Understanding Corporate Governance in the United States

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Gregory Jackson Understanding Corporate Governance in the United States 223 www.boeckler.de Arbeitspapier Unternehmensmitbestimmung und Unternehmenssteuerung

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Understanding Corporate Governance in the United States

Transcript of Understanding Corporate Governance in the United States

Page 1: Understanding Corporate Governance in the United States

Gregory JacksonUnderstanding

Corporate Governancein the United States

223

www.boeckler.dewww.boeckler.de

Arbeitspapier223Arbeitspapier

Unternehmensmitbestimmungund Unternehmenssteuerung

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Arbeitspapier 223

Gregory�Jackson��

Understanding Corporate Governance in the United StatesAn Historical and Theoretical Reassessment

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Jackson, Gregory,�Prof.�Dr.,�Professor�für�Personalpolitik�an�der�Freien�Universität�Berlin,�sowie�International�Research�Fellow�Centre�for�Corporate�Reputation,�Oxford�University.�Zahlreiche�Publikationen�zu�den�Themen��Corporate�Governance,�Corporate�Social�Responsibility,�Mitbestimmung��und�Personalmanagement�im�internationalen�Vergleich.

ImpressumHerausgeber: Hans-Böckler-Stiftung Mitbestimmungs-,Forschungs-undStudienförderungswerkdesDGB Hans-Böckler-Straße39 40476Düsseldorf Telefon:(0211)7778-175

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Inhaltsverzeichnis

Kurzfassung�.................................................................................................................5

Preface�..........................................................................................................................7

0� Introduction:�Understanding�Corporate�Governance��� in�the�USA��...........................................................................................................9

1� The�Recent�History�of�U.S.�Corporate�Governance,�1960-2001�...............111.1� Managerial�Capitalism:�1960s-1970s�...........................................................111.2� Investor�Capitalism�and�the�Deal�Decade:�1980s�........................................131.3� Executive�Defence�and�the�Ideology�of�Shareholder�Value:�the�1990s�........161.4� Enron:�2001�.................................................................................................21

2� The�Crisis�of�the�Shareholder�Value�Paradigm:�Post-Enron�Debates.......232.1� Limits�of�shareholder�activism.�...................................................................242.2� Limits�of�the�market�for�corporate�control.�.................................................262.3� Limits�of�board�independence.�....................................................................292.4� Limits�of�board�incentives.�..........................................................................312.5� Limits�of�gatekeepers�as�informational�intermediaries................................342.6� Absence�of�Employee�Voice�........................................................................352.7� A�Complementary�System?���.......................................................................36

3� Sarbanes-Oxley�and�its�Influence�on�Corporate�Governance�...................393.1� The�Influence�of�SOX�and�Related�SEC�Regulations�on�U.S.�Firms�..........403.1.1� External�aspects:�Disclosure,�Earnings�Management�and�Investor��

Reactions.�....................................................................................................413.1.2� Internal�aspects:�Corporate�Boards�and�Employee�Whistleblowers��...........423.1.3� Costs�of�Compliance�....................................................................................453.2� The�Influence�of�SOX�on�Foreign�Firms�.....................................................463.3� Compliance�with�SOX�and�Compatibility�with�German�Corporate��

Governance�..................................................................................................47

4� Conclusion�and�Implications�for�Understanding�Corporate��� Governance��........................................................................................................ 51

5� Bibliography�.......................................................................................................53

6� Appendix�A:�Statistical�Tables�........................................................................71

7� Appendix�B:�The�Contrast�in�US�and�UK�Approach��� to�Takeover�Regulation�.....................................................................................77

Über�die�Hans-Böckler-Stiftung�............................................................................89

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Kurzfassung

TheU.S.isoftenseenasbeingtheparadigmaticcaseoftheshareholder-orientedormarket-basedmodeltocorporategovernance,anddescribedintermsofseveralinter-relatedelements:activistinstitutionalinvestors,anopenmarketforcorporatecontrol,independentoutsidedirectorsontheboard,long-termequity-basedcompensationforexecutives, and gatekeeperswhomonitor the process ofmarket disclosure.Howev-er, scandalssurroundingEnrongeneratedcriticismand inducedsubstantialchangesthroughtheSarbanes-Oxley(SOX)legislation.ThisreportreexaminesthehistoryandempiricalevidenceonU.S.corporategovernance,showinghowitsevolutionhasbeenshapedbyanegativeforminstitutionalcomplementarities–thelimitedeffectivenessofoneelementcreatingexternalitiesorlimitingtheeffectivenessofotherrelatedele-ments,eventuallyleadingtoasystemiccrisis.ThisperspectivehelpsmaketheEnroncasemoreunderstandable,butalsoshowsthelimitedimpactofSOXinfixingthesys-tem.Theimplicationsforthecurrenteconomiccrisisareexplored.

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Preface

ThesystemofcorporategovernanceintheUnitedStatesisamovingtarget.AlthoughtheU.S.isoftentakenasakeybenchmarkforshareholder-orientedcorporategovern-anceandsometimesalsoequatedwitha“model”forgoodcorporategovernance,inter-nationalaudienceshaveoftenfailedtoappreciatethecontinuousevolutionanddebatesintheU.S.itselfregardingtherealityofcorporategovernanceinpractice.

