Ownership Structure, Legal Protections

and Corporate Governance

I.J. Alexander DyckAssociate Professor

Harvard Business SchoolBoston, MA 02163

adyck@hbs.edu

April, 2000

**Comments Welcome **

Abstract

This paper surveys the issues and devises an analytical framework for policy makers andpolicy advisors concerned with corporate governance. The framework takes a functionalapproach, identifying six functions provided by a governance system. The paperhighlights the possibilities and limits to governance reform through the adoption of legalprotections and the use of ownership structure. I caution against excessive emphasis onlegal rules themselves, demonstrating their insufficiency to provide the functions ofgovernance. Instead, I first emphasize the importance of effective legal protections thatrequire complementary governance institutions including political structure, the locationof judicial authority, norms, and information/reputation intermediaries. Second, I drawattention to ownership structure, reviewing theoretical and empirical support for thebeneficial effect of identity and concentration on the functions of corporate governance inthe absence of effective legal protections. A review of the evidence from established andnewly privatized firms reinforces these contentions. The paper concludes with four broadagenda items for both reformers and future research.

Parts of this paper draw heavily on Dyck (2000), “Privatization and Corporate Governance: Principles,Evidence and Future Challenges.” For helpful discussions, I thank Harry Broadman, David Ellerman,Avner Greif, Roumeen Islam, Carl Kester, Rafael LaPorta, Jay Lorsch, Thomas McCraw, David Moss,John Nellis, Katharina Pistor, Julio Rotemberg, Bruce Scott, Mary Shirley, Joseph Stiglitz, Philip Wellonsand seminar participants at the Harvard Business School and the World Bank. All errors that remain are myown. I am grateful to the World Bank and the Division of Research of Harvard Business School for theirsupport.

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Corporate governance systems increasingly are a focus of concern for policy

makers. Liberalization, deregulation and privatization policies have shifted decision-

making responsibility from government to private sector actors. Experience has shown

that the effectiveness of corporate governance mechanisms cannot be taken for granted.

Many investments in firms by suppliers, labor, management and financiers are not

exchanged simultaneously with payments but with a promise of future returns. Both the

explicit and implicit terms of such promises are routinely violated.

Russian firms provide vivid illustrations of ‘grabbing hands’ of insiders in private

firms as they violate promises made to almost all investors. As one example, Black,

Kraakman and Tarassova (1999) report that following the privatization of Yukos Oil, one

of the largest Russian oil companies, the controlling shareholder “skimmed over 30 cents

per dollar of revenue, while stiffing his workers on wages, defaulting on tax payments ...,

destroying the value of minority shares ..., and not reinvesting in Russia’s run-down oil

fields, which badly needed new investment.” Nellis (1998) reports such concerns echoing

across the transition economies leaving even countries with much better starting points,

such as the Czech republic, in precarious situations. As one foreign investor trumpeted in

a full page ad in the New York Times, “think twice before you invest in the Czech

Republic. Otherwise, you could be left to ‘twist in the wind.’”1 Firms have been

‘tunneled out,’ left with debts, disenchanted workers and investors, and great difficulty in

raising capital to fund future investment projects. Johnson, LaPorta, Lopez-de-Silanes

(2000) report that tunneling activities do not stop here, being widespread in developed as

well as developing economies.

A revealing summary measure of the strength of private ‘grabbing hands’ is

offered by measurements of the difference in the share prices of voting and non voting

shares within a country. Where such shares bring the same legal right to cash flows one

would think that the shares would trade at close to the same value. In most of the world

this simply isn’t true. Voting rights bring power, including the power to grab and divert

returns. The weaker a country’s protection of minority shareholders rights, the more the

market estimates that power is worth, with just a 5 percent difference in the US, a 13

1 New York Times, Monday November 8, 1999. Numerous other papers provide illustrative anecdotes from Weiss andNitikin (1999) for the Czech republic to Djankov (1999) more generally for the transition economies.

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percent gap in the UK, 45 percent in Israel, 32 to 54 percent in Korea, 82 percent in Italy,

and even higher percentages in the Czech republic and Russia. 2

Comparing the value the market places on comparable assets across countries

provides another indicator of ‘grabbing hands,’ both private and public. For example,

Black et. al (1999) report that in May 1999, Yukos oil’s market value was just $90

million while it was estimated to be ‘worth’ $50 billion based on its assets (556 times

less), Gazprom was valued at just $20 billion while it was ‘worth’ $600 billion (30 times

less). While one can argue with the specifics of these estimates, the magnitude of the

discounts suggest the real financial costs associated with governance weaknesses.

More important than the redistribution of returns from promised channels is the

dynamic implication of the violation of promises - a reluctance to invest in firms that

have valuable investment projects. Laborers are reluctant to invest in training specific to

their firms out of fear that they will not get future payments to compensate for these

specific investments. Suppliers are reluctant to provide trade credit. Managers with good

reputations and ability are reluctant to work in many firms fearing that they will not be

able to demonstrate their ability to manage. Financiers are reluctant to provide capital

out of fear that they will never get anything back but the paper given in exchange for the

investment. Weak corporate governance limits investments in corporations with resulting

difficulties for growth and development

What steps can public and private decision makers take to promote promise

fulfillment and in so doing foster investment in corporations? Research going under the

title corporate governance provides insights and evidence. I do not offer a

comprehensive survey of this literature. Excellent surveys are already available (e.g.

Shleifer and Vishny (1997), Berglof and Von Thadden (1999)). Instead, this paper tries

to contribute by focusing on the role of national legal protections and ownership structure

in corporate governance systems. These variables have been the focus of much recent

work, most notably in a series of papers by LaPorta, Lopez-deSilanes, Shleifer and

2 These results, reported in Macey (1998), are based on Lease, McConnell and Mikkelson (1983) for the US,Megginson (1990) for the UK, Levy (1982) for Israel, and Zingales (1994) for Italy. The Korean discount is presentedin Kim (1996) and cited in Pistor and Wellons (1999).

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Vishny (hereafter LLSV) summarized in LLSV (1999a), and the findings have stimulated

academic and policy interest. I will argue that such work has often been misunderstood.

The paper’s principal contribution is to offer a framework to think about corporate

governance rooted in a functional approach. This framework captures the channels

through which ownership structure and legal protections affect firm and national

performance. The argument is that for ownership structure and legal protections to affect

investments they have to influence beliefs about promise fulfillment. Legal protections

deserve a position of prominence because the presence of effective legal protections

provides minority shareholders power when there are competing claims over the wealth

generated by the firm and lowers the cost of dispute resolution. With effective legal

protections, shareholders can be anonymous and diversified, the cost of funding

investment projects is low, and promising investment projects are funded.

The functional framing cautions against excessive focus on legal protections. The

goal of corporate governance reform is not to create specific legal rules, but to lower the

cost of providing the functions of corporate governance to foster investments in firms. A

review of the literature suggests that legal protections are not sufficient to provide these

functions. To change beliefs about promise fulfillment, legal protections need to be

complemented by additional corporate governance institutions that provide information

and manage incentives. Recognizing and understanding the specific institutions that

complement legal protections and the nature of this complementarity is argued to be an

important element of policy formation.

The functional approach also cautions against universal recommendations for

corporate governance policies. A review of the literature on ownership structure suggests

that it can be beneficial to not embrace the ‘efficient’ ownership structure of anonymous

small diversified shareholders common to the US, UK and economic theory. When legal

protections are ineffective, ownership identity and concentration can provide the

functions of a corporate governance system and enhance promise fulfillment. Identity

and concentration provide information, manage incentives and lower the costs of

resolving competing claims on the wealth generated by the firm. At a minimum, the

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evidence on ownership structures suggests corporate governance recommendations

should be defined relative to the state of existing legal protections.

The second and third sections of the paper put more empirical flesh onto this

theoretical form by reviewing notable empirical contributions on legal protections,

ownership concentration and performance. This data provides international benchmarks

of corporate governance institutions. Comparing national governance infrastructure

against these benchmarks is a starting point for policy actions. These studies suggest the

significant potential gains associated with improvements in legal rights and

complementary infrastructure. Privatization evidence confirms and reinforces these

findings from established publicly-traded firms. Privatization experiences from transition

economies provide perhaps the most compelling evidence of the value of aligning

ownership structures with the state of existing legal protections.

The fourth section offers policy implications and areas for future research. There

is great potential to improve corporate governance through reforms in governance

institutions and policies. There is also ample opportunity to make things worse by not

properly interpreting the lessons from existing studies. This section suggests four broad

agenda items and a prioritization for both reform and future research.

The focus on corporate governance is the papers’ strength and a weakness, for

effective governance is not a sufficient condition to maximize social welfare. With

effective governance, investors are willing to invest resources in corporations and

deadweight losses are avoided. But effective governance does not create new investment

projects. As Berglof and Von Thadden (1999) caution, this lack is perhaps a greater

problem in developing economies than weaknesses in governance. And without effective

competition and regulation, even perfectly governed privatized firms will not produce

social welfare. It is therefore important to simultaneously consider competition reform

and regulation and there interaction with governance mechanisms. Such a task is beyond

the scope of this paper.

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1 A Framework

Do investor protections and ownership structure matter for firm and national

performance? Thinking about a corporate governance system provides an intellectual

framework to understand the paths through which these variables operate.

1.1 A corporate governance system

There are different ways to approach corporate governance policy. An

institutional approach takes existing institutions as given – for example the bank-centered

governance systems of Germany and Japan - and asks how these institutions could

produce the services they offer more effectively. In contrast, Caves (1989) characterizes

the modern analytical economic approach that “is treated by its practitioners as institution

free, exposing the consequences of fundamental human motives and technological

opportunities unclouded by any detritus of law, culture, language, custom or history.”3 It

ignores institutional factors and concentrates solely on the functions of governance. A

functional approach differs from both of these. It takes the functions of governance as

given and asks how different institutional arrangements address these functions.

This paper takes a functional approach. A functional approach does not presume

that there is only one institutional way to address governance concerns. It forces an

examination of the range of institutions and policies involved in governance, a range that

is much greater than that suggested by the institutional perspective. It is well suited to

understand the possibilities for reform.

When talking about corporate governance it is helpful to keep the transaction we

have in mind in constant view. The transaction at the heart of corporate governance is an

investment in a corporation that is not simultaneously met with payment but with a

promise of the distribution of future returns. There is a separation between the quid and

the quo.4 I use the term promise deliberately to suggest factors in addition to contracts.

With any investment transaction there are natural limits to the ability to completely

specify actions under all future contingencies. In addition, the terms of the initial

3 Quotation drawn from Khanna (2000) based on Caves (1989), p. 1226.4 I borrow this phrase from Greif (1997) who emphasizes the importance of this difference in his analysis of medievaltrade.

