Three Models of Corporate Governance from Developed Capital Markets

Three Models of Corporate Governance from Developed Capital Markets 

Introduction 

      The corporate governance structure of joint stock corporations in a given country is determined by several factors: the legal and regulatory framework outlining the rights and responsibilities of all parties involved in corporate governance; the de facto realities of the corporate environment in the country; and each corporation’s articles of association. While corporate governance provisions may differ from corporation to corporation, many de facto and de jure factors affect corporations in a similar way.  Therefore, it is possible to outline a "model" of corporate governance for a given country. 

      In each country, the corporate governance structure has certain characteristics or constituent elements, which distinguish it from structures in other countries. To date, researchers have identified three models of corporate governance in developed capital markets. These are the Anglo-US model, the Japanese model, and the German model. 

      Each model identifies the following constituent elements: key players in the corporate environment; the share ownership pattern in the given country; the composition of the board of directors (or boards, in the German model); the regulatory framework; disclosure requirements for publicly-listed stock corporations; corporate actions requiring shareholder approval; and interaction among key players. 

      The purpose of this article is to introduce each model, describe the constituent elements of each and demonstrate how each developed in response to country-specific factors and conditions. Readers should understand that it is not possible to simply select a model and apply it to a given country. Instead, the process is dynamic: the corporate governance structure in each country develops in response to country-specific factors and conditions. 

The Anglo-US Model¹ 

      The Anglo-US model is characterized by share ownership of individual, and increasingly institutional, investors not affiliated with the corporation (known as outside shareholders or “outsiders”); a well-developed legal framework defining the rights and responsibilities of three key players, namely management, directors and shareholders; and a comparatively uncomplicated procedure for interaction between shareholder and corporation as well as among shareholders during or outside the AGM. 

      Equity financing is a common method of  raising capital for corporations in  the United Kingdom (UK) and the US. It is not surprising, therefore, that the US is the largest capital market in the world, and that the London Stock Exchange is the third largest stock exchange in the world (in terms of market capitalization) after the New York Stock Exchange (NYSE) and Tokyo. 

       There is a causal relationship between the importance of equity financing, the size of the capital market and the development of a corporate governance system. The US is both the world’s largest capital market and the home of the world’s most-developed system of proxy voting and shareholder activism by institutional investors. Institutional investors also play an important role in both the capital market and corporate governance in the UK. 
 
 
 
 

¹ The Anglo-US model governs corporations in the UK, the US, Australia, Canada, New Zealand and several other countries.

 

Key Players in the Anglo-US Model 

      Players in the Anglo-US model include management, directors, shareholders (especially institutional investors), government  agencies, stock exchanges,  self-regulatory organizations and consulting firms which advise corporations and/or shareholders on corporate governance and proxy voting. 

      Of these, the three major players are management, directors and shareholders. They form what is commonly referred to as the "corporate governance triangle." The interests and interaction of these players may be diagrammed as follows: 
 
 
 
 
 
 
 
 
 
 
 
 

       The Anglo-US model, developed within the context of the free market economy, assumes the separation of ownership and control in most publicly-held corporations. This important legal distinction serves a valuable business and social purpose: investors contribute capital and maintain ownership in the enterprise, while generally avoiding legal liability for the acts of the corporation. Investors avoid legal liability by ceding to  management control of  the corporation, and paying management for acting as their agent by undertaking the affairs of the corporation. The cost of this separation of ownership and control is defined as “agency costs”. 

      The interests of shareholders and management may not always coincide. Laws governing corporations in countries using the Anglo-US model attempt to reconcile this conflict in several ways. Most importantly, they prescribe the election of a board of directors by shareholders and require that boards act as fiduciaries for shareholders’ interests by overseeing management on behalf of shareholders. 

      Two diagrams at the end of this article explain the dynamics of the Anglo-US model in theory and in practice. 

Share Ownership Pattern in the Anglo-US Model 

      In both the UK and the US, there has been a marked shift of stock ownership during the postwar period from individual shareholders to institutional shareholders. In 1990, institutional investors held approximately 61 percent of the shares of UK corporations, and individuals held approximately 21 percent. (In 1981, individuals held 38 percent.)  In 1990, institutions held 53.3 percent of the shares of US corporations.² 

       The increase in ownership by institutions has resulted in their increasing influence. In turn, this has  triggered regulatory changes designed to  facilitate their interests and interaction in  the corporate governance process. 
 
 
 

² The term “capital market” is broad, encompassing all the markets where stocks (also known as shares), bonds, futures, derivatives and other financial instruments are traded. “Securities market” is more specific, referring to stocks and bonds. “Equity market” is most specific, referring only to stock, also known as equity.