ThisreportwascommissionedbytheHans-Böckler-Foundationasanattempttopar-tiallyfill thisgapinordertoprovideamorecompleteviewoftheU.S.debatesandbetterassess the influenceof recentdevelopmentsonEuropeandGermany, inpar-ticular.This taskprovedmore challenging thanwas initially anticipated.While thehistoriclegislativeturning-pointoftheSarbanes-Oxley(SOX)actwasalreadyinplace,empiricalevidenceontheinfluenceofSOXonlybegantoemergeaftertheresearchforthisreportalreadybegan.Thedownpourofnewstudiesalsopresentedapuzzlingpicture,showingimportantaspectsofchangeandcontinuitythatdefiedbothsupport-ersandcriticsofthelegislation.Infollowingthisdevelopment,manypeoplesupportedthisprojectwithadvice,comments,logisticalhelp,andtheirpatience.Severaldeserveparticularthanks–MasahikoAoki,JohnCioffi,NicolaEbert,RonaldGilson,HowardGospel,BruceKogut,RichardMarens,KarstenSchneiderandSigurtVitols.

Beforethedustofthepost-SOXdebatescouldsettle,U.S.corporategovernancenowfacesanotherhistoriccross-roadsthroughtheonsetofthebankingcrisisandresultingfinancialandeconomiccrisis,whichwasmarkedbythecollapseofLehmanBrothersin2008.Whiletheworkofsocialscientistsseemstoalwaysremainonestepbehindthedevelopmentsoftherealworld,IhopethatthisreporthelpsputthecurrentcrisisintoalongertermperspectiveofhowU.S.corporategovernancehasevolvedbothintermsofa theoretical idealandasamorecomplexsetofpractices.Onceagain,corporategovernancepracticesintheUnitedStatesareopenfordebate,theirfutureupforgrabs,andthe“model“remainsincomplete.

GregoryJackson

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0 Introduction: Understanding Corporate Governance in the USA

TheU.S.isoftenseenasbeingtheparadigmaticcaseoftheshareholder-orientedormarket-based approach to corporate governance.Ownership of corporations is dis-persed, but involves high engagement from institutional investors, such as pensionfunds.Corporateboardsaresmall,haveahighproportionofoutsideorindependentmembers,andutilizecommitteestoimproveboardprocesses.Executivepaylinkspaytotopmanagers’salariestoshareholderreturns.Theinternalandexternalaspectsofcorporategovernancearelinkedthroughthemonitoringofgatekeepers,suchasauditfirms, that certify the flow of information frommanagers to capitalmarkets.Andthemarketforcorporatecontrolexertsafinaldisciplineonpoorlyperformingfirms,whofaceaheightenedriskoftakeover.Thesedifferentelementsarealsothoughthavestronginstitutionalcomplementarities,operatingasapositiveandmutuallyreinforc-ingsystemofeffectivecorporategovernance.ThesestylizedcharacteristicsoftheU.S.modelarewidelycitedasbestpracticesorevenaglobalstandardforgoodcorporategovernance.

ScandalssurroundingEnronandWorldcomfocusedsubstantialcriticismontheU.S.corporategovernance.Somecriticsandscholarsusedtheseeventstomountastrongchallengetotheprevailingwisdomaboutmarket-basedsystemsofcorporategovern-ance(Blair,2003,Bratton,2002).OthersstresstheoverallgoodperformanceoftheU.S.economy,andseetheriseofequity-basedpayformanagersandthestockmarketboomas triggeringshort-termandsometimes illegalbehavioras“sideeffects”ofabasically sound system (Holmstrom&Kaplan, 2003).Thepolitical reaction, devel-opmentofSarbanesOxley(SOX)legislation,andsubsequentchangesinSEClistingrequirementshavealsoalteredthewayU.S.corporategovernancepracticesoperate.TheconsequencesofSOXhaveremainedhotlydebated.YettheonsetofthesubprimefinancialcrisisandresultingglobaleconomicdownturnhasraisedrenewedquestionsaboutthefundamentaleffectivenessofU.S.corporategovernanceinstitutions.

The era afterSOXalso greatly increased awareness of the differences between theU.S.andBritishapproachestocorporategovernance.Whilebothareconsideredtobebroadlysimilarshareholder-orientedmodels,theU.S.regulatoryregimeisbasedmuchmoreonhardlawandaregulatorystate,unliketheBritishapproachthatreliesmoreon soft law and self-regulatorymechanisms, such asCodes.The “one size fits all”approachofU.S.lawsparkeddebateoverthebenefitsofmandatoryrulesrelativetomoreflexiblesetsofprinciplesbasedonenablingsetofrules(Anand,2006).NewU.S.regulationgivesgreaterpowerandinstitutionalscopetothestateagenciessuchastheSECtoregulateimportant‘gatekeepers’andprofessionalintermediarieswhoarecen-traltomarket-basedmechanismsofmonitoring(Baker,BealingJr,Nelson&Staley,

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2006).Finally,takeoverrulesarealsoverydifferent,sincetheU.S.allowsbutregulatesarangeofanti-takeoverdefenses,whicharenotallowedunderUKrules.