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contract may themselves be violated. When making the investment, the investor therefore

calculates expected returns based not only based on specific terms in a contract, but on

the expected outcome from inevitable competing claims on the wealth generated by the

firm.

A corporation can be identified with many such transactions. Financiers

investments are obviously corporate governance transactions - payment is by definition

delayed. But we also need to think about other corporate governance transactions.

Laborers, when asked to invest in skills of use only to a particular firm rather than in

general skill formation and where payment for that investment is deferred, are engaged in

corporate governance transactions. Managers’ also make investments in exchange for

promises, as they often invest in specific skills and knowledge and put their reputation at

risk with only limited security that they can retain their positions and have the discretion

to take actions that reveal their ability. The set of corporate governance transactions in a

given corporation thus depends on the specific investments required for an industry at a

point in time.

The definition of governance I employ follows naturally from this focus on those

investments that are uncertain. I define a corporate governance system broadly as the

complex set of socially-defined constraints that affect the willingness to make

investments in corporations in exchange for promises. The paper’s focus on the security

of the promises made to all investors in the firm is broader than the definition of La

Porta, Lopez-de-Silanes, Shleifer and Vishny (1999a), for whom “Corporate governance

is, to a large extent, a set of mechanisms through which outside investors protect

themselves against expropriation by the insiders.” My approach closely follows that of

Williamson (1985) and particularly Zingales (1997), who defines corporate governance

as “the complex set of constraints that shape the ex-post bargaining over the quasi-rents

generated by the firm.”

The overriding function provided by a governance system is to facilitate resource

allocation to investment projects in corporations. More headway is made by focusing on

core functions that contribute to this objective. The outlines of a classification useful for

our purposes is provided by Merton and Bodie (1995) who categorize the functions

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provided by the financial system, a system that shares many things in common with a

governance system. Merton and Bodie identify core functions performed by the financial

system to include: (1) clearing and settling payments, (2) pooling resources and

subdividing shares, (3) transferring resources across time and space, (4) managing risk ,

(5) providing information, and (6) dealing with incentive problems.

With the exception of clearing and settling payments, these functions are also core

functions provided by corporate governance systems. Since many investments are beyond

the capacity of individual investors, a well functioning corporate governance system

provides a way to pool resources. Investments are also more likely when risks associated

with those investments are pooled, shared and allocated to those with greater risk bearing

capacity. Providing information and managing incentive problems are correctly placed at

the heart of analyses of governance systems because asymmetries in information

discourage investments by increasing the probability of adverse selection and moral

hazard.

But to this list must be added an additional function performed by governance

systems – (7) to resolve competing claims on the wealth generated by the corporation.5

As Hart (1995) and others emphasize, when contracts are incomplete (as they inevitably

are) who is in control of the firm matters because they retain residual rights to specify

how assets are distributed in ways not specified in the original contract. Expectations

based on (a) who has residual rights and (b) their incentives will affect the willingness to

invest. Similarly, expectations as to (c) who has the power in society to enforce legal

protections and (d) their incentives will affect the willingness to invest as this defines the

prospect for contracting and the scope of incomplete contracts. In short, the costs of

resolving competing claims on the wealth generated by the corporation depends on who

has power in the firm and in society more generally.

In highlighting functions rather than institutions it is easy to characterize good

corporate governance. A good corporate governance system provides the functions of a

governance system at low cost and thus facilitates investments. It supports capital

investments by financiers, trade credit by suppliers, and investments in specific human

5 I thank Jay Lorsch who provided this phrasing.

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capital by labor and management. Equivalently, a good corporate governance system

finds a way to address the most common corporate governance breakdowns that

discourage investments by redirecting resources from their promised uses - management

abuse, controlling shareholder abuse and state actor abuse.

1.2 Institutions and policies of corporate governance systems

Institutions of corporate governance and internal governance policies provide

these governance functions. Both institutions and internal governance policies affect

beliefs about whether promises will be fulfilled, influence expected future returns, and in

so doing influence investment choices. But they are different in that institutions are taken

as exogenous by investors in making their decisions, while policies are under the control

of at least some of the investors. The important questions are: what types of institutions

and policies improve promise fulfillment and how do they relate to each other?

1.2.1 National legal protections

The most prominent institution of corporate governance is legal protections for

financiers embodied in national laws.6 The claim is that national legal protections have a

profound influence on the willingness to invest resources in firms. This point is not

universally agreed.

A view prominent in the law and economics literature is that the only legal

protection required is contracts and a judicial apparatus to enforce contract law. National

legal protections are neither required nor likely to be important. They are not required, as

sophisticated investors can negotiate complex contracts with sophisticated insiders in the

firm to anticipate eventualities and build in contractual safeguards. They may not be

important, as even in the presence of a national legal protections, sophisticated investors

can contract out of or expand on these protections.

The new legal protections approach, associated most closely with the pioneering

work of LLSV, challenges this view. This approach has emerged from the theoretical

work noted above that emphasizes the limits to contracting and the realization that no

6 In the spirit of recent work by Greif, I see institutions as social factors viewed as exogenous to investors in firms, thataffect beliefs regarding transactions yet are endogenous to societal decision making. Not all institutions of society are

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countries rely solely on such simple legal solutions. Everywhere governments introduce

additional legal mechanisms that specify procedures and remedies for the most common

recognized governance breakdowns. A key assumption of this approach is that such

artificial constraints can improve outcomes by affecting the bargaining over competing

claims on the wealth generated by the corporation, and consequently the willingness to

invest in firms at all.

The work of LLSV has focused attention on those elements of the company code

that favor minority shareholders in corporate decision making as opposed to management

or a dominant shareholder. The vast majority of these mechanisms provide for little

interference with management during normal times, but allow for significant interference

with low transaction costs when a situation deteriorates. Specifically, LLSV focus on six

anti-director rights to indicate who holds power in firms: the right to vote by proxy

through the mail, shares are not blocked before meetings, the use of cumulative voting,

the presence of oppressed minority rights, the existence of a preemptive right to new

issues for existing shareholders, and a low threshold to call an extraordinary meeting.

They also collect information on the presence or absence of two additional provisions in

the company code, one share one vote rules that link cash flow rights to voting rights and

thus help protect the interests of minorities, and a mandatory dividend that also could

protect the interests of minorities.

A shared feature of these legal protections is their clear allocation of power.

Legal protections temporarily concentrate control and provide for the credible threat to

replace insiders, be they managers or controlling shareholders. In addition to shareholder

meetings, extraordinary actions hinge on such protections such as class-action lawsuits

and takeovers. In such a lawsuit, a group of equity investors seek to sidestep the board

and to directly stop current management actions, or actions approved by the board. In a

takeover, current controlling investors are replaced with a new controlling investor that

can redress problems in the current ownership structure, and take more forceful action

vis-a-vis management. Takeovers help to overcome the public good problem associated

with monitoring management faced by many small shareholders. These efforts to

institutions of corporate governance. This label is reserved for those institutions that are central to the governancetransaction of investments in corporations.

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temporarily increase ownership concentration can be very expensive to utilize and are

best viewed, therefore, as extraordinary measures.

LLSV’s work also focus on legal protections for financiers in case of anticipated

and undesired outcomes, such as a failure to make promised distributions of returns.

Bankruptcy laws specify criteria for determining when promises have not been kept and a

procedure for reallocating control over the use of assets and the distribution of assets,

normally focusing control temporarily on a judge who often transfers it to a trustee

controlled by creditors. With strong protections, there are low costs of invoking these

protections and a speedy and predictable bargaining process to realize a new distribution.

1.2.2 Beyond national legal protections: complementary institutions

The legal protections approach runs the danger of shifting focus from lowering

the costs of providing the functions of a governance system to adopting specific laws. A

plausible (but misleading) interpretation of the legal protections literature is that legal

protections are the goal rather than the instrument.7 But by themselves legal protections

do not produce the information necessary for investors to avail themselves of their

protections. By themselves, legal protections do not address the potential incentive

problems of the state actors tasked with resolving competing claims and enforcing

judgements. Unless parties believe enforcement will be efficient and that they will have

access to information, such legal protections will not affect expectations regarding

promise fulfillment.

There is ample empirical evidence of the insufficiency of legal protections alone

to improve governance. For example, Black, Kraakman and Tarassova (1999) suggest

that with the perfection of the legal protections in Russia (many of the laws which they

helped to draft) there was a worsening of the effective protections for investors.

[T]he principal problem is not that the laws aren’t strong enough, but thatthey aren’t enforced… unhappy shareholders can rarely develop enoughfacts to prove the rampant self-dealing that occurs every day. The courtsrespect only documentary evidence, which is rarely available, givenlimited discovery and managers’ skill in covering their tracks. ...pursuing acase ... will take years, and when you're done, enforcing a judgment is

7 The authors consistently note that they are interested in both laws and their enforcement. However, the question ofenforcement has consistently received much less attention.

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problematic, because enforcement is by the same biased or corrupt lowercourt that the shareholder began at.

Russia’s experience is extreme but not unique. Disappointment with legal

reforms and the importance of enforcement and information have historical precedents.

To cite just one example, in 1964 the Brazilian government tried to use legal protections

reform to improve investor protections, closely copying US legislation. Such efforts

were sorely disappointed. As Goldstein (1998) recounts, “many notorious cases of gross

managerial irresponsibility or outright fraud by high-flying financiers” were left virtually

unpunished.8 The presence of the legislative reforms did not improve information quality

or render the stock market watchdog effective. Brazil’s current position with corporations

“largely based on majority control, little monitoring from the stock market and

institutional investors, and disregard for the rights of minority shareholders,” occurs in

spite of efforts to create the opposite.

If legal protections are insufficient, what else is required? This cannot be

answered from theory alone. Reference to the history of institutions in markets that have

developed provides a guide. Literature that has adopted this approach suggests the

effectiveness of legal protections for providing the functions of corporate governance

rests substantially on four additional institutions: social norms, political structure to limit

the sovereign, the location of judicial authority and what I call information/reputation

intermediaries.

Social norms and judicial efficiency

Cooter (1996), among others, emphasizes that there needs to be social support for

legal reforms to have an impact. In states where laws are consistent with social norms,

“the law is obeyed out of respect. Under such a system private citizens supplement

official enforcement of the law, which is critical because officials lack the information

and motivation to enforce the law effectively on their own.”9Critically, he argues that

legal protections will simply be ignored where the legal protections is inconsistent with

social norms.

