional situations arising from substitution of one or the other (art.41.5 and 44 RPFP). Moreover, the EG and the depository must act in the interest of the FPs that they administer and perform custody for and will answer to the promoters, members and beneficiaries for injury that they cause as a consequence to the non-fulfilment of their duties, being required to demand of each other such liability (arts.22 LPFP and 42 RPFP)108. 107
See VERGEZ, supra n. 63, at 120 and ALBELLA, supra n. 106, at 129. See DUQUE DOMINGUEZ, supra n. 63, at 78; VERGEZ, supra n. 63, at 114 and ALBELLA, supra n. 106, at 133. In the comparative literature, see CASEY & OTHERS, supra n. 21, at 219 ff. regarding the "custody of assets" of the pension plans and at 231 ff. regarding the "fiduciary responsability" in the ERISA regulation. 108
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3. Investments and Operations of Pension Funds Under the title "Pension Funds Financial System", the LPFP and the RPFP, in their Chapter V, approach the issues which affect directly the profile of those institutional investors, their possible investments and the conditioning of their operation109. a) Investments of Pension Funds The investment behaviour of FPs is doubly conditioned. From the general and external point of view, by social importance of the function of social security that they carry out; and, from special and internal point of view, by their role as instruments for investments of generated resources according to the foressen conditions in one or several PPs, whose obligations they seek to meet (art.26.3 RPFP)110. Several aspects of FPs investments -in view of their potential influence in corporate control- are better deal with separately: aa) Investment Criteria FPs assets must be invested in accordance with criteria on security, income, diversification and suitability of adequate term of their purpose (arts. 16.1 LPFP and 34.1 RPFP). These criteria establish, albeit genetically, a key I'mitation on the performance of FPs in corporate control111.
bb) Assets in Which the Net Worth of FPs Can Be Invested 90% of the FPs assets have to be invested in financial assets traded in organised markets which are officially recognised and functioning regularly, open to the public or, at least, to financial firms; in bank deposits; in credits with mortgage guarantee and in real estate (arts. 16.1 LFPF and 34.1 RPFP). 109
See J. HUERTA DE SOTO, "Regimen financiero de los Planes de Pensiones", in Martinez Lafuente & Others, supra n. 63, at 169; QUESADA F.J. SANCHEZ, Planes y Fondas de Pensiones: Estudio contable y financiero, at 98, (Madrid 1989) and SAENZ DE JUBERA, supra n. 104, at 241. Recall Proposal of Directive in supra n. 104. 110 See DUQUE DOMINGUEZ, supra n. 63, at 59 and 63 and E. ANGULO RODRIGUEZ, supra n. 97, at 89. In the comparative literature, see CASEY & OTHERS, supra n. 21, at 208 ff. regarding the "Plan Investment Process". 111 See BUXBAUM, supra n. 4, at 18 and 19 regarding the investments of pension funds in USA and in Germany. In particular, see CASEY & OTHERS, supra n. 21, at 237 ff. regarding the principle of "prudence" and at 242 ff. about the principle of "diversification" in ERISA regulation.
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cc) Diversification of FP Investments The regulation of FPs establishes diversification rules (similar to that those for IICs) which operate in relation to the net worth of an FP, as well as in relation to issuer firms. Hence, investment in securities issued or guaranteed by one firm cannot exceed in nominal value, 5% of the total of securities in circulation, while the total sum of investments in the same firm, plus credits given or guaranteed by the same, cannot exceed 10% of the total financial assets integrated in the FP. Particularly, when the degree of risk concentration is deemed high or can compromise financial integrity of the PPs integrated in the FP, the Ministry of Economy and Finance can set special limitations in addition to the former ones, on FP investments in assets which appear in the liabilities of promoting firms of PPs assigned to the FP, of the EG and depository or of enterprises pertaining to the former groups (arts. 16.4 LPFP and 34.4 RPFP). It may be added that, in the case of FPs administered by the same EG or by different EGs belonging to the same group of companies, the former limitations are calculated in relation to the consolidated balance of the FPs (art. 34.7 RPFP). Lastly, we must point out that limitations on the concentration of an FP's securities investments do not apply to securities issued or guaranteed by Spanish State, by foreign public entities, etc. (arts. 16.4 LPFP and 34.5 RPFP). dd) Reference to FP Investments in Spanish Practice The net worth of the FPs in Spain, as well as the number of their members, have experienced a continuing increase from the time of their establishement112. However, their influence in corporate control is still limited because high rates of interest in Spanish financial markets have led to a conservative investment policy that put a small percentage of assets in equities113.
112
According to the figures of the Asociadon de Institutiones de Inversion Colectiva y Fondas de Pensionen (INVERCO) the total assets of pension funds in Spain were on 31.12.1988, 25.430.947.349 ptas. with 317.777 participants and on 31.12.1991 the total assets were 813.764.219.689 ptas. with 842.301 participants. These amounts are small in comparison to developed countries, as United Kingdom, USA, Holland, etc., whose figures were shown by C. LLUCH SAN, "Los fondos de pensiones", Cap. XXXII, in Curso de Introduction a Bolsa, at 875, (Madrid 1987). 113 For example, the portfolio of FONPENSION DE CRECIMIENTO, which is a significative pension fund managed by the BBV group had on 31.12.1991 the 2.72% in Spanish equities and the 0.83% in Foreign equities. Regarding the distribution of FPs portfolios between fixed-interest securities and equities see J. HUERTA DE SOTO, Planes de Pensiones Privados, at 161, (Madrid 1984). Regarding the impact of FP in the Spanish securities market see URETA DOMINGO, supra n. 101, at 203.
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b) FP Operations As regard corporate control, we must emphasize that FPs have to carry out their operations on listed securities in such a way that they influence prices effectively with the concurrence of multiple offers, unless the operation can be carried out on more favourable terms for the FP that those of the market (art. 17.1 LPFP and 35.1 RPFP)114. £. Insurance Firms 1. Concept Insurance activity in Spain can only be carried out by private or public companies if they comply with legal conditions (arts. 7 LOSP and 17 ROSP). The corporate purpose of these insurance firms will be the practice of insurance operations, reinsurance and capitalisation (arts. 8 LOSP and 18 ROSP)115. The different legal form of insurance companies permit them to develop various branches of insurance (life, surety for credits and tort liability, accident, illness and travel assistance, and so on) and requires them to count on corporate capital or adequate mutual funds (arts. 10 LOSP and 21 and 22 ROSP)116. 2. Management It is evident that the management system of insurance companies depends directly on the legal form that these have adopted. However, some applicable rules of a general nature exist for insurance firms (i.e. composition of the Board of Directors) which can influence their behaviour as institutional investors (arts. 11.1 and 40 LOSP). It is necessary to bear in mind that the exercise of insurance activity, its advertising, as well as the financial situation and the solvency of insurance companies are subject to the control of the State through
114
See URETA DOMINGO, supra n. 101, at 200. See also CASEY & OTHERS, supra n. 21, at 217 ff. regarding the "execution of investment transactions". 115 Regarding the former Regulations see F. SANCHEZ CALERO Curso de Derecho del Seguro, Vol.1, at 111 ff., (Bilbao 1961), and regarding the current Regulations see F. DEL CANO ESCUDERO & J.R. DEL CANO PALOP, Comentarios al Reglamento de Ordenacion del Seguro Privado, at 66, (Madrid 1987). 116 See SANCHEZ CALERO, supra n. 45, at 580 ff; VICENT CHULIA, supra n. 23, at 481 ff.; DEL CANO ESCUDERO, supra n. 115, at 79 ff. and CUERVO, supra n. 65, at 382 ff. In Portuguese law, see "Decreto-Lei" n. 188/1984, of July 5, on insurance activity ("Acesso ä actividade seguradora") reprinted in CAEIRO, supra n. 64, at 1051 ff.
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the Ministry of Economy and Finance (arts. 22 LOSP and 42 ROSP, Chapter IX LOSP and Chapter X ROSP)117. 3. Insurance Companies' Investments a) Regulation As pointed out earlier, insurance companies are institutional investors of the second degree in the sense that their investment in securities is not an aim in itself, but a consequence of their corporate purpose which is carrying out insurance operations. It is precisely the need to invest their own net worth which has to be maintained as a margin of solvency and fund of guarantee (arts.25 LOSP and 76 ff.ROSP) as well as the need to invest their technical reserves which determine their profile as institutional investors and their potential intervention in the market for corporate control. In this particular, the technical reserves of insurance companies must be invested in accordance with congruence, security, liquidity and income principles (art. 24.2 LOSP)118. Among the assets suitable for investment of technical reserves -which are grouped into five categories: treasury household, securities, credits, real estate and other investments (arts. 62.1 and 64 ROSP)119 - there are various categories 117
Regarding the former Regulations see L. BENITEZ DE LUGO REYMUNDO, Tratado de Seguros, Vol. IV, at 82 ff., (Madrid 1955). Regarding the current Regulations see S. MARTIN RETORTILLO, "La empresa aseguradora: marco institucional de su ordenacion jurfdico-administrativa", in Comentarios a la Ley de Ordenaclon del Seguro privado, Vol. I, at 57 ff., (E. Verdera Υ Tuells, ed., Madrid 1988); E. CABALLERO, "El control estatal del seguro y el rSgimen de libre concurrencia", Revista Espaflola de Seguros n. 14 (1978), at 197 ff. and DEL CANO ESCUDERO, supra n. 115, at 129. 118 See BENITEZ DE LUGO, supra n. 117, at 360 ff.; J.L. CARCELLER, J.L., "La materializacion de las reservas de las entidades de seguros", Hacienda Publica Espaflola, n. 12, 1971, at 103 ff.; J. FERNANDEZ PALACIOS, "Garantfas fmancieras durante el funcionamiento: El tratamiento de las provisiones t&nicas, margen de solvencia y fondo de garantfa", in Verdera, supra n. 117, at 575 ff. and DEL CANO ESCUDERO, supra n. 115, at 197. In the comparative literature, see BUXBAUM, supra n. 3, at 16, "A second major type of institutional investor is the private insurance company which increasingly offers the saver a mixed insurance and investment package -the variable annuity- that combines the two motives for the purpose of a deferred payout". 119 See BENITEZ DE LUGO, supra n. 117, at 366 ff.; SANCHEZ CALERO, supra n. 115, at 170 ff.; FERNANDEZ PALACIOS, supra n. 118, at 581 ff. and DEL CANO ESCUDERO, supra n. 115, at 178 ff. Compare with M. PAWLEY, D. WINSTONE & P. BENTLEY, U.K. Financial Institutions and Markets, at 91, (London 1991), "The nature of the investment portfolio is decided in relation to the type of business which the company is underwriting and the need to match the
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of securities susceptible of having influence in the market for corporate control. Among the securities that are not susceptible to influence in the corporate control we can mention, the financial assets of monetary market, debts of the Treasury, securities representatives of Public Debt, etc.. Among the securities susceptible to influence corporate control, we can mention equities that are listed in stock exchanges, securities denominated in foreign currency, etc. (art. 64.2 and 65 ROSP). Moreover, insurance companies must diversify their investments (art.70 ROSP). b) Reference to Spanish Practice Insurance companies' investments share the characteristics of those of other institutional investors previously analysed (IICs and FPs). That is, their portfolios are mainly composed of securities representative of Public Debt, followed by other securities of fixed-interest and a very low percentage of equities120. From the composition of portfolios we can deduce that they have only a modest influence on corporate control as well as an effect of financial results on insurance results121. Certain recent decisions can be pointed out in the insurance sector such as the agreement by ten Spanish companies to create a common information system to improve the process of taking decisions regarding their investment portfolios122. F. Credit Entities 1. Concept, Classification and Management Although the credit entities fulfil in capital markets a predominant role as a financial intermediaries, their central role in the market for corporate control require us to refer to them, even if only very brief123. investment portfolio with the potential cash requirement needed to meet claims". 120 In 1990, insurance companies invested 649.886,23 mn. ptas in Public Debt Securities; 412.264,98 mn.ptas in fixed-interest securities and 268.405,54 in equities (see Cinco Dias 12.5.1992, pag.3). The perspectives for investments in 1991 were 55.2% of the portfolio in fixed-interest securities (public and private) and 13,4% in equities (see "Expansion," 24.1.1992, at 13). Compare with PAWLEY, supra n. 119, at 91: "Portfolios are a mixture of Government securities, equities, debentures, property holdings and the like". 121 For example, in 1990, the technical and financial profit of the insurance companies in Spain was 27,514 mn. ptas. and the benefit for investments was 244,023 mn. ptas. (see Expansion, 24.1.1992, at 13). 122 See Cinco Dias, 24.4.1992, at 10. 123 In the comparative literature, see BUXBAUM, supra n. 5, at 8 regarding the behaviour of "German Grossbanken" and BAUMS, supra n. 12, at 5.
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In accordance with EC Directive 77/780, the Spanish Law defines the credit entity as any enterprise that has, as its typical and habitual activity, receiving funds from the public in the form of deposits, loans, cession of financial assets or other analogous transactions that imply a duty of restitution, applying them for their own account to the concession of credit and analogous operations (art. 1 Royal Legislative Decree 1298/1986, according to the text introduced by the art.39.3 LDIEC)124. The list of credit entities -that includes public banks, private banks, savings banks, etc.- embraces entities which are heterogeneous in their legal form (SAs, cooperative companies, etc.), in their private or public nature and in their universal or limited capacity125. The same difference in legal structure determines the existence of various management systems. In particular, as far as corporate control is concerned, one must bear in mind that private banks are SAs with a Board of Directors (art.2 Royal Decree 1144/1988126. 2. Credit Entities and Corporate Control Credit entities can carry out several active roles in the field of corporate control: As they perform active operations as lenders to companies, they exercise a certain external control127. As they are shareholders which invest their assets in shares of financial, industrial or commercial companies, they dominate these directly or by creating an industrial corporation (for example, in Spain, the "Corporacion Industrial y Financiera de Banesto")128. 124
See F. SANCHEZ CALERO, "La delimitacion de la figura de entidad de cretlito y la de otros sujetos", in "El proyecto de Ley de Disciplina e Intervencion de Entidades de crodito", RDBB n. 28 (1987) at 709; TOMAS-RAMON FERNANDEZ, "El concepto de entidad de cr6dito y su ambito", in Comentarios a la Ley de Disciplina e Intervencion de las Entidades de Cridito, at 28, (Madrid 1989) and A.J. TAPIA HERMIDA, "Aspectos generales de las actividades parabancarias en el Derecho espanol", RDBB n. 47 (1992), at 631 ff. . 125 See SANCHEZ CALERO, supra n. 45, at 526 ff., TOMAS-RAMON FERNANDEZ, supra n. 124, at 29 and TAPIA HERMIDA, supra n. 124, at 633 ff.. In Portuguese law, see "Decreto-Lei" n. 23/86, February 18, regarding access to banking activity ("Acesso ä actividade bancaria") and "Decreto-Lei" n. 24/86, February 18, regarding constitution of commercial and investment banks (" Constitugao de bancos comerciales e de investimento") reprinted in CAEIRO, supra n. 64, at 1068 ff. and 1083 ff. 126 See M. BROSETA PONT, "Referencias al regimen de los bancos", supra n. 124 ( 1 Proyecto de Ley..."), at 739. 127 See BAUMS, supra n. 12, at 4, 5 and 18. Regarding the consequences of the pledges of secutities in corporate control see WEIGMAN, supra n. 8, at 1100. 128 See BAUMS, supra n. 12, at 8. Compare with the situation in U.S. banking described in R.J. BRUEMMER & M.S. HELFER, "Interstate Nonvoting Equity Agreements and Control under the bank Holding Company Act: The Impact of the
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In particular, they are intermediaries in the securities market, providing a series of banking services that have a decisive influence on corporate control. Credit entities with unlimited capacity can carry out in Spanish securities market, among others, the following activities (arts.71 and 76 LMV): a) Operating on behalf of their holders as depositories of securities represented in form of titles or as administrators of securities represented by account entries (art.71.k LMV). In Spanish law, the depositors of securities are obliged to practise, in general, all acts that are necessary so that those securities conserve their value and their inherent rights (art. 308 Cdec). This field of securities deposit has had a very important effect on corporate control inasmuch as the bank depositors obtain proxies from absentee shareholders in order to use them for their own benefit. This relationship between deposit of securities and corporate control was manifested in relation to the regulation of the public application of representation in the new 1989 LSA, which in its article 107 establishes certain precautions for proxy statements and voting instructions. b) Managing their customers' portfolios (art.71.j LMV), in as much as portfolio management agreement allows them a very broad discretionary power. c) Mediating for the account of the issuer in placing of securities offerings and insurancing the subscription of securities offerings (art.71, c and d LMV). These activities can have important consequences in the market for corporate control129.
IV. Institutional Investors and the Legal Techniques for Corporate Control in Spanish Law A. General Observations The relation between legal techniques of corporate control and institutional investors is characterised by a bilateral or ambivalent feature: Federal Reserve Board's 1982 Policy Statement", The Business Lawyer Vol.39 (February 1984), at 383. 129 See J. GARRIGUES, Contratos bancarios, at 410, (Madrid 1975); GIRON TENA, supra n. 12 ("Las reformas..."), at 3; A.J. TAPIA HERMIDA, "Los contratos bancarios de deposito, administracion y gestion de valores negociables", in Contratos Bancarios, at 603 ff., (Garcia Villaverde, ed., Madrid 1992) and IDEM, supra n. 124, at 641 ff. In comparative literature, see WEIGMAN, supra n. 8, at 1099 and 1100; BUXBAUM, supra n. 4, at 51 regarding the "Großbanken" and the "Depotstimmrecht" in Germany and BAUMS, supra n. 12, at 2.
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a) From the point of view of the control techniques, the ambivalence is clear because it deals with techniques of acquiring as well as relinquishing control and also because they can developed in a friendly or hostile context130. b) From the point of view of the institutional investors, the bilaterality exists because they can be active or passive subjects of corporate control and because they can exercise control in a direct or indirect manner131. From these various configurations we can deduce that the relationships of corporate control by institutional investors are multiple, flexible and changeable132. Another issue which must also be recalled is the "exponential effect" that the behaviour of institutional investors can have on the behaviour of investors and intermediaries in the securities market. Institutional investors not only follow the tendencies of the market but they also mark them in a more or less limited manner133. This exponential effect is not only projected to the dimension of the securities market as a market of financial assets, but also extends, moreover, to the aspect of that market which channels the market for corporate control. Hence, the behaviour of institutional investors in the market for corporate control marks tendencies in such market. Lastly, it must be remembered that in Spain, institutional investors have escaped from the stock exchanges in pursuit of fixed-interest securities in a context characterised by high rates of interests134. This effect is neither good for such investors who reduce their area of investment; nor for the stock exchange, 130
See BUXBAUM, supra n. 4, at 3 regarding the implications of these institutional investors for the merger and takeover movement of the 1980,s. 131 Regarding the juridical techniques of control, see EMBID IRUJO, supra n. 23, at 37. 132 Regarding the risks of the excessive power of institutional investors in corporate control in the American Crash of 1929 see GALBRAITH, supra n. 1, at 205. See also, THE BUSINESS ROUNDTABLE, supra n. 12, at 245 regarding "the governance tension -innovation versus control", where they say: "The tension between innovation and control is a central issue of corporate governance. It is an issue that exists at all levels of corporate governance. For instance, at international economic level, it is clera that the exercise of control of the central planned economic systems has dismished innovation and efficiency when compared with the much freer market economies". 133 See BUXBAUM, supra n. 3, at 21, "As already suggested, the very size of these institutional savings dictates an investment policy that seeks to reflect existing markets rather than to outperform them". 134 Institutional investors had the following percentages of their portfolios in stock exchanges (figures in Cinco Dias, November 23, 1991, at II): investment funds, in January 1991, 4,17% and in November 1991, 1,93%. Pension Funds, in January 1991, 1,00% and in November 1991, 1,00%. Insurance companies, in January 1991, 21,3% and in November 1991, 7,7%.
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which sees big flows of investments, qualified by their estabilizing effect, escape; nor for the market for corporate control, which is being deprived of resources needed for its efficiency135. B. Notification of Significant Shareholdings and Institutional Investors 1. The Legal System The system for reporting acquisitions or transfers of significant shareholdings in listed companies has been established for the first time in article 53 of the LMV and has been developed further by Chapter I of Royal Decree 377/1991, of 15 March, on Notification of Significant Shareholdings in Listed Companies and Acquisitions by such Companies of Treasury Stock; by Ministerial Order on 23 April 1991 and by Circular 2/1991 of the CNMV, of 24 April, which establishes the forms of reports136. This system does not regulate properly techniques for acquisition or cession of control, but only the disclosure and transparency of control relationships137. The essential features of the regulatory scheme contained in such dispositions consist on the imposition of an obligation to report to the listed company affected, to the Stock Exchange Management Companies ("Sociedades Rectoras de las Bolsas de Valores") of respective stock exchanges and to CNMV, regarding purchases and sales of shares of listed companies that make the acquirer reach or descend respectively from 5% of total equity and all multiples thereof. The report has to take place within seven working days following the operation and will be made public. 2. Institutional Investors as Buyers and Sellers of Significant Participations in Listed Companies All types of institutional investors can acquire, at a minimum, up to 5% of the securities issued in one company. In fact, IICs can concentrate their investment to a maximum of 5% in securities issued or guaranteed by one firm; just like FPs. Insurance companies and credit entities can also reach that percentage of concentration. Therefore, all categories of institutional investors can sale shares of listed companies which lower the percentage of capital left below 5 %. The 135
In the Spanish literature, see VERDERA, supra n. 18, at 125 and 126 regarding the effects of investment funds on the stock exchange. See also WEIGMAN, supra n. 8, at 1091 regarding the effets of concentration of investment power in few hands. 136 As to Royal Decree 377/1991, see CNMV, supra n. 1, at 219. Regarding the adaptation to the EC Directive 88/627, see TAPIA HERMIDA/SANCHEZ-CALERO GUILARTE, supra n. 83, at 993. See also ARRUNADA, supra n. 15, at 202 ff. In Portuguese law, see arts.345 ff. of "Codigo do Mercado de Valores Mobiliarios" ("Decreto-Lei" n. 142-A/91). 137 See CNMV, supra n. 5, at 126 regarding the reporting of major shareholdings.
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legal consequence of the purchases and sales will be the obligation to report which will devolve upon the institutional investor. In the case of a companytype institutional investor (i.e. SIM, SIMCAV, insurance company, private bank), its administrative organ will be responsible for the reporting requirement (art.8.2 of Royal Decree 377/1991)138. In the case of an institutional investor of contractual structure (i.e. FIM or FP), the duty to report will correspond to its management company (SGIIC of an FIM or EG of an FP, respectively). 3. The Special Reporting System and Disclosure of Significant Shareholdings in IICs Article 5 of LIIC and article 6 of RIIC establish a specific system of reporting and disclosure of significant shareholdings in IICs, which acts in a subsidiary manner with respect to the general system formerly described, in the case of SIMs or SIMCAVs whose shares are listed for trading on the stock market (art. 13 RIIC)139. In accordance with this specific system, the shareholder or participant who buys, sells or obtains the reimbursement of shares or participations issued by IICs and, as a result of such operations, the percentage of capital or net worth reaches, exceeds or falls below determined percentages, is required to make corresponding reports. The heterogeneous composition of the IICs category reflects this system in different specialities: Firstly, the heterogeneous legal structure of IICs reflects the different significant participation percentages, which are 5% and its multiples for SIMs and SIMCAVs and 20% and its multiples for FIMs and 138
See art.7 of the Ministerial Order of April 23, 1991 providing for special regulation of the reporting of major shareholdings by SIMCAVs. Compare with the American practice described in T.P. LEMKE & G.T. LINS, "Disclosure of Equity Holdings by Institutional Investment Managers: An Analysis of Section 13 (f) of the Securities Exchange Act of 1934", The Business Lawyer, Vol.43 (November 1987), at 93 where they said: "For nearly a decade, large institutional investment managers have been reporting detailed information about equity holdings under their investment discretion to the Securities and Exchange Commission ("Commission" or "SEC"). This information is filed pursuant to the institutional disclosure program mandated by section 13(f) of the Securities Exchange Act of 1934 ("1934 Act"). Added as part of the Securities Act Amendments of 1975, this provision requeres the Commission to create a reporting and disclosure system to collect specific information concerning the investment activities of institutional investment managers". 139 See Section Two of the Ministerial Order of July, 30, 1992 (supra n. 80). The CNMV, supra n. 5, at 120 says: "Significant shareholdings. This area has been reorganised to adapt it to the Securities Market Law, and there has been a modification in the percentages regarded as "significants", while these rules have been extended to apply to portfolio management firms, which had not been included in the previous norms. Likewise, the format for public notification has been established, and a public "registry of Major Shareholdings" has been created".
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FIAMMs (art.5.2 RIIC). This reveals the different view that the Spanish legislator has of control relationships within each type of IIC. Secondly, the heterogeneous functioning of IICs leads to the establishment of a system of reports by the shareholder and the IIC of closed-end nature (SIM) and a different reporting system for SIMCAVs or for SGIICs of FIMs or FIAMMs (art.6.1 y2). C. Takeover Bids and Institutional Investors 1. Legal System Takeover bids in general and hostile ones in particular constitute the fundamental technique that creates a market for corporate control140. The legal regulation of takeover bids in Spanish law starts with article 60 of the LMV, which has been the object of regulatory development through Royal Decree 1197/1991, of July 26141; a measure that is inspired directly by the modified Proposal of 13th. Directive on Company Law in the EC, from which it differs, however, in some essential respects 142. 140
See J.M. GARRIDO, "Täcticas defensivas frente a ofertas de adquisicion hostiles: la experiencia anglosajona", RDBB n. 42 (1991), at 356 regarding the role of hostile takeovers; J.L. URQUIJO, "Las OPAS y el Mercado de Control", in La lucha por el control de las grandes sociedades. Las Ofertas Publicas de Adquisicion, at 517 ff., (Sanchez Andres & others, eds., Madrid 1992) and J. MASCARENAS, "Adquisiciones hostiles", in Mascarenas & Others, supra n. 102, at 93 ff. Generally, see EMBID IRUJO, supra n. 23, at 38 ff. 141 See CNMV, supra n. 1, at 221 regarding Royal Decree 1197/1991. In the Spanish literature, see SANCHEZ CALERO, supra n. 10, at 936. In Portuguese law, see arts.523 ff. of the "Codigo do Mercado de Valores Mobiliarios" ("Decreto-Lei" n. 142-A/91) and their commentary in J.M. JUD1CE, M.L. ANTAS, A.A. FERREIRA & J. DE BRITO PEREIRA, . Ofertas Publicas de Aquisifao. Legislacao Comentada (Lisbon 1992). 142 Regarding the EC Regulation see K. HOPT, "La regulation europea sobre ofertas publicas de adquisicion," at 19 ff.; E. WYMEERSCH, "Las ofertas publicas de adquisicion obligatorias. Una vision crftica," at 47 ff. and G. ARRANZ, "El proyecto de directiva comunitaria y la normativa espanola," at 67 ff.; these three papers have been published in Sanchez Andres & Others, supra n. 141. See also U. IMMENGA & B. NOLL, Feindliche Übernahmeangebote aus wettbewerbspolitischer Sicht (Studie erstellt der Kommission der Europäischen Gemeinschaften. Generaldirektion IV) (Göttingen, Juni 1990); SIMMONS & SIMMONS, "European Community Regulation", in A Practitioner's Guide to European Take-over Regulation and Practice, at 75 ff., (P. Sutherland, ed., London 1990); TAPIA HERMIDA & SANCHEZCALERO GUILARTE, supra n. 83, at 1000 ff. and BUXBAUM, supra n. 4, at 29. Regarding the general guidelines of Spanish regulation, see CNMV, supra n. 5, at 131, which explains the two basic principles that guide the CNMV in its approach to
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The fundamental features of the Spanish takeover bids regulation -which reaches the companies which are entirely or partially quoted- can be synthesized in three principles143: a) Firstly, the Spanish scheme tends towards a system of "a priori" or preventive takeover bids; making the takeover bid an obligatory way to acquire a significant interest (art. 1.1 RD 1197/1991). This first characterisation contrasts with the conception of "a posteriori" or succesive takeover bid, i.e., as a consequence of the acquisition of a significant interest, that is present in the modified Proposal EC Directive (art. 4). b) Secondly, and regarding what we could call the takeover bid's "point of outlay", the system is established for "a priori" determination of percentage of the interest which is considered significant, whose acquisition gives rise to the obligation to make a takeover bid. It is set to 25% and 50% of the capital actual or potential- with voting rights of the offeree company (art. 1.2 RD 1197/1991). Here also the prevailing Spanish system differs from the projected EC system because the modified Proposal Directive sets the percentage at 33.3% of the capital with voting rights of the offeree company (art.4). c) Lastly, and as regards takeover bid's "point of arrival", Spanish regulation admits, in general, partial takeover bids, i.e., takeover bids directed at only one part of the capital of the offeree company, restricting it only as regards certain percentages of acquisition (10% of acquisition or 75% of voting capital) (art. 1.2 RD 1197/1991). Only in special situations, in case of takeover bids involving amendment of by-laws, delisting etc. (arts.5 and 7 RD 1197/1991) is the offerer required to direct its bid to all voting shares of the offeree company. Here the prevailing Spanish system differs from the system projected in the EC as the modified Proposal Directive establishes, in all cases, an obligation to takeover bids. These are the generic protection of shareholders in situations of effective change of control and the endeavour to guarantee that the premium offered by the bidder for control is shared equitably by all company's shareholders. 143 See SANCHEZ-CALERO GUILARTE & A.J. TAPIA HERMIDA, "The Spanish Bill on takeovers", The Company Lawyer, vol.13, No.9 (1992), at 190 ff.; J. ZURITA, "El rigimen espafiol de la OPA: anälisis del Real Decreto 1.197/1991, de 26 de julio", in Sanchez Andres & Others, supra n. 141, at 91 ff.. See also SANCHEZ CALERO, supra n. 45, at 510 ff.; VICENT CHULIA, supra n. 23, at 392 ff.; A.J. TAPIA HERMIDA. "El nuevo rigimen de las ofertas publicas de adquisicion de valores", RDBB n. 43 (1991) at 836; ARRUNADA, supra n. 15, at 182 ff.; J. GUITARD MARIN, "Principales innovaciones en el rogimen jurfdico de las OPAS establecidas por el Real Decreto 1197/1991, de 26 de julio", in Derecho de los Negocios, at 1 and A.J. TAPIA HERMIDA, "La regulation de las ofertas publicas de adquisicion de valores en el ordenamiento Juridico Espanol", in Mascareftas & Others, supra n. 102, at210ff.
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make a complete takeover bid (art. 4). The Spanish regulation provides for several types of takeover bids: 1. Takeover bid in the event of acquisition or increase of a significant interest (arts.l t o 4 R D 1197/1991). 2. Takeover bid in the case of an amendment to the by-laws (arts.5 and 6 RD 1197/1991). 3. Takeover bid in the event of delisting (exclusion of quotation) (art.7 RD 1197/1991). 4. Voluntary takeover bids (art.8 RD 1197/1991). 5. Reduction in capital through the acquisition of the company's own shares (art.9RD 1197/1991). 6. Competing bid (arts.31 to 36 RD 1197/1991). The Spanish regulatory system is a consequence of a firm and comfortable attitude to the takeover bid that Spanish law has adopted, as a result of a similar attitude in EC law144. Nevertheless, in Spanish financial practice, the takeover bids do not play a relevant role in the market for corporate control inasmuch as a great part of them have been bids previous to the exclusion of quotation or friendly bids which have tried to restructure markets with much public intervention (i.e. the electricity sector). Hostile takeover bids have been crowned with the most absolute failure.
144
The CNMV, supra n. 5, at 133 says: "As with other operations with securities, takeover bids must observe the strictest fulfilment of transparency requirements". As regards to the Spanish practice in 1991, the best description is contained in the CNMV, supra n. 1, at 177. See A. SANCHEZ ANDRES, "Teleologfa y tipologfa de las ofertas publicas de adquisicion en la nueva regulacion espafiola", in Sanchez Andres & Others, supra n. 141, at 3 ff. Compare this European and Spanish faith in positive role of takeover bids and, therefore, in the need to limitate the powers of offeree companies' boards of directors with the American controversy. In this last sense see M. LIPTON, "Takeover Bids in the Target's Boardroom", The Business Lawyer Vol.35 (November 1979) at 101 stating: "The heightened level of takeover activity during the past five years has focused the attention in the legal, moral and practical questions faced by the directors of company that becomes the target of an unsolicited takeover bid". For a different view, see F.H. EASTERBROOK & D.R. FISCHEL, "Takeover Bids, Defensive Tactics, and Shareholders Welfare", The Business Lawyer, Vol.36 (July 1981) at 1733, "In Lipton's view, hostile tender offers jeopardize the economy because they jeopardize planning, encourage speculation, and divert resources awway from productive investments". Finally, see E.N. VEASEY, J.A. FINKELSTEIN & R.J. SHAUGHNESSY, "The Delaware Takeover Law: Some Issues, Strategies and Comparisons", The Business Lawyer, Vol.43 (May 1988) at 865.
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2. The Active Role of Institutional Investors in Takeover Bids Institutional investors can develop several active roles in the takeover bids which will be given in detail: a) Institutional Investors as Offerers The possibility that an institutional investor acts as offerer in a takeover bid process is conditioned by rules regarding diversification of its portfolio and by the type of takeover bid in question. The form in which an institutional investor can formulate a takeover bid depends on its legal structure. aa) IICs as Offerers IICs can neither formulate a takeover bid in the event of acquisition or increase of a significant interest nor can they bid in case of amendment of by-laws, nor can they do competing bids because that would lead them to acquire an interest, of at least 25% of the voting stock of one company, contrary to their 5% maximum diversification rules (arts.4.2.a LIIC and RIIC). However, certain categories of IIC, such as SIMs or SIMCAVs, can be required by CNMV to make a takeover bid in the event of delisting. Similarly, IICs can make voluntary bids at their own convenience. Moreover, SIMs and SIMCAVs can be required to make a takeover bid in the event of reduction in capital through the acquisition of the company's own shares. When IICs are required to launch a takeover bid or make it voluntarily, the consequences will differ according to wether the IIC has company structure (SIMs or SIMCAVs) or contractual structure (FIMs). In the first cases, no special problems exist because such IICs enjoy juridical personality as special SAs. It should be recalled that the decision to pursue the bid, in such cases, will correspond to the Board of Directors, except when the decision is adopted by the General Meeting itself, or an equivalent body (art. 12.2 RD 1197/1991). In the case of a FIM, its SGIIC should act on behalf of the participants. bb) The Remaining Institutional Investors as Offerers As regards FPs, it must be pointed out that the diversification rules for their investments impede them from making takeover bids in the event of acquisition or increase of significant interest, in the event of amendment of by-laws, and also competing bids which reach or equal the 25% of capital of the offeree company, because they cannot invest more than 5% of their net worth in securities issued or guaranteed by the same entity (art. 16.4 LPFP). In the same way, its own nature eliminates the possibility of being required to make takeover bids in the cases events of delisting or reduction of capital.
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As regards insurance companies, given their freedom to dispose of their net worth, nothing impedes them from being the owner of all shares of a quoted company and, in consequence, no obstacle exists to an insurance company being required to make a takeover bid to acquire or increase a significant interest or to amendment by-laws of a quoted company, a competing bid, a takeover bid in the event of delisting or a takeover bid in case of reduction of capital, or lastly, a voluntary bid. In such cases, since insurance companies can have a variety of forms of organization, they will have to apply, as far as decision to formulate a takeover bid is concerned, the equivalence between bodies which art. 12.2 of Royal Decree 1197/1991 refers. Finally, credit entities can be obliged to make all types of takeover bids or formulate them in voluntary manner. It must be pointed out in this case, as for insurance companies, that different company types that serve as channels for credit entities (i.e. private banks are special SAs versus credit cooperatives that are cooperative companies) will make it necessary to take into account such differences at the moment of taking the decision to make a takeover bid (in accordance with art. 12.2 RD 1197/1991). b) Institutional Investors that Act on the Offerer Scene In practice, institutional investors -especially FIMs or FPs- can be utilised by the main offerer in the course of a takeover bid. In this sense, such investors can appear in various roles: a) Institutional investors belonging to the same group of companies, as defined in article 4 of the LMV, governed by the offerer company. In the case of these could be FIMs and FPs, control relationships exist regarding SGIICs and EGs, respectively. b) Institutional investors acting -acquiring shares- in their own name but for the account of the offeror. c) Institutional investors acting in concert with the offeror145. The common consequence in the three cases is that shares or other securities owned by such institutional investors will be considered owned by the offeror for the purpose of computing the significant interest (art.2.1 RD 1197/1991). To this effect, it is important to remember that the mere redistribution of 145
Compare with D.C and J.Y.M., "N..- L'arret Devanlay sa/ Galeries Lafayette un triple interet jurisprudentiel: le contröle judiciaire des decisions des CBV, la notion d'action en concert, la notion de contröle majoritaire en droits de vote entire de portage des procedures de garanties de cours et d'OPA obligatoires," Revue des Societes, n. 1, Janvier/Mars (1992), at 82 regarding the concept of acting in concert.
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securities among companies of the same group, without any alteration in the unity of decision-making or control thereof, shall not entail any obligation to make a takeover bid (art.2.2 RD 1197/1991). A second consequence of this role subordinated to the offeror of institutional investors is the extension of certain limitations on offerer's action to them; limitations established in the article 23 of the RD 1197/1991 (dealing with the "limitation on the action of the offeror and automatic modification of the bid"). 3. The Passive Role of Institutional Investors in Takeover Bids a) Institutional Investors as Acceptants The fundamental passive role that institutional investors can assume -as far as investors are concerned- before a takeover bid consists of accepting it. It is evident that the premium over market value that offerers offer to potential acceptants when it deals with an takeover bid made to acquire or increase their control, leads institutional investors, in general, to be willing to accept the bids, be they fiendly or hostile. From the point of view of the investment value inherent to shares, the perception of an extra-premium of control contributes to improve institutional investors' results. Only in those cases wherein the institutional investor has an interest in maintaining a position of control, will it make comprehensible not to accept the takeover bid. However, in these cases it can be difficult for their managers to demonstrate that they acted in the shareholders' or participants' interest, if they have acted to benefit the group that controls the institutional investor's management body. On the other hand, the acceptance, in Spanish law, of partial takeover bids states a problem as regards equitable treatment of individual and institutional investor146. 146
Recall the words of H. Bosch - cited by I. RAMSAY, "Balancing Law and Economics: The Case of Partial Takeovers", The Journal of Business Law (July 1992), at 369 - with regard to this problem: "By far the most important of these changes was the virtual elimination of partial takeovers. When I came to the Commission many senior businessmen told me that partials were the worst feature of our takeover system and I was glad to use my influence to help restrain them. By 1986 pro-rata partials had become extremely common. They provided a cheap means by which offerers could gain control of a company without buying the majority of its shares. They left a large part, usually a majority of the equity capital in the hands of shareholders whose ability to influence the affairs of a comnpany was always diminished and in many cases had disappeared. It later became apparent that many of those groups of shareholders were unfairly disadvanteged by the new controllers. Of more immediate concern in 1985-86, was that pro-rata offers frequently created a stampede to sell as shareholders tried to avoid being locked in. In such circumstances individual shareholders were usually at a severe disadvantage against the institutions". Regarding the other problems, see F.H. EASTERBROOK, & D.R. FISCHEL, supra n. 144, at 1734 stating: "A cash tender offer a premium over the market price gives each shareholder the opportunity to obtain
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b) Institutional Investors as Offeree Companies Institutional investors have to meet a double requirement in order to be offeree companies directly affected by takeover bid: a) A prime and elemental requirement is that the institutional investor have a company structure and, more particularly, a SA form (see art. 1.1 RD 1197/1991). This first requirement eliminates those institutional investors without company form (i.e. FIMs or FPs) or with a cooperative corporate form (i.e. as occurred to certain categories of insurance entities or credit entities). b) A second requirement is being a listed company, all or part of whose shares are listed on the stock exchange (see art. 1.1 RD 1197/1991). Institutional investors can belong to the the field of the offeree company or act in concert with it147. The fundamental consequence of the role of offeree company is the imposition of important limitations on the actuation of its board of directors. These limitations also apply to companies belonging to the same group as the company a return exceeding the current value of his stock". See WEIGMAN, supra n. 8, at 1092 regarding the role of institutional investors in the hostile takeovers and BUXBAUM, supra n. 4, at 31 ff.. We can compare the position of shareholders or participants in institutional investors with the position of shareholders in general and recall the paper of J.C. McINTYRE, "Shareholders' Recourse under Federal Securities Law against Management for Opposing Advantageous Tender Offers," The Businnes Lawyer vol.34 (April 1979), at 1283. 147 In the European context, see RABINOWITZ, supra n. 35, at 3315 where he says that, among the "defensive measures in the face of a bid," there is the "purchasing shares in the market". In particular, he says: "A factor in these purchases may be S.Co's merchant bank, using the bank's own funds and perhaps those of invesment trusts, unit trusts and pension funds managed by it". See also Y.E. VAN GERVEN, "In Search for an Efficient and Equitable Balance between Hostile Takeover Attempts and Defensive Tactics," in D.P.C.I., Tome 16, n. 3 (1990), at 518 about "the actual limits imposed by the primary purpose test on Board discretion: a motive analysis" in relationship with the ESOP and ESOT action. In the Spanish literature, see GARRIDO, supra n. 140, at 372 and 373 about the employ of ESOTS and ESOPS and BLANCO J.M. FERNANDEZ & C.A. SCHWARZ, "Medidas de rechazo de una OPA hostil en el Derecho holandes," RDBB n. 33 (1989), at 139. In the American literature, compare the opinions of S.A. HOCHMAN & O.D. FOLGER, "Deflecting Takeovers: Charter and By-law tecniques," The Business Lawyer, Vol.34 (January 1979), at 551 regarding "external friendly transactions"; J.H. HALPERIN, "Tender Offers and Employee Stock Options," The Business Lawyer Vol.34 (April 1979), at 1375 and A.G. BRECHER, S. LAZARUS III & W.A. GRAY, "The Function of Employee Retirement Plans as an Impediment to Takeovers," The Business Lawyer Vol.38 (February 1983), at 503.
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concerned and to any person who may act in conceit with the latter (art. 14 RD 1197/1991)148. D. Company Mergers and Institutional Investors 1. Legal System The legal system for mergers in Spanish law is contained in Section 2, Chapter VIII of the LSA (arts.233 to 251), which adapted the Spanish system to the Third EC Directive in Company Law149. The essential features of this regulation are: a) Firstly, the basic distinction between merger by the creation of a new company or by absorption of one or more SAs by another SA (art.233 LSA)150. b) Secondly, the extinction of the merged or absorbed SAs by a dissolution without liquidation and in the transfer in block of their respective net worth to the newly-created SA or to an absobent SA (art.233 LSA). c) Thirdly, the establishment of an "aristocratic" merger procedure which starts with the elaboration by managers of a merger plan (arts.234 and 235 LSA) and which has to be accompanied with an expert report (art. 236 LSA) and other report of their own managers (art.237 LSA). These plan and reports, together with yearly accounts and merger balance (art.239 LSA), and other documentation has to be at the disposal of shareholders (art.238 LSA), who will adopt the merger agreement in a General Meeting (art.240 y 241 LSA), which will have to published (art.242 LSA), and incorporated in a public deed (art.244 LSA) and, finally, inscribed in the Commercial Register (art.245 LSA151. 148
See J. GARCIA DE ENTERRIA, "Los recursos y acciones contra las OPAs como medida defensiva" Revista de Derecho Mercantil, n. 201 (1991), at 423 ff. and WEIGMAN, supra n. 8, at 1093 and 1094. 149 See SANCHEZ CALERO, supra n. 45, at 321 ff.; BROSETA PONT, supra n. 45, at 301; VICENT CHULIA, supra n. 45 (T.I, vol.2) at 832; A. BERCOVITZ, "La fusion de sociedades", in La reforma de las sociedades de capital, at 631, (Madrid 1989) and F.J. GARDEAZABAL DEL RIO, "La fusion en la Ley de Sociedades Anonimas", in Las Sociedades de Capital conforme a la nueva Legislacion, at 713 ff., (Madrid 1989). In Portuguese law, see arts.97 ff. of the "Codigo das Sociedades Comerciais" ("Decreto-Lei" n. 262/86). 151 GARDEAZABAL DEL RIO, supra n. 149, at 746 ff. 152 R. LARGO GIL, La fusion de sociedades mercantiles. Fase preliminar, proyecto de fusion e informes (Madrid 1992); BERCOVITZ, supra n. 149, at 646 and GARDEAZABAL DEL RIO, supra n. 149, at 770.
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d) Lastly, an essential feature of the merger system is the protection which it tries to offer shareholders of the merged SAs, as well as creditors. As regards shareholders, they are protected before adoption of the merger agreement through an exhaustive disclosure that is placed at their disposal (art.238 LSA) and are protected "a posteriori" by giving them a right to impugn the merger (art.246 LSA). Similarly, the principle of "continuity of participation" is established (art.247 LSA). As to creditors, their protection is assured by a right to opposite the merger (art.243 LSA)152. In conclusion, mergers are mechanisms of managerial concentration which are characterised by being aristocratic as regard its procedure and being total as far as the merged companies net worth is concerned; compared to the takeover bids that go through a democratic procedure and have effects of partial concentration153. 2. Institutional Investors in Mergers From the point of view of corporate control, the most interesting merger formula is absorption, which is, on the other hand, the most common in practice. In mergers by absorption, institutional investors can be situated in an active-passive double role, i.e., as absorbing companies or as absorbed companies. The distinction between institutional investors with company or contractual nature has to be established again: a) Regarding the first type, in which SIMs, SIMCAVs, insurance companies and credit entities would be included, it can be asserted that are applicable the general rules contained in the LSA. However, as they are special SAs, their mergers are submitted to public authorization or notification. In fact, statutory modifications of IICs are submitted, in general, to a proceeding of authorization by the Minister of Economy and Finance that is similar to the their constitution (arts.8.3 LIIC and 9.5.a RIIC). Modifications in by-laws of insurance 153
See GARDEAZABAL DEL RIO, supra n. 149, at 808; BERCOVITZ, supra n. 149, at 657; R. LARGO GIL, "La informacion de los accionistas en la fusion de sociedades", RDBB n. 38 (1990), at 277 ff. and J. FLAQUER RIUTORT, "La protection de los accionistas en los procedimientos de fusion de sociedades", in Cuadernos de Derecho y Comer do, n. 10 (December 1991), at 105 ff. 153 Art.3 of RD 1179/1991 contains the norms regarding "interest or supervening acquisitions of a significant interest" in relation to mergers. See GARDEAZABAL DEL RIO, supra n. 149, at 722 ff.; A.J. TAPIA HERMIDA, "El regimen jurfdico de las Ofertas Publicas de Adquisicion (OPAS) de valores en el Derecho espanol", Actualidad Financiera n. 47 (1991), at 824 and J.L. GARCIA-PITA Υ LASTRES, "Oferta publica de adquisicion y procesos de fusion de sociedades en la jurisprudencia del Tribunal Supremo", RDBB n. 41 (1991), at 147.
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companies will have to notify the General Direction of Insurances (art. 14.2.5 ROSP). Lastly, mergers, absorptions and splitting of credit entities are submitted to authorization, whose non-observance constitutes a very serious infraction (art.4.a LDIEC). b) As regards institutional investors with foundational form (FIMs and FPs), although the phenomenon of merger does not affect them directly, it can affect them indirectly when it devolves upon their management firms. Firstly, the SGIICs are SAs and can merge. Their special status require them to obtain the pertinent administrative authorization for modifying their by-laws (art.9.5.b RIIC). As regard the EGs of FPs, in which they are submitted to regulation, seem to relinquish an obligation to notify the general Direction of Insurances the modifications that are produced in their by-laws (arts. 11.5 and 20 LPFP and art.40 RPFP). E. Public Offerings of Securities and Institutional Investors 1. Legal System Spanish law distingishes between public offerings of listed securities and of nonlisted securities. These latter were regulated by article 61 of the LMV and have been developed by Chapter IV of Royal Decree 291/1992, March 27. The former have been regulated by the Second Additional Disposal of the said Royal Decree 291/1992154. The common feature to the system is that both types are not considered as phenomenon of cession of corporate control (the reverse of the takeover bit155, but that they are thought as extraordinary operations in the primary or secondary securities markets that originate, in similar manner as issues of securities, some special needs of disclosure. Hence, the offerer in a public offering of non-listed securities must meet requirements similar to those for issues of securities (arts.28 and 29 RD 291/1992), by virtue of which an advance notification, some accredited documents, a prospectus and its auditing reports corresponding to the last two fiscal years are to be presented to the CNMV for verification. Similarly, the offerer in a public offering for listed securities has to ewrite a propectus (Second Additional Disposal RD 291/1992). 154
See AJ. TAPIA HERMIDA, "El desarrollo reglamentario del rogimen de las emisiones y ofertas publicas de venta de valores", RDBB n. 45 (1992), at 301 ff. See in Spanish practice, the Public Offering of Shares ("Oferta Publica de Venta de Acciones") by S.A. REPSOL, (see El Mundo, 11.3.1993, at 11), which is directed to institutional investors. In Portuguese law, see arts.585 ff. of the "Codigo do Mercado de Valores Mobiliarios" ("Decreto-Lei" 142-A/91). 155 Regarding the cession of control see EMBID IRUJO, supra n. 23, at 52 ff..
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2. Institutional Investors in Public Offerings Institutional investors can appear as offerors in the public offerings for listed or non-listed securities. In such cases, they must meet the requirements indicated above. Such requirements do not include anything unusual as regards institutional investors with company structure, but in the case of institutional investors with foundational structure (FIMs or FPs), the respective SGIICs of FIMs or EGs of FPs has to appear as the offeror. On the other hand, institutional investors can come to buy securities in a public offering for listed or non-listed securities. In these cases, an important difference of treatment can exist for this type of investors. Public offerings for non-listed securities that are directed exclusively to institutional investors, i.e., IICs, FPs and insurance companies, are not subject to verification and register with CNMV of the offerer's auditing reports for its annual accounts and the prospectus. However, the offeror will enjoy this "partial exemption" only if it does not involve securities of the same nature as others of the same issuer listed in an organised market established in Spanish territory and if institutional investors who acquire those securities do not transfer them to another type of investors (art.7 and art.29.1, RD 291/1992).
V. Conclusions 1. The Spanish financial system, where the institutional investors act, presents the following features: lack in efficiency of the securities market, increasing internationalization with the opening of the Spanish stock markets to foreign securities, predominant role of the banks in the field of the institutional investors and in corporate governance, spectacular increase of assets of the investment funds (FIMs and FIAMMs) during the years 1991 and 1992 and harmonization of the legal framework in the EC context with regard to SAs, institutional investors and control mechanisms. 2. In Spanish law, the evolution of the large corporations has shown that the democratic system of control has been replaced by a "Financial Feudalism". The 1989 LSA has not reformed the main characteristics of the organisational structure. 3. The intervention of institutional investors in the governance of corporations produces a "second gap" in the relationships between property and control. This gap is superimposed on the "first gap" produced by the "managerial revolution". 4. In order to improve the efficiency of Spanish companies and to establish a market for corporate control in Spain; institutional investors, given the weight
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of their votes, should encourage the contact with the boards of directors, make a positive use of their voting rights and take a positive interest in the composition of boards of directors. 5. Royal Decree 291/1992 regards as institutional investors the IICs, the FPs and the insurance companies, giving them a different legal treatment in the primary securities market. 6. From the point of view of corporate control, a dual classification of institutional investors may be made in Spanish law: a) According to a purpose criterion, there are institutional investors of the first degree (IICs) and institutional investors of the second degree (FPs and insurance firms).
b) According to a structure criterion, there are institutional investors with company structure (SIMs, SIMCAVs, and insurance firms) and institutional investors with contractual structure (FIMs, FIAMMs and FPs). 7. The IICs are regulated by the Act 46/1984, modified by the LMV of 1988 in order to adapt it to the EC Directives, and by a 1990 Royal Decree. There are two types of IICs: financial and non-financial. The financial ones are divided into two categories, in accordance with their corporate structure (SIMs and SIMCAVs) and their contractual structure (FIMs and FIAMMs). The investments of IICs are dominated by the principle of diversification which operates on both IICs' resources and the capital of corporations which issue the securities in which IICs invest. In Spanish practice, SIMs and SIMCAVs have a limited importance in corporate governance. The spectacular increase of FIMs and FIAMMs in 1991 and 1992 would permit to cherish on its leadership in corporate governance. However, their concentration on fixed-interest securities and, in particular, on public debt, has reduced their role in the control of large corporations. 8. The FPs are regulated in Spanish law by the Act 8/1987 and a 1988 Royal Decree. They are investment instruments of savings-pension generated in accordance with the PPs integrated in them. The investment behaviour of FPs is doubly conditioned: From the general point of view, by social significance of their role of complementary social security; and, from the special point of view, by their being instruments for the investment of resources generated according to the payouts requirements of one or more PPs. In Spanish practice, the net worth of FPs, as well as the number of their participants, have experienced a continuing increase from the time of their introduction. However, their influence in corporate governance is still limited because high rates of interest in
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Spanish financial markets have led to a conservative investment policy that puts only a small percentage in equities. 9. Insurance firms are regulated in Spanish Law by the Act 33/1984, reformed in 1990 in order to adapt it to EC Directives and by a 1985 Royal Decree. They are institutional investors of the second degree in the sense that their investment in securities is not their main goal, but a consequence of their corporate purpose. In Spanish practice, insurance firms' portfolios are mainly composed of public debt securities, followed by other private fixed-interest securities and a very low percentage of equities. 10. Credit entities, in capital markets, operate mainly as financial intermediaries. Nevertheless, their leading role in corporate governance must be noted. Spanish law, according to EC Directive 77/780, defines in a 1986 Royal Decree (modified in 1988) a credit entity as any enterprise that has the indirect intermediation of credit as a typical and habitual activity. Credit entities can carry out several active roles in corporate governance: Firstly, when they realize active credit operations, they exercise an external control. Secondly, as they are shareholders, they can dominate financial, industrial or commercial corporations. Thirdly, their role as intermediaries in the securities market gives them a decisive influence on corporate control because they can carry out several activities (acting as depositories of securities, as portfolio managers, as securities underwriters, etc.). 11. The relationship between institutional investors and control techniques presents a bilateral aspect because there are techniques for acquisition and cession of control that can be, moreover, friendly or hostile; and because institutional investors can be active or passive subjects of corporate control and can exercise their control directly or indirectly. 12. In Spanish law, we can distiguish four legal techniques for transfering the control of a corporation: a) Reporting of significant shareholdings. This was established by art.53 of LMV and has been recently extended by Royal Decree 377/1992, which has followed EC Directive 627/1988. This is a technique for obtaining transparency of control relationships. All types of institutional investors can acquire, in Spanish law, up to 5% of the securities in circulation of the same corporation. They are, then, required to report the acquisition or sale to the listed corporation, to the Stock Exchange Management Companies and to the CNMV. In Spanish law, there is a special system of reporting and disclosure of significant shareholdings in IICs that is established by their special Act of 1984 and their special regulations of 1990.
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b) Takeover bids were regulated by art. 60 of LMV and extended by Royal Decree 1197/1991. aa) Institutional investors can take several active roles in takeover bids: First, institutional investors can act as offerers. This possibility is conditioned by each portfolio diversification rules and by the type of takeover bid. The ways in which institutional investors can make a takeover bid depends on their legal structure. Second, institutional investors can be on the offerer's scene, belonging to the same group of corporations, acquiring shares in their own name but for the account of the offeror or acting in concert with the offerer. bb) Institutional Investors can also take a passive role in takeover bids, accepting the bid or being the offeree company: First, the price premium that all offerers pay in a takeover bid made to gain or increase control makes institutional investors, in general, willing to accept the bids. Second, institutional investors have to meet two conditions in order to be the offeree company in a takeover bid (being organized as S A and being listed). c) Mergers are regulated in the LSA of 1989, which has adapted the Spanish system to the Third EC Directive on Company Law. In mergers by absorption, institutional investors can play a double role, as absorbing corporations or as absorbed corporations. Here, the fundamental distinction between institutional investors with company or contractual structure is again important: aa) As regard institutional investors with company structure, apply the general rules contained in the Corporations Act of 1989 with several modifications, because the changes to the by-laws of IICs, insurance firms and credit entities require public authorization.
bb) As regard institutional investors with contractual structure, as long as the merger phenomenon does not affect them directly but it can affect them indirectly when it operates on their management firms (SGIICs and EGs). d) Public offerings of securities were regulated by art.61 of the LMV and extended by Royal Decree 291/1992. Institutional investors can appear as offerers in public offerings for listed and non-listed securities. In such cases, they must meet the requirements indicated above. Moreover, institutional investors can purchase securities in a public offering for listed or non-listed securities. In these cases, an important difference in treatment can exist. Public offerings that are directed exclusively to institutional investors - IICs, FPs and insurance firms - are not subject to registration with CNMV of audit reports of annual accounts and the prospectus.
Chapter Sixteen
Institutional Investors and Corporate Governance: The Austrian View Waldemar Jud
I. Introduction This paper deals with the development of institutional investment, already a dominant element of the stock markets of Anglo-American countries, in Austria. Institutional investment has completely changed the exercise of company control and the rights of shareholders in the relevant stock markets, and thus highlights controlling mechanisms to which the policies of institutional investors are subject, in particular with regard to voting rights. This topic has not yet been dealt with in Austria, and a first question is why this is the case : 1. Are there no institutional investors in Austria? 2. Do institutional investors lack the opportunity to exercise a controlling influence on stock corporations due to factual and legal circumstances and conditions in Austria? 3. Do US-style institutional investors, as described in technical American publications, exist in Austria, without their control potential having not yet been recognized? It should be noted at the beginning that the essential prerequisites for a comprehensive presentation of the Austrian stock market, its structure, and the impact of institutional investors do not exist. There are no complete data and figures, but only fragmentary publications of individual data. In order to make it easier to understand the particularities of the Austrian stock market, the essential statutory regulations relating to stock corporations will be illustrated along with a survey of the situation on the Austrian stock market. Proceeding from this survey we shall analyze whether a scenario such as that of the US stock market would be possible in Austria, given its statutory regulations concerning institutional investments for institutional investors.
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Finally, the data collected, systematized and interpreted will serve at least as a first inventory of the amount of participation and the possibilities of influence by institutional investors. Preliminary, first conclusions can then be drawn with regard to the need for normative regulation.
. The Structures of Stock Corporations in Austrian Law The Austrian "Aktiengesetz" of 19651 (Stock Act) represents the Austrification of the German "Aktiengesetz" (dAktG) of 1937, which was applied in Austria in this year. The legal situation is, therefore, comparable to that of Germany before 1965. However, this is not true of the legal situation in Germany after the adoption of its own law of 1965, as it currently applies in a repeatedly amended form. As a consequence, the characteristics of a stock corporation will be presented under Austrian law and significant differences with regard to German law will be pointed out. A. Organizational Structure The Austrian AktG of 1965 provides for a structure composed of several organs. Compulsory organs are comprised of the management board ("Vorstand"), the supervisory board ("Aufsichtsrat"), the (general) meeting of shareholders ("Hauptversammlung") and the auditors ("Abschlußprüfer"), who can functionally be considered as organs. These organs have to fulfil tasks which are clearly separated and cannot be altered by the articles of association. 1. The management board (§§ 70-85 AktG) is appointed for a maximum period of five years. It may consist of one or more members. Its main tasks are the management and the representation of the stock corporation and it is free from interference in performing this function. Certain transactions, however, require the consent of the supervisory board (§ 95 AktG). The duty of the management board to ask for supervisory board approval may, on one hand, be required in the articles of association or result from instructions given by the supervisory board. On the other hand, in contrast to the legal situation in Germany, this duty may result from an obligation concerning particular transactions specified by law. The right of the supervisory board to give consent, enacted in the "Gesellschaftsrechtsanderungsgesetz" of 1
Aktiengesetz 1965 BGB1 1965/98 under present law; cf. for the following: HÄMMERLE/WÜNSCH, Handelsrecht, at 225-353, (3d ed., vol. 2, 1978); SCHIEMER, Handkommentar zum Aktiengesetz , (2nd ed., 1986); KASTNER/ DORALT/NOWOTNY, Grundriß des österreichischen Gesellschaftsrechts, at 215-318 (5th ed., 1990).
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19822 (amendment to company law), is, in fact, the strictest means of supervising the management board, as it permits permanent ex ante supervision. If the supervisory board's consent is not obtained, the binding character of the effected transaction nevertheless remains unchanged towards third parties. However, the management board may internally be liable for damages and, in some cases, this may constitute a cause for dismissal. 2. The supervisory board (§§ 86-99 AktG) of a stock corporation consists of at least three members. The maximum number of board members may be increased in proportional relation to the corporation's share capital. The members of the supervisory board are appointed by shareholders' resolution at a general meeting of shareholders. This appointment can be revealed prematurely by a shareholders' resolution (at a general meeting of shareholders), on a threefourths majority of votes cast. For every two members of the supervisory board elected by the shareholders the council of shop stewards has a right to delegate one representative of workers/employees. The participation of workers/employees in management, however, is not laid down in the "Aktiengesetz" but in the "Arbeitsverfassungsgesetz"3 (§ 110 ArbVG, Austrian Labor Relations Act). It is, therefore, a peculiarity of Austrian law that the participation of workers/employees in the management of a stock corporation is not based on company law but on labor law. In contrast to the legal situation in Germany the ArbVG provides for a constant proportional relationship between representatives of employee/workers and those of employers, irrespective of the size and the object of business of the corporation. Particularly in big stock corporations this results in a lower degree of influence of employers on the supervisory board and, as a consequence, on the composition of the management board than is the case in Germany. Furthermore, the appointment and removal of board members, the chairman, and the deputy chairman require a "double majority". This means i) that both an effective resolution of the (total) supervisory board and ii) the consent of the majority of all members of the supervisory board appointed and delegated by the meeting of shareholders pursuant to the articles of association have to be obtained. This "Aktionärsschutzklausel" (clause for the protection of shareholders) is supposed to protect the representatives of the shareholders in such a way that it is not possible for representatives of employees/workers and a small group of shareholder representatives to form a coalition to effectively outvote the majority of the representatives of the shareholders on the supervisory board.