RecentdevelopmentsremindusthatU.S.corporategovernanceisnotastaticsysteminequilibrium,buthasevolvedcontinuouslyoverthepastdecades.Priortothe1980s,theU.S.wascharacterizedbystrongmanagersandweakowners.Topmanagerstendedto view themselves as loyal to the corporation, rather than as agents of sharehold-ers.The1980ssawahugewaveofhostiletakeoversthatthreatenedthehegemonyofU.S.managers.Likewise,institutionalinvestorsandparticularlypublic-sectorpensionfundssuchasCALPERsbecamemuchmoreactiveplayersincorporategovernance,usingtheirgrowingblockstoexercisegreatervoiceincorporatemanagement(Useem,1996).Bythe1990s,managershadfoughtbackbylobbyingstategovernmentstoen-actanti-takeoverlegislation,whichmadehostiletakeoversmuchmorecostly(Useem,1993).Butmanagersalsoacceptedthenotionof“shareholdervalue”asanewunderly-ingideologyforcorporateAmerica.Inparticular,theriseofequity-basedpaysuchasstockoptionsgavemanagersagreaterstakeinpromotingrestructuringandorientat-ing their strategies toward the stockmarket.This shiftwent hand-in-handwith thecatalysedroleofindependent,outsidedirectorsintheboardroom(Gilson,2006).Thissystemcontinuestoevolvetoday.

ThisReporttotheHans-Boeckler-Foundationaimstooutlinethelong-termchangesin theU.S. systemof corporategovernance that culminated inSOX legislation andcontinueintothecurrentperiodofthefinancialcrisis.ThereportwillalsohighlightsomeimplicationsforcorporategovernancedebatesinGermany,eitherbythedirectapplicationofU.S.rulestoGermancompaniesorindirectlybysettingsymbolicbench-marksforcorporategovernancereform.Themainfindingshighlightedinthereportareasfollows:

thevariouselementsof theU.S.corporategovernancesystemhaveemergedinapiecemeal historical fashion, often showing substantial misalignment among itsvariouselementsleadingtowavesofspeculativeactivity(e.g.junkbonds,thedot.combubble,andcollateralizeddebtobligations)andsubsequentcollapse;thecrisisofEnronsubstantiallyalteredtheunderstandingofhowtheU.S.corporategovernancesystemoperatesintheacademicliterature;the regulatory responseofSOXhas sharpened thedifferencesbetweenU.S.andBritishapproaches;SOXlegislationhasmadesomegenuine,ifcostlyimprovementsregardingtheroleofgatekeepers,buthasnotfundamentallyalteredtheweaklinkagesamonglimitedshareholderengagement,excessivemanagerialincentivesforrisktaking,andcon-flictedroleofindependentdirectorswithinU.S.boards;Overall,themarketforcorporatecontrolmayplayalesserrolewithintheU.S.thanisoftenhypothesizedbasedontheexperienceofthe1980s.

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1 The Recent History of U.S. Corporate Governance, 1960-2001

TheU.S.systemofcorporategovernancehasevolvedcontinuouslyoverthelastseveraldecades.UnlikemanytreatmentsthatseetheU.S.modelasawell-established,coher-entandstablemodelofcorporategovernance,thehistoricalfactssuggestamuchmorepiecemealevolution.

1.1 Managerial Capitalism: 1960s-1970s

The1960s and 1970sweredecadescharacterizedbystrongmanagersandweakown-ers.Corporateownershipbecamedispersedasearlyasthe1930s.Theresultingsepara-tionofownershipandcontrolwasseenasgivingpowertomanagersandresultinginwhatcametobecalledagencyproblems(Berle&Means,1932).Table 1showsindi-vidualshareownershipremainedthedominantformwellintothe1980s.Individualsrarelywereactivelyengagedincorporategovernance.Despiteafewpioneeringefforts,shareholderproposalshadslowlyclimbedtoaround200peryearby1970buttheSECexcluded“ordinarybusiness”fromsuchproposalsandultimatelyshareholderactivismachievedlittleinfluence(Marens,2002,p.380).Hostiletakeoversremainedveryrare.Onlyin1974didatopinvestmentbanktakeonahostilebidderasaclient,whenMor-ganStanleyrepresentedInternationalNickelinitsbidforElectronicStorageBattery(Gilson,2006).Meanwhile,thoseoutsidethecorporateestablishmenthadlittleabilitytoraisesufficientfundstolaunchahostiletakeover.