8 Armijo (1993), p. 276, cited in Goldstein (1998).9 Cooter (1996), p. 191, emphasis added.

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There is growing recognition of the interaction between behavioral patterns and

legal institutions. The most recent Transition report by the EBRD (EBRD (1999)) goes

to great length to emphasize the importance of such social capital, and points to its lack

as a source of difficulty in reform. Likewise, some discussions in the aftermath of the

Asian crisis emphasize that reforms introduced by many Asian countries are unlikely to

have the desired impact because they do not coincide with societal beliefs. As the Far

Eastern Economic Review put it in an article summarizing the Thai experience and other

reforms in asia, “New laws aren’t enough to stimulate financial restructuring. Changing

a culture is necessary.”10

Political structure and judicial efficiency

For legal protections to matter, there must also be expectations that those laws

will be followed. The efficiency of the judiciary does not just come from sophistication

in the organizations of the state that interpret and implement judicial judgements, it

comes from their interest in enforcing the law. Such an interest has been linked to

political structures that limit the power of the sovereign relative to other interest groups in

society.

A precondition for the development of external finance in the United Kingdom, as

North and Weingast (1989) argue, was not specific refinements in the statutory or

common law, but rather was the creation of political institutions that gave the common

law courts true authority relative to the crown. The dominance of the common law waned

in the 1600s under the Stuart monarchy, with the increasing role of perogative courts, the

centralization of power in the Star Chamber and the use of the executive power of pay

and appointment of judges to influence their decisions. To resurrect the role of the

common law, complex organizational reforms were introduced including the abolishment

of perogative courts, new legislation that made judicial appointments for life and removal

only with the assent of both houses of Parliament (or in case of criminal behavior), and

constraints on the sovereign, including the Bill of Rights. These changes were supported

by inducements and credible threats for the sovereign, including a fiscal revolution that

provided a steadier stream of revenues and by the successful replacement of two

10 Goad et. al, “Debts to Society,” Far Eastern economic Review, Oct. 7, 1999, pp 87-88.

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sovereigns over the previous fifty years. In short, what made the common law courts

predictable venues to resolve commercial disputes was the creation and development of a

complex set of self-supporting political institutions.

Rajan and Zingales (1999) present similar arguments that emphasize political

structure. Based on their reading of capital market development and then retraction in a

number of European countries, they argue that legal protections can be changed by a

determined government. More important than legal protections for investment in their

view are structural features that limit the ability or willingness of government to change

the rules of the game.

Location of judicial authority and judicial efficiency

A different approach to understanding judicial efficiency emphasizes not political

structure writ large, but how the government organizes and allocates judicial authority.

The argument here is that to provide information and lower the costs of enforcement it

may be optimal not to keep judicial authority in the general court system, but to delegate

authority to a specific regulatory agency tasked with that job, or even to allow that

regulator to delegate further to private sector organizations. This is not an argument that

delegation is always superior, giving authority to a specialized institution might lead also

to abuse, but that the location of authority can affect efficiency.

An analogy to agency problems within firms is appropriate. Firms neither

completely centralize or decentralize decision making, but rather identify who has the

relevant information, and combine a provision of incentives with an allocation of

delegated authority to those with information. The same logic applies one level up. A

system of legal protections will be ineffective if it merely demands information or

sanctions. A more effective system involves identification of those with potential access

to information, delegation of authority, and a way to harness the incentives of these

delegated decision-makers.

Many examples could illustrate the complementary role of the design of oversight

institutions so that legal protections fulfill their desired functions of providing

information and incentives for promise fulfillment, and lowering the costs of resolving

competing claims over the wealth generated by the firm. One of the best examples is the

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formation of the US Securities and Exchange Commission (SEC) and its impact on

equity markets, a system that to this day facilitates greater equity investment in

corporations than anyplace else in the world.11

The importance of quality information for investors had long been appreciated,

but the great stock market crash of 1929 revealed the inadequacy of previous attempts to

address information asymmetries through simple disclosure rules. Restoring the faith of

investors was intimately entwined with the passage of the Securities Act of 1933, the

Securities Exchange Act of 1934 (that created the SEC) and years of work by SEC

officials to get the details right. To reduce information asymmetries, and increase

incentives for disclosure and enforcement, some penalties were imposed by the SEC

itself. Particularly important were those that had an effect immediately, even if subject to

later judicial review.12 But as important, McCraw (1982) emphasizes, was the SEC’s

focus on critical third-party agencies rather than the firms issuing securities themselves.

By regulating those intermediaries and granting them significant powers, including the

power to police themselves, the SEC utilized their informational advantages and lowered

transaction costs for investors in case of conflict. Importantly, these third parties were

not subject to the legal due process required if public agencies attempted to institute the

same rules.

Johnson and Shleifer (1999) provide more recent evidence of the importance of

legal protections and their enforcement through specific regulatory authorities rather than

relying on a laissez-faire approach backed by the general court system. As they recount,

Poland and the Czech republic started their reforms with roughly similar (low) levels of

investor protections but had dramatically different experiences with corporate governance

concerns. The Czech’s suffered widespread looting of firms by managers and insiders

and the rapid loss of faith in the stock market with delisting of firms and no new private

companies. Poland, in contrast, has many fewer reports of investor dissatisfaction and

many more new firms able to raise external capital. Part of the relative success of Poland

11 I thank Rafael LaPorta for encouraging me to explore this example in more detail, and my colleague Tom McCrawfor helpful clarifying discussions.12 Among other factors, the SEC required a 20-day cooling off period to scrutinize documents before issuing securitiesand had the power to place a ‘stop-order,’ that legally simply suspended the issue. This was a simple but powerful toolas it shattered investor confidence in the issue, regardless of whether the SEC was overturned on appeal.

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is attributed to the far more stringent regulation of securities in Poland, including the

ability of the security regulator to control financial intermediaries through licensing, and

its much wider demand for disclosure by issuers of securities. In contrast, there was little

initial regulation in the Czech republic and few changes in the approach despite

deteriorations in economic performance.

Delegating authority to a specialized agency in credit markets, when combined

with incentives to focus on oversight, can similarly lower the cost of providing functions

of governance. Central banks and bank regulators are particularly important as they

collect information and can coordinate responses through their influence over financial

intermediaries. Their powers include the ability to withdraw licenses, to impose capital

adequacy conditions (e.g. the Cooke ratio), to circumscribe loans to classes of debtors,

and even the power to trigger bankruptcy proceedings for firms or for the bank itself.

The point is that lowering the costs of providing the functions of governance

involves design at two levels. First, there is the choice of the general courts or a

specialized regulatory authority with specific rules. Second, there is the choice where the

regulator delegates power, given the existing intermediaries. In the US, this delegation

harnessed the incentives of intermediaries and in the end the regulators of the SEC did

not use their authority, as they might have, to reward themselves. It is likely that the

narrowing of the specific tasks of the SEC and its use of delegated monitors enhanced the

ability for their respective organizations to tie rewards to the fulfillment of these specific

goals.

Efficient collection of information

Information, in addition to an efficient judiciary, is essential for anonymous

minority shareholders to avail themselves of the power granted them by legal protections.

Without information received in a timely manner, investor resources will be squandered.

With the information, investors can use their powers embodied in legal protections to

change the allocation of resources or simply exit the firm. In short, investors will factor

in the efficiency of information intermediaries in calculating the impact of any legal

reforms.

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The institutional requirements to support information for anonymous exchange in

equity and capital markets are significant. Publicly audited income statements and

balance sheets require professional accounting firms. But the short recounting of the

formation of the SEC suggests information does not come exclusively from firms

responding to state mandates about information disclosure. Rather in developed markets

information intermediaries emerge to lower the transaction costs of collecting

information and to improve the overall information flows. The expected efficiency of

information intermediaries, which is what matters for investor confidence, depends on

access to information, capabilities to process the information, and on incentives. In some

cases, intermediaries incentives stem from the prospect of penalties imposed by a

regulatory agent of the state. But in many cases, the incentives that drive conduct are self-

interested concerns that they could lose their reputation (and future business) if they fail

to perform.

Intermediaries that are important in environments that rely on legal protections

are those that provide information in channels open to existing and potential investors.

For example, intertwined with the rise of trade credit for American retailers in the 19th

century was the development of financial reporting, external auditors, and credit rating

agencies. No longer was information about reliability just possessed by those with past

experience, but rather specialized agencies collected the information and made it

available to clients. Similarly, organizations that provided information on assets and

those with liens on the assets, such as property registries, helped to facilitate credit and

the use of collateral. For equity markets, intermediaries that proved important were

accounting firms, financial analyst firms, and stock markets.

Summary

In sum, historical evidence from developed economies that have been able to

support anonymous investments backed by legal protections suggests surprising

requirements for institutional depth. Legal protections are an immensely helpful

institution of corporate governance, but to provide the functions of corporate governance

legal institutions need to be accompanied by other institutions of corporate governance.

These institutions are not just those directly targeted on clarifying competing claims, but

18

institutions such as social norms, political structure, the location of judicial authority, and

self-regulating organizations that indirectly but significantly affect the costs of resolving

competing claims. It is the interaction of these institutions of corporate governance that

history and theory suggests will matter.

1.2.3 Internal governance policies: Ownership structure

An entirely different approach to addressing the functions of corporate

governance is to look inside the firm and focus on policies at the discretion of those in

control. One could evaluate many such policies that produce information, manage risks

and incentives and resolve competing claims such as the structure and role of the board of

directors, the design of executive compensation, and financial structure. These are all

important but beyond our focus. Here we concentrate on ownership structure, both the

identity and the concentration of owners. To what extent can ownership structures that

deviate from the hypothesized anonymous small diversified shareholder fulfill the

functions of corporate governance at lower cost?

The impact of ownership structure on the functions of governance is not nearly as

straightforward as the impact of legal protections. Deviations from corporations owned

by anonymous small shareholders has ambiguous effects in theory. The main argument

advanced here is that there is significant support for the proposition that where legal

protections are weak due to institutional weaknesses, the advantages of employing

identity and concentration can outweigh the costs. Ownership structure can, like legal

protections, provide the functions of corporate governance.

Promise fulfillment through ownership identity

Where there are no legal protections, investors are likely to be extremely reluctant

to give up resources to someone else in exchange for a promise because if that promise is

violated they have no clear penalty they can impose. There is the danger of no

investments in corporations. The theory of repeated games suggests one way out of this

trap. The prospect of linking current violations of promises to future penalties can lead

those in control of investor resources to honor their promises. But bilateral reputation

mechanisms will often not achieve an efficient level of investment. Insiders in the firm

might violate the interests of one financier and lose the ability to appeal to him again for

19

finance, but this threat is a weak deterrent if he can freely access finance from other

financiers. Such reputation mechanisms can be made more effective if a way is found to

magnify the penalty in case promises are unfulfilled – in effect replacing bilateral

reputation with multilateral reputation.

In particular, where networks exist that provide information, allow for

coordinated action, and can enforce coordinated actions, the identification of an

individual who receives the investment with a network can create a multilateral

reputation mechanism. Greif (1997) documents that such augmented reputation feedback

mechanisms had a position of prominence in driving the commercial revolution. He

shows that the Community Responsibility System whereby any member of a community

could be held liable for unmet promises of another member, the identification of traders

with specific religious communities such as the Maghribi traders, and even artificial

communities created by merchants such as the German Hansa, were all examples

whereby the identification of an individual with a larger community helped to increase

the scope of investment opportunities.