2 3
Gesellschaftsrechtsändeningsgesetz (GesRÄG), BGB1 1982/371. Arbeitsverfassungsgesetz 1973 (ArbVG), BGB1 1974/22.
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The main tasks of the supervisory board are the appointment and, provided that there is substantial cause, the removal of the management board or of individual board members, as well as the supervision of the management. 3. Because of the enactment of the "Aktiengesetz" (stock act) of 1937 and the AktG of 1965 did not change anything in this respect, the general meeting of shareholders (§§ 102-124 AktG) has lost its function as the supreme organ of policy formation within a stock corporation. It can only pass a resolution within its area of responsibility as provided by law or laid down in the articles of association. These are the appointment and the removal of members of the supervisory board, but generally not matters concerning the management of the corporation. In such matters the shareholders' vote is only decisive in cases in which the management board requests it to do so or with regard to certain transactions specified by law that require supervisory board approval. In the latter case the shareholders have to be requested to do so by the supervisory board (§ 103 Abs 2 AktG). Basically one share has one vote. However, it is permitted to provide for a maximum number of votes (§114 Abs 1 AktG), although multiple-voting shares are not allowed (§ 12 Abs 2 AktG). It is also possible to issue non-voting preference shares (§ 115 AktG) up to half the overall nominal amount of ordinary shares (equity shares). Non-voting preference shares have to be provided with (dividend) preferences to be paid to the respective shareholders upon the distribution of the profits. If the amount due is not paid or not fully paid within a year, and if payment including the current (fresh) preferences has not been effected subsequently within the following year, non-voting preference shares assume a right to vote until the satisfaction of the preferences. In other words, holders of non-voting preference shares are granted a right to vote temporarily, but they have no claim to reimbursement of the capital contributed. In general practice, however, many minor shareholders furnished with a vote do not personally make use of their right, but allow themselves to be represented by depositary banks. These banks have to be authorized specifically in writing, by the shareholders to be able to exercise their depositary votes. This authorization can be revoked at any time and expires after a maximum period of 15 months. As there are no corporations with widely distributed ownership, indeed, without a majority shareholder or a syndicate holding the majority of shares, strict legal provisions concerning the voting rights of depositary banks have not yet been issued. 4. The fourth organ of a stock corporation, the auditors (§§ 268-276 HGB Austrian Commercial Code)4, are responsible for inspecting the books and paperwork of the corporation. 4
Handelsgesetzbuch (HGB), DRGB1 1902 S 218.
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Under the "Rechnungslegungsgesetz" of 1990 (accounting act)5, which amended the HGB and harmonized the act with EC standards in company law, small stock corporations whose shares or other securities are admitted to official trading on the Austrian stock market or are traded in the unofficial market are treated the same as large corporations (§ 221 Abs 2 HGB). So are corporations meeting at least two of the three following criteria 300 employees/workers, a turnover of 300 million Austrian shillings, and a balance-sheet value of 200 million Austrian shillings. This equal treatment means that large as well as public corporations are under duty to furnish information and are subject to strict disclosure requirements. This satisfies the need of the capital market for greater transparency and introduces the regulatory approach of capital market law into the accounting regulations based on company law. B. Capital Structures With capital structures we have to distinguish between principles of procurement of capital and principles of maintenance of capital. 1. Principles of Procurement of Capital a. The minimum share capital of a stock corporation amounts to one million Austrian shillings (§ 7 AktG) at present. The statement of the share capital is a compulsory part of the articles of association. The shares can have a nominal value of 100, 500, 1,000 or any multiple of 1,000 Austrian shillings (§ 8 AktG). The shares can either be purchased at the time of formation of a stock corporation or when fresh shares are issued in order to increase the share capital. The capital to be contributed by the shareholders is the larger of the nominal value or the issue price, which is increased by the net book value (§ 49 AktG); issuing a share below its nominal value is prohibited. b. Each stock corporation is obligated to use 5 per cent of the net profits per year to create reserves prescribed by law, until the reserves reach 10 per cent of the corporation's share capital (§ 130 AktG). These reserves may only be used to offset an impending net loss. c. As a means of protection against the dilution of porportional share capital there is a subscription right (preemptive right) of shareholders to shares of a new issue for the purpose of increase of capital in proportion to their existing equity interest. This right can only be barred if the intended suspension of this right has been properly announced in the agenda and if the holders of at least 5
Rechnungslegungsgesetz (RLG), BGB1 1990/475.
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three-fourths of the existing share capital agree (§ 153 AktG). The suspension must be based on appropriate reasons and the principle of equal treatment must be observed. d. Apart from issuing shares, there are also some alternative possibilities of financing available to stock corporations, such as issuing convertible bonds, profit-sharing bonds and participation rights (§ 174 AktG). Furthermore, the amendment of the provisions concerning a corporation's own resources in the "Kreditwesengesetz" (act relating to the credit system)6 as well as in the "Versicherungsaufsichtsgesetz" (insurance control act)7 of 1986 brought about the legal recognition of surrogates of shareholders' equity in the form of participation and supplementary capital8. On the one hand, these surrogates enable a firm to meet the increasing demand for the provision of its own resources, which is especially true of financial corporations (banking and insurance firms); on the other hand, surrogates created a new form of investment in firms, which is available to a firm regardless of its legal form. The so-called "participation capital", which enjoys the same participation rights as shares do, is legally treated as equal to equity capital (§ 12 Abs 3 KWG and § 73 b Abs 2 VAG). As far as its economic character is concerned, it resembles non-voting preference shares in spite of the very different legal nature of the two concepts. Like capital, participation capital participates both in profits and losses. However, as opposed to non-voting preference shares, participation capital is not granted a temporary right to vote. 2. Principles of Maintenance of Capital a. The prohibition of returning contributions to shareholders is one of the essential principles of capital maintenance. The shareholders have no right to have their contributions returned (§ 52 AktG), except for reduction of capital with due regard to the provisions relating to the protection of creditors (§ 178 AktG) and in case of reduction of capital owing to withdrawal of shares (§ 192 AktG). b. A stock corporation is basically prohibited from repurchasing its own shares, as this will economically lead to the returning a shareholder's contributions. A stock corporation may only purchase its own shares if this is indispensable to
6
Novelle zum Kreditwesengesetz (KWG), BGBI 1986/325. Novelle zum Versicherungsaufsichtsgesetz (VAG), BGBI 1986/558. 8 Cf. the author's paper in: "Europäische Integration und österreichisches Kapitalmarktrecht," Beiheft zur Zeitschrift für Schweizerisches Recht, Heft 14, at 17, especially at 25 ff., (Klein, ed., 1991). 7
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prevent material damage to the corporation. Furthermore, redeemed stock is not votable (§ 114 Abs 6 AktG). c. The annual statement of accounts of the stock corporation is produced by the management board, inspected by the auditors, and as a rule, approved by the supervisory board, which adopts the annual accounts (§ 125 AktG). If the supervisory board does not approve the annual accounts or if the management board and the supervisory board decide to have the annual accounts approved at the general meeting of shareholders, the general meeting of shareholders is required to do so. As a matter of fact, only in very rare cases do the shareholders have an influence on the annual accounts and, as a consequence, on the amount of the net profit quoted in the annual accounts. The net profit shown in the annual accounts has an impact on the amount of the dividends, as only the net profit can be distributed to the shareholders. If only a part of the net profit is to be distributed, a resolution needs to be adopted by the general meeting of shareholders, a procedure that also requires special authorization in the articles of association (§ 126 Abs 3 AktG). The distribution of dividends during a stillopen business year is not permitted. C. Provisions of the Law Relating to Groups 1. According to the definition in § 15 AktG, legally independent firms that are united under joint management for economic purposes form a group; the individual firms are companies of the same group. The same applies whenever a legally independent company has come under the controlling influence of another company. With this possibility that a controlling company may exercise an influence on another company, the group concept represents the most important means of achieving concentration of economic power next to the merger of companies. 2. § 51 Abs 2 AktG deals with the original acquisition of shares by a controlled firm. This provision prohibits a company which is controlled within the meaning of the law relating to groups from acquiring shares of the controlling company. The registration court can reject the application for registration of the company or deny permission to increase the capital of the company on grounds of non-compliance with this prohibition. Even if the court does not intervene, shares acquired in violation of the prohibition do not receive a right to vote (§ 114 Abs 6 AktG). 3. § 66 AktG represents another essential provision of the Austrian law relating to groups. This article permits the derivative acquisition of ownership and pledge of shares of the controlling company by the controlled company only in
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the same limited sense as is provided for with regard to the acquisition of one's own shares. Furthermore, the right to vote cannot be exercised for shares belonging to a controlled company (§ 114 Abs 6 AktG). 4. Generally speaking, the Austrian law relating to groups appears to be comparatively poor when compared to German law. Apart from a few further legal provisions such as those of the RLG, which provides for group accounts, there are no comprehensive regulations. Thus, the law relating to groups remains in need of reform.
. A Survey of the Current Situation on the Austrian Stock Market A. Financing of Companies by Means of Equity Interest9 as a More Recent Phenomenon 1. For many decades the financing of Austrian companies had taken place almost exclusively in the form of the raising of direct loans (mainly bank loans) as well as in the form of internal financing. Financing via the capital market did not play a significant role, either in self-financing or in the field of debt financing. Since 1985, however, financing by means of shares has undergone a renaissance. The volume of the capital mobilized at the stock exchange by means of increase of capital and new issues of shares has multiplied within few years. In 1987 566 stock corporations were registered in the commercial register in Vienna (now referred to as the firm book, "Firmenbuch") with a total share capital of 100 billion Austrian shillings10. As of January, 1990, 720 stock corporations were already registered, with a nominal capital of 120 billion Austrian shillings11. Also, the average share capital has increased considerably, by 67 per cent between 1978 and 199012. With 720 stock corporations in Vienna and approximately 800 in all of Austria, this type of business organization is still far less numerous than companies with limited liability. As of January, 1990, 30,708 companies with limited liability were registered in Vienna and approximately twice that number in all of Austria. However, as far as their 9
For the concept of equity interest ("Anteilsrecht") cf. JUD/SCHUMMER, Anteilsrechte von Banken und Anlagenbegrenzung nach § 75 KWG, Diskussionsreihe Bank & Börse (vol. 2, 1992). 10 KASTNER/DORALT/NOWOTNY, supra n. l, at 184. 11 BEER, "Erhebungsgrundlage, Repräsentationsgrad, vergleichbare Untersuchungen und Statistiken," in Wem gehört Österreichs Wirtschaft wirklich?, Studie der Arbeiterkammer, at 23, (1991). 12 GOLDMANN/BEER, "Gesamtergebnisse der Kapitalerhebung," in Wem gehört Österreichs Wirtschaft wirklich?, at 57.
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(economic) significance is concerned, stock corporations are at least as important as companies, with limited liability, as most large firms make use of the legal form of a stock corporation. This can be made evident by comparing the nominal capital of both forms of companies which is identical in spite of the numerical difference of the companies13. The largest domestic shareholder was the Republic of Austria with 37.3 per cent in 1989, followed by domestic private shareholders including banking and insurance firms with 21.9 per cent, foreign shareholders with 18.4 per cent, the nine federal states ("Bundesländer") and the local communities ("Gemeinden") with 7.3 per cent and the saving banks with 4.2 per cent. Scattered shareholdings amounted to 10.9 per cent14. However, only a small percentage of the existing stock corporations, 98, with 117 stock issues, are listed on the stock exchange (as of October 1992). Nevertheless, even this number indicates a gradual increase: In 1984 the number of quoted shares amounted to 66, while the number of corporations listed at the Viennese stock exchange was 58. In September 1990, 108 shares were quoted and 94 corporations listed at the stock exchange15. The overall value of the shares quoted at the Viennese stock exchange also saw a dramatic increase, from 28 billion Austrian shillings in 1984 to 263 billion in 198916. All figures listed refer only to the shares quoted at the stock exchange in official dealing. They do not cover securities on the unofficial market and any other trading in securities on the stock market. The numerical difference between shares and stock corporations can be explained by the fact that some corporations list ordinary shares and preference shares. The corporations listed at the stock exchange form the main part of the following investigation. 2. The Reasons for the Increasing Recourse to the Capital Markets by Means of Issuing Shares or Instruments Comparable to Shares17 a. Private Enterprises The abolition of double taxation of stock corporations and companies with limited liability and the generous promotion of the acquisition of new shares by the Austrian government, in combination with an increasing demand by foreign 13
GOLDMANN/BEER, id. at 53. GOLDMANN/BEER, id. at 57. 15 Source: Kapitalmarktperspektiven, Berichte und Studien 4/90, Österreichische Nationalbank, published by Aktienforum 66 Tabelle 1. 16 Source: Kapitalmarktperspektiven, Band I, Der österreichische Beteiligungsmarkt, Entwicklungsstand und -erfordernisse (März 1990) published by Aktienforum, Anlage 5. 17 Concerning the following presentation cf. Jud, ZSR-Beihefi 14, 24-33 (supra n. 8); cf. also "Holdings in Österreich", Österreich - Das Domizil für Holdinggesellschaften, Broschüre der Girozentrale, at 50 ff., (1989). 14
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investors, have led to a considerably changed climate at the stock exchange. This development has been encouraged to a substantial degree by the discussion concerning Austria's progressive alignment with the EC. A further stimulation of the capital market was caused by the possibility of issuing profit participating certificates, as did banking and insurance companies, as this encouraged many firms to go public. b. Banking and insurance companies The amendments to the "Kreditwesengesetz"18 as well as to the "Versicherungsaufsichtsgesetz"19 required the banking and insurance companies to increase their liable funds (§ 12 KWG) as well as the provision with their own funds (§ 73 b VAG). This lead to an increased demand of banking and insurance companies for capital. The procurement of equity capital was mainly effected by means of issue of profit participating certificates and non-voting preference shares. c. Privatization The situation on the Austrian capital market has further been influenced by measures of privatization with regard to national enterprises. These concerned the enterprises of ÖIAG20 and led to the abolishment of the restrictions on the sale of shares with regard to Creditanstalt-Bankverein AG (hereinafter referred to as CA), and Länderbank AG, and brought about a partial privatization of the electricity supply industry - both of the individual state corporations and of the federal corporation - and of Austrian Airlines österreichische Luftverkehrs-AG (hereinafter referred to as AUA). 3. In spite of the above observations the overall capital invested at the stock exchange amounted to only 15 per cent of the gross domestic product in 1989, which is considerably lower than the European average of 47.9 per cent21. This indicates that the procurement of capital via the stock exchange is comparatively weak in Austria. The market value of the shares quoted at the Viennese stock exchange is still below the average of the overall economic potential of Austria.
18
Kreditwesengesetz (KWG), BGBI 1979/63. Versicherungsaufsichtsgesetz (VAG), BGB1 1978/569. 20 ÖIAG stands for Österreichische Industrieholding Aktiengesellschaft. 21 Source: Kapitalmarktperspektiven, Band I, Anlage 6. 19
Institutional Investors and Corporate Governance in Austria
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B. Reasons for the Comparatively Low Amount of Capital Invested at the Stock Exchange 1. One obstacle to the use of the stock market in order to raise equity capital is found in the current system of taxation. Basically, the preference given to loan capital over equity capital under fiscal law, the existing double taxation of the assets of corporations, and the existence of a stock exchange turnover tax on the transaction of securities are of importance in this context22. In fact, double taxation of profits has largely been eliminated by the introduction of a split corporate tax rate and of a half-rate procedure with regard to income taxes. However, an actual preference for loan capital still exists because large-scale evasion of taxes on interest of loans is tolerated.23 This evasion is supposed to be reduced soon by a reform of the tax on investment income, although the disadvantage of risk capital will not be removed completely. It is, therefore, quite understandable that the capital market is still making the following demands: the abolition of the stock exchange turnover tax, the same overall tax rate on profits from interest and distribution of dividends, the equal treatment of equity capital and loan capital with regard to income and property taxes, an amendment of the law relating to turnover taxes, a general abolition of the property tax, and the introduction of tax privileges for capital gains from domestic holding companies in order to enable the establishment of wellfunctioning venture financing24. 2. A further reason for the relatively slow development of the Austrian stock market is to be seen in the fact that many majority shareholders of corporations listed on the stock exchange and of corporations that would like to go public do not want to give up their influence25. This is best illustrated by the following examples: a. Holding Companies The many recently formed holding companies represent a special case of procurement of equity capital. They provide maximum security for the previous spheres of influence because holding companies have only a holding by means 22
Konzept Finanzmarkt Österreich, Schwerpunkt Beteiligungsmarkt, at 12, ("Österreichische Kontrollbank Aktiengesellschaft", ed., Juli 1992). 23 Cf. on this issue: SWOBODA, Aktienemission, Ein Handbuch der Börseneinführungen, Bankwissenschaftliche Schriftenreihe Nr 65, at 14 ff., (Swoboda, Lucius &Zapotocky, eds., 1988). 24 Konzept Finanzmarkt Österreich, at 12. 25 For the question concerning the retainment of influence on a company cf. TORGGLER, "Vertragliche Gestaltung zur Wahrung des Gesellschaftereinflusses," GesRZ 1990, 186.
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of non-voting preference shares in operating companies. Their shareholders do receive voting shares, but the holding company selected by them does not have any influence on the companies in its portfolio. b. "Cementation" of rigid majorities A similar attempt to retain power can be observed with corporations in which enough shares are held by one shareholder or by a syndicate so that the organs of the corporation can be influenced according to the vested interests of the power block. This is to be found both in the actual articles of association of family-owned (closely owned) stock corporations and corporations held by public authorities. In particular, with partly privatized corporations owned by the Republic of Austria and other regional or local authorities certain protective measures were taken. On the one hand, no more than 49 per cent of the share capital was issued. On the other hand, in spite of the fact that the corporation went public, some further measures were occasionally taken to secure the influence of the public authorities. Thus, for example, § 5 Abs 1 2. VerstG26 (law relating to the nationalization of enterprises) provides as a special measure that in Verbund-AG each shareholder's right to vote in the general meeting is restricted to a maximum of 5 per cent of the share capital of the corporation, unless the shareholder is a regional or local authority or a corporation in which a local or regional authority holds 51 per cent of the shares. This restriction of the right to vote, which was enacted by means of special statutes before the introduction of the corporation on the stock exchange, creates a multiple voting share, which has so far been prohibited under the law relating to shares. It is meant to secure the public authorities a direct or indirect quota of 51 per cent in perpetuity27, even with regard to the possible sale of shares. 3. These influence-securing factors must be observed in the light of the numerous partly privatized corporations operating in areas of business where price formation is subject to a regulated market. This group of nationally controlled corporations primarily consists of corporations supplying energy but also includes Austrian Airlines. These enterprises do not necessarily have to, or rather are not always able to, adapt to economic factors exclusively. This may lead to results distorting the market which cannot be upheld in case of Austria's accession to the European Economic Area. These market-distorting factors may also discourage potential investors.
26
2. Verstaatlichungsgesetz 1947 (VerstG), BGB1 1947/81. With regard to this issue cf. my further elaborations in ZSR-Beiheft 14 (supra n. 8), at 27 ff. 27
Institutional Investors and Corporate Governance in Austria
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4. Furthermore, the large number of securities traded at the stock exchange with different rights and obligations is confusing to investors. Ordinary shares are sold as well as non-voting preference shares, profit-participating certificates, and other securities. This diversity of products plus insufficient access to information on the part of potential shareholders about the securities as well as insufficient analyses by various investment counsellors do not lead to greater transparency of the stock market. Therefore, it will be necessary to improve the policy of information required of corporations listed at the stock exchange in order to stimulate the market. For this purpose it will be indispensable to institute strong and binding guidelines for publication as a prerequisite of official quotation in order to provide investors with comprehensive information. Furthermore, it will be extremely useful for the stock exchange to provide an on-line information system covering all data concerning corporations listed. This data should also be made available to the public. Additionally, and perhaps most importantly, sanctions should be enacted against corporations whose policy of information is insufficient or which intentionally and demonstrably report incorrect information.28 5. A further obstacle to increases in investment through the stock exchange is the absence of a law relating to the capital market that meets current European requirements, a first step towards adapting the legislative measures to the requirements of Europe in the present context is represented by the reform of the stock exchange act29, the goals of which were to achieve conformity with EC standards and to improve the protection of investors. These include improvements concerning disclosure requirements, general duties of issuers, prospectus liability, and a statutory prohibition on insider trading.30 Further issues regulated concerned the institution of a certain degree of autonomy of the stock exchange, revised arrangements concerning the organization of the stock exchange and of the stock markets, as well as the institution of an Austrian options exchange. A second step was the passing of the "Kapitalmarktgesetz" (law relating to the capital market)31, which also regulated the important area of investments not quoted at the stock exchange. Its most significant feature can be seen in the prospectus liability with regard to offers to multiple addressees of instruments of financing by way of credit or holding.32 This represents an introduction of EC law into Austrian law with regard to the capital market.33 28
KONZEPT FINANZMARKT ÖSTERREICH, at 19. Börsegesetz 1989 (BörseG), BGB1 1989/555. 30 cf. JUD, ZSR-Beihefi 14 (supra n. 8), at 43. 29
31
32
Kapitalmarktgesetz (KMG), BGB1 1991/625.
HASCHEK, Vorwort zu Nowak, Praxiskommentar zum Kapitalmarktgesetz, at 3 (1992). 33 NOWAK, Praxiskommentar zum KMG, at 12.
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In spite of this reform, the legal situation in Austria does not fully correspond with the legal requirements of the European Communities. Further reforms are still called for. Demands are still made for greater transparency of stock exchange transactions, improvements concerning the supervision and the organization of the stock exchange, and for effective provisions concerning insider trading.34 6. The biggest problem of the Austrian stock market, however, is the increasing shortage of offered securities. It is significant that only 18 out of 117 shares quoted at the stock exchange exhibit widely distributed ownership of more than 50 per cent and cover mainly non-voting preference shares. The missing depth of the market currently leads to the fact that larger orders have to be settled in partial amounts as sufficient quantities of shares are not available. This results in the need for certain corrective measures to be taken including increasing the amount of widespread shareholdings, and the number of corporations listed at the stock exchange, and creating a structure of issuing companies that corresponds to the economic scenario of Austria.35 7. These peculiarities of the domestic stock market result in the discouragement of all investors alike. In 1988 insurance companies held only 5 per cent36 and investment corporations only 1 per cent of the (total) share market (in 1989). This is true in spite of the fact that the assets of domestic investment funds increased from 9 billion Austrian shillings in 1983 to 150 billion in 1989.37 The proportion of shareholders also increased from 1 per cent of the total population in 198538 to 4 per cent in 199239, but is still significantly lower than that in other countries in Western Europe.40
34 35
Konzept Finanzmarkt Österreich, at 15 ff. For further reading cf. Konzept Finanzmarkt Österreich, at 14.
36
Kapitalmarktperspekiiven, Band I, Anlage 8. According to a more recent source, namely KARNER, Die Anlagepolitik der österreichischen Versicherungswirtschaß, ein Geschäftsbericht des Verbandes der Versicherungsunternehmen Österreichs über den Zeitraum vom 1.7.1991 bis 30.6.1992, at 13, insurance companies are attributed 2.7 per cent of the share capital of stock corporations. However, whether this actually indicates a decrease of the share capital of insurance companies or whether the different figures maybe result from imprecise statistical data cannot be clarified as none of the two sources states whether the figures refer to the total number of stock corporations in Austria or whether only corporations listed at the stock exchange were taken into consideration. 37
Kapitalmarktperspektiven, Band I, Anlage 8.
38
KASTNER/DORALT/NOWOTNY, supra n. 1, 183 n. 19.
39 40
Konzept Finanzmarkt Österreich, at 13. Kapitalmarktperspektiven, Band I, Anlage 7.
Institutional Investors and Corporate Governance in Austria
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Furthermore, the Austrian economy is considerably behind other European countries in the area of risk capital. The raising of 460 Austrian shillings of new risk capital averaged within a period of five years lags far behind the European average, which amounts to 2,700 Austrian shillings per capita.41 These figures indicate that there is a gap of capital of approximately 17 billion Austrian shillings (that is 85 billion if calculated retrospectively for the years from 1985 to 1989). In order to provide sufficient quantities of capital for the Austrian economy and in order to offer quotations interesting to investors, it would be necessary to encourage further corporations to go public, an idea which is in fact quite welcomed by many companies. An opinion poll conducted with 149 companies on the topic of "going public" in 1990 shows that almost one half of the companies asked had at least considered in detail or in principle procuring capital via the stock exchange.42 It is very questionable, however, whether this attitude still exists and whether it is still appropriate in view of the rather ruinous recent development at the Viennese stock exchange. The deterioration of the situation at the Viennese stock exchange is also revealed by the fact that introductions of new stock corporations on the stock market have often been postponed recently, because of the fear that too few people would subscribe for shares at the issue price.
IV. A Survey of Institutional Investors in Austria Unfortunately, exact data are not available with regard to the structure of shareholders in Austria at present, as the obligation to register (material) alterations of shareholdings in domestic stock corporations listed at the stock exchange was only introduced fairly recently as a general legal duty by § 91 BörseG43 ,44 Each purchaser or seller of a material shareholding is required to notify both the corporation concerned and its executive committee of his/her share of votes whenever - as a consequence of the respective transaction - 10 per cent, 25 per cent, 50 per cent, two thirds or 75 per cent of the votes have been achieved, exceeded or fallen below. This provision is not applicable to acquisitions and sales effected in the exercise of the securities business. A stock corporation whose voting rights experience material alteration is required to notify the public thereof if the alteration in question deviates from statements concerning the voting rights and the capital structure published 41
Source: Kapitalmarktperspektiven, Band l, Anlage 5. Kapitalmarktperspektiven, Berichte und Studien,k at 56 ff. 43 This provision entered into effect as of 1st January 1992 and applies to general meetings of shareholders that were held or will be held after 31st March 1992. , ZSR-Beihefi 14 (supra n. 8), at 47. 42
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previously. In any case, the notification has to be effected if the alteration of the share capital achieves, exceeds or falls below the shareholdings specified in § 91 Abs 1 BorseG. If the notification is not made, the executive committee may, upon the expiration of an additional period of time of reasonable length, notify the public at the expense of the corporation. Because the non-compliance with this provision - as opposed to the German legal situation, which provides for a suspension of the voting rights on shares purchased in non-compliance with the obligation of notification (§ 20 dAktG) - does not lead to any legally effective sanctions, the only possibility that remains in order to investigate the amount of shareholdings in stock corporations is the examination of the minutes of (general) meetings of shareholders. The evaluation of the data available for 73 stock corporations listed at the stock exchange shows the following situation:45 In 10 corporations banking firms hold more than 50 per cent of the share capital, CA alone does so in 6 corporations, Z-Landerbank Bank Austria AG (hereinafter referred to as Bank Austria) in 2. Important and well-known corporations such as Semperit AG, Steyr-Daimler-Puch AG and Wagner Biro AG are to be found among these corporations. Insurance companies hold the majority of shares in two insurance corporations, but in no other stock corporations. Apart from the majority shareholdings listed, the banking firms hold 15 minority shareholdings of more than 10 per cent (CA 5, Bank Austria 7). Further shareholdings of less than 10 per cent, some of which are substantial, are not subject to the obligation of notification and therefore are not dealt with. The Republic of Austria turns out to be the largest shareholder. It is the majority shareholder of the most important corporations such as Österreichische Mineralölverwaltungs AG (ÖMV), Verbund AG (51 per cent), AUA (51 per cent), CA (66 per cent) and a minority shareholder of Bank Austria (25.9 per cent, the majority shareholder of which is the local authority of Vienna ("Gemeinde Wien"). These data prove that institutional investors, apart from banking companies, do not play as important a role as other shareholders in corporations listed at the stock exchange. This is by no means surprising as there are numerous provisions and restrictions concerning institutional investors.
45
Statement made by Wiener Börsekammer on Oct. 6, 1992.
Institutional Investors and Corporate Governance in Austria
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A. Pension Funds The possibility to form pension funds in order to counteract the impending impossibility of financing old age pensions has only existed since 1990.^ There exist special provisions for pension funds concerning investments. According to § 25 PKG47 (law relating to pension funds) pension funds are only entitled to invest a maximum of 30 per cent of the assets attributed to an investment and risk company in shares and other securities. Shares of an individual stock corporation may only be acquired up to an amount of 5 per cent of the total share capital of that stock corporation. As opposed to the US-pension fund system, there are no pension funds in Austria that can exercise a controlling influence on corporations listed at the stock exchange via shareholdings. B. Investment Funds The importance of investment funds in institutional investing in stock corporations in Austria is - as indicated before - also minimal. In addition, investment funds are subject to restrictions with regard to their freedom of investment under the "Investmentfondgesetz" (law relating to investment funds)48 . § 20 Abs 1 InvFG provides that the choice of securities is to be effected according to the principle of spreading of risks. Accordingly, investment funds are only entitled to purchase shares at the maximum extent of 7.5 per cent of the total share capital of an individual issuing corporation. Furthermore, securities may only be acquired up to a maximum of 10 per cent of the total assets of the investment fund. C. Insurance Corporations As stated before, the two institutional investment funds discussed above play a minor role in Austria as shareholders. Insurance corporations are attributed shareholdings between 2.7 and 5 per cent of all national shares and, thus, form the second biggest institutional investor on the Austrian stock market, are of greater significance. It should be noted that in spite of the fact that the crediting for shareholdings in stock corporations as premium reserves was raised from 5 to 10 per cent 49 , no increasing use of the capital market by insurance companies 46
Cf. on this issue: LOITLSBERGER, "Die Publikumsaktienfinanzierung als betriebswirtschaftliches und gesellschaftspolitisches Problem (I)," GesKZ 1986, 184 (at 188). 47 Pensionskassengesetz (PKG), BGB1 1990/281. 48 Investmentfondsgesetz (InvFG), BGB1 1963/192. 49 Novelle zum VAG, BGB1 1990/181. Cf. also JUD, "Konsumentenschutz durch aufsichtsrechtliche Veranlagungskontrolle," VersRdsch 1993 (forthcoming).
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was to be observed. A controlling influence in stock corporations, however, would - at least under present law - be impossible, because under the insurance control act the acquisition of shareholdings in stock corporations is largely restricted. 1. The acquisition of shareholdings in a stock corporation by an insurance corporation is subject to approval by the insurance supervisory authority: i) whenever the shareholdings to be purchased exceed 10 per cent of the overall share capital of the respective stock corporation or ii) the purchase price of the shareholdings exceeds 10 per cent of the assets of the insurance company. This also applies to the acquisition of additional rights to shares and the increase of the approved shareholdings whenever the above limits are exceeded or would be exceeded (§ 76 Abs l VAG). This provision represents the first comprehensive regulation for the total investment of capital of insurance companies.50 This regulation results in a considerable restriction of the right of insurance companies to acquire shares. This could change completely in the near future. As the government bill concerning the VAG-Novelle of 1991 (amendment to the VAG)51 provides with regard to the acquisition of rights to shares previously subject to approval by the insurance supervisory authority now only an obligation to notify the former authority thereof. This alteration to be enacted is based on Art 18 Para 1 of the EC directive 73/239 and on Art 21 Para 1 of the EC directive 79/267, which provides that free assets must not be subject to an obligation of approval.52 2. There are also restrictions on acquisitions concerning the provision of the premium reserves pursuant to § 77 VAG. Only shares quoted at an acknowledged stock exchange may be used to form premium reserves and only as long as the 10 per cent-reserve ceiling of the issuing company is not exceeded. These shares and other securities and special investment certificates are only credited up to a maximum of 20 per cent of the full cover required. In special cases the insurance supervisory authority is entitled to permit the exceeding of the limits specified. Shares issued by an individual stock corporation are credited a maximum of 3 per cent with regard to the total cover required.
50
Erläuternde Bemerkungen zur Regierungsvorlage des VAG 1978, BGBL. 1978/569, aus KREJCI/WEILINGEN, Österreichisches Versicherungsrecht, at 224 (1992). 51 694 Big NR XIII. GP, 12. 52 EB zur RV 694 Big NR XIII. GP, 23.
Institutional Investors and Corporate Governance in Austria
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D. Banking Corporations Banking corporations undoubtedly exercise the largest influence on corporations listed at the stock exchange. In particular, the two big banking companies Bank Austria and CA hold substantial blocks of shares of stock corporations listed at the stock exchange and repeatedly appear as major shareholders. 1. Provisions for Investments a. Under the KWG (§ 8 Abs 1 KWG) special approval by the federal ministry of finance is required for each form of association among banking firms. These include the direct, indirect, or fiduciary acquisition of shareholdings in other banking firms (even by partnerships under commercial law (OHG, KG) and legal entities that do not operate in banking, but in which banking firms participate ), as well as the increase or decrease of such participations. Shareholdings of banking firms in their parent corporations and vice versa are exempted from the obligation to apply for approval. In addition, there exists an obligation of notification of the acquisition and the abandonment of shareholdings of banking firms in non-banking firms (§ 10 KWG), if special approval pursuant to § 8 KWG is required. b. Furthermore, banking companies are obligated in each case of a large-scale investment to reduce the high risk of that investment reasonably (§13 KWG). A large-scale investment exists when the accounting value of all investments in a natural person or legal entity or partnership exceeds 15 per cent of the liable funds of the banking company.53 Furthermore, irrespective of the legal effectiveness of a transaction such investments require the express consent of the competent supervisory body of the banking firm under the respective articles of association. This provision is supposed to protect banking firms against insolvency resulting from large-scale investments.54 c. § 15 Abs 1 KWG provides for a limitation of the amount a bank can invest: Pursuant to this article the total amount of investments specified there, including rights to shares in banking and non-banking firms and calculated in terms of their accounting value, may not exceed the liable funds.55
53
PÖTZELBERGER, in Handkommentar zum Kreditwesengesetz, (Fremuth/Laurer/ Pötzelberger/Rues, eds., 2d ed., 1991), § 13 n. 2. 54 PÖTZELBERGER, «f., § 13 n. l and 2. 55 Cf. for a more comprehensive treatment JUD/SCHUMMER, supra n. 9, at 69; cf. also KOPPENSTEINER, Bankenaufsicht und Unternehmensverbindung, Bankwissenschaftliche Schriftenreihe Nr 75 (1991) at 22.
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It should be noted that the Second Banking Directive of the EC56 provides that each single holding may not exceed 15 per cent and all holdings together 60 per cent of the capital of the bank. These provisions, however, cannot be an effective means of protection against the controlling influence of banking firms on corporations listed at the stock exchange. This results from the fact that the maximum limits on investments of banking firms are comparatively very high while limitation based on the share capital of the stock corporation in which investments are effected is absent. In addition, it should be noted that banking firms can exercise their influence on stock corporations in a variety of ways. 2. Possibilities of Influence of Banking Firms a. Banking firms as shareholders As illustrated before, the distribution of the rights to vote in the general meeting of shareholders has a major impact on the overall management of the corporation. Of course, the general meeting of shareholders does not have any direct influence on the management of the corporation, but it exercises a substantial degree of influence by its right to elect the representatives of shareholders for the supervisory board, the members of which appoint and remove the management board. The impact of banking firms as shareholders can easily be deduced from the data just presented. The increasing influence of banking firms is also reflected in the following data: The shareholdings of private shareholders, including banking firms, in stock corporations increased from 11.5 per cent in 1978 to 21.9 per cent in 1989, and, the holdings of savings banks in terms of investment in and formations of as well as expansion of subsidiaries increased by 0.4 to 4.2 per cent within the same period of time.57 b. Banking corporations as holders of depositary votes Unfortunately, there is no research available on the amount of depositary voting rights exercised by banks in Austria. It may, however, be assumed that the proportions of voting rights present a picture similar to that of the corporations listed at the stock exchange in Germany. Small shareholders quite often are not very interested in participating in the meeting of shareholders because of their rather insignificant shareholdings. The uniting of voting rights has not yet become common in Austria, and there are actually no associations of shareholders important enough to be able to do so. What results from this fact is that banking firms exercise numerous depositary voting rights plus their own voting rights and the voting rights of shares they hold as dealers. If, on the other hand, a small shareholder does not appear at the 56
Gazette of the EC no. L 386 (30th December 1989) Art. 12. "GOLDMANN/BEER, supra n. 12, at 59.
Institutional Investors and Corporate Governance in Austria
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general meeting of shareholders and does not authorize anybody to vote on his behalf, the votes of the shareholders present assume greater importance and a minority shareholder may find himself/herself in the position of holding an absolute majority of votes. c. Further possibilities of influence Further possibilities of influence by the banking firms result from their function as creditors and also from interlocking directorates, as many executives of banking firms are represented on various supervisory boards. It is certainly no longer a secret that the actual power in many corporations is exercised by banking firms, as the granting or not-granting of bank loans is often essential to the continuance or the destruction of an enterprise. From the point of view of banking firms it is, therefore, only natural to regulate and intervene in the management of stock corporations. This applies particularly whenever financial difficulties of the debtor corporation become apparent and the bank does not have enough confidence in the management of that firm. The importance of banking firms can also be seen by the fact that most reorganization measures are carried out according to the financing plans of banks. As a means of supervision seats on the supervisory board are often taken by banking firms so that the employment of the capital invested can be scrutinized. Unfortunately, no more precise data concerning the distributions of seats on the supervising board are available. However, under the "Firmenbuchgesetz" (law relating to the firm book)58, which regulates the obligation to register the members of the supervisory board in the firm book (§ 5 FBG), and under the stock act, which provides for an obligation of the management board to register each change of the members of the supervisory board in the firm book without delay (§ 91 AktG, passed by the FBG), it will in the future be possible to conduct more precise investigations into the composition of the supervisory boards in stock corporations. Before the former regulations were passed changes in the members of the supervisory board only had to be published in the respective gazettes and no registration in the firm book was necessary. If the publication was not made, no method of finding out about such a change existed. Nevertheless, in view of the complexity involved, it is highly questionable whether such an investigation will actually ever be carried out.
58
Firmenbuchgesetz (FBG), BGB1 1991/10.
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V. Conclusion
As can be deduced from the above presentation, among institutional investors only banking firms - and to a very limited extent also insurance companies occupy an important position on the Austrian stock market. The potential goals attributable to institutional investors are not uniform. The most obvious difference is between investors intending rapid rate gains and those focusing on long-term capital investments. The latter, such as holders of shares quoted on the stock exchange and large-scale investors such as the public authorities and banking firms, pursue strategies of providing security for their enterprise in order to also secure the assets invested therein as well as unredeemed loans. This is not always true of other institutional investors that display an interest in short-term investments. However, at present such investors do not exist in Austria. Austria displays a picture significantly different from the Anglo-American situation: In Austria major shareholders, holders of blocks of shares, majority (family) syndicates and holding corporations control the market and do not give much space to small shareholders. Institutional investors, such as banking firms, are also regarded as large-scale shareholders, but they do not take over other companies. In fact, institutional investors in Austria have a preserving rather than a destroying influence on corporations listed on the stock market. Their goals are, in fact, opposed to the US-style institutional investors, who have to achieve a high return on their investments within a short time. The rigid character of majority participations in Austria makes it impossible for institutional investors to exercise a controlling influence by means of shareholdings in stock corporations listed at the stock exchange. The restrictive policy of the Austrian stock corporations concerning dividends partly results from this peculiarity. This restrictive policy is also blamed for the relatively discouraging profit situation. It is an entrepreneurial policy designed to increase the power of the corporations listed on the stock exchange, and partly also results from the fiscal policy of promoting of the preservation of capital (§ 208 HGB). Consequently, domestic institutional investors are discouraged from making further investments. The decrease of corporate profits has been responsible for the reduction of numerous credit ratings and may further reduce the "danger" of large investments by institutional investors to practically next to nothing. This development is still exacerbated by the sagging share prices at the Viennese stock exchange and by the low level of the "Wiener Börsekammer Index" (share index at the Viennese stock exchange). Apart from these factors there are legal provisions relating to share capital that make it difficult to exercise a controlling influence by means of institutional investments. Under the Austrian law relating to share capital the taking over of the majority of shares does not automatically entitle the majority shareholder to direct the corporation. It requires a certain period of time and numerous
Institutional Investors and Corporate Governance in Austria
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measures and resolutions to install a management board willing to act in accordance with the interests of the new owner. The premature removal of a member of the supervisory board requires a resolution of the general meeting of shareholders with a majority of at least three-fourths of the votes cast. The premature removal of the management board, which can only be resolved by the supervisory board, requires substantial cause. If this new controlling influence caused damage, which cannot be legitimated by the pursuit of group interests, the person causing the damage is liable for the damages under the stock act (§ 100 f AktG). In view of the undercapitalization of enterprises, it would in fact be desirable and necessary that enough quantities of equity capital are supplied by means of a well-functioning capital market. It is therefore not surprising that claims are raised in favour of an increasing involvement of institutional investors on the Austrian stock market.59 Owing to the stabilizing effect they are expected to have on the stock market, they are regarded as one of the main pillars of a wellfunctioning capital market.60 In spite of all attempts to stimulate the share market, attention has to be paid to the fact that the promotion of the involvement of institutional investors might lead to an unjustifiable concentration of economic power over stock corporations.61 There is no need to fear such a concentration if institutional investors operate side by side with large-scale shareholders, who can function as a counterbalance of power. However, the absence of sufficient measures for the inspection of newly introduced groups on the stock market is considered to be a defect, as is the lack of measures to control the influence of power if the stock market is made open to widespread shareholdings. It will, therefore, be necessary, in order to improve the availability of capital for the stock market to optimize the conditions for and to introduce a mechanism of control against the formation of controlling influence of institutional investors. Simple obligations of notification as those provided by § 91 BörseG certainly will not suffice. In addition, the clarification of the specific investment and voting policies of institutional investors is necessary. Once precise information is available as to which interests are typically pursued upon the involvement of institutional investors, the influence of institutional investors on the management policies can be determined. Once this has been clarified, the qualification of institutional investors as large-scale shareholders or as holders of blocks of shares, as small shareholders or as a third community of interests will be possible. Reactive legislation should depend upon this qualification. 59
Cf. Kapitalmarktperspektiven, Band I und Band II, Forderungskatalog (März 1990). 60 Konzept Finanzmarkt Österreich, at 13. 61
Cf. NOWOTNY, "Schutz des Anlegers (I and II)," GesRZ 1990, 126 and 186.
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Waldemar Jud
For the time being, we may conclude that institutional investors do not present a danger to the Austrian economy as uncontrolled invaders who utilize their unregulated exercise of voting rights in stock corporations to "plunder" them. This situation will not change as long as regulations concerning investments restrict the purchase of blocks of shares of a quantity that enables the holder to get control. However, once institutional investors are permitted greater involvement in order to stimulate the capital market, the investment policies of banking firms will also change. This would require us to change our way of thinking as the principle of reconciliation of interests that currently applies in the law relating to shares would have to be sacrificed to the internal influence of institutional investors in stock corporations listed on the stock exchange.
Chapter Seventeen Institutional Investors in Switzerland Martin Anderson and Thierry Hertig· I. Introduction Despite the growing strength of institutional investors in Switzerland, particularly pension funds, their investment behavior and potential influence have not yet received much attention in the financial and legal literature1. This probably stems from the relative lack of empirical information as well as from the conservative investment approach of Swiss institutions in the past. The purpose of this study is to analyze the changes in behavior of institutional investors in Switzerland as well as their influence on recent developments in Swiss financial markets and public companies. This paper further attempts to identify and examine the major changes that might result from the increasing power and activity of these investors. Finally, this study analyzes the impact of legal constraints and discusses some conceivable legislative improvements. In order to achieve this study, a questionnaire was sent to 555 of the largest Swiss institutional investors managing approximately 80 % of the estimated Sfr. 530 billion held by this type of investor2. The questionnaire contains questions about investment strategies, relations with stock exchanges and * The authors wish to thank Professor Geiard Hertig, Geneva, and Professor Alain Hirsch, Geneva, for suggesting this study as well as for their helpful and critical review of this paper. They also wish to thank all the institutional portfolio managers who kindly agreed to grant them some of their time to answer their questions or send back their questionnaire. 1 Exceptions to this are, in particular, the studies by HEPP, The Swiss Pension Funds: An Emerging New Investment Force (Berne 1990) and LUSENTI, Les institutions de pravoyance en Suisse, au Royaume-Uni et en Allemagne (Geneva 1991) which investigate the situation of Swiss pension funds and to some extent Swiss life insurance companies. 2 Calculations of the authors based on the figures available in relation to Swissbased institutional investors (not taking into consideration consolidated figures concerning foreign subsidiaries of Swiss groups).
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financial intermediaries, relations with public companies as well as internal structures. It also focuses on the current asset allocation of these major actors, highlighting the differences according to the type and size of institutions. The results yielded provide data which supplement the most recent official statistics (published in summer 1992). Those statistics are based on figures as of December 31, 1990 and cover only pension funds. The empirical results reported in this study should be considered as representative for large Swiss institutional investors given that more than one third of the managers questioned answered all or most of the questions raised. Furthermore, twenty people representative of the different actors on the stage of Swiss institutional investment were interviewed with the aim of identifying more precisely the feelings and wishes of these investors.
Π. Framework of Institutional Investment in Switzerland A. Classes of Institutional Investor The largest and most typical class of institutional investor is without dispute that of pension funds. As is the case in many other countries, e.g. the United States, the United Kingdom or the Netherlands, pension funds constitute the second pillar of the retirement funding system. Aside from this employmentbased second pillar, the Swiss retirement funding system also includes a first pillar relying upon the distribution principle (social security) and a third pillar of private savings which are partially tax exempt. The introduction of a compulsory social security occurred in 1948, while the second pillar developed from the middle of this century and has been governed by a federal statute since 1985. The third pillar has more or less always existed but was reinforced in 1987 with the granting of tax privileges. The main resources of Swiss pension funds are the periodic payments made by both employees and employers (which account for approximately 60% of the total income of pension funds) and the financial revenues (27% excluding capital gains and losses)3. The contributions of employers represent 65% of total periodic payments, which is substantially higher than the minimum proportion required by Swiss law (50%). According to the latest available statistics, the total assets held by Swiss pension funds4 amounted to Sfr. 215 billion as of December 31, 19905. Based 3
FEDERAL OFFICE FOR STATISTICS, Statistique suisse des caisses de pension 1990, at 14 (Berne 1992). 4 Swiss pension funds can be divided into two classes: (i) private pension funds, i.e. funds constituted in the form of foundations or mutual associations and generally intended for employees of private sector companies, and (ii) public pension funds, i.e. institutions organized under public law and managed with the cooperation of public
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upon the assumption that the growth rate observed over the 1987-1990 period was maintained during 1991, the amount of funds under management can be estimated at Sfr. 235 billion as of December 31, 1991. Bearing in mind the fact that the active members of these funds are, and will over the coming years remain, far more numerous than the pension beneficiaries, it seems realistic to assert that their total assets will approach Sfr. 500 billion by the end of the century6. However, these figures may well not represent the real amount managed by such funds because of their accounting practices: according to these practices, real estate and stocks are evaluated at historical costs by many pension funds and bonds often figure at par value. Taking these practices into consideration, which lead to the undervaluing of real estate and stocks and the overvaluing of bonds under the present circumstances (higher interest rates), we estimate that the real value of assets held by Swiss pension funds amounts to approximately Sfr. 250 billion as of December 31, 1991 (of which almost one-third is held by public pension funds). Moreover, according to our calculations, 2% of Swiss pension funds (with more than 1,000 affiliated members) manage more than 3/4 of this estimated asset value7. Life insurance companies constitute a second major class of institutional investor in Switzerland. As of December 31, 1991, the total assets held by the 20 largest companies (which manage almost all funds held by this class of investor) exceeded Sfr. 160 billion8. Swiss life insurance companies manage the funds received both from individuals under life insurance policies (partially benefiting from tax privileges) within the third pillar and from numerous medium and small size pension funds within the framework of the second pillar. Institutional investors also include investment funds. In Switzerland, there exist two different types of "investment funds": ordinary mutual funds and investment foundations specifically intended for pension funds. As far as the first type is concerned, the 226 such funds subject to Swiss law held assets in
law bodies which are most often designated for people working in the administration or for public corporations. 5 See supra n. 3, at 16. 6 This figure is consistent with the estimated amounts discussed in HELBLING, Les institutions de provoyance et la LPP, at 31 (Berne 1991). 7 Calculations based upon the data appearing in FEDERAL OFFICE FOR STATISTICS, Statistique suisse des caisses de pension 1987, at 30 (Berne 1990). 8 This figure was derived from the data available as of December 31, 1990 appearing in, "Die grössten Unternehmen in der Schweiz 199 , Schweizer Handelszeitung, Zürich 1991, at 156.
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excess of Sfr. 34 billion as of December 31, 19919. As regards the 15 investment foundations, their total wealth amounted to approximately Sfr. 14 billion as of the same date. Another class of institutional investor which must be mentioned is that which encompasses non-life insurance and pure reinsurance companies. The total value of their assets was higher than Sfr. 50 billion as of December 31, 199110. Finally, we believe that the financial power of large Swiss companies (banks trading for their own account and industrial corporations) allows their portfolio management (mainly bonds and stocks) to be regarded as a further class of institutional investor in Switzerland. For instance, the second largest Swiss public company in terms of market capitalization, Hoffmann-La Roche, holds on a consolidated basis Sfr. 3.2 billion in stocks and Sfr. 5 billion in bonds and equivalent securities11. A brief overview of the short-term financial assets (excluding permanent minority shareholdings) held by the 25 largest players in terms of corporate cash management yields a figure of approximately Sfr. 100 billion (including Sfr. 70 billion in marketable securities), 70% of which is held for own account by the seven largest banks12. The approximative size of the various Swiss institutional investors examined above is illustrated in Figure 1. Figure 1. Distribution of the Funds Held by Swiss Institutional Investors
Foundations • Self Manag. P. Funds 32.20%
• 2nd Pillar in Life Ins. LJ Life Insurance 9.50% 2.70%
D Non-Life Insurance LJ Cash Management
6.40%
18.90% S Mutual Funds
9
SWISS NATIONAL BANK, Monthly statistics report, April 1992, Table D15. This number does not include the estimated Sfr. 55 billion held by the 352 foreign mutual funds authorized to issue certificates in Switzerland. 10 This figure has been derived from the data available as of December 31, 1990 (see supra n. 8, at 156-157). 11 Figures derived from the annual report 1991. 12 Calculations of the authors based upon the annual reports of the major Swiss companies (including banks).
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From international perspective, this figure shows some striking Swiss peculiarities. First, the overall weight of pension funds (i.e. self-managed pension funds, second pillar managed by insurance companies and investment foundations specifically intended for pension funds) as institutional investors is particularly high (44.1%). This is not surprising as the total assets held by Swiss pension funds represent more than 60% of the Swiss GNP13. Another interesting point is the relatively low weight of mutual funds (6.5%), particularly compared with their importance in the United States. However, this second observation must be qualified by taking into consideration the fact that most mutual funds newly created by Swiss entities are located abroad for legal and tax reasons. B. Economic and Financial Environment A study of the behavior and influence of institutional investors in Switzerland cannot be undertaken without taking into consideration the major changes that are currently affecting the Swiss economic and financial investment environment. Of particular importance is the gradual disappearance of the country's comparative advantages (the strength of the Swiss franc, political and economic stability). In view of this phenomenon and of the internationalization of financial markets, comparatively low interest rates and other Swiss peculiarities should lead to a more critical approach towards Swiss investments and, in turn, influence the geographical asset allocation of institutional investors. 1. Investment Vehicles In view of the fact that more than 80% of the institutional investors' portfolios are invested in Swiss assets, an examination of the importance and peculiarities of these investment vehicles in Switzerland would appear to be necessary. Basically, aside from the absence of a money market, the investment vehicles available in Switzerland are more or less the same as in other financial markets. As far as stocks are concerned, the Swiss market is characterized by the considerable size of its multinational companies in relation to the country's population (6.7 million inhabitants). As a consequence, the Swiss stock market ranks seventh in the world in terms of capitalization with a total value exceeding Sfr. 250 billion as of March 31, 199214. Expressed in terms of capitalization per inhabitant, this figure represents Sfr. 40,000. A comparison with the same ratios computed for the United States (Sfr. 15,000), the United 13
See LUSENTI, supra n. 1. ASSOCIATION TRIPARTITE BOURSES, Swissindex: Quarterly Report 1/92 (Zurich). 14
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Kingdom (Sfr. 18,500) or the Netherlands (Sfr. 17,500) clearly demonstrates the comparative importance of the Swiss stock market. Another peculiarity of this market is its strong concentration on a few companies, the 10 largest ones accounting for almost two-thirds of total market capitalization15. The Swiss market has always been important for bond issues. This is mainly due to the high savings rate of Swiss citizens and to the large inflow of foreign funds attracted by the stability of Switzerland. These phenomena have created the basis for low interest rates. To illustrate the size of the Swiss bond market, the aggregate net amount of Swiss franc bond issues amounted to Sfr. 39.5 billion in 199016. Despite the gradual disappearance of Switzerland's comparative advantage in this respect, interest rates payable on Swiss franc bonds remain attractive for issuers compared with those payable on other currencies (average return to maturity: around 7.6% as of December 31, 1991)17. This peculiarity is one of the major factors which explain why, until 1991, more than 70% of the total Swiss franc bond issues consisted of bonds issued by foreign entities. Other asset classes significantly represented in the portfolios of institutional investors are real estate and mortgages. In comparison with other countries, the Swiss real estate market can be characterized by high values, in particular due to the limited constructible area, and low mortgage rates. However, because of the general pressure on Swiss interest rates, the latter peculiarity is gradually losing importance (for instance, from January 1, 1989 to December 31, 1991, the average mortgage rate increased from 5.0% to 7.8%). The investment vehicles available to institutional investors in Switzerland also include various types of options and futures as well as ad hoc products. A fully automated exchange was introduced in May 1988: the SOFFEX (Swiss Options and Financial Futures Exchange). Today, this continually developing market offers both options on 15 blue chip stocks and stock indices, and futures on interest rates and stock indices. Different types of longer term stock options are also available. The first type (the so-called "Stillhalter") is issued by financial intermediaries with the cooperation of large stockholders, including institutional investors, who agree to "freeze" the underlying stocks. The second type ("bonus options") is freely issued by the companies themselves as an indirect means of increasing their equity.
15 16
Id.
See supra n. 9, table D10. However, for foreign issuers, the cost of a currency swap (entered into to cover the exchange rate risk) reduces the spread between the interest rates payable on Swiss francs and those payable on foreign currencies. 17
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2. Particularities of the Swiss Stock Market For many international investors, the Swiss stock market is often regarded as a complex, illiquid, non-transparent and often unfair market18. However, this image should change significantly as a result of the current "big bang" occurring in Switzerland. Substantial efforts are being made by all interested parties (financial intermediaries, stock exchanges and listed companies) to improve the efficiency of the Swiss stock market. This trend can be illustrated first by the efforts being made to increase market liquidity. Until a few years ago, transactions in Swiss stocks took place on eight different exchanges the size of which was highly variable. Today, only three stock exchanges remain and the improvement in the liquidity of the market resulting from the concentration of orders should continue with the foreseen creation in 1994 of a single, electronic Swiss exchange largely based on the Australian model. The creation of this electronic exchange will contribute to the establishment of a market-making business in Switzerland. This second element should further contribute to alleviate one of the problems often mentioned with respect to the Swiss market's liquidity, i.e. the absence of counterparties, in particular for larger orders. A further liquidity obstacle stems from the capital structure of Swiss corporations. The significance of this impediment is rapidly declining with the simplification of the capital structure and the opening of Swiss companies to foreign investors. However, these various improvements will not eliminate altogether the liquidity problem which is inherent in the size of the Swiss stock market: except for the 10 to 15 largest multinational companies, Swiss corporations are not large enough to offer market-wide liquidity. As regards transparency, it must be remarked that the stock exchanges started publishing daily transaction volumes in April 1990. These volumes include not only transactions carried out on Swiss stock exchanges, but also transactions executed by the members of Swiss stock exchanges both offexchange and abroad: according to the estimate of the Swiss Stock Exchanges Association, more than 90% of all transactions on Swiss stocks are included in these volumes19. The disclosure of such information has improved the Swiss market's transparency. However, the stock exchanges only publish aggregated data of the previous day's transactions and do not give any information as to the number and size of individual transactions. It is worth noting, however, that this latter element is not specific to the Swiss stock market. 18
For a recent assertion of some of such feelings, see MAKINSON COWELL & FINANCIAL TIMES, Anglo-American Perspective: A View of Europe from New York and London at 116-123 (1992). 19
See HERTIG G. & HERTIG-PELLI M. (eds), Colloque: L'avant-projet de Ιοί f dtrale sur les bourses et le commerce des valeurs mobilieres, at 97 (Zurich 1992).
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Important changes are also occurring in relation to transaction costs. In order to reinforce the ability of Swiss exchanges to face increasing international competition and to protect the consumer interests, the Swiss authorities have decided, following the recommendation of the Swiss Cartel Commission, to enjoin the Swiss banks to abrogate important conventions such as that governing brokerage fees20. As a result, the transaction costs' structure is being readjusted in order to ensure that every user of banking services pays for the effective costs generated by his transactions. This readjustment process favors large investors such as the institutions whilst at the same time penalizing the smaller ones. C. Legal Environment The investment behavior of institutional investors as well as, in turn, their effects on financial markets and public companies are not influenced by economic factors alone. The legal environment must also be taken into account. This includes both regulations specific to institutional investors (such as the provisions affecting the investment policy of pension funds or insurance companies) and general regulations (such as stock market legislation and corporation law) which indirectly affect the investment decisions of institutions. In Switzerland, the latter two legislations are of particular interest in view of the important changes that are affecting them. Obviously, the legal environment of institutional investment also includes the various applicable tax laws. Finally, and although this issue will not be discussed further in this study, the impact of European Community legislation on institutional investment in Switzerland must also be bourne in mind. 1. Statutes Specifically Applicable to Institutional Investors As far as Swiss pension funds are concerned, they are primarily subject to a federal act which came into force on January 1, 1985 (statute on occupational old age, survivors and disability benefit plan, "LPP") and its implementing ordinances. This statute made employment-based retirement funding compulsory in order to allow pension beneficiaries to maintain, through the first and second pillars, their previous standard of living. It further provides for an organization consisting of both a management and supervisory board. Employers and employees are equally represented on the latter board. This federal act is not applicable to all Swiss pension funds: some of them (nonregistered funds) offer allowances additional to those prescribed by the LPP 20
For more details regarding the Commission's recommendations, see COMMISSION DES CARTELS, "Les effets de ported nationale d'accords entre banques," in Commission des Cartels et Surveillance des Prix 1989 III, at 111 ff.
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and are subject to cantonal regulations. The importance of this class is secondary, as it only covers approximately 15 % of all insured people21. In any event, the regulatory framework of the two classes of pension fund does not differ significantly, as all Swiss funds are subject to the control of a supervisory authority (either federal or cantonal) and have to respect similar limits for their investments amongst the various asset classes. As regards the federal limits, a complicated system with specific and general quotas was set up under an ordinance implementing the above-mentioned statute ("OPP 2" of April 18, 1984). The most relevant limits are as follows: a maximum of 30% of the total assets may be invested in Swiss stocks, 25% in foreign stocks, 50% in Swiss real estate, 5% in foreign real estate, 100% in bonds issued by Swiss debtors, 30% in Swiss franc bonds issued by foreign debtors and 20% in foreign currency bonds. In addition, the following general limits apply: 50% in stocks, 70% in "real" assets (stocks and real estate), 30% in bonds issued by foreign debtors (whether in Swiss francs or in foreign currency) and 30% in foreign currency assets22. More generally, pursuant to the provisions of LPP and OPP 2, Swiss pension funds have to follow the principles of security, return, risk diversification and liquidity. Private insurance companies (which must be established either as stock corporations or as mutual associations) are highly regulated in Switzerland. In particular, they are subject to a federal law of June 23, 1978 (statute on supervision of private insurance companies, "LSA") and its implementing ordinances which set severe reserve requirements and strict investment limits. The latter are more specifically prescribed by an ordinance of September 11, 1931 and correspond to those set for pension funds, except for Swiss real estate and mortgage investments which are not restricted. Swiss mutual funds are subject to a federal statute of July 1, 1966 and its implementing ordinance of January 20, 196723. The main purpose of this statute is the protection of unitholders. It forces Swiss mutual funds to follow a conservative investment policy based on the principle of risk diversification and forbids the establishment of specialized funds such as those investing in commodities, options etc24. This statute further provides for an obligation to
21
See supra n. 7, at 23. For more details regarding the applicable investment limits, see art. 53-60 of the OPP 2. It should be noticed that the general limit for investments in foreign currency assets has been increased from 20% to 30 % by an amendment to the OPP 2 in effect since January 1, 1993. 23 Funds constituted by the combination of bilateral contracts between die unitholders and the fund's management and custodian bank fall under the scope of application of this statute. 24 This act is presently in die process of being revised: a draft statute was submitted in March 1993 to the Parliament. The forthcoming statute should, inter alia, allow the 22
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redeem the units offered for redemption by a unitholder thus giving Swiss mutual funds an "open-ended" character and forcing them to dispose permanently of sufficient liquid assets. Finally, Swiss banks are governed by the federal law on banks and savings banks of November 8, 1934, as amended in 1971, and its implementing ordinance of May 17, 1972, as recently amended. With the aim of protecting the interests of creditors and the Swiss financial system, these statutes impose severe equity and liquidity requirements and lending limits. As regards the behavior of banks as institutional investors (cash managers investing in stocks and bonds for their own account), the following equity requirements warrant consideration: a bank's equity must represent at least 2% to 7% of the value of bonds held for its own account, 10% for listed stocks and even 100% for its own stocks25. 2. Stock Market Legislation and Corporation Law At present, the regulatory framework of the Swiss stock market is still rather inconsistent. First, securities' trading is governed by old cantonal acts and selfregulation developed by the three major stock exchanges (Zurich, Geneva and Basle). This unsatisfactory situation should, at least partially, disappear with the forthcoming implementation of a federal statute on stock exchanges and securities trading26. This new legislation will replace the inadequate cantonal laws and provide for general principles, leaving a large range of issues to selfregulation in order to achieve the necessary flexibility. Of particular importance in this respect are the proposed disclosure obligations which will apply when specified levels of shareholdings in listed companies are reached. Second, Switzerland does not have any regulations on takeovers and mergers. Nevertheless, the members of the Swiss stock exchanges (the Swiss banks) have entered into an agreement, the takeover code of September 1, 1989 (the so-called "codex"), whereby they agree not to participate in any tender offer which does not comply with the terms of the codex. The codex should, however, be regarded as only a first step towards an appropriate takeover regulation (such as the City of London code on takeovers and mergers) providing for equal treatment of shareholders27. For this reason, during the last three years, most stock purchases allowing the buyer to obtain a majority stake creation of so-called "risky mutual funds" (investing in commodities, options, illiquid stocks etc.). 25 Equity ratios such as those mentioned above must be added together in order to determine the total required equity. 26 For details of this new federal act, see supra n. 19, in particular art. 6 of the preliminary draft enclosed therein and at 93 ff. 27 This observation is not specific to Switzerland: many countries have not yet taken this first step.