U.S.corporatelawisamatterofstateratherthanfederalregulation.Onlysecuritieslawisregulatedatthefederallevel,andtheemphasisoftheSECisusuallyondisclo-sureratherthansubstantiveprovisionsregardingcompanystructure(Hollister,2005).Manyinvestorrightsareessentiallyvestedwiththeboard,yetcompanieshavegreatlatitudeinshapingthestructureandpowersofboardsinpractice.ThefederalnatureofcorporatelawlaidthefoundationsformanagerialismwithinU.S.corporategovern-ance,sinceshareholdersrightsremainedrelativelyweakunderthiscompetitivestruc-turedespitetheexistenceofstrongernationalregulationoversecuritiestrading(Cioffi,2010).

Corporateboardswerepredominatelymadeupofinsiders,chosenfromcompanyex-ecutivesandformerexecutives,orfriendsoftheCEOfromthe“oldboys’network”(Mace,1971).Thesedirectorshadalargelyadvisoryrole,andwouldrarelyoverturnorevenmountmajorchallengetoCEOdecisions.Whilethestrongboardinterlocksbetweenmajorbanksandnon-financialcompaniescharacteristicoftheeraofJ.P.Mor-gan, these declined sufficiently to the pointwere bank control seems to have been

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negligiblebythe1960s(Mizruchi,1982).1Meanwhile,shareholdershadlittledirectsayontheelectionofboardmembers,sincelegalrulesrequiredthemtogothroughanex-pensiveprocessofproxyvotingratherthanhavingdirectaccesstoproposecandidates(Gordon,2007,p.1496-1497).Table 2showsthatoutsidedirectorsremainedveryrare–makingup25%orlessofalldirectorsupthroughthe1970s.Amongtheseoutsiders,theconceptofindependencedidnotyetplaymuchrole.Ratherdirectorsweredefinedas“outsiders”iftheywerenotemployedbythefirmasfull-timeexecutiveofficersorso-callednon-managementdirectors(ABACommitteeonCorporateLaw,1978).Ofcourse,somedebateemergedregardingtheideaofa“monitoringboard”andthecon-ceptofindependence(Eisenberg,1976).In1974,theSECbeganrequiringdisclosureof theexistenceofanauditcommitteeandpublishedguidelinesabout theactivitiesofauditcommittees in1978.Likewise,onlyin1977did theNYSErequireanauditcommitteewith“directorsindependentofmanagement”aspartofitslistingrequire-ments—althoughdirectorsfromaffiliatedfirmscouldserveamongthesedirectorsun-lesssuchrelationships“wouldinterferewiththeexerciseofindependentjudgement…”(Gordon,2007,p.1480).TheserequirementswereonlyintroducedtoNASDAQattheendofthe1980s.

Meanwhile,noregulationsexistedregardingcompensationcommittees.Executivere-munerationconsistedmostlyoffixedsalariesandbonusestiedtoannualperformanceofthecompany.Salarieswerestronglycorrelatedtothesizeofcompanyrevenues,andremainedrelativelyinsensitivetocorporateperformanceorlong-termvaluecreation(Jensen&Murphy,2004).Forexample,only20%ofCEOcompensationwastiedtostockmarketperformancein1980(Hall&Liebman,1998),andaccountingmanagerslikesalesgrowthandearningswerewidelyusedtosetlong-termincentives.

Thiseraofmanagerialcontrolwasassociatedwiththeriseofaparticularsetofbusi-nesspractices.Thestrategyandstructureof largecorporationsshifteddramaticallythroughthespreadoftheunrelatedbusinessdiversificationandtheconglomerateform.Duringthe1960s,conglomeratemergersinvolvedmovesintounrelatedindustriesandthecreationofdiversifiedgroupsby(Steiner,1975).Thetheorybehindthesemergerswastointernalizethecapitalmarket,sothatfirmscouldreducerisksandachieveef-ficientallocationofresourcesamongdifferentbusinessesinternallybyacentraloffice.Thesemergersoccurredduringaperiodofhighstockmarketvaluationandgenerallywerefinancedthroughexchangeofshares(Shleifer&Vishny,2003).Theseverylargefirmshadhighexcesscapacityandoftenunderperformingassets.Boardshad littleincentivetoimprovetheirfinancialperformance.Butthe“firms-as-portfolio”helpedfirmsovercomethelimitsofpreviousfunctionalcorporatestructures,becomingmorediversified and effectively administered under the multi-divisional form (Fligstein,1990).