The key point is that when the controller of investor resources is not anonymous

but has an identity it is possible to go from no investment to investment. In exchange

based on bilateral reputation, such exchange is personal, the information demands are

large, and the scope for investments is limited. With exchange based on multilateral

reputation, trade can be impersonal, information demands for individual investors are

lower and the scope for investments is increased. Information demands for individual

investors are lower in that an investor need not know the history of the controller of the

investment, but rather needs to know the community affiliation of the individual to whom

he entrusts his resources. This identification with a community conveys information

about the penalties that will be imposed if the controller of the investment violates the

terms of the agreements. Community affiliation affects investors’ beliefs.

This deceptively simple logic constructed to explain historical evidence on the

emergence of long-distance trade has much broader scope. It helps to explain why some

economic agents are able to support investments in current day situations while others

have more difficulty.

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For example, family-centered and ethnic-based business groups common to much

of the developing world are networks where identity matters. For members of the

business group, the information that can be gathered and the penalties that can be

collectively enforced are greater than for individuals that are not member of the

community. In theory, this helps to facilitate investments that are insupportable in the

absence of these community ties. It is consistent with the observed pattern of much

broader diversification of such firms than in developed economies.

Khanna (2000) summarizes available evidence on the impact of group affiliation.

The general sense is that group affiliation helps rather than harms performance,

consistent with the framing described above, but also consistent with other theories of

group formation. One of the more notable individual studies is provided by Khanna and

Rivkin (1999) where for 14 emerging markets they find that group affiliation improves

outcomes using accounting measures of performance for four countries, and only

produces negative performance for one. These findings are consistent with individual

country studies that employ accounting measures and Tobin’s Q.

Business associations are artificial communities that can also support investments

in firms, if they collect information, coordinate action and have the incentives to enforce

penalties for non-compliance. There is recent evidence of their ability to support trade

credit in weak legal environments of Vietnam, (McMillan and Woodruff (1998)) Poland,

Romania, Russia and Ukraine (Johnson, McMillan and Woodruff (1999)).

Certain owners are also, in effect, members of networks. Foreign owners, when

they assemble a controlling stake for example, become subject to stricter regulations of

their home country (both legal requirements and any additional requirements demanded

by the stock exchange that lists their shares). These regulations often require them to

disclose far more information than demanded by the country where the investment is

located and the penalties for violating these rules are often the same as if the investment

was in the home country. Penalties can also be applied to assets in the firms’ home

country. Thus, the foreign owner has posted something greater than his word when he

operates in a foreign country. Evidence consistent with this contention has been found in

the superior performance of foreign controlled firms in India (Chhibber and Majumdar

21

(1999)) and, as described in more detail below, in the transition economies (e.g.

Frydman, et al (1999), Djankov (1999))

The argument that identity supports investments is not an argument that identity is

optimal. There are clear costs with the use of identity in investment relationships. The

ability to pool investments, allocate them across space, and manage risks are all

constrained by the need for those controlling investments to have clear ties to an

identifiable community. There may be inefficiently low levels of information collection

by investors.13 There are also dynamic costs. As Johnson, McMillan and Woodruff

(1999) found, investors relying on informal mechanisms to support investments are

inclined to maintain these relationships rather than use other mechanisms even when

there are costs to doing so. The costs can be deep, producing inflexibility. Members of a

community that that collect private benefits from the networks’ presence have a strong

interest in seeing that these mechanisms are maintained even if they are no longer the

most efficient mechanism.

While not optimal, factors such as identity should not be dismissed out of hand.

When there are no effective legal protections, mechanisms such as identity can provide

the functions of governance. What is clear from the evidence cited above is that identity

can improve outcomes in developing economies with weak legal protections. This is

consistent with the argument that identification with a larger community helps to provide

the functions of governance, substituting for an inability to appeal as an anonymous

owner to the state for enforcement of legal protections. Where legal protections are

stronger, the costs of identity may very well exceed the benefits as there is another

channel available to provide the functions of governance.

Promise fulfillment through ownership concentration

A second deviation from anonymous disperse shareholding that can enhance

promise fulfillment is ownership concentration. The traditional motivation for

concentration is that it reduces the public good problem associated with monitoring. The

13 In the Community Responsibility System, for example, an investor knows that he can get payment from any memberof that community, so he has little incentive to examine the capabilities of the controller of the investment and theviability of the proposed investment project. Bad projects will be pursued and punishment will come by thecommunity only after the fact.

22

greater the ownership stake, the greater the personal returns to monitoring and exercising

voice and the more information that these owners will collect. Coffee (1999), among

others, suggests the corporate finance evidence shows that the activism of shareholders is

proportional to the extent of ownership concentration. Concentrated owners often become

what Jensen (1991) calls the active investor, “one who holds large equity and/or debt

positions and actually monitors management, sits on boards, is sometimes involved in

dismissing management, is often closely involved in the strategic direction of the

company and, on occasion, even manages.”

A more recent rationale for concentration is offered by Bebchuk (1999).

Consistent with this papers’ framing, he focuses on how concentration can resolve

competing claims on the wealth generated by the corporation. He suggests concentrated

structures are the only viable arrangement in countries with weak legal protections.

Where legal protections are weak, the scope for redirection of resources is large. Faced

with this situation, if a single owner wants to sell a stake he would be much better off

selling a large controlling stake in the firm, rather than selling disperse shares. The

problem with dispersion is that each disperse shareholder anticipates that someone will

assemble a controlling stake and will use that control to redirect resources to themselves.

Concern for this eventual theft will lower share prices today. The single shareholder

maximizes his returns to sale by maintaining control - control protects rents.

In Bebchuk’s story, concentration primarily affects distribution of rents rather

than efficiency. In fact, the pure efficiency impact is negative, as concentrated

shareholders do not benefit from diversification. But concentration may be efficiency

enhancing. With possibilities to divert returns and disperse shareholding, it may not be

clear initially which of the disperse shareholders will assemble a controlling stake. In

such a situation, those with limited control but uncertainty about future control, have an

incentive to dilute quickly and destructively. In contrast, if control is delivered by having

a large cash flow stake in the firm, those in control know they will keep it and their

temptation to dilute is limited by their ownership stake. At least to some extent, they are

simply stealing from themselves. Concentrated control may not only be the only viable

option in countries with weak legal protections, it may be more efficient than efforts to

introduce disperse shareholding.

23

Other researchers have argued that it may be optimal to have more than one large

owner in environments with weak legal protections, particularly if that owner has

identifiable characteristics tied to the functions of corporate governance. For example, a

potential investor with financial capital might be more willing to invest if suppliers or

buyers also have stakes because even without legal protections these agents have

potential leverage vis-a-vis the insider (hold-up power). The small investor knows that if

insiders attempt to reallocate promised returns, financiers and suppliers as co-financiers

can credibly threaten to penalize them directly and consequently such diversion can be

reduced. Aoki (1984) underscores how labor might be able to police against abuse due to

its ability to withhold its services. Financial institutions are very well positioned to serve

this role. Their hold-up power derives from their ability to provide long-term finance, but

more importantly from their ability to cut off the supply of short-term capital if a firm has

committed to a particular banking relationship.

Up through the early 1990s, many analysts of German and Japanese corporate

governance systems suggested that a key to the relatively strong performance of firms in

these countries has been the ownership and control structure that involved banks, workers

and concentrated owners. These parties have information, the ability to impose

sanctions, and the incentive to use their powers. Investors believed that the presence of a

bank mattered and this affected their willingness to invest. Kaplan (1993) and Kaplan

and Minton (1995) show that, at least for management turnover, there is little difference

in sensitivity of turnover to changes in financial performance between these countries that

rely more heavily upon informal mechanisms than in the US with its largely formal

system. In addition, Hoshi et. al (1990a,b) show that Japanese firms with bank

relationships have greater access to capital and lower costs of resolving financial distress.

As with ownership identity, the argument here is not that ownership concentration

is optimal. Rather, the argument is that ownership concentration can provide the

functions of governance, and particularly where legal protections are weak, the benefits

provided by concentration outweigh the costs.

In fact, the costs can be sizable. Most obviously, with concentrated ownership,

there is no longer a separation and specialization based on comparative advantage of

24

those providing management and those with capital to invest. There is an inferior

management of risks and a more limited pool of investors. Second, as Bolton and Von

Thadden (1998) emphasize, there is a loss in liquidity, with a resulting decline in the

value of shares. Third, with concentrated ownership, those in control are difficult to

dislodge. When these insiders are not well motivated, there will be a decline in

efficiency. Aghion and Blanchard (1996) for example emphasize the particular problems

that arise when workers or managers have control over the firm. Recent literature on the

Japanese and German systems also now sees bank affiliation as costly, with bank

involvement leading to overlending, and deferred restructuring (e.g. Weinstein and Yafeh

(1998)).

Fourth, to the extent that initial owners maintain their concentration through

voting rights rather than cash flow rights this is costly as it reduces incentives to use

control in the interests of minority shareholders. There are various vehicles through

which an owner can maintain control by reducing cash flow stake, for example through

shares with different voting rights, through cross shareholding, or through pyramid

structures. As discussed in more depth below, Claessens, Djankov and Lang (1999)

provide evidence of costs associated with concentration of control when it is not

associated with similar cash flow rights in their study of Asian firms.

Summary

In sum, by examining ownership structure it is clear that governance policies, like

institutions, provide the functions of corporate governance. Relative to a situation with

anonymous, disperse shareholder, owners identified with a network, and with significant

concentration can have a comparative advantage in providing information, managing

incentives and lowering the costs of resolving competing claims over the wealth of the

firm. Evidence in support of this contention comes mainly (but not exclusively) from

countries where legal protections are weak. This is consistent with theory, which shows

that with weak legal protections other ownership structures are not supportable, and even

costly. When legal protections are strong, the theoretical results are more ambiguous, as

is the evidence.

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2 International Data on Legal Protections and Ownership Structures

The previous section provided a conceptual framework for thinking about

governance focusing on the functions performed by a governance system and linking

institutions and policies to these functions. Recent research provides statistical evidence

to evaluate the relevance of these institutions and policies and their impact on firm and

national performance.

2.1 Data

This paper does not provide any new data, but instead brings together data from

international cross sectional studies by LLSV(1998), LLS(1999), Pistor (1999),

Claessens, Djankov and Lang (hereafter CDL) (1999), and Becht and Broell (1999),

reproduced in appendix Table 1 and 2. LLSV (1998) collected information on corporate

governance characteristics of countries and cash flow ownership for a cross-section of 49

countries. This sample is heavily weighted to higher income economies, covering 93% of

high income economies and 62% of upper middle income economies, but still covers a

significant number of developing countries, with a third of the sample defined by the

World Bank as low or middle income.14 Pistor (1999) extended this sample to include

data on legal protections for 24 transition economies, both in 1992 when the transition

began and in 1998.