 

Composition of the Board of Directors in the Anglo-US Model 

      The board of directors of most corporations that follow the Anglo-US model includes both “insiders” and “outsiders”. An “insider” is as a person who is either employed by the corporation (an executive, manager or employee) or who has significant personal or business relationships with corporate management. An “outsider” is a person or institution which has no direct relationship with the corporation or corporate management. 

      A synonym for insider is executive director; a synonym for outsider is non-executive director or independent director. 

      Traditionally, the same person has served as both chairman of the board of directors and chief executive officer (CEO) of the corporation. In many instances, this practice led to abuses, including: concentration of power in the hands of one person (for example, a board of directors firmly controlled by one person serving both as chairman of the board of directors and CEO); concentration of power in a small group of persons (for example, a board of  directors composed solely of “insiders”; management and/or the board of directors’ attempts to retain power over a long period of time, without regard for the interests of other players (entrenchment); and the board of directors’ flagrant disregard for the interests of outside shareholders. 

      As recently as 1990, one individual served as both CEO and chairman of the board in over 75 percent of the 500 largest corporations in the US. In contrast to the US, a majority of boards in the UK have a non-executive director.  However, many boards of UK companies have a majority of inside directors:  in 1992, only 42 percent of all directors were outsiders and nine percent of the largest UK companies had no outside director at all.³ 

      Currently there is, however, a discernible trend towards greater inclusion of “outsiders” in both US and UK corporations. 

      Beginning in the mid-1980s, several factors contributed to an increased interest in corporate governance in the UK and US.  These included:  the increase in institutional investment in both countries; greater governmental regulation in the US, including regulation requiring some institutional investors to vote at AGMs; the takeover activity of the mid- to late-1980s; excessive executive compensation at many US companies and a  growing sense of loss of competitiveness vis-а-vis German and Japanese competitors. 

      In response, individual and institutional investors began to inform themselves about trends, conduct research and organize themselves in order to represent their interests as shareholders. Their findings were interesting. For example, research conducted by diverse organizations indicated that in many cases a relationship exists between lack of effective oversight by the board of directors and poor corporate financial performance. In addition, corporate governance analysts noted that “outside” directors often suffered an informational disadvantage vis-а-vis “inside” directors and were therefore limited in their ability to provide effective oversight. 

       Several factors influenced the trend towards an increasing percentage of “outsiders” on boards of directors of UK and US corporations. These include: the pattern of stock ownership, specifically the above-mentioned increase in institutional investment the growing importance of institutional investors and their voting behavior at AGMs; and recommendations of self-regulatory organizations such as the Committee on the Financial Aspects of Corporate Governance in the UK and shareholder organizations in the US. 
 

³ Data from “Board Directors and Corporate Governance:  Trends in the G7 Countries Over the Next Ten Years,” a study prepared for Russell Reynolds Associates, Price Waterhouse, Goldman Sachs International, and Gibson, Dun & Crutcher, by Oxford Analytica Ltd. Oxford, England, September 1992.

 

 

      Board composition and board representation remain important shareholder concerns of shareholders in the UK and US. Perhaps this is because other corporate governance issues, such as disclosure and mechanisms for communication between corporations and shareholders, have largely been resolved. 

      UK and US boards are generally smaller than boards in Japan and Germany.  In 1993, a survey of the boards of the 100 largest US corporations conducted by the executive search firm Spencer Stuart found that boards were shrinking slightly; the average size was 13, compared with 15 in 1988. 

Regulatory Framework in the Anglo-US Model 

      In the UK and US, a wide range of laws and regulatory codes define relationships among management, directors and shareholders. 

      In the US, a federal agency, the Securities and Exchange Commission (SEC), regulates the securities industry, establishes disclosure requirements for corporations and regulates communication between corporations and shareholders as well as among shareholders. 

Laws regulating pension funds also have an important impact on corporate governance. In

1988, the agency of the Department of Labor responsible for regulating private pension funds ruled that these funds have a “fiduciary responsibility” to exercise their stock ownership rights.  This ruling had a huge impact on the behavior of private pension funds and other institutional investors: since then, institutional investors have taken a keen interest in all aspects of corporate governance, shareholders’ rights and voting at AGMs. 

      Readers should note that because US corporations are registered and “incorporated” in a particular state, the respective state law establishes the basic framework for each US corporation’s rights and responsibilities. 

      In comparison with other capital markets, the US has the most comprehensive disclosure requirements and a complex, well-regulated system for shareholder communication. As noted above, this is directly related to the size and importance of the US securities market, both domestically and internationally. 