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in a listed company were made without giving sufficient consideration to the interests of minority shareholders. The Swiss authorities are thinking of legislating on takeover offers in listed companies within the framework of the federal statute on stock exchanges and securities trading28. However, there are serious doubts whether the provisions on takeover offers will become effective within a few years. As regards Swiss corporation law, it must be stressed that new legislation came into force on July 1, 1992 after more than 20 years of discussion. It seems important to briefly point out the major changes that are likely to affect institutional investors indirectly. First, the new law suppresses the possibility for Swiss listed corporations to decline registration of undesirable shareholders in their stock ledger, in particular foreign investors. However, the new provisions continue to allow the boards of directors of listed companies to refuse registration to investors in three main cases: (i) upon passing of a limit expressed as a percentage of the registered shares fixed in the by-laws, (ii) where there are restrictions to foreign shareholdings prescribed by federal legislation (regarding banks, insurance companies, acquisition of real estate) and (iii) upon failure to provide a declaration of acquisition for own account. Second, the reduction of the minimum permitted par value allows corporations to split their shares. Third, the quorum and majority provisions have been adapted in order to take into account the low rate of participation in shareholders' meetings29. Fourth, as regards the representation of shareholders by financial intermediaries at shareholders' meetings ("Depotstimmrecht"), the new provisions require the latter, if they decide to exercize the voting rights, to request specific instructions before each shareholders' meeting. If this requirement is not fulfilled, the financial intermediaries are not allowed to vote. If no specific instructions are received from the shareholders, the intermediaries have to follow the general instructions of the former or, in the absence of such instructions, to vote in favor of the board of directors' proposals30. Furthermore, with the purpose of improving the transparency of annual reports, new accounting rules and an obligation to disclose the names of
28
ff.
29
See supra n. 19, art. 19 ff of the preliminary draft of the federal law and at 149
For instance, only approximately 36% of all voting rights were represented at the last shareholders' meeting of CS Holding. 30 The new regulation of the voting by proxy to a certain extent takes account of the practice prevailing before July 1, 1992: pursuant to a recommendation of the Swiss Bankers Association, custodian banks exercized the voting rights in favor of the board of directors' proposals unless specific instructions were given by the shareholder.
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shareholders holding, whether alone or pursuant to a voting agreement with other shareholders, more than 5% of the voting rights have been introduced31. 3. Tax Regulations Although it is undisputed that applicable tax rules influence the management of their portfolios by institutional investors, a thorough investigation of these issues is beyond the scope of this paper. Nevertheless, it seems useful to briefly present the main tax issues affecting the investment decisions of Swiss institutional investors, in particular pension funds. First of all, all institutional investors, whether Swiss or foreign, buying or selling securities in Switzerland must pay the often critized Swiss stamp duty32. A 35% withholding tax hits all dividend payments and interest payments made by Swiss entities33. This withholding tax is fully recoverable by Swiss institutional investors. Its recovery by foreign investors is subject to the applicable double taxation treaties. On the other hand, Swiss institutions may recover foreign withholding tax levied on dividends and interest payments under the provisions of the same double taxation treaties. Finally, it must be mentioned that the income and capital of pension funds which are fully devoted to retirement funding benefit from a general tax exemption. However, this exemption prevents Swiss pension funds from benefiting from the tax credit on foreign withholding taxes34.
ΙΠ. Institutional Investors and Swiss Financial Markets A. Investment Strategies of Swiss Institutional Investors The empirical study conducted on the basis of the responses to the questionnaire makes it possible to analyze the asset allocation of Swiss institutional portfolios with up to date data and to identify the trend in asset allocation in the rapidly changing environment. Before discussing the results of the empirical study, it seems necessary to present the data collected and the calculation methods used. The questionnaire 31
The disclosure threshold is lower if the limit fixed in the company's by-laws for the registration of purchasers of registered shares is lower than 5% (art. 663c of the Swiss Code of Obligations, hereafter "CO"). 32 Federal law on stamp duties of June 27, 1973. It should be n.d that an amendment of this statute, tending to alleviate Swiss stamp duties in order to reinforce the competitiveness of the Swiss financial market, has been accepted by the Swiss people on September 27, 1992. 33 Federal law on withholding tax of October 13, 1965. 34 Federal ordinance on tax credit of August 22, 1967 (art. 3).
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was sent to 555 of the largest Swiss institutional investors. 200 anonymous answers were received, which represents a participation rate of 36%. In order to identify more specifically the behavior of each different class of institutional investor, the sample was divided into 5 categories: private pension funds (participation rate of 32%), public pension funds (59%), insurance companies (69%), mutual funds and foundations (41%) and cash managers (13%). Furthermore, the answers received were separated according to the size of the investors' portfolios: considered overall, 51% of the 200 questionnaires were received from investors holding less than Sfr. 200 million, 20% between Sfr. 200 and 800 million, 13% between Sfr. 800 and 2000 million and 16% more than Sfr. 2000 million. The results obtained for the various categories of institutions outlined above do sometimes differ significantly from the overall average results. Therefore, aside from the analysis of the average figures, the most noticeable differences observed between these figures and those yielded for the various categories defined will be specifically discussed. The results of such a study cannot, however, be explained efficiently without taking into consideration the general attitude and characteristics of Swiss institutional investors. 1. General Investment Approach Despite the fact that Swiss institutional investors hold substantial assets, their in-house management structure can be considered generally as being rather light as compared with the amount of assets managed. This conclusion follows from a comparison of two sets of figures. While 66% of the entities which responded declared that their staff includes less than four people, it appears that only 51% of the investors included in the sample have less than Sfr. 200 million under management. Simultaneously, whereas 16% of the sample consists of large investors holding more than Sfr. 2 billion in assets, only 9% (essentially insurance companies) admit to having a work force of more than ten people. One of the reasons often given by managers to explain the low level of in-house staff is the cost of an adequate, independent professional management structure. As a result of this observation, the portfolio management of many private pension funds is handled by employees of the company's financial department. In addition to the costs of an in-house management structure, the insufficient knowledge of finance and/or the various other tasks of many private and public pension funds managers lead 51 % of the surveyed Swiss institutional investors to entrust financial professionals with the management of a part of their portfolio. This proportion is higher for pension funds than for the other classes of investor. However, of this 51%, only approximately one-fourth (mainly private pension funds) entrusts outside managers with the investment of more
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than 50% of their portfolio. The empirical results further demonstrate that stocks constitute the asset type which is most often managed, at least partially, by external professionals. However, this latter observation does not apply to insurance companies and other large institutional investors. This can be explained by the larger in-house staff of these investors. As regards the dynamism of Swiss institutional investors' asset management, the empirical study yields two relevant observations which tend to demonstrate that most Swiss institutional portfolios are, by far, not managed as actively as American or British portfolios. First, 42% of the managers who responded declare that their investment strategy is not reexamined within a six-month period35. Second, a large majority of investors (72%) holds more than 80% of its stock portfolio for more than a year. A similar pattern of behavior (80%) can be observed in the case of bonds, i.e. more than 80% of bonds are subject to a buy-and-hold policy. Furthermore, as far as the use of derivative instruments is concerned, the empirical study shows that 46% of the Swiss institutional investors holding a stock portfolio who responded have, at least once, followed a stock hedging strategy. The figure is even higher (56%) for strategies designed to increase the return of the stock portfolio. These observations must be qualified by the fact that derivative instruments are mainly used by larger institutional investors (holding more than Sfr. 800 million in assets). In addition, the return-oriented strategies followed essentially consist of the issuance of "Stillhalter": 41% of the investors following this type of strategy cover more than 10% of their stock portfolio with these transactions, whereas the figure is much lower for covered short call writings (27%). Although attitudes are gradually changing, Swiss pension funds and, to a lesser extent, insurance companies are not yet subject to strong pressure in relation to the level of return they must achieve. Their only constraint in this respect is to achieve a long-term return at least equal to the low capitalization rate (at least 4% per annum36). Despite this low level of return, it must be noted that many of these investors seem to be reluctant to take decisions that would be profitable in the long run if the latter might have the effect of preventing them from obtaining year after year a return equal to the long-term constraint. Besides, the pension fund managers are relieved from a great deal of pressure by the opportunity they are afforded to evaluate assets at historical cost (in the case of real estate and stocks) or nominal value (in the case of
35
However, it must be observed that investment funds and cash managers reexamine their investment strategy on a far more regular basis. 36 Art. 12oftheOPP2.
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bonds)37. This favours buy-and-hold policies and the overweighting of bonds. In addition, the possibility of integrating into their own reserves part of the retirement allowance of leaving employees offers a kind of "pillow" to Swiss pension funds. However, this latter possibility should disappear with the forthcoming implementation of legislation providing for a complete "free passage" from one pension scheme to another. 2. Asset Allocation by Asset Classes and Geographical Areas The average asset allocations are equally-weighted arithmetic means computed on the basis of portfolio compositions expressed in percentage terms and not in Swiss francs. Therefore, they show the general behavior of Swiss institutional investors as at the end of 1991 with respect to allocation strategies and do not represent the amounts allocated to each class of asset. Nevertheless, the stronger weight and influence on Swiss financial markets of the largest investors is not disregarded in this study in that deviations in the results obtained for this class of investor from the average figures are specifically examined. a) Asset Classes The overall average asset allocation of Swiss institutional investors appears in Figure 2. Figure 2. Average Asset Allocation of Swiss Institutional Investors
__ Claims vs Emp. 3 Bonds : H Own Shares :
37
CO.
~· J •JS 3%
0.4%
D Stocks :
10.4%
Π Real Estate :
19
_ Mortgages :
9.6%
S Other :
78-,
This possibility is granted by art. 47 and 48 of the OPP 2 and art. 957 to 964
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This figure shows that, on average, Swiss institutional investors manage their portfolios in a far more defensive manner than that prescribed by the already conservative provisions set forth in the applicable statutes. In particular, interest rate-linked assets are over-represented in Swiss institutional portfolios (70.1% considered overall). Among these assets, claims against employers represent on average a substantial share (7.4%)38. This figure must, however, be examined with caution as the mean result stems mainly from the public pension funds which lend considerable amounts to the State (federal, cantonal or local): the proportion reaches 21.2% for this class of investor. In addition, it must be observed that every fourth Swiss public pension fund holds more than 40% in this type of asset and that some of them (large funds) are even fully invested in claims against the State (as employer). Considering the low interest rates paid on this type of asset, the quality of the latter asset allocation (if it can be admitted that these funds are managed) must be questioned in view of the interests of pension fund beneficiaries. As far as bonds are concerned, the relatively high share (45.3%) is mainly due to private pension funds (which hold 51.0% in bonds on average)39. The overall share allocated to mortgages (9.6%) is upwardly biased by the importance of this type of investment to insurance companies (20.3%). Finally, the last type of interest rate-linked asset, i.e. the other assets (7.8%), mainly includes shortterm loans: the average proportion of this class of asset can be explained by the reverse yield curve prevailing at the time of the data collection and fulfills the legal requirement (for pension funds and insurance companies) of disposing permanently of sufficient liquid assets to meet current payments. The relatively low weight allocated to "real" assets (real estate and stocks) is mainly due to the aversion of most Swiss institutional investors to stocks. Although the average proportion allocated to stocks (10.4%)40 is increasing41, it remains low in view of the 30% limit fixed by the Swiss legislation applicable to pension funds and insurance companies. It is particularly striking that, aside from the below average proportion observed for public pension funds (5.8%), insurance companies only allocate 7.4% of their portfolio to this asset class, which is surprisingly low even for non-life business. The adequacy 38
This high average share is paradoxically low in comparison with the limit fixed for pension funds in art. 57 of the OPP 2, which allows unsecured investments in the employer of up to a maximum of 20% of the total assets. 39 However, the latter only grant a small proportion of their portfolio to claims against employers and to mortgages. 40 It must be stressed that the figure yielded for large private pension funds (holding more than Sfr. 800 million in assets), i.e. 18.3%, differs significantly from this average result. 41 For instance, in the case of pension funds, this share amounted to 3.3% in 1978, 6.8% in 1987 (see supra n. 4, at 22) and can be estimated on the basis of our empirical study at 10.1% in 1991.
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of the Swiss institutional asset allocation in this respect appears questionable if one considers that institutions' investment strategies (except for cash managers and, to a lesser extent, non-life insurance companies) should focus on the longterm and the fact that stocks have represented the best investment vehicle in the long run in Switzerland42. However, 26% of all managers who responded allocate more than 15% of their portfolio to stocks. One aim of the questionnaire was to determine the proportion of employer's shares in the portfolios of institutional investors. The result (0.4% on average) was significantly lower than expected; it may stem from one or both of the two following assumptions. First, institutional managers might follow a prudent investment strategy in order to avoid being confronted with conflicts of interest between employer and affiliated members. Second, the answers given might have been governed by a certain caution despite the anonymity of the empirical study, pursuant to which employers' stocks have been included in the overall share of stocks. Finally, the empirical study has shown that private pension funds, which have a rather young age structure (44% have at least six active members for each pension beneficiary), allocate a larger proportion of their portfolio to "real" assets than do public pension funds, the age structure of which is older on average (32% have less than three active members for each pension beneficiary). This observation is consistent with the characteristics of these investment vehicles and with the assumption in financial literature that "real" assets should be preferred by investors with a long-term investment horizon43. The empirical study further indicates that a majority of institutional managers have tried to increase their investment in stocks over the last five years (77%). This trend should continue over the five coming years, as 89% of the Swiss institutional investors who responded intend to put even more emphasis on stocks. Many of them seem to consider a share of 20-25% in stocks as a reasonable long-term objective. However, despite these encouraging overall observations, it appeared from both the questionnaires and the interviews that the increase in the proportion of stocks in institutional portfolios does not stem from the fact that Swiss pension funds define their investment strategies according to the age structure of their affiliated members (which determines the
42
This assumption is confirmed in a recent study by HOESLI & ANDERSON, "Swiss Real Estate: Return, Risk, and Diversification Opportunities," Journal of Property Research (1991), at 133 ff. 43 This assumption about the asset allocation optimization for Swiss institutional investors is discussed in a modern portfolio theory framework by HOESLI, Le röle de l'investissement immobüier dans la constitution d'un portefeuille, PhD dissertation (Geneva 1992).
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structure of their liabilities)44. This increase rather seems to be the consequence of an increasing awareness that stocks constitute the best opportunity in the long run. b) Geographical Areas Figure 3 illustrates the average geographical allocation of assets held by Swiss institutional investors. Figure 3. Average Geographical Allocation of Swiss Institutional Investors
D Switzert. : 88.7% B Europe :
8.4%
• N.Amer: 1.8% G Asia :
0.8%
| D Other :
0.3%
I
This figure clearly demonstrates that Swiss institutions still focus mainly on Swiss assets (88.7%)45despite the developments that have occurred in the economic environment, specifically with respect to the European Community46. This is particularly true of public pension funds and small institutions holding 44
For a discussion of this topic, see AMMANN & STREBEL, "Ein ganzheitliches Konzept für die Bewirtschaftung von Pensionskassenvermögen," Finanz und Wirtschaft Nr. 87, 89, 91 and 93 (1991). 45 In comparison with pension funds of other countries, the average stake of domestic investments yielded for Swiss pension funds (89.1% globally) does not appear to be disproportionate. For a brief discussion of die attitude of foreign institutional investors, see Section III.B hereafter. 46 It must be stated that Swiss cash managers allocate a much higher stake than the average figure to foreign assets. In particular, die foreign asset stake of the largest Swiss banks is higher than 75%. However, because of the relatively low participation rate of cash managers, the average figure does not take this peculiarity fully into account. Therefore, this figure can be considered to represent the other classes of institutional investor.
Institutional Investors in Switzerland
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less than Sfr. 200 million in assets (93.9% and 92.0%, respectively). This geographical allocation can be explained by three main factors. First, Swiss institutional investors are still afraid of running exchange rate risks as their liabilities are due in Swiss francs. Second, despite the hedging opportunities available against currency risks, many of them seem not to take into account the higher interest rates (for similarly rated debtors) and the greater liquidity of other European currencies as compared with Swiss franc issues. Third, for reasons related to valuation principles (the possibility of valuing bonds at their nominal value) and to the relative lack of pressure on return, many institutional investors do not want to book today the losses made on Swiss bonds (resulting from the rise in interest rates over the last few years) with a view to benefiting from higher returns abroad. Nevertheless, the share of European assets held has increased over the last five years to reach a level of 8.4%, and this trend should continue as 94% of the managers who responded indicated that they intend to increase the share of European assets in their portfolios. Moreover, investments in North America (1.8%) and in South-East Asia (0.8%) are at present marginal. According to the results yielded by the empirical study, their weight in Swiss institutional portfolios should rise over the next five years (particularly in the case of large investors holding more than Sfr. 800 billion in assets). Although on average Swiss institutional investors are still far from reaching the recently amended legal ceiling on foreign currency investments (30%), some pension funds which have taken advantage of higher European interest rates by purchasing foreign currency bonds are restricted by Swiss law and cannot increase their portfolio of foreign assets. B. Investment Strategies of Foreign Institutional Investors on Swiss Financial Markets An analysis of the influence of institutional investors on Swiss financial markets also requires that the attitudes of foreign investors be taken into consideration. A thorough investigation of their investment strategies is beyond the scope of this study. However, it would be useful to highlight briefly some characteristics of the approach of foreign institutions which affect Swiss financial markets. As far as the geographical asset allocation of foreign institutional investors is concerned, a recent study has indicated that French pension funds allocate on average 95% and German pension funds 94% of their assets to domestic investments47. According to the same study, British pension funds are the funds which allocate the largest stake of their portfolio to foreign assets (25%). The weight of foreign assets within the stock portfolios of British institutions even reaches 47%, and amounts to 24% in the case of American 47
See the study published in Neue Zuercher Zeitung (May 4, 1992).
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institutional investors48. It is interesting to note that institutional investors in these latter two countries, which are the most important foreign institutional players on the Swiss stock market, seem to look to Continental Europe as a whole. In this context, they allocate to Swiss stocks a proportion which is more or less equal to the share of Swiss stocks in the Continental Europe market capitalization49. However, their stock selection focuses mainly on the 15 largest Swiss companies because of the importance they attach to liquidity. Furthermore, it must be said that they carry out a large number of their transactions on the foreign markets, in particular on the SEAQ in London, where most of the largest Swiss companies are listed50. C. Relations Between Institutional Investors and Financial Intermediaries Relations between institutional investors, in particular pension funds, and financial intermediaries in Switzerland are currently subject to a process of complete readjustment. This phenomenon is due to the increasing financial strength of institutional investors and the deep restructuring which is occurring within the Swiss banking sector. Its consequences can be observed in the various fields in which institutional investors and financial intermediaries are in contact, i.e. portfolio management, investment advice and brokerage businesses. Traditionnally, because of the universality of the services of Swiss banks, Swiss corporations have often entrusted their financial partners with the management of their pension fund portfolios. According to our empirical study and interviews, this peculiarity tends to diminish progressively. This observation can be illustrated by the fact that 95% of all Swiss institutional investors who responded manage at least a part of their portfolio themselves. Approximately 90% of the investors holding more than Sfr. 200 million in assets even manage more than 50% of their own portfolio. This evolution may be explained by the increase in the size of funds which makes it possible for more and more institutions to reach the critical size for self-management to be possible. However, the desire to be more independent, sometimes linked with a certain criticism of the ability of banks to manage these portfolios, cannot be disregarded. It should further be noted that a significant number of mediumand small-sized pension funds pass the management of all their assets and liabilities on to insurance companies (see Figure 1).
48
See supra n. 18, at 35. According to this empirical study, American institutional investors intend to increase their holdings of Swiss stocks in 1992 (at 53 and 117). 49 W., at 38. 50 This allows them to benefit from the advantages of an electronic stock exchange and simultaneously to avoid Swiss stamp duty.
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In this context, it can be observed that the decrease in management mandate business is being replaced in some banks with new products (such as specialized mutual funds) or products more specifically designed for institutional investors (such as synthetic products which guarantee a return equal to the funds' capitalization rate but simultaneously offer opportunities to benefit from bull stock markets). Whereas investment advice was previously to a large extent offered along with general portfolio management services, the competition between Swiss financial intermediaries, further stimulated by the pressure of foreign banks and brokerage firms, seems to lead Swiss banks to start considering investment advice as a business per se. This strong competition is presently very favorable to Swiss institutions in that they are largely advised (company studies, direct calls) without having to pay directly for the advice. This situation, which seems to be unsustainable by the banks in the long run for obvious cost reasons, stems from the necessity to be present on the new market for investment advice. However, in the near future, institutional investors will certainly have to pay for such services. The form of such remuneration has not yet been established, but it could take one of the following forms: fixed price for general advice, full advice services subject to a minimum brokerage amount or performance fees on advice. As far as brokerage business is concerned, in the past few years it has constituted an important source of income for Swiss banks. This situation is now changing because of the strong competition induced by the abrogation of the brokerage convention. Brokerage business seems to be evolving as a simple "physical" link between stock markets and investors. The expected introduction in 1994 of an electronic stock market might well crystallize this evolution. According to our survey, a majority (59%) of large institutional investors, i.e. holding more than Sfr. 800 million in assets, would like to be directly connected to this electronic stock market51. However, this evolution of brokerage activities does not affect the block trading transaction business in which banks and other financial intermediaries play a real intermediate role in finding counterparties. In view of the evolution described above of both the role of financial intermediaries and the costs of their services, the question of whether Swiss pension funds will develop their own global in-house management structure or rather take advantage of the increasing competition in the field of investment services in Switzerland arises. The answer to this question, which will be specific to each fund, should mainly depend on how independent institutional investors want to be and what price (in terms of expenses and liability) they will agree to pay for it. 51
If such an opportunity is granted to entities which are not financial intermediaries, the cost of being connected will certainly be the decisive factor.
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D. Effects on Swiss Financial Markets The effects resulting from the growing financial weight of institutional investors, the gradual changes in their investment strategies as well as the various requests by foreign investors in relation to liquidity and transparency have highlighted the inadequacy of the markets' organization in Switzerland. This inadequacy is apparent both in relation to the problems concerning liquidity and volatility and in relation to the issues regarding transparency and fairness. An analysis of these matters will lead to outline solutions, already in the process of being introduced or currently only being discussed, capable of improving the organization of Swiss financial markets. 1. With Respect to Liquidity and Volatility The latest developments on the Swiss stock market have shown that the conjunction of two elements (the rise of institutional shareholdings and the growing number of stocks traded abroad) has, to a certain extent, reduced the market's liquidity and, together with a third phenomenon (the investment approach of foreign institutional investors towards Swiss stocks), apparently caused an increase in its volatility. The gradual rise of institutional shareholdings resulting from the increase of both the funds under management and the share allocated to Swiss stocks has reduced the number and increased the size of the players on the Swiss market. This phenomenon, linked with the low turnaround observed in Swiss institutional portfolios, may progressively reduce the liquidity of the Swiss stock market. When they manage their stock portfolio more "actively", Swiss institutional investors often participate in the issuance of "Stillhalter" (44% of the surveyed managers, but 81% of the largest institutions holding more than Sfr. 2 billion in assets and even 94% of the insurance companies). Such a strategy involves freezing a part of the underlying stock portfolio for the issuance of long-term options. According to the empirical results, this part can be substantial, as it exceeds 10% of the portfolio in more than half of the cases. If the issuance of "Stillhalter" does not increase the stock market's liquidity in the short-term, it might have a positive effect in the long run in the event that these options are exercized. As the fragmentation of transactions on various exchanges is a factor reducing a stock market's liquidity52, the growing number of stocks which are traded abroad tends to reduce the Swiss stock market's liquidity53. If it is not 52
The validity of this assumption relies on the observation that most investors do not present their purchase or sale orders simultaneously on the various exchanges. 53 The trading abroad occurs for various reasons, such as the absence of market makers on the Swiss market or the desire of avoiding Swiss stamp duty.
Institutional Investors in Switzerland
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surprising that foreign investors purchase Swiss securities on their own markets when available, it is interesting to notice that 54% of the Swiss institutional investors who answered this question (i.e. two-thirds of the sample) use (occasionally or even often) foreign markets for their transactions in Swiss securities. The figure amounts to 62% in the case of investors holding more than Sfr. 800 million in assets. Aside from the decreasing number of players and the increasing number of stocks traded abroad, the third element which warrants consideration with respect to volatility results from the different approach foreign investors display towards the management of their stock portfolio and the fact that their weight in the Swiss stock market is proportionately increasing54. Foreign institutions seem to react more impulsively and in greater measure when purchasing or selling Swiss stocks than do Swiss investors. Such active portfolio management, added to the decreasing liquidity described above, induces, on a market characterized by the existence of different stock exchanges and various types of share, a higher volatility. 2. With Respect to Transparency and Fairness The inadequacy of the Swiss stock market with respect to transparency and fairness has become more inconvenient with the growth of institutional investment. Despite the efforts of the Swiss stock exchanges to improve the information available about transactions in Swiss stocks (in particular through the publication of daily volumes since April 1990), the information available still remains insufficient because of the increase in the volume of transactions effected by financial intermediaries who are not members of the Swiss stock exchanges55. A further element which might affect the transparency of Swiss financial markets lies in the transactions effected outside the official stock exchanges. The legal freedom granted in Switzerland leads large investors such as the institutions to purchase and sell substantial blocks of shares without having to disclose to the public the amount and/or price of each transaction. According to our empirical results, 62% of the managers who answered sometimes or even often (often: 6%) buy or sell securities by mutual consent. The relevant figures, in the case of the large investors holding more than Sfr. 2 billion in assets, are 87% and 13%, respectively. 54
According to a study conducted in June 1991 by the Bank Julius Bär, Besitzverhältnisse von Schweizer Aktien, the weight of foreign institutional investors in terms of Swiss stock market capitalization is higher than 20%. 55 It must be n.d however that this observation is no Swiss peculiarity, as companies of many other countries are also listed on international stock exchanges such as SEAQ.
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The existence of off-exchange transactions, which include both ordinary but large operations and transactions related to "underground takeovers", also affects the fairness of the Swiss market for corporate control. Under the present legislation, it is possible to take a controlling stake in a public company through the participation of large institutional investors alone. It is not compulsory to go through a public tender offer pursuant to which the same price would be paid to all shareholders without regard to the size of their stake. As a result, minority shareholders often do not at all benefit from changes in control56. 3. Improvement of the Organization of Financial Markets The organization of Swiss financial markets has revealed its limits with the increase in institutional investment. The purpose of this section is therefore to examine both the improvements that have been achieved and those which would further be necessary. As far as liquidity is concerned, the unavoidable concentration of stock exchanges, which has already led to a reduction to three main markets, will continue with the expected creation in 1994 of a single electronic Swiss exchange. This latter step should make it possible to concentrate all purchase and sale orders of Swiss securities on one single Swiss market. It will also allow the development of a new trading organization relying on market-makers. Furthermore, the changes affecting the capital structure of more and more Swiss corporations should also contribute to improving liquidity. Aside from these improvements which affect stock exchanges and stocks themselves, a further step that should be taken in order to make the Swiss stock exchange more attractive for large investors and increase its liquidity is the abolition of stamp duty on transactions of securities57. This would contribute to prevent even more transactions being effected on foreign markets such as the SEAQ in London. As regards transparency, the forthcoming law on stock exchanges and securities trading will crystallize the current practice of stock exchanges and banks by introducing a reporting obligation for all transactions, whether on or off exchange. This forthcoming statute should also reinforce the obligation for listed corporations set forth in the new company law to disclose the names of their main shareholders (holding more than 5%) by obliging investors increasing or decreasing substantial shareholdings in quoted companies to disclose when they cross certain fixed thresholds. Even though such obligations should improve the transparency of the market by increasing the information available, in particular about block tradings, they 56 57
As already mentioned above, this criticism does not only apply to Switzerland. See supra n. 32.
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will not prevent minority shareholders' interests from being disregarded. The only way to ensure greater fairness on the Swiss stock market is to put in place a takeover legislation. In our opinion, such legislation should require a buyer to disclose the passing of fixed thresholds and to launch a public tender offer at a price at least equal to the average price paid to obtain his current stake (whether on or off exchange). The conjunction of these various improvements should lead to the Swiss stock market becoming more liquid and transparent. On the other hand, it is interesting to note that the focus of institutional investors on stocks of corporations with a large market capitalization might lead to the stock market being split into two segments: the first segment would include the large capitalizations subject to higher information requirements (semestrial reports, internationally accepted accounting standards, etc.) and the second segment would contain all other listed stocks58. According to our empirical study, 71% of the institutional investors who responded would not be against such a split.
IV. Institutional Investors and Swiss Public Companies A. General Approach Towards Investments in Swiss Stocks Before analyzing the attitude of institutional investors as shareholders and their influence on Swiss public companies, it would be worthwhile to examine the general framework of Swiss institutional investments in Swiss stocks as highlighted by our empirical study. This framework covers both the analysis of the structure of the stock component in institutional portfolios and the general philosophy of institutions towards investments in stocks. 1. Stock Portfolio Structure The stock portfolio structure of Swiss institutions is characterized by three main elements. First, as mentioned above, Swiss institutional investors generally adopt a passive investment strategy with respect to stocks (with more than 80% of their stock portfolio being held on a long-term basis). As large capitalizations represent a high proportion of the market index (the 30 largest Swiss corporations account for almost 80% of total market capitalization), it is possible to consider that the passively held stake of an ordinary stock portfolio
58
Furthermore, it seems conceivable that the stocks included in such a first segment may in the future join a European stock exchange for blue chips. The main advantage to institutional investors of such a market would be its high liquidity, which would enable them to carry out large transactions rapidly.
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more or less reflects the Swiss stock market index; it can therefore be considered as an indexed sub-portfolio59. Second, the empirical study shows that institutional stock portfolios are well diversified, as 67% of them and even 92% of the large investors' (holding more than Sfr. 800 million in assets) portfolios include more than 20 positions, which is the number at which non systematic risk can be considered as being diversified away60. The proportion of institutional investors holding more than 30 positions remains surprisingly high: it amounts to 47% on average and reaches 64% in the case of the large investors. These high results may be explained by the two following main factors. The gradually increasing share of foreign stocks in institutional portfolios naturally increases the number of positions. Further, the passive management of Swiss stock portfolios adopted by many institutions leads them to follow a "passive selling strategy", i.e. to keep small positions in the portfolio and further reduce their relative importance by allocating new resources to other stocks, rather than to sell positions. Third, as regards the types of share held, our empirical study has demonstrated that the proportion of registered shares is particularly high in the case of institutional investors61. 53% of the managers surveyed hold more than 50% of their stock portfolio in registered shares, whereas this type of share accounts for 40% of the total Swiss stock market capitalization62. This observation is of particular importance in view of the capital structure of many Swiss corporations, which allows them to attach the same voting rights to registered and bearer shares without taking into account the higher par value of the latter. For instance, in 14 of the 30 largest market capitalizations, it is possible to hold (with registered shares) the majority of the voting rights by owning less than 40% of the relevant company's total market capitalization63. 59
In this context, the emergence of mutual funds focusing on smaller capitalizations might attract institutional investors and, as a result, reinforce the long-term financing of smaller, performing companies. At present, institutions are not eager to make direct investments in this type of company because they would either have to allocate an amount which would not be significant enough as compared with their other positions or to allocate a significant stake and become, in turn, a monitoring and strongly involved shareholder. 60 For an empirical investigation of this issue, see for instance SOLNIK, The Advantages of Domestic and International Diversification, in International Capital Markets (Elton & Gruber, eds., Amsterdam, 1975) and FAMA, Foundations of Finance, (New York 1976). 61 For a discussion of the attitude of Swiss corporations towards institutional investors as holders of registered shares, see Section IV.D.3 hereafter. 62 See supra n. 14. 63 Calculations of the authors based upon the publicly available information. However, it must be n.d that some of these companies have announced their intention
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Taking into consideration the "higher voting power" of registered shares and the overweighting of this share type in the stock portfolios of Swiss institutions, it appears that institutional investors own proportionately more voting rights than market capitalization. 2. General Philosophy As far as the general philosophy towards institutional investments in stocks is concerned, it is possible to identify two different approaches. The most usual approach in Switzerland is without contest that of a financial investor who remains a non-monitoring shareholder and does not attach any particular importance to the concept of ownership. Such an approach is fully understandable in the case of short-term investments (which do not correspond to the strategy described above) and in the case of marginal shareholdings, where the size of the position does not justify a typical owner attitude. However, with the gradual increase of the size of institutional stock portfolios and the related awareness of the inevitable participation in the stock capital of the major Swiss companies, such an approach might well become inappropriate. Such considerations lead to the second institutional investment philosophy, already developing in some other countries: a monitoring shareholder who takes part in, or supervises, some of the strategic decisions taken by the company64. Finally, it must not be forgotten that some investment decisions may also be guided by a third philosophy: the concern of some institutional investors to play a social role. This role may involve taking care indirectly of the interests of affiliated members by improving the competitiveness of some companies, for instance by providing them with long-term financing65.
to change their capital structure (in most cases by transforming their non-voting participation certificates into voting shares). 64 The advantages and drawbacks of increased institutional involvement in corporate management are currently being much discussed, in particular in the United States where some institutional investors exercize their shareholder rights more actively (see, for instance, BLACK, "The Value of Institutional Investor Monitoring: The Empirical Evidence," 39 UCLA L. Rev. 895 (1992). It is argued that large minority shareholders should be given a right to participate in or supervise decisions related to the composition of the board, the appointment and remuneration of management or corporate strategy for instance. However, the problems of conflicts of interest or insider information cannot be disregarded when considering greater institutional shareholder involvement. 65 This social role most often concerns the related company. It involves, in particular, purchasing the company's stocks, granting it credits or purchasing real estate in order to rent it to the company on preferred terms.
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B. Determining Factors for Stock Selection Our empirical study also concentrated on the various conditions a corporation has to fulfill in order to meet the requirements of Swiss institutional portfolio managers. The questions raised can be divided into three categories: public information policy, relations with management and evaluation-related criteria. As far as the first category of questions is concerned, it appears that Swiss institutional investors consider a company's information policy and accounting transparency to be amongst one of the most important factors to take into consideration. According to the empirical results, more than half of the managers who responded even regard these parameters as absolutely fundamental and almost three-quarters consider that their importance will even increase over the coming years. These figures may have been affected by the increasing requests made by foreign investors and Swiss financial analysts regarding publicly available information in view of the more transparent information policies followed by foreign companies66. With regard to the relations with the corporations' management, the empirical results show an apparently inconsistent attitude. Whereas 70% of the managers who answered consider direct contacts with the management to be unimportant, 98% of the same sample regard the quality of management as being important or fundamental to an investment decision. If it is obvious that the' quality of management is essential to the success of an investment in stocks, the above figure appears nevertheless surprising insofar as a pertinent judgment on the quality of both management and its strategy largely depends on the contacts which can be generated with managers. However, the links existing between Swiss industrial corporations, banks and insurance companies may allow institutional investors to benefit from informal contacts at the highest level, thus enabling them to avoid direct relations with management. This is not the case of foreign investors. As a result, many of them ask for regular direct contacts with the management of Swiss corporations. The study further shows that Swiss institutional managers do not pay any particular attention to evaluation-related factors such as a company's intrinsic value or its growth rate and even less attention to its payout ratio. If this attitude can be considered to be consistent with the above-mentioned informal sources of information, its extension appears highly questionable when one considers future investments in foreign stocks where the supposed indirect and informal links between institutional investors and corporate management do not exist.
66
The statistical study under n. 18 supra, at 123, shows that accounting transparency and availability of information also constitute important factors in the investment decisions of foreign institutional managers with respect to Swiss stocks.
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C. Attitude of Institutional Investors as Shareholders In most cases, institutional investors can be regarded individually as nonmonitoring shareholders in Swiss companies. This conclusion follows from two main observations. First, as mentioned above, institutional investors generally consider themselves to be passive shareholders not involved in the management of companies. Second, for both legal and financial reasons, it is difficult for a single institution to obtain a monitoring stake in a large Swiss company. From a legal point of view, pursuant to the provisions of the applicable statutes, pension funds and insurance companies are not allowed to allocate more than 10% of their total assets to stocks in a single company. Moreover, the large majority of Swiss corporations have set a limit in their by-laws to the exercice of the voting rights attached to shares (which can correspond to the aforementioned limit fixed for the registration of purchasers of registered shares in the stock ledger); such limits are frequently fixed between 2% and 5% of share capital67. Aside from these legal constraints, the acquisition of a substantial stake is further restricted by financial considerations. It has been shown that stocks represent 10.8% of Swiss institutional portfolios and that a typical stock portfolio comprises on average 25 to 30 positions. As a result, an average stock position represents 0.4% of the total assets under management. As the 30 largest Swiss corporations all exceed Sfr. 1 billion in terms of market capitalization, it is obvious that a single institutional investor cannot easily hold a monitoring stake. This conclusion must however be examined more cautiously by taking into account some further financial elements. First, a few dozen institutional investors manage more than Sfr. 2 billion in assets (some of them even hold more than Sfr. 10 billion for their own account). Furthermore, these big players sometimes allocate more than 15% of their total assets to stocks. Finally, it must be remembered that Swiss institutions invest proportionately more in registered shares, which reinforces their voting power. As a consequence, the normal stock positions of the few dozen large institutional investors may represent, in Swiss corporations ranking between 10th and 30th position in terms of market capitalization, up to 10% of the voting rights68. Obviously, such large stakes do not necessarily lead to these large institutions 67
The potential impact of shareholders' agreements should not be disregarded in this respect: in some corporations which have not set limits to voting rights in their by-laws, a single institutional investor may well also be prevented from obtaining a monitoring stake because of the existence of controlling pools bound by such shareholders' agreements. 68 Calculations of the authors based on publicly available information. It must be n.d, however, that many of these corporations are more or less controlled by one or more shareholders (private investors, banks, State) and their shares therefore are not widely dispersed among the public.
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playing a more active role as monitoring shareholders: only a change in their investment philosophy could have such a consequence. In the case of smaller companies, i.e. those with a market capitalization of less than Sfr. 1 billion, an institutional investor is more likely to become a monitoring shareholder. According to our survey, 21% of the institution s who answered declare that they hold one or more strategic stakes which allow them to be considered as reference shareholders. Logically, this figure varies with the size of an investor's portfolio. This can be illustrated by the fact that 26% of the largest institutional investors (holding more than Sfr. 2 billion in assets) have even more than 3 of such strategic stakes in their portfolio. Before analyzing the specific situations in which institutional investors are, together with others, reference or determining shareholders, it seems necessary to discuss the present relationship between institutional investors and corporate organs, i.e. shareholders' meetings and boards of directors. 1. With Respect to Shareholders' Meetings Our empirical study has shown that in Switzerland, on average, institutional investors are more often represented by a third party (in the large majority of cases, a bank) than directly present at shareholders' meetings. 55% of the managers surveyed never participate directly at such meetings. This figure further confirms that a significant proportion of Swiss institutional investors is not interested in monitoring corporations, even in such a limited way. However, the absence of direct participation significantly depends on the size of the institution: for instance, the figure is 76% in the case of small institutions (holding less than Sfr. 200 million in assets) and 17% in the case of the largest ones (more than Sfr. 2 billion). Furthermore, 94% of the insurance companies participate, at least sometimes, directly at shareholders' meetings. The reasons most often given to explain this low participation rate are the lack of time available, the feeling that the own votes would not change the final result and the general impression that shareholders' meetings of Swiss corporations are purely formal and that the "game is already played". On average, 60% of the managers who responded ask financial intermediaries (on either a regular or occasional basis) to represent them at shareholders' meetings. These representatives generally vote in accordance with the proposals made by the boards of directors of corporations. This observation seems to result from two major factors. First, as they are generally non-monitoring shareholders, Swiss institutional investors are not inclined to vote, either directly or through representatives, against proposals. This observation can be illustrated by the fact that only 16% of the managers who responded sometimes oppose proposals made by boards of directors. It is interesting to note that this figure is higher for public pension
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funds which are often considered to be the most independent institutional investors. Second, the much discussed relationships between the largest Swiss banks and the largest Swiss listed corporations are such that it seems rather unlikely that an opposition would emanate from these intermediaries69. Despite the newly-introduced requirement that custodian banks should request specific instructions from each shareholder in order to exercize voting rights, it seems likely that this situation will remain unchanged under the new corporation law. It may further be noted that the voting of institutional investors' shares at shareholders' meetings, added to the banks' own stock portfolios and the voting rights they exercize as custodians for private investors, gives financial intermediaries substantial weight in general meetings. Although only little empirical data is available in Switzerland regarding the voting rights exercized by the various shareholders and in particular by banks70, the above-described voting weight of banks and their relationships with companies contributes to explain why the proposals of boards of directors are so largely ratified in shareholders' meetings71. Finally, considering the rare publicly known cases where a board of directors has withdrawn its proposals before a meeting following requests from shareholders, it is possible to assert that informal contacts sometimes occur between the board and the major shareholders of a corporation. This observation seems to be confirmed by our empirical study, according to which 14% of the surveyed managers admit to being, at least on some occasions, consulted before a shareholders' meeting. 2. With Respect to Boards of Directors The issues of the representation of institutional investors on, and of their influence on, boards of directors of Swiss public companies should become more important with the rise of institutional funds. According to publicly available information, it seems that such investors are neither really represented 69
These relations can be illustrated by the fact that approximately two-thirds of the 30 largest Swiss companies have at least one representative of the big three (Union Bank of Switzerland, Swiss Bank Corporation and Credit Suisse) on their board of directors (calculations of the authors based on the annual reports of the 30 largest Swiss corporations). 70 Under the new corporation law (art. 689e CO), the number of shares represented by each category of representative, i.e. company organs, custodians and independent representatives, has to be disclosed at the request of a shareholder. However, this information does not indicate the overall influence of banks (own shares and shares in custody) at shareholders' meetings. 71 This conclusion may further be explained by the fact that registered shares are quite often represented directly by the board of directors in shareholders' meetings.
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on these boards (by the financial intermediaries) nor considered as potential directors by the companies. This remark does not apply to the three major Swiss banks which are represented on many of the boards of the 30 largest companies72. Issues such as the influence of Swiss institutional investors on a corporation's policy or on the choice of its management are therefore still somewhat remote from their preoccupations. As a result, this study focuses on the issue of the ability and desire of institutional investors to be represented on boards73. In this context, it must be observed that there are still various obstacles in the way of appointing institutional investor representatives as directors of large Swiss corporations. First, it seems that a kind of establishment exists within the boards of directors of the largest Swiss companies. Among the 293 people sitting on the boards of the 30 largest Swiss companies, 31 have three to six different mandates and thereby occupy more than 25 % of the seats available in these companies74. This figure even reaches 45% if the 38 people holding two mandates are included. If the seats held by representatives of the companies' main shareholders are added to these figures, it appears that only a few director mandates are available for outsiders. Second, given the present investment philosophy of institutions (which is more that of financial investors than that of shareholders), there is not yet any interest or pressure to have institutional representatives appointed to boards. Third, there is the further obstacle of having to select a person who would be acceptable to the different classes of institutional investors in the way of electing an institutional representative. In particular, it would be difficult for cash managers, insurance companies and private pension funds, because of their lack of independence vis-ä-vis the Swiss economic establishment, to vote for the appointment of a director not acceptable to the board75. Such behavior would certainly be construed as being in opposition to the establishment. It may, in turn, have similar effects within their own organizations.
72
This last observation, however, results more from their business relationships with the companies as universal banks and their weight as stockholders' representatives than from their own shareholdings. 73 Obviously, a representative of institutional shareholders on the board of directors of a Swiss corporation would be confronted with conflicts of interest. However, this issue is not specific to institutional investors and a thorough discussion of it is beyond the scope of this study. 74 Calculations based upon the most recent available data, i.e. in most cases annual reports as of December 31, 1991. 75 This statement can be illustrated by the fact that in six of the largest Swiss corporations, at least one-half of the board is composed of people present in three or more of the 30 largest companies: CS Holding (50%), Nestli (50%), Winterthur (54%), Ciba Geigy (54%), Sulzer (58%) and Zurich (80%).
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As far as the issue of having a representative on the board of directors is concerned, the opinions of the institutional investors questioned are, as would have been expected, rather divergent. While Swiss institutional investors are on average slightly in favor (57%) of having a representative for one or more shareholders holding a substantial amount of voting rights, public pension funds and investment funds are clearly more in favor of this proposal than the other classes (more than two-thirds). This latter result can be explained, at least in the case of public pension funds, by their high degree of independence vis-avis the boards of such companies and the Swiss economic establishment. 3. Links Between Institutional Investors and Constitution of Shareholders' Pools The above considerations show that, while institutional investors generally do not act as monitoring shareholders, together they hold substantial stakes in a large number of Swiss public companies. Therefore, the question of what use could be made of this voting power arises. Interestingly, it seems that some financial intermediaries and some large shareholders have been more capable of channeling the scattered stock holdings of institutions for specific purposes than the institutional investors themselves. In a few recent cases, some financial intermediaries have been able to make use of the voting power of institutional investors by collecting their scattered holdings in what may be called "de facto pools". The "unconscious"76 participation of large institutional investors was mainly observed in the few cases of partial and hostile takeovers which occurred without a tender offer and outside the stock exchanges. In view of the stakes the largest institutional investors hold, making offers to them for the purchase of their stakes at an attractive price may be the easiest and quickest way of taking control of a corporation (with a market capitalization of between Sfr. 500 and 2000 million distributed among the public77). Despite the potential economic consequences of this type of transaction, it appears that some institutional investors are rather cooperative because of the return opportunities offered78. 76
The participation of these large institutional investors was unconscious insofar as they entered into bilateral agreements with the financial intermediaries without being informed of the precise aim of the transaction nor knowing if, and to what extent, other investors had been contacted. 77 The choice of this type of company is based on the observation that, above Sfr. 2 billion of market capitalization, it is difficult to put together enough substantial stakes, and that the large institutional investors may not hold stocks of corporations under Sfr. 500 million for reasons related to insufficient liquidity. 78 It must be remembered that this kind of transaction is not yet restricted under Swiss law by statutes providing for disclosure obligations and a duty to launch a public tender offer as soon as a specific stock threshold is reached.
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Aside from these de facto pools, two types of conscious and voluntary coalitions may be mentioned. The first, the existence of which is undisputed although not yet wide-spread, is constituted by one or more large stockholders entering into shareholders' agreements with institutions with the aim of keeping a firm hold on a majority stake. This type of coalition can be regarded as a defensive measure against possible hostile takeovers such as those described above. However, it must be observed that the institutional investors participating in such pools often seem to lose their independence vis-ä-vis the stocks concerned without receiving a real monitoring role, for instance through the grant of a seat on the board of directors. The second type of conscious pool still seems to belong to the realm of wishful projects of some institutional investors: an agreement between institutions with the aim of joining together their stakes in order to be able to play a monitoring role or, in companies with a larger market capitalization, protect more effectively their rights and interests as important minority shareholders. The answers given by the Swiss institutional investors to the question of whether they would agree to become members of shareholders' pools illustrate once more the ambiguous position which they are in with respect to the monitoring of companies. Although most institutional investors seem to have not yet entered into conscious and active pools such as those described above, on average, 49% of the managers who responded declare themselves disposed to participate in this type of coalition. As would have been expected, public pension funds are the investor class most favorable to this proposal (63%) and the small-sized private pension funds the least interested (42%). These results can easily be explained if one takes into consideration the fact that public pension funds are totally independent from companies, whereas there are two major obstacles to the entry by small private pension funds into this type of agreements. They would certainly not be included in a pool agreement (because of their small size) and, furthermore, their associated companies would come under threat as objects of this type of agreement79. D. Effects on Swiss Public Companies The behavior of Swiss public companies has significantly evolved over the past three years and is presently changing even more rapidly. However, despite their increasing weight as shareholders, Swiss institutional investors have not up to now played a significant role in this evolution. The requests of foreign 79
Managers of these small private pension funds often appear also to be members of the management of associated companies, which are often listed. This might contribute to explaining why they are not eager to constitute such pools with monitoring purposes and effects.
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investors, foreign stock exchange regulations as well as, to a certain extent, the implementation of the new Swiss corporation law have indeed been much more determinative. The purpose of this section is to examine the major changes affecting Swiss public companies with respect to their information policy, their capital structure, their shareholding structure and their governing bodies, and to determine what role has been played by Swiss institutional investors in relation to these various changes. 1. With Respect to Information Policy It is undisputed that some Swiss public companies, in particular the larger ones, have significantly improved their information policy over the past two years. This evolution can be observed in two major fields. First, more and more Swiss companies have adopted new accounting rules, such as the International Accounting Standards (IAS) or the 4th and 7th European Directives. This change has largely increased accounting transparency as compared with the practices permitted by the more tolerant and flexible Swiss accounting rules80. The latter in particular (i) allow the discretionary constitution and dissolution of hidden reserves with limited disclosure obligations81, (ii) make it possible to evaluate assets at historical cost and (iii) do not provide for an obligation to present consolidated statements until the 1994 financial year. Second, some Swiss corporations have started to work on improving their public image abroad by presenting their strategies, their projections and giving more details of their day-to-day business. This improvement has been particularly marked by the organization of "road shows", the creation of "investor relations" functions and the possibility offered to investors of having direct contacts with the management. These improvements, which will necessarily affect more and more Swiss corporations, are the result of the conjunction of three main phenomena: (i) the need of Swiss companies to increase their equity in order to finance their 80
It should be n.d that, as far as Swiss listed corporations are concerned, more restrictive accounting rules are likely to enter into force in the near future (see INSTANCE SUISSE D'ADMISSION, "Propositions de la Commission de Regulation," Bulletin 2/1992). 81 Whereas the former Swiss corporation law did not provide for any disclosure obligation, the new provisions (applicable to financial statements from 1993) make it compulsory for Swiss corporations to disclose in the n.s to the balance sheet the amount of hidden reserves dissolved if two conditions are fulfilled: (i) the amount dissolved exceeds the amount created during the same accounting period and (ii) the economic result announced is materially more favorable (article 663b para. 8 CO). It should be noticed that Swiss banks have, since 1990, been subject to a specific regulation introduced under a circular letter regarding the creation and dissolution of silent reserves issued by the Swiss Federal Banking Commission.
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development, (ii) the desire to diversify internationally the composition of their shareholders with the purpose of raising more equity abroad and (iii) the comparatively high cost of stock capital issues for Swiss companies due to the undervaluation of their stocks. In order to resolve these three major issues, large Swiss corporations have had to adapt their information policy to the requests of foreign investors, both to provide evaluation bases comparable to those applicable to their foreign competitors and to satisfy the more severe requirements set for listing on foreign exchanges82. As a result, foreign investors, in particular institutions, will become more and more interested in these increasingly transparent Swiss companies. This should, in turn, improve their evaluation and reduce their cost of capital. As this has been confirmed by all the people interviewed, Swiss institutional investors have not put corporations under pressure in order to achieve these changes. However, their stock portfolios should benefit substantially therefrom. 2. With Respect to Capital Structure Another field in which important changes are presently occurring is that of the capital structure of Swiss public companies. This structure can be considered to be complicated by the existence in Switzerland of two types of voting shares (bearer and registered) and two types of non-voting certificates (participation certificates and "Genusscheine"). This structure originates from the desire of shareholders who floated their companies on the market to collect funds from the public without losing the control over them nor the right to determine their strategy independently. This phenomenon was particularly prevalent in the case of family-owned corporations83. With the internationalization of financial markets and the emergence of larger investors attaching increasing importance to liquidity, this structure has proved to be detrimental to liquidity and to foreign investors (who were generally not allowed to buy registered shares). As a consequence, an increasing number of public companies have decided to simplify their capital structure by transforming their certificates into voting shares. Moreover, thanks to the possibility under the new corporation law of reducing the par value of shares, some corporations with "heavy-weight" shares have decided to split
82
For more details of the unified stock exchange requirements in Switzerland, see Regulations Governing the Acceptance and the Listing of Securities applicable to the three stock exchanges of Zurich, Geneva and Basle effective at January 1, 1987. 83 This structure made it possible for such companies to resolve succession problems by giving non-voting participation certificates to family members who wanted to sell their stake in the company.
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their shares in order to enlarge their shareholder base84. It is interesting to note that these changes have already been taken into account by the stock market: the premiums often payable on bearer shares have more or less disappeared. Here again, it must be stated that the changes that are presently observed in Switzerland with respect to the capital structure of Swiss companies do not result from pressure from Swiss institutions (which focused mainly on registered shares) but far more from the requests of their foreign likes. 3. With Respect to Shareholding Structure Although the changes affecting the shareholding structure of Swiss public companies are less visible than those concerning their information policy and capital structure, the development of institutional investment (from both Swiss and foreign sources) progressively modifies the power of the various classes of shareholder and the links between them. This evolution forces Swiss corporations to modify their approach towards institutional investors and to adopt new measures to preserve their independence. As far as Swiss institutional investors are concerned, their importance in the shareholding structure of Swiss companies is increasing with the growth of the funds under management, the rise of the share allocated to stocks and the overweighting of registered shares in their portfolios. Until recently, the general approach of Swiss companies towards such investors was to consider them as suitable shareholders for registration in the stock ledger in view of their passive and long-term oriented portfolio management. This attitude has made it possible for some corporations to count among their owners stable and nevertheless non-monitoring shareholders. The latest developments on the Swiss market have shown that this approach may present relatively high risks for a corporation and its board and management. These risks may stem from a third party contacting the corporation's largest institutional shareholders and offering them an attractive price for their stake, but also from a concerted action by such shareholders (for instance on the occasion of a shareholders' meeting). Furthermore, some Swiss corporations have opened up their registered capital to foreign funds over the last four years and most of the others are being forced to follow the same route with the entry into force of the new corporation law on July 1, 1992. In addition, the transformation of non-voting participation certificates into bearer or registered shares has allowed foreign investors to increase their weight as voting shareholders. This considerable change in the shareholding structure of Swiss corporations should allow large foreign 84
The positive impact of these splits on market liquidity is often exaggerated. Institutional investors, in particular, are not affected by the "heavy weight" of some Swiss stocks because of the size of their portfolios.
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institutional investors to play a more influential role as shareholders than in the past. With the purpose of channeling the evolution of their shareholding structure, Swiss corporations have fixed ceilings for both voting rights at shareholders' meetings and the entry of purchasers of registered shares in the stock ledger85. However, the adequacy of these new defensive measures, which are intended to preserve the independence of the boards of directors and management of corporations, may be questioned by reason of two concerns86. First, these limits might well not be accepted by the foreign investors whom Swiss public companies particularly wanted to attract by opening up their registered capital87. Second, it is not certain that these voting and registration restrictions would prevent cooperation between shareholders with a view to participating in a public or underground takeover or, considered more generally, to opposing the proposals made by a board and exercizing their control rights. Another measure which may be developed by Swiss corporations to preserve their independence consists in the constitution of defensive pools with the participation of institutional investors. These investors would agree to freeze their shareholdings by entering into an agreement with the company pursuant to which they would agree to vote in accordance with the board's proposals. Nevertheless, it seems unlikely that the companies will be able to obtain such support from institutional investors without offering them satisfactory compensation in return, such as a right to participate in the policy decisions. 4. With Respect to Corporate Organs Our study has demonstrated that Swiss institutional investors do not play at shareholders' meetings a role in proportion to their holdings and, as a result, are not generally represented on boards of directors (with the exception of large banks). The impact of foreign institutional investors in this respect also seems to be very limited, although the causes are rather different (in particular, limited voting power). As far as shareholders' meetings are concerned, the limited role played by institutional investors mainly stems from their non-monitoring investment philosophy and the fact that they are generally confronted with a substantial 85
It must however be mentioned that these ceilings have existed for a few years in Switzerland, in particular in relation to the companies which opened their registered share capital to foreign investors. 86 A ftirther consideration may be mentioned: the introduction of such ceilings may prevent shareholders holding large stakes from selling their stakes as a whole. They might be forced to break up the transaction in order to respect the limits set for purchasers in the by-laws. 87 This remark should not substantially affect the 10 largest Swiss market capitalizations because of the size of the freely purchasable stake.
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number of voting rights exercized in accordance with the proposals of the board of directors. This situation might change. On the one hand, institutional investors may increase their direct participation and involvement in shareholders' meetings and thereby create pressure groups by uniting their forces88. On the other hand, due to increasing competition in the banking industry, some intermediaries may upset the present balance by playing a more active role as corporate monitors. It might be argued that decisions based upon the above-mentioned type of deliberate coalition could be regarded as violations of the provisions of by-laws adopted by some Swiss companies, which forbid any concerted action regrouping more than a fixed percentage of voting rights. However, a distinction must be made between two situations: i.e. whether the concerted action occurs before or after the purchase and the registration in the stock ledger. Whereas the provisions of by-laws would be applicable in the first situation, their enforceability must be considered to be highly questionable in the second. As regards the composition of the boards of directors of Swiss public companies, it has been shown above that Swiss institutional investors do not presently express any desire to have a representative on the board who would enable them to supervise decisions taken by the board and management. In any event, if they changed their investment philosophy in this respect, institutions would have to bring together a substantial number of votes (by acting together with other institutional investors) in order to be able to overcome the various obstacles described in Section IV C.2 above.
V. Conclusions This study has shown that Swiss institutional investors, particularly pension funds and insurance companies, still follow a very conservative investment strategy. They favor interest rate-linked assets and allocate a rather small proportion of their total portfolio to stocks. By adopting such a strategy, they do not take into account the results yielded by studies conducted under a modern portfolio theory framework, even though they are precisely the kind of long-term oriented investor for whom asset allocations favoring real assets would be profitable in terms of performance. Swiss institutional investors further appear to focus on Swiss assets, as they seem particularly reluctant to
88
Of particular interest in this respect is the possibility under the new Swiss corporation law of shareholders holding at least 10% of the company's capital (including participation certificates) or Sfr. 2 million par value to request a so-called "special control" (art. 697a ff CO).
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expose their portfolio to exchange rate risks despite the availability of hedging instruments. It has been shown that this prudent behavior is caused mainly by two important factors. First, Swiss pension funds and insurance companies are not subject to real pressure with respect to the level of return which they must achieve. The affiliated members of pension funds do not yet pay much attention to the performance realized on their compulsory savings by fund managers. Furthermore, the Swiss insurance sector was not until recently characterized by a high level of competition. These parameters should gradually evolve, leading Swiss pension funds and insurance companies to follow a more active and return-oriented investment strategy. Second, the investment limits provided for by the Swiss legislation applicable to pension funds and insurance companies prevent them from taking advantage of the higher interest rates offered on some foreign currencies. However, the 30%-ceiling on foreign currency investments currently only affects the most professional institutional portfolio managers. If this limit can be justified by the fact that the funds' liabilities are expressed mainly in Swiss francs, it is interesting to note that the Swiss legislator does not pay so much attention to the interests of affiliated members in all respects. Unsecured investments with the employer, including in its shares, are in fact permitted up to a maximum of 20% of the total assets of Swiss pension funds. In addition, there are no specific restrictions on the purchase of real estate by a pension fund to be rented to the associated company. In addition, this study has shown that the development of institutional investment has contributed to highlight the inadequacy of the organization of Swiss markets. Although substantial efforts have already been made to improve the liquidity and transparency of the Swiss stock market, it appears that further improvements are necessary and forthcoming. From a technical point of view, a significant step forward should occur in 1994 with the creation of the Swiss electronic stock exchange. At the same time, a new statute on stock exchanges and securities trading should be implemented. This legislation will provide for federal organization and supervision of stock exchanges and securities dealers. It will further introduce an obligation for investors purchasing or selling stocks of a company to disclose the passing of certain fixed thresholds. Finally, the draft statute also includes provisions governing takeover offers which are designed to improve the protection of the interests of minority shareholders. However, the implementation of these latter provisions is confronted by opposition similar to that met by the 13th European Community directive. As regards relationships between institutional investors and Swiss public companies, the empirical study presented in this paper has shown that Swiss institutional investors, despite their collective weight and potential power, are still in most cases non-monitoring shareholders. They have not put any pressure on Swiss companies to improve their information policy and simplify their
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capital structure. The major changes that have occured in these respects are much more the result of foreign investors' requests and foreign stock exchange regulations. In the recent past, Swiss companies have been confronted by gradual changes in their shareholding structure. On the one hand, a change in the behavior of Swiss institutional investors has been observed in that some of them have participated in transactions allowing a third party to take control of a corporation. By doing so, these investors have started to behave as "active" non-monitoring shareholders. This might change the traditional image of Swiss institutional investors as non-contradicting shareholders. On the other hand, the opening up of registered capital to foreign investors as well as the simplification of the capital structure of Swiss corporations should lead to foreign institutions playing a more important role. These two phenomena should change the relationship between the governing bodies of corporations and their major shareholders significantly. Furthermore, the possibility that the latter may decide (even on a purely occasional basis) to act in concert for the purpose of protecting their interests cannot be disregarded. Finally, it is important to note that the growth of Swiss institutional investors and their concentration on liquid stocks might cause severe financing difficulties for smaller Swiss listed companies. First, the development of compulsory employment-based savings is likely to increase the cost of commercial credits for medium- and small-sized companies which are not able to issue bonds. Second, the costs of more transparent information policy and the low liquidity of their stocks will probably make it difficult for medium- and small-sized listed companies to obtain equity financing on the stock market. This possible evolution has not yet received much attention despite its importance in Switzerland where two-thirds of the corporations listed on the main stock market have a market capitalization of less than Sfr. 500 million.