LLS (1999) provide an alternative measure of ownership concentration for a

different sample of 691 firms from the 27 most developed countries in their original

sample. This study has been complemented by more detailed studies of the concentration

of voting rights in particular regions. Studies of 8 European countries under the umbrella

of the European Corporate Governance Network based on 1381 firms are reported in

Becht and Broell (1999). Another example is the study of 9 East Asian countries by CDL

(1999) of the World Bank based on 2,980 firms.

2.2 Legal Protections for Equity Investors

The data reveals a surprising lack of investor protections and a dispersion of

approaches to protections when one looks around the world. Of a maximum score of 6

14 The choice of countries emerged after imposing the restrictions that a country had to have 5 publicly-tradedcompanies without significant government ownership and not be a former socialist country.

26

for anti-director rights, the highest score is five and the average for the sample is just 3.

The subsequent research by Pistor to collect evidence on legal protections for the

transition economies expands our understanding of legal protections in non high income

countries. Echoing the LLSV findings, there is a widespread variation in the extent of

legal protections across countries and many countries have a relatively low level of

protections. In 1992, protections averaged just 1.8. In 1998, the level raised to 3.0,

identical the level in the established economies investigated by LLSV. Interestingly, the

scores for anti-director rights are not driven by differences in per capita income, with

average levels indistinguishable at different income quartiles.

The change in the extent of legal protections from 1992 to 1998 in the Pistor

sample demonstrates one reason why legal protections have become such a variable of

policy interest. Unlike the complementary institutions described above, legal protections

can be changed very rapidly indeed. And efforts of the international community do

matter. As Pistor (1999) shows, countries that received US aid have higher legal

protections than other countries in the sample, including those preparing for membership

in the EU.

2.3 Complementary institutions

Existing statistical research has not focused on measures of the complementary

institutions of social norms, judicial efficiency, and information intermediaries that

produce publicly available information. Where these complementary institutions have

found a way into the analysis, this has come through relatively crude proxies, also

included in Table 1. A number of studies use ‘rule of law’ indices compiled by experts in

commercial risk agencies as proxy measures for judicial efficiency. To capture the

presence of publicly available information, these studies make use of an index of whether

90 factors that accountants identify as useful indicators of the financial affairs of a firm

are included in firm annual reports.15

The rule of law measure reveals significant attention to legal practices. The

average level is 6.8, with almost a quarter of countries receiving a perfect score of 10,

and half of the countries scoring higher than 7. The extent of the rule of law is very

15 See LLSV(1998) for a further description of these variables and their source.

27

closely linked with per capita income. The correlation coefficient between the log of gdp

per capita and the rule of law measure is 0.87. The measured accounting standards vary

from a low of 24 for Egypt to a high of 83 for Sweden, while this data is unavaiblable for

some countries. The correlation coeficient with respect to log gdp per capita is a lower

but still significant 0.51.

One additional variable included in these analyses is a country’s legal family. The

work of LLSV, building on the classification provided by comparative legal scholars,

focus on two legal traditions and four legal families. In the common law tradition of the

UK, the US, and Commonwealth countries, the law evolves as judges resolve specific

disputes. Civil law, in contrast is a system that relies upon written statutes often based on

abstract principles, with its roots in Roman law. There are three distinct variants: French

civil law, German civil law and Scandinavian civil law. A good case can be made that

legal families are exogenous to policy makers. The legal family was adopted long in the

past, and often as a result of colonization.

The exogeneity of legal families makes legal family a good variable for statistical

purposes. It also has explanatory power. There is a significant effect of legal families on

antidirector rights, and on other variables. The strongest difference comes from

comparing countries with a french civil law origin and those with a common law origin.

The mean index for anti director rights, rule of law and accounting standards is all higher

in common law countries, with the difference significant for anti-director rights.

For policy purposes, legal family has much less use. The exogeneity of the

instrument makes it relatively uninteresting, as by definition it cannot be changed. It is

also unclear for policy purposes what the variable ‘legal family’ actually captures. In

subsequent work, LLSV suggest that the common law evolved to protect private property

against the crown and that civil law is correlated with greater interference in economic

activity. Thus the legal origin in a sense proxies for the other institutions of corporate

governance that we describe above, particularly measures of political structure.

For the purposes of this paper, I create a more direct index that captures the

argued complementary nature of the presence of legal protections, quality information

and enforcement and also include this in Table 1. It is constructed by taking the simple

28

product of adjusted measures of anti-director rights, the index of information, and the rule

of law measure.16 The weighting used is arbitrary, but at least captures the hypothesized

interactions between these institutions.

2.4 Ownership Structure

Who controls firms? Recent research has added greatly to our understanding of

types of ownership structures around the world, with results from four of the most cited

studies in this literature reproduced in Table 2. LLSV (1998) collected data on cash flow

ownership for the same sample of 49 countries described above. The higher the cash flow

ownership of the most concentrated owner(s), the greater alignment of that owners’

interests with those of the firm. But cash flow ownership might not capture who controls

firms when voting concentration can differ from cash flow concentration. LLS(1999)

focus on concentration of voting rights. To measure whether there is an entity with

sufficient voting rights to have control of a firm, they use a methodology to identify

voting rights that involved tracking ultimate owners through pyramids and cross

shareholding arrangements. A shareholder with a direct or indirect voting stake of 20

percent is said to have control.

So what does ownership look like? The strongest result from all of these studies

is that firms held by anonymous disperse shareholders are the exception rather than the

rule when one looks around the world.

This is clearly demonstrated in the first column, which shows that the combined

stakes of the 3 largest shareholders (using cash flow) averages a surprisingly high 46

percent. Only in the United States, the United Kingdom, Taiwan and Japan are cash flow

ownership stakes less than 20 percent. Using voting rights as the concentration measure

reinforces this result. Defining control as a 20 percent direct or indirect voting stake,

only 36 percent of the largest firms in countries in the LLSV sample are widely held.

These results are robust. The limited role of dispersed shareholders is evident in Europe,

where based on the data in Becht and Roell (1999), only 22.4 percent of firms from

Austria, Germany and Netherlands have a controlling shareholder with less than a 25

percent stake. This result is echoed in Asia, where CDL (1999) report only 32 percent of

16 The index is created after transforming the variables to have a similar range to the antidirectors rights index.

29

firms are widely held. What is true for the largest firms around the world holds with even

greater strength for medium sized firms. In the LLSV voting right sample, for example,

the percentage of medium sized firms that are widely held is just 24 percent. One also

finds within the sample of large firms that the smaller the size, the greater the likelihood

of a controlling shareholder.

The distinction between cash flow rights and voting rights noted above turns out

to be important for cash flow rights are routinely separated from voting rights. The

evidence shows that the most common way to break these rights is through the use of

pyramid structures. Less common is the use of cross shareholding, although this is

important in countries such as Japan. Surprisingly rare are instances of issuing multiple

shares with different voting rights.

Jensen’s contention based on US evidence is consistent with the international

evidence. With a controlling shareholder the distinction between owners and managers is

eliminated in most cases. When a family is the controlling shareholder they participate

directly in management 69 percent of the time in the LLSV sample and 67 percent of the

time in the Claessens et al sample for East Asia.

This evidence also allows for an examination of the theoretical argument that

having multiple large shareholders might facilitate investment in firms. When a family

is in control, other concentrated owners are only found 25 percent of the time in the LLS

sample. This is seen even more clearly in the European evidence, where the median stake

of the second largest shareholder was almost always below the minimum reporting level

of 10 percent. Interestingly, a second large shareholder is far more common in the CDL

sample of East Asian economies. In this more economically diverse sample, in 49

percent of such firms there was another shareholder with a significant stake. This

evidence reopens the question whether such multiple large shareholders are important to

governance in less developed economies.

3 Findings

Armed with this statistical data on legal protections and ownership, a growing

number of authors have related these variables to other firm and national performance

measures. It is only possible to scratch the surface of this work here. I organize the

30

discussion around the impact of legal protections first on ownership structure, second on

financial measures, and third on investment and growth. In addition to the data from

established publicly-traded firms, I also relate legal protections to privatization evidence.

3.1 Legal protections, ownership structure and performance in established firms

Legal protections and ownership

Figures 1 and 2 provide a visual of the raw data described in the previous section

and the relationship between these variables. In figure 1, the top two plots relate the

index of anti-director rights and the rule of law index to ownership concentration

measured using cash flow rights, while the bottom two plots focus on concentration

measured using voting rights. For the voting rights measure I use the average levels of

concentration reported from the LLSV and CDL samples. Figure 2 presents data using

my index of ‘effective’ legal protections formed by the interaction of anti-director rights,

the rule of law measure and the accounting measure. In all figures, I also plot the

predicted line of best fit based solely on these variables.

The main result, regardless of presentation, is of a strong negative relationship

between legal protections and ownership structures in large firms reflected in the

downward sloping line of best fit. Even without control variables, legal protections

matter. Analysis by LLSV(1998) that control for other contributors to concentration bear

out these results. The conclusion is that in established publicly traded firms ownership

concentration is a substitute for legal protections in providing the functions of corporate

governance.

An advantage of this presentation focusing on the raw data is to suggest that while

anti-director rights are important, other dimensions of legal protections matter, as well as

the interaction of the various elements. For the raw data, the explanatory power (r

squared) provided by anti director rights and rule of law alone are comparable, with anti-

director rights explaining 15-16 percent of the observed variation in cash flow and voting

rights concentration respectively, while rule of law explains 21 and 19 percent. Figure 2

reveals the value of considering the interaction of governance institutions. This measure

of effective protections alone explains 36 - 30 percent of the variation in cash flow and

voting rights concentration respectively. When combined with controls for the average

31

size of firms, the explanatory power rises to 44 and 56 percent respectively. The point

here is not to offer a new evaluation of the data but to reveal the empirical support for the

contention that complementary factors are critical contributors to the observed

relationships between legal protections and other variables.

A second result, apparent in the raw plots of data is of the particular difficulty of

supporting anonymous diversified shareholders in countries with weak legal protections.

The bottom left corner in all of these figures is pretty much a blank space. This finding is

consistent with theory that suggests disperse shareholding with weak legal protections is

unsustainable. The raw data suggests that the rule of law is of particular importance. For

example with the voting rights measure of concentration, when the rule of law measure

falls below 7 only South Korea has more than 10 percent of its firms that are widely held.

The relationship at high levels of legal protections is not so striking. While high levels of

protections are necessary to support small diversified shareholders, there are many

countries with strong legal protections that still utilize concentrated ownership structures.