1 Thenetworksamongoutsidedirectorsbecameevenlessdominatedbycommercialbanksoverthecomingdec-ades(Davis&Mizruchi,1999).

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AlthoughtheU.S.neverdevelopedastakeholdermodelofcorporategovernance,man-agerialcapitalismdidallowscopeforcertainelementsofquasi-stakeholderorientation.Firmsremainedrelativelyshelteredfromcapitalmarketsandfollowedthestrategyofretainingprofitsandreinvestingthemintothefirm(Lazonick,2007).Alongsidethis,firmsdevelopedpaternalisticformsof‘welfarecapitalism’characterizedbystableem-ployment and large internal labourmarkets, particularly forwhite-collar employees(Jacoby,2004).Largecorporationsdevelopedstronginternallabormarketswithrela-tivelyhighpay,lowturnover,training,andadministeredrules(Berger&Piore,1980,Doeringer&Piore,1971).Althoughblue-collaremployeeshadnarrowjobdefinitions,employees couldgain seniority-basedpromotions and firms sought to avoid layoffs(Osterman,1987).Amongwhitecollaremployeesweretheso-calledmenandwom-enofthecorporation,whoservedintheofficesenjoyingjobsecurityandpromotionopportunitiesinexchangeforloyaltyandcommitment(Kanter,1978,Whyte,1956).However,unionsremainedrelativelydistantfrommanagementandsoughttosecurebenefitsandlimitmanagerialprerogatives insidethefirmlargelythroughcollectivebargaining and workplace rules, rather than employee participation or other formsofworker representation in the governance of the firm (Aguilera& Jackson, 2003,O‘Sullivan,2000). U.S. lawenshrinedastrictdistinctionbetweenfirmgovernanceandcontractualbargainingrelationshipswithemployees,whowereseenasexternaltothecorporationandrestrictedthescopeofcollectivebargaininginwaysthatprotectedmanagerialprerogative(Cioffi,2010).Still,unionstrengthandcommitmentstocoreemployeesexertedsomecheckonmanagerialauthorityandretainedsomesignificanceinmanagerialdecisionmakingduringthisperiod(Mizruchi&Kimeldorf,2005).

1.2 Investor Capitalism and the Deal Decade: 1980s

Duringthe1980s,thepowerofmanagerswaschallengedbyavarietyofnewdevelop-ments. Macroeconomicgrowthhasslowed,andU.S. industrycameundergrowingpressurefromforeigncompetition.Interestrateswerehigh,andstockmarketreturnshadstagnated.In thisclimateofeconomiccrisis,powerbegantoshiftsubstantiallytowardinvestorsduetotheriseofnewtypesofinstitutionalinvestorsandtheadventofhostiletakeovers.

Institutionalinvestorsemergedasanimportantnewcategoryofshareholder.SincethefundingrequirementsimposedbyEmployeeRetirementIncomeSecurityActof1974(ERISA),privatepensionfundshadbecomemoreimportantasinvestorsintheU.S.By1985,pensionfundsowned28%ofcorporateequity(seeTable1).Institutionalinves-torshaddiversifiedportfoliosanddislikedtheexistingU.S.conglomerates.Alongsideindividual shareholdersprone ‘exit’, institutional investorsbegan to exercise ‘voice’intheaffairsofcorporations.Public-sectorpensionfundssuchasCALPERsbecamemuchmoreactiveplayersincorporategovernance,usingtheirgrowingblockstoex-ercisegreatervoiceincorporatemanagement(Useem,1996).Othernewsocially-ori-

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entedandunion-backedinitiativesalsoplayedapioneeringroleinadoptinganenlight-enedshareholder-valueapproachtomakeabusinesscaseforendingunethicalbusinesspractices.2Meanwhile,majorinvestmentbanksalsoshiftedtheirbusinessawayfromsupportinglong-terminvestmentthroughcorporatebondsandtowardmorefee-basedstrategiesinvolvingincreasedtradinginequity(O‘Sullivan&Lazonick,2000).

Moststrikingly,awaveofhostiletakeoversthreatenedthedominanceofU.S.manag-ers.Thediversifiedconglomeratesofthepastdecadesprovedtobeundervaluedinthestockmarketbytheemerginginstitutionalinvestors–theso-called“conglomeratedis-count.”Diversifiedfirmsweretakenoverathighrates,splitintocomponentbusiness,andsoldtofirmswithinthesameindustry(Davis,Diekmann&Tinsley,1994).Thisunprecedentedtakeoverwavewasspurredbychangesinanti-trustlaw,butalsomajorfinancialinnovationsaroundso-calledjunkbonds(Blair,1993).MichaelMilkenandDrexelBurnhamdevelopedthepublicofferingofnon-investmentgradedebt,whichwaseventuallyused to finance leveragedacquisitions.3 Junkbondswerepurchasedbymutualfunds,andlateralsopensionfunds,insurancecompaniesandsavingsandloansbanksaseachsoughttocombatthelowstockmarketreturnsduringthe1970s(O‘Sullivan&Lazonick,2000).Thisnewsupplyoffinancemeantthatlargecompaniescouldbepotentiallytakenoverbyoutsideinvestorsforthefirsttime,whowereoftenaimingatfinancialgainsbyplanningtoselloffthetargetfirms’assetstorepaytheacquisitiondebt.Debtfinancingbecamewidespreadandwasusedtoretireover$500billionincorporateequity,asfirmsrepurchasedtheirownshares,borrowedtofinancetakeoversorweretakenoverthroughleveragedbuy-outs(LBOs)(Holmstrom&Kap-lan,2003).Outsideinvestorscouldaimatfinancialgainsbysellingoffthetargetfirms’assetstorepaytheacquisitiondebt(Bhagat,Shleifer&Vishney,1990).AparadigmaticcasewasKKR’sacquisitionand“bust-up”ofBeatriceFoodsin1986(Baker,1992),aswellastheirtakeoverofRJRNabiscothatwasfamouslydocumentedinthebookBar-barians at the Gate(Burrough&Helyar,1990).Fewtargetfirmsresumeddiversifica-tionstrategies,andotherssoughttoavoidtakeoverbyproactivelydivestingunrelatedassets,engaginginmergers,orbuyingbackshares(Fligstein,2001).