Chapter Eighteen Duties of Banks in Voting Their Clients' Stock Johannes Köndgen I. A Continental Version of Proxy Voting: the Depositary Vote A. Ensuring Adequate Shareholder Representation at Meetings Voting his or her stock in person is not normally worthwhile for the average minority shareholder. It is indeed unfair to charge inactive stockholders with apathy and ignorance, since, as is well known, their apathy is perfectly rational.1 Given the single stockholder's marginal influence on the outcome of a vote, his expenses would by far outweigh any expected benefit from casting his vote in person. This indifference has long been recognized as posing grave problems for the corporate voting process, especially where corporation laws or bylaws require that a qualified number of shares be present or represented at the shareholder meeting to constitute a quorum for elections or resolutions of major importance. So why not beat quorum requirements and at the same time make the most of the fragmented minority vote by having a common agent or intermediary cast the vote? Modern corporation laws have developed various devices to cope with this problem and generally allow shareholders to cast their vote by some sort of proxy, the most widely known, if only for its sometimes spectacular proxy fights, being the Anglo-American proxy system.2 The focus of this paper will be 1
For a general statement of the "rational apathy" theorem see J. CHOPER, J. COFFEE & R. MORRIS, Cases and Materials on Corporations, at 547 (3d ed. 1989); F. EASTERBROOK & D. FISCHEL, The Economic Structure of Corporate Law at 66 et seq. (Cambridge, Mass., 1991). 2 For a brief summary see W.A. KLEIN/J.C. COFFEE, Business Organization and Finance: Legal and Economic Principles, at 115, 164 (4th ed., Westbury, N.Y., 1990); the more technical aspects are adressed by B. KRIKORIAN, Fiduciary Standards in Pension and Trust Fund Management, at 187 et seq. (Stoneham, Mass., 1989). On the British proxy system see R. PENNINGTON, Company Law, at 627 et seq., 638
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on the system of representative voting most widespread in continental western Europe: namely, having banks or other financial institutions vote their clients' stock. Being myself a German emigro to Switzerland, I will take as my reference legal order German law, with some occasional glances at Swiss law. This point of reference should not, however, keep us from adopting a broader comparative legal perspective. Questionable as the practice of proxy voting in the Anglo-American corporate world may be, both as a system and in some of its excesses3, we can still benefit from the abundant American experience with regard to the fiduciary responsibilities of "institutional proxies" such as pension funds and other institutional investors. Our analysis will begin with a brief outline of the legal framework for banks voting their clients' stocks and will then present some of the factual background ofthat system. B. The Statutory Framework of Depositary Voting in Germany, Switzerland, and the European Community In most of Europe4 we do not have a Glass-Steagall-type division of the banking industry into commercial and investment banks. In particular, any bank may engage in the business of buying and selling securities to or for its customers. As the times when small customers used to hide their bonds and stocks in a closet or under their bed are long gone, it has become the common business practice of banks to keep the securities purchased by their customers in deposit. Although banks do not store the securities in their own vaults but entrust them to special deposit companies for safekeeping, they assume the legal position of depositary toward their customers.5 By this very position and their general expertise in financial matters, banks are thus best suited to assume the role of a professional intermediary between the corporation and its stockholders whose shares they keep as deposit. The German Corporation Code6 legitimized and at the same time regulated what had developed as common bank practice, by putting banks under an obligation to act as intermediaries in either direction. First, banks are charged with communicating to their clients the issuing corporation's notices of shareholder meetings, which under German law must not only state time and place of the meeting but also must specify the agenda items and notify any proposal made by a shareholder as to elections or other resolutions at the meeting, if such et seq. (6th ed., London 1990); GOWER's Principles of Modern Company Law, at 512 et seq. (5th ed., London 1992). 3 For a brief critique from an English point of view see GOWER, id. 4 With the notable exception of Belgium. 5 See AGB-Banken (standard form contract) Nr. 36. The American distinction between "recorded" and "beneficial" owners of shares is unknown to German law. 6 Aktiengesetz of 1937, as amended in 1965; henceforth briefly: AktG.
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proposals oppose recommendations submitted by the board of directors.7 Likewise, by tradition banks have made it their business to vote the customers' shares which they are keeping in custody. Although bidding for stockholders' voting rights in Germany lacks the sometimes aggressive character of proxy solicitation in America, it is clearly banks, not stockholders, who take the lead in proxy voting activities. When, in the 1920s, widespread misuse of voting rights that were not (or not fully) backed by their respective ownership interests resulted in a call for fundamental reform, the practice of proxy voting by banks could not remain unaffected.8 Hence, the new German Corporation Code of 1937 made a first attempt to regulate what had come to be known as "depositary voting right" (Depotstimmrecht)9. The basic policy of these rules and regulations was in the first place to reinforce the shareholder's power of control, even though he delegates part of this power to a proxy; secondly, to keep the bank's leeway in voting the proxy at a minimum, and, thirdly, to mandate both disclosure prior to voting and subsequent reporting to the customer. As amended and enlarged in 1965, this complex set of restrictive rules is of procedural rather than substantive character. A few details may be worth reporting. If a bank offers to vote its clients' shares which are in its custody, it is under a legal duty to accept a client's request to cast the vote for him (AktG § 135 (10)). The appointment of a proxy has to be in writing and may not be included in the general standard form contract governing the bank-customer relation (AktG § 135 (1)). Its permissible duration is 15 months, yet the shareholder may revoke it at any time (AktG § 135 (2)). Prior to voting the proxy, the bank has to seek instruction from the customer on how to cast the vote. To enable the client to make an informed decision, the bank at the same time has to submit its 7
AktG § 125 (1) reads as follows: Der Vorstand hat binnen zwölf Tagen nach der Bekanntmachung der Einberufung der Hauptversammlung im Bundesanzeiger den Kreditinstituten und den Vereinigungen von Aktionären, die in der letzten Hauptversammlung Stimmrechte für Aktionäre ausgeübt oder die die Mitteilung verlangt haben, die Einberufung der Hauptversammlung, die Bekanntmachung der Tagesordnung und etwaige Anträge und Wahlvorschläge von Aktionären einschließlich des Namens des Aktionärs, der Begründung und einer etwaigen Stellungnahme der Verwaltung mitzuteilen. Correlative to AktG § 125 (1) is § 128 (1): Verwahrt ein Kreditinstitut für Aktionäre Aktien der Gesellschaft, so hat es die Mitteilungen nach § 125 Abs. l unverzüglich an sie weiterzugeben. 8 For details see G. HUECK, Gesellschaftsrecht, § 20 II 4 (19th ed., München 1991). 9 The term is something of a misnomer as it covers any proxy voting by banks regardless of whether they keep their client's stocks as deposit. Moreover, the regulations as to depositary voting apply equally to shareholder associations voting their members' shares and to persons holding themselves out as a professional aid in corporate voting matters (AktG § 135 (9)).
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own proposals for its intended proxy vote. Only in default of express instructions may the bank vote the client's stock in accordance with the proposals it has submitted to the customer beforehand (AktG §§ 128 (2), 135 (5)). When casting the client's vote at the meeting, banks, without having to identify their principal, are required to disclose their role as an agent. Any vote that departs from either the customer's guidelines or the Bank's own proposals has to be reported and accounted for to the customer (AktG § 135 (8)). Much more sketchy is the regulation of depositary voting under the revised Swiss corporation law10. While the German law places a tight time-limit on the appointment of proxies, under Swiss law a proxy may be appointed for an indefinite time. By Obligationenrecht Art. 689d, the depositary, if the depositor does not communicate his instructions in the proper time, casts the vote in accordance with any earlier general instruction of the depositor; in the absence of any such general instruction, the bank is to vote in accordance with the recommendations of the board of directors11 - the apparent assumption being that the board is a proper guardian of shareholder interests. It should be mentioned that the revised Swiss corporation law not only allows for depositary voting by banks but also for proxy voting by management, corporate officers, or related individuals. Swiss law does not, however, simply duplicate the American model. Obligationenrecht Art. 689c requires that a proxy solicitation by management nominates at the same time an alternative, an independent person, who may then be appointed by shareholders. It should also be mentioned that proxy voting by management seems a rather exceptional case in publicly held and traded corporations, being confined to the voting of registered stock (Namenaktien), whereas depositary voting is used on a larger scale.12 At the shareholder meeting, both depositary banks and corporate directors have to disclose their acting as a proxy (Obligationenrecht Art. 689e (1)). Neither German nor Swiss law have much to say about the substantive responsibilities of depositary banks. The provision that banks comply with express directions by their clients (AktG § 135 (5), (8); Swiss Obligationenrecht Art. 689b (1)) is certainly not a path-breaking innovation. In addition, German AktG § 128 (2) requires that the bank's own proposals for voting the proxy be in the best interest of the shareholder. In only two provisions are conflict-ofinterest situations addressed. Firstly, the bank has to disclose, if one of its 10
Obligationenrecht, Title 24, as amended October 4, 1991. For details see P. BÖCKLI, Dai neue Aktienrecht, at 364 et seq. (Zürich 1992). 11 Unlike Germany, Switzerland does not have a "two-tier system" of corporate governance; the governance of the corporation is centralized in a board of directors, of whom a few perform executive tasks whereas the majority are restricted to a supervisory function; see, for a comparative view, C. MEIER-SCHATZ, "Corporate Governance and Legal Rules: A Transnational Look at Concepts and Problems of Internal Management Control," 13 /. Corp. Law 431, 448 et seq. (1988). 12 P. BÖCKLI, id. at 365, 366 et seq. But see infra, text following n. 30.
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managers is a member of the supervisory board of the issuing company or vice versa (AktG § 128 (2)). Secondly, if the bank, by virtue of a proxy, is entitled to vote the stock of its own company, it may do so only to the extent of the client's express instructions regarding specified items on the agenda (AktG § 135 (1)). By and large European law will adopt the German-Swiss approach to small shareholder representation.13 While leaving the door open for proxy voting by management14, the proposed model seems to be proxy voting by professional intermediaries holding themselves out for such a financial service. As to the procedure of and the restrictions on conferring discretionary authority on proxies, the European law does not substantially deviate from AktG § 135.15 We should not que-tion the righteous intentions of the drafters of such regulations. To get the whole story, however, we have to turn from the letter of the law to the facts and particulars of depositary voting. Only if we look at the economic and regulatory environment of depositary voting and at the overall ownership structure of German industrial firms, will the crucial importance of the depository vote for corporate governance be fully understood.16 C. The Factual and Economic Background of Depositary Voting in Germany I have to start here with a general disclaimer. Data on the factual background of depositary voting is still inadequate. We do have some data on the size of the banks' industrial holdings or shareholder representation on general meetings, but there is precious little information about how banks make actually use of their influence in corporate decision-making bodies.17 13
Cf. amended proposed directive Mr. 5 as of 19 August 1983 Art. 28; amended proposed ordinance of an organizational statute for Societas Europea as of 25 August 1989 Art. 88. A German translation of the two provisions is reprinted in: M. LUTTER, Europäisches Unternehmensrecht, at 243, 579 (3d ed. 1991) 14 See proposed directive Art. 28 (2) (id.). Remarkably, this subsection is not part of the more recent, otherwise almost identical provision in Art. 88 of the organizational statute (id.) Among the member states, Great Britain has, for obvious reasons, by tradition been closer to the American system of proxy voting by board members; see references supra, note 2. France, too, basically followed some sort of proxy system (practice of "pouvoirs en blanc"; see M. JUGLART & B. IPPOLITO, Traita de droil commercial, at 767 [3eme id. 1982]) until 1983, when voting by correspondence was introduced; see Code des soci&es Art. 161-1. 15 Art. 88 (2) of the organizational statute (id.) even adopts the permissible duration of a proxy of 15 months. 16 To be sure, American banks too make it their business to vote their client' shares held in a custodial capacity; see KRIKORIAN, supra n. 2, at 198 et seq. But neither do they solicit proxies nor do they appear to vote the proxies in a systematic fashion. 17 The most comprehensive and most recent survey is JÜRGEN BÖHM, Der Einfluß
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German banks are not only universal banks offering the whole range of financial services; they are also industrial entrepreneurs, as they have the unrestricted right to buy, sell, and own industrial firms or parts thereof.18 Of the domestic publicly held corporations (Aktiengesellschaften), in 1988 banks held approximately 8% of all stock outstanding19. This figure becomes even more impressive if one bears in mind the fact that the twelve largest private banks themselves owned 30 industrial holdings of at least 5 % capital share in one or several of Germany's largest industrial20 firms. Among this group the five largest owned 23 holdings (= 76,7%), the three largest 19 holdings (= 63,3%).21 The typical size of banks' direct holdings is a "controlling minority interest" ranging between 5 and 25% of the stock outstanding.22 This order of magnitude - which allows banks at least some influence over the firm's financial structure23 - , together with the long-term character of most bank holdings, and their concentration in very large firms all suggest that, rather than going for entrepreneurial control or for a high-yield financial investment, banks view their industrial holdings as a means of sustaining, enlarging, and intensifying their business relations with large-scale customers.24 Solely on the ground of their direct industrial holdings banks wield considerable voting power at shareholder meetings; moreover, the accumulation of depositary voting rights in the hands of a few large banks serves to strengthen their clout through direct ownership. The policy of the Corporation Code is to let the stockholder retain control, even though he does not vote his stock in person; thus it relies on the willingness of stockholders who disagree with their banks' general proposals to give the latter detailed instructions when asked prior to the annual meeting. Obviously this cannot work in practice. Making a wellfounded decision on how the vote is to be cast would mean that detailed information would here to be provided by the bank on every substantial and not merely technical item of the agenda. As providing information of this kind would be too costly, banks usually content themselves with mailing a proxy der Banken auf Großunternehmen (1992). See also (but with older data) THEODOR BAUMS, "Corporate Governance in Germany: The Role of the Banks," 40 Am. J. Comp. L. 503, 507 et seq. (1992). 18 See generally J. BÖHM, id. at 34 et seq. 19 See BÖHM, id. at 224 (tab. 1). The fraction of banks' ownership interests in public corporations was lowest in 1965 (6%) and reached a 10% high in 1980. 20 Leaving aside holdings not only in the financial industry but also in the retail trading, transport and other services sector. 21 BÖHM, supra n. 17, at 37, 227-28. 22 Id. at 45, 227 (tab. 3/4). With shareholder attendance at meetings effectively ranging between 50 and 70% on average (see id. at 66), even a 5% holding may yield sizeable influence. 23 e.g. the choice of debt instruments. 24 For a more elaborated argument see BÖHM, supra n. 17, at 48 et seq.
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form sheet routinely suggesting that the vote should be cast in accordance with the proposals of the management. To find out, exactly what the management's proposals are and why he might consider challenging them, would be so timeconsuming that the client's not responding25 to the inquiry cannot sensibly be interpreted as tacit consent26. If the drafters of the Aktiengesetz did indeed design the mandatory inquiry to safeguard the shareholder's prerogative in deciding how to cast his vote, in practice it has come to be a rather meaningless formality.27 One may even suppose that banks anticipate this when preparing their proposals.28 Thus, in most cases, a bank votes the proxy on the basis of a carte blanche and in accordance with proposals that are of its own making29 and which are not necessarily designed to promote its customers' interest. It comes as no surprise then that voting their clients' stock is one of the few financial services which German banks offer for free. They do, however, get some compensation from the corporations themselves, yet it is open to speculation whether, and to what extent, this compensation covers their expenses.30 Again, it is indicative of a conflict-of-interest situation that their Swiss counterparts, with much smaller, and mostly transitory, industrial holdings and therefore with no incentive to push their ownership interests by means of depositary votes, are no longer willing to vote custodial stock for small shareholders unless they receive full compensation from the issuing corporation31. The result of all this is a separation of corporate control and corporate ownership which Berle and Means would not have imagined in their worst dreams. And there is still another paradox to be pointed at: banks are able to accumulate voting power deliberately without there being any concerted 25
Empirical surveys have shown that customers give directions of their own in only 2-3% of all cases; see M. PURUCKER, Banken in der kartellrechtlichen Fusionskontrolle, at 96 (Berlin 1983). 26 A similar diagnosis of proxy voting in America is submitted by M. EISENBERG, "The Structure of Corporation Law," 89 Colum. L. Rev. 1461, 1474 (1989) and, even with regard to institutional investors, by KRIKORIAN, supra n. 2, at 214 et seq. A related example of such "conscious ignorance" is the reluctance of consumers to read the fine print of standard form contracts. 27 See also A. GOTTSCHALK, "Der Stimmrechtseinfluß der Banken in den Aktionärsversammlungen von Großunternehmen," WSI-Mitteilungen 1988, 294, 296. 28 A. GOTTSCHALK, id. 29 But usually taking sides with the proposals of the management; see infra, text accompanying n. 39. 30 Usually, banks are compensated by way of a lump sum covering their sizeable expenses both for disseminating mandatory corporate information to shareholders and for acting as proxies; for some hints see W. VALLENTHIN, "Die Neuregelung des Bankenstimmrechts im Aktiengesetz von 1965," Bank-Betrieb 5 (1965), 244. 31 This practice is of recent origin, and it remains to be seen how it will affect small shareholders' voting behavior.
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collective action on the part of their constituency, the shareholders. At least in the retail banking business, this voting power, if there is no meaningful authorization on the part of the customer, has hardly any basis other than a "relational" one. Selling and buying securities for a customer is mostly a followup business to the bank's administering a customer's checking account. Thus, while institutional investors or other trustees may claim at least some legitimate basis for exercising their accumulated voting power, such a basis is difficult to see when banks vote their depositors' proxies. Even worse, its accumulated depositary voting rights may place a bank in the position of a de-facto controlling shareholder without its being subject to the fiduciary standards imposed on such shareholders32. The aggregated depositary voting rights of banks, added to rights based on their own equity holdings or rights transferred to them by mutual funds33 run by a subsidiary34, thus provide a comfortable and stable power basis at shareholder meetings, a power basis which is unique among institutional investors.35 Frequently it is the depositary voting rights which yield the critical mass necessary to determine corporate policies. Several studies suggest that this influence is greatly concentrated in Germany's three largest private banks.36 In publicly held companies with a large and dispersed membership this tripartite group - to the extent that they form alliances, which they normally do - is virtually unchallenged.37 Notwithstanding the legal restrictions placed on an issuing corporation voting its own stock, the three largest banks control up to 40% of the vote at "their" shareholder meetings.38 Empirical findings further suggest that when casting their vote banks usually side with the company's management.39 In that respect the outcome of the 32
See generally KARSTEN SCHMIDT, Gesellschafisrecht, §§ 20 IV 2, 21 II 3 (Köln, 2d ed. 1991); more specifically W. TIMM, "Treuepflichten im Aktienrecht," Wertpapiermitteilungen 1991, 481 - 494. See also text, infra, preceding n. 102. 33 Major mutual funds hold up to 17% of the voting rights in large public corporations; see A. GOTTSCHALK, supra n. 27, at 295. 34 When voting stocks held by mutual funds, the fund manager does not have to seek authority from the owners; see Kapitalanlagegesetz § 9. 35 See the comprehensive report by J. BÖHM, supra n. 16, at 63-84. 36 See A. GOTTSCHALK, supra n. 27, at 299, and J. BÖHM, supra n. 17, at 6768, 244 (tab. 26). 37 In 1986, the three largest private banks controlled an average 45% of the vote in the 32 largest public industrial firms; in 15 of those firms they controlled the majority of the vote; A. GOTTSCHALK, id. at 299; similar findings are reported by J. BÖHM, id. 38 J. BÖHM, id. at 75; A. GOTTSCHALK, id. at 302/3. Jointly, the three large banks control slightly over 50% at their own shareholder meetings. 39 See, e.g., the report of the committee "Grundsatzfragen der Kreditwirtschaft," Schriftenreihe des Bundesministeriums der Finanzen Heft 28, n. 369 et seq. (1979).
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voting process may not differ so much from proxy voting by management. Mostly it is not until a bail-out situation arises that management and depositary banks part company. The dominant voting power of banks is most visible in the number of seats they hold in the supervisory boards of companies with a fragmented ownership structure.40 Bank representatives sit in the board rooms of 75 of the 92 largest industrial firms (= 81,5%)41, placing banks at the center of corporate interlocks.42 In short, one cannot escape the conclusion that the regulation of the depository vote in AktG §§ 128 (2), 135 falls a long way short of its policy goal of strengthening shareholder control.43 And, for that matter, the vision of "shareholder democracy" is hardly ever more remote than when it comes to casting votes at a shareholder meeting of a public corporation. D. Political Critique and Parliamentary Activities The depositary vote faced adverse political criticism almost from the time it first became common practice. Post-enactment commentators on the Corporation Code 1937 were skeptical about the efficacy of the new provisions regulating depositary voting.44 After the war, the debate was resumed und has not yet subsided. Conducted under the new catchword "power of banks" (Bankenmacht) it has become both more fundamental and more aggressive. Depositary voting had to be challenged not as an isolated phenomenon but as part of the banking industry's iron grip on the corporate world and its accumulation of a resulting uncontrolled economic power. Anything short of overall socialization of the banking industry45 has been suggested as a means of curbing the - putative or real - economic power of financial institutions. In 1979 a committee appointed by the Federal Minister of Finance46 came forward with a report recommending that the depository vote be retained but that banks should substantially curtail See also J. BÖHM, supra n. 17, at 137. 40 For exact data see A. GOTTSCHALK, id. at 300. 41 J. BÖHM, supra n. 17, at 194; the somewhat odd figure of 92 stems from the fact that among the 100 largest firms only 92 have supervisory boards. 42 See again A. GOTTSCHALK, id.; also KLAUS FISCHER, Hausbankbeziehungen als Instrument der Bindung zwischen Banken und Unternehmen. Eine theoretische und empirische Analyse, at 148, 149 (Diss. Bonn 1990). 43 Much too optimistic . RAISER, Recht der Kapitalgesellschaften, at 117 (München 1983), claiming that the regulation by the Aktiengesetz has proven effective and successful. 44 See B. KROPFF, Aktiengesetz. Textausgabe mit Materialien, at 194 (1965). 45 See generally BÜSCHGEN & STEINBRINK, Verstaatlichung der Banken? (1977). 46 So-called Bankenstrukturkommission.
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their direct holdings in non-banks47 and that their representatives should not be allowed to hold more than 5 seats on supervisory boards simultaneously.48 Moderate though these proposals were, no legislative action ensued. Therefore it took nobody by surprise when, in the late eighties, the issue was back on the political agenda. In 1990 the parliamentary committee for economic affairs (Bundestagsausschuß für Wirtschaft) held extensive hearings with testimonies from reputed experts, interest groups, and the federal agencies involved.49 Again, the tenet prevailed that there was no viable alternative to depositary voting; the increasing omnipotence of banks thus had to be offset by strengthening competition on the market for financial services and by putting a ceiling on the banks' industrial holdings and multiple memberships in supervisory boards. In pursuance of the proposals voiced in the committee hearings the parliamentary group of the Social Democratic Party (SPD) recently advocated abolishing proxy voting on the basis of carte blanche and making the depositary voting right contingent on particular and itemized instructions by the depositor. Furthermore, a shareholder's option to cast his vote should be facilitated by allowing postal voting.50 E. L· There a Viable Alternative to Depositary Voting? The German discussion takes it for granted that there is no alternative to shareholder democracy51. Furthermore we may learn from the French that
47
Another government-appointed committee - the Monopolkommission - suggested that holdings of banks in non-banks not exceed 5% of the equity capital of a single firm; see MONOPOLKOMMISSION, Hauptgutachten 1973/75, n. 568 (2d ed. 1977); Zweites Hauptgutachten 1976/77, n. 599 et seq. (1978). 48 See Report "Grundsatzfragen der Kreditwirtschaft," supra n. 39. The Report has been commented by U. IMMENGA, "Grundsatzfragen der Kreditwirtschaft," ZHR 143 (1979), 539 et seq. 49 See Anhörung des Bundestags-Ausschusses für Wirtschaft of 16 May 1990, "Gegen wachsende Bankenmacht und für mehr Wettbewerb im Kreditgewerbe". 50 Reported by Handelsblatt, 16 June 1992, at 6. 51 Among the more radical proposals at least one deserves further attention. As early as in 1929 R. MÜLLER-ERZBACH suggested that common voting stock be reserved for "responsible" entrepreneurial shareholders whereas small shareholders should be offered primarily preferred nonvoting stock; see R. MÜLLER-ERZBACH, Umgestaltung der Aktiengesellschaft zur Kerngesellschaft verantwortungsvoller Großaktionäre, at 20 et seq. (Berlin 1929). While this arguably mitigates the problem in a middle-sized (especially family-owned) corporation with a group of active shareholders, it is no recipe for the large corporation with an increasingly dispersed membership. In the absence of a controlling shareholder willing to assume an entrepreneurial risk this proposal cannot but result in a surrender to unrestrained management control.
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shareholders' acceptance of postal voting is anything but overwhelming52, the reason plainly being a general dislike for all sorts of demanding paperwork. Thus, debates on the depositary voting right usually result in a grudging acceptance that there is no alternative to this type of proxy voting. Is there really none? First, there is indeed no alternative to offering, and providing, large-scale proxy voting as a professional financial service. Professionalization is not only in the best interest of the stockholders delegating their voting right; professional proxies, by contributing their expertise in financial matters, will also enhance the quality of corporate decision-making. Among the various types of voting minority shareholders' stock, proxy voting "American style" is not being considered (at least in Europe) as an option to be taken seriously - on both political and cultural grounds. With no other mode of proxy voting the conflictof-interest problem becomes more poignant when managers are entrusted with casting the vote of shareholders whose prime responsibility is to control their managers. One might as well trust the fox to watch over the geese. At least one debatable alternative is proxy voting by shareholders' associations. Contrary to what one might expect, however, German experience with this alternative is anything but encouraging. A poll taken in the late seventies found that the representation of shareholders by shareholder associations at meetings of Germany's largest publicly traded corporations was less than 1% compared with over 50% of the vote cast by banks.53 An explanation for this might be that the membership rate of shareholders in shareholder organizations is presumed to be rather low.54 More important is the fact that shareholder associations, unlike banks, lack a strong incentive to solicit proxies from their members.55 Arguably the state could create such an incentive by subsidizing shareholder organizations just as it subsidizes consumer organizations. However, considerations of social policy discount this idea of equal treatment of consumers and well-to-do investors, though that is not an obstacle. Calling for the state to help shareholder organizations to bid for shareholders' voting rights would be a precipitous step unless we have tried to find a market answer to our problem.
52
I am grateful for this hint to Professor Yves Guyon. See also supra, n. 14. See Report "Grundsatzfragen der Kreditwirtschaft," supra n. 39, at n. 438 f. 54 Exact data are not available. 55 Members would not probably be willing to compensate their organization for rendering that service in addition to membership dues. Membership approval would not provide an incentive sufficient as to stimulate such activities on the pan of the executives. 53
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. The Economics of Depositary Voting A. A Market for Voting Rights?
For a German company lawyer the very notion of a market for voting rights is anathema. One of the paramount principles enshrined in our company law is the inseparability of a shareholder's equity interest and what we call membership rights, i.e. voting rights, claims to information by management, inspection of corporate records, etc.56 Once we leave such doctrinal niceties aside, however, we cannot but acknowledge that a shareholder's right to vote is also an asset of economic value. Furthermore, capital markets yield an ascertainable price for this good. On German stock markets there is a marked spread between prices for common stock and the prices for non-voting stock, even though non-voting stock is almost invariably issued as preferred stock, i.e. entitled to a higher dividend.57 There is an obvious conclusion that follows: why not replace the almost generally disfavored depositary voting system by an auction-like market that allocates voting rights to the economic entities placing the highest value on them? This idea has indeed been put forward in Germany recently.58 It has no doubt considerable appeal, yet it cannot work. On the supply side we have small in56
So-called Abspaltungsverbot; for details see KARSTEN SCHMIDT, supra n. 32, at 455 et seq. The principle of "unity of membership" precludes not only the definitive transfer of membership rights but also the granting of irrevocable authority to third parties to exercise such rights. In the United States, too, some states ban the sale of voting rights by statute; for details see F. EASTERBROOK & D. FISCHEL, supra n. 1, at 65. 57 See AktienG §§ 12 I 2, 139 ss. A recent survey for the years of 1989/90 shows that among a sample of 28 publicly traded corporations the average spread amounted to 29,1%. However, this seems to vary considerably over time, reflecting changes in general market influences; for example, the preferred stock dividend is valued higher in times of lower corporate profits, which may reduce the spread or even turn it into the negative. For more details see H. KRUSE, E. BERG & M. WEBER, "Erklären unternehmensspezifische Faktoren den Kursunterschied von Stamm- und Vorzugsaktien?," Zeitschrift fllr Bankrecht und Bankwirtschaft 4 (1993), 23 et seq. For a general report see RECKINGER, "Vorzugsaktien in der Bundesrepublik," Die Aktiengesellschaft 1983, 216. In the United States it has been found that of two classes of publicly traded stock earning equal dividends the class with superior voting rights usually traded higher by 2 to 4 percent; see R.C. LEASE, J.J. MCCONNELL & W.H. MIKKLESON, "The Market Value of Control in Publicly Traded Corporations," 11 Journal of Financial Economics 439 (1983). See also F. EASTERBROOK & D. FISCHEL, supra n. 1, at 71/72. 58 See expert testimony by E. KANTZENBACH & H. KALLFASS, in: Anhörung des Bundestags-Ausschusses für Wirtschaft, supra n. 49.
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vestors who are largely ignorant of the fact that their voting right might be of economic value, and as they do not consider that right a marketable good, they give it away to depository banks. They could be made cognizant of their rights' economic value if there were competitive bidding on the demand side. Indeed some sort of "vote trading" among shareholders themselves may already occur in cases where voting really matters, e.g. in takeover battles, bail-out situations and the like. In German corporations major shareholders interested in gaining a majority sometimes try to come to an understanding with other, uninterested59 but "befriended" shareholders to the effect that the parties are to coordinate their voting behavior.60 We need not discuss here whether the almost universal condemnation of vote buying is an efficient solution61, because it does not affect the question of whether we should allow competitive bidding for voting rights by financial intermediaries. The incentive to bid for votes - and the incentive to cast the vote in the first place, for that matter - are inextricably linked to the specific risk bearing of residual claimants.62 I have pointed out earlier why, some rather technical difficulties aside63, competition among professional suppliers of financial services fails to come about. It is only banks that are able to realize the economic value of voting rights to an extent that (at least) compensates them for the costs of bidding. Even if banks did not enjoy this comparative advantage because they were stripped of most of their equity holdings, a free rider problem would remain. To bid successfully for a voting block, someone has to take the lead, giving others a free ride.64 59
If the other stockholder is himself interested to gain influence, the transaction cannot even economically be said to be a "sale", because there is no exchange but rather a pooling of resources. 60 This is almost common practice where a company's by-laws put a ceiling on the number of votes which a shareholder may cast irrespective of the number of shares he owns, thereby abrogating the "one share one vote" principle. As vote buying is prohibited in Germany (as elsewhere, see following text), there is no pecuniary compensation for the "selling" stockholder but rather some indirect quid-pro-quo. 61 See, e.g., German AktG § 405 (3) No. 6/7. For an affirmative answer see F. EASTERBROOK & D. FISCHEL, supra n. 1, at 74 et seq.; the general view is challenged by R. C. CLARK, "Vote Buying and Corporate Law," 29 Case West. L. Rev. 776 (1979). The present writer's opinion is that the ban on vote buying should be lifted, as vote buying is basically a market solution for the failure of a corporation to issue preferred nonvoting stock for the benefit of small shareholders. There remain, however, some problems of valuation; see F. EASTERBROOK & D. FISCHEL, id. at 75; M. ADAMS, "Höchststimmrechte, Mehrfachstimmrechte und Markt für Unternehmenskontrolle," Die Aktiengesellschaft 1990, 62, 67/68. 62 See F. EASTERBROOK & D. FISCHEL, supra n. l, at 67 et seq. 63 Only a small fraction of corporate stock is issued as registered stock, rendering competitive bidding by circular an impossibility. 64 See A. CONARD, "Fiduciary Obligation of the Asset Manager," in Proxy Voting of Pension Plan Equity Securities, at 86, 103 (D. McGill, ed., Homewood, III., 1989).
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In the absence of workable competition one could try to mimic a market by compensating other potential suppliers for the service they render to small investors. As investors, for the reasons mentioned above, are not willing to compensate a proxy, compensation would have to be raised either by the issuing corporation65 or by way of state subsidy. Again, given the institutional environment of proxy voting in Germany, this cannot work. The crucial point is not only how the third-party compensation is to be measured. What can be substituted, is at best a market for financial services, not a market for voting rights. Moreover, nor does third-party compensation of proxies come out of nowhere. If the issuing corporation itself is to pay for it, this would ultimately burden the shareholders, although there may be compensating benefits. But even if independent professional proxies were indeed better maximizers of shareholder value than are banks, and out-competed banks on the market for voting rights, the potential gain to shareholders would be more than offset by the discounted "perennial" (and additional66) expenditures needed to compensate these proxies. With third-party compensation failing to yield any significant efficiency gains, it makes even less sense to call for the state to subsidize proxy voting. Of course, the potential value gain may exceed the discounted expenditures, but it would be contrary to sound policy to subsidize proxies simply on the assumption that this is necessarily the case.67 B. The Impact of Depositary Voting on Other Markets It has long been recognized that depositary voting by banks has distorting effects on the market for financial services. As has been said before, depositary voting rights are distributed very unevenly, placing the largest banks with their network of branch offices at a competitive advantage over smaller institutions. Their aggregated voting power at shareholder meetings along with their multiple memberships in supervisory boards adds to their market expertise and bargaining power, thus providing them with special opportunities in almost each segment of the banking business68 at almost no extra cost. Similar effects can be observed on capital markets and on the "market for corporate control".69 Here, too, the synergy of banks exercising both voting rights of their own and voting their clients' stock adds to the value of their 65
This is the proposal advanced by E. KANTZENBACH & H. KALLFASS, supra n. 58. 66
See supra, text accompanying n. 30. I owe this point to Professor Hartmut Schmidt, University of Hamburg. 68 e.g. credit transactions, underwriting the issue of stocks and bonds, trading with blocks of securities on secondary markets, etc.. 69 See generally E. WENGER, "Die Rolle der Banken in der Industriefinanzierung und in der Unternehmenskontrolle am Beispiel der Bundesrepublik Deutschland," Wirtschaftspolitische Blätter vol. 37 (1990), 155, 163 et seq. 67
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equity holdings at almost no price. If, on the other hand, banks do not have a stake in the company, solely voting other shareholders' stock, they lack any incentive to invest into supervising the management, unless they are also a lender to the company.70
. A Contract-Law Approach to Depositary Voting A. Regulatory Law vs. General Fiduciary Responsibility The foregoing analysis has demonstrated that, like it or not, there is no viable alternative to the depositary voting system, at least in the present institutional environment. Accordingly, the lawyer's concern must be to eliminate, or at least to mitigate, the adverse side effects of that system for investors, companies, and markets. The focus of this paper, then, is on the responsibilities which banks have to meet toward their customers. Raising this issue means, at least in Germany and Switzerland, breaking ground that is largely uncultivated. While the political debate over depositary voting has always been lively, the issue of the requisite standards of conduct in proxy voting has long been dormant both in the jurisprudence and in the relevant literature. Commentators have been concerned rather with the procedural aspects of depositary voting71; pertinent case law does not exist, except for one single lawsuit pending against a self-appointed shareholder lobbyist.72 Amazingly, in those three legal orders to which we refer - German, Swiss, and American - the provisions relating to proxy voting are invariably part of corporation law and, as in America73, of capital market law. This is indeed amazing, since representation of stockholders by proxies is basically a plain principal-agent relationship extraneous to the corporation, even if the proxy happens to be a corporate officer or director. However, we need not fault our legislators (or regulators) for disregarding the intrinsic systematic borderlines of the legal order. Whether a shareholder may cast his vote in person or by proxy, 70
E. WENGER, id. at 164. See C. W. CANARIS, Bankvertragsrecht, n. 2187 et seq. (Berlin, 2d ed. 1981); W. ZÖLLNER, Kölner Kommentar zum Aktiengesetz, §§ 128, 135 (1973); GESSLER/HEFERMEHL/ECKHARDT/KROPFF, Aktiengesetz, vol. 2, §§ 128, 135 AktG (1973); KARSTEN SCHMIDT, Gesellschaftsrecht, supra n. 32, at 716 et seq. 72 See Landgericht Düsseldorf of 22 December 1992, ZIP 1993, 350 (appeal pending); also Amtsgericht Düsseldorf of 20 May 1992, ZIP 1992, 1155 (appeal pending). The ruling in this case will set a precedent as to the fiduciary responsibilities of proxies in general. 73 Securities Exchange Act Regulation 14 A: Solicitation of Proxies (1934). For corporate law provisions see Revised Model Business Corporation Act § 7.22. 71
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whether there is individual or collective representation of shareholders, whether the proxy is a directed agent or endowed with discretionary authority: all these questions are not the private affair of individual shareholders. At stake are the fairness and the efficiency or, more generally speaking, the institutional integrity of the corporate decision making process. Accordingly, the national laws relating to proxy voting are, for all their variety, in the first instance procedural, technical, or, as a German commentator puts it74,, "public-law" in character. A graphic example of this (and of regulatory overreaching, for that matter) is Regulation 14A under the U.S. Securities Act, caring for trivia such as the type and size of print style on proxy statements.75 It would be illusory to believe that meticulous regulation of procedural details could serve as a substitute for substantive rules. Institutions are not protected for their own sake but for the sake of individuals acting and interacting in such institutions. By the same token, procedural safeguards are not an end in themselves but a special technique to protect individual rights. Accordingly, regulatory and procedural law are not designed to preclude but to supplement and to buttress individuals' substantive claims and responsibilities.76 To be more specific, regulations of proxy voting in corporation laws need not keep us from predicating the duties of persons voting other people's stock on general principles of fiduciary responsibility.77 Fiduciary duties are common law duties in the anglo-saxon world, judgemade duties in the civil law world. Courts have usually found fiduciary duties in a principal-agent relation or contract78, specifying and particularizing the agent's fundamental and general duty to advance the principal's interest to the best of his ability. This paper, too, will embrace a contract-law approach, exploring the potentialities of fiduciary responsibility as a means of governing the behavior of professional intermediaries who vote other people's stock. This is not to imply that courts alone can be trusted to take on the burden of spelling out comprehen74
ZÖLLNER, supra n. 71, § 135 n. 24. See Securities Exchange Act Rule 14a-5 (d). 76 It is intriguing to observe that even in the United States, with its complex regulatory fabric, there is a growing interest in the substantive aspects of proxy voting, stimulated in particular by the increasing impact of pension plan funds on corporate governance; see generally the contributions in Proxy Voting of Pension Plan Equity Securities (D. McGill, ed., Homewood, 111., 1989). 77 Cf., however, C. W. CANARIS, Bankvertragsrecht, supra n. 71, at Rdz. 2190/91, positing a priority of the regulatory provisions in AktG § 128 (2) over general principles of fiduciary law: "Man darf diese klare Regelung nicht mit Hilfe des diffusen allgemeinen Begriffs der Interessenkollision unterlaufen und dadurch die Mitteilungspflicht vom fest umrissenen Ausnahmetatbestand zur generalklauselartigen Regel machen; vielmehr ist insoweit ein argumentum e contrario aus [AktG § 128] Abs.2 Satz 5 zu ziehen." 78 The notion of a "quasi-contractual" relation is largely unknown to the civil law. 75
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sive standards of conduct. There are inherent limitations both as to the substance of duties a court can impose and to the remedies it can grant to redress a plaintiff's grievance. Courts of law are not regulators. Court-imposed duties can only be general standards, and the distinctive mode of judicial enforcement is holding a wrongdoer liable for damages. Keeping this caveat in mind, we may now turn to analyzing the general structure of fiduciary responsibility. B. Depositary Voting and Economic Principal-Agent Theory As has been said, the legal relationship between a shareholder and his depository bank is basically one of principal and agent. I need not elaborate here the point that the relation of principal and agent is a paradigm of economic theory which has been applied profitably to a variety of issues, generally to any situation where one person gets another to do some business for him, particularly in all kinds of economic organizations.79 Put succinctly, agency theory is an analysis of cooperation in situations where externalities, uncertainty, limited observability, or asymmetric information preclude the smooth operation of market mechanisms.80 In its normative ingredient, agency theory teaches contracting parties how to structure an agreement that will induce agents to serve the principal's interest notwithstanding the lack of effective market control.81 It is easy to see how neatly depositary voting fits the definition of an agency relation. A few remarks may suffice to highlight the structural differences between a normal exchange contract and agency.82 The essence of agency, accounting for most of its other features, is the delegation of decision making involving the granting of discretionary power. With regard to proxy voting, this needs no further explanation. The need to confer discretionary authority on the agent ensues from a second salient feature of agency: asymmetric information. The agent has knowledge usually in the form of professional expertise - which the principal does not have. Again, this is self-explanatory. The principal's inferior knowledge compels him to rely entirely on the agent. When hiring an agent, he may direct him what to do, but will be unable to instruct him how to do it. For similar reasons, monitoring the agent's activities is not feasible, or feasible only at a cost (problem of limited observability). 79
Among an abundant literature two text books may be singled out; for a general introduction see Principals and Agents: The Structure of Business (J. Pratt & R. Zeckhauser, eds., Boston 1985); more specific is Agency Theory, Information, and Incentives (G. Bamberg & K. Spremann, eds., Heidelberg 1987). 80 Cf. K. ARROW, "The Economics of Agency," in Pratt & Zeckhauser, id. at 37 et seq. 81 PRATT & ZECKHAUSER, id. at 2. 82 Our analysis draws on E. SCHANZE, "Contract, Agency, and the Delegation of Decision Making," in Bamberg & Spremann, supra n. 79, at 463-470.
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Even post facto monitoring of the service rendered may be difficult. A successful reorganization of a company heading for bankruptcy may be due to the proxy's assistance in ousting an incompetent management, but may as well be owed to a benign turn-around on the company's markets (problem of quality uncertainty). All this leaves the principal at the mercy of his agent. Unlike the parties to a contract, principal and agent interact in a hierarchical setting, rather than, on an equal footing. On the part of the agent, this creates an incentive either to shirk or to engage in self-dealing (problem of moral hazard). To be more specific: a depository bank without a stake in a corporation either as a shareholder or a lender lacks any incentive to invest in monitoring activities and will acquiesce to the proposals of the management. Conversely, if the bank is a stakeholder, then it will be tempted to maximize its own utility rather than advance its client's interest. Generally speaking, agency theory seeks to align the conflicting incentives of principal and agent at a minimum cost. In exchange contracts it is the market that takes care of this problem; yet market guidance does not work in agency relationships in general, and even less so if the agent is a depository bank. On the market for voting rights, banks do not compete regarding quality of proxy voting, because shareholders are ordinarily unable to assess the quality of such a service. Nor do banks compete regarding price, for depositary voting is a service offered free.83 This, in turn, undercuts any strategy which aims at tackling the moral hazard problem through a compensation scheme which would prevent both shirking and self-dealing. Finally, closely monitoring the proxy's voting behavior involves a cost which the shareholder is not willing to bear, as he systematically tends to undervalue his voting right. The only answer to the principal-agent problems inherent in proxy voting, then, is to charge the agent with fiduciary duties. This does not mean, to be sure, that we adamantly have to regress to those traditional legal concepts of fiduciary responsibility which have been rightly said to be fuzzy and banal in their general content and overly casuistic in their implementation.84 To lawyers, the findings of agency theory are novel, and not only to the extent that it is economists who teach us how such duties may substitute other mechanisms and designs in resolving the problem of "forced reliance" in agency relationships. In addition, economic analysis reveals a specific incentive structure of fiduciary duties.85 The point of reference is a (hypothetical) "complete" agency contract86 83
See supra, text accompanying n. 30. See, e.g., R. CLARK, "Agency Costs versus Fiduciary Duties," in Pratt & Zeckhauser (eds.), supra n. 79, at 55, 71. 85 See generally R. COOTER & B. FREEDMAN, The Fiduciary Relationship: Its Economic Character and Legal Consequences, John M. Olin Working Papers in Law and Economics No. 90-6 (1990). 86 On the economic concept of "complete contract" see, e.g., R. COOTER & T. 84
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providing for such incentives and obligations as the parties would have agreed upon had they had perfect information and been able to bargain at no cost. Such a bargain would, in particular, include standards of conduct for anticipated conflict-of-interest situations deterring disloyal or opportunistic behavior on the part of the agent. The problem to be solved then is, first, that disloyal behavior is not easy to detect and even more difficult to prove, secondly that gains from such wrongdoing are potentially large and, by the same token, difficult to prove against the disloyal agent.87 Accordingly, fiduciary duties must be designed to operate prophylactically, i.e. preclude conflict-of-interest situations even from arising; remedies for breach must be supracompensatory, i.e. must exceed the agent's expected gain from disloyal or opportunistic behavior.88
IV. Particularizing the Proxy's Fiduciary Responsibility A. The Duty of Care Occasionally during the last few years Germany's largest banks were blamed for their failure to invest due care in supervising the management of a company that later went bankrupt or needed restructuring. Primarily, any such criticism would focus on the role which bank officers play on the company's supervisory board. By AktG § 116 members of the supervisory board may be held liable for negligence if they have failed to act with due care. There is no provision for the liability of proxies who have cast their principals' vote in a manner that turned out to be perilous or even fatal to the corporation. And, to the best of my knowledge, in only one case has it been tried to hold a non-bank proxy liable for negligence in casting his vote.89 When discussing the duty of care of proxies we have to bear in mind first and foremost that it is not the shareholder meeting but the management which is running the company. And under the German two-tier system of corporate governance even the task of controlling management is allocated in the first place to the supervisory board. Statutory separation of powers restricts the shareholder meeting to decision-making on so-called organic corporate changes (mergers, charter amendments, dissolution of the company) and on the distribution of profits: furthermore the meeting has to elect the supervisory board
ULEN, Law and Economics, at 229-236 (Glenview 1988); H.B. SCHÄFER & C. OTT, Lehrbuch der ökonomischen Analyse des Zivilrechts, at 250 et seq. (Berlin 1986). 87 R. COOTER & B. FREEDMAN, supra n. 85, at 28 et seq.; see also KÖNDGEN, "Immaterialschadensersatz, Privatstrafen und Gewinnabschöpfung als Sanktionen für vorsätzlichen Vertragsbruch," Rabeis Zeitschrift 56 (1992), 696 et seq. 88 See in greater detail KÖNDGEN, id. at 750 et seq. 89 See Landgericht/Amtsgericht Düsseldorf, supra n. 72.
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and give annual approval to the board of directors.90 It is important to note, however, that management may, and under certain circumstances is obliged to, submit matters of daily business to the shareholder meeting for approval91; in matters of vital importance the board will indeed be well advised to do so. It is obvious that a professional proxy cannot be held to the stringent standards of care that govern the behavior of managers in conducting the company's business. Equally, there is little doubt that the standard of care imposed on members of the supervisory board is not applicable to professional proxies. The reasons are straightforward: neither in corporate law nor in corporate practice is there such a thing as the professional role of a supervisory board member. To be sure, in boards of publicly held corporations we can observe an ever increasing degree of professionalization. But as a countervailing factor mandatory workers' co-determination has opened the board room to union officials, whose self-conception is to bring employees' interests to bear rather than to monitor the performance of management.92 Even more to the point is another argument. Most of the decision-making powers allocated to the shareholder meeting are original and conclusive competences which do not purport to supervise other decision-making bodies. Legally, therefore, if perhaps not factually, the relationship between shareholder meeting and management is not hierarchical in either way. Even when management makes a proposed business decision contingent on shareholder approval, the meeting votes to legitimize rather than supervise the decision proposed by management. Failure to establish a specifically corporate legal responsibility of proxies thus brings us back to the contract law approach which I proposed earlier. Legally, the proxy is undoubtedly an outsider to the corporation. As a professional agent making investment decisions on behalf of and for the benefit of shareholders, he is acting in the role of an investment manager. Voting his client's stock is no different from trading stocks that form part of the client's portfolio. Both activities serve to maximize the portfolio's value. Hence it is justified to hold the proxy to that standard of care which may reasonably be expected from a professional investment manager. This standard may vary according to what the proxy offered as his services. On the other hand, for depositary voting, a homogeneous standard of care can be easlily defined, as banks are a highly uniform professional group. 90
AktG § 119 (1); for details see KARSTEN SCHMIDT, Gesellschaftsrecht, supra n. 32, §28 IV 1. 91 AktG § 119 (1). The obligation to submit is judge-made law; see Federal Court in BGHZ 83, 122 -"Holzmüller". The ruling has been challenged on the grounds that it defeats the statutory separation of decision-making powers: see MERTENS in Kölner Kommentar zum Aktiengesetz, § 76 n. 51 et seq. (2nd ed., 1988); KARSTEN SCHMIDT, id. at § 28 V 2b. 92 See GESSLER, HEFERMEHL, ECKHARDT & KROPFF, supra n. 71, AktG § 116 n. 10.
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There is no difference if the proxy votes a large block of shares thus putting himself in a position similar to that of a controlling shareholder. The analogy holds only if a proxy is appointed by a group of minority shareholders for the sole purpose of enlarging their voting power by pooling a dispersed minority vote.93 Even then, this would not affect the proxy's duty of care. Whether it would affect his duty of loyalty, is of course a different story. B. The Duty of Loyalty As has been said, with depositary voting the interests and incentives of banks and their customers are not, and cannot be, aligned by paying banks an appropriate compensation for rendering this service. Banks seek their compensation by seizing opportunities which accrue from their accumulated voting power. Under such a compensation scheme, self-dealing (taken in its widest sense) becomes a problem that is as ubiquitous as it is intractable. Attention has been called to the types of potential conflict-of-interest situations so frequently94 that I may be very brief. The most egregious type of conflict of interest occurs when banks, as the issuing company, vote their own stock. In this situation a conclusive presumption holds that conflicts of interest must exist. If it is true that fiduciary duties should be designed so as to prevent conflicts even from arising, there is only one solution to this problem: banks have to abstain from voting altogether.95 As enforcement of a common law duty to this effect seems impractical, regulatory law should provide that banks are not eligible for appointment as a proxy for voting their own stock. With the conflict of interest situation being ascertainable by formal criteria, such a per-se rule seems appropriate. The drafters of the revised German Corporation Code of 1965 rejected that solution, giving credit to the argument that it would put banks at the risk of their shareholder meetings being dominated by their competitors purely by virtue of the depositary voting right.96 Such an argument is telling and reveals how inconsistent the whole system is. As a compromise answer, German law seeks to neutralize conflict of interest by making the bank's right to vote its own stock contingent on the client's giving express instructions on how to cast the vote. Sensible as that may sound, it does not work in practice, because the 93
See BGH ZIP 1988, 301. See, most recently, K. HOPT, "Inside Information and Conflicts of Interest of Banks and Other Financial Intermediaries in European Law," in European Insider Dealing at 219 et seq. (K. Hopt & E. Wymeersch, eds., 1991). 95 This seems to be the law in the U.S. since 1967; cf. Cleveland Trust Co.v. Eaton, 229 N.E. 2d 850, 862 (C.P. 1967); but see for national banks the provisions in 12 U.S.C. § 61 (2) (1982). 96 See ZÖLLNER, supra n. 71, § 135 n. 67. 94
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instructions may be, and mostly are, given through the proxy form sheet, i.e. by simply accepting the bank's proposals to follow the management's lead97. Furthermore, such an approach is subject to a doctrinal controversy98 whether the bank may deviate from the client's directive if it has reason to think the client would agree. Such discretionary authority cannot but result in the very conflicts of interest which the solution I have suggested intends to avoid. Other, less grave conflict of interest situations - depository bank is a fellow shareholder, or a principal lender to the company; bank has a representative on the supervisory board pending re-election by the meeting, etc. - do not normally call for an equally strict stance. In fact, denying the bank eligibility in those cases would make the whole system break down. Under German law the bank is obliged to disclose, when there are interlocking directorates or supervisory board memberships (AktG § 128 (2)). It has been suggested that, by negative inference, the bank in any other case had no such duty, the client being adequately protected through the bank's substantive duty to advance its client's interest.99 Again, this suggestion ignores the prophylactic character of most fiduciary duties. These are designed to release the fiduciary from the burden of having to make a complex choice in weighing his own possible gain against the interests of his principal: lead him not into temptation. Thus, in any conflict-ofinterest situation the maxim should prevail: disclose or abstain!100 A conflict-of-interest situation of quite a different kind arises when a bank disregards its client's interests because it seeks to promote some superior interest which is not its own. In casting such a "social vote", the bank might invoke the "interest of the firm" (Unternehmensinteresse), the corporation's social responsibility, or even the public interest. One commentator has indeed suggested a rule to the effect that banks, on principle, should place the "interest of the corporation" above the client's interest in maximizing shareholder value.101 However, none of this warrants the arbitrary disregard of the principal's interest. To begin with the "interest of the firm", even the Germans, with their penchant to mistake formal organizations for living autonomous entities, are beginning to accept that the "interest of the corporation" is pure mystification and that the only real thing is the interests of individual shareholders.102 Secondly, even if we are willing to accept that there is some such thing as corporate social responsibility, it is not for a proxy to enforce this responsibility 97
See supra, text preceding n. 25. See again ZÖLLNER, supra n. 71, § 135 n. 58, 73. 99 C.W. CANARIS, supra n. 71, at n. 2190/1. 100 Accord ZÖLLNER, supra n. 71, at § 128 n. 28. 101 C.W. CANARIS, supra n. 71, at n. 2189. Although this statement relates only to banks' proposals to be submitted in the proxy materials, it is no doubt of more general relevancy. 102 But see H.J. MERTENS, "Der Aktionär als Wahrer des Rechts," Die Aktiengesellschaft 1990, 49, 53. 98
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against the countervailing interest of his principal in maximizing shareholder value. Almost by necessity, still another type of conflict of interest would arise if we adopted the proposition to make a proxy who is not himself a (major) shareholder but casts the aggregated vote of a major group of small shareholders subject to the specific duties owed by a "controlling minority shareholders". A proxy cannot at the same time serve his minority constituency and give consideration to the majority position he is charged to oppose.103 C. Fiduciary Responsibility as Applied to Rescue Operations When it comes to applying fiduciary standards in proxy voting to specific issues subject to shareholder approval, most lawyers seem to think of voting on takeover bids and related defensive measures. For good reasons, I am not going to join in those efforts. Not only are we told that the takeover craze in America is rapidly subsiding, but there is also abundant writing on the subject in America which I need not duplicate here.104 Instead, I will single out a case where the taking of fiduciary responsibility by banks is most visible and most crucial: corporate rescue operations. This case study also highlights the complex interplay of the duty of care and the duty of loyalty. To prepare a proper vote the depositary bank has, with due care, to decide whether the company is worth reorganizing in the first place. This involves a duty to enquire into the causes of the company's poor performance in the past and to examine the prospects of the company's being able to turn round its critical condition. If the answer is affirmative, then the bank's duty is to make a scrupulous choice as to the appropriate ways and means of reorganization. The duty of care is complemented and, in part, superseded by manifold duties of loyalty. Before casting the final vote and asking the shareholders for instruction, the bank has to give full information about its own stake in the company as a fellow shareholder and/or a principal lender. Having made such disclosure, the bank has to support a decision that is in the shareholders' best interest. A lender bank, for example, may not vote in favor of a recapitalization of the company solely to reduce the company's debt as a borrower. As a controlling fellow shareholder, the bank has to resist the temptation to place the burden of raising new capital unilaterally on the minority shareholders. Finally, both as a principal lender and a controlling shareholder the depositary bank may have to take account of other creditors' interest in not launching a costly but ultimately futile rescue operation. This panoply of fiduciary duties may not be conclusive, 103
But see M. DREHER, "Die Schadensersatzhaftung bei Verletzung der aktienrechtlichen Treuepflicht durch Stimmrechtsausübung," ZIP 1993, 332. I will be dealing with these questions more specifically in a forthcoming publication. 104 I may refer the reader to A. CONARD, "Fiduciary Obligation of the Asset Manager," in McGill (ed.), supra n. 64, at 86-108.
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but it does convey an idea of the complexity of fiduciary responsibility.
V. Conclusions 1. Voting by proxy is an indispensable device of corporate decision-making in publicly held corporations. Large-scale proxy voting is a financial service that is best rendered by professional intermediaries. 2. Given the inherent dilemmas of proxy voting by management, proxy voting by banks (depositary voting) may be acceptable as a second-best solution. The idea of making voting rights subject to competitive bidding by professional financial intermediaries does not and cannot work in practice. 3. The fiduciary responsibility of proxies has to be implemented both by procedural regulations and by substantive common law duties originating from the principal-agent relationship between proxies and shareholders. 4. Fiduciary responsibility involves both a duty of care and a duty of loyalty. The proxy is held to the standard of care owed by a professional investment manager. In conflict-of-interest situations which can be ascertained by formal criteria, a per-se rule requiring the proxy to abstain from voting seems appropriate. In other situations the proxy is subject to a general duty to disclose any conflict of interest.
Chapter Nineteen The Equity Market in Germany and its Dependency on the System of Old Age Provisions Michael Hauck
I. Introduction A study published by Georg Hauck & Sohn and other European Banks in 19641 and a study published by the Austrian "Aktienforum" Österreichischer Verband für Aktien-Emittenten und Investoren in 19922 show the market capitalization of all quoted national equities in percentage of gross national product (1963) and gross inland product (1991).
USA Great Britain Netherlands France Germany Austria Italy
1963
1991
not included over 100 % 38% 24 % 22 % not incl. not incl.
74.5 % 91.5 % 54.1 % 26.7 % 21.7 % 14.3 % 12.6 %
Both studies disclose remarkable differences between two groups. A) The group with "big" equity markets USA UK Netherlands 1
"The European Stock Exchanges" by Groupement European d'Etudes Financieres. See Schriftenreihe der Vereinigung Oesterreichischer Industrieller, at 13 (Wien 1992). 2
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B) the group with "small" equity markets Germany France Austria Italy "Group A" countries pay most pensions (companies and many public institutions) out of funded pensions funds. "Group B" countries pay pensions mostly out of current income or pension reserves built up within the companies' balance sheets. There seems to be a strong interdependence between the size, strength and importance of national equity markets and the national old-age pension systems.
Π. Methods of Financing Industry in Germany In its monthly report of October 1991 the German Bundesbank3 conducted a survey of equity financing. According to the study, between 1980-1990 German companies issued new equity of a total value of DM 126.1 billion, which includes DM 27.7 billion issued by banks. According to the Bundesbank, this is roughly comparable with company financing by means of pension reserves, which increased during the same time by DM 120 billion. According to the Bundesbank the equity ratio of public companies was 30 % in 1990, despite strong expansion of the balance sheet. Higher issuing prices as well as increased earnings contributed to this improvement. The pension reserves in the balance sheets still amount to 10 % of the balance sheet total or DM 240 billion in 19904. From whatever perspective we look at the structure of the German equity market, whether from its comparative small size vis-a-vis other markets or visa-vis the economic strength of Germany, one must look at the structure of German old-age provisions.
ΙΠ. The "three pillars" of Pension Payments in Germany In this area, Germany encounters different problems than does, for example, the US. Professor Buxbaum5 has pointed out many of these differences in his paper on "Institutional owners and management". 3
See DEUTSCHE BUNDESBANK, Monthly Report October 1991, at 22ff. See DEUTSCHE BUNDESBANK, Monthly Report November 1991, at 21. 5 See RICHARD M. BUXBAUM, "Institutional Owners and Corporate Managers: A Comparative Perspective," 57 Brooklyn Law Review 1 (1991). 4
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I can refer to it and leave out many factors covered in this paper. I want, however, to stress only those factors influencing the equity markets. A. Social Security System The public security system was introduced by Bismarck at the end of the 19th century. It is even more and more elaborated each time a political party attempts to win an election. It is so perfect, so wide-spread and also so costly that it takes away individual incentive. This "pillar", one of three, is the most important. But in 1990 only about DM 38 billion were funded through Zusatzversorgungskassen des öffentlichen Dienstes6. Out of this, most money is invested in bonds and very little goes into the equity markets. So let us forget about the enormous figures and the fact that no one seems to think of the mathematical value of all future liabilities discounted for today and nobody seems to bother much about the enormous charge on the future generation. B. Business Related Pension Money The second pillar comprises pension money internally managed by companies. 1. Pension Reserves within the Company Here we find estimated figures. The total obligations of companies amounted in 1988 to about DM 345 billion7. Out of this, about DM 210 billion has been given as "Direktzusage". In other words, the company gives its promise, builds up a "Pensionsrückstellung" (Pension Reserves), keeps the money in its treasury and invests it within the company. The companies engaged in this are legally mandated to join a kind of mutual reinsurance, which guarantees the pensions. You could say that German companies, aside from their industrial activities, are also, in a way, life insurance companies. Siemens, for example, has over DM 14 billion of pension reserves8 and can be compared in this respect with a good medium-sized life insurance company.