      The regulatory framework of corporate governance in the UK is established in parliamentary acts and rules established by self-regulatory organizations, such as the Securities and Investment Board, which is responsible for oversight of the securities market. Note that it is not a government agency like the US SEC. Although the framework for disclosure and shareholder communication is well-developed, some observers claim that self-regulation in the UK is inadequate, and suggest that a government agency similar to the US SEC would be more effective. 

      Stock exchanges also play an important role in the Anglo-US model by establishing listing, disclosure and other requirements.

 

      

Disclosure Requirements in the Anglo-US Model 

      As noted above, the US has the most comprehensive disclosure requirements of any jurisdiction. While disclosure requirements are high in other jurisdictions where the Anglo-US model is followed, none are as stringent as those in the US. 

      US corporations are required to disclose a wide range of information. The following information is included either in the annual report or in the agenda of the annual general meeting (formally known as the “proxy statement”): corporate financial data ( this is reported on a quarterly basis in the US); a breakdown of the corporation’s capital structure; substantial background information on each nominee to the board of directors (including name, occupation, relationship with the company, and ownership of stock in the corporation); the aggregate compensation paid to all executive officers (upper management) as well as individual compensation data for each of the five highest paid executive officers, who are to be named; all shareholders holding more than five percent of the corporation’s total share capital; information on proposed mergers and restructurings; proposed amendments to the articles of association; and names of individuals and/or companies proposed as auditors. 

      Disclosure requirements in the UK and other countries that follow the Anglo-US model are similar.  However, they generally require semi-annual reporting and less data in most categories, including financial statistics and the information provided on nominees. 

Corporate Actions Requiring Shareholder Approval in the Anglo-US Model 

      The two routine corporate actions requiring shareholder approval under the Anglo-US model are elections of directors and appointment of auditors. 

      Non-routine corporate actions which also require shareholder approval include: the establishment or amendment of stock option plans (because these plans affect executive and board compensation); mergers and takeovers; restructurings; and amendment of the articles of incorporation. 

      There is one important distinction between the US and the UK: in the US, shareholders do not have the right to vote on the dividend proposed by the board of directors. In the UK, shareholders do vote on the dividend proposal. 

      The Anglo-US model also permits shareholders to submit proposals to be included on the agenda of the AGM. The proposals - known as shareholder proposals - must relate to a corporation’s business activity. Shareholders owning at least ten percent of a corporation’s total share capital may also convene an extraordinary general meeting (EGM) of shareholders. 

      In the US, the SEC has issued a wide range of regulations concerning the format, substance, timing and publication of shareholder proposals.  The SEC also regulates communication among shareholders. 

Interaction Among Players in the Anglo-US Model 

      As noted above, the Anglo-US model establishes a complex, well-regulated system for communication and interaction between shareholders and corporations. A wide range of regulatory and independent organizations play an important role in corporate governance. 

      Shareholders may exercise their voting rights without attending the annual general meeting in person. All registered shareholders receive the following by mail: the agenda for the meeting

 

      

including background information an all proposals ("proxy statement"), the corporation’s annual report and a voting card. 

      Shareholders may vote by proxy, that is, they complete the voting card and return it by mail to the corporation. By mailing the voting card back to the corporation, the shareholder authorizes the chairman of the board of directors to act as his proxy and cast his votes as indicated on the voting card. 

      In the Anglo-US model, a wide range of institutional investors and financial specialists monitor a corporation's performance and corporate governance. These include: a variety of specialized investment funds (for example, index funds or funds that target specific industries); venture-capital funds, or funds that invest in new or "start-up" corporations; rating agencies; auditors; and funds that target investment in bankrupt or problem corporations. See the diagram "Diversified Monitoring  in  Anglo-US  Corporate  Governance"  for  a  pictoral  explanation  of  this phenomenon. In contrast, one bank serves many of these (and other) functions in the Japanese and German models. As a result, one important element of both of these models is the strong relationship between a corporation and its main bank. 

The Japanese Model 

      The Japanese model is characterized by a high level of stock ownership by affiliated banks and companies; a banking system characterized by strong, long-term links between bank and corporation; a legal, public policy and industrial policy framework designed to support and promote “keiretsu” (industrial groups linked by trading relationships as well as cross-shareholdings of debt and equity); boards of directors composed almost solely of insiders; and a comparatively low (in some corporations, non-existent) level of input of outside shareholders, caused and exacerbated by complicated procedures for exercising shareholders’ votes. 

      Equity financing is important for Japanese corporations. However, insiders and their affiliates are the major shareholders in most Japanese corporations. Consequently, they play a major role in individual corporations and in the system as a whole.  Conversely, the interests of outside shareholders are marginal. The percentage of foreign ownership of Japanese stocks is small, but it may become an important factor in making the model more responsive to outside shareholders.