Paralleltothesechanges,theroleoftheboardalsounderwentacriticalexamination(BusinessRoundtable,1978).Theboardroomoflargecompanieswaspreviouslyseenasan“innercircle”ofcorporateinsiders,whereinbanksplayedacentralrolethroughinterlockingdirectorates(Useem,1986).Yetbetween1982and1994,thecentralityofbankssharplydeclinedascorporationsgainedaccesstonewlyregulatedfinancialmar-kets(Davis&Mizruchi,1999).Meanwhile,Table 2showstherapidincreaseinthepro-portionofindependentdirectorsfrom30%in1985to60%by1990.Likewise,studies

2 PossiblytheearliestexampleofunionactivismconcernedthecampaigntoabolishsegregatedseatingattheGreyhoundbuscompanyviaashareholders’resolutionstartingin1948.TheAITUunionalsocampaignedtopressureAT&Ttobargainregardingpensionrights,buttheseeffortswerecutshortbyaregulatoryrevisionbytheSECexcluding“ordinarybusiness”fromshareholderproposals(Marens,2002)..

3 In1988, for example, an amount equal to1.25%of total stockmarket capitalizationwas available tonon-investmentgradeissuerstofundtakeovers(Gilson&Black,2000).

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bytheSECshowthattheproportionoffirmswithnominatingcommitteesincreasedfrom19%in1979toroughly30%in1989(Gordon,2007,p.1498).Whileagrowingnumberofoutsidedirectorswereappointed,CEOsstillretainedalmostcompletecon-trolovertheactualselectionprocess(Lorsch&MacIver,1989).Thus,outsidedirectorsremainedverymuchasan“advisoryboard”whereinsidemanagementretainedmostofthepower.CEOscontinuedtoseedirectorsnominatedbyshareholdersaslackingindependenceandrepresentingtheparticularinterestsofashareholdergroup.

Thegrowingattentiontostockpricesand‘shareholdervalue’alsoplacedexecutivepayundergrowingscrutiny,andshiftedattentiontostrengtheninglinksbetweenpayandcompanyperformance.Akeydevelopmentherewastheintroductionofshareoptionsandotherequity-basedincentives(Jensen&Murphy,2004).Whereasthevalueofstockoptionsrepresented10%ofCEOpayin1980,thisproportionincreasedto48%by1994(Hall&Liebman,1998,p.661).Equitybasedincentivesbecamethuswidespread,inpartasaresultofhostiletakeovers.AsCongressplacedlegallimitsoncash-basedcompensationduringtakeovers,equity-basedincentivescametoconstituteagrowingproportionoftotalremuneration(CoffeeJr.,2003).Equity-basedincentiveswerealsousedtorewardmanagersunderleveragedbuy-outschemes.Finally, toweakentheirresistancetohostilebids,managerswereoffered‘goldenparachutes’thatawardedbo-nusestothosemanagerswholosttheirjobsinassociationwithchangesincorporatecontrol.Suchchangeincontrolagreementswereinplaceat41%ofthelargest1000firmsin1988,andcontinuedtospreadto57%in1996and70%in2000(Jensen&Murphy,2004).However,shareholdershavenodirect‘sayonpay’undercorporatelaw,henceleavingittotheboardtoinfluencethesizeandformofmanagerialpayschemes.Thisopenedthedoorfortheexplosionofmanagerialcompensationinthe1990s.

Theso-calleddealdecadeofhe1980swasassociatedwithalargewaveofcorporatere-structuringandassociatedjoblossescentredonthehighlyunionizedblue-collarwork-ers in themanufacturing industries (Baumol,Blinder&Wolff, 2003,Montgomery,1991).Manyofthelargefirmsknownfortheirwelfarecapitalistpractices,suchasIBMorDelta,abandonedthesepoliciesinfavourofsubstantialworkforcereductions(Wein-stein&Kochan,1995).Unionizationratesdroppedfrom47.4%ofthelaborforcein1970tojust27.8%in1983and18.2%in1994(O‘Sullivan&Lazonick,2000,p.19).Corporationsincreasinglyabandonedtheir“retainandreinvest”strategyinfavourof“downsizeanddistribute”(seediscussioninO‘Sullivan&Lazonick,2000).Dividendpay-outratiosincreasedfrom42%ofprofitsduringthe1970stoover49%inthe1980sandthereafter.Inadditiontodividends,corporationsdistributedagrowingamountofcorporateprofitsthroughsharebuybacks,whichincreasedfromaround5%ofprofitsin1980toapeakofover25%inthelate1980s.Whereasaveragefactorywagesshrankby5%inrealterms,CEOpayincreasedbysome415%inthesameperiod.