6
See supra n. 4. Statement of Arbeitsgemeinschaft ffir betriebliche Altersversorgung e.V. (ABA), Heidelberg. 8 See Annual report 1991 Siemens AG, at 34. 7
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In the past few years, since the liquidity of many companies has been high, also through addition to pension reserves, some companies have invested some money in the markets, mostly in bonds but some also in equities. This may be done through "Spezialfonds". One company, Klöckner, Möller9, has published in its yearly report its desire to balance out its pension obligations with investments in securities. This is, however, no legal funding. There are no statistics on how much money has been invested by industrial companies in the equity markets as non-industrial investments. Siemens10 is the biggest investor, with about a total of DM 15.1 billion invested in securities and promissory notes out of which about DM 1.7 billion are in equities. 2. Independent Pension Funds Out of the total of DM 345 billion of pension obligations of German companies, DM 82.5 billion11 are funded through external "Pensionskassen", independent pension funds. They invest under the life insurance laws and regulations in the bond and equities markets. DM 30 billion are channelled through "Unterstützungskassen"12, which in turn invest mostly by giving loans to the companies for which they work. They are no important sources of money for the equity markets. 3. Life Insurances The last DM 30 billion of the DM 345 billion obligations by companies are transferred to life insurance companies as "Direktversicherungen"13. The company insures its employees through a life insurance company. According to the investment philosophy of life insurance companies, this money is invested in the markets but probably not more than up to 10 % in equities.
9
See Annual report 1988/89 ofMoeller Group, at 23. See Annual report 1991 Siemens AG, at 41. 11 See Annual report 1990 Bundesaufsichtsamt fllr das Versicherungswesen, table 210. 12 ARBEITSGEMEINSCHAFT FÜR BETRIEBLICHE ALTERSVERSORGUNG E.V. (ABA), Handbuch der betrieblichen Altersversorgung (Wiesbaden 1991). 13 See DEUTSCHE BUNDESBANK, Monthly Report Mai 1992, at 23, table: "Ersparnis, Geldvermögensbildung und Kreditaufnahme der westdeutschen privaten Haushalte". 10
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C. Private Pension Savings The third pillar is savings by private individuals. The savings rate, at 14.7 % in 199114, is very high. Much of the savings accumulates in saving accounts, which at the end of 1991 totalled DM 746.7 billion15. Much of private saving goes into bonds and some into money market funds. Only 5.5 %16 of private resources is invested in the equity markets. In 1991, out of DM 238.2 billion new savings only 0.5 % were invested in equities. Private individuals also saved DM 41.8 billion through life insurance companies in 199117, which in turn invested about 10 %18 in equities. So much about the "three pillars system". D. Additional Institutions May I add that outside of this system there are some more institutions collecting money for old age provisions, the "Private Versorgungskassen" resp. the socalled "berufständische Versorgungswerke". In 1990 48 of these institutions existed, and disposed of assets of about DM 41 million, of which 15.4 % were invested in stocks and other securities compared to nearly 49 % invested in bonds19. Among them the collective saving institutions of the medical profession are the most important, followed by those of the churches. Some of them are relatively aggressive investors and can be compared in this respect with UK and US pension funds. Universities are, with the exception of a few new private universities, completely dependent on the budget of the "Lander". The pensions are paid out of the current budget, there is no such thing as the CREF Fund with its $ 35 billion invested in equities. The German post office, for example, employs over 500,000 people. It has no pension fund. If there were such a fund, I would estimate it at DM 18 billion. But this, unfortunately, is an Utopia.
14
See supra n. 13. See Deutsches Institut fur Wirtschaftsforschung (DIW), Wochenbericht 30/92. 16 See supra n. 15. 17 See supra n. 13. 15
18 19
See supra n. 3.
Statement of Arbeitsgemeinschaft berufsständischer Versorgungseinrichtungen (ABV).
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IV. Investment Strategy and Exercise of Voting Power A. Investment Philosophies Until now I have explained the structure of the system and have talked about the possible sources of money flows to the equity markets. I now should make a few remarks on the investment philosophies and practices of the institutions investing pension money. Here again you will find many differences from the US and UK. Life insurance companies are very strictly regulated and have a limit of 30 % for investments in equities (recently recreased from 20 %). Their limits and regulations also apply to pension funds. But in reality, the actual equity proportion of all investments of life insurance companies is, according to the Bundesbank report of October 1991, around 10 % and of the pension funds at 3 %. The association of pension funds questions this 3 % and talks of 10 %. I know, however, that the biggest pension fund of Germany, the BVV, a joint venture of most members of the private banking sector, with total assets of DM 11 billion, is below 5 % with its equity allocation. This figure has been published in its annual meeting. This lack of propensity to invest in equities we find again with private individuals which, I repeat, hold only 5 % of their financial resources in equities. The reason for this could be discussed in a new conference but I would be hesitant to give a convincing and simple answer. Maybe there would be more professional confidence in equities if we had more professional pension fund management. This would provide a constant flow of new money into the equity market and would give better support to it then the currently dominating investments from abroad. B. The Structure of the Ownership of Equities These two factors: a) lack of funding of money for old age provisions by the public and by companies, and b) lack of interest in equity investments by the institutions managing oldage pension money, and the same lack of interest in equities by private individuals have led to the structure of ownership of German equities as described in the October 1991 issue of the Bundesbank report.
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Structure of Stock Ownership in Germany as % of total market capitalization at the end of 199020: Private Households Companies Public Households Foreign Savings Institutes Insurance Companies (not including participations)
17 % 42 % 5% 14 % 10 % 12 %
Stock holdings in 1990: -pension funds around 3 % of investments in securities -insurance companies around 10 % of investments in securities (without including direct investments in the form of stakes in special funds) -securities-based investment funds around 16.5 % of the funds under management -private households 5.5 % of total financial assets -current assets of companies 2.2 % of the balance sheet (= around 10 % of the overall market capitalization at the end of 1990) -long-term financial assets of companies around 7 % of the balance sheet (= around 32 % of the market capitalization at the end of 1990)
The figure of 12 % of insurance companies and pension funds is unfortunately not separated. Rough guessing leads to 2-3 % for pension funds only. An exact calculation will in any case not make much difference if a comparison is being drawn with the UK and the US. The shareholdership of pension funds in the US is said to be over 40 % of their total assets of around than $ 2,400 trillion21.
20 21
See supra n. 3. See BUXBAUM, supra n. 5, 17.
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That represents about 25 % of the quoted share capital of US companies and around 60 % in the UK. The gap caused by the two factors described above was filled in Germany by foreign investors. The percentage of total foreign holdings with 14 %22 is certainly much higher than in the UK or in the US. If our markets are reacting sometimes rather hectically, and if during the recent crash days the German equity market declined more than other markets, my explanation for this is again the dominance of foreign trading and the lack of domestic institutional money. Foreign investors tend to react rather procyclically and mostly in the same direction. C. Representation of Shareholders in Shareholders Meetings and Codetermination Private investors and businesses are fundamentally free to hand over their securities to be managed by a bank. Investment trusts do not have this choice for their organized fund management. Securities are maintained in deposits at banks for security reasons. Private and institutional investors - as long as they are not investment trusts can exercise these voting rights either directly or through their deposit bank. Unit trusts should, in accordance with section 10 (1) (4) KAGG23, as a rule exercise the voting right themselves. I would like to come to another German peculiarity, which is also part of our main subject. Codetermination has led to a structure in which most quoted companies have a Board consisting of 50 % members representing "the owners" and 50 % "the employees". I can very well understand the fears of management and owners that under a system with pension funds, these funds might control so much of the total equities as they do in the UK or in the US. In this case a combination of Codetermination and voting rights of pension funds might lead to a situation where the overwhelming voting power in the boardrooms is in the hands of the employees or their organisation, the unions. The now existing difficult balance of board membership might be endangered through one additional seat for the employees or the Unions in the boards. A proxy fight might lead to the domination of a company through the employees and a complete loss of influence of the owners, which has already been reduced by Codetermination.
22
See supra n. 3. Gesetz über Kapitalanlagegesellschaften as of 1/14/70, BGB1. I 127 (law concerning unit trust management companies). 23
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V. Unit Trust Business and "Special Funds'* According to the BVI (Bundesverband Deutscher Investment-Gesellschaften e.V.), the number of mutual funds in 1990 was 308, with assets under management of DM 122.5 billion; this includes equity funds (including mixed funds) with assets of DM 16.4 billion at the end of 199024. The number of special funds, which is a trust in the legal form of a mutual fund with only one investor, 1,679, is far greater than the number of mutual funds, and, with managed assets of DM 113.3 billion in 1990, almost at the level of mutual funds. In 1990 all funds (mutual funds and special funds combined) held only around DM 36 billion or 16.3 % of their managed funds in shares of domestic issuers and DM 8.6 billion (3.9 %) in shares of international issuers. These funds are managed by banks through bank-controlled KAG's (unit trust management companies)25 which they control. Deutsche Bank alone has about 30 % of the market with DM 50 billion under management (Frankfurt and Luxemburg combined). Voting rights are by now with the KAG, which - I repeat - are controlled by banks. There have been cases where a KAG talked and asked questions in a shareholders' meeting, but I do not know of any case of an opposition against the management of the company in which KAG owned shares. The policy of the KAG in general is coordinated with the basic policy vis-a-vis the management of companies. The law does not say much about influence on companies by KAGs, but the current legal opinion and the literature say that KAGs should not exercise any dominating influence on management decisions and strategies of companies of which they hold shares.
VI. Summary and Conclusion We in Germany do not have too much money funding our old-age pensions, we have too little. We have no problems with pension funds, we just have too few of them. However, more influence of the pension funds through voting power in combination with codetermination might lead to a complete loss of influence of the owners, the shareholders, and might in the extreme give all the power to the unions.
24
See BUNDESVERBAND DEUTSCHER INVESTMENT-GESELLSCHAFTEN E.V. (BVI), Investment, at 91. 25 so-called Kapitalanlagegesellschaften, set up according to the rules of the KAGG (compare supra n. 23).
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But on the other hand, if we do not get more institutional money, especially more money from old-age provisions, into the equity market, the strength and size of the German equity market will continue to lag behind the strength and the size of the German economy. The influence of foreign investors will remain too great and London, with its ever-growing institutional money, might play an ever bigger role in German equities. German private savings would then probably be even less attracted to the equity markets than now. There are certainly ways out of this problematic situation. One way would be if more people with influence on politics, the media, the banks, the national associations and last but not least the universities would become aware of these problems which will be even more important in an United Europe.
Chapter Twenty
Institutional Investors and Corporate Governance: A German Perspective Friedrich Kubier
I. Introduction It is still not an easy task, to present and explain the impact of institutional investors on corporate governance in Germany to an international forum. Twenty years ago, during summer 1972, I had for the first time the opportunity to visit the Securities and Exchange Commission and to interview some members of its staff. They were by no means reluctant to express their view of the German system: it was determined to economic decline as it was and is dominanted by banks allowed to engage in any lawful business activity. I was and I still am impressed by their arguments which certainly reflect the dominating American view. At the same time I appreciate the intellectual support provided by more recent and very thoughtful comparative evaluations which show the German scene in a more favorable light1. Their analysis encourages to emphasize policy issues which I have called - in a similar context - a German dilemma2. In order to explain this dilemma I shall use the American system implicitly as a contrasting model and present my observations in three steps: - First, I will mention very briefly some of the basic features of the German scene in order to illustrate the marked differences - or perhaps more accurately: the wide gap - between the two systems. - Next, I will review in a nutshell the current proposals for change and the discussions they have triggered. 1
R.M. BUXBAUM, "Institutional Owners and Corporate Managers: A Comparative Perspective", 57 Brooklyn L.Rev. 1 (1991); M.J. ROE, "A Political Theory of American Corporate Finance", 91 Col.L.Rev. 10 (1991); M.J. ROE, Differences in Corporate Governance in Germany, Japan, and America, supra ch. 2 2 F. KÜBLER, "Institutional Owners and Corporate Managers: A German Dilemma", 57 Brooklyn L. Rev. 97 (1991).
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- And finally, I will address what might be the basic choice Germany is facing today. I hope this will bring me back to what I have learned from the articles by Professors Buxbaum and Roe.
. Institutional Investors and Corporate Governance in Germany Towards the end of his article, Professor Buxbaum refers to "the European experience with older forms of finance and governance relations"3. This description appears to be particularly true for Germany; in terms of Robert Clark's "Four Stages of Capitalism"4 we are still sitting on the first two steps of the stairway. While this cannot be fully explained here, it may prove useful to provide a few key notions to four essential points: 1. The general structure of German corporate law is very rigid; it is much closer to its American counterpart of three generations ago than to the actual Delaware or California Statutes or the Revised Model Business Corporation Act. The emphasis is still on creditor protection. This is particularly true for the stock corporation (Aktiengesellschaft). Germany requires a legal capital to be fixed by the articles of incorporation; its minimal amount is prescibed by statute5; the distribution of earnings is restricted by mandatory reserve requirements; in most cases the repurchase of the corporation's own stock is illegal6. Existing stockholders are preferred to investors: there is no general disclosure requirement for the public distribution of securities7, but whenever the corporation issues new stock there are mandatory peemptive rights for its shareholders8. All private companies (GmbH) with more than 500 employees and all stock corporations are required to have a managing and a supervisory board. One third of the seats on the supervisory board are given to the representatives of the employees and their unions. This number is increased to
3
BUXBAUM, supra n. l at 38. R.C. CLARK, "The Four Stages of Capitalism: Reflections on Investment Management Treatises", 94 Harv. L. Rev. 561 (1981). 5 Actually it is 100.000 DM for the stock corporation and 50.000 DM for the private company (GmbH). 6 For a comparative analysis, see F. KÜBLER, Aktie, Unternehmensfinanzierung und Kapitalmarkt (1989). 7 K.J. HOPT, "Vom Aktien- und Börsenrecht zum Kapitalmarktrecht?" 140 Zeitschrift für das Gesamte Handels- und Wirtschaftsrecht 201 ff. (1976) and 141, 389 ff. (1977); H.-D.ASSMANN, Prospekthaftung, at 75 ff. (1985). 8 For a comparative and economic study see F. KÜBLER, M. MENDELSON & R. MUNDHEIM, "Die Kosten des Bezugsrechts", 35 Die Aktiengesellschaft 461 (1990). 4
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one half in enterprises with more than two thousand employees9. This institutionalisation of codetermination is only one aspect of a dramatically different system of labor relations: its key element is the works council (Betriebsrat), a mandatory comittee elected by the employees to represent their interests and voice their demands against management; thus codetermination integrates the works council and - to a lesser extent - the unions into some parts of corporate planning and responsibility. 2. Institutional investment in Germany is not easily explained by few words. Endowments are non-existent. Industrial foundations - like the Carl-ZeissStiftung or the Robert-Bosch-Stiftung - are instituional owners but not really institutional investors: they are mostly limited to holding shares in just one enterprise10. Pension funds so far have very little importance11. The same is largely true for investment funds. It may be that they have never fully recovered from the blow they received a generation ago from Bernie Cornfield and his International Overseas Services12. Their number is very limited13, and they appear to be particularly unappealing if they invest in the equity segment of the securities market14. Moreover, they are dominated by the banks15. Thus among the five categories of institutional investors dominating the American markets16 only two are relevant for the German scene: these are insurance companies and banks. Insurance companies have always been subject to strict limitations with regard to investment in equity17; and often they do not even use the very restricted
9
For details, see F. KÜBLER, Gesellschafisrecht, at 407 ff. (3rd ed., 1990); for a comparative evaluation, see C. SUMMERS, "Codetermination in the United States: A Projection of Problems and Potential," 4 J. Comp. Corp.L. & Sec.Reg. 155 (1982). 10 For details, see H. KRONKE, Stiftungstypus und Unternehmensträgerstiftung, at 188 ff., 271 f. (1988). 11 See infra n. 28 - 33. 12 See C.RAW, B.PAGE & F.HODGSON, Do You Sincerely Want to Be Rich?, at 244 ff. (1971). 13 At the end of 1988 there were 35 domestic funds offering shares to the public; 28 invest in securities, 7 in real estate; see J. BAUR, "Investmentgeschäfte", in Handbuch des Kapitalanlagerechts, at 534 (H.-D. Assmann & R. Schütze, eds., 1990). 14 See 31 Monatsberichte der Deutschen Bundesbank Nr. 8, 11 ff.; U.H.SCHNEIDER, "Auf dem Weg in den Pensionskassenkorporatismus?" 35 Die Aktiengesellschaften, 319 (1990). 15 See Bericht der STUDIENKOMMISSION "Grundsatzfragen der Kreditwirtschaft", at 67 ff. (1979). 16 BUXBAUM, supra n. l, at 7; ROE, "Political Theory" supra n. l, at 7 ff. 17 The general rule is that they may invest only 5 % of their capital (only) in shares of listed corporations; for a discussion see D. REUTER, "Welche Maßnahmen empfehlen sich, insbesondere im Gesellschafts- und Kapitalmarktrecht, um die
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opportunities allowed by law. However, the largest German insurance conglomerate, Allianz, by the sheer volume of its funds appears to have some impact on public corporations18. The most obvious issue, however, has been and remains the banks19; and it may become still more acute by the circumstance, that the factual seperation between the banking and the insurance business, which has never been legally mandated, is slowly evaporating20. For a long time the big banks have owned blocks of shares of industrial corporations. The most spectacular example is certainly the 28,5 % holding of Deutsche Bank in Daimler-Benz21; it has become still more of an issue since Daimler-Benz controls AEG and was allowed to acquire Messerschmidt-Bölkow-Blohm, thus becoming the number one among the German industrial conglomerates. In terms of statistics, the situation appears to be less dramatic. But the figures differ: the Federation of German Banks contends, that the holdings of the ten largest private banks - and they are the only ones to matter - in the aggregate equity of all German stock corporations declined from 1,32 % in 1976 to 0,57 % in 198922; as far as I can see, these figures23 have not been openly contested24. But the statistics presented by the Deutsche Bundesbank convey a slightly different impression: by the end of 1989 German banks held 4,69 % of all shares of publicly owned stock corporations25. These figures do, however, not disclose that the holdings are concentrated on both sides: primarily the three biggest private banks own substantial - but mostly Eigenkapitalausstattung der Unternehmen langfristig zu verbessern?", 55. Deutscher Juristentag B 90 (1984). 18 This can be inferred from the number of seats its top managers occupy on the supervisory boards of such corporations; see the figures in MONOPOLKOMMISSION, "Gesamtwirtschaftliche Chancen und Risiken wachsender Unternehmensgrößen", m Hauptgutachten 1984/85, at 156. 19 . BAUMS, Banks and Corporate Control (Universität Osnabrück, Working Paper No. 91-1, at 4), refers to the "populist discussion" in Germany about the "power of the banks". 20 Deutsche Bank has started its own insurance business; Aachen Münchener Versicherung has acquired control of Bank für Gemeinwirtschaft; and there are particularly close links between Allianz and Dresdner Bank. 21 MONOPOLKOMMISSION, supra n. 18 at 139. 22 Informationen des BUNDESVERBANDES DEUTSCHER BANKEN, Zur Diskussion um die "Macht der Banken", at 7 (Sept. 1989). 23 They compare favorably with other institutions; the insurance industry (including all sorts of pension funds) owns 11,8 % of the aggregate equity of German stock corporations, see H. GUTHARDT, "Pensionskassen und Börse", 43 WertpapierMitteilungen 1789 (1989). 24 They are accepted by informed critics like O. GRAF LAMBSDORFF, "Die Macht der Banken", 43 Zeitschrift für das gesamte Kreditwesen Heft l, 12 f. (1990). 25 Deutsche Bundesbank, written testimony for the hearing before the Bundestagsausschuß für Wirtschaft, April 16th, 1991, at 9.
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not controlling - blocks of stock in selected industrial or commercial companies. But there are still good reasons to assume that the influence exercised by Allianz, the largest insurance enterprise, exceeds the corresponding weight of any bank. In fact, Allianz owns 23 % of Dresdner Bank's stock (and Dresdner Bank 10 % of Allianz); the Federal Antitrust Agency (Bundeskartellamt) charges Allianz to control through joint holding companies more than additional 20 % of the bank's equity; this could be a violation of the German merger control provisions. At the same time Allianz and Dresdner own substantial blocks in some other major corporations26. The 1992 annual meeting of Dresdner Bank has elected Wolfgang Schieren, the former CEO and now chairmann of the Allianz supervisory board to the supervisory board of Dresdner Bank. Wolfgang Roller, the top manager of the bank, sits on the supervisory board of Allianz27. 3. In general the sources of retirement funding are the same as in the United States, but there are significant differences with regard to their function, structure and respective importance. Social security in Germany is an old, and today also a very comprehensive system. It covers about 90 % of the population28; and after a lifetime of work it offers a retirement income of about 70 % of the last salary29. On the other hand, the third pillar, privately invested savings, appears to be less important than in the United States30. The second pillar, employment-based private pensions, may have the same respective weight in both countries. But in Germany the structures are radically different. As already mentioned, in Germany the American-type pension fund is a rare phenomenon; the characteristic feature of the system is the "Pensionszusage", the pension commitment given by the employer to the employee. The basic mechanism is simple. The employment contract provides that the employee, having reached retirement age, will receive monthly payments of a specified amount. In order to be able to honor this commitment, the enterprise - not necessarily a corporation - will start to accumulate reserves. In technical terms the pension commitment is a tax-relevant liability on the
26
For a - contested - description see Der Spiegel 14/1992, at 128 - 132. Sec. 100 par. 2 No. 3 AktG (German Stock Corporation Law) prohibits cross membership in corporate boards: if a manager of company A sits in the supervisory boards of company B, B's manager cannot be elected to A's board. 28 M. STOLLEIS, "Hundert Jahre Sozialversicherung in Deutschland", 69 Zeitschrift für Versicherungswissenschafi 155 ff. (1980). 29 The figure includes the pension paid to "public officials" (judges, diplomats, high government servants, university professors etc.) out of the state's tax income. 30 This is certainly true for life insurance and for securities; it is less obvious for real estate. 27
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balance-sheet31. It thus generates liqudity which is normally used for the expansion of the business. All firms entering into pension commitments are under a statutory duty to buy insurance against the risk of insolvency32. For this purpose German industry has organized its own insurance system, the PensionsSicherungs-Verein, Versicherungsverein auf Gegenseitigkeit (PSV)33. 4. The most striking contrasts relate to the markets. The size and the importance of the German stock market are exemplified by just two figures: there are not more than 2.700 German stock corporations, and less than 640 are listed on one of the German stock exchanges34. Apart from the very big enterprises other forms of business organisations like limited partnerships or the private (closed) company clearly are predominant. The activity and the depth of the stock market is further reduced by a traditional attitude of long term investment and by the comparatively modest impact of institutions. The internationalisation of the securities markets accounts for some change: the increasing volatility of the German stock market - as illustrated by sharp market breaks on October 19, 1987 and again in 1990 as a result of the Persian Gulf crisis - is generally attributed to the influx and sudden withdrawel of American, Japanese and British institutional funds. But the most significant aspect may be that so far there is no real market for control. In order to be very clear: of course there is a market for enterprises, there are mergers and acquisitions, but there have been no proxy fights and no serious unfriendly take over bids35. This phenomenon is generally explained by the very small number of truely public corporations36; the estimates range from 40 to about 80 companies37. But this lack of a market for control is still surprising when one considers that some of these corporations enjoy a very substantial amount of liquid assets. It has been assumed that in times of depressed stock prices (as in early 1988) they have come close to the aggregate 31
For some time pension-commitments could be given off-balance sheet. This regulatory gap has fortunately been closed by the statute transforming the Fourth EC Directive on Company Law into German law. 32 For details see W. BLOMEYER & K. OTTO, Gesetz zur Verbesserung der betrieblichen Altersversorgung, at 579 ff., (Kommentar 1984). 33 For details see BLOMEYER & OTTO, id. at. 781 ff. 34 For these and other relevant figures see H.-D. ASSMANN, Großkommentar zum Aktienrecht, Einleitung n. 295, (4th ed., 1992). 35 H.-D. ASSMANN & F. BOZENHARDT, "Übernahmeangebote als Regelungsproblem zwischen gesellschaftsrechtlichen Nonnen und zivilrechtlich begründeten Verhaltensgeboten," in Übernahmeangebote (H.-D. Assmann, F. Bozenhardt, N. Basaldua & M. Peltzer, eds., 1989), at l ff. 36 MONOPOLKOMMISSION, "Die Wettbewerbsordnung erweitern," in Hauptgutachten 1986/1987, at 296. 37 U.H.SCHNEIDER, supra n. 14 at 318; ASSMANN, supra n. 34 at n. 306.
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market value of the enterprise. For this reason there have to be and there are other explanations. One may be the complications resulting from the two-tier board structure and from codetermination38. Another may be the role of the banks39 and the lack of institutional investors eager to take large qualities of DM-denominated junk bonds into their portfolios.
. Aspirations for Reform At least from an American perspective it must be obvious that a system as the one I have tried to outline suffers from very serious deficiencies. In Germany there exists so far no consensus, but a certain uneasiness, a growing awareness that some change will be inevitable. However, the debate is quite controversial where specific reforms are under consideration. Again I have to restrict my observations to a few particularly illustrative examples: 1. Several proposals target the "deregulation"40 of stock coporation law. The recommendations include the abolition of cumbersome formalities required for the process of incorporation,for shareholders' meetings and for the listing of smaller corporations41; the abolition of legal capital and par value requirements, the liberalisation of corporate distributions42; and the elimination of mandatory preemptive rights43. Others suggest that existing ability to restrict the voting power of block holdings be outlawed by new mandatory provisions44. With regard to the underlying policy considerations it is widely, although not universally, agreed that medium sized and small enterprises tend to be undercapitalized and should therefore be encouraged to go public in order to gain immediate access to the capital market45. This should provide the stock market with more volume, depth and turnover and thus help to redirect retirement funding from the existing system to
38
This may be one of the reasons why management today tends to have a more favorable view of codetermination than 15 years ago. 39 MONOPOLKOMMISSION, supra n. 18. 40 See H. ALBACH, C. CORTE, R. FRIEDEWALD, M. LUTTER & W. RICHTER, Deregulierung des Aktienrechts (1988). 41 Id. at 52 ff. 42 F. KÜBLER, supra n. 6, at 55 ff. 43 F. KÜBLER, M. MENDELSON & R. MUNDHEIM, supra n. 7, at 474 f. 44 U.H. SCHNEIDER, "Gesetzliches Verbot fiir Stimmrechtsbeschränkungen bei der Aktiengesellschaft?", 35 Die Aktiengesellschaft 56 (1990); TH.BAUMS, "Höchststimmrechte," 35 Die Aktiengesellschaft 221 (1990). 45 For the discussion see D. REUTER, supra n. 17, at B 7 ff.; F. KÜBLER & R. SCHMIDT, Gesellschaftsrecht und Konzentration, at 107 ff., (1988).
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American-type pension funds46. The most recent and proably the most controversial debate relates to unfriendly takeovers: the issue is whether Germany should improve - or even create - the framework conditions for an efficient market of corporate control. It is not surprising, that the arguments in favor and against such measures follow the much more elaborate American discussion47; I will have to come back to a few aspects of this debate48. 2. It is not surprising that a second major issue is the impact of banks on corporate governance. The relationship between a bank and a non-bank corporation may involve the following four elements: (a) providing the whole range of commercial and investment banking services (this is called the "Hausbank" function); (b) under the German proxy system the banks represent the small shareholders in shareholders' meetings49; (c) a bank manager may sit on the corporation's supervisory board (or vice versa); and (d) finally the bank may own a substantial block of the corporation's stock. The prevailing "cumulation theory" contends that the combination of these four elements generates an undesirable concentration of power and therefore calls for legislative action50. But for a closer look there is no easy solution. The "cumulation theory" is at least not fully supported by empirical evidence51. For example (and as already mentioned): The big public corporations in general have accumulated substantial amounts of liquid assets; for this reason they are rather independent from commercial and investment banking services. And in commercial banking competition ist tough: the market share of the Big Three accounts for less than nine percent; they have to compete with other private banks (including internationally operating foreign banks), with mutually linked cooperative banks and with the public law system of savings banks which accounts for roughly half of the German market52. Another problem is what measures should be taken. So 46 47
For details, see infra to 3.
H.-D. ASSMANN & FR. BOZENHARDT, supra n. 35, at 10 ff.; W. WERNER, Probleme "feindlicher" Übernahmeangebote im Aktienrecht (1989); M. ADAMS, "Was spricht gegen eine unbehinderte Übertragbarkeit der in Unternehmen gebundenen Ressourcen durch ihre Eigentümer?", 35 Die Aktiengesellschaft 243 (1990). 48 See infra IV. 2. c). 49 The impact of the German proxy system on corporate decision-making is discussed by A. GOTTSCHALK, "Der Stimmrechtseinfluß der Banken in den Aktionärsversammlungen der Großunternehmen," WSI-Mitteilungen 5/1988, 294. 50 MONOPOLKOMMISSION, Hauptgutachten 1984/85, supra n. 18, at 176; LAMBSDORFF, supra n. 24, at 10 ff. 51 Compare the carefully researched and balanced conclusions of the "STUDIENKOMMISSION", Bericht, supra n. 15, at 166 ff. 52 For the latest figures see Deposit Insurance Reform and Financial Modernization, (1990): Hearings Before the Senate Comm. on Banking, Housing, and Urban Affairs
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far nobody has come forward with a plausible concept for a system of proxy voting that could operate without the assistance of the banking sector53. What remains is the proposal of the Monopoly Commission, an independent body of antitrust experts appointed by the government, to limit bank holdings in nonbank corporations to a maximum of 5 %54. If we leave out the Deutsche BankDaimler Benz and the Allianz-Dresdner Bank combinations this is not a very exciting proposal. There are already safety and soundness restrictions for industrial holdings by banks55. In addition, there would have to be a number of exceptions, including those for underwriting purposes and for corporate reorganisations. Thus it appears uncertain if such a measure would produce any real change. 3. Retirement funding is also a source of permanent concern. The very comprehensive social security system56 operates on a current account basis: the contributions paid in by those who work are used to provide for the living of those already retired; this is, in a somewhat euphemistic way, called the "generation contract". This mechanism has several defects: it does not provide for savings and investment; it increases the burden imposed on the working generation as more people grow older and need more health and other care; and it has difficulties coping with irregular demographic developments. It is therefore suggested that social security be reduced in order to stimulate private savings and investment57. While this may happen over a long time, a sudden change is highly unlikely. Within the private sector the main issue is whether employment-based retirement funding should be transformed from the present system of "pension commitments" to an American-style system of pension funds. This would have to be achieved by amendments to the tax laws. The conflicting interests and positions are rather clear: the manufacturing on Reforming Federal Deposit Insurance, Modernizing the Regulation of Financial Services, and Maintaining the International Competitiveness of U.S. Financial Institutions, 101st Cong., 2nd Sess. (1990) (statement of U.Cartellieri, June, 13, 1990). 53 Bericht der STUDIENKOMMISSION, supra n. 15, at 287 ff.; LAMBSDORFF, supra n. 24, at 12; J. KÖNDGEN, Duties of Banks in Voting Their Clients' Stock, supra, ch. 18. The banks have repeatedly announced that they are not particularly interested in retaining the present system. 54 MONOPOLKOMMISSION, supra n. 18, at 176. 55 Provided by § 12 Kreditwesengesetz, BGB1. I, 1472 (1985). These Provisions will probably become more restrictive once the Second EC-Banking Coordination Directive has been transformed into national law. 56 See text accompanying n. 28-33, supra. 57 H. SCHLESINGER, Der Bürger istflr seine Rente verantwortlich (Commerzbank 1985); M. HAUCK, "Pensionskasse - ein Instrument der Altersvorsorge," Frankfurter Allgemeine Zeitung June 13, 1987, at 13; M. HAUCK, The Equity Market in Germany and its Dependency on the System of Old Age Provision, supra ch. 19.
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industry wants to retain the present system58, while stock exchanges59, banks60 and insurance companies61 would like to have the pension funds. In a moment I shall come back to some of their arguments62. 4. A last point, while arguably less important, may serve as one more example to illustrate the differences between the American and the German scenes. With the internationalization of the securities markets, American and other nonGerman institutional investors have acquired substantial blocks of stock of the major German corporations. As in the United States increased institutional ownership preoccupies management. But this happens for different reasons: it is not the - actual or potential - activity, but the inactivity, the lack of interest shown by foreign institutional owners which is viewed as a problem63. The main concern is that decreasing attendance at shareholders' meeting will produce random majorities and facilitate unfriendly takeovers. In addition, problems of legitimacy could arise within the supervisory board if representatives elected by 20 % of the owners face representatives elected by 90 % of the workers. A study group has investigated, if and how foreign institutional investors could be encouraged to attend shareholders' meetings. There appears to be no solution to the problem.
IV. The German Dilemma In the last part of my paper I should like to explain what I consider to be the German dilemma. 1. We have seen that the German system of financial institutions and markets is characterized by a long list of defects and weak spots; they are particularly obvious when viewed from an American perspective. The stock market is narrow, thin and boring. At least in comparison with most of the English speaking countries, our industries are thought to be undercapitalized. At the
58
E. REUTER (CEO of Daimler Benz), Verhandlungen des 55. Deutschen Juristentages K 181 ff. (1984). 59 M. HAUCK (former President of the Frankfurt Stock Exchange), supra n. 57. 60 H. GUTHARDT (CEO of Deutsche Genossenschaftsbank), supra n. 22, at 1790 ff. 61 M. VON BARGEN, Verhandlungen des 55. Deutschen Juristentages K 190 (1984). 62 See infra IV. 2. a). 63 F.W. CHRISTIANS, "Der Aktionär und sein Stimmrecht," 35 Die Aktiengesellschaft 47 f. (1990).
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same time they appear to be dominated by a small number of big banks. This, in turn, may have several anticompetitive effects64. The system of retirement funding is largely controlled by the political process and by enterprises and therefore to a much lesser extent by markets. The mechanisms of corporate law are rigid and cumbersome. And there is no market for corporate control. This last aspect can be generalized: the financial system as a whole is dominated somewhat more by institutions and somewhat less by markets. It can be assumed that this impact reduces allocative efficiency and slows down economic growth, handicapping the country where it has to compete with other nations. In the terms of modern finance theory it is an underdeveloped system, marked by distinct welfare state features which still reflect some of the conflicts and ideologies of the early stages of industrialization. It may be likened to a steam engine in the age of computers. 2. Seen from that perspective there can be no doubt that Germany should not waste its time with incremental modifications and modest reforms but rather combine its forces and efforts for a much more comprehensive and radical change which would promote it to the stages of a more advanced capitalism65. But even assuming that this could be achieved by the slow and heavy mechanics of a democratic government, there may be some reasons to hesitate and to think twice before such a big reform gets underway. Let me explain this by returning to three issues which have been mentioned before. a) The German system of enterprise-based pension commitments clearly suffers from the disadvantage that savings are accumulated and reinvested by and for the immediate benefit of the employer. This involves the accumulation of risks for employees66 and may, in comparison with the pension fund model, produce a less efficient resource allocation as the investment decisions are determined by management and not by the capital market. However, there are some advantages to this system. It provides financing not only for public corporations but also for Jensen-type privately owned enterprises67. At the same time the employees acquire a financial interest in the business of their employer; this interest increases commensurate with the length of their employment and may benefit
64
This is the main concern of the Monopoly Commission. For instance in terms of CLARK'S model, see n. 4 supra. 66 Higher pensions are not completely covered by the PSV-insurance. Sec. 3 (3) Gesetz zur Verbesserung der betrieblichen Altersversorgung, BGB1. I, 845 (1974). 67 M. JENSEN, "The Eclipse of the Public Corporation," 67 Harv.Bus.Rev. 61 (Sept/Oct. 1989). 65
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the enterprise by improving the motivation and the work attitude of the employees68. Of course, they own debt and not equity. But their claims are long term and not redeemable before retirement and therefore show some of the characteristics of equity. This seems to be particularly true where the sum of the pension reserves, the "social capital", exceeds the capital contributed by the shareholders69. This solution may appear to be very paternalistic. But the system is based on contract, and, more important, the employees participate in the governance of the corporation: their agents sit on the supervisory board. This perspective affects and changes the meaning of codetermination. In reality, the two "benches" of the supervisory board, shareholders and employees, represent much more two types or classes of capital than an "antangonistic" conflict between owners and workers70. At the same time, the character of the enterprise is affected: the corporation adopts some of the features of a cooperative organisation71. Finally, there is an impact on labor relations: the system clearly provides incentives for both sides to understand employment as a long term relationship. This encourages human capital investments by both parties and may produce a better educated and more highly qualified workforce. b) The German banking structure can be characterized by its (comparative) lack of regulation. (Private) banks are subject to close supervision and to strict capital and (some) structural requirements; for the rest they are business corporations allowed to offer all sort of services to the public. This liberal approach allows the enterpreneurial combination of financial service functions generally referred to by the notion of the "universal bank". Their concentration can generate anitcompetitive effects and conflicts of interest72 which could be mitigated by imposing the separation of these functions. But in a moment when Glass-Steagall in the United States and comparable provisions in Japan seem very close to being repealed, Germany would hardly be well advised if it would require the strict separation of commercial from 68
For a general discussion see H. HANSMANN, "When Does Worker Ownership Work? ESOPs, Law Firms, Codeterminations, and Economic Democracy," 99 Yale L.J. 1749, 1761 ff. (1990). 69 It has to be remembered that with the decline of equity debt has to bear more of the risk of equity. 70 E. STEINDORFF, "Einzelfragen zur Reichweite des Mitbestimmungsgesetzes," 141 Zeitschrift für das gesamte Handelsrecht und Wirtschqftsrecht 457, 464 (1977); F. KÜBLER, W. SCHMIDT & S. SIMITIS, Mitbestimmung als gesetzgebungspolitische Aufgabe, at 195 (1978). 71 In the sense that it prevents worker ownership to "degenerate" into investor ownership; see H. HANSMANN, supra n. 68, at 1774 ff. 72 Bericht der STUDIENKOMMISSION, supra n. 53 at 46 ff.; MONOPOLKOMMISSION, Hauptgutachten 1984/85, supra n. 18, at 167 ff.
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investment banking. On the contrary, it appears that a "universal banking system" is stabilized by allowing its institutions broader diversification of risks. If this is correct, the only measure which remains available is the limitation or even the prohibition of bank holdings in non-bank corporations. One of the questions to be asked again is how this would affect the soundness and safety of the banking system73. Let us assume that German banks are correctly thought to be comparatively healthy. This may be due to differences in regulation, but it might also be explained by the close or even symbiotic relationship between German banks and German industry. The investment of bank funds in blue chips may improve the diversification and thus may lower the risks of the bank's asset portfolio. But another aspect could be still more important. Symbiotic bank-industry relations are not a one way street of influence or control. Manufacturing companies own banking stock (and sometimes banks); industrial managers are sitting on the supervisory boards of the "Großbanken"; and corporations like Siemens or Hoechst are enormously important banking customers able to benefit from the tough competition between banks74. At the same time these corporations depend from the continuation of banking services; this is paticularly obvious with regard to export financing. Thus the industrial customers and business partners of the banks are primarily interested in their stability and much less in their profitability. This is not to say that any statutory limitation of bank holdings will necessarily be harmful; but it might well be that the special relationship between private banks and big corporations generates monitoring effects in both directions and thus encourages and promotes a certain amount of prudence in the exercise of the banking business. c) The last issue is how far Germany should go in order to provide the framework for a workable market for corporate control. Assuming for a moment that in the United States the beneficial effects of the takeover game outweigh its costs, the question is whether this would be equally true in Germany. This is uncertain at least with respect to the monitoring of management. The supervisory board is an institution linking the public corporations (including the big private banks) with each other and with the major unions. The top managers are regularly sitting on the boards of other companies75. They have at least one interest in common: not to shake a system, to whom they owe their positions and the opportunities these positions provide, by allowing obvious violations of the fiduciary duties of care and of loyalty. 73
Compare R.C. CLARK, supra n. 4, at 571: the "concept of soundness" is the "basic regulatory approach" to the third stage of capitalism which is characterized by the dominant role of institutional investors and financial intermediaries. 74 See ROE, Differences in Corporate Governance, supra n. 2, at 34. 75 But direct cross relations are not allowed; see supra n. 27.
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This results in a network of mutual monitoring. In comparison with the United States it considerably reduces the autonomy of individual (public) corporations: top management of German business can be seen as a comparatively homogenious group of people interacting to run the private economy or - in other terms - as a less monocratic than oligarchic structure of corporate governance. This interaction, which includes to a limitied extent some of the union leaders, operates as an element of moderation and balance. For example, management compensation in Germany is, at least from the point of view of an academic, by no means paltry; to a certain degree it is linked to the performance of the corporation. But compared to their American colleagues, with wonderful opportunities for stock options and golden parachutes, the German top management looks comparatively poor. This may be an effect of codetermination76; the German system seems to exercise a certain function of (re-)distribution, aiming at a balanced relationship between dividends, salaries and management compensation. 3. Up to this point the German dilemma has been stated in a somewhat narrative or anecdotal form: Germany knows that it has to modernize, yet it is afraid that by going to far it may lose more than it wins. The recent American analysis forcefully asks for a more theoretical definition77. But there are limits to generalisation: it is still an open question, to what extent Germany can be labelled "Japan of Europe"78; and the categories of "liberal" and "corporatist"79 may be too traditional and too simple to cover the increasingly sophisticated blends of "markets and hierachies"80 existing today. For this reason I should like to come back to the element of time. I agree with Professor Buxbaum that little is gained by the mere contraposition of "short term" versus "long term"81. But his reference to ecological concerns82 may help my point: the East German experience clearly demonstrates how, in the long run, irresponsible pollution affects the interests of enterprises, owners and workers. This may be seen as an element of culture: in Germany, and in most of Western Europe, financial markets are shaped by more permanent social relations between enterprises and workers, between corporations and 76
Management compensation is fixed by the supervisory board. See supra n. 1; and R.M. BUXBAUM, Comparative Aspects of Institutional Investment and Corporate Governance: Review and Agenda, supra ch. 1. 78 R.M. BUXBAUM, "Institutional Ownership and the Restructuring of Corporations," Festschriftfllr E.Steindorff, at 7 (1990). 79 See R. ROMANO, "Megapolitics and Corporate Law Reform," 36 Stan. L. Rev. 923 (1984); BUXBAUM, id at 29. 80 O.E. WILLIAMSON, The Economic Institutions of Capitalism, at 206 ff. (1985). 81 BUXBAUM, supra n. 1, at 28; but see also M. LIPTON, "Corporate Governance in the Age of Finance Corporatism," 136 Penn.L.Rev. 1, 7 (1987). 82 BUXBAUM, supra n. 1, at 28. 77
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management and between banks and manufacturing industry. This appears to indicate a different rythm, perhaps more in line with other segments of society. Business is slower and steadier: there is less mobility, less growth and less color and excitement. Germany has no Michael Milken and no Donald Trump. But there is also more continuity and somewhat less risk. From such a conservative point of view the question will be whether Germany can respond to the challenge of larger markets without losing the balance of its institutional structure.
Part Four: Australia and Japan
Chapter Twenty-One Institutional Investors and Corporate Governance in Australia Jennifer Hill* I. Introduction The changes to the corporate terrain occasioned by the remarkable increase in institutional shareholding have not been restricted to the northern hemisphere. The Campbell Committee, reporting on the Australian Financial System in 1981, drew attention both to the rise in institutional investment and to the emergence of non-traditional financial intermediaries. The trends identified by the Campbell Committee have continued exponentially. In the wake of dramatic corporate collapses which occurred in Australia at the end of the 1980's,1 there have been attempts to enliven managerial accountability. This has been done through, for example, the imposition of liability upon passive directors,2 increased recognition of the monitoring role of outside directors,3 proposed legislation imposing more stringent duties on directors,4 and recommendations that there should be enacted in Australia a statutory derivative action for shareholder suits.5 * I would like to thank Patrick Keyzer for his helpful research assistance. Financial support for this research was provided by the Law Foundation of New South Wales. 1 Perhaps the best known of these was the collapse of Alan Bond's group of companies. This had ramifications in Europe as well as in Australia. For example, the group, acting through a subsidiary, Bond Finance (DM) Ltd, defaulted on two German bond issues, which had been sponsored by the BHF-Bank - see "BHF-Bank wirft Gericht Übersehen eines Faktes bei der Urteilsbegründung vor," Handelsblatt, 21 October 1992. 2 An extreme example of this was Commonwealth Bank of Australia v Friedrich (1991) 9 ACLC 946, where a judgment of $97 million was given against an honorary and part-time chairman. 3 AWA Ltd v Daniels (1992) 10 ACLC 933, 988. 4 Corporate Law Reform Bill 1992, Part D. 5 See Companies and Securities Law Review Committee (CSLRC) Report No 12, Enforcement of the Duties of Directors and Officers of a Company by Means of a Statutory Derivative Action (1990), and Report of the House of Representatives
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Within this general framework, there has been considerable interest in, and reassessment of, the position of institutional investors and their capacity to become another source of regulation of management. This interest has manifested itself at many levels - in questioning of the traditional presumptions about institutional investors and their relations with corporate management, in the clearly altered self-perception of many of the large Australian institutional investors and finally in strong concern about the internal workings and accountability of the institutions themselves. While the question of the distinctiveness of the role of institutional investors - the issue of whether the difference between them and other shareholders is qualitative or quantitative only - lies at the heart of the corporate governance issue, it is underpinned and dependent upon issues relating to the institutional cultures6 themselves. Matters concerning the regulation and legitimation of the institutional investors have been at the forefront of several recent Australian discussion papers and reports on collective investments.7 The purpose of this paper is to examine changes in the role of institutional investors in corporate governance in Australia. By way of background to this issue, the paper briefly outlines the underlying flow of funds and patterns of investment in Australia and discusses some important developments concerning collective investment, particularly superannuation. On the question of greater involvement by institutional investors in corporate governance, the paper examines some specific instances of investor activism and discusses the extent to which legal principles present an obstacle to increased institutional investor activity and power in Australia. Π. Fund Flows and Investment by Superannuation Funds in Australia The main focus of recent discussions on institutional investment in Australia has been upon pension or superannuation funds providing for retirement income. Australian household savings have more than halved since the mid 1970's8 and, Standing Committee on Legal and Constitutional Affairs, Corporate Practices and the Rights of Shareholders (1991), Recommendation 26. 6 For an interesting discussion of a sample of US institutional investors from an anthropological perspective, see CONLEY & O'BARR, "The Culture of Capital: An Anthropological Investigation of Institutional Investment," 70 NCLRev 823 (1992). 7 See, for example, Australian Law Reform Commission (ALRC) and Companies and Securities Advisory Committee (CSAC) Issues Paper 10, Collective Investment Schemes, September 1991; ALRC and CSAC, Discussion Paper 50, Collective Investment Schemes: Superannuation, January 1992; ALRC and CSAC, Report No 59, Collective Investment Schemes: Superannuation, March 1992; First Report of the Senate Select Committee on Superannuation (Sherry Committee), Safeguarding Super: The Regulation of Superannuation, June 1992. 8 From 15% of disposable income in the mid 1970's to a little over 6% in 1990-91
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central to the Labor government's strategy to increase long term savings, has been a commitment to occupational superannuation.9 Of the three pillars of retirement funding, 10 the first, social security, has a somewhat chequered past. In 1909, the Commonwealth Government introduced an aged pension11 funded from consolidated revenue. For much of the century since its introduction, the aged pension has been subject to stringent means testing, which for a long time made it unavailable to a substantial proportion of the aged.12 In the past, there have been a number of initiatives to replace the non-contributory pension scheme with a new contributory social insurance scheme paralleling the national superannuation schemes which emerged in Europe, however these were ultimately unsuccessful.13 Liberalisation of means testing for the aged pension in the 1970's significantly increased the percentage of the aged population entitled to benefits under the pension, with the percentage covered in 1991 standing at 75.6%.14 Yet, while there is now a broad entitlement to the aged pension, the entitlements, which are paid from current revenues,15 have been low in relation to many other OECD countries, where substantial social security contributions are levied.16 Current (Second Report of the Senate Select Committee on Superannuation, Super Guarantee Bills, p 88.) This slide has also been reflected at an international level. Australia was ranked 7th in OECD ratings for household savings rate in 1974, but in 1990 15th out of 19 countries for which data was available. 9 On the issue of whether Australia truly has an under-saving problem, see FITZGERALD & HARPER,"Super Preferred or Level Playing Field? Implications for Saving and the Financial System", February 1992, at off. 10 See BUXBAUM, "Institutional Owners and Corporate Managers: A Comparative Perspective," 57 Brooklyn L.Rev. 1 (1991). 11 The legislation introducing this age pension was founded upon s 51 (xxiii) of the Australian Constitution, which enables the Commonwealth to make laws with respect to invalid and old age pensions. 12 See JONES, The Australian Welfare State: Growth Crisis and Change, at 113, (Allen and Unwin, Sydney, 1983), stating that on its introduction, the aged pension was available to approximately one third of the aged population and that this figure had risen to only 45.8% in 1957. 13 On the economic, social and political reasons for their lack of success, see CARNEY & HANKS, Australian Social Security Law, Policy and Administration, at 22-24, (Oxford University Press, 1986). 14 SHERRY COMMITTEE, Safeguarding Super: The Regulation of Superannuation, June 1992, para 2.4. According to the Committee (para 2.12), as at June 30 1991, 1.41 million people were in receipt of the aged pension and overall government pension outlays for 1991-2 were $12.06 billion. 15 See Security in Retirement: Planning for Tomorrow Today, Statement by The Honourable John Dawkins MP, Treasurer of the Commonwealth of Australia, 30 June 1992, p i . 16 See VANN, "Fiscal Law", Law and Legal Thinking in the 1980's: A Collection of
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benefits under the aged pension are approximately 25% of average weekly earnings. The failure of the aged pension to provide a comprehensive retirement income scheme17 has, as in the US,18 resulted in the increasing significance of the second pillar of retirement funding, namely, employment-based "private pension" income and the third pillar, privately and voluntarily initiated and purchased retirement income. Public sector employment-based superannuation was introduced in NSW in the late 19th century and Commonwealth encouragement to private sector schemes was given through the introduction in 1915 of tax concessions to employers setting up occupational superannuation schemes. Although only 32% of the Australian workforce was covered by occupational superannuation in 1974, this figure has increased significantly,19 aided by important changes in the 1980's in the industrial relations sphere, which resulted in almost all awards of the Australian Industrial Relations Commission comprising a 3% superannuation component. Approximately 20% of the Australian workforce, or just under 2 million employees, are entitled to benefits under public sector superannuation schemes of the Commonwealth and State governments, investments estimated to total around $32 billion.20 Public sector superannuation has traditionally had a reputation for being far more generous than most private sector schemes.21 Public sector schemes, which have until now tended to be defined benefit schemes, have been much in the news of late. There has been criticism of the high level of unfunded liabilities of public sector schemes in Australia - that is, where no fund has been established but the employer meets the cost of the benefits defined as they arise. It has been estimated that accumulated unfunded Australian Contributions to the 12th International Congress of Comparative Law, at 577 (1986). 17 In spite of its inadequacies, the Australian Government, in its 1989 statement on Better Incomes: Retirement into the Next Century, endorsed the view that the aged pension should remain "the cornerstone of equity and adequacy in the retirement income system" (see SHERRY COMMITTEE, Safeguarding Super: The Regulation of Superannuation, June 1992, para 2.5). 18 See BUXBAUM, "Institutional Owners and Corporate Managers: A Comparative Perspective," 57 Brooklyn L.Rev. 1, 9-10 (1991), where the US experience is contrasted with that of Germany, in which a far higher level of state pension payments prevails. 19 See SHERRY COMMITTEE, Safeguarding Super: The Regulation of Superannuation, para 2.22 and 2.24, citing ABS statistics for 1991 showing that occupational superannuation stands at 80% for full-time workers and 42.3% for parttime workers. 20 21
Who's Who of Public Sector Funds, Superfunds, at 36 (November 1991). Id. at 32.
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liabilities in the public sector are over $80 billion and possibly as high as $90 billion, Queensland being the only state to have a fully funded scheme.22 Problems faced by public sector schemes have been highlighted by recent events concerning the NSW State Superannuation Investment and Management Corporation (SSIMC), which manages the largest occupational fund in Australia. This covers around three quarters of a million public servants, all but 179,000 of which were in defined benefit schemes, guaranteed by the State Government.23 In the annual report for the SSIMC, it was announced that the fund had achieved "an unsatisfactory 0.1 per cent return"24 on its $10.6 billion portfolio for 1991/92. This was mainly due to a writedown of almost a billion dollars on the fund's $3.5 billion property portfolio.25 The government's unfunded superannuation liabilities reached $14.1 billion. A few days after the reports of the fund's performance, it was announced that entry into the superannuation scheme had been frozen and that new employees could join only a new and considerably less generous scheme. The new scheme will be an accumulation, rather than defined benefit, scheme. There has been debate about whether the action of freezing entry into the superannuation scheme was due to the fact that the old scheme was too generous, or to the high level of unfunded liability, or was a direct result of the concern aroused by the announcement of the magnitude of the property writedowns.26 Personal superannuation schemes are the main source of retirement saving by the self-employed and by those wishing to supplement employer sponsored superannuation.27 Tax concessions, if certain conditions are met,28 provide an 22
Australia's $80 billion shortfall, Superfunds, at 18 (November 1991). Australian Financial Review, 14 August 1992, p 1. 24 Managing Director's Report, 1992 Annual Reports for State Authorities Superannuation Board and State Superannuation Investment and Management Corporation, p 13. 25 "Property Falls in on State Super," Sydney Morning Herald, 14 August 1992 pi. The "property crisis" in Australia has had a direct effect on the asset mix of the fund in recent times, with an increased holding of Australian shares. As at 31 March 1990 and 31 March 1992, property has fallen from constituting 32.8% of the fund to 23.4%. There has been a corresponding rise in the percentage of Australian shares from 25.1% to 34.3% (Review of Business Operations, 1992 Annual Reports for State Authorities Superannuation Board and State Superannuation Investment and Management Corporation, p 21.) 26 Under the new scheme, First State Superannuation, the government contribution would be an escalating 4% in accordance with the superannuation guarantee levy, in contrast with average government contribution under the previous scheme equal to 14.5 per cent of income - Sydney Morning Herald, 17 August 1992, p 6. 27 See, generally, ALRC and CSAC, Report No 59, Collective Investments: Superannuation, March 1992, chapters 2 and 3. 28 Id, para 5.4. The Opposition's election platform, Fightback!, (p 50) argues however that current taxation arrangements for superannuation systematically favour 23
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incentive for this form of investment. The major types of institutions marketing personal superannuation in its various guises to the public are companies regulated under the Corporations Law, life insurance companies, State government insurance offices and friendly societies. Banks have in recent times entered the life insurance field, with some of the major trading banks establishing life office subsidiaries29 and "superannuation savings accounts". Nonetheless, life offices dominate the personal superannuation market and in September 1991 there were $62 billion in the statutory funds of life insurance companies.30 The picture of superannuation in Australia has recently undergone a radical shift, with the introduction of Superannuation Guarantee Levy (SGL) legislation from 1 July 1992. The SGL effects a fundamental change to retirement funding by making occupational employer funded superannuation compulsory, with a gradual increase in compulsory employer contributions from 3% to a targeted 9% by the year 2000-2001.31 Major objectives of the SGL include increasing both the scope of coverage and the average level of superannuation savings under employment based schemes32 and, on a macro-economic level, bolstering national savings to reduce reliance on foreign debt.33 Since an Australian Federal election is on the horizon, it is worth mentioning that the Opposition's policy on superannuation differs fundamentally from that of the current Labor government. Although also directed at increasing national savings, the the wealthy, who receive a far larger "tax break" than lower income earners. 29 See RICE, "An Overview of the Current Life and General Insurance Market," The InterData Financial Handbook, at 31-33, (InterData Pty Ltd, Sydney 1991). 30 The life insurance market is itself dominated by the large players. According to a report in The Age (7 June 1991, p 7) the largest life insurance company, the AMP Society, holds one third of the nation's total life insurance and the holding of AMP with the other largest life office, National Mutual, amounts to approximately one half of all life insurance. 31 It is anticipated that contributions will rise from $328 million in 1992-3 to $4795 million in 2000-1 (present value dollars) - Second Report of the Senate Select Committee on Superannuation, Super Guarantee Bills, June 1992, para 3.13. 32 Targeted interim retirement income under the SGL is 40% of pre-retirement income. 33 Support for the SGL has not however been universal. In their minority report for the Senate Select Committee Report on Super Guarantee Bills, Senators Alston and Watson complained that "[w]ith Australia still suffering from the deepest economic recession in 60 years, and with unemployment over ten per cent, the last thing which business needs is policies which undermine the capacity of employers to expand their enterprises and increase employment" (p 87). They also disputed the claim that the SGL will result in any specific increase in national savings and stated that "the structural shift of savings from retail financial institutions to superannuation funds will have profound and largely unforeseen consequences for the composition of investment flows" (see at 88-91).
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Opposition's policy provides for a non-compulsory system of superannuation with greater institutional neutrality, especially aimed at encouraging lower income earners to make their own provision for retirement. Although the Opposition has stated that it will retain the current level of employer contribution under the SGL if it wins office at the next election, there would be no further compulsory increases.34 It has been said that, through the SGL, the government will, "transform superannuation from a voluntary collective investment used by a minority of the workforce to an almost universal, compulsory retirement savings policy".35 The SGL has also been described as "perhaps unique by world standards. It will be a curious combination of compulsory but private sector located funding".36 It would appear that the Superannuation Guarantee Levy has placed Australia in the realm of Clark's fourth stage of capitalism, with the government appropriating the savings-decision function.37 These developments in Australia have resulted in predictions of major growth in superannuation fund assets. Superannuation fund assets, which in 1983, stood at $32.6 billion dollars, have reached a current level of approximately $140 billion. This figure is however expected to rise to somewhere between $300 and $600 billion by the year 2000 and $1400 billion in current dollars by 2010.38 Recognition of the accelerating growth rate of superannuation funds has led to interest in their current and prospective investment patterns.39 Superannuation funds invest the great majority of their funds in Australia, only around 13% being invested overseas. Of the $114.3 billion invested in Australia as at 31 March 1991, 27% or $31.4 billion was invested in shares in Australian companies.40 34
See Fightback! programme of the Liberal and National Parties, November 1991, chapters 5 and 7; Allerdice, "Fightback! The Opposition's proposed superannuation reforms'1, (1992) 3 Australian Superannuation Law Bulletin, p 41, and FITZGERALD & HARPER, Super Preferred or Level Playing Field? Implications for Saving and the Financial System, at 3-4, February 1992. 35 ALRC & CSAC, Report No 59, Collective Investments: Superannuation, 31 March 1992, lix. 36 Evidence of Association of Superannuation Funds of Australia representative, Senate Select Committee on Supernannuation, p 643. 37 CLARK, "The Four Stages of Capitalism: Reflections on Investment Management Treatises," 94 Harv.L.Rev. 561, 565-6 (1981). 38 SHERRY COMMITTEE, Safeguarding Super: The Regulation of Superannuation, paras 2.51-2.52 and FITZGERALD, Australians' Superannuation Savings: Nestegg or Honey Pot?, at 44, October 1991, citing data of the Australian Bureau of Statistics (ABS). 39 See, for example, LEIGH HALL, Where Will the Superbillions Be Invested in the 1990's?, 20th Conference of Economists, Hobart, 3 October 1991. 40 FITZGERALD, Australians' Superannuation Savings: Nest Egg or Honey Pot?, at 44-47, (October 1991), using ABS statistics. The figure for investment in shares in
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As at 30 June 1992, the total market capitalisation of all entities listed on the Australian Stock Exchange (ASX) was A$276.8 billion41 and the total market capitisation of all domestic entities was $193.8 billion.42 According to the Australian Shareownership Survey 1991, only about 10.2 % of Australian adults are direct shareholders in the sharemarket and the ASX has described the level of individual share ownership as "well below that in comparable economies. "43 The percentage of listed shares held by individuals is also relatively low. Australian superannuation funds' equity holdings constitute a little over 20% of total market capitalisation, however the figure is said to be "more meaningfully near 30%".44 Although the major superannuation funds do hold investments in small to medium sized companies, unlisted companies and venture capital etc, investment in equities has in recent times tended to be heavily concentrated in "blue chip" stocks or the top 50 or 100 ASX listed companies. This is not surprising given the caution engendered among many fund trustees following the 1987 stockmarket crash, biases in the tax system towards investment in these blue chip stocks, and the relative illiquidity of many stocks listed on the Australian Stock Exchange.45 In view of the fact that a typical large fund may have a portfolio of only around 50 stocks, the high concentration within investment in equities is apparent. As fund managers compete to outperform the index, there may be a developing counter trend to greater interest in up-and-coming green chip companies. The exodus of individuals from direct investment on the ASX has been subject to one notable reversion in recent times, with the privatisation and public float of the New South Wales Government Insurance Office. The $1.2 billion float, in which institutional investors had been invited to bid for 35% of the stock, was massively oversubscribed by small investors. A slide in the price of GIO shares since the privatisation may however have dampened the enthusiasm of small investors for future issues.46 Australian companies by superannuation funds rises to 38% or $43 billion if investments through unit trusts are included. 41 The figure as at 30 June 1991 was $228.1 billion. See ASX Annual Report for year ended 30 June 1992. 42 The figure as at 30 June 1991 was $163.4 billion. 43 1992 ASX Annual Report, p 7 and ASX Shareownership Survey 1991, p 7. 44 FITZGERALD, Australians' Superannuation Savings: Nest Egg or Honey Pot?, at 51-52, (October 1991). The 30% figure was reached through the exclusion of the approximately ten largest overseas companies listed on the ASX, but not having major operations in Australia. 45 Id. at 54-55. 46 Many small investors missed out when the share issue closed oversubscribed by about $1 billion only 32 hours after opening. See Walker and Howard, "Implementing Privatisation: The Case of the GIO Float", Public Sector Research Centre Working Paper, September 1992. Since the failure of the Westpac share issue (see below),
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The growth of superannuation funds and the widely voiced complaint that their investment has been too conservative has led to debate on the desirability of restricting and channelling their investment through investment controls. It has been argued, for example, that Australia needs capital and that there should thus be a prohibition on overseas investment by superannuation funds. The Senate Select Committee on Superannuation ("the Sherry Committee"), in its recent report on the regulation of superannuation recommended against any such restriction, noting the hardly excessive 13% level of overseas investment by superannuation funds and the advantages offered by overseas investment in terms of portfolio diversification and reduction of volatility of investment returns.47 More concerted have been the calls for channelling, through mandatory investment rules, of a percentage of superannuation funds into areas of public interest, such as venture capital, infrastructure or low-cost housing. Justifications for introducing investment controls have been said to exist in the tax advantages of superannuation funds and conservative investment policies of fund managers. The imposition of investment controls on funds would not be new to Australia. The so-called "30/20 rule", introduced in 1961, provided for higher taxation of life offices and superannuation funds, unless they invested a minimum of 30% of their assets in public securities, with at least 20% invested in Commonwealth securities. The arrangement was strongly criticised and its abolition recommended in the early 1980's by two influential reports on the Australian financial system, the Campbell Report48 and the Martin Report.49 The Campbell Committee rejected the argument that the rule performed a prudential function, suggesting that the converse could sometimes be true. Since the rule prevented "captive institutions from adopting the optimum composition of their portfolios", the Committee concluded that the institutions might sometimes be prompted to invest the balance of assets in compensatory high risk investments. Other distortions and anomalies created by the rule were identified. Recent committees, considering the issue of investment controls anew, have tended to remain negative. The report on superannuation by the Law Reform Commission (ALRC) and the Companies and Securities Advisory Committee (CSAC)50 recommended against any form of prescriptive asset allocation, on the however, at least one large float has been delayed and doubt expressed about the timetable of future scheduled privatisations. 47 SHERRY COMMITTEE, Safeguarding Super: The Regulation of Superannuation, June 1992, p 110. 48 Australian Financial System, Final Report of the Committee of Inquiry, September 1981, chapter 10. 49 Australian Financial System, Report of the Review Group, December 1983, chapter 9 part 5. 50 ALRC and CSAC, Report No 59, Collective Investments: Superannuation, ch 11.