32

33

34

Legal protections and financial performance

Some of the most striking results relate institutions of corporate governance to

financial measures of performance. LLSV (2000) report that firms in countries with

stronger legal protections are more likely to disgorge earnings through dividends.

Consistent with this result and with theory, LLSV (1999b) and CDL (1999b) also show

that legal protections enhance the value of shares (measured using Tobin’s Q). The

interpretation here is that by conveying power to minority shareholders through legal

protections, the market places a higher value on such shares. As with studies relating

legal protections to ownership, the impact of legal protections comes not only through

antidirector rights but also through other variables. Legal families and to a lesser extent

anti-director rights raise the value of shares.

These studies also show concentrated ownership through cash flow stakes is

valued. To avoid confounding concentration with control, they look at concentration in

firms that are ‘controlled’ according to their measure of direct and indirect control.

CDL(1999b) finds strong evidence, consistent with theory, that concentrated cash flow

ownership improves value, while concentrated voting rights reduces value. LLSV

(1999b) present weaker evidence of the benefits of concentrated cash flow ownership.

Johnson, Boone, Breach and Friedman (2000) illustrate that legal protections

might matter during times of crises even more so than during normal times. They show

that countries in Asia with weaker formal mechanisms suffered larger declines in share

prices and currency values than countries with stronger protections. These institutional

variables have at least as much predictive power as standard macroeconomic variables.

Legal protections, investment and growth

Probably the most interesting findings are those that get directly at the goal of

governance – to foster investments in firms. LLSV (1997) provide evidence that the

extent of legal protections is correlated with the depth of equity markets and the rate of

initial public offering activity. The rationale for this finding is straightforward. With

effective legal protections investors have good reasons to expect their promises will be

fulfilled. They are more willing to exchange their resources for promises, the costs of

finance drop and financial markets develop.

35

Wurgler (2000) shows further that the efficiency of the allocation of investment is

related to legal protections. In his study, he estimates a greater sensitivity of investment

to growth opportunities in countries with more developed financial markets (an indirect

link to legal protections) and a greater willingness to cut funding from declining

industries in countries with weak legal protections. Consistent with the presentation

above, his measure of legal protections is a measure of ‘effective legal protections,’ in his

case the product of rule of law and the sum of creditor and anti-director rights.

The links between legal protections and growth and performance remain indirect

but very suggestive. Other studies (e.g. Rajan and Zingales (1998), Levine and Zervos

(1998)) show strong links between the extent of financial development and subsequent

growth and development.

3.2 Legal protections, ownership structure and performance in privatized firms

Privatized firms provide another data set to examine whether legal protections

help explain ownership structure and performance. In many ways, privatized firms are

ideal. They are often large firms for which governance concerns are most important.

The initial ownership at the time of privatization is in many ways a choice variable, so

examining initial structures reveals whether political decision makers believe the existing

state of legal protections imposes some constraints on their actions. Most importantly,

this is a good data set to see whether the effectiveness of legal protections affects the

evolution of ownership structures and firm performance. If legal protections are a

binding constraint, this should be reflected in disappointing performance and an

instability to disperse ownership structures in environments with weak protections. In

these same environments, concentration and identity should contribute to better

performance.

Legal protections and initial ownership structures

No studies have provided the same systematic information on ownership

concentration for privatized firms as collected for established publicly-traded firms. As

an (imperfect) proxy, for which there is data, studies by Megginson, Nash, Netter and

Poulsen (2000) and Bortollotti, Fantini, Siniscalco and Vitalini (1997) examine the

relative tendency of governments to use asset sales as opposed to share issue (SIPs) as the

36

privatization method in countries with established private sectors. Share issue

privatizations are likely to produce ownership structures where there is no controlling

shareholder. Asset sales in contrast are usually associated with sales of a majority stake to

a single investor or a consortium of investors arranged before the sale. Governments

often establish pre-qualification criteria prior to the sale and conduct the sale through an

auction or through a more direct sale to a targeted investor. Investigation of winning

consortia show in almost all circumstances the presence of a core investor. Thus, asset

sales are likely to produce a controlling shareholder.

Using this data, the empirical results are broadly consistent with the results for

established publicly-traded firms. In regressions for privatizations from 80 countries that

control for a variety of factors, Megginson, Nash, Netter and Poulsen (2000) report that

legal protections and the government’s ability to credibly commit to property rights are

both significant explanatory variables in the privatization design choice. The UK, for

example, with excellent legal protections relied upon share issue privatizations with

widely dispersed shareholding. The average ownership stake of the largest shareholder

for a sample of 25 electricity and water supply companies privatized in the United

Kingdom was 4.6 percent. in the year of privatization.17 Privatizations in middle income

countries with weak effective legal protections such as Argentina, Mexico and Bolivia in

contrast used asset sales, accounting for 89%, 91% and 100% of transactions

respectively. In the Mexican privatization program, for example, Lopez de Silanes (1997)

describes how controlling stakes were sold in 87 percent of firms in his privatization

sample and when non-controlling stakes were sold, in 83 percent of the cases the shares

were bought by the preexisting controlling shareholder.

The transition economies, in contrast, do not follow the patterns found in

established publicly-traded firms and in privatized firms elsewhere. Figure 3 makes this

point graphically. On the vertical axis I identify the primary approach to privatization

based on the EBRD (1999) classification of economies by whether direct asset sales,

management and employee buy-outs or voucher privatization was the primary approach

to privatization. A voucher privatization is a share issue privatization that results initially

17 For further information on the companies included in this comparison see Cragg and Dyck (1999).

37

in disperse ownership. Direct asset sales, like in the rest of the world, result in more

concentrated ownership. Management and employee buy-outs are somewhere in between

direct sales and voucher privatization at creating concentration at the time of

privatization. On the horizontal axis I provide a rough characterization of the level of

effective legal protections. Pistor (1999) provides precise data for antidirector rights and

this is included in Table 1, but all of the legal protections must be considered ineffective

given initial weaknesses in rule of law and accounting standards. The key difference

between this figure and the preceding ones is the large number of countries in the bottom

left quadrant. In an environment with ineffective legal protections many countries did not

adopt a privatization approach that facilitated concentrated ownership initially, and they

largely eschewed attempts to identify owners that had the capability to enhance promise

fulfillment. They followed a path without empirical support and with little theoretical

backing.

38

Figure 3 – Legal protections and approaches to privatization– transition

Direct sales –concentrated ownershipwith openness tooutsiders

BulgariaEast Germany**Estonia*Hungary*Kazakhstan*LatviaPoland*Hungary*Slovak Republic*

Primaryapproach toprivatization

Direct sales –concentrated ownershipto management andemployees

RomaniaSlovenia*Belarus*TurkenistanUkraineUzbekistan*

Voucher –predominantly disperseownership

Czech republicLithuaniaArmeniaAzerbaijanGeorgiaKrgyzstan*MoldovaRussia

Low HighEffective Legal Protections at time of privatization

Source: EBRD Transition Report 1999, Table 2.2. with modifications by the author. Growth data and regiondefinition from IMF data presented in Havarylyshyn and Wolf (1999)

Note: * indicates that country had growth 1991-1998 that exceeded the mean for their region. The regionsconsidered are central and eastern Europe, the Baltics and the Commonwealth of Independent States.

** eastern Germany has no direct comparison group

Interestingly, contrary to many descriptions, a number of countries held to

international benchmarks, reflected in their presence in the top left quadrant. Estonia’s

privatization program, for example, followed closely that of Germany.18 While vouchers

were used, in most instances only minority stakes of approximately 40 percent were

targeted to voucher holders, while 60 percent was sold to a strategic investor. Most

strategic investors were foreign, with Swedes and Finns of Estonian descent playing an

important role. The German experience is also illustrative. They had significant freedom

to choose the degree of ownership concentration, with many demands for a widespread

distribution of shares to eastern Germans. However, as Dyck (1997) describes, their

approach in using asset sales instead of share issues, with openness to foreigners and a

preference for firms that had established experience in the sector and management

capabilities, resulted in eastern German firms being bought by established western

German firms. The result was that eastern German firms inherited the corporate

18 Nellis (1996) provides a description of this program.

39

governance structure of established western German firms, a governance structure that is

viewed internationally as very effective in addressing both types of governance problems.

Legal protections, financial performance and the evolution of ownership

There have been no systematic efforts to evaluate whether the initial ownership

structure at the time of privatization relative to the legal environment helps to explain

subsequent performance experiences. But, in broad strokes, the evidence is consistent.

As Megginson and Netter (2000) emphasize in a comprehensive survey of available

privatization evidence, the financial impact of privatization is overwhelmingly positive,

with the exception of the transition economies. Within the transition economies, a simple

examination of the relationship between the initial approach to privatization and

subsequent growth is thought provoking.

To a large (and perhaps surprising) degree the initial approach to privatization

predicts very well the country’s subsequent growth experience. As revealed in Figure 3,

those that held to international benchmarks have done better than average in their regions.

Those that did not have done worse, sometimes spectacularly worse. In terms of the

figures, countries have tended to remain in the quadrant in which they started, with little

movement rightward to show increased effective protections, and only limited movement

upward to increase concentration.

More convincing is microeconomic evidence that controls for confounding factors

that might influence the ownership choice as well as differences in country starting

points. In the transition economies, there is a growing body of microeconomic evidence

to draw from and a few results are clear. Based on the discussion in section 1, the

following statement from the EBRD (1999) should not be surprising, “Unambiguously

positive results have been found only for those enterprises privatised to strategic foreign

investors or to other types of concentrated outside owners.” Specific studies supporting

this contention include Djankov (1999) for the CIS and Frydman, Gray, Hessel and

Rapaczynski (1999) for the Czech Republic, Hungary and Poland. The Djankov (1999)

study for example found that for privatization to have a positive impact, the ownership

stake needed to be greater than 30 percent and the owner had to be a foreigner.

40

A recent survey of 3,000 enterprises completed by the World Bank and the

EBRD, reinforces these results. While this study does not control for possible

confounding factors, it has the advantage of broad coverage and a consistent

methodology. Chart 1, reproduced from EBRD (1999) shows the significant impact of

ownership concentration with privatization. For all indicators of restructuring - from

reducing workforce, to new products and technology, to sales and employment increases

– reform is much greater in firms with less than three shareholders than in more

diversified firms with more than three shareholders. Chart 2, also reproduced from EBRD

(1999), shows that identity in addition to concentration is required to improve

governance. Using the same survey it is evident that firms privatized to foreigners

outperform state-owned firms and firms privatized to domestic citizens again on all

fronts. Firms privatized to domestic insiders do not perform consistently better than

state-owned firms, although their performance is stronger outside of the commonwealth

of independent states.