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1.3 Executive Defence and the Ideology of Shareholder Value: the 1990s

Bythe1990s, thetrendtowardgreatershareholderinfluencecontinued,butwasre-shapedbytheresponsesofmanagers.Ononehand,executivessoughttodefendtheirownpowerbyshieldingfirmsfromunwantedtakeoverbids.Ontheotherhand,man-agersalignedthemselvesincreasinglywiththeinterestsofshareholdersthroughnewformsofexecutivepayandadoptingtheideologyofshareholdervalue(Dobbin&Zorn,2005).Shareholdervaluereferstotheconceptthattheprimarygoalforacompanyistoincreasethewealthofitsshareholdersbypayingdividendsand/orcausingthestockprice to increase.4Somewhatparadoxically,althoughshareholderpowerwas tamed,shareholdervaluebecameapowerfulnewideology.

Intermsofshareownership,institutionalinvestorscontinuedtogaininsignificance.Pensionfundownershiphadalreadypeekedduringthe1980s,butownershipbymutualfundsbecameevermorewidespread(seeTable 1).Institutionalinvestorsnotonlygrewinsize,butgraduallybeganvotingmoreactivelyagainsttakeoverdefencesproposedbymanagementandevensupportedinitiativestoremovesuchdefences(Bainbridge,2008).ThompsonandDavis(1997)findthatshareholderresolutionstotaled275inthe1984proxyseasonwithanaveragevoteof5.7%,butincreasedto487resolutionswithanaveragevoteof24.1%by1991.SomepublicpensionssuchasCALPeRSbecamefamous for their high degree of engagement. Initial studies suggested that activismleadtoincreasesinshareholderwealth,althoughnotnecessarilyinimprovedoperatingperformanceoftargetedcompanies(Smith,1996).

In1992, federalproxy ruleswere revised togive shareholders enhanced latitude tocommunicateamongstthemselves(Schwab&Thomas,1998).Thescopeofissuestar-getedbyshareholderactivismexpandedfurthertocoverchangesinboardstructureandfunction,aswellasexecutiveanddirectorcompensation.Pensionfundswithlaborun-ionrepresentationhavebeenattheforefrontofinnovation—forexample,filing75outofthe265proposalstrackedbytheInvestorResponsibilityResearchCenter(IRRC)in1995(Schwab&Thomas,1998).Thethreatoftakeoveralsogaveinstitutionalinvestorsmoreleveragetomakeinformaldemands,andleadtoboardmembersputtingmoreemphasisoninvestorrelations,evengoingonroadshowstomaintainloyalinvestors.Despitethesetrends,theinfluenceofshareholderactivismremainedtantalizing,butmodestonthewhole.Eventhemostactivistinvestorshavelimitedresourcesdevotedtocorporategovernanceand institutional investors rarelyget involved inmattersofcompanyspecificpolicy,makeshareholderproposalsorseekdirectrepresentationbynominatingcandidatestotheboardofdirectors(Black,1998,Choi&Fisch,2008).

4 Morespecificconceptssuggestthatreturnstoshareholdersshouldoutperformcertainbench-markrateofreturnforinvestmentscarryingsimilarlevelsofrisk(Rappaport,1986).

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Asecondimportantshiftduringthe1990swasthatthenumberofhostiletakeovershad started to decline.Figure 1 shows takeovers during the 1990s and subsequentdeclineinboththeUSandUK.Duringthe1990s,mergersbecamelesshostile,werelargelyinrelatedindustries,andusedstockswapstoconsolidateindustrystructures(Holmstrom&Kaplan,2001).ThenewM&Awaveofthemid-1990sledtoadoublingofthetransactionvalueofM&Aactivityfrom5.4%ofGDPin1991-1997tosome10.8%ofGDPin1998-2005,butwasfocusedongrowingindustriesandnewtechnologies,sparkedbytheITrevolutionandso-calledDOT.COMbubble(Jackson&Miyajima,2007).Hence,whilethemarketforcorporatecontrolremainedveryactive,hostilebidsbecameratherraresincethemid-1990s.Atleastthreereasonsexistforthisdecline:thecollapseofjunkbondmarkets,theenactmentofstate-levelantitakeoverlawsandcon-sequentspreadofpoisonpilltakeoverdefenses,andthechangingattitudesofmanagerstowardshareholdervalue.Eachofthesewillbediscussedinturn.

Onereasonfortheslowdownwasthatthejunkbondmarketbegantocollapse.Amajorsourceofinvestmentinjunkbondshadbeenthede-regulatedSavings&Loansfunds,buttheircollapseinthelate1980sbroughtsignificantpoliticalattentiontotherisksofthejunkbondmarket.MichaelMilkenandDrexelBurhamLambertwerearrestedin1988forviolatingaseriesofsecuritieslaws,includingracketeering,marketmanipula-tion,andinsidertrading.In1989,followingseveraljunkbonddefaults,DrexelBurhamLambertbecameinsolventandfiledforbankruptcy.MichaelMilkenwasconvictedforlesseroffencesin1991.Intheearly1990s,thedefaultrateonjunkbondsrosetoaround9%,andtheLBOmarketcooled.