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basis that such approach may result in lower investment returns. The same conclusion was reached by the Sherry Committee, which noted arguments that prescriptive asset allocation would conflict with the fiduciary obligations of trustees to act in the best interests of their members, and that some funds were now in fact broadening their investment range to include areas of public interest.51 Nonetheless, the Sherry Committee recommended that the issue be reexamined within three years. In spite of the apparent antipathy to politically decided bases for investment, it has been noted that there is one sector of superannuation which is wholly politically dictated.52 This is in the area of unfunded public sector schemes. In these unfunded schemes, which are substantial, no fund is explicitly set aside for investment, and budget resources representing accruing liablities may be directed to areas deemed politically desirable. As has been noted, there is increasing criticism of the level of Australia's unfunded public sector schemes.
ΙΠ. Regulation of Collective Investment Regulation of collective investment, particularly superannuation, is high on the law reform agenda in Australia at present. The reports of the Law Reform Commission and the Companies and Securities Advisory Committee and of the Sherry Committee stress the need for greater cohesion in regulation of superannuation and for increased prudential controls. Superannuation regulation in Australia tends to be a haphazard affair due to the fact that superannuation schemes are currently regulated by a number of Commonwealth and State laws and an array of different authorities. The Sherry Committee has recommended that the Commonwealth assume sole control of the area through a combination of its powers over taxation, corporations and pensions under the Constitution and that the Insurance and Superannuation Commission (ISC) become the sole regulator of the industry.53 Additional controls which have been recommended by the Committees include - preconditions to the ability to act as trustee, See also Discussion Paper 50, para 7.4. 51 See paras 9.13 and 9.15-9.17. Specific reference was made to the Development Australia Fund (DAF), a joint venture of the Australian Chamber of Manufacturers, the Australian Council of Trade Unions and the Australian Mutual Provident Society (AMP), which, subject to normal investment criteria, specialises in providing capital in areas such as housing and development projects. 52 FITZGERALD, Australians' Superannuation Savings: Nest Egg or Honeypot?, at 52, (October 1991). 53 SHERRY COMMITTEE, Safeguarding Super: The Regulation of Superannuation, June 1992, Recommendations 3.1 and 4.1. See generally Security in Retirement: Planning for Tomorrow Today, Statement by The Honourable John Dawkins MP, Treasurer of the Commonwealth of Australia, 30 June 1992.
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clarification of the duties of trustees and directors of corporate trustees, certain prudential controls, including a recommendation that the limit on in-house investment be reduced from 10% to 5%, more stringent auditing requirements and greater powers for the ISC. The Sherry Committee also favours the establishment of a fidelity fund to safeguard against fraud in superannuation schemes. Heightened levels of prudential control are now seen as particularly important in view of the increasing element of compulsion in superannuation. Recent reform proposals have also focused on legitimation of instititutional investors through accountability to members and through adequate participation in fund governance structures by the beneficiaries. It seems that many of the collective action problems which have traditionally beset shareholders are now being seen in this new arena, behind the institutional veil. For example, while the Sherry Committee recommends that rights of members be clearly defined by legislation and "supports in principle" members being empowered to remove trustees and directors of corporate trustees through meetings, it nonetheless considers that where fund members are widely dispersed, it may be more appropriate that grievances against trustees be pursued by the main regulatory authority or through industrial relations tribunals.54 Similar considerations led the Committee to recommend against the holding of annual general meetings for funds. Current regulations require that only private and public funds established after specified dates and with more than 200 members are required to have equal employer/employee representation on trustee structures. Less than one per cent of all superannuation funds are affected by this requirement.55 This threshold level for equal employee participation was viewed as inadequate in the reports on superannuation, on both prudential and legitimation grounds. The Sherry Committee accepted an active member interest as "a potent form of prudential supervision" and considered that, since superannuation moneys belong to the fund's members, "there is a need for an arms' length relationship between the employer and the superannuation fund and that members have a right to participate in the decision making process of the fund".56 The ALRC report recommended that equal representation requirements be extended to all schemes with 50 or more members,57 but the Sherry Committee went even further, recommending that all funds with five or more members be subject to the requirements. The ALRC report discussed, but made no recommendation on another matter concerning representation, namely whether representation of employers on the boards of accumulation funds should be phased out. The 54
Id., para 4.45. Id., para 5.2. 56 Id., paras 5.5 and 5.9. 57 ALRC and CSAC, Report No 59, Collective Investments: Superannuation, 31 March 1991, at 177-178. 55
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argument behind such an approach was that, while employer representation on the board of a defined benefit scheme is appropriate given the fact that the employer bears the investment risk, there is no compelling reason for representation in the case of an accumulation scheme.58 One area, where the potential for tension between the interests of employer and employee has been clearly demonstrated, concerns the respective rights of the parties to any surplus in defined benefit schemes - a matter which many deeds do not properly address. Both the Sherry Committee and the ALRC report commented on the level of uncertainty regarding treatment of surpluses in defined benefit schemes. The question is of particular significance in view of the fact that current tax concessions have often led employers to overfund superannuation schemes, surpluses thereby being created.59 Neither committee was fully persuaded by the arguments of industry groups that, where the trust deed is silent, the employer should be entitled to any surplus since the employer bears the investment risk in a defined benefit scheme and that a contrary result would lead to underfunding of schemes. Focusing on the often ephemeral nature of an actuarial surplus, the ALRC report recommended the introduction of strict preconditions to any return of surplus to the employer.60 The Sherry Committee, which was particularly concerned about appropriation of surplus by employers following changes to the trust deed, called for a review into the purposes for which surpluses in funds are currently used.61 This particular issue was at the centre of a recent decision, Lock v Westpac Banking Corporation62 concerning the superannuation fund of one of Australia's largest banks, a case showing that equal employee participation on the trustee structure is no guarantee against disputes of this kind. The plaintiff, a member of the Bank's defined benefit staff superannuation scheme, which had produced a surplus of up to $1.2 billion, challenged certain resolutions of the Bank's board. First, the board purported to exercise a power to amend the trust deed to insert a provision enabling the board in certain circumstances to apply the surplus in the fund in various ways, including repayment to the Bank. It was also resolved, with the consent of the trustees as required under the amended provision, that $300 million of surplus assets in the fund should be returned to the Bank, and an equivalent amount applied to increase benefits of members. Prior to the amendment, the trust deed made no provision for return of surplus 58
Id., para 12.15. See also Discussion Paper 50, Collective Investment Schemes: Superannuation, January 1992, para 9.8. 59 From 1995, this form of tax minimisation will no longer be available. See ALRC and CSAC, Report No 59, Collective Investments: Superannuation", at 245, 31 March 1992. 60 Id. at 248. 61 SHERRY COMMITTEE, Safeguarding Super: The Regulation of Superannuation, June 1992, at 75. 62 Unreported, 26 August 1991, SC (NSW), Waddell CJ in Eq.
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to the Bank. The plaintiff alleged that the amendment and subsequent resolution returning $300 million to the Bank were invalid and that the sum should be refunded to the trustees. Employing a meticulous construction of the scheme deed, to reach the conclusion that the Bank through its board had indeed been entitled to amend the deed and appropriate the impugned sum to itself, the judge rejected arguments that the amendment was beyond power, that the amendment had been made for an improper purpose and that the Bank had breached fiduciary duties or duties of good faith owed to scheme members. The judge made some interesting comments about the overlap of traditional legal categories in this area, stating that "pension plans are different in nature from traditional trusts. They are based upon a contract between the employer, the Trustee and employees". Yet at the heart of the ALRC report is the proposition that "the trust structure is the most appropriate for superannuation".63 Also unsuccessful in the Westpac case was the claim that the trustees, in consenting to the arrangement, had been in breach of their fiduciary duty. According to the judge, the trustees had been entitled to take into account the interests of the Bank in relation to the surplus, in finding a resolution "which was fair" to both the Bank and employees. One commentator, however, has questioned why the trustees should have considered the Bank's interests at all.64 Intimately connected with the issues of legitimacy and members' rights, is the question of enforcement of rights and determination of superannuation disputes. A recent High Court decision, Re The Amalgamated Metal Workers Union of Australia; ex pane The Shell Company of Australia Ltd,65 will have important ramifications in this regard. It, like the Westpac decision, demonstrates the tension between an analysis of employment superannuation schemes as based on contract as opposed to trust law. The case involved yet another dispute concerning the surplus in certain superannuation funds. In 1949, Shell Australia Ltd established a contributory pension fund and over time most employees in the Shell group of companies were required to join and make contributions to this fund. It was a defined benefit fund, the trust deed for which provided only for payments of benefits and specifically prohibited any amendment which could enable moneys from the fund to be returned to the employers. By 1990, there was a substantial surplus in the fund. Shell established a new fund, which was also a defined benefit scheme. The deed of the original fund was varied to enable its members to transfer to the new fund and most did so. 63
ALRC & CSAC, Report No 59, Collective Investments: Superannuation," para
2.18. 64
GLOVER, "Lock v Westpac Banking Corporation and the Problem of Superannuation Fund Surpluses," (1992) 9 Aust.Bar.Rev. 172, 177. 65 (1992) 66 ALJR 645, (27 August 1992), Mason CJ, Brennan, Deane, Dawson, Toohey, Gaudron and McHugh JJ.
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Under the trust deed for the new fund, however, the trustees were required, upon request from Shell Australia, to repay any part of the surplus to the employers. Some of the employees objected to intended payment of the surplus to the employers and issued a log of claims in the Australian Industrial Relations Commission, on the basis that this was an "industrial dispute", including a claim that if an actuarial surplus were found to exist in the funds, the employers should "use their best endeavours" to procure certain amendments to the trust deed requiring that 50% of the surplus be directed to the employees. The majority of the High Court held that the principal claim was an industrial dispute within the meaning of the Industrial Relations Act 1988 (Cth), being "about matters pertaining to the relationship between employers and employees". The majority66 stated that "[i]t must now be accepted that the general question of superannuation entitlements is a matter which may form the subject of an industrial dispute...It follows that a dispute between an employer and its employees as to the form that a scheme should take is a matter pertaining to the relations of employers and employees". The minority,67 however, distinguished between the obligation of an employer to contribute to a superannuation scheme and disputes concerning payment from the fund. While the minority considered that the employer's obligation to contribute to the fund could be characterised as involving the terms and conditions of employment, the relationship arising from the fund itself was treated as a relationship of trustee/beneficiary, not employer/employee. The majority's holding that the principal claim was an "industrial dispute" meant that the substance of the dispute could be referred back to the Industrial Relations Commission for arbitration. The decision of the High Court is notable for several reasons. The broad approach taken by the majority means that a wide range of potential disagreements concerning superannuation funds will now fall within the aegis of "industrial dispute". This is beneficial to employees since referral to the Industrial Relations Commission by an employee or union is a more convenient and less costly process than pursuance of a claim through the court system and it has been suggested that financial considerations may in the past have deterred employees from bringing superannuation complaints to court. Also of great importance is the fact that the decision-making process of the Industrial Relations Commission in making an award is more flexible and less constrained by legal precedent than that of a court. The president of the Australian Council of Trade Unions applauded the decision as "further confirmation of the right of unions to be involved in issues such as the negotiation of superannuation, the form of schemes, the need for employee
66 67
Mason CJ, Deane, Toohey and Gaudron JJ. Brennan, Dawson and McHugh JJ.
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trustees, full information about funds and the ability of unions to act as watchdogs for fund members".68 IV. The Position of the Institutional Investor within the Corporation There is a substantial and growing literature on the desirability and feasibility of greater activism by institutional investors in matters of corporate governance.69 Yet there is a level of ambiguity regarding the precise role envisaged for institutional investors in such a new order. Under some proposals, the institutional investor remains clearly distanced from management.70 Other commentators view the rise of institutional investors as having the potential to obviate the traditional problems of dispersion of shareholders and co-ordination difficulties. In the most optimistic versions of this scenario, the institutional investor is transformed into the idealised responsible shareholder, which the separation of ownership and control has previously made unattainable. This suggests a return to a 19th century version of the corporation with shareholder/owners viewed as supreme. The traditional image of institutional investors in Australia has been akin to their image in the US, where they have been depicted as passive and supportive of management, with exit from the company as the primary expression of dissatisfaction. This image is now however being reassessed. Several factors have led to this reassessment of the role of institutional investors in corporate governance in Australia. The severe corporate collapses from the 1980's tainted such a passive stance as insufficiently responsive or responsible. And the trend in the 1990's towards simplification of corporate structure through deconglomeration has arguably led to a greater confidence by institutional investors in assessing performance of businesses through comparison. Also, exit by selling out71 has become increasingly difficult for larger institutional investors as a result of the concentration of the Australian market. The level of concentration is demonstrated by the fact that in the six 68
"IRC's control of super expands," Australian Financial Review, 28 August 1992,
all. 69
See, for example, BLACK, "Shareholder Passivity Reexamined," 89 Mich.L.Rev. 520 (1990); ROE, "A Political Theory of American Corporate Finance," 91 Colum.L.Rev. 10 (1991); ROCK, "The Logic and (Uncertain) Significance of Institutional Shareholder Activism," 79 Geo.LJ. 445 (1991). 70 See, for example, GILSON & KRAAKMAN, "Reinventing the Outside Director: An Agenda for Institutional Investors," 43 Stan.L,Rev. 863, 865 (1991), where the central question is framed as "How should a passive investor relate to its portfolio companies?" 71 Note, however, that there has been growth in trading in derivatives. See SCHOLES, Risk Management: A Historical Perspective, Australasian Finance and Banking Conference, 28 November 1991.
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months to June 1992, the top 50 of the 1,116 entities with listed equities accounted for approximately 80% of equity turnover and market capitalisation. A mere 20 companies constituted 60% of turnover and capitalisation.72 A company's share price may be pushed down as a result of the sale of a large holding by a major institutional investor and, even if the investor is able to exit before the share price drop, this course of conduct may be unwise from a public relations perspective. The enervation of the market for corporate control has also played a part. The number of takeovers has declined sharply in recent years73 and the limitations of the market for corporate control as an efficient mechanism for disciplining errant management - the fact that it operates as a loose, often ill-timed and misdirected, cannon - have been recognised.74 Takeover law amendments in 1986, which outlawed pro-rata partial bid takeovers, have also been instrumental in quelling the number of takeovers.75 Furthermore, defensive tactics and strategies have been employed by many target companies76 and takeovers are sometimes blocked by the Trade Practices Commission on the basis that they may lead to market dominance.77 At first sight, the legal background, in which shareholder rights have over time been steadily attenuated, appears less than auspicious for the re-emergence of active and powerful shareholders. Although a level of control has always been available to shareholders through, for example, their right in certain circumstances to convene general meetings, their right in a public company to remove a director by ordinary resolution and the power to alter the company's articles by special resolution,78 the strategic superiority of the board generally
72
1992 ASX Annual Report, p 41. The number of takeovers in Australia dropped from 289 (24% of which were opposed) in 1988 to 86 (26% of which were opposed) in 1991. RAMSAY, "Corporate Governance, Shareholder Litigation and the Prospects for a Statutory Derivative Action," (1992) 15 UNSWLJ 149, 154. 74 Id. at 154-155. 75 See FORD & AUSTIN, Ford's Principles of Corporations Law (6th ed, 1992) paras [2008] and [2025] and RAMSAY, "Balancing Law and Economics: The Case of Partial Takeovers," (1992) J.Bus.L 369. 76 Id., paras [2054-2055]. See also CASEY & EDDEY "Defence Strategies of Listed Companies Under the Takeover Code," (1986) 11 Australian Journal of Management 153. 77 A recent example was the TPC's veto of the $560 million takeover by Santos Ltd of another gas company, Sagasco Holdings Ltd (Australian Financial Review, 1 October 1992, p 1.) 78 On shareholder rights generally, see the Report of the House of Representatives Standing Committee on Legal and Constitutional Affairs, Corporate Practices and the Rights of Shareholders, November 1991, chapters. 73
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and, in the case of election of directors, specifically, has in the past rendered such power theoretical only.79 Also, the Australian courts have consistently held80 that, where a company's articles vest managerial power in the board, the shareholders have no power to override or interfere with a decision of the directors. This principle was taken to its logical extreme in NRMA v Parker** where a requisition by shareholders for the convening of a general meeting, otherwise in accordance with the companies legislation, was invalidated on the basis that the object of the meeting was not one which could be effected by a general meeting resolution. In reponse to a further argument that the proposed resolutions would inform management of the NRMA of the general meeting's opinion on certain matters, the judge stated his view that "it is no part of the function of the members of a company in general meeting by resolution...to express an opinion as to how a power vested by the consititution of the company in some other body or person ought to be exercised by that other body or person...The members of the plaintiff no doubt have a legitimate interest in how these powers are exercised, but in their organic capacity in general meeting they have no part to play in the actual exercise of the powers".82 There has even been diminution of shareholder powers in areas traditionally assigned to them, such as the power to cure breaches of directors' duties. Although the shareholders in general meeting have traditionally been treated as the appropriate organ to cure any breaches of fiduciary duty by the directors, in Kinsela v Russell Kinsela Pty Ltd,*3 it was said that a shareholder decision, even by unanimous consent, was ineffective to cure a breach of duty to take into account the interests of creditors. In spite of these developments suggesting a diminished role in corporate governance for shareholders, countervailing trends are also apparent. The introduction in 198584 of a provision permitting shareholder access to corporate 79
One decision which to some extent curbed the level of the board's advantages was Advance Bank Australia Ltd v FAI Insurances Ltd (1987) 5 ACLC 725. FAI Insurances Ltd, which owned just under 10% of shares in the Bank, nominated four persons for election as directors at the Bank's annual general meeting. The board of the Bank opposed FAI's involvement at board level and conducted a campaign using corporate funds to ensure reelection of the board's candidates. The court held that while there is no absolute prohibition on expenditure of corporate funds in an election for company directors, here the level of expenditure and the form of the campaign amounted to an abuse of authority by the directors. 80 Following the early English decision in Automatic Self-Cleansing Filter Syndicate Co Ltd v Cuninghame (1906) 2 Ch 34. 81 (1986) 4 ACLC 609 (SC (NSW), McLelland J). 82 Id. at 614. 83 (1986) 4 ACLC 215. 84 The relevant provision is now found in Corporations Law s 319.
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documents and information has been the source of many incursions by shareholders into the managerial realm. Nonetheless, the ambivalence concerning the role and rights of shareholders is still apparent in the courts' relatively narrow conception of what is a "proper purpose" for shareholder inspection under the relevant provision. There is also increased reliance on shareholder approval as a legitimating precondition in recent legislative reform proposals.85
V. Investor Activism in Australia The clearest manifestation of a new approach to the role of institutional investors in corporate goverance was the creation in late 1990 of the Australian Investment Managers' Group (AIMG). The group comprises around 40 of the largest institutional fund managers in Australia, each with more than $500 million in funds and collectively holding more than $200 billion. Members agree to be bound by a code of conduct, establishing a minimum set of principles for fund managers.86 The purposes of the AIMG were defined at its inception as - to advance the integrity of the Australian capital markets; to protect the rights of investors; to promote the interests of investors; to facilitate investors taking action when warranted by circumstances; to provide assistance to the Australian Securities Commission, the Stock Exchange and other government agencies in matters relating to investors' interests and to assist companies in understanding the requirements of investors.87 At the time of the creation of the AIMG, its chairman, Leigh Hall, described the group as "a reflection of the growing maturity of the securities markets that investors can no longer rely on the Wall Street Walk; that is, if you don't like you sell. You can only sell to another institution so the problems are only inherited by someone else."88 There is a broad spectrum over which activism and influence by institutional investors may range. At one end of this spectrum, institutional investors might seek to improve corporate governance generally through, for example, discussions with regulatory agencies over law reform proposals; at the other of the spectrum, institutional investors might, in response to particular managerial conduct, act directly to remove management from office. Between these poles lies conduct including informal negotiations with management, proxy contests, agenda setting and appointment of directors. 85
See, for example, Part RP, Corporate Law Reform Bill 1992, "Financial Benefits to Related Parties of Public Companies". 86 Information obtained from discussions with the Chairman of the AIMG. 87 Australian Investment Managers' Group Statement of Purposes. 88 Quoted in Australian Super Review, December 1990/January 1991, p 1.
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It seems that the AIMG is prepared to engage in a wide variety of such activities. For example, the AIMG put general pressure on companies to adhere to certain standards of corporate governance when it endorsed a Corporate Practices and Conduct code prepared by the Business Council of Australia in conjunction with a number of other business and legal associations.89 A significant percentage of Australian listed public companies have now explicitly adopted the principles in the Corporate Practices and Conduct code as a result of a statement by the AIMG that, in making investment decisions, its members would give preference to corporations following the principles. One of the issues in the code is corporate governance and, like the Cadbury Committee in the UK,90 attention is focused upon creating a series of checks and balances over management through, for example, guidelines to the effect that generally the roles of chairman and chief executive should be separate, that public companies should have boards and audit committees comprising a majority of nonexecutive directors,91 and that boards should perform a monitoring function, ensuring that adequate systems of internal control exist. The Corporate Practices and Conduct paper also encourages public companies to develop and enforce codes of ethics, setting out their relationship and responsibilities to groups such as shareholders, customers and suppliers, employees and the community. There have been several high profile examples of more aggressive forms of activism by institutional investors in Australia in the last few years. For instance, shareholder pressure has been applied to obstruct increased managerial compensation.92 There have also been a number of attempts led by institutional investors to remove incumbent managers. In August 1991, there was "an institutional shareholder revolt"93 in the company, Darrell James Ltd. Five
89
Business Council of Australia, Corporate Practices and Conduct, 1991 (chairman, Henry Bosch AO). 90 Committee on the Financial Aspects of Corporate Governance, Draft Report, 27 May 1992. 91 The Corporate Practices and Conduct code recommends that at least two of the non-executive directors be truly independent in the sense that they have no other contractual relationship with the company or any other relationship "which could affect the exercise of independent judgement". 92 In 1990, shareholders of Goodman Fielder Wattie Ltd voted against an executive option plan as originally formulated, while approving a scheme to issue options to employees other than executive directors ("Shareholders set aside executive option plan," The Australian, at 15), 27 November 1990. In 1991, fund managers of institutional investors used their voting power against an increase in remuneration for directors proposed by the board of Westpac Banking Corporation. 93 Shareholder revolt rocks Darrell James, Australian Financial Review, 9 August 1991, at 16.
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institutions, led by the NSW State Authorities Superannuation Board,94 requisitioned a meeting to remove three directors of the company. Initially unsuccessful in unseating the incumbent management, the fracas nonetheless resulted in the appointment of five independent directors. Even more recently, institutional investors, representing over 50% of shares in Bennett & Fisher Ltd, one of the oldest listed companies in Australia, combined to force out more than half the board members in December 1991.95 Having reconstituted the board in this way, the rout was then completed when the managing director was sacked as managing director by the new board and resigned from his position as director two days before a shareholders' general meeting to remove him.96 One of the ironies in the saga was said to be the fact that the market's response to the removal of the managing director led to an appreciation of the value of his shareholding in the company by around 30% following his removal from office.97 There is by no means consensus amongst commentators on the desirability of institutional investors exercising a greater level of power over corporate managers. Optimal results are often thought to be general improvements in corporate governance and removal of inefficient managers. Professor Conard, however, refers to one of the potential negative consequences as the possible "entrenchment of enterprise managers through alliances between them and institutional managers".98 Concerns of this kind emerged as a result of a strategic alliance which was announced in mid-1991 between Australia's largest life office, the AMP Society, which has been at the forefront of investor activism, and the Westpac Banking Corporation. The terms of the alliance involved AMP lifting its shareholding in Westpac and provided for four interlocking directorships. The potential for a situation of conflict to arise where an institution aligns itself in this way with incumbent management became clear in a recent attempt by Westpac to raise $1.2 billion through a rights issue. Dramatic falls in the Westpac share price raised concerns that there would be a significant shortfall in 94
Other institutions involved included a subsidiary of the National Australia Bank and the State Electricity Commission of Victoria's superannuation fund. 95 "Holders oust directors in reshuffle at Bennett," The Australian, 16 December 1991, at 21. 96 "MD gets the boot in big Bennett clean-out," The Age, 9 May 1992, at 25. This was an extreme instance, with massive company losses, a highly controversial transaction involving the company and the managing director's wife and failure to make proper disclosure on certain matters to the corporate regulator, all contributing to the removal. 97 "Bennett & Fisher's shares gain as Summers leaves," Australian Financial Review, 12 May 1992, at 16. 98 CONARD, "Beyond Managerial ism: Investor Capitalism?," 22 JL Ref 117, 119 (1988).
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the fundraising. The AMP Society, which, with a 14% holding was the largest shareholder in Westpac, had, according to one press report, "little choice but to make a contribution to the rights issue resuscitation efforts"99 and publicly restated its commitment to the bank and the share issue. This was in spite of an announcement in May of a $1.6 billion interim loss and the fact that the fall in the market price of Westpac shares had already wiped $300 million from AMP's investment.100 All this was still not enough to sway other shareholders, including other institutional investors, dissatisfied with the board's performance. The rights issue was a debacle, with an $883 million shortfall, and following intense pressure from shareholders and the press, the chairman and four other directors resigned from one of Australia's most prestigious boards.101 The divergence of AMP's response to the Westpac issue from that of several other institutional investors is noteworthy, suggesting that in this situation AMP's role had shifted from one of institutional investor to one of "partner".102 Soon after the failure of the Westpac rights issue, it was announced that another major float, by Woolworths, would be deferred, amidst reports in the financial press of another "revolt" by major institutions over the pricing for the subunderwriting of the float.103
VI. Legal Obstacles to Institutional Investor Activism in Australia Several commentators in the US have criticised the network of legal rules inhibiting greater activism by institutional shareholders. Assuming that Australian institutional investors have sufficient motivation to take a more active role, to what extent are they obstructed by existing legal rules? At first blush at least, there seems to be considerable leeway under Australian corporate law for institutional investors to engage in many different forms of shareholder activism. For example, proxy solicitation is not subject to restrictions like those which have been criticised in the US,104 and occurs not 99
KERRY, "AMP strange bedfellows," Sydney Morning Herald, 11 September 1992, at 22. 100 "AMP and Packer shore up Westpac," Sydney Morning Herald, 11 September 1992. 101 "Directors go in Westpac Bloodletting," Sydney Morning Herald, 2 October 1992. The new appointment to deputy chairman of Westpac was Sir James Balderstone, chairman of AMP. 102 Indeed, one financial commentator asked whether the saga was actually a backdoor takeover of Westpac by AMP. See Walsh, "How it all went horribly wrong," Sydney Morning Herald, 25 September 1992, at 25. 103 "Woolies float a doubtful starter," Sydney Morning Herald, 24 September 1992, at 33. 104 On the SEC's proxy reform proposals brought about by such criticisms, see
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infrequently in Australia. It may in fact be used as an inexpensive and straightforward way to obtain control of a company through a minority shareholding position, bypassing the restrictive and highly technical takeover rules. One possible glitch in proxy solicitation - breach of the takeover provisions through the person authorised to vote obtaining a "relevant interest" in the shares voted - is obviated by a provision expressly stating that a relevant interest in shares arising in this way, otherwise than for valuable consideration, is to be disregarded.105 So far, however, institutional investors, whilst vital to the success or failure of any proxy solicitation attempt, have not tended to be the motivating shareholders. Another suggested method by which institutional investors might exert greater control at board level and more effectively monitor board decisions is by means of the appointment of nominee directors. Although there is one Australian decision106 adopting, as a strict and uncompromising principle the view that a nominee director has an overriding duty to the company and not to an appointor, other decisions have taken a far more pragmatic and commercial approach. It is clear that there are a range of circumstances in which the court will not intervene even though a director has given overriding consideration to, or acted solely in the interests of an appointor.107 Express legislative authorisation for this liberal approach to nominee directors has also been recommended by the Australian Companies and Securities Law Review Committee.108 In spite of the apparent flexibility of the law relating to nominee directors, interest by institutions in such arrangements will, it seems, vary depending upon the type of company involved. Although institutional investors may desire a greater level of control, which can be achieved through the appointment of nominee directors, in the case of investment in smaller green chip companies, there seems little enthusiasm, the Westpac-AMP alliance aside, for the BLACK, "Agents Watching Agents: The Promise of Institutional Investor Voice," 39 UCLA L.Rev. 811, 829 (1992). For a discussion of other obstacles to greater activism by institutional investors in the U.S., see BLACK, "Shareholder Passivity Reexamined," 89 Mich.L.Rev. 520 (1990) and ROE, "A Political Theory of American Corporate Finance," 91 Colum.L.Rev. (1991). 105 Corporations Law s 41. 106 Bennetts v Board of Fire Commissioners of New South Wales (1967) 87 WN (Pt 1) (NSW) 307. As well as the possibility of breach of fiduciary duty, overriding regard for the interests of an appointor might also be attacked under s 260 Corporations Law, a minority shareholder protection provision, as "oppressive, or unfairly prejudicial to, or unfairly discriminatory against, a member or members". 107 See, for example, Levin v Clark [1962] NSWR 686, Re Broadcasting Station 2GB Pty Ltd [1964-65] NSWR 1648, and in New Zealand, Berlei Hestia (NZ) Ltd v Fernyhough [1980] 2 NZLR 150. 108 Report No 8, Nominee Directors and Alternate Directors, (1989).
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appointment of nominee directors to the boards of blue chip companies. In blue chip investments, institutional investors still appear to prefer a role more detached from management. There are several possible reasons for this, both commercial and legal. There are, for example, concerns about insider trading constraints. Another deterrent to more hands-on involvement in managerial matters may be the fear that the institutional investor might be treated as a shadow director, the definition of "director" under the Corporations Law extending to any "person in accordance with whose directions or instructions the directors of the body are accustomed to act".109 Were institutional investors to be so classified, numerous duties would be imposed upon them, to which shareholders are not currently subject. What of institutional shareholder involvement of a more subtle kind? To what extent are institutional investors able to request and obtain information which may be denied by management to other shareholders? There is no doubt that, in the past, information has been imparted routinely in this way to institutional investors through selected briefings and roadshows. New insider trading laws were introduced in Australia in August 1991, which broadened the scope of insider trading provisions. One commentator has argued that technically, the most prolific insider traders in Australia are probably stockbrokers and the major institutional investors.110 Under the previous insider trading legislation, the basic prohibition applied to a person who was "connected" with a body corporate. For the institutional investor, probably the most relevant way in which a connection could arise was through a person being a substantial shareholder, holding not less than 5% of voting shares in the company. Institutional investors holding less than this percentage would fall outside the scope of the basic prohibition; however, even when the shareholding level exceeded 5%, it was arguable that any information possessed by the investor was not possessed "because of" the connection of substantial shareholding, as required by the provision.111 Under the amended provisions, there is no longer any requirement that a defined connection exist between insider and the relevant company. Rather, a person may be an insider purely through the posssession of material information which is not generally available.112 Arguably, this marks a shift in the underlying policy of insider
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Corporations Law s 60(1). Cf, however, Kuwait Asia Bank EC v National Mutual Life Nominees Ltd [1990] BCC 567. 110 BEERWORTH, "New Insider Trading Legislation," (1991) 19 Butterworths Corporation Law Bulletin, para [373]. 111 Corporations Law s 1002(1). Although s 1002(3) dealt with tippees, institutional investors would have been unlikely to fall within that section since the section required that the tippee must be an "associate" of the person giving the information or have had an "arrangement" for the communication of the information. 112 Corporations Law s 1002G(1).
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trading legislation in Australia from one based on fiduciary relationships to one based on informational advantage.113 It seems that the broadening of the scope of the insider trading laws in Australia makes institutional investors more susceptible to claims of insider trading. The crucial issue will now be whether the information is to be regarded as material and information will be treated as material "if the information would, or would be likely to, influence persons who commonly invest in securities in deciding whether or not to subscribe for, buy or sell" the relevant securities. Under this broad notion of materiality, it is arguable that possession of information by institutional investors, which gives them greater certainty about generally available information, might nonetheless in some circumstance be material. Insider trading laws in Australia have in the past been anodyne and ineffective.114 Whether the amendments to the law will result in more prosecutions and greater enforcement is yet to be seen. However the presence of the new laws will almost certainly be taken seriously by institutional investors. Finally, what of groups such as the AIMG? Are there any legal barriers to institutional investors coming together in this way? One possible constraint arises under the takeover provisions of the Corporations Law. Australia's takeover laws are highly technical and labyrinthine and are more than capable of catching conduct not strictly associated with a takeover bid at all. Furthermore, the remedies for breach of the basic prohibition can be draconian. Remedial orders which the court may make include orders restraining the exercise of voting power attached to shares, orders restraining their disposal, even orders vesting shares in the Australian Securities Commission. Technical breach of the takeover provisions would be anathema to institutional investors. The basic prohibition under the takeover provisions prevents a person from "acquiring" shares in a company if this would result in any person's "entitlement" to voting shares in the company exceeding a 20% threshhold, unless certain lawful pathways are taken.115 In computing a person's entitlement to shares, the shares in which that person has a relevant interest are aggregated with shares in which an "associate" of that person has a relevant interest. Might institutional investors be classified as "associates" of each other by virtue of their activities within a group such as the AIMG? The concept of "associate" is very broad. One shareholder may become the "associate" of another by virtue of an agreement, arrangement or understanding for the purpose of controlling or influencing the composition of the corporation's board »3 See generally BLACK, "The Reform of Insider Trading Laws in Australia," 15 UNSWL.J. 214 (1992). 114 From the time that criminal sanctions against insider traders were introduced by legislation in 1961, there were no successful prosecutions for insider trading in Australia. See TOMASIC, Casino Capitalism? Insider Trading in Australia (1991), chapter 3. 115 Corporations Law s 615.
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or the conduct of its affairs or through acting in concert with the other shareholder.116 The agreement, arrangement or understanding may be formal or informal, written or oral and the courts have given the terms a broad scope.117 It is thus arguable that in certain circumstances coordinated institutional investor activity might result in the parties becoming associated. There will however be no breach of the takeover provisions unless somebody has "acquired" shares as a result of a "transaction".118 The transactional requirement will generally be lacking in the type of conduct undertaken by the AIMG. Overall, the legal obstacles to greater activism by institutional investors are far from daunting. Institutional investors have shown on several occasions that they are prepared to break with their traditional patterns of behaviour and managers are increasingly aware of the need to keep institutional investors satisfied. Against this background, the future of corporate governance in Australia will be intriguing indeed.
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Corporations Law s 12(l)(e), s 9 and s 15. See, for example, dicta in Adsteam Building Industries Pty Ltd v Queensland Cement and Lime Co Ltd (No 4) (1984) 2 ACLC 829 and Industrial Equity Ltd v CCA (1989) 1 ACSR 153. 118 See Corporations Law ss 51 and 64. 117
Chapter Twenty-Two
Institutional Investors and Corporate Governance in Japanese Perspective Harald Baum and Ulrike Schaede*
I. Introduction In the Berle & Means world, the control of a corporation comes with the power to select a majority of the board of directors1. This power can have the formal setup of a private ownership, legal devices, or, most importantly, majority control. Majority control is defined as the minimum holding by one or a few groups of 20% of outstanding stock2. It is possible that there is control even if stock is defused among many owners, as long as there is unanimous majority over the voting stock (i.e., if major investors cooperate). From there, research took several turns, e.g., the "managerial" theories with their rejection of the classical entrepreneur and their search for managerial incentives, or the "property rights" approach and its analysis of contracts and the importance of rights in the setup. Fama3 topped this off by interpreting the firm as a set of contracts, where the separation of ownership and control is an efficient form of economic organization: corporations simply do not have owners in a meaningful sense. Management and risk-bearing are naturally separate factors of production, and management is a type of labor but with a special role (decision making), checked by competition on the labor market for * We are grateful to Ronald J. Gilson, Ortrud Kerde and Erich Pauer for helpful comments. 1 Adolf A. BERLE & GARDINER C. MEANS, "The Modern Corporation and Private Property", 1932, at 69/70. See also GEORGE J. STIGLER & CLAIRE FRIEDLAND, "The Literature of Economics; The Case of Berle and Means", 26 Journal of Law and Economics 237 et. seq. (1983). 2
3
Id. at 93.
EUGENE FAMA, "Agency Problems and the Theory of the Firm", 88 Journal of Political Economy 2, at 288 et seq. (1980).
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managers, within and outside of the firm4. This may well be true for the U.S. and maybe even, with certain restrictions, for Germany. If we take it to Japan, however, it poses a puzzle. Only rarely will we find the classical entrepreneur in large Japanese corporations, but what we see is a neat structure of sets of contracts, which on an individual basis are called "firms" (almost exclusively organized as joint stockholding companies) and on an upper layer "corporate groupings". We undoubtedly also see the results of what must be efficient management in Japan's economic strength. But what we do not see, among others, is an efficient market for managers. Instead, there is an in-house monitoring system which sends non-performers on a sidetrack. Moreover, we find strong institutional investors, aligned in a network of cross-shareholdings, which allegedly waive all or part of their property rights for the sake of stable shareholding agreements and mutual trust; i.e., even if they hold majority or minority control in the Berle & Means sense (i.e., as majority owners or a an unanimous group), they supposedly do not exercise it5. But where does the efficient management come from if managers are not checked by managerial market competition and if ownership structures either do not matter or if owners do not intrude? Are there different features to the Japanese setup? What do differences, if any, imply for the general applicability of our current theories on corporate governance? In this paper, we pursue these questions by, first, looking at the legal background of corporate Japan (Part 2). We find that Japanese business regulation is marked by a significant disparity between codified legal concepts and corporate reality, because legal devices for corporate control are rarely used, while there is an unusual importance of extralegal influence by the bureaucracy. In Part 3, we analyze corporate groupings, institutional investors, the organization of management, and stakeholders. We consider horizontally as well as vertically organized corporate groups and show that (a) corporate governance is not related to the existence of corporate groupings or crossshareholdings, and (b) institutional investors do not assume the role of corporate governors. We develop a new concept of the "main bank" and show that its behavior vis-a-vis companies does not primarily aim at corporate governance either. If external corporate governance is not a viable concept for Japan, we have to look at internal structures. Here, too, we find that the concept of "corporate governance" does not lead to a conclusion. We then suggest that the 4
From the "nexus of contracts" perspective, Fama argues, ownership is an irrelevant concept. Ownership of capital and technology should not be confused with ownership of the firm, but should rather be seen as the function of the risk-bearers, while the function of management is "to oversee the contracts among factors and to ensure the viability of the firm" (supra n. 3 at 290-292). N. that the underlying assumption is that markets — for capital and for managers — are "Fama-efficient". 5 See, e.g., PAUL SHEARD, The Economics of Interlocking Shareholding in Japan, CEPR Publication No. 259, Stanford Dept. of Economics, at 7 (1991).
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stakeholders of a Japanese firm must include bureaucrats, for two reasons: first, because of the bureaucrats' influence on corporate behavior while a government official, and second, because of the practice of amakudari (stepping "down" from civil service to private management at age 55). Any model of Japanese corporate governance has to include this particular influence variable. In Part 4, we conclude that corporate control by institutional investors is not correlated with the percentage of ownership by investors and is hardly quantifiable. Efficient management is mainly the result of inter-firm/inter-stakeholder personnel exchange and networks, and of influence by the bureaucracy. In other words, a major part of "corporate governance", if one wants to stick to the term, in Japan comes in the form of personal relations between a company's "old boys" and ministries; the framework for the influence is administrative guidance. Corporate governance, as discussed in the U.S., while a helpful analytical concept, does help us to understand Japan only to a certain degree.
Π. Legal Framework Mechanisms and effects of corporate governance are intimately related to the legal regime regulating the corporation, its stakeholders and markets — or so one would think. Surprisingly, the regulatory background of the corporate governance discussion until now has found only little consideration with respect to the situation in Japan. We therefore begin our analysis with a rough sketch of the different and complex set of formal legal and informal rules and regulations in Japan6. A. Regulations and Realities It is widely known that the Japanese law in general, and the laws regulating corporations and financial markets in particular, are a mixture of originally German and French legal concepts and, after World War II, legislation influenced by the U.S. occupational forces in Japan (1945 - 1952). Quite a number of the U.S. regulations were aimed at the "democratization" of the Japanese economy, formulated with the explicit aim to change the pre-war corporate governance structure. These legal concepts, however, which all were based on the notion of individual rights and the so-called "Kampf ums Recht", were now imported into an entirely different legal culture, and over time they developed into something totally different from what we would have expected. The outcome is a mix of Western legal concepts and of the application (or non6 For discussions and further substantiations we will as much as possible refer to sources in Western languages which are easily accessible.
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application) of the resulting laws 7. There are three outstanding and controversially discussed features of the current Japanese legal situation which are of primary importance for our paper: comparatively little litigation, corporate realities and administrative guidance. (1) Comparatively little litigation: In comparison with the U.S. and even continental Europe, the number of lawsuits in Japan is 'significantly low. Various, partly contradictory, reasons are cited as explanations. One point of view is that litigation as a means of direct confrontation does not suit the Japanese mentality and civilization. As with all strictly cultural explanations in the context of law and economics, one may have doubts with this one, too. To be sure, litigant confrontation bears the risk of severing existing business ties between the parties, which in the end may sum up to higher costs even with a judicial victory. While this is true for all societies, the high propensity for maintaining numerous "good business ties" between firms in Japan could indeed work as a deterrent against litigation. Another, and probably more important, reason for little litigation is costs, law suits are lengthy in Japan because the number of judges and lawyers is kept artificially low, so that there is no sufficiently easy access to courts8. Furthermore, litigation is expensive, because as a rule, and different from German practices, the winning party has to pay for her own expenses; the American-style contingent fee is not customary, and punitive damages are not widely known either. Moreover, the outcome of a trial is hard to predict in advance because judges tend to resort to a non-codified rule of reasonableness (jori) as a guiding (not a supplementary) principle9. As a matter of principle, contending parties are hardly pressed for a non-contentious settlement, and conciliation (chotei) is still the most widely used institution for resolving 7 For a detailed albeit controversial discussion of this topic see YOSHIYUKI NODA, Introduction au droit japonais (Paris 1966); TAKEYOSHI KAWASHIMA, Nihonjin no ho ishiki [The Legal Consciousness of the Japanese] (Tokyo 1967); GUNTRAM RAHM, Rechtsdenken und Rechtsauffassung in Japan (Munich 1990); JOHN O. HALEY, Authority without Power: Law and the Japanese Paradox (Oxford 1991); and especially the comparative overview with respect to the law of corporations and securities regulation by DAN F. HENDERSON, "Security Markets in the United States and Japan: Distinctive Aspects Molded by Cultural, Social, Economic, and Political Differences", 14 Hastings Int'l & Comp. L. Rev. 263-301 (1991). β Only about 2 % of the applicants are allowed to pass the Japanese National Legal Examination every year. In 1985 the total number of judges and private attorneys has been 2.740 and 12.937 respectively; that means there has been roughly one attorney for every 10.000 and one judge for every 50.000 Japanese. Figures are drawn from HALEY, supra n. 7, at 102 et seq. 9 This of course does not mean that there are no shareholder suits at all or that their outcome is arbitrary.
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disputes. Put together, this leaves but few incentives for the individual investor/shareholder and his lawyer to challenge management via the courts. Another consequence is that if the courts do not settle conflicts, other institutions, such as the bureaucracy, have a greater say as a mediator, and indeed there is evidence that disputing corporations try to find non-contentious solutions by involving the ministry concerned as a mediator. (2) Corporate realities: In 1989, roughly 1.2 million corporations in Japan were established in the form of a kabushiki kaisha (KK), the Japanese stock corporation, and about 1.3 million firms operated under the legal form of a limited partnership corporation (yugen kaisha)10. Quite different from Germany 11 , virtually all important firms are organized as a KK in Japan. Out of these, less than 2% had a nominal capital of more than 100 million Yen, roughly 70% had a capitalization of less than 10 million Yen n. In 1989, 2019 stock corporations were listed on the eight Japanese stock exchanges and about 200 were registered in the OTC-market 13. Accordingly, there is a large number of small stock corporations, many of which are not organized strictly according to the rules for stock corporations; in fact, there is a significant disparity between the codified law of corporations and the actual corporate reality. This was one of the main reasons for the substantial amendments to the commercial code in 1991. A further factor one should keep in mind when talking about the regulatory framework of Japanese corporations is that legal institutions, which seem to be identical or at least very similar to American or German institutions, in effect function in a significantly different way. A good example is the general meeting of shareholders which in Japan is downgraded to a mere formality, even with large corporations, and totally devoid of a governance function. Another example are the so-called "paper meetings" of the board of directors, where 10 Cf. Bessatsu hogaku semina No. 104, Kihonho komento kaishaho (Tokyo 1991), 1 et seq. n In 1989, there were 2508 stock corporations (Aktiengesellschaften) in Germany, out of which only 497 were listed on a stock exchange, and 163 were traded on the semi-organized OTC-market (geregelter Markt); 376 429 firms were organized as limited partnership corporations (GmbHs), which also include large corporations like the Robert Bosch GmbH; figures according to KLAUS J. HOPT, "Präventivmaßnahmen zur Abwehr von Übernahme- und Beteiligungsversuchen", in WM Festgabe fllr Theodor Heinsius vom 25. September 1991, at 22 et seq. with further references. 12 Supra n. 10. 13 An additional 119 foreign corporations were registered on the TSE in the foreign section, cf. TOKYO STOCK EXCHANGE, 1990 Fact Book (Tokyo 1990), at 53.
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papers are signed without discussions; the meeting is for the minutes only14. Moreover, actions taken by the Ministry of Finance (MOF) add to the deviations of reality from law. For example, in Spring 1992, MOF initiated "special stock investment trust funds" which were established by brokerage houses in order to enable corporate investors to indirectly repurchase their own stock and thus halt the price decline of their equity15. It did not seem to matter that a repurchase of own shares is explicitly prohibited under the Japanese commercial code (Art. 210). These examples indicate not only a comparatively greater flexibility in the handling of the law and a pragmatic approach towards legal concepts 16. They also hint at the influence of the bureaucracy in shaping the legal reality. (3) Administrative guidance and the role of the bureaucracy: The typical Japanese "regulatory set" for handling a certain section of, e. g., the financial world consists of four layers: (i) the pertinent statute; (ii) the significant scope of administrative discretion as provided by the law; this discretion is exercised by ordinances (seirei and shorei) issued by the cabinet, through the ministry concerned (in this case, MOF); (iii) written notifications (tsutatsu); these add to the scope of administrative discretion under the ministerial ordinance17; and (iv) informal, typically oral, "invitations" to certain actions, addressed to individual, or a group of, market participants. Notifications and "invitations", which are delivered by the ministries without cabinet approval, come under the name of administrative guidance (gyosei shido) 18. 14 For details see below at II. B. 1. and III.C. 1., "The Board of Directors". is Cf. THE NIKKEI WEEKLY, April 14, 1992, at 4. is One experienced commentator puts it bluntly: " Even though the Japanese closely followed American verbal models when they [the business regulations] were enacted during the Allied Occupation (1945-1952), the Japanese laws work quite differently. Indeed, they hardly work at all, in the American sense. However, the alternative methods used in Japan, which largely circumvent American expectations of these laws, have worked quite well ....", cf. HENDERSON, supra n. 7, at 280. ι? The official 1991 collection containing the statutes, ordinances and notifications regulating the securities markets (without banks or insurance companies) has some 3.000 pages, cf. Shaken Roppo (Tokyo 1991). is Research on this topic includes WOLFGANG PAPE, Gyoseishido und das AntiMonopol-Gesetz in Japan (Cologne 1980); MICHAEL K. YOUNG, "Judicial Review of Administrative Guidance: Governmentally Encouraged Consensual Dispute Resolution in Japan", Colum. L. Rev. 923 et seq. (1984); AKIRA NEGISHI, "Administrative Guidance and the Japanese Antimonopoly Law", 49 RabelsZ 277 et seq. (1985); R SSEL A. YEOMANS, "Administrative Guidance", 19 Law in Japan 125 et seq. (1986); JOHN Ο. HALEY, "Administrative guidance versus Formal Regulation: Resolving the Paradox of Industrial Policy", in Law and Trade Issues of the Japanese Economy, at 107 et seq., (Gary R. Saxonhouse & Kozo Yamamura, eds., Washington 1986).
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According to Japanese securities lawyers and investment bankers, administrative guidance is the most important way of regulating the Japanese financial markets by MOF and other financial authorities19. As if by definition, it is not transparent and therefore hard to assess, as a rule non justiciable and sometimes contra the codified law. It is estimated that this specific regulatory practice makes up for 60-90% of all the regulation in a given industry. One could argue that administrative guidance is a unique Japanese feature, which in our view it is not, but the scope of application as a means of regulation appears to be so. In other words: "While justiciable law is at the center of American culture, it is new, shallow, and of peripheral importance in Japan, especially in business regulation"20. Administrative guidance has been described in a famous government statement before a committee of the Japanese Diet as follows: "Administrative guidance does not involve the legal authority for enforcement, as would be the case with a restriction of civil rights or the imposition of a duty on the public. Administrative guidance refers to the function of an administrative agency acting within the scope of a duty under the laws establishing the agency or within the scope of its jurisdiction - to persuade and guide a party to conduct business in a certain way, in order to realize an administrative goal through the party's cooperation"21 Another observer states that at least with respect to the Japanese industrial policy as exercised by the Ministry of International Trade and Industry (MITI), the judicial role is "almost nonexistent" and as a result he sees a "judicially unaccountable bureaucracy" which is operating without clearcut statutory limits to its powers 22. In a socio-politological setting, the process of administrative guidance within the ministries can be explained with the help of the concept of "negative coordination"23. "Positive coordination" - open negotiations within the minisis Based on interviews conducted in Tokyo in 1991. 20 HENDERSON, supra n. 7, at 296. One of the leading Japanese civil law scholars recently n.d,"that one would fail to grasp the actual situation under Japanese law if one uses the legal framework of a Western legal system and does not pay enough attention to the private law consequences of government-business interrelationships in Japan", cf. ZENTARO KITAGAWA, "Unfair Contract Terms in Administrative Guidance", 16 Rechlstheorie, 181, 183 (1985). 21 Cited after NEGISHI, supra n. 18, at 278 with further references. 22 See FRANK K. UPHAM, Law and Social Change in Postwar Japan, at 199 (Cambridge, Mass. 1987). 23 RENATE MAYNTZ & FRITZ W. SCHARPF, Policy Making in the German Federal Bureaucracy at 147 et seq. (Amsterdam, 1975) , and FRITZ W. SCHARPF, "Die Handlungsfähigkeit des Staates am Ende des 20. Jahrhunderts", PVS - (Politische Vierteljahresschrift) Vol.32 No.4, 621-634. See also ORTRUD KERDE, Entscheidungsprozesse in der LDP Japans, M.A. Thesis, Center for Japanese Studies, University of Marburg (forthcoming).
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terial bureaucracy - rarely happens in reality. "Negative coordination" means the endeavor of leading bureaucrats to restrict options a priori such that there is potential consensus between all parties on any alternative. That is, this constitutes the negative way of "consensus finding" by an a priori exclusion of options that are deemed undesirable, and ensures that no one will lose face and the outcome of negotiations will not be totally unexpected. "Negative coordination" therefore describes a rational mechanism within the decisionfinding process which helps to coordinate different ministries and at the same time economize on negotiations costs. This is often labelled "consensus finding" in literature on Japan; it should be noted, however, that this is the usual way of making politics in major Western countries24. The enforcement of decisions and their translation to the industry level works with the help of a pronounced carrot-and-stick mechanism. It typically works because relationships between the ministries are long-term and work through multiple routes and in various forms, while firms know that following an "advice" could reap rewards later. If they find a noncompliance with administrative guidance, the ministries have a wide variety of options to obstruct future business of the party concerned, either directly or via other governmental branches if it finds a noncompliance with its guidance. The pressure could be directed against other members of a corporate group, or could take the form of delays in processing loan requests from other companies or reduced procurement contracts from different agencies25. Given that compliance with ministerial suggestions is at least legally considered "voluntary", there is little ground for a judicial review by the courts. Because of some peculiarities of the administrative proceedings in Japan, even in case of blatant retaliation by the authorities, judicial help is difficult to obtain26. For the questions raised in this paper, the informal character of administrative guidance is relevant in its effect upon the government-business relationships. Administrative guidance in some way "institutionalizes" the constant contact between the two sides. We identify two primary tools for implementing this 24 It is possible that Americans have problems seeing this point, because it is often claimed that the administrative system in the U.S.A. is markedly different in that it builds on a "top-down" mode of discussion. N., however, that the German theory is well-suited to explain the Japanese situation. Maybe, then, it is the U.S.A. that is "unique", not Japan. 25 Cf. UPHAM, supra n. 22, at 203, and GEORGE C. EADS & KOZO YAMAMURA, eds. "The Future of Industrial Policy" in The Political Economy of Japan Vol.L: The Domestic Transformation 423-468, at 433 (KOZO YAMAMURA & YASUKICHI YASUBA, eds., Stanford, 1987). 26 An impressive narrative is the so called Lions Oil-Case, where the entrepreneur, who did not comply with the MITI's guidance, summarized his experiences with the ministry in a book: TALI I SATO, Ore wa tsusansho ni barasareta [How I was butchered by MITI] (Tokyo 1986).
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guidance, particularly on the informal level: (i) amakudari, the "descend from heaven, where former bureaucrats, who on principle retire early, assume a position in the board of a leading bank or manufacturing firm or become the head of an industry association, such as the Tokyo Stock Exchange; and (ii) the setup of special legal entities, such as the Japan Housing Corporation, which are directed by former high-ranking bureaucrats who ensure that actions correspond with the ministry's ideas27. In sum, law in Japan does not rule as much as it provides for a rather loose framework within which bureaucrats and industry, through carrot-and-stick mechanisms, "cooperate" in what appears to be "Japanese consensus finding" but really is a rational give-and-take process or even a repetitive game. This needs to be kept in mind when we now look at the legal framework within which corporate governance could be exercised. As with other modern legal regimes we find three layers of rules which supplement each other: the regulation of the corporation, the financial markets and finally the legal frame for the institutional investors. B. Regulation of the Corporation28 1. The Legal Structure of Internal Governance Board of Directors The law on stock corporations is found in the Commercial Code (CC)29 and in smaller supplementary statutes30. Quite different from the German Aktiengesellschaft , the Japanese KK has a (more or less) one-tier structure: it has a board of directors as the main organ, but no supervisory body like the German Aufsichtsrat. The board is empowered to manage the corporation and to supervise the directors, which gives it a double function (Art. 260 I CC). Codetermination, which characterizes the German supervisory board with its equal representation of owners and employees, is unknown in Japan. Unlike U.S. or Swiss board (Verwaltungsrat), Japanese board is typically 27 See ULRIKE SCHAEDE, The Institutions of Administrative Guidance - MOF and the Financial Markets, Working Paper, Center for Japanese Studies, University of Marburg (forthcoming). 28 As we concentrate on a few selected topics, some further references might be helpful: a comprehensive up-to-date overview and comparison the the U.S. system can be found with HENDERSON, supra n. 7; extensively, but partially outdated CHRISTOPHER L. HEFTEL, "Corporate Governance in Japan: The Position of Shareholders in Publicly Held Corporations", 5 U.Haw.L.Rev. 135 et seq. (1983); for the German reader several contributions in ULRICH DROBNIG & HARALD BAUM, eds., Japanisches Handels- und Wirtschaflsrecht (forthcoming) might be of interest. 29 Shoho, Law No. 48 of 1899 as amended to 1991, Book II, Arts. 165 - 456. 30 Of special importance is the Shoho tokurei ho, Law No. 22 of 1974.
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composed of inside directors only. There is no legal requirement to divide the board into managing and supervisory divisions. The law simply stipulates that the board must have a minimum of three directors (Art. 255 CC). In large corporations, there are usually more directors on the board, with an average of 37 members (in 1991). This size is due primarily to the fact that senior managers are by definition board members. The few "outside" directors who sit on Japanese company boards are not necessarily independent. They normally come from affiliated firms, or from firms with close business relations, such as the main bank or the parent company31. These "outside" directors do not primarily represent the interests of ordinary shareholders, but rather those of their own company. Other, outside directors are often retired bureaucrats from the ministries supervising the corporation, who provide a useful network within important political and commercial circles32. Directors are appointed at the annual shareholders' meeting, serve for two years, and can be reelected (Art. 254, 256 CC). At least three directors have to be nominated (Art. 255 CC). The corporation is legally represented by those directors who have been especially appointed by the board for that purpose (Art.261 CC). As we will see below33, there is a hierarchy of power within the board. The allocation of power is independent from the authorization to represent the company legally and official titles used to express intra-firm ranking vary among companies. The Commercial Code deals with the difficulties outsiders have in differentiating between various degrees of authorization. A company is liable for transactions between bona fide parties and apparent representatives (Art. 262 CC). Strengthening the board in its function as a supervisory body with respect to individual directors has been discussed for a long time. Since a 1981 amendment to the Code, only the board is entitled to decide important matters like the acquisition or sale of substantial assets, large-scale borrowing, the appointment or dismissal of managers or other senior officers, and substantial organizational changes (Art. 260 II CC). Furthermore, individual directors have to submit a report on their activities to the board at least every three months. Decisions have to be made at board meetings, at which directors must be present; representatives and voting by proxy are not permitted. Resolutions can only be accepted by a majority vote and 50 percent of the directors must be present (Art. 260-2 CC). All attending directors must sign the minutes of a meeting. Shareholders can upon judicial approval demand to inspect the minutes for 31 A good example is the auto-parts manufacturer Koito which has two outside directors from its main purchaser, Toyota, on its board. Koito gained some notoriety when it was unsuccessfully attacked by the American raider T. Boone Pickens, who tried in vain to push his interest as the biggest shareholder and to have outside directors of his choice appointed to the board. 32 See below, atlll.C.l. 33 See below, atlll.C.l.
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protection of their interests (Art. 260-4 CC). As will be discussed below, reality deviates remarkably from these legal rules34: decisions are made by the so-called jomukai, a small executive group of managers headed by the president, and are rubber-stamped by the board. In some companies there are no board meetings at all, and decisions made by an executive group are approved in "paper meetings", where pre-prepared minutes are signed by the directors. However, board members who neglect their supervisory duties can be held responsible for the resulting damage by third parties (Art. 266-3 CC)35. Furthermore, directors have a general duty of care on behalf of their company (Art. 254-3 CC)36. A special responsibility for certain actions, such as breach of the laws or the charter, is stipulated in Art. 266 CC. The company and, in case the company does not act, the shareholders have the right to claim damages on behalf of the company from directors violating these provisions (Art. 267 CC); this right, however, is used only very rarely. Additionally, shareholders can demand the discontinuance of unlawful actions by directors (Art. 272 CC) and, provided that they have held at least three percent of the outstanding equity for at least six months, in case of grave misconduct, shareholders can resort to the courts for the removal of the director concerned (Art. 257 III CC). Auditors In order to establish some kind of control over the board - other than by itself or at the general meeting that appoints the directors - the Commercial Code stipulates that an auditor (kansayaku) must be appointed by the shareholders' assembly (Arts. 280, 254 CC). The auditor may not also serve as a director or employee of the company (Art. 276 CC). His duty is to supervise the board with respect to the legality of its actions. In small corporations37, this control is reduced to auditing the financial statements; in large corporations38, at least two and usually more auditors must be appointed. The annual financial auditing must be entrusted to an independent auditing company; the auditors have to check the 34 See below, at III.C. for further details. 35 Cf. MISAO TATSUTA, "The Risks of Being an Ostensible Director under Japanese Law", 8 J. Comp. Bus. & Cap. M. L. 455 et seq. (1986); ROBERT W. DZIUBLA, "Enforcing Corporate Responsibility: Japanese Corporate Directors' Liability to Third Parties for Failure to Supervise", 18 Law in Japan 55 et seq. (1985). 36 Together with Art. 254 III CC and Arts. 644 Civil Code [Mimpo, Laws No. 89 of 1896 and No. 9 of 1898 as amended]; cf. MITSUO KONDO, "The Management Liability of Directors", 20 Law in Japan 150 et seq. (1987), and HEFTEL, supra n. 28, at 179 et seq. with further references. 37 Stated capital less than 100 million Yen and total liabilities of less than 20 billion Yen. 38 Stated capital at least 500 million Yen and total liabilities of at least 20 billion Yen.