40

Appendix Table 1 - Institutions of Corporate Governance: Legal ProtectionsLLSV Sample Pistor Sample

COUNTRY LegalOrigin

Anti-directorRights

Rule of Law AccountingStandards

Effective legalprotections'

COUNTRY Anti-directorRights 1992

Anti-directorRights 1998

Australia Eng 4 10.00 75 90 Albania 3 3Canada Eng 5 10.00 74 111 Armenia 2,5 5,5Hong Kong Eng 5 8.22 69 85 Azerbaijan 2,5 2India Eng 5 4.17 57 36 Belarus 1,5 1,5Ireland Eng 4 8.75 na naIsrael Eng 3 4.82 64 28 Bosnia 0 0,5Kenya Eng 3 5.42 na na Bulgaria 4 4Malaysia Eng 4 6.78 76 62 Croatia 0 2,5New Zealand Eng 4 10.00 70 84 Czech Rep 2 3Nigeria Eng 3 2.73 59 15 Estonia 2 3,75Pakistan Eng 5 3.03 na na FYR Macedonia 0 2,5Singapore Eng 4 8.57 78 81 Georgia 2,5 3South Africa Eng 5 4.42 70 47 Hungary 2,5 3Sri Lanka Eng 3 1.90 na na Kazakhstan 2,5 5,25Thailand Eng 2 6.25 64 24 Kyrgyzstan 2,5 2,25UK Eng 5 8.57 78 101 Latvia 3,5 3,5US Eng 5 10.00 71 107 Lithuania 2,5 3,75Zimbabwe Eng 3 3.68 na na Moldova 3 3,5Argentina Fra 4 5.35 45 29 Poland 3 3Belgium Fra 0 10.00 61 0 Romania 3 3Brazil Fra 3 6.32 54 31 Russia 2 5,5Chile Fra 5 7.02 52 55 Slovak Rep 2,5 2,5Colombia Fra 3 2.08 50 9 Slovenia 0 2,5Ecuador Fra 2 6.67 na na Ukraine 2,5 2,5Egypt Fra 2 4.17 24 6 Uzbekistan 2,5 3,5France Fra 3 8.98 69 56 Average 1.8 3.0Greece Fra 2 6.18 55 20Indonesia Fra 2 3.98 na naItaly Fra 1 8.33 62 16Mexico Fra 1 5.35 60 10Netherlands Fra 2 10.00 64 39Peru Fra 3 2.50 38 9Phillippines Fra 3 2.73 65 16Portugal Fra 3 8.68 36 28Spain Fra 4 7.80 64 60Turkey Fra 2 5.18 51 16Uruguay Fra 2 5.00 31 9Venezuela Fra 1 6.37 40 8Austria Ger 2 10.00 54 33Germany Ger 1 9.23 62 17Japan Ger 4 8.98 65 70South Korea Ger 2 5.35 62 20Switzerland Ger 2 10.00 68 41Taiwan Ger 3 8.52 65 50Denmark Scan 2 10.00 62 37Finland Scan 3 10.00 77 70Norway Scan 4 10.00 74 89Sweden Scan 3 10.00 83 75Average 3.0 6.9

Source: LLSV (1998), Pistor (1999) and calculations by the author.

41

Appendix Table 2 - Ownership concentrationCountry Combined cash flow

stakes of 3 largestshareholders (LLSV

(1998))

Percentage of large firms with acontrolling shareholder using 20%

def. (LLS(1999), CDL (1999))

Percentage of medium sized firms with acontrollling shareholder using 20% def.

(LLS(1999), CDL (1999))

Argentina 0.53 100 100Australia 0.28 35 70Austria 0.58 95 100Belgium 0.54 95 80Brazil 0.57Canada 0.40 40 40Chile 0.45 0Colombia 0.63Denmark 0.45 60 70Egypt 0.62Finland 0.37 65 80France 0.34 40 100Germany 0.48 50 90Greece 0.67 90 100Hong Kong 0.54 90 100India 0.40Indonesia 0.58 95 94Ireland 0.39 35 37Israel 0.51 95 90Italy 0.58 80 100Japan 0.18 10 70Malaysia 0.54 95 88Mexico 0.64 100 100Netherlands 0.39 70 90New Zealand 0.48 70 43Nigeria 0.40Norway 0.36 75 80Pakistan 0.37Peru 0.56Phillippines 0.57 95 84Portugal 0.52 90 100Singapore 0.49 85 60South Africa 0.52South Korea 0.23 45 70Spain 0.51 65 100Sri Lanka 0.60Sweden 0.28 75 90Switzerland 0.41 40 50Taiwan 0.18 85 64Thailand 0.47 95 94Turkey 0.59UK 0.19 0 40US 0.20 20 10Venezuela 0.51Zimbabwe 0.55

average 0.46 68.13 75.27

Source: LLSV (1998), LLS(1999), CDL(1999).Note: LLS measure used when LLS and CDL disagree.

42

Finally, looking at more focused studies that examine the evolution of ownership

concentration there is clear support for Bebchuk’s contention that disperse ownership

structures are unsustainable. In one such study, Claessens and Djankov (1999) examine

the developments in measures of ownership concentration for Czech firms and report

steady increases in concentration over time.

Offsetting benefits to deviating from international benchmarks are hard to find.

Pistor (1999) presents evidence that countries that pursued mass privatization programs

did start with higher levels of legal protections (2.55 versus 1.85 in 1992), and that the

difference between mass privatizers and others has been maintained (3.61 versus 2.71 in

1998). But the improvements in protections often were introduced after privatization

rather than before and possible benefits with these legal protections appear to have been

undermined by poorer market oversight. Pistor’s index reveals that despite starting with

higher levels in 1992, by 1998, the level of oversight was lower in mass privatization

countries than in those that did not pursue mass privatization.

4 Policy Implications and Future Research

So what does this functional framing and evidence suggest should be priorities for

policy makers interested in improving corporate governance systems? I identify four

broad agenda items, in declining order of importance.

First, policy makers should benchmark a country’s corporate governance system.

The impressive recent performance of the US economy, an economy characterized by

effective legal protections and anonymous diversified shareholders, has stimulated

interested in replication. Appreciation of the real requirements of such an undertaking

demands a stocktaking of a country’s corporate governance infrastructure. This

stocktaking includes legal protections, but also the efficiency of the judiciary, social

norms, and the extent of existing information/reputation intermediaries.

After completing a stock taking, policy makers can target their scarce time and

resources to the areas that will improve the situation the most. Without such a stock

taking, there will be many uncoordinated policies. As suggested by the discussion above,

some of these policies might be unsustainable at best, and at worst harmful. The research

43

described here has made significant progress in outlining the tools to conduct such a

benchmarking. Much work remains to fill in the details.

One tool is identification of a sequence, if any, in the introduction of various

institutions of corporate governance that support anonymous diversified shareholders.

The source of such evidence lies not in cross sectional studies, but in more in-depth

historical studies of economies that have successfully introduced effective legal

protections. There appears to be considerable support for the contention, offered most

recently by Rajan and Zingales (1999), that political constraints on the sovereign deserve

prominence as they are a precondition for legal protections to matter. More precision on

these dynamics from the history of countries that have developed legal institutions could

only help guide the allocation of scarce resources.

For legal protections, the technique of LLSV to identify key legal protections for

financiers is a good starting point. As the authors are the first to acknowledge, it is also

incomplete. Other legal protections not found in the company law can substitute for the

protections they discuss to lower the cost of competing claims over the wealth generated

in the firm. Expansions to the list of legal protections, like those offered by Pistor

(1999), are worth consideration.

Whether the set of legal protections should also include protections for other

stakeholders in the firm remains an open question. Theoretically, it is clear that labor,

management, and suppliers, like financiers, condition their willingness to provide

resources based on their expectations whether the explicit and implicit promises

exchanged for these investments will be fulfilled. It is an empirical rather than a

theoretical question whether legal protections for these investments should be included.

To my knowledge, such work remains to be done.

A second institution of corporate governance that needs benchmarking is the

efficiency of a nation’s judiciary. Summary measures of efficiency as viewed by

participants in the system or by commercial agencies provide a strong signal of efficiency

and perhaps the best currently available. But there is ample scope for better measures.

Pistor and Wellons (1998) provide some alternatives. In their study of Law and Asian

economic development, they focus on collecting information on the time it takes to get

resolution of cases, the willingness to take cases to court, and the fraction of cases that

44

rule against the sovereign. More importantly, it would be useful if we had indicators of

what structural variables at the discretion of policy makers contributed to judicial

efficiency. The historical evidence from developed economies, and the correlation

between common law tradition and some efficiency measures, suggests features such as

constitutions, the distribution of powers among branches of government at the federal

level, the degree of decentralization of federal authority, and the degree of devolution of

power and taxing authority to regional and local levels might matter. More systematic

work would clearly aid understanding.

A third institution to support anonymous investment in firms by diversified

shareholders is information/reputation intermediaries that provide information through

open channels. In most developing economies, the creation of such intermediaries is

likely to rely on using intermediaries headquartered in other countries, creating

conditions to facilitate the entry of foreign intermediaries, or the transformation of

existing closed intermediaries such as banks into producing information for public

purchase. Recent research by Kang, Khanna and Palepu (1999) that uses IBES data on

the extent and accuracy of analyst activity across the world reveals one way to

benchmark such activity. More research is needed here to decide if this is a priority area

for policy making.

Second, improve the effectiveness of legal protections. Theory and empirical

evidence support the contention that the functions of corporate governance are provided

at lower cost when investor protections are stronger, there is judicial efficiency, and there

is information available to anonymous investors. While each institution has value, there is

greater value when they occur together. In other words, the aim of corporate governance

policy reform should not be to increase an index of legal protections alone but to increase

an index that includes an interaction term that measures the effectiveness of legal

protections as I have done in the figures above. Crudely put, if it was equally costly for

policy makers to raise an index of institutional efficiency by one point for legal

protections, judicial efficiency and information, and each institution was at say 2 on a

five point scale, policy makers would get a greater return for their investment if they

raised each by 1, than if they raised legal protections alone by 3. The end level in

effectiveness would be 27 as opposed to 20.

45

A few observations flow from the complementarity of these institutional factors

and the need to consider the interaction of different institutions. The fact that the depth of

complementary institutions differs across countries suggests that efforts to devise a

checklist of legal protections that should be introduced everywhere are misguided. While

there might be a common set of legal protections that countries can aspire to, the specific

legal protections appropriate to a country need to take into account the existing

institutions to be most effective. Where these complementary institutions are very

inefficient, little should be expected from changes in legal protections and scarce policy

attention might be better directed to either developing these complementary conditions or

to other approaches to improve governance. Again, this returns us to a question of

sequencing and the lessons from history.