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report by this company39. An auditor does not have the power to appoint or dismiss directors. This, together with the limitation on control of legality, distinguishes him from the German Aufsichtsrat and seriously curtails his ability to monitor the board. In this respect, the authority of the auditor, as established by law, is limited. This limitation is further exacerbated by the fact that typically, and unlike in America, the auditor is not an independent external expert but rather a retired employee or former director of the company.
Shareholders' Meeting This leaves us with the shareholders' meeting as a possible means of monitoring the KK, but again we see a disparity between the legal concept and corporate reality40. The general meeting must take place at least once a year (Art. 234 CC). Since the 1950 amendment of the Commercial Code, the competence of the shareholders' meeting has been restricted to issues stipulated by law or in the charter of the corporation (Art. 230-10 CC). Thus, power shifted towards management; the general meeting does not have a say in many important matters. The main functions of the shareholders' meeting are the nomination (and, theoretically, the dismissal) of directors and auditors and the approval of annual financial reports. The law requires that important issues like mergers, sale of the corporate business, changes in the charter, issues of shares below market price, and the restriction of transferability of shares should be brought before the general meeting. Depending on the issue, the majority necessary for acceptance of a proposal varies and may be as much as two-thirds of the shares represented at the meeting, which have to be more than 50 percent of the shares outstanding. As a rule, one share carries one vote (Art. 241 CC). Non-voting shares are legal but have attracted attention only recently. Cumulative voting is legally possible but frequently precluded by the charter. In contrast to the German law of corporations, restrictions on voting rights (Hochststimmrechte) are not permitted in Japan. Voting by proxy is allowed and used in practice. Very often, charters provide that only other shareholders of the company are allowed to act as proxies. The corporation solicits a power of attorney and not merely a proxy ballot from the shareholder. Often, a blank proxy is returned to the company, thus authorizing employees of the company to vote as instructed by management. This further increases the power of management. Furthermore, anecdotal evidence shows that voting instructions that imply criticism of management are sometimes ignored, either by not voting at all or even by voting expressly against instructions41. Since 1982, large corporations with 1000 or more shareholders 39 Arts. 2, 4, 13, 18, 22 of Law No. 22 of 1974. 40 A detailed survey is in AKIO TAKEUCHI, "Shareholders' Meetings Under the Revised Commercial Code", 20 Law in Japan 173 et seq. (1987). 41 See HEFTEL, supra n. 28, at 175 et seq. with further references.
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are required to provide for a system of ballot voting. These companies have to send out a form for the postal ballot, an information statement together with the invitation for the general meeting, and the financial statements of the corporation42. Shareholders who have held at least three percent of the total shares for at least six months have the right to demand the convocation of an extraordinary general meeting (Art. 237 CC). A 1981 amendment reinstated for holders of at least one percent or 300 round lots a (limited) proposal right, if the shares were held for at least six months (Art. 232-2 CC). The same amendment also introduced the obligation for directors and auditors to answer shareholder questions related to the agenda of the meeting (Art. 237-3 CC). These amendments were intended as a means of reviving shareholders' meetings and strengthening their supervisory functions. They may not have been very effective, however, as the following figures indicate. Between July 1990 and June 1991, about 90 percent of the 2,108 recorded shareholders' meetings of Japanese stock corporations in Japan lasted less than 40 minutes, and 76 percent, or 1,609 meetings, were held on the very same day, i. e., June 27, 199143. This evidence of corporate reality shows that law functions only formally in this area. We identify two reasons for this. First, it should be noted that while there is an exchange between major shareholders and management, this takes place on a rather informal level , not at the annual meeting (see below)44. Second, Japanese managers dislike critical questions as much as their German or American colleagues, or maybe even more, and obviously are less scrupulous, since they make use of paid help to intimidate individual shareholders at general meetings to ensure quick and smooth proceedings. However, these paid hands, the so-called sokaiya (or, more recently, tokushu kabunushi), very often connected to the Yakuza or right-wing groups, have turned the tables and acquired the minimum number of shares required for them to attend - and disturb - general meetings. For either their non-appearance or their disturbance they had been paid regularly by management until the 1981 amendment of the Code. Since then, these payments have been forbidden (Art. 497 CC), but whether these or other benefits have really ceased remains doubtful. One response to the new legal situation has been the simultaneous holding of shareholders' meetings on the same day, which has the side effect that it is impossible for individual shareholders to attend more than one or two meetings. The ultimate aim, quick and smooth proceedings, still ranks high on management's list. This can be seen by the fact that most corporations practice 42 Art. 23-3 of Law No.22 of 1974. 43 Cf. SHOJI HOMU KENKYU KAI, ed., "Kabunushi sokai hakusho" [White Paper on Shareholders' Meetings], 1268 Shoji Homu 26, 83 (1991).
44 See below, at III. B.
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weeks in advance with their lawyers how to answer possible shareholder questions, and video-cassettes with relevant instructions on shareholder meetings are best-sellers. Interestingly, all of the major revisions of the Commercial Code after World War II - in 1950, 1974, 1981, and 1990 - had, albeit from different perspectives, some bearing upon problems of internal governance45. While the 1950 revision shifted power away from the owners and the auditors to the board of directors, later revisions were aimed, in varying degrees, at reintroducing limits to the powers of management. The 1974 amendment tried to improve the governance structure of the KK by strengthening the role of the auditors, and the 1981 and 1990 amendments were designed, among other things, to give power back to the shareholders. But, as shown above, these attempts do not appear to have been overly successful in installing an effective monitoring system. 2. The Antimonopoly Law and the Regulation of Combines Two sections of the Japanese Antimonopoly Law (AML)46 have helped to shape the present corporate landscape in Japan. First, Art. 9 AML prohibits the formation and operation of holding companies in Japan. The law defines a holding company as a company whose principal business is to control the business activities of other companies by means of holding shares (Art. 9 III AML)47. Second, Art. 11 AML restricts stockholding by financial institutions to five percent of the outstanding shares of a given company. For insurance companies the limit is ten percent. Firms engaged in trading securities in the 45 Amendments cited after the year of enactment; for the 1950 amendment cf. THOMAS L. BLAKEMORE & MAKOTO YAZAWA, "Japanese Commercial Code Revisions", Am. J. Comp. L. 12 et seq. (1953); for the 1974 amendment cf. MALCOLM D. H. SMITH, " The 1974 Revision of the Commercial Code and Related Legislation", 7 Law in Japan 113 et seq. (1974); ICHIRO KAWAMOTO, "Können Goßunternehmen kontrolliert werden?", l Recht in Japan 22 et seq. (1975); for the 1981 amendment cf. TAKEUCHI, supra n. 40; YOICHIRO TANIGUCHI, "Japan's Company Law and the Promotion of Corporate Democracy", 27 Colum. J. Transnat'l L. 204 et seq. (1988), at 200 et seq.; for the 1990 amendment cf. MASARU HAYAKAWA, "Der Grundsatz der beschränkten Haftung im japanischen Gesellschaftsrecht", 23 Sandai Hogaku28 et seq. (1989); MASARU HAYAKAWA & ELISABETH RAIDL-MACURE, "Japanische Gesellschaftsrechtsreform: Teilnovelle 1991 zum Aktien- und GmbH-Recht," RIW2%2 et seq. (1992). 46 Shiteki dokusen no kinshi oyobi kosei torihiki no kakuho ni kansuru horitsu, Law No. 54 of 1947 as amended to July 1, 1991. 47 To avoid possible misunderstanding, it should be stressed that die AML does not prevent foreign companies from operating wholly owned subsidiaries in Japan, even if the foreign company itself is owned by a non-Japanese holding company.
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course of their business and securities trusts are exempted. At the time of their enactment in 1947, these provisions were intended to help dissolve the excessive concentration of economic power, which had been typical for prewar and wartime Japan. The regulations were aimed at the then existing 15 zaibatsu, large industrial combines, which were mostly family-owned and structured around a bank under the legal roof of a holding company48. After their dissolution, some of the affected banks and other former zaibatsucompanies had to find a different way to regroup. They succeeded in regaining much of their prewar industrial power by setting up extensive webs of crossshareholdings between firms of the same group. Others followed. This so-called keiretsu-system49, which presently seems to be the most touted peculiarity of the Japanese industrial system, can at least partly be traced back to the legal changes that occurred after WW II. There are, however, some limitations on the extent of cross-shareholdings. A 1977 amendment of the AML introduced certain restrictions on shareholding by very large stock corporations engaged in businesses other than finance. Put simply, and setting aside some exemptios, a non-financial stock company with capital of more than 10 billion yen or net assets of more than 30 billion yen is prohibited from holding shares of other companies (in Japan), if the value of these shares would exceed the greater of its capital or its net assets (Art. 9-2 AML)50. The reason for the amendment was that big Japanese general trading firms, which had at first been integral parts of zaibatsu, and most of whom were later closely connected with a keiretsu-group, had amassed enormous amounts of shares in a large number of companies. This created an excessive anticompetitive concentration of economic power. Following the amendment, which provided for a ten-year grace period, the shareholdings of these companies have been reduced somewhat. Another, albeit not very effective, limitation of reciprocal shareholding can be found in the Commercial Code. Subject to exceptions, Art. 211-2 CC prohibits the acquisition of shares of a parent company by a subsidiary. This prohibition supplements Art. 210 CC, which prohibits the repurchase of a company's own shares. In spite of these restrictions, and although shareholdings of a given keiretsu-company in a specific co-member company of the same group is on average less than two percent, the accumulated shareholdings of member companies by keiretsu-companies exceed twenty percent on average. This is why some commentators regard this legal restriction as practically irrelevant51. 48 A good overview is in JOSEPH H. IYORI & AKINORI UESUGI & CHRISTOPHER HEATH, Das japanische Kartellrecht (forthcoming). 49 It will be discussed in greater detail below, at III. A. so For details cf. MICHIKO ARIGA, "Japan," in Competition Laws of the Pacific Rim Countries (von Kalinowski, ed., 1989), Part 6, § 15.03. 5i Cf. MISAO TATSUTA, "Reciprocal Shareholdings Among Corporations," CaMRIRev. 30 Apr. 1990, 25 et seq.
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Finally, it should be mentioned statutory regulation of combines course, regulate certain aspects of with respect to disclosure duties in
that there has so far been no comprehensive under Japanese law. The above rules, of combines. Further scattered regulations exist annual financial statements and for listings52.
C. Regulation of Financial Markets53 Corporation law establishes most of the legal regulation of corporate governance, but regulations relating to financial markets, especially capital markets, have some influence as well. 1. Outline and the Reforms for Monitoring Like corporate law and competition law, Japanese securities regulation was reformed in the late 1940s. When the Securities and Exchange Law (SEL)54 was enacted in 1948, Japan more or less adopted the American model and segregated the securities business from other types of financial activity (cf. Art. 65 SEL, previous version). As a consequence, only securities companies are allowed to conduct securities business, and only banks are permitted to engage in banking operations. Within the banking sector there is further segmentation, which is slowly disappearing due to ongoing reforms55. A far-reaching reform of the SEL 52 An informative overview of the different regulations is in MASARU HAYAKAWA, "Zum gegenwärtigen Stand des Konzernrechts in Japan," in Das Gesellschaftsrecht der Konzerne im internationalen Vergleich, at 391 seq. (ErnstJoachim Mestmäcker & Peter Behrens, eds., 1991). 53 As we shall again concentrate only on a few selected topics, some further references might be helpful: cf., e.g., MISAO TATSUTA, "Japan," in International Capital Markets and Securities Regulation (Bloomenthal, ed., New York 1982 et seq.), Chap. 11; HENDERSON, supra n. 7; JAPAN SECURITIES RESEARCH INSTITUTE, ed. Capital Markets and Financial Services in Japan, Regulation and Practice (1992); JONATHAN ISAACS & TAKASHI EJIRI, Japanese Securities Market (London 1990); YOSHIKI SHIMADA, " A Comparison of Securities Regulation in Japan and the United States", 29 Colum. J. Transnat'l. L. 319 et seq. (1991) [issue market only]. 54 Shoken torihiki ho, Law No. 25 of 1948. The law was substantially amended twice in 1992: Law No.73 of June 6, 1992 (effective July 20, 1992) and Law No. 87 of June 26, 1992, which will go into force in April 1993. For an English translation of these two amendments, see CaMRI Rev. No. 25, at 2 et seq., No. 26, at 2 et seq. (1992). 55 An overview of the different reforms of the Japanese securities markets in the 1980s can be found in HARALD BAUM, "Die japanischen Finanzmärkte in den achtziger Jahren: Ein Jahrzehnt der Liberalisierung, Internationalisierung und Gesetzesreformen", WM 1989, Special Supplement No. 4 (1989).
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is scheduled for April 1993, and will abolish Art. 65 SEL56. According to the bill that has already passed the Diet, banks will be allowed to engage in the securities business through subsidiaries, subject to a number of restrictions. Conversely, securities companies may participate in the banking business by acquiring banks or trust banks (Art. 43-2 SEL as amended). In both cases the permission of MOF is necessary. In the postwar era of high economic growth, MOF was the only regulatory authority governing capital markets, and operated primarily through the Securities Bureau, one of the Ministry's seven bureaus57. When the securities scandals surfaced in 1991, the MOF regime of monitoring and enforcement came under severe criticism58. In an attempt to separate the surveillance of the securities market from the administration of the securities industry, the so-called "Securities and Exchange Surveillance Commission (SESC)", a semiindependent watch-dog body, was established in July 199259. Further amendments to the SEL include: (i) changing oral administrative guidance 60 into (written and accessible) tsutatsu, as far as possible; (ii) clarifying the licensing process for securities businesses, and (iii) strengthening the role of SROs61. 56 See AKIO NAKAMURA & HIROSHI ΝΑΚΑ, "Kinyu seido, shoken torihiki seido kaikakuho no gaiyo" (Overview of the Law Reforming the Financial and Securities Trading System), 1293 Shoji Homu 2 et seq. (1992). 57 An informative description of the securities administration in its previous version can be found in JAPAN SECURITIES RESEARCH INSTITUTE, ed., Securities Markets in Japan, at 251 et seq., 1992 (Tokyo 1992). One experienced commentator explains: "While the notification requirement under the SEL is technically a reporting requirement, filing of such notification will not be accepted by the Bank of Japan unless the the issuing company has obtained beforehand an informal approval, called 'naininka', from the International Capital Section of the International Finance Bureau of the MOF.", cf. KUNIO HAMADA, "External Issues of Securities by Japanese Companies", in: JAPAN SECURITIES RESEARCH INSTITUTE, supra n. 53, at 254. 58 See, e. g., MITSURU MIS AW A, "Loss Compensation in the Japanese Securities Market: Causes, Significance and Search for a Remedy", 25 Vand. J. Trans'l L. 37 et seq. (1992); WATARU HORIGUCHI, "Differences in Culture, Society, Economics, and Politics and their Effect on Enforcement of Securities Laws," 14 Hastings Int'l & Comp. L. Rev. 306 et seq. One of the rare early criticisms of the weak enforcement of securities regulations is found in MISAO TATSUTA, "Enforcement of Japanese Securities Regulation", 1 J. Comp. Bus. & Cap. M. L. 95 et seq. (1978). 59 The SESC is based on Arts. 210 - 227 of the amended SEL. 60 For an explanation of administrative guidance, see above, at II. A. 61 For an overview of the administrative reforms, cf. MASAO NISHIHARO, "Kosei ο kakuho sum tame no shoken torihiki ho to kaisei ho no gaiyo" (Overview over the Law Reforming the Securities Exchange Law to Ensure Fairness), 1288 Shoji Homu 2 et seq. (1992); KUNIO HAMADA, "Recent Developments in Securities Laws -
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The new SESC has a staff of about 120 , most of whom come from MOF62. MOF has the exclusive right to appoint the three SESC commissioners, subject to approval by the Diet. While the Commission has the right to launch investigations, the authority for administrative sanctions and reforms remains exclusively with MOF; the SECS can only make proposals. The authority for criminal sanctions remains with the public prosecutor's office. The standing and the role of the SESC, therefore, are markedly different from those of the U.S. SEC. The SESC is, contrary to earlier proposals, a dependent agency attached to MOF. 2. Rules for the Protection of Investors During the last few years various regulations were formulated to strengthen the protection of investors. As they are part of the legal environment for corporate governance, we mention them briefly. In 1988 and 1989 Japan introduced rules and regulations on insider trading63. Art. 166 SEL subjects insider trading to a penalty. A prohibited insider transaction is present under this provision when certain persons who have a specifically defined contractual or legal relationship with a company (or who were in such a relationship within the previous year), on the basis of their position with the company, receive specifically defined, important information and then conduct trades with shares or other papers of the relevant company before such information has become generally accessible. Art. 167 SEL extends this insider prohibition to tender offers. Because of the weak sanctions (a maximum fine of 500,000 Yen and/or imprisonment of six months or less, Art. 200 SEL) and the fact that the so-called "chain tip" is not covered by the prohibition, the efficiency of this regulation seems doubtful. In addition to the introduction of this ban on insider trading, short-swing profit provisions were also amended. Principal shareholders and officers must report transactions in shares of their own (listed) company (Art. 163 SEL). Any profits realized by these persons from the purchase and sale of any securities of the company within a six-month speculation period are regarded as short-swing profits and must be paid over to the company (Art. 164 SEL). A more important disclosure requirement, the so-called "5 % Rule", went into force December 1, 199164. Persons directly or beneficially owning more Japan", Int. Bus. Lawyer 270 et seq. (1992). 62 Cf. ICHIRO KAWAMOTO, "Shoken torihiki to kanshi iinkai no setchi oyobi jishu kisoku kikan no kino kyoka" (Setting up of the Securities and Exchange Surveillance Commission and the Strengthening of the SROs), 1294 Shoji Homu 2 et seq. (1992). 63 An overview with further references can be found in HARALD BAUM, "Japanese Capital Markets: New Legislation", 22 Law in Japan 20 et seq. (1989). 64 Cf. HARALD BAUM, "Aktienbesitz und Publizität in Japan", in Wege zum
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than five percent of the outstanding shares of a listed or OTC-registered company have to file a report with MOF, stating the percentage and purpose of ownership, as well as the sources and amount of financing for the acquisition (Art. 27-23 SEL). Copies of this report will be sent to the stock exchange(s) where the shares are listed or to the Japan Securities Dealers Association. Subsequent changes in ownership of more than one percent must also be reported. The holdings of persons who engage jointly in these purchases of shares are added up for purposes of the rule. Finally, it should be mentioned that the rules for tender offers were substantially amended in 1991. The rather complex new regulations (Arts. 27-2 to 27-22 SEL) improve the position of investors and enhance comprehensibility during the offer period65. D. Regulation of Institutional Investors Each institutional player in Japanese financial markets is regulated under an individual statute and under special supplementary administrative regulations66. Despite this legal complexity, at least three features are shared by all. With the notable exception of life insurers, who are as a rule organized as mutual insurance associations, almost all of the other institutions take the legal form of a KK. Second, virtually all institutions are under the supervision of MOF, albeit under the auspices of different bureaus67. Finally, each institution needs a licence from MOF to do business and, more often than not, different licences with different requirements must be obtained to conduct a range of financial activities68. The actual conditions an applicant must fulfill are determined at MOF's discretion, within a comparatively loose legal framework69. japanischen Recht, Festschrift für Zentaro Kitagawa, at 633 et seq. (Hans G. Leser & Tamotsu Kitagawa, eds., 1992). 65 For details, cf. HARALD BAUM & KARL H. PILNY, M&A In Japan: Rechtlicher Rahmen und wirtschafiliche Realität (paper, forthcoming 1993). 66 A choice of recent (Western) publications on the different industries includes MEGUMI SUTO, " The Securities Industry in Japan: An Overview of Market Structure, Corporate Strategies, and Current Issues", in: JAPAN SECURITIES RESEARCH INSTITUTE, supra n. 53, at 81 et seq.; FEDERATION OF BANKERS ASSOCIATIONS OF JAPAN, ed., The Banking System in Japan (1989); NOBURU TANABE, "Japanese Investment Trusts," BJIBFL at 78 et seq., 118 et seq., 169 et seq. (1992); ULRIKE SCHAEDE & HARALD BAUM, "Toshikomongyo Anlageberatung in Japan," RIW104 et seq. (1989). 67 See above, at n. 56. 68 E.g., a securities company needs four different licences to act as broker, dealer, distributor, and underwriter (Art. 28 SEL). 69 Cf. e.g. Art. 29 SEL: "(1) The Minister of Finance may attach certain conditions to licences set forth in paragraph 1 of the preceeding article [requirement for a licence
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ΠΙ. Corporations and Institutional Investors Institutional investors are all investors who do not invest as individuals. In different countries, they come in various forms and degrees of importance. Most important in Japan are corporations, commercial banks (city banks and banks for long-term credit), life insurance companies, trust banks and investment funds. Pension funds in Japan are managed by trust banks and life insurers. Table 1 shows shareholdings by group of investors, and Table 2 summarizes the amounts of funds invested by each. It becomes clear that corporations, banks and life insurers are the biggest animals in the investor zoo. The question is, however, what these data tell us. How do institutions invest, what are their motivations and do they participate in management? Is there a difference between funds invested by a corporation and funds invested by a financial institution? An obvious starting point for the analysis is inter-corporate governance, especially because cross-shareholdings are so pronounced in Japan. One could assume that this particular feature of industrial organization translates into special relations between corporations, which in turn result in peculiar forms of corporate governance. However, as everywhere, there are great differences between individual firms in Japan, of which only a relatively small number are organized in horizontal keiretsu. There is no evidence whatsoever of corporate governance being exercised between firms. The starting point for the analysis, therefore, is the question whether there is a difference between horizontally structured ("group") and vertically structured ("independent") firms with respect to shareholder participation. A. Cross-Shareholdings and Corporate Groupings Current research on the industrial organization of Japan concentrates on horizontally organized keiretsu. One can see two reasons for this: first, these groupings constitute an important part of the Japanese economy, and they are organized according to principles of economies of scope (rather than scale), which seem to be "in" topics in current research in the U.S. Second, they are different from the forms of industrial organization found elsewhere70, while to conduct securities business]. (2) The conditions set forth in the preceding article shall be the minimum necessary in the public interest or for the protection of investors." 70 It is interesting to n. that there are German firms that resemble the Japanese horizontal organization with strong economies of scope (VEBA, Daimler, the prewar IG Farben), but these have not been scrutinized to the same extent. Maybe it is administrative guidance and economic policy rather than the actual form of organization that makes Japanese horizontal keiretsu so interesting.
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vertical organization is well-known around the world71. Over time, the word keiretsu ~ meaning horizontally organized groups — entered the English language and became the "magic word" in research on Japan, the potential key to explaining all differences between Japan and the rest of the world. It became successor, so to say, to the magic word of the 1970s, "lifetime employment". However, while this line of research has certainly contributed important insights, the concept does not explain as much as we would like it to. The preoccupation with keiretsu is unfortunate for three reasons. First, we could probably learn even more from the efficient world leaders of commerce, such as Toyota, Matsushita or Sony, which are not members of horizontal groups, than from the former families of Mitsubishi, Mitsui or Sumitomo, which display obvious inefficiencies. Keiretsu is an expensive form of industrial organization, because firms organized in this way have to carry the "ballast" of those firms in the group which have seen their heyday, and now can only be labelled "more than matured"72. Second, in order not to omit the independent "big shots" from the analysis, they are typically included in the framework of horizontal keiretsu and labelled "dependent", for unwarranted reasons. This clouds the picture of Japanese industrial organization, as it blurs the one distinctive feature of firm organization in Japan that could help us better to understand the costs and benefits of different forms of industrial organization. Third, it creates a pitfall to attribute virtually all aspects of corporate Japan to this particular organizational feature - and an analysis of corporate governance is likely to falter. Aware of this pitfall, we propose a different concept for looking at Japan's corporate world, at least for the purpose of this paper. We do differentiate between different organizational forms, but we do not deal exclusively with only one aspect of Japan's industrial organization. 1. Classifications A 1988 MITI survey showed that some 75% of all stocks in Japan are held by "relationship-oriented" investors; of these, financial institutions held 47%, and parent and other companies 28 %73. In a Nikkei survey conducted in autumn 71
This is true on the assumption that vertically organized Japanese firms are exactly the same as vertically organized firms around the world. As we will see, this is not the case in every respect. 72 That is, sound strong firms have to pay an insurance premium (see below) although they do not need insurance, in order to pay for the implicit bail-out mechanism of the group which is beneficial for old, matured industries only. This is one reason why profitability of keiretsu firms on average is lower than that of otherwise organized firms. 73 Quoted according to MASASUKE IDE, Corporate Financial Policy and International Competition - A Financial Analyst's View, 55, Nomura Research Institute
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1989, 4.4% out of 182 firms stated that more than 80% of their shares were in "friendly" hands; in total, 83.5% answered that they thought that 50% or more of their equity was held by "stable shareholders" and that they would like to see that number increase74. Cross-shareholdings are said to constitute a protection against hostile takeovers without intruding on in management. They have three major characteristics: (1) the percentage of stocks held by institutions is around 60 or 70%; (2) corporations involved have medium- or long-term business relationships with each other; and (3) shareholding is reciprocal and typically stable, in order to provide for capital market protection or "insurance"75. Sheard76 lists three major features of stable shareholding: (1) the investing institution agrees to waive its property rights (not only does it agree not to exercise its control rights, but it does not ask for high dividends either); (2) it agrees not to sell, especially in times of trouble such as a market decline; and (3) it agrees, if at all, not to sell without prior notice to the company concerned so that the company can look for another (a new) stable friend. Among these, feature (1) is fairly strong and should, if accepted in this form, end all discussions on corporate governance: the part of shareholdings that creates a stable relationship precludes investor interference in management. The question then is whether there are differences among groups of investors as to the degree to which they waive their interference rights. Cross-shareholdings are usually associated with keiretsu. It is important to note, however, that (a) there are two major forms of corporate groupings, (b) cross-shareholdings can also occur outside the keiretsu structure, and (c) the mere existence of a "group" does not necessarily imply "governance". The two forms of groupings are horizontal on the one hand and vertical on the other. The horizontal groups are few in number. They date back to the prewar zaibatsu and bear the familiar names of Mitsubishi, Mitsui, Sumitomo, Fuyo (Fuji, formerly Yasuda) plus, without a direct connection to prewar groups, Sanwa and Dai-ichi (Tokyo, 1992). 74 NIHON KEIZAI SHIMBUN INC. ("NIKKEI") (ed.), Zeminaaru gendai togyo nyumon (Textbook: Introduction to Modern Japanese Corporations), at 18 (Tokyo, 1991). 75 PAUL SHEARD, Interlocking Shareholding, Corporate Governance, and the Japanese Firm, Working Paper 4 (Osaka, 1992). Characteristic number (3) is not valid for life insurance companies, as we will see, because they are not organized as stock corporations. Recently, there have been rumors on the market that the "stable" part of the agreement might be dissolving, as firms, like investment funds, switch their investment strategies to indexing in order to make use of derivative markets (futures, options). 76 Id.
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Kangyo. The structure is "horizontal", both in the industrial organization meaning of the word (in terms of scope of production) and in terms of rights and power within the group, as there is no one member which is in control of other members. To be sure, there is a bank in the center of the group, typically together with a trading company and a major manufacturer. This bank is of pivotal importance, but it is in no position whatsoever to "dictate" group decisions. The number of members of these groups is hard to infer, because firms are more or less loosely affiliated (e.g. borrow from different banks), some firms change groups, and others leave the group altogether to form (vertical) groups of their own. Hoshi et al.77 find that in the 1980s about 89 of the top 200 industrial firms had strong business connections with one of the six largest groups. Vertical groupings come in different forms. The most prominent of them are large firms which either "emancipated" themselves from group membership (e.g. Toyota, which left the Mitsui group and established a grouping of its own) or which are so-called founder firms that never "married" into a specific group in the first place (e.g. Matsushita Electric, Sony). These groups, again, are vertical both in terms of scope of production and in hierarchy (the main firm has the final say in the group). It is interesting to note that these "independent" firms are on average more profitable than the firms belonging to a horizontal group78, and that there are certain differences in stock- and debtholder composition, as will be discussed below. Current research tends not to differentiate clearly between the two forms. Accordingly, questions of corporate governance, shareholder composition and related issues are discussed primarily in the context of horizontal groups, although it is vertical groups that represent the most successful and, possibly, well-known Japanese firms. Vertical groups, or rather the firms that founded them, are typically labelled "independent". While it is not clear to what this term refers, it is probably meant to signify that these firms are not dependent on one particular bank of one particular group. Whether these firms are independent in terms of corporate governance is a different matter altogether. Nakatani79 uses a sample of 859 manufacturing firms, listed in the First 77
TAKEO HOSHI & ANIL KASHYAP & DAVID SCHARFSTEIN, "Corporate Structure, Liquidity, and Investment: Evidence from Japanese Industrial Groups," The Quarterly Journal of Economics 33-60 (Feb. 1991). Their method of group classification will be discussed below. 7» Id. at 53; the evidence they find, however, is not strong, possibly because of their categorization of keiretsu firms. See also TAKEO HOSHI, ANIL KASHYAP & DAVID SCHARFSTEIN, "Bank Monitoring and Investment: Evidence from the Changing Structure of Japanese Corporate Banking Relationships" in Asymmetric Information, Corporate Finance, and Investment, at 105-126 (R. Glenn Hubbard, ed., Chicago, 1990). 79 IWAO NAKATANI, "The Economic Role of Financial Corporate Grouping" in
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Section of the Tokyo Stock Exchange in 1984, and assigns 317 of them to one of the six horizontal groups, leaving 542 firms as "subsidiaries","independent" or "unknown". He finds that the horizontally grouped firms do not use their power80 to raise profits or increase growth rates, but to maximize the joint utility function of their major constituents, the employees. This use of discretionary power leads to a stable corporate performance over time. Nakatani argues that shareholders are interested neither in growth nor in returns (which is reflected in low dividend payout), but in a long-term increase in corporate quality. Also, rather than aiming at monetary profits, shareholders, which engage in mutual and stable relationships, offer a mutual insurance scheme: the forgone profits on investment constitute the insurance premium they pay for having stable shareholders. They do not intrude in management because they do not want investors to intrude in their own companies' policy-making process; i.e., they are quiet, patient shareholders. Nakatani's analysis is confirmed by Hoshi, Kashyap and Scharfstein81 who, using a similar data set, found four interesting aspects: (1) "independent" firms82 are more profitable than "group firm s "(meaning horizontally organized firms), are larger and have slightly higher rates of sales growth; (2) independent firms tend to invest more and their investment is more volatile; (3) independent firms are more sensitive to liquidity in their investments (while group firms can always count on their bank) and (4) group firms on average have higher debt/equity ratios; also, they rely more on bank loans than on bonds. From this, one can conclude two things: the tax advantage associated with debt financing, might be one reason why the Japanese stock market did not really develop for a long time; at the same time, because there are also costs associated with the issuance of debt, debt financing took the form of bank loans and the bond market did not develop for a long time either. Second, shareholdings are smaller than debtholdings, so that institutional investors, exert influence if at all as creditors rather than as owners (shareholders). In other The Economic Analysis of the Japanese Firm, at 227-258 (Masahiko Aoki ed.,Amsterdam, 1984). Eleanor Hadley as early as in 1984 criticized the grouping as established by Nakatani. See E. HADLEY, "Counterpoint on Business Groupings and Government-Industry Relations in Automobiles," at 319-327 in The Economic Analysis of the Japanese Firm (Masahiko AOKI ed., Amsterdam 1984). One could imagine that the analysis of profitability and growth patterns by Hoshi, Kashyap and Scharfstein (supra n. 57) would probably have shown more statistically significant results had they not followed the Nakatani division into "dependents" and "independents", but had they labelled Toyota etc. as independent. 80 Nakatani uses the term "monopoly of power"; id. at 228. 81 See supra n. 77. 82 While using the Nakatani set of firms, they found that only 83 of the 859 firms listed on the Tokyo Stock exchange were "completely" independent of an industrial group (meaning a horizontal keiretsu). The problem remains one of classification.
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words, at least historically, the degree of shareholding is only of secondary importance if one is looking for the influence exerted by institutional investors. This leads to the role of banks and loans. Prowse83, again using the Nakatani classification of firms, found a significant correlation between the percentage of outstanding debt and the percentage of outstanding equity held in the same firm. He attributes this to a desire by banks to economize on agency problems either between shareholders and debtholders, or shareholders and managers, or both, but not to a desire to interfere in the management of the firm concerned. Prowse does not consider other institutional investors in detail. His conclusion is that large debtholders (which, in 1984, on average held 22.3% of the firm's outstanding debt and at the same time 6.2% of the same firm's outstanding shares) have a significant influence over firm policy by virtue of their control of the voting rights attached to their shares. As will be shown below, this is not necessarily the case: while there is certainly a possibility that large debWshareholders exert influence, they usually do not do so. By means of rigorous statistical testing, Tachibanaki and Taki84 tried to locate the largest lenders that were simultaneously top shareholders. They show that there are not just main banks but also "quasi" or "semi" main banks which take second, third or fourth position. Further, more often than not, insurance companies hold more shares than do city banks; at times they are also the largest debtholders. It becomes clear that while there is high stability among main banks (once the bank is the largest debtholder, there is a good chance that it remains such), the correlation between lending and shareholding position is low. Finally, there were only a few cases of a main bank, being defined as "largest shareholder cum largest debtholder", and if so, it typically did not remain in that position for a long time. We can only think of one reason why this should be so: corporations do not like the dependency structures involved in the main bank system as herein defined here, and therefore try to avoid having the main bank as largest simultaneous share- and debtholder. 2. A New Definition for "Independent" Firms One of the reasons why explaining the structure of Japanese firms with the help of the corporate governance concept is difficult is that one needs to classify firms and their actions in a pattern. This pattern usually reads "horizontal groups", and characteristics attributed to it include the "insulation from capital 83
STEPHEN PROWSE, "Institutional investment patterns and corporate financial behavior in the United States and Japan," 27 Journal of Financial Economics 43 et seq. (1990). 84
TOSHIAKI TACHIBANAKI & ATSUHIRO TAKI, "Shareholding and Lending Activity of Financial Institutions in Japan," at 23 et. seq., BOJ Monetary and Economic Studies, Vol.9 No.l (March 1991).
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markets" function and a "mutual insurance scheme". According to a Japanese definition, a firm is strongly affiliated with a group if it meets at least one of three criteria:85 1) one of the group banks was the largest lender to the firm in three consecutive years and shareholdings within the group exceed 20 percent; 2) the largest lender provided at least 40 percent of the firm's bank debt; 3) there is a historical affiliation. Obviously, condition (3) leaves ample opportunity to group firms as dictated by the expected outcome of the analysis. History is helpful and important, but is in no way determinative: a firm today might not be what it was 60 years ago. Further, this definition neglects the relation between shareholdings and loans. We therefore propose a new way of looking at Japanese firms with the help of two propositions. We will show with a small sample of firms that this approach will alter the usual "grouping structure", particularly as far as very large firms are concerned. Proposition 1: Definition of a horizontal keiretsu affiliation A firm is organized in and in some way dependent on a horizontally organized industrial grouping if a) among the shareholders of a firm one bank holds 4% or more of shares outstanding, and b) among the largest bank-shareholders (4% or more) one bank has loans outstanding to the same firm at a level significantly higher than other banks or of more than 10% of total outstanding debt. Shareholders of firms in horizontal groups earn fewer dividends and enjoy lower growth rates. They do not exert their influence, because they want other companies to stay clear their own board (as discussed below). In contrast, independent firms show higher dividend payouts, which could be a reflection of the fact that shareholders (in particular those who appreciate dividends, such as individuals) play a different role. Further, it can be assumed that if there is a high concentration of stock in only a few hands, these few hands could influence management. In other words, the higher the number of shareholders, the smaller the influence that one or a small group of investors can exert on management. An investigation into shareholders and shareholder groups could therefore help to differentiate between firms with respect to potential shareholders' influence and to the importance of shareholder groups. As a benchmark for measuring this relation, we propose a rough "one third" rule. Proposition 2 therefore reads: Proposition 2: On shareholder dispersion If the top 10 shareholders hold less than 30% of outstanding equity, dispersion 85
Based on KEIZAI CHOSA KYOKAI, Keiretsu no kenkyu, quoted according to HOSHI et al. 1991, supra n. 77, at 41.
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is too great for institutions to have influence. If the top 10 shareholders hold over 35%, the affiliation with one or a few institutional investors is strong. Tables 3 and 4 show, respectively, the top 10 and top 50 manufacturing firms in 1991 according to "general business results", primarily profitability, as defined by the Japanese weekly economic journal "Toyo Keizai"86. Table 3 provides the total number of shareholders (holding round lots), the horizontal keiretsu group that the firm is usually affiliated with (according to the Nakatani classification), and the largest shareholder for the top 10 corporations. Only 2 of these are labelled "non-affiliated". One firm, Nintendo, has an individual as its largest shareholder; four firms are primarily owned by other corporations (Sony by a subsidiary, Shimizu Corp., Fujitsu and Sekisui House by parents); seven firms have an insurance company as their largest owner; and Toyota, the number one firm, has its main ownership divided among three banks. Table 4 presents a test of propositions 1 and 2: it shows the number of banks that own 4% or more of the firm and debt outstanding, the number of banks among the top 10 shareholders, and the percentage held by the top 10 shareholders. Nonaffiliated, vertically organized companies according to our definition, are marked with "*" and printed in bold. Firms marked with "#" are either founder firms or affiliates/subsidiaries and therefore defined as not involved in a horizontal keiretsu 8 7 . According to our definitions, of the top 50 Japanese firms, 23 are members of horizontal keiretsu groups, 4 are founder firms (typically with an individual as largest shareholder), 5 are affiliates of or subsidiaries in vertical groups, and 18 lead independent vertical organizations of their own (mostly with zero outstanding loans). It is interesting to note that the top 6 firms,-and 10 out of the top 20, are "independent". This substantiates the findings by Hoshi et al.88 that vertically organized firms are in general more profitable. It also supports our notion that horizontal organization in the keiretsu style is an expensive variant of industrial structure, because profitable firms must carry the burden of not-soprofitable firms, in the form of an insurance premium for the mutual horizontal insurance scheme. With respect to shareholder dispersion, the differences between horizontal and vertical firms are not significant. Excluding founder firms, the top 10 shareholders hold on average 32.74% of the outstanding equity of vertical firms, and 36.41% of horizontal keiretsu firms. Proposition 2, therefore, does not really help to differentiate between the two groups of firms, even though the 8« SHUKAN TOYO KEIZAI (The Weekly Toyo Keizai), Special Issue May 30, 1992, "Ninon no kaisha - 120,000" (120,000 corporations of Japan). 87 Founder/owner firms could, of course, be part of a horizontal keiretsu, but surprisingly, none of them is. This is due to a different management organization in these firms, which display a more "independent" character than other firms. β» supra n. 77.
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results are in line with our rough "one third" rule. Table 4 also shows the number of banks among the top 10 shareholders. Vertical firms have significantly more banks in the top 10 group than horizontal firms. Most of these are trust banks, which also manage investment funds (which help to disguise the fact that a firm trades "stable" shares; see below). At the same time, the number of life insurance companies among the top 10 shareholders does not show a correlation with organizational form. Some of the independent firms, such as Toyota, seem to employ an outright "equilibrium in banks as shareholders" policy. It can be inferred that Toyota, by combining a small number of total shareholders with a high degree of shareholdings among the top 10, tries to achieve three things. First, Toyota replaces the implicit insurance scheme with an "assembly" of well-chosen top shareholders who are in competition with each other. Second, the small number of shareholders ensures good business relations and stable shareholders even though Toyota is not organized in a horizontal group. Third, Toyota is not dependent on any of these shareholders.89 What is true for Toyota probably holds for other independent firms as well. Half of the successful independent firms, 3 of the top 6, are "founder" firms which are now in the second generation of presidents (not necessarily relatives of the first). The biographies of these founders are as thrilling as detective novels, and the Mr. Honda, Toyota or Matsushita display one common personal feature: they do not fit into the typical image we have of the Japanese (worker, "salaryman"), but rather correspond to Schumpeterian ideals, and show a strong belief in market forces and meritocracy90. While this classification may shed new light on issues of industrial organization, Table 4 leaves us with one major problem with analyzing corporate Japan as to questions of corporate governance: no clear image pops up regarding shareholder composition. Whether firms are big or not so big and whether they are dependent or independent, horizontally or vertically organized, the differentiation into groups does not develop into a clear scenario for corporate governance. From this, we infer:
Proposition 3: In analyzing owner influence on management, it is not relevant whether a firm 89 Toyota seems to be a special case in other aspects, too. First, it used to belong to the Mitsui group, from which it "liberated" to form its own vertical keiretsu. Toyota has three banks as major shareholders, followed by Toyota Automatic Loom Works (the original firm founded in 1927), three insurance companies, two commercial and one trust bank. 90 Which is why they are also famous for avoiding administrative guidance by the ministries. Only if no other way can be found, and under much lamenting in public do they bow to the Minister of International Trade and Industry or the Minister of Finance.
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is integrated in a horizontal keiretsu group or has created its own vertical group. Rather, the relevant difference lies in shareholder composition by groups and combinations of top shareholders; i.e., it is a function of equilibrium between shareholders. For example, a firm that has six trust banks among its top 10 shareholders, as Sony does, can not simply be called dependent on any of these, especially if there are zero outstanding loans. From here, we argue that in horizontally organized keiretsu firms, shareholders could have influence on corporate management. They usually do not, as we will see below, but the potential influence exists. With vertically organized firms, big shareholders are carefully composed such that no single one of them can exert influence. In neither organizational form are firms subject to explicit "corporate governance" in the U.S. meaning of the word, i.e., through the owners. Corporations, the top candidates as active corporate governors - at least in American eyes - therefore play various and unexpected roles in Japan. For vertically organized groups, the ability to exert influence on affiliated small- and medium-sized companies is certainly a motive for shareholding; in the context of relationships with these smaller firms, then the Western concept of governance holds. As for shareholding in large firms, vertically or horizontally organized, however, the situation is different. Only rarely does one find a corporation among the top 10 or even top 20 shareholders of large firms. The top-notch group consists almost exclusively of financial institutions; if there is a corporation among the top 10, it is typically an affiliated or parent firm. This could be either a function of portfolio diversification of corporations (or rather, insurance scheme and reciprocal services diversification) or a reflection of the fact that corporations are not interested in intruding. It will get back to a firm directly if it interferes with another firm's management decisions. More than creating a threat to one's own management, such an intrusion would constitute a breach of the implicit contract and carry high reputational costs. It could lead to other corporations starting to sell stocks they promised not to sell (rather than getting busy in intruding themselves), thereby destroying either the insurance pattern of horizontal firms or the carefully designed "shareholders' power equilibrium" of vertical firms. A further explanation of why corporations do not intrude is that there are few outside directors on corporate boards (see below), and due to the high degree of cross-shareholdings, a CEO cannot possibly participate in all shareholders' meetings of all firms in which his firm has a stake91. Therefore, even if they wanted to, corporations would have a hard time in interfering; usually, they do 91
Shareholders' meetings in Japan are typically a matter of less than one hour (see above, at II. B. 1, general meeting) and are usually held all at the same day and at the same time, nationwide, in order to make it more difficult for the mafia (yakuza) to disturb.
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not want to in the first place92. The motive of companies for buying other companies' stocks is to enter the mutual insurance scheme, not to interfere with management. If corporations stay clear of other firms' management issues, financial institutions are the next potential candidates for the "corporate governor" job. B. Financial Institutions as Shareholders The discussion on cross-shareholdings in Japan centers on two major features: the cross-shareholdings as observed in keiretsu, and the main bank which belongs to these groups. Two major motives can be distinguished for holding shares "cross": (1) such shareholding constitutes "reciprocal insurance", with the forgone returns on the investment constituting the insurance premium; (2) Alternatively or additionally, it provides a system of "reciprocal services" in the sense that business ties are created and implicit long-term contracts established. Which motive is more important depends on the characteristics of the investor concerned93. 1. Motivations for Investment One might suspect that financial institutions, in particular life insurance companies, have a keen interest in the quality of management, given the scope of their their investments. In order to evaluate the stance taken by these investors, we need to distinguish between motives for investment by groups of financial institutions. 92
The fact that there are so few outside directors is a reflection of the fact that corporations do not see the need for interference with other boards - if they saw a need, outside directors would become more popular in the shortest period of time. 93 Literature does not necessarily see it this way. Sheard distinguishes two motives for reciprocal shareholdings: the insulation from the market of corporate control and the provision of a financial buffer against economic and/or financial crises. McKenzie argues that exchange rate losses are a good point for proving the second aspect: in 1986, some life insurers realized capital gains to cover exchange rate losses in the wake of the steep appreciation of the Yen against the US-dollar. It is not obvious, however, how the "financial buffer" motif could possibly imply stable shareholdings if they were "stable" in the strict sense, they would loose their buffer function. See PAUL SHEARD, Intercorporate Shareholdings and Structural Adjustment in Japan, Pacific Economic Papers No. 140, Australia-Japan Research Center (Canberra, 1986), and COLIN MCKENZIE, "Stable Shareholdings and the Role of Japanese Life Insurance Companies," in International Adjustment and the Japanese Firm (Paul Sheard, ed., forthcoming: Allen & Unwin).
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Life insurance companies The largest group of institutional investors, life insurance companies, have only the second motive of "reciprocal services". Because life insurers are not stock companies but "mutual companies" (sogo kaisha), reciprocal shareholdings are not feasible and thus the "insurance" function is irrelevant. Instead, the life insurer becomes a stable shareholder in a company, and in return the company has its employees buy pension schemes and group life insurance from this particular insurer. The system works because the market for life insurance in Japan does not really rely on a price mechanism: insurance premiums and dividends are preset, according to mortality tables plus administrative costs set by a cartel or by the Ministry of Finance through administrative guidance94. Therefore, stable shareholdings of life insurance companies constitute a kind of non-price competition in trying to gain or keep market share95. Once an implicit contract is established, it remains stable because there are reputational costs associated with breaking a long-term implicit contract, added to by an externality problem, as all life insurers will suffer should one of them renege on an implicit contract96. In addition, life insurance companies do not actively trade stocks for regulatory reasons. They are not allowed to distribute capital gains as dividends to clients, so an increase in capital gains does not bring then any advantage in the competition with other insurers. Therefore, good long-term investment is much more important than short-term gains. Further, as of February 1990, there were 34 outstanding ordinances (tsutatsu, letters sent by the Ministry of Finance containing administrative guidance) for life insurance companies. The most important of these stipulates the percentage of total assets that life insurers are allowed to invest in various instruments. These ratios, include: up to 30% in domestic stocks, 20% in real estate, 10% in the total outstanding equity, bonds or loans of one particular firm, and up to 30% in foreign equity97. 94 MCKENZIE, supra n. 93. On the organizational structure and shareholder role of Japanese life insurance companies see also RYUTARO KOMIYA, "Kigyo toshite no seiho" (Life insurers as corporations), in Nihon no kigyo (Japanese Corporations), at 441-470 (Kenichi Imai & Ryutaro Komiya, eds., Tokyo, 1990). 95 N. that the average Japanese holds six life insurances of varying styles. One big company as a friendly firm means the number of employees times six as new contracts to be sold. See HENDRIK MEYER-OHLE, Lebensversicherung und Konsument, M.A.Thesis 1992, Center for Japanese Studies, University of Marburg. 96 See McKENZIE, supra n. 93. 97 OKURASHO GINKOKYOKU (ed.), Ginkokyoku genko tsutatsu-shu (Outstanding Ordinances by the Banking Bureau, Ministry of Finance)(Tokyo 1990), at 1522-1523. It is understood that exceptions to these rules are dependent on the benevolence of the Minister of Finance. The 30% (on equity) and 10% (on one single corporation) rules seem to be relatively binding.
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In 1991, 22.1% of all life insurers' assets were in the stock market, 35.8% were given away as loans, and 7.8% rested in bonds98. This substantiates the hypothesis that if life insurers exert corporate influence, their debtholdings are probably more important than their shareholdings. Also, there is a cyclical pattern in life insurers' investment behavior. In times of tight money, when interest rates rise, life insurers typically get out of a portion of their shareholdings and either invest in bonds or forward loans to companies. Through loans they change the implicit contract, but they do not necessarily breach it, because the long-term relation continues. This investment behavior can be independent from bank or group relationsips, but it can also be directly related. For example, in autumn 1991, when banks had problems answering the credit needs of big customers, life insurance companies stepped in and increased their loans to these firms. The decision was partly based on group relations: certain banks asked certain life insurers to forward loans on the bank's behalf in order to ensure the market share of the bank". This is where data leave us in the lurch, because we do not know what kind of relationship develops between the firm and the insurer in the process. However, one can assume that even a closer credit relationship, which comes with a decrease in shareholdings, does not change the stance taken by the life insurer vis-a-vis management: life insurers do not forward loans to corporations in order to strengthen ties with the corporation (and intrude in management), but to strengthen ties with the bank that is asking for a favor. In total, there is a strong economic reason for life insurers to be more or less stable, non-intrusive shareholders: an implicit long-term contract that ensures clientele. The contract also implicitly stipulates that the life insurance company is in no position to interfere with management. This makes life insurers a popular candidate for the top shareholder, as it is ensured that the insurer will not intrude. Trust banks Trust banks are a different breed of animal. They are like life insurance companies in that both manage pension funds. The difference, however, is that trust banks actively invest money that belongs to someone else on a short-term basis. They aim at portfolio diversification to minimize risk in order to outdo their competitors (there are seven trust banks in Japan), mainly through indexed investment and the derivative markets100. In so doing, they are, as if by 98 99
See MEYER-OHLE, supra n. 95. NIHON KEIZAI KINYU SHINBUN The Nikkei Financial Daily, July 17, 1991,
at 3. 100 "Indexing" means that institutional investors buy all of the stocks in a stock index (e.g., the Nikkei 225) in order to mimic the market and/or use derivative markets (futures, options) for hedging, arbitrage, or speculation, while minimizing the tracking error with the market. See also LOUIS LOWENSTEIN, What's Wrong with Wall
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definition, not interested in the firms (and their management) that they invest in, and would therefore not strive to interfere with management. On the other hand, trust banks may participate in some grouping, too. This is seen in their connection to city banks, which is mostly, but not necessarily, reflected in the name (e.g. Mitsubishi Bank and Mitsubishi Trust Bank). That is, to the degree that trust banks belong to city banks, they can be involved in some keiretsu setup. Whether or not this implies a voice in corporate management will be discussed in connection with the "main banks". An interesting feature of the trust banks is that they offer a vehicle for other institutional investors to "hide" their investments and break out of implicit, tacit stable shareholding agreements101. That is, a firm can trade shares of a "befriended" company regardless of the fact that they are involved in a longterm stable contract, as long as the firm keeps a minimum number of shares of the other firm. Also, the firm does not appear on the scene, but entrusts the investment to the bank. Therefore, trust banks offer a way out of the reciprocal stable system without undermining the mutual insurance scheme.
Investment funds Investment funds, large as they may be, do not, have an interest in management of individual companies. Like trust banks, they aim at portfolio diversification and short-term returns, based on indexed investment. It is often said that Japanese management tends to aim at long-term rather than short-term business results, which theoretically offers these investors an incentive to intrude. However, even if it were true that companies aim primarily at long-term profits, investment funds would not intrude. If all companies behave similarly, there is no need to change the management system for purposes of fund competition; what is important for the fund is whether a company's stock shows higher shortterm volatility than other stocks. In any event, the investment fund is "impersonal", as it manages mostly the money of, individual investors, and therefore has only little incentive to get involved in day-to-day management decisions. 2. The "Main Bank" The Japanese main bank has been subject to intense research for quite a while. Findings range from its role as a bail-out institution, which economizes on legal and other bail-out costs as known in the U.S., to new explanations with the help Street (Reading, MA 1988), at 3. 101 This comes especially in the form of so-called "tokkin" funds, "special accounts", which allow investors to file short-term trading in stocks separately form long-term holdings in the balance sheet; i.e., stable shares appear at book value, tokkin shares in the current year at market value.
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of agency theory on the issue of economizing on information and monitoring costs102. Some of this research, again, centers on horizontally organized keiretsu, which almost by definition (or rather for historical reasons) have banks in the central positions within their structure. While the monitoring and information cost economizing functions are certainly important, for our analysis of general aspects of corporate governance we propose a different view of the main bank: 1) The main bank is the marginal supplier of funds and the "lender of last resort" in times of crisis, and it is the institution that primarily provides help should a firm get into trouble. 2) The main bank is the one institution that the Ministry of Finance picks for organizing a bail-out if it deems a company in trouble worthy of being bailed out. The main bank is not the one and only bank of a corporation, and it is not necessarily the biggest lender at all times either103. Rather, the main bank more often than not remains in the background, at least for those firms not involved in a horizontal keiretsu; it is the marginal rather than the main supplier of funds104. There is a lot of anecdotal evidence on how "main banks" bail out a company 102 See, for example, MASAHIKO AOKI, Information, Incentives, and Bargaining in the Japanese Economy, at 142 et seq. (Cambridge, 1988); HOSHI et al, supra n. 58, AKIYOSHI HORIUCHI & FRANK PACKER & SHIN'ICHI FUKUDA, "What Role has the "Main Bank" played in Japan?", 2 Journal of the Japanese and International Economies 2, at 159 et seq. (1988); AKIYOSHI HORIUCHI, "Informational Properties of the Japanese Financial System", Japan and the World Economy 1 (1989) 255-278; and PAUL SHEARD, Main Banks and Structural Adjustment in Japan, Australia-Japan Research Center, Research Paper No. 129 (1985). 103 This is probably the biggest difference between Japanese and German main banks. In Germany, under the universal banking system, the main bank is the biggest lender, the main underwriter and syndicate leader for bond and stock issues, the principal organizer of all financial business and, in most cases, it also has a member on the supervisory board (Aufsichtsrat). 104 Other activities of the main bank have been highlighted, for example, its function of the single central settlement organization for a firm. However, this does not necessarily imply a main bank status but reflects economizing on transaction costs: each individual would have, for his/her personal settlement of money transfer, one or a few accounts with one bank, instead of running around and settling one bill here and another one there. This one bank, the "main bank", performs none of the functions we would normally associate with a main bank of a firm. Therefore, the function as the "settlement manager" is not a sufficient condition for being a main bank. This is true for"independent" firms such as Toyota, which distributes business equally over several banks in order not to become dependent on one single bank.
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in trouble105. What remains largely unclear is why the alleged main bank — which, incidentally, is rarely on its own but forms a "bail-out syndicate" — would incur all those costs (at times in the order of magnitude of trillions of Yen) and dispatch an executive manager to the firm with the task of restructuring the organization, if the only thing it can expect is a slight chance that the firm might need a loan in some distant future after its recovery (which, however, bears no relation to the loans written off for the bail-out). There is one anecdotal ground for why, rather than how, banks accept the bail-out plan: the so-called "Tateho-shock" of 1987106. A regional, mediumsized manufacturing firm got into trouble because of unsound speculation on the newly established futures market. Losses amounted to Yen 28.6 billion, not counting fines for tax evasion and other affairs that came to the fore later on. The main bank, Taiyo Kobe, did not want to bail the firm out, as it saw the costs but no future benefit of this action. The Ministry of Finance, at the same time, saw an acute danger that this "shock" would shatter the bond futures market. The president of the main bank was a former high-ranking MOF official who had, while in the Ministry, been responsible for the development and introduction of this very bond futures contract. Taiyo Kobe put together a bail-out team consisting of all banks that the firm had business ties with plus the broker who had reneged on his responsibility to inform his client on the riskiness of speculation on futures. The company is still alive today. Almost every incident of main bank bail-out is understandable only in light of the fact that administrative guidance is at work. Usually only large firms are bailed out; the bail-out takes the form of a government subsidy; and, of course, the taxpayers bear the ultimate financial burden. The main bank function therefore, put harshly, boils down to one of a government "agent" who helps execute official bail-out schemes. The main reason why the bank is willing to perform this function is not that it is in a superior monitoring function, has close business ties or even group responsibility, or that Confucius told Japanese banks to act benevolently but irrationally. It is rather that the bank follows administrative guidance, hoping to get favorable treatment by the Ministry next time it wants to open a branch, introduce a new kind of saving deposit, or, more generally, apply for exemption from one of the innumerable ordinances that rule bank behavior on a daily basis107. 105
See, for example, SHEARD supra n. 82, and BRIAN STEWART, Corporate Insolvency in Japan: Sanko Steamship Co., Ltd., Sophia University Institute of Comparative Culture, Business Series No. 112 (Tokyo 1986). 106 For details, see ULRIKE SCHAEDE, Der neue japanische Kapitalmarkt Finanzfutures in Japan, at 183-190 (Wiesbaden 1990). 107 There is anecdotal evidence how this mechanism works, too. For example, after German reunification in 1990, the four leading Japanese securities firms applied at MOF to be allowed to open branches in Berlin. All but Daiwa Securities were allowed to do so; Daiwa happened to be in big trouble at the time because it had paid out large
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This shows that our two aspects of a main bank -- being the lender of last resort and the one picked by MOF to perform the bail-out role - are in effect the same thing. All other aspects of a main bank are not particular to Japan and can be explained with economic reasoning; unprofitable bail-outs of maturing industries cannot. This in turn shows that there is a corporate stakeholder involved much more important than shareholders, and possibly even more important than the employees: the Ministry of Finance, i.e., the Ministry of the banks108. Our definition of the Japanese main bank leaves room for "independent" firms, which are also likely to have a main bank. Because they are independent, they are careful to disperse business between banks (one for settlement, one as a major bondholder, a few as shareholders, quite a number for loans, etc.). However, suppose Toyota all of a sudden faces bankruptcy. The Ministries (in this case, of International Trade and Industry and of Finance) would decide that the Japanese economy cannot afford to lose its flagship firm. MOF would then designate a bank to orchestrate a restructuring and loan plan. This bank would either be one with historical ties to Toyota, or a neutral one, and would become the main bank. In our definition, therefore, there is no large company in Japan that does not have a main bank. The functions of this bank, however, are much simpler than usually assumed. The main bank system constitutes a form of institutionalized administrative guidance109. The "institutionalization" here comes in the form of (1) a give-andcompensations to customers on stock investment losses (this was before the big compensation scandal of 1991). 108 However, n. that even this is not necessarily an exclusively Japanese feature. When Herstatt Bank in Germany faced bankruptcy in 1974, the governor of the Bundesbank, Karl-Otto Pöhl, decided not to bail out the private bank. Had he decided otherwise, the bank would probably still be alive today. The Bundesbank cleared running international liabilities of the bank after bankruptcy had been declared. Remember also the October 1987 stock market crash, when FED governor Alan Greenspan told banks to expand credit lines of specialists at the New York Stock Exchange so that they had additional funding to buy against the falling market. However, motives here are mostly macro, rather than micro (on the individual firm level) as in Japan. 109 There a many examples of how administrative guidance has been institutionalized in the Japanese economy. The main objective of the institutionalization, i.e. establishing fixed forms and organizations for the implementation of a Ministry's appeals, is to economize on transaction costs, primarily in the form of monitoring the effectiveness of administrative guidance. One example of an "administrative guidance" institution are the so-called securities financing companies, which guide and monitor margin transactions for banks and securities firms, and loans on the basis of securities. The top management of these companies consists of former high-ranking officials from the Bank of Japan, the Ministry of Finance, as well as current directors of large commercial banks and securities firms. See ULRIKE SCHAEDE, "Securities
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take mechanism between the banks and the Ministry of Finance, and (2) the amakudari-mechanism ("descent from heaven" of a government official on retirement to, among other places, the board of directors of a private firm, here: a bank). Concerning corporate governance, this means that a "main bank" (or the group of major banks of a firm) perform monitoring and other functions not necessarily in order to pursue corporate governance on a day-to-day basis. Rather, the bank stands ready to perform a main bank function in times of crisis, with the ultimate aim of gaining favorable treatment by the ministry. The activities of Japanese banks concerning "good customer relations" can be divided into two categories: (1) on a daily basis, long-term monitoring facilitates and expedites decisions on whether to forward further loans to a firm, and helps assess inherent risks (a universal strategy of banks), and (2) it reduces the time costs, should a bail-out be required, in deciding whether following the Ministry's advice would be too costly. In sum, neither corporations nor financial institutions nor the main banks are active corporate governors in our understanding of the word. The "insurance" bought through cross-shareholdings covers three areas: (a) capital market insulation, (b) implicit bail-out mechanism in times of corporate crisis, and (c) non-intrusion into management. With this we do not say that there is no corporate governance in Japan - it has to be somewhere, unless we resort to culture to explain management behavior. One possibility is internal governance, as reflected in a powerful board of directors. If we do not find it there, then some decisive portion of power must lie in the hand of some stakeholder. C. Management If institutional investors do not engage in "corporate governance" in the U.S. sense of the word, then management organization becomes particularly important. The question is whether there are certain structural features of Japanese management that provide for mechanisms of control and monitoring within the firm, rendering outside governance superfluous. Is there an internal corporate governance system at work that accounts for the superb business results of Japanese firms? In the early 1980s, only 316 firms or 1.14% had capital of more than Yen 1 billion, and 0.16% were owner-type firms with few shareholders and the owner holding the biggest part of outstanding equity himself10. While there are still Financing in Japan," in Handbook of Japanese Capital Markets (Shinji Takagi, ed., London, forthcoming), and ULRIKE SCHAEDE, supra n. 27. 110 AKITOSHI IKI & TATSUO KIMURA, Nihon kigyo dokuhon (Textbook: Japanese Corporations), at 82 (Tokyo 1990). On the organization of the board see also NIHON KEIZAI SHIMBUN-SHA (ed.), Keiei nyumon (Introduction to Management) (Tokyo 1990).