Recent research hints that positioning judicial authority can enhance legal

efficiency. The work of McCraw (1982) on the history of the US SEC and Johnson and

Shleifer (1999) on regulatory authorities in the Czech Republic and Poland suggest the

value of an independent securities and exchange commission that focuses its scarce

resources on regulating intermediaries rather than the issuers of securities. Effective

functioning also requires that the regulator not abuse this authority. The US experience

suggests the additional value of harnessing the incentives of existing intermediaries and

fostering the development of self-regulating organizations so that concentrated authority

in a regulators’ hands does not lead to abuse. Pistor (1999) provides a possible index of

the strength of such institutions.

Third, governance policies should be aligned with the existing state of legal

protections. Institutions are amenable to change, but changing the effectiveness of legal

protections only occurs in the medium to long-run. My reading of the existing evidence,

particularly the privatization evidence, is of large costs associated with a misalignment of

ownership structure with the legal environment. Not only are anonymous, disperse

ownership structures unsustainable, but the recognition of their lack of sustainability

encourages socially wasteful activities. A possible rationale for such an approach, that it

will stimulate an increase in effective legal protections, does not have significant support.

The lesson I draw for countries with weak existing legal protections is of the importance

of identity and concentration to support the functions of governance.

46

The implications for privatization design are to align ownership structure to legal

protections at the time of privatization. With weak legal protections, concentrated

ownership, and owners with identities that facilitate promise fulfillment, (e.g. foreign

owners), despite their weaknesses, are likely to enhance the willingness to invest

resources in firms. The implications for established firms is caution with policies to

transform established ownership patterns. Increasing cash flow ownership and reducing

the gap that might exist between cash flow ownership and voting rights (e.g. limiting

pyramiding) are policies likely to be beneficial. But attempts to move towards disperse

structures are problematic. There are costs with such structures relative to anonymous,

disperse shareholding, but that does not imply that benefits of such arrangements do not

overwhelm these costs where legal protections are weak.

This conservative perspective on ownership is controversial. I do not disagree

with scholars that see in some ownership structures the source of a lack of development.

As Colin Mayer (2000) argues, in developing countries “ the retention of control in the

hands of political and business oligarchies is probably the single most important

impediment to economic development.” CDL (1999) agree suggesting that family groups

with concentrated structures are the major obstacles to legal reform. “If the role of a

limited number of families in the corporate sector is large and the government is heavily

involved in and influenced by business, the legal system is less likely to evolve in a

manner to protect minority shareholders, and more generally to promote transparent and

market-based activities.” But the available evidence is not convincing that efforts to

replace such structures with anonymous owners will be any improvement. In my reading

of existing evidence, the ownership structure is more of a response to the institutional

environment than the source of that environment.

More generally, policy actions that produce marginal improvements in developed

economies, might have opposite effects in economies with poor investor protections.

Simply put, economists’ intuition based on the assumption that contracts will be upheld

can be misleading in environments with weak legal protections. This suggests caution

with approaches that suggest one common practice to address governance concerns.

Policy makers are advised to focus on fostering the functions of effective governance

systems rather than creating identical institutions.

47

Consider legislation that raises the costs of takeovers. An economists’ intuition is

that such legislation is costly, making it more difficult to overcome the public good

problem associated with monitoring management. In environments with weak legal

protections, as investors in Czech and Russian firms have learned, takeovers can be part

of the problem rather than the solution. Opening up a firm to takeovers can expose the

firm to raiders far more expert at dilution than existing insiders. Moreover, in any

competition amongst raiders, the ones skilled and interested in dilution are always willing

to pay more.

There are also examples from developing economies, where the lowest cost way

to reduce information asymmetries and resolve disputes could easily be within groups or

banks rather than a marginal change in information intermediaries. For example, it is

costly to introduce information intermediaries that provide open information, for there

may be insufficient demand for services to just perform one role or indivisibilities in

scarce management talent. If an intermediary attempts to perform multiple roles, their

ability to do so will be downgraded by the markets concern over conflicts of interest.

Banks or other networks can use information internally with less concerns about conflicts

of interest (although they need not do so). In Germany for example, there has historically

been no active corporate bond market for medium sized firms. Instead, large banks have

floated their own bonds and onlent to medium sized firms using their own internal

information on firms to evaluate their reliability. At some stages in development, such an

approach appears to be a much cheaper way to address this function.

Fourth, there is scope for improvement in corporate governance policies in

countries with weak legal protections. When one sees the goal of governance policy to

enhance promise fulfillment, a range of additional actions can be considered. That there

is scope for improvement is revealed in the data. I started this paper talking about the

governance problems with oil and gas companies in Russia and the discounts of market

value relative to ‘worth’ of 30-556 times. What I did not mention was that another

Russian company in the same industry, Lukoil, had a significantly lower estimated

discount of market value relative to worth. Black et. al (1999) report this to be only 7.5

times ($6 billion market/ $45 billion ‘worth’). While it remains to be seen what Lukoil

does differently so that the market increases its estimate, what is clear is that if such

48

practices could be identified and transferred the gains are astounding. The combined

value of Gazprom and Yukos alone would increase by $ 67 billion if they could improve

to this discount.

An approach that has worked in countries with weak legal protections is to

identify domestic companies with well functioning foreign networks. An important

example of this is efforts to piggyback on legal protections of established economies by

having domestic companies cross list their shares on foreign exchanges. The firm is no

longer anonymous, but has identified itself with a foreign exchange. When foreign

companies list on US stock exchanges, for example, they are required to comply with

international accounting standards and to increase their information disclosure. Equally

as important, this exchange presumably has the incentive to delist the firm if they violate

their commitments to the exchange. This has costs when the firm values the option to

raise future capital and has limited other windows to international capital sources. By

allying themselves with the exchange, they enhance beliefs about promise fulfillment.

Investors and firms are apparently pleased with foreign listings. Reese and

Weisbach (2000) provide evidence that more capital is raised with subsequent share

issues, both through the US and through domestic markets. The extent of the increase in

listings is greater for countries with weak legal protections. Johnson and Shleifer (1999)

emphasize the growth of the Neuer Markt in Germany, a creation of the Frankfurt stock

exchange with higher listing requirements, that has served as the vehicle for many new

listings both in Germany and from surrounding countries. Interestingly, privatized firms

have led the way in cross listing. Most of the privatized foreign companies that have

pursued share issues rather than asset sales have included a tranche listed on a western

stock exchange.

While the early evidence is promising, limitations to this approach must also be

noted. This approach is of little help for remaining competing claims over the wealth

generated by the firm. Disputes are still resolved in the firms’ domestic court that faces

problems of judicial inefficiency. The experience with shares of Chinese companies

floated on the Hong Kong stock exchange (so called H shares) is cautionary. Despite the

greater disclosure rules from listing in this more transparent exchange, this did not stop a

number of firms from violating terms of their prospectus to the detriment of minority

49

shareholders. In addition, questions emerge about the penalties associated with delisting.

This is only a significant penalty if those in charge of the firm value the continued access

to finance through that channel, and if they think delisting from one foreign exchange

will eliminate their possibilities of listing on other foreign exchanges. There are multiple

possible listing sights and little coordination at present.

A second way forward is to foster the development of domestic networks that offer

a reliable channel to follow promise fulfillment with sure penalties. Business associations

are one such potential channel to improve information and penalties when courts are

arbitrary or unlikely to side with investors. They have the potential to collect information

and to impose penalties upon their members, particularly if business associations require

a large bond to join the association and if continued membership is valuable. In that

circumstance, investors need only to know of a firms’ membership to increase their

beliefs that their promise will be upheld.

This approach also has its limits though. An investor is likely to have legitimate

doubts that an association will truly impose penalties on its members for non-compliance.

There are legitimate questions about the possible strength of such incentives. There is

also an incentive for firms that have no interest in complying to pretend to comply, for

example forming a competing business association. Where such mimicking is possible,

and the real characteristics are only known in the long run, this will undermine the

prospects for such business associations.

5 Conclusions

Policy makers are right to concern themselves with systems of corporate

governance. The evidence suggests that when the functions of a corporate governance

system are not provided, or provided at high costs, promises are violated, resources for

new investment projects dry up with resulting costs for growth and development.

This paper has suggested the value of approaching the question of corporate

governance reform with the functions of corporate governance in mind, not specific

institutions. The functional perspective leads to two main points. First, little can be

expected from reforms that take one common set of legal protections and apply them in

many countries. Legal protections are insufficient to provide the functions of

governance. Effective legal protections require complementary institutions, from

50

structural restrictions on the sovereign, to social norms, a carefully designed delegation of

judicial authority, and a surprising depth of information and reputation intermediaries.

Second, adopting governance policies without an appreciation of the existing state

of effective legal protections can be extremely costly. This is clearly demonstrated with

ownership structure. Evidence shows that disperse shareholding is unsupportable in

countries with weak legal protections, and privatization evidence from transition

economies indicates the costs with mis-aligning ownership structure with legal

protections. Ownership structure can substitute for legal protections in providing the

functions of corporate governance.

There are great possibilities to tie the ‘grabbing hands’ of public and private

actors in private sector firms. Keeping the functions in mind is a worthwhile place to

start.

51

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Source: Survey of industrial firms (excluding new enterprises) with over 200 employees, EBRD (1999), Chart 9.3

C h a r t 1 - R e s tru c t u r i n g a n d O w n e r s h ip c o n c e n tra t ion

0 1 0 2 0 3 0 4 0 5 0 6 0 7 0 8 0 9 0

O v e r 1 0 % w o r k f o r c er e d u c t i o n

D is c o n t i n u a t i o n o f ap r o d u c t l i n e

M a j o r r e o r g a n i s a t i o n

U p g r a d i n g o f t e c h n o l o g y

N e w p r o d u c t l i n e

S a l e s i n c r e a s e

E x p o r t i n c r e a s e

E m p lo y m e n t i n c r e a s e

P e r c e n t a g e o f f i r m s r e p r t i n g a c t i v i t y o v e r l a s t t h r e e y e a r s

F i rm s w i th m o r e t h a n t h r e e s h a r e h o l d e r sF i rm s w i th a t m o s t 3 s h a r e h o ld e rs

56

Chart 2 - Ownership Type and Restructuring

Central and eastern Europe and Baltics

0 10 20 30 40 50 60 70 80 90

Over 10% workforce reduction

Discontinuation of a product line

Major reorganisation

Upgrading of technology

New product line

Sales increase

Export increase

Employment increase

Percentage of firms reporting activity over last three years

foreign-owned privatized domestic state-owned

57

Commonwealth of Independent States

0 10 20 30 40 50 60 70 80 90

Over 10% workforcereduction

Discontinuation of aproduct line

Major reorganisation

Upgrading of technology

New product line

Sales increase

Export increase

Employment increase

Percentage of firms reporting activity over last three years

foreign-owned privatized domestic state-owned