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some owner-type firms among the largest (mostly now in their second generation, such as Toyota), most firms listed on the TSE have as their president a "salaryman-type", i.e., employed manager, executive. The Japanese board structure is closer to the U.S. model than to the German. There is a board of directors, headed by the president (shacho),who for all intents and purposes is the equivalent to the CEO in the U.S.. Together with the vice-president(s) and a group of senior or executive managing directors, he forms the "executive group" (jomukai), a subgroup of the board which is a more or less unofficial group for making important decisions. The board in total consists of the executive group plus a group of directors plus advisers and auditors. The board has a chairman (kaicho), whose functions vary, among other things, according to his background and personality, but are mostly representative. One of the distinctive features is the almost non-existence of outside directors; in 1988, 43.5% of manufacturing companies listed on the Tokyo Stock Exchange did not have an outside director on the board111. 1. The Board of Directors The current setup and function of the board can best be understood through its historical development. Before WWII, large companies were either owner-type firms (with no board) or, more importantly, zaibatsu-related firms with a strict hierarchical order and a holding family which owned the group and made final decisions. After the War, the U.S. occupational forces "democratized" the holding structures by stipulating that the board should not be an assembly of "capital" (owners), but of representatives of the interests of the firm, i.e., employees. This had two effects. First, directors came to be chosen from among the employees; second, the distinction between decision-making and executive functions within the board became blurred112. The semi-official institution of the "executive group" within the board may be a response to this confusion of director functions. Directors are, on average, 58.2 years old; 37% are in the age bracket 55-59, followed by 22% in the bracket 60-64, and 30% in the bracket 50-54. In 1990, the number of board members of the top 100 firms averaged at 30.7, with a mode of 37 and a range from 8 to 56113. The same 100 firms had a total of 2737 111
ROBERT J. BALLON & I WAO TOMITA, The Financial Behavior of Japanese Corporations, at 185 (Tokyo 1988). The definition of "outside", however, is problematic, as the term usually includes directors who come form affiliated or parent firms; see below. 112 Id. at 184 et seq. 113 HIROTAKA TAKEUCHI, The Japanese system of corporate governance: Will Stakeholders Remain Silent?, Working Paper, Hitotsubashi University, December 1991. The sample of the 100 firms was complied according to a list of the "Top 100 Best-Managed Firms in Japan" by Nihon Keizai Shinbun, which is based on four
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"regular directors", of which 56 (or 2%) were outside directors; only 19 of the 100 firms had an outside director on their boards. Table 5 shows a comparison of Japanese and American boards of directors as compiled by Kaplan114; there are considerably more directors on the Japanese boards, but with a striking absence of outside directors. In 1985, the 1793 listed companies plus 23 life insurance companies had a total of 31,268 directors, of whom 21,728 (69%) held a university degree. Of these, 12,312 or 56.5% graduated from one of the top 5 universities115 . Because Japanese universities do not provide for specialized education, these executives learned their skills after they joined the company upon graduation, and "rotated" through the firm, from one department to the other, thereby steadily climbing the corporate ladder. On their way they left behind most of their school colleagues, mostly on the kacho (section chief) level, because of skills hard to define, such as "loyalty, devotion, sincerity" and "motivation"116. One can assume that they display the same qualities that are in high demand in Western countries, such as abilities to decide, organize, improve on current structures and manage personnel. The promotion from chief manager (bucho) to director most often takes place one of two ways. A questionnaire among the leading Japanese firms in 1989 showed that in 37% of all firms, top management compiled a list with the names of the most respected chief managers, among whom the new director(s) came to be elected, either by the board or (in 5% of all cases) by all employees. 31% answered that the president decides who is promoted to the director level, and in 28% the president and the chairman decide together. That is, in 59% of all companies represented in this questionnaire, top management decided on promotion directly, and in all companies remaining, it did so indirectly117. variables: size, growth rate, leverage and profitability. IM STEVEN N. KAPLAN, Internal Corporate Governance in Japan and the U.S.: Differences in Activity and Horizons, Working Paper November 1991. Kaplan's research is based on data of the early 1980s. There was a so-called "inflation of directors" in the late 1980s, when the old group of presidents, born before the Showa period (i.e., before 1925) retired and a new generation of directors and presidents took over; at the same time, new positions on the boards were created. Kaplan's figures for Japan are therefore slightly lower as they would read today, but relations seem to be still valid. 115 These are three state universities (Tokyo, Kyoto and Hitotsubashi University) and two private universities (Keio and Waseda University). Out of 21,728, 5004 managers held a degree from Tokyo University. See IKI/KIMURA, supra n. 110, at 87-88. 116 Id. at 89. 117 NIKKEI, supra n. 74, at 178. The election system comes in various forms. It seems to be primarily aimed at avoiding a loss of face on the side of those chief managers who are not promoted. If top management decides, the situation is ugly. If
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The "inflation of directors", their increase in number in the 1980s, as if following an economic principle, reflects their role in the decision-making process, which is close to zero. In general, the board does not discuss issues, but agrees to whatever the president decides. Board meetings are even characterized as "a formality... a ceremony in which the minutes are 'conducted'...a 'consensus machine' ""8. Decisions are not made by the board, but by the executive group. This group then proposes a plan (answers included) and directors agree ex post119. Why would directors give in to playing such a low-key role? The major reason seems to be that they have had their share of work, responsibility and decision-making one step before becoming a director, at the chief manager (bucho) level. This is the level within the company where proposals from the bottom are decided upon, proposals to the top are forwarded, decisions on a day-to-day basis are made, and speeches to be held by top managers are written. It is the "central processing unit", so to say, of the company, where ideas from the bottom are translated into changes in production and where demands from the top are satisfied. The reward for being an efficient and effective chief manager with innumerable overtime hours is promotion to the board. Once the chief manager becomes a director, there is not that much to do any more; the major benefit of the promotion, next to monetary, is that the hardship of being a middle manager is over. Grateful as they are for the recognition of their hard work, and knowing that the company has been this way since they joined it, they give in to the role of tacit approver of top decisions. The chairman of the board typically does not play a major role. He often is the ex-president of the firm; in 1990, the ex-president was on the board either as chairman or as advisor in 57 of the top 100 firms (cf. Table 5). A questionnaire by Nikkei in 1989 showed that the functions of the chairman are primarily seen in (1) advice to and guardianship of the president, (2) external affairs vis-a-vis the business community, and (3) selection of top management (personnel affairs). Whether or not the chairman can influence corporate decisions depends on his personality and his prior role within the company rather than on his position as chairman. This is also true of auditors and advisors, who do a lot of things except there is an election, the situation is still ugly, but not as obviously. When all employees elect, the president usually is the only one who knows the results and has veto power. He will most likely not need it, however, because he himself made up the list of candidates in the first place. 118 NIKKEI, supra n. 74, at 180. 119 A good example is the merger between Mitsui Bank and Taiyo Kobe Bank (the result is now Sakura Bank) in 1989. Shortly before the press release, the president of Mitsui announced the merger in a board meeting and the directors agreed, after the fact, unanimously. Only 5 or 6 board members, the members of the executive group, had known about the plans before the fact. See NIKKEI, supra n. 74, at 180.
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auditing. To be sure, the law grants auditors some power and authority, but (or because of this) auditors more often than not are "inside", i.e. long-time servants of the company. Together with the advisors and retired top executives (or founders), they are members of the so-called "Old Boy (OB)" group, which is highly influential in shaping decisions, although not necessarily through official channels. OBs come in two forms, either in company positions such as auditor or advisor, or as unknowns who "rule" as "shadow shoguns" behind the scenes120. This arrangement might become a thing of the past, as the introduction of real outside auditors is now being discussed, and the classical OBs, founders or owners from prewar years, have become rare. However, considerable changes will most likely not become evident before the turn of the century. 2. How to Become a President in Japan In 1990, a total of 86.5% of the presidents of the largest 287 Japanese companies were promoted through the ranks; 15.2% were relatives of the founder, and 30.3% were assigned from the parent or an affiliated company (as such they are labelled "outside")121. Inside presidents on average have been with their company for 34.3 years and are 62.2 years old when they become president. One term typically lasts two to three years and presidents customarily stay in office for two terms; that is, a president is in office for five to six years, after which time he either retires or becomes a board member122. Although the term of a president is rather short, the pursuit of long-term corporate strategies covering ten or more years is possible, because his 120
A good example of this later category are former founder-owners as Matsushita Konosuke or Honda Soichiro, who after retirement still exerted influence on board decisions (or CEO decisions). These founder-owners often exhibited strong entrepreneurial spirits and had considerable influence in shaping Japanese management practices. For example, one story has it that Matsushita Electric planned major layoffs in the wake of the oil crisis in 1974 (which was after the formal retirement of the founder). Matsushita Konosuke stepped in and urged management rather to incur losses than lay off what he called "the treasure of the company" (see NIKKEI supra n. 74 at 14). The Japanese employment system could look differently today without this piece of advice. 121 TAKEUCHI, supra n. 114, at 9. 122 KAPLAN (supra n. 115) observes through regression analysis that Japanese firms react faster on corporate performance in turnover of top executives; he finds an average of 6.34 years in office for presidents and chairmen, which is shorter than the average U.S. term. He then finds a correlation to stock performance and income measures and concludes that Japanese firms react faster to these measures and therefore have a higher turnover. An alternative explanation for turnover and length of terms is that Japanese top executives retire voluntarily after some 6 years in office. It also looks as if they did not care that much about the stock market.
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achievements are evaluated in the long-run perspective: if he builds the basis for future success, this is an achievement, even if there are no immediate results123. More importantly, perhaps, the president can assure that long-term strategies are continued in a successful manner, because he typically designates his successor himself. In answering the question, "Who determines the next president?", out of 759 presidents, 69.6% answered "myself, 11.9% said it was decided by the parent company (i.e., the top manager there), 7.8% assigned this task to the board of directors (which might be a nice way of saying "myself), and 4.4% said the chairman and the OBs (advisors, ex-presidents, founders); 3.7% said that shareholders would decide124. The right to decide on personnel in fact makes the president "almighty"125. In Western eyes, this can only lead to inefficiencies of the worst kind. That it does not in Japan is a function partly of custom — all presidents stay in office for some six years (no one can afford to stay much longer) and the president is loyal to his company, otherwise he would not have been promoted to the director level in the first place — and partly of the influence of the OBs, the former executives and current "shadow shoguns"126. The president basically runs a "one man-show" and is not monitored by the board. He is, however, subject (if not slave) to "advice" by the OBs. The OBs in turn are part of in an OB-network consisting of former high-ranking officials in private industry and, more importantly, government institutions. The OBs are often former highranking ministerial bureaucrats who joined the firm through amakudari and then turned OB to provide a useful network to all kinds of institutions. On top of all his rights, the president shoulders only little responsibility. The work usually associated with the position of president is performed by chief managers127. This means that even if the board turned active, it would matter 123
NIKKEI, supra n. 74, at 14. Id. at 169. 125 Id. at 172. 126 It is highly unusual that a president is fired, but there is one great exception in Japanese business history. In 1982, the president of Mitsukoshi department store, one of the biggest and the most traditional of its kind, was fired by a board decision, mainly because of fraud. It is said that newspaper campaigns were decisive in influencing board members, who otherwise would not have turned against their president. See NIKKEI, supra n. 74, at 170 et seq. There are also instances where the OBs veto presidential decision. In 1969, when the presidents of Mitsubishi Bank and Taiyo Kobe Bank (the one that merged with Mitsui in 1989) agreed to merge and set out to have their boards agree, the OBs suddenly jumped in and formed and "anti-group" which succeeded in letting the plan die (see NIKKEI, supra n. 74, at 180). 127 N. that large founder firms might well be different. Not only do they pay greater attention to successors, but they also tend to be more international. Sony, for example, has two non-Japanese directors on its board, who are not used to tacit agreement. 124
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only insofar as the board could give chief managers new directives. More importantly, however, chief managers, have at some point in their careers been dispatched to affiliated or befriended firms. These very firms are likely to be shareholders, and could at times be interested in influencing the firm. If so, they would not use the board of directors, but would first try the route through the upper layer of middle management. This is easy because there is a good chance that managers know each other through having worked in the same department for a while. Corporate governance at the highest level, if at all, is neither conducted through the board nor the shareholders' meeting either. Both are sufficiently irrelevant not to worry about. Instead, it might be exercised on the golf course - presidents might be graduates of the same university, as they are likely to come from one out of five major schools, possibly even the same year; they may also know each other from old days when they were chief managers. In addition, they meet regularly in their institutionalized interest group, the Keidanren (Federation of Economic Organizations; major business organization), where they cooperate and exchange views on corporate policies. Data on board constellation or shareholder composition do not tell whether or not outside influence is exerted. Indeed, it looks as if the whole concept of "corporate governance", as we discuss it in terms of "owners", "shareholders" or "rights" did not help to fully analyze Japan. D. Corporate Stakeholders In checking the Japanese corporate governance system, we have found evidence of corporate governance in the U.S. sense of the word neither in the form of external governance ~ through cross-shareholdings, main banks or financial institutions — nor in the form of internal governance - through a strong board of directors. Instead, we have seen implicit contracts with "non-intrusion" clauses between institutional investors, and intercorporate personal relations on chief manager, top manager, and "old boy" levels. The most outspoken form of corporate governance seems to come from the OBs. One further factor we have not mentioned up to now is market competition. There is strong competition between firms (and industrial groups) within Japan, but international competition seems to be an important factor, too. Table 4 shows that the most profitable Japanese corporations are those that are world leaders in their industries. Moreover, founder firms such as Toyota, Matsushita, or Honda are also well-known for their "open-mindedness"128. 128 For example, Honda Soichiro is quoted as having answered the question of who is going to be the next president of his firm after his own retirement in the following way: "The successor is elected from among the employees. If there is no suitable person among them, among the shareholders. If there is no one there, among the
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An even more important factor with respect to corporate governance, however, seems to be stakeholder influence. Stakeholders are those groups who affect, and/or are affected by, the achievements of a company, as brought about by top management129. We identify as major groups of stakeholders in Japan consumers, shareholders, employees and bureaucrats. Among these, consumers exert influence through the market; i.e., are a factor of market competition. 1. Employees and Shareholders In a 1990 Nikkei questionnaire, 100 Japanese presidents were asked to whom the firm should belong and to whom it actually belonged (n=55; up to 3 answers). 87.3% answered that shareholders were most important, followed by employees (80%), society (69.1%), customers (30.9%) and managers (7.3%). In reality, they thought, it belonged to employees (89.1%), shareholders (80.0%), customers (36.4) and managers (29.1%). Asked what they attached importance to in their daily management, the presidents answered "profit accumulation" (38.2%), "contribution to society" (23.6%), the "welfare of workers" (16.4%) and, lagging far behind, "return to shareholders" (3.6%)130. Given that the company supposedly belongs to the employees, it is surprising that among the 3069 board members of the 100 best-managed Japanese firms in 1990, none was a union representative131. What is meant by "most important stakeholder" here is not necessarily what we read in these words. Due to the management practices of lifetime employment and on-the-job training, as stipulated in implicit contracts with permanent employees, human capital is not just one form of capital, but the most important and probably most capitalintensive capital factor of a firm. It also has added value; human capital is seen as a value creator132. However, this does not mean that the interests of employees influence management decisions. Rather, "employees" enter the management decision function simply as one cost factor albeit an important one. Japanese. If there is no one there, among foreigners" (NIKKEI, supra n. 74, at 176). Incidentally, Honda Motors was praised as one of the best-managed Japanese companies by the Nikkei Industrial Newspaper in 1990. One could argue that the most "international" firms, which happen to be primarily vertical, outdo other Japanese firms exactly because they have been exposed to more competition, international on top of domestic. This would substantiate the notion that a firm's qualities (and that of its managers) is primarily a function of competition on the market place rather than internal or secondary factors, such as the capital market. 129 R. EDWARD FREEMAN, Strategic Management: A Stakeholders Approval, at 46, (Boston, 1984). 130 TAKEUCHI, supra n. 113, at 3 et seq.. 131 We cannot help adding with some German sarcasm that this might be one of the reasons why they are best-managed. 132 NIKKEI, supra n. 74, at 14.
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This means that in times of crisis there are no lay-offs, and it is the shareholders who have to bear the burden: a decline in stock prices is preferred to a major reshuffle in personnel structure. Shareholders simply do not count when it comes to management decisions. As we have seen, institutional investors tend not to intrude on management except in cases of crisis. Individual shareholders do not count either, for two major reasons: (1) the shareholders meeting is a farce, and (2) individual shareholding accounts for some 22% of total shareholding, that is, most of the equity outstanding that is not in stable hands. Given that some 50-60% are in stable hands, it does not matter whether or not individual investors decide to sell their stock if they do not like management. In contrast to the U.S., where a decline in stock prices and a subsequent sell-out of a company's equity is seen as a direct reflection and the most important signal of the quality of management, in Japan the stock price is only one, and a secondary, indicator of corporate quality. Rather, it is the number of employees and the tangible assets such as land which count under the long-term investment perspective. The neglect of individual investors is reflected in low dividend payouts133. Here, again, it is interesting that the most profitable, vertically organized firms tend to pay higher dividends; one can surmise that they do so because they need individual shareholders more than horizontally organized firms do. One reason why firms do not care more for this group of investors can be found in the history of the Japanese stock market and the history of economic thought. For a long time, "growth mentality" dictated that surplus money had to be made available to big business for the sake of the nation (not the shareholder). In addition, the stock market was not the major vehicle for channelling funds from the saving to the investing sector of the economy. That is, if money was made available to companies through the capital market, it was not done primarily for the sake of high investor returns134. Employees as well as shareholders do not have a pronounced effect on the management of their firm. They are stakeholders, but not necessarily everpresent in the minds of the managers. In contrast, ministerial bureaucrats and retired officials seem to play a more important role in corporate Japan than any other group of stakeholders. 133 In the 1980s, average dividend payouts in percent of profits were 38.6% in Japan and 50.1% in the U.S.. Firms such as Toyota and Matsushita paid out some 20% of profits, in contrast to the roughly 40% distributed by General Motors and General Electric; see NIKKEI, supra n. 74, at 15. 134 The reason why this worked in the "period of rapid economic growth" (19501975) is that interest rates were regulated and kept artificially low, so that the low dividend payout did not imply considerable forgone return on investment. On stakeholders, "growth" as a corporate aim and shareholder value maximization as a corporate objective see also W. CARL KESTER, Japanese Takeovers - The Global Contest for Corporate Control, at 75-80 (Boston, 1991).
654
Harald Baum/Ulrike Schaede
2. Bureaucrats As we have seen, the regulatory framework for corporate governance in Japan is critically affected by the existence of administrative guidance. Furthermore, the typical president of a Japanese firm is guided less by the board of directors or institutional investors, than by "advice" by "Old Boys" who more often than not are former government employees. Bureaucrats thus become stakeholders of the Japanese firm: during their career in the ministry, they cooperate with the firm in order to have corporate decisions formulated which are in line with government interests. On retirement the ministry, the heavyweights among the bureaucrats, through amakudari, join a firm and contribute directly the formulation of corporate policies. While occupying a seat on the board, typically as a director, auditor or advisor, they are interlinked in a network of old colleagues and acquaintances at other firms. Table 6 shows board positions occupied by amakudari bureaucrats in major Japanese banks. Current total figures are unknown, but there was an annual average recruitment of 154 bureaucrats into industry between 1963 and 1972l35. Bureaucrats are stakeholders because (a) they affect corporate policy through their intervention either as active or ex-bureaucrats, and (b) they are affected by corporate achievements in their ministerial career path and later employment opportunities. The influence they exert on a firm is hardly quantifiable, just as the affect on future business results of a firm 's decision to comply or not to comply with ministerial guidance is not quantifiable. However, given the importance of administrative guidance to business regulation on the one hand, and the high number of amakudari board members on the other, it is safe to assume that bureaucrats constitute the most decisive factor in shaping the day-today decisions of corporate Japan.
V. Conclusions In this paper, we have pursued questions of shape, scope, determination and relevance of corporate governance by taking the Japanese perspective. Concerning the legal framework, the important factor is the relevance of administrative guidance in the process of day-to-day corporate decision-making as well as in the long-term strategies of Japanese firms. On the level of external governance through institutional investors, one would expect to find relevant governance factors, given the high degree of cross-shareholdings in Japan. 135
CHALMERS JOHNSON, "The Reemployment of Retired Goverment Bureaucrats in Japanese Big Business," Asian Survey 14 (November 1974) 953 et seq., at 955.
Institutional Investors and Corporate Governance in Japan
655
However, there are no clear patterns in profitability, number of shareholders and form of organizations either in horizontally or in vertically organized firms and industrial groups. Further, cross-shareholdings are based on an implicit contract with a "non-intrusion" clause, which means that institutional investors waive their governance rights as owners of the firm. In terms of internal governance, there is no evidence of governance in the U.S. sense of the word either. Neither the shareholders nor the board of directors are in a position substantially to influence management. However, the personnel exchanges between firms have a strong effect on the cooperation between chief managers of affiliated firms. Moreover, and more importantly, the president of a firm is subject to guidance through a special group within corporate Japan: the network of "Old Boys", advisors who are either founders, owners and former presidents or former bureaucrats. These are "old buddies" who know each other well and meet regularly within and across industries. Among stakeholders the bureaucrats, through administrative guidance and the amakudari mechanism, seem to play the most important role. This leads to three general conclusions on corporate governance in Japan: 1) Corporate governance and influence through institutional investors are a function neither of anti-monopoly and other legislation nor of industrial organization in horizontal or vertical groups. 2) The influence of institutional investors or other stakeholders is not readily quantifiable -- whether an institution owns x% or y% of outstanding equity does not determine its influence on management. 3) Japan's economic strength cannot be explained by reference to a particular form of corporate governance. The most important influence on corporate management takes place through a mechanism combining administrative and personal guidance, the roots, functions and mechanisms of which are based on an intricate combination of power and efficiency structures within (a) the firms and (b) firms and ministerial bureaucrats. A discussion which aims at a U.S. - Japan comparison of corporate governance in order to explain differences in corporate performance has to begin with the fact that the term "corporate governance" in Japan includes a special group of stakeholders - the bureaucrats - which are not part of the U.S. model. In order to make consistent equations and reach general solutions, we need to broaden the definition of corporate governance and of the stakeholder group. The corporate governance model as we currently use it is too narrow to offer universal solutions: neither institutional investors nor mechanisms of internal governance nor the usual set of stakeholders can fully explain Japanese corporate reality.
656 Table I:
Harald Baum/Ulrike Schaede Shareholdings by Groups of Investors, Japan, 1988-1990 Source: Zenkoku Shföken-torihikisho kyogikai (ed.) Kabushiki bunpujökyo chösa 1990 (in %)
1988 number of listed companies government/regional public institutions financial institutions - commercial banks - trust banks - life insurance companies - other insurance companies - other financial institutions corporations securities firms individuals foreigners
1989
1990
1978
2031
2079
0.7
0.7
0.6
45.6 16.3
45.2 16.4
9.9
46.0 16.4 10.3
13.1
13.1
13.2
4.2
4.1
4.1
9.8
2.1
2.1
1.8
24.9
24.8
2.5 22.4
2.0 22.6
25.2 1.7 23.1
4.0
3.9
4.2
Institutional Investors and Corporate Governance in Japan Table 2:
life insurance companies*
tokkin trusts fund trusts equity investment funds bond investment funds
657
Assets and Asset Allocation by Major Institutional Investors as of June/July 1990 Source: The Nikko Monthly Bulletin, December 1990, p.3-13 (in trillion Yen, %)
% in foreign % in bonds total assets % in stocks (in ¥ trillion) securities 21.4 7.8 15.3 121.33
11.22
36.8
23.0
10.7
26.61 42.42
36.4 46.7
14.9 14.4
10.1 2.4
10.37
0
61.5
11.6
*46.6% of total assets was allocated in securities, 36.1% in loans.
Harald Baum/Ulrike Schaede
658 Table 3:
The Top 20 Manufacturing Companies, 1991/92 Shareholders and Affiliations Sources: Shukan Toyokeizai special issue 5/30/1992, Kigy keiretsu söran 1992
of total number labelled "affiliated of shareholders with" (round lots) horizontal keiretsu 80437 Mitsui Toyota Motor* (loosely)
name company
Matsushita* Electric Industrial Hitachi Ltd.* Toshiba Corp.* Fuji Photo Film* Nintendo Co.*
170 608 Sumitomo 328 358 none 451 108 Mitsui 20724 Mitsui
6514 none
Mitsubishi Electric Mitsubishi Heavy Industries Shimizu Corp. Sony Corp.* Kajima Corp.
231 798 Mitsubishi
Nissan Motor NEC Corp. Taisei Corp.* Kirin Brewery Fujitsu
113 834 119 633 120 679 111 975 185 402
Nippon Steel*
542 551 none
361 370 Sumitomo
45771 Mitsubishi 208 060 Mitsui 42206 Sumitomo Fuyo Mitsubishi Fuyo Mitsubishi Fuyo
biggest (%)
shareholder
Sanwa Bank (4.98) Taiyo Mitsui Kobe Bank (4.98) Tokai Bank (4.98) Sumitomo Bank (4.66) Nippon Life (3.87) Dai Ichi Life (4.14) Mitsui Trust (7.38) Yamauchi (11.49) Mitsuibishi Bank (4.52) Mitsubishi (7.03)
Hiroshi Trust Trust
Shimizu Estate (7.6%) Raykay Co. (5.38) Sumitomo Bank (4.74) Dai Ichi Life (5.73) Sumitomo Life (6.78) Chiyoda Life (4.49) Meiji Life (4.86) Fuji Electric Co. (13.50) Mitsubishi Trust Bank (4.72)
Institutional Investors and Corporate Governance in Japan Sekisui House*
29863 none
Mitsubishi Corp. Mitsubishi Estate
43860 Mitsubishi 86985 Mitsubishi
659
Sekisui Chemicals (21.53) Tokyo Marine&Fire (6.09) Mitsubishi Trust Bank (8.95)
The table excludes NTT (which is still partly government-owned) and utilities (which are subject to special regulation). = proposed to be "independent" from a horizontal keiretsu in our paper
660 Table 4:
Harald Baum/Ulrike Schaede Test of Top 50 Manufacturing Firnis according to Propositions Sources: Kigyo keiretsu soran 1992, Shukan Töyö keizai 5/1992
prop.l:
keiretsu definiti on
prop. 2:
influenc e on manage ment
shareho Ider dispersi on
no. of rankbanks firm that own dependency more (* = no than 4% horizontal (a) affiliation)
no. of (a) with more than 10% of total debt of the firm
no. of banks among the top 10 stockholders
no. of insuranc e compani es among the top 10 stockholders
top 10 shareholders share in total equity
top 20 shareholders share in total equity
3
0
6
3
35.66
n.a.
1
0
5
4
26.96
n.a.
0
0
6
3
25.48
38.02
0
0
4
4
25.80
37.23
2
0
7
1
39.05
53.14
6
0
8
0
55.49
68.29
1
1
5
4
29.51
42.99
1
1
53
4
25.67
35.45
1
1
5
1
33.27
44.84
l)Toyota Motor* 2)Matsushi ta Electric Industrial* 3)Hitachi Ltd.* 4)Toshiba Corp.* 5)Fuji Photo Film * 6)Nintend Co.*# 7)Mitsubis hi Electric 8)Mitsubis hi Heavy Industries 9)Shimizu Corp.
Institutional Investors and Corporate Governance in Japan 10)Sony Corp.* ll)Kajima Corp. 12)Nissan Motor 13)NEC Corp. 14)Taisei Construct! on* 15)Kirin Brewery 16)Fujitsu, Ltd. 17)Nippon Steel* 18)Sekisui House* # 19)Mitsubi shi Corp. 20)Mitsubi shi Estate 21)ItoYokado* 22)Daiwa House Industry 23)Honda Motor 24)Bridges tone 25)Matsus hita Electric Works*# 26)Nippon denso*# 27)Sumito mo Corp.
661
2
0
81
0
32.59
n.a.
1
1
7
2
31.55
44.79
2
2
5
4
32.81
48.25
2
2
4
4
36.10
45.52
0
0
73
2
26.51
37.49
1
1
6
3
26.08
35.57
1
1
6
3
38.41
n.a.
1
0
6
4
23.97
n.a.
17
1
7
2
44.78
54.85
3
1
5
4
42.02
57.90
2
2
2
3
36.81
48.02
0
0
3
4
38.78
n.a.
4
1
6
3
38.01
51.74
2
1
7
3
33.64
48.50
1
1
54
2
37.12
n.a.
1
0
4
3
56.58
n.a.
2
0
5
2
61.10
n.a.
2
05
5
2
35.05
47.80
662 28)Takeda Chemi-cal Industries * 29)Canon Inc.* 30)Dai Nippon Printing* 31)Sharp Corp.* 32)Fanuc Ltd.* # 33)Asahi Chemi-cal Industry 34)Obayas hi Corp. 35)Nippon Oil* 36)Kumag ai Gumi* 37)Toyo Seikan 38)SevenEleven Japan * # 39)Tokyo Steel 40)Yamano uchi Pharmaceut ical 41)Marui 42)Toppan Printing* 43)Mitsui Real Estate 44)Asahi Glass* 45)Kyocer a Corp.*
Harald Baum/Ulrike Schaede
1
0
73
2
37.56
48.81
1
0
6l
3
33.00
45.46
2
0
8
2
34.43
43.77
3
3
5
5
37.64
55.74
0
0
63
1
54.56
58.88
1
1
3
7
34.78
50.18
1
0
6
1
37.92
47.01
0
0
83
1
26.50
39.58
0
0
4
1
39.30
47.56
2
1
5
1
44.20
61.64
0
0
6
2
66.10
n.a.
0
0
4
0
44.87
59.34
2
2
8
2
35.73
47.79
2 1
2 0
5 7
4 2
32.02
46.79
37.19
n.a.
2
2
5
4
27.71
38.91
2
0
4
4
44.85
57.02
2
0
8
0
33.51
47.34
Institutional Investors and Corporate Governance in Japan 46)Kawasa ki Steel 47)Taisho Pharmaceutical *# 48) Mitsui Co. 49) Sankyo Co.* 50) Mitsuibishi Motors
663
2
2
4l
5
31.95
46.15
2
0
5
0
58.89
68.07
1
1
6
4
31.82
n.a.
2
26
83
1
35.48
47.53
1
1
3
2
60.72
68.85
* = independent firms according to proposition 1 #
=
founder firm or affiliate/subsidiary with high stockholding ratio
corporate/private
1 = six of these are trust banks 2
= the No.l stockholder is Mitsubishi Trust Bank (7.03%), the largest debtholder is Mitsubishi Bank (16.37%)
3 = five of these are trust banks 4
= the founder family, Ishibashi, holds 6.48% and 9.94% are held by the Ishibashi Foundation
5 = Sumitomo Bank and Sumitomo Trust Bank hold together 10.95% of equity and 15% of debts. " = the two banks are from different horizontal groups (Dai-Ichi Kangy_ and Mitsui), the firm does not belong to either = the largest shareholder is Sekisui Chemicals with 21.53%
664
Harald Baum/Ulrike Schaede
Table 5:
Board of Directors and Top Management in Japan and the U.S. Source: Kaplan 1992 (average for 119 Japanese and 146 U.S. companies)
Japan number of directors number of inside directors number of outside directors % of firms with outside directors number of representative directors % of presidents who become chairman after retirement % of presidents who remain on board, but not as chariman, after retirement
USA
22.41 21.63
14.79 4.83
0.78
9.96
34.5%
100%
4.23
n.a.
67.5%
15%
13.2%
62.8%
Chapter Twenty-Three Institutional Investors and Corporate Governance in Japan Zenichi Shishido I. Introduction In this article, I consider the situation of institutional investors and corporate governance in Japan in the 1970's and 1980's by comparing it with that in the United States in the same era. In these two decades, philosophies of corporate governance in both countries — market oriented monitoring in the United States and organization oriented monitoring in Japan — were created and preserved in almost pure form. In other words, distinct differences between the two systems appeared. The topic of this symposium, "Institutional Investors and Corporate Governance," is, of course, along the lines of the principal-agent framework,1 which is based on the Berle & Means theory of separation between ownership and control.2 Shareholders, the owners of the corporation, are forced to have an agent for managing the corporation. Shareholders, as principals, will inevitably bear the agency costs of monitoring management. As monitors of the management of large publicly held corporations, independent directors first appeared in the United States. People noticed that the "independence" from management is fragile, however, and became skeptical of the monitoring function of independent directors. Next, Americans believed in hostile takeovers, or monitoring by the market. The 1980's was the decade of hostile takeovers in the United States. Numerous huge takeovers were concluded, and the equity capital market and the control market appeared to be combined. Theoretically, inefficient management will be replaced by hostile takeovers and a business society with many hostile takeovers will be efficient. The United States during the 1980's, however, was not a good 1
See, e.g., MICHAEL C. JENSEN & WILLIAM H. MECKLING, "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure," 3 J. Fin. Econ. 305 (1976). 2 ADOLF A. BERLE & GARDINER C. MEANS, The Modern Corporation and Private Property (1932).
666
Zenichi Shishido
period for American business. On the other hand, Japan, which has experienced almost no hostile takeovers, appeared to be a very successful business society. Many negative side effects of hostile takeovers on American business have been pointed out.3 Experts now express doubt as to the future of hostile takeovers.4 After the hostile takeover fever had passed, the hot issue in the United States became institutional investors as monitors. In this context, the Japanese main bank system catches the attention of American scholars as an example of successfully "internalizing the market for corporate control."5 I have to point out, however, that very few Japanese can understand the meaning of this topic and the meaning of the principal-agent problem itself. First, I will try to explain Japanese institutional investors and the related monitoring system along the lines of the discussion above, and next, try to reorganize and generalize the Japanese corporate governance system apart from the framework of Berle & Means. The Article proceeds in six parts. Part Two provides an overview of the general characteristics of institutional investors in Japan and a survey of each category of institutional investor. Part Three explains the mechanism, history, and problems of cross-share holding, which is the core of the keiretsu system and the indispensable point we need to understand the Japanese monitoring system. Part Four provides an image of the Japanese corporate system to explain the reason why equity-oriented monitors are weak. Part Five proposes a framework to generalize monitoring systems in different countries. Part Six concludes that the difference between Japanese and American monitoring systems is not fundamental but relative, and we need to reconsider corporate governance without preconceived notions. Part Six also provides some reports on current changes in the Japanese system and some predictions of future changes.
Π. Institutional Investors in Japan A. General Characteristics There are three problems in describing the Japanese monitoring system by focusing on institutional investors. First, there are few institutional investors within the original meaning of the term. Second, almost every monitor in Japan 3
ZENICHI SHISHIDO, "Corporate Takeovers in Japan," Japan Security Research Institute, Capital Markets and Financial Services in Japan, 129, 130 (1992). 4 RONALD J. GILSON & REINIER KRAAKMAN, "Reinventing the Outside Director: An Agenda For Institutional Investors," 43 Stan. L. Rev. 863, 871 (1991) [hereinafter GILSON & KRAAKMAN, Outside director]. 5 PAUL SHEARD, "The Main Bank System and Corporate Monitoring and Control in Japan," 117. Econ. Behav. & Org. 339, 407 (1989).
Institutional Investors and Corporate Governance in Japan
667
is equity oriented and non-equity oriented at the same time. Third, equity oriented monitors are relatively weak. 1. Definition of Institutional Investors There is no clear definition of institutional investors yet. Even the Institutional Investor Project at the Columbia University School of Law does not define the term directly, but simply just requires a situation in which "money is being professionally — or institutionally —managed," and identifies seven principal categories of institutional investors: private pension funds; state and local retirement funds; mutual funds; life insurance companies; property and casualty insurance companies; non-pension fund money managed by banks; and foundation and endowment funds.6 The image of institutional investors may be of various types of collective share holding for which professional fund managers try to make optimal portfolio investments. If so, however, there are few real institutional investors in Japan. Even banks and insurance companies generally never sell the stock they own. It would be more appropriate to call banks and insurance companies "corporate investors" or "inside shareholders" with other business partners. To continue this discussion, I have to use a very broad definition of institutional investors "non-individual investors", which includes not only collective share holdings but also corporate investors. It should also be noted here that Japanese institutional investors are not as influential as their American counterparts (Chart I).7 2. Categories of Monitors and the "Total Transaction" The concept of a monitor is not the same in every country. As I already mentioned, in the United States, the primary discussion is whether monitoring should be market oriented (hostile takeovers) or not directly market oriented (independent directors, institutional investors). It seems to be accepted as a matter of course in the United States that monitors are equity oriented, because equity holders are the principal monitors of management. In Japan, however, there are two categories of monitors: equity oriented and non-equity oriented (Table I).8 As I will discuss below, the latter have played a more important role 6
Institutional Investor Project, Columbia University School Of Law, Institutional Investors and Capital Markets: 1991 Update 1 (1991). 7 TSUSHO SANGYO SHO SANGYO SEISAKU KYOKU (Ministry of International Trade and Industry, Division of Industrial Policy), Nichibei No Kigyo Kodo Hikaku (A Comparative Study of Activities of Enterprises in Japan and the United States), at 37 (1989). 8 RONALD J. GILSON & REINIER KRAAKMAN categorize monitoring systems into three types: bank centered monitoring (Germany); exchange centered monitoring
668
Zenichi Shishido
than the former. Another important distinction between Japanese monitors .and American monitors is that most corporate investors in Japan have a dual status: they are equity holders and trading partners. Therefore, it is not easy to determine whether their monitoring function derives from their status as equity holders or as trading partners. Such a situation is often called the "total transaction."9 3. Weak Equity Oriented Monitors Equity oriented monitors have been relatively weak in Japan. There are several reasons for this: (1) The monitoring by main banks has also been working for the interest of shareholders to some degree;10 (2) Corporate shareholders have been compensated for the low return on equity holdings through other benefits, either from long term business transactions or cross share holding (total transactions); (3) Legal restrictions on participation in the equity market have prevented institutional investors from being influential on corporate governance. Equity holding by most institutional investors other than banks and nonfinancial businesses, such as insurance companies, pension funds and mutual funds, are restricted either by laws or governmental releases; and (4) no shareholder has been necessary to complain to management as long as the stock market is always going up. B. Characteristics of Institutional Investors 1. Banks Although Japanese banks can own no more than five percent of the equity of a company,11 their relatively weak bargaining leverage as shareholders is offset by cross share holdings. On the other hand, bank loans have been the most important source of corporate financing. Therefore, Japanese banks are thought to monitor as creditors rather than as shareholders.12 The main bank system has played the most important role in the Japanese (Japan); and investor centered monitoring (U.S.). See RONALD J. GILSON & REINIER KRAAKMAN, Investment Companies as Guardian Shareholders: The Place of the MSIC in the Corporate Governance Debate, supra ch. 8, [hereinafter GILSON & KRAAKMAN, Investment Companies]. 9 See infra text accompanying n. 19-22. 10 See infra text accompanying 13. 11 Antimonopoly Law art. 11. 12 In the point of equity control, the German house bank system is different from the Japanese main bank system. In Germany, three major banks control more than 40 percent of all outstanding stock. See GILSON & KRAAKMAN, Outside Director, supra n. 4, at 878.
Institutional Investors and Corporate Governance in Japan
669
monitoring system. A main bank, which holds the largest share of a company's loans and equity among banks, will take responsibility for monitoring the company. In case of financial distress, the main bank is expected to rescue the company by sending directors or providing additional loans. Other banks and even shareholders can utilize the monitoring by the main bank. Overall monitoring costs can be saved.13 2. Nonfinancial Businesses Nonfinancial businesses own stock mostly for cross share holding purposes. That is the reason why their portfolios contain many bank stocks. In 1991, the share of stocks of financial institutions in the portfolios of nonfmancial businesses was 42 percent.14 Such businesses usually own stock as stable shareholders without raising a voice to management. Recently, however, they also began to buy stock in part as a genuine investment, so their turnover rate is a bit higher than that of financial institutions. 3. Insurance Companies Insurance companies can own no more than ten percent of the equity of a company, and total stock holdings of an insurance company are restricted to thirty percent of its total assets.15 Life insurance companies could be more equity oriented monitors than banks because most life insurance companies are not corporations but mutual companies. They do not find it necessary to keep stable shareholders, but still have transactions with the corporation, such as taking pension funds, selling insurance, or making loans, which would work as hostages.16 The interest of life insurance companies in holding stock is different from that of other corporate investors. Life insurance companies invest in stock in order to earn dividends rather than to secure capital gains. Although corporate stockholders in general do not need to pay tax on dividends received from other corporations, banks and nonfmancial businesses have little interest in increasing dividend income, because the gain from receiving dividends from their cross 13
See YOSHINORI SHIMIZU, "Ninon no Kinyu, Shihon Shijoh no Tokushusei to Jouhou" (The Uniqueness of the Japanese Financial and Capital Market and Information), 37-3 Bijinesu Rebyu (Business Review) 1, 5 (1990). 14 HIDETAKA KAWAKTTA, "Kigyozaimu o Mushibamu 141 Chyoen no Kabushiki Mochiai" (Cross Share Holding Amount to 141 Trillion Yen and Unstable Corporate Financing), 1992. 10. 12. Kinyu Zaisei Jijo (Banking & Financial Policy) 40, 41 [hereinafter KAWAKTTA, Mochiai]. 15 Antimonopoly Law art. 11; Hoken Gyouho Sekou Kisoku (Operating Regulations of Insurance Industry Law) art. 19. 16 See infra text accompanying n. 19.
670
Zenichi Shishido
share holding partners will be offset by the dividends they themselves pay. Life insurance companies, on the other hand, do not need to pay dividends and must retain capital gains as quasi-capital. Therefore, life insurance companies have been demanding increased dividends. Japanese life insurance companies provide loans to corporations directly rather than through banks. They are considered to have the ability to monitor. This distinguishes them from their American or German counterparts. Unlike life insurance companies, most casualty insurance companies are publicly held corporations, and, like banks, they own stock mainly for cross share holding purposes. The fact that they invest heavily in the stocks of petroleum, transportation, and electric companies, which are major customers of insurance business, shows that they approach investment decisions with an eye to more than simple investment gains. 4. Pension Funds
No pension fund can work as an independent monitor because it must be managed either by life insurance companies or by trust banks. No more than thirty percent of a pension fund's investment may be in equities, for safety purposes.17 The share of outstanding stock owned by pension funds was only one percent in 1990. Because of these regulations, pension funds have not become influential institutional investors in Japan. 5. Mutual Funds
The only genuine equity oriented institutional investors in Japan may be mutual funds. Although mutual funds became popular during the first stock market boom in the early 1960's, with their share of stock ownership once amounting to almost 10 percent, they have not regained popularity since the shaken ßikyo (securities recession).18 Their share of stock ownership was 3.7 percent in 1990. They actively trade stock and have a strong influence on market price. They have, however, neither the ability nor the intent to serve as monitors.
17
Okura Shou Ginko Kyoku Tsutatsu (Release by Ministry of Finance, Banking Department) no.906. 18 See also infra text accompanying n. 28.
Institutional Investors and Corporate Governance in Japan
671
m. Rationality of Cross Share Holding and Total Transactions A. Mechanism of Cross Share Holding
One of the major distinguishing characteristics of Japanese institutional investors is that they take and serve as "hostages" with respect to other institutional investors, usually in two ways: cross share holding and business transactions. A very important term used to describe this situation is mochiai. In a narrow sense, mochiai simply means cross share holding for defensive purposes. In a broad sense, however, mochiai also means stable share holding in the context of total transactions, which include both equity transactions and business transactions.19 Keiretsu is the network of such total transactions based on long term give-and-take relationships. 1. Defensive Effect
Cross share holding is a very effective pre-offer defensive tactic against hostile takeovers. Consider a simple case: Company A and Company B own each other's stock. If Company A sells the stock of Company B, Company B would also sell the stock of Company A. Then Company A will also be vulnerable to hostile takeovers unless Company A finds a new cross share holding partner. There are also more complex cross share holding matrices. For example, Company A holds the stock of Company B, Company B holds the stock of Company C, and Company C holds the stock of Company A. 2. Business Advantages
In many cases, cross share holding works to preserve long-term business relationships. When Company A would like to sell the stock of Company B, Company A must take into consideration the consequences of losing business with Company B. Because of these hostage effects, inside shareholders (financial institutions and other corporations) usually neither speak up nor retreat,20 as long as the total net gain of equity holdings, including defensive effects and business advantages, remains positive. In addition to the agency theory, another American oriented framework used to analyze business systems is markets and hierarchies (firms).21 The Japanese business system can hardly be explained, however, by a simple two-tier markets and hierarchies model. We need a four-tier model: (1) corporate community, a 19
See KAWAKITA, Mochiai, supra n. 14, at 40. See infra text accompanying n. 43-44. 21 See OLIVER E. WILLIAMSON, Markets and Hierarchies (1975). 20
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Zenichi Shishido
firm in a narrow sense; (2) business organization, a firm in a broad sense; (3) organized market; and (4) free market (Chart 2).22 An important characteristic of the keiretsu system is the mutual interaction between equity transactions and business transactions. In other words, the image of markets and hierarchies is different in the United States and Japan. In the United States, markets (free markets) and hierarchies (business organizations) are clearly divided. On the other hand, in Japan the border between markets and hierarchies is ambiguous, and organized markets play an important role. Just as a business enterprise can be operated like a market, so can a market be operated like an enterprise. B. History of Cross Share Holding Chart 3 shows the historical change in ownership of stocks traded on securities exchanges.23 The post-war history of the Japanese equity market and of cross share holding can be divided into three eras: (1) from the re-opening of stock exchanges in 1949 until the shaken ßikyo (securities recession) around 1965; (2) from 1965 until the opening of the capital market for foreign capital in the early 1970's; and (3) from the early 1970's until the present.24 1. Creating Mochiai by Zaibatsu Group For about ten years after World War II, even in Japan the equity capital market and corporate control market were connected. Zaibatsu conglomerates, which had dominated the Japanese pre-war economy, were liquidated and the stocks which they had owned were sold to individual investors from 1947 to 1951. In 1949, the share of individual investors, whose turnover rate was quite high, amounted to almost 70 percent.25 In fact, hostile takeover attempts were not rare in this period.26 When stock exchanges were re-opened in 1949, many individual equity holders tried to sell their stocks, and markets declined. The Bank of Japan demanded that banks and life insurance companies buy stocks to sustain the stock market. Deregulation of antitrust restrictions on stock holdings by banks and nonfmancial businesses in 1949 and 1953 also encouraged cross share 22
See infra Chart 5. ZENKOKU SHOKEN TORIHIKISHO KYOUGIKAI (Round Table of National Stock Exchanges), Kabushiki Bunpu Joukyou Chousa (Survey of Stock Ownership Distribution) (1992). 24 KAWAKITA, Mochiai, supra n. 14, at 41. 25 HIDETAKA KAWAKITA, "Kabushikishijo no Kozo to sono Henka" (The Structure of Equity Markets and its Changes), 1992-8 Nissei Kiso Kenkyusho Chosa Gappo 3, 6 [hereinafter KAWAKITA, Kabushikishijo]. 26 Id. at 7. 23
Institutional Investors and Corporate Governance in Japan
673
holding by banks and nonfinancial businesses in the former zaibatsu groups. Available data demonstrate that the first stage of mochiai was in place until around 1958.27 2. Reinforcing Mochiai for Opening the Capital Market From 1955 until 1961, the Nikkei Dow rose 29 percent per year. From 1961 until 1965, conversely, it declined 14 percent per year. This period of decline is called the shaken fitkyo (securities recession). The symbolic event which happened in the last stage of the shaken fukyo was the financial crisis of Yamaichi Securities Company, which is one of the big four securities firms in Japan, and the loan provided by the Bank of Japan to rescue Yamaichi.28 Important events in the history of mochiai during the shokenßikyo include the creation of Nihon Kyodo Shaken (Japan Cooperative Securities Co.) by the banking industry in 1964 and the creation of Nihon Shaken Hoyu Kumiai (Japan Securities Holding Partnership) by the securities industry in 1965. Both bought and held stocks to sustain market price, and were partly funded by the Bank of Japan. From 1966, the stocks owned by the two organizations were sold to banks, life insurance companies and nonfinancial businesses which did business with the issuing companies. This stock selling to "stable shareholders" reinforced mochiai, which continued until the early 1970's.29 Liberalization of the market for foreign capital in this period provided incentives to stabilize share holding. In 1964, Japan acceded to the International Monetary Fund's (IMF) article 8, which prohibits exchange restrictions, and joined the Organization for Economic Cooperation and Development (OECD), which, in principle, prohibits restrictions on direct foreign investment. The Japanese Government was forced to liberalize its policy on foreign capital investments and gradually opened the market from 1967 to 1975. In 1971,. regulation on takeover bids was also implemented in the Securities Exchange Act. Japanese industry felt the threat of hostile takeover by foreign capital.30 3. Increasing Share of Financial Institutions Before 1969, most equity financing was made to current shareholders at par value, which was usually far below the market price. Such equity financing did not change the share of equity holding. From the early 1970's, however, equity financing by public offering at market price began to prevail in the Japanese capital market, which increased the share of equity holding by corporate 27 28
Id. at 7.
Id. at 9-15. 29 Id. at 14-17. 30 Id. at 16.
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investors, especially financial institutions.31 From 1985, banks themselves began to undertake aggressive equity financing to meet capital adequacy requirements established by the Bank for International Settlements (BIS).32 Most newly issued bank stocks were bought by mochiai companies. Therefore, equity financing by banks in this period induced more equity financing by nonfmancial businesses, and banks were forced to buy their stocks. The increase in stock prices from 1986 to 1989 was huge. In four years, from the end of 1985 to the end of 1989, the Nikkei Dow tripled. The average return on investment in Japanese stock from 1985 to 1989 was 30.2 percent per year. Even in the long run, the Japanese stock market has been a good market. The average return on investment from 1952 to 1989 was 20.2 percent per year.33 There was a myth among Japanese investors that stock prices would always rise at least in the long run. The myth, however, has now been exploded. The Nikkei Dow began to retreat in the beginning of 1990, and dropped 59.6 percent by the end of June 1992.34 Mochiai is pointed out as one of the reasons for such rapid increase and retreat of the Japanese stock market.35
C. Problems and Rationalizations of Cross Share Holding
Two major problems related to cross share holding have been long pointed out. The first is a corporate financing point. The criticism is that cross share holding provides no substantial financing effect, and therefore, that the mochiai portion of stated capital is artificial. A counter argument is that cross share holding has real financing effect because the company which first issues stock can use the money until another company issues its stock, and the timing of stock issuance is determined on the basis of the cash demands of each company.36 The second problem with cross share holding is a corporate governance point. The criticism is that mochiai stock is always voted pro management; in other words, that cross share holding is just like exchanging treasury stock, which strengthens management control too much. A counter argument is that cross share holding is, like going-private transactions, such as leveraged buyouts and management buyouts in the United States, an attempt to resolve "the central weakness of the public corporation — the conflict between owners and managers 31
Id. Id. 33 Id. 34 Id. 32
35
at 17-18. at 20. at 22. at 22.
See KAWAKTTA, Mochiai, supra n. 14, at 43. KUNIO ΓΓΟΗ, TAKASHI MISUMI, & TOYOHIKO ICHIMURA, "Kabushiki Mochiai no Rasenkei" (Spiral Shift of Logic of Interlocking Shareholdings in Japan), 37-3 Bijinesu Rebyu (Business Review) 15, 27 (1990). 36
Institutional Investors and Corporate Governance in Japan
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over the control and use of corporate resources,"37 and successfully avoids management being put into the principal-agent relationship.38
FV. Corporate Community and Weak Equity Oriented Monitors More equity oriented monitors are at work in the United States than in Japan. The relatively low cost of equity capital in Japan is often cited as evidence of this (Chart 4).39 It is impossible to neglect the Japanese business system, especially the existence of "corporate communities", in explaining the reason for this effect (Chart 5).40 When we speak of corporate governance, we refer to the ownermanagement(principal-agent) relationship. Of course, the owners of the corporation are shareholders. In Japan, however, most people seem to act as though that were not the case. Most Japanese people consider employees to be the owners of the corporation, although some of them do not consider this situation to be ideal. Employees, board members and management compose the core of the corporate organization (corporate community).41 They are the real insiders, who identify themselves with the corporation and who often have access to important information about the company. Even in Japan, a quarter of the board members of publicly held corporations are outside directors, who are not ex-employees (Chart 6).42 Japanese corporation law also provides for specialized monitors called kansayaku (auditors). In most cases, however, outside directors and auditors have been nominal monitors. Most auditors are ex-employees, which means members of the corporate community. Outside directors usually consider saying something against the policy decided by other management to be interference in another business community. Roughly 60% of the outstanding stock of a Japanese publicly held corporation is owned by "stable shareholders." Of this, 30% is owned by cross share holding partners and the other 30% is owned by insurance companies and trust 37
MICHAEL C. JENSEN, "Eclipse of the Public Corporation," Harvard Business Review, September-October 1989, 61. 38 ΠΌ, MISUMI, & ICHIMURA, supra n. 36, at 32-33. 39 R. MCCAULEY & S. ZIMMER, "Shihon Costo no Kokusai HikakiT (Comparative Cost of Equity Capital in the World), 92-3 Shoken Analyst Jahnal (Securities Analysts Journal) 16 (1992). 40 See Shishido, supra n. 3, at 132-35. See also supra Chart 2. 41 Managements of Japanese corporations are elected among board members by the board of directors. See Commercial Code art.261. 42 Toyokeizai" (East Asian Economics), Kigyo Keiretsu Soran '92 (Survey of Keiretsu 1992), at 90.
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banks. Only one-third of outstanding stock is actively traded on exchanges.43 We can divide shareholders into two categories: inside shareholders and outside shareholders. Inside shareholders are stable shareholders, who would never sell the stock they own, so they have little liquidity. They are also trading partners of the corporation and members of the corporate organization in the broad sense (business organization). Institutional investors like banks, insurance companies, and cross share holding partners are inside shareholders, which share some inside information. Outside shareholders are individuals, foreigners and mutual funds, which have a high share turnover rate (high liquidity). They are not part of the corporate organization, but are in the free market zone. They do not generally have access to inside information. Table 2 shows the different share turnover rate of each sector.44 The low turnover rate of inside shareholders and the high turnover rate of outside shareholders appear clearly. Corporate communities (management and employees) of most publicly held corporations in Japan have succeeded in obtaining stable management control. They not only stabilize a majority of outstanding stock by way of cross share holding among inside shareholders, but also ensure that no single unit financial institutions, corporations, or individuals — has a majority (Table 3).45 In the United States, the corporation is sometimes thought of as a nexus of contracts.46 Jensen and Meckling say, "The firm is not an individual...the 'behavior1 of the firm is like the behavior of a market". They clearly deny the personality of the corporation.47 Such a concept of the corporation would never lead to sentimental obstacles to hostile takeovers. In other words, a corporation is a good to be owned. In Japan, however, the firm is an individual which has a personality, and is never considered a good to be sold and bought. In Japan, hostile takeovers are out of the question not only because of the existence of cross share holding but also because of the "corporate community." Different concepts of the corporation in the United States and Japan lead to different situations in the market for corporate control in the two countries. V. The Compound Vector of Monitoring 43
See infra n.s 44-45 and accompanying text. NISSEI TOUSHI KENKYUKAI (Japan Life Insurance Workshop on Investment), Senryakuteki Shouken Toushi (Tactical Stock Investments), at 85 (1989). 45 ZENKOKU SHOKEN TORIHIKISHO KYOUGIKAI (Round Table of National Stock Exchanges), Kabushiki Bunpu Joukyou Chousa (Survey of Stock Ownership Distribution) (1992). 46 See JENSEN AND MECKLING, supra n. 1, at 310-11; FRANK H. EASTERBROOK & DANIEL R. FISCHEL, The Economic Structure of Corporate Law, at 14 (1991). 47 JENSEN & MECKLING, supra n. 1, at 311. 44
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The image of the monitoring system as a whole is the sum of the vectors of pressure by all stakeholders (Chart 7). Every stakeholder (shareholders, banks, trading partners, employees, etc.) will try to put pressure on the management to run the corporation in its best interest. "[M]onitoring is not a neutral phenomenon; all monitors have characteristic biases."48 The directions of the vectors are not opposite, but are different. The length of each vector is decided by the bargaining leverage of the stakeholder and the persuasiveness of its proposals. Management tries to balance the interests of the stakeholders and run the corporation in the direction which the compound vector indicates.49 Fortunately, from the 1950's until the 1980's, Japanese stakeholders have shared the same interest in the growth of companies. The vectors of pressure by all stakeholders are headed in the same direction. Monitors will watch management by gathering either published or inside information, and may demand something like a change in management, and, if necessary, threatening retaliatory measures. An effective monitor will have enough incentive to monitor, which may be the result of less liquidity,50 enough bargaining leverage, which is the result of both scarce resources and the legal system and enough persuasiveness, which comes from the ability to gather and analyze information. Japanese banks have the qualifications to be efficient monitors: (1) enough incentive to monitor because of loans, equity holding, and social responsibility as main banks; (2) enough bargaining power mainly because of their power to reject applications for bank loans; and (3) enough ability to persuade management, because of information they have not only of the company, but also of the related industry. Every stakeholder, not only shareholders, will monitor management in its own interest to make sure the company is managed efficiently. Although each stakeholder will monitor management from a different perspective, the essential parts of the monitoring overlap each other. Therefore, some stakeholders may be able to free-ride on the monitoring performed by other stakeholders.
48
JOHN C. COFFEE, "Liquidity versus Control: The Institutional Investor as Corporate Monitor," 91 Colum. L. Rev. 1277, 1336 (1991). 49 See MASAHIKO AOKI, "A Model of the Firm as a Stockholder-Employee Cooperative Game," 70 American Economic Review 600 (1980). 50 COFFEE, supra n. 48, at 1281.
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VI. Conclusion: The Japanese System Will Be Changed The Japanese monitoring and corporate governance system may not be easy to understand. The difficulty arises mainly from American perspectives on the corporate system, such as the principal-agent framework, markets and hierarchies, and the nexus of contracts. Without these perspectives and with a framework of the compound vector of monitoring, we can view different corporate governance systems relatively, and can understand the rationalities of each system. Although the main focus of this article is on institutional investors and corporate governance in Japan in the 1970's and 1980's, I will try here to provide a short sketch of current changes in the system and some predictions for the future. Some of the premises of the Japanese system have recently collapsed: (1) The significance of bank loans in corporate financing has declined and the monitoring effect of the main banks has become weaker because of the availability of other capital markets and the capital adequacy requirements imposed by the Bank for International Settlements (BIS); (2) The collapse and huge retreat of the Tokyo Stock Market since 1990 has made shareholders vocal toward management because they can no longer expect high capital gains; (3) The total net gain from stable equity holding turned negative in some circumstances, such as cross share holding or share holding by insurance companies, even calculating the benefit from business transactions; and (4) Stakeholders have different interests in stock holding because of the end of the growth period of the Japanese economy. Therefore, the Japanese monitoring system is expected to change: (1) Generally, shareholders will be more vocal, especially in demanding higher ROI; (2) Financial institutions, and insurance companies in particular, will be more like real institutional investors, which are portfolio oriented and buy and sell stock on short terms; (3) Cross share holding will collapse because it does not pay and because banks will be forced to restrict equity holding, which is not profitable, by BIS capital adequacy requirements; and (4) Even hostile takeovers will occur. To sum up, corporate governance and the monitoring system, including the role of institutional investors, in the United States and Japan in the 1970's and 1980's were both historically contingent.51 The difference is not fundamental but relative. In the United States, the market for corporate control, which has created too much friction, will be replaced by much more organized ways of monitoring. In Japan, shareholders will need to have their own monitors after losing the shared interest in corporate growth.
51
See MARK J. ROE, "A Political Theory of American Corporate Finance," 91 Colum. L. Rev. 10 (1991).
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Institutional Investors and Corporate Governance in Japan Chart 1. Who is the Largest SH ?
Nonfinancial Bus. (Trading Partners) Others
Japan
0%
Financial Institutions (Trading Partners)
20%
40%
80%
Table 1. Two Categories of Monitors Equity-Oriented Monitors (from direct to indirect ways): - Hostile Takeovers - Institutional Investors (pension funds, mutual funds, insurance, etc.) - Outside directors Non-Equity Oriented Monitors: -Banks - Employees - Governments
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Zenichi Shishido
Chart 2. Double-Structured Markets & Hierarchies A-Model
corporate community Mgmt. + SH business organization
&
J-Model
[Mgmt. + EE] [Mgmt. + EE] + inside SH Main Bank Business Partner^
monopoly Joint Ventures cartel Franchises Product Markets (keiretsu)· ι-assembler - suppliers l-maker - dealers organized market Capital Markets •Corporate SH •Bank Labor Markets Product Markets
Product Markets Consumer •International
free market Capital Markets
Capital Markets [-Individual SH '•International
Institutional Investors and Corporate Governance in Japan
681
Chart 3. Stock-Ownership Distribution
70 τ 60
Individuals Financial Institutions
50 ·· 40 ·· 30 ··
Nonfinancial Businesses
20 ·· 10 ---)
r^ T
-T--
1950 52 55 58 60 62 65 68 70 72 75 78 80 82 85 88 90
Zenichi Shishido
682
Chart 4. Cost of Equity Capital Earnings after Tax
Cost of Equity Capital =
Stock Price (substantial)
U.K.
1977
78
79
U.S.
Germany ·
80
81
82
Japan
\
1
1
l·-
83
84
85
86
87
Institutional Investors and Corporate Governance in Japan
683
Chart 5. The Image of the J-Corp.
Control Market
Labor Market
"Business Organization"
"Corporate Community".
Organized Capital Market
EE
Organized Product Market
Bank
Capital Market Outside SH Bond Holders
Product Market Consumers Int'l
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Zenichi Shishido
Chart 6. Outside Directors in Japanese PubUcly Held Co.
39.482 (2.086) 37.699 (2.037) 36.211 (1.995) 34.203. (1.933) 33.012 Num. of Dir. (1.898) (Num. of Co.) ^
0
Outside Directors (Non ex-EEs) 1990
Trading Houses Ministries 11 %
Non Bus. 62
Institutional Investors and Corporate Governance in Japan
Table 2. Share Turnover E U
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