Anotherreasonforthedecliningnumberofhostilebidswasthe“executivedefence”mountedbymanagersby lobbyingstategovernments toenactanti-takeover legisla-tion(Useem,1993).Thesenewstateanti-takeoverlawsallowedamuchwiderrangeofdefensiveactions.Thesemadehostiletakeoversmoredifficultandcostly,asdefensivemeasuressuchaspoisonpills,goldenparachutesandstaggeredboardsprotectedthepositionofmanagement(seelegaldetailsinCioffi2010).Table 3showsthatofthe332hostiletakeoversattemptedintheU.S.between1991and2005,only22%weresuc-cessful.Notably,thesuccessratiowasfarlowerthanintheUK,where176hostiledealswereattemptedleadingto42%oftargetfirmsbeingsoldtotheraider.Didtakeoverdefensesplayasubstantialroleinthisstory?Furtheranalysisofthesedatashowsthattakeoverdefenseswereinvolvedinatleast130bids,whichissomewhatover1/3ofallhostilebids.In76cases,thesewerepoisonpilldefensesthatareforbiddenintheUK.Astatisticalanalysisofhostileattemptsshowsthatthepresenceofapoisonpillreducedthelikelihoodofasuccessfulbidfrom50%toaround33%(Jackson&Miyajima,2007).Thus,thelegalchangesinfluencedbutdidnotfullyshieldmanagersfromthedisciplineofthetakeovermarket.While47%oftargetfirmsremainedindependent,another 31%of targetswere sold to alternative bidders. Poison pills, in particular,donotnecessarilyfrustrateadealentirely,but leadtofurthernegotiationsandmay

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improvethepriceofabid.5Anddespitethenewpoweroftheboardto“justsayno”inhostilebids,takeoveractivityreachednewalltimehighsduringthe1990sdespiterelativelyfewhostilebids.Intheend,evidencesuggeststhatfirmstargetedbyhostilebidswerenomorelikelytobesoldtoraidersinthe1980sthaninlaterdecades(Brat-ton,2007).6Thesefactssuggestthattheexecutivedefencewasonlyachievedbytheirpartialagreementinhelpingtoinstitutionalizetheroleoftheshareholderandtheim-portanceof“shareholdervalue”forcorporateAmerica.Tounderstandtheemergenceandtriumphofshareholdervalueasamanagerialideology,onemustalsolookattheparallelchangesinshareownershipandtheroleoftheboardofdirectors.

Finally,athirdandoftenneglectedreasonforthedeclineinhostiletakeoversrelatestothebroaderchangesintheroleoftheboard(Gilson,2004,Gordon,2003).Fewerbidsmaybehostilebecauseboardresistanceto takeoverbidswassoftenedbythewide-spreaduseof“goldenparachutes”thatcompensatemanagerswholoosetheirpositionfollowinga takeover.Thesepackages areoften considered an important elementofexecutivecompensationaligningmanagerialinterestswiththoseofshareholders.So-calledchangeofcontrolcontractswereinplaceat41%ofthetop1000companiesin1988,buthavesinceincreasedto57%in1996and70%in2000(Jensen&Murphy,2004,p.29).Likewise,directorstendtobepaidthroughstockoptionsthatgivethemincentives to seekhighbidders. Independent or outsidedirectors also increased thesalienceofshareholderinterestsduringM&A.

Bytheearly1990s,welloverhalfoflistedfirmshadamajorityofindependentoutsidedirectors (Linck,Netter&Yang, 2008).Table 3 shows that the proportion of inde-pendentdirectorsincreasedfrom60%in1990to67%by2000.Amongthelargestfirms,onlyaround10%hadinsider-dominatedboards.Meanwhile,thistrendslowlyspreadtosmallerfirms,particularlyafterthemidtolate1990s.Despitethegrowingimportanceofindependence,twofactsareworthnoting.First,thelegaldefinitionofanindependentdirectorremainedratherweaklydevelopedandwasspecifiedonlyinstatecorporationlaw.Second,Table 4showsthatamajorityofU.S.firmsstillcombinedtheroleofCEOandChairmanwithintheboard.Thisfactputssomedoubtonthegenuineindependenceofotherboardmembers.AnumberofstudiesfromthisperiodnotethatoutsidedirectorsfeltstrongloyaltytotheCEOregardingissuessuchas“goldenpara-chutes”(Wade,CharlesA.O‘Reilly&Chandratat,1990)andthatCEOinfluenceledtoboardswithdemographicallysimilar(Westphal&Zajac,1995)orfromrelatedfirms(Shivdasani&Yermack,1999).

5 Forexample,in2000,MGMGrandIncinitiallyofferedachoiceof$17incashoracombinationof$7incashand$10incommonstockpershareinMirageResortsInc(MR).MR‘sboardrejectedtheoriginaloffer,andadoptedapoisonpillplangivingshareholderstherighttopurchasestockatadeepdiscountintheeventofanacquisitionoranattempttoacquireastakeof10%ormoreofthecompany.MGMlaterofferedasweetened$21incashpershare,oratotalvalue$6.483bil,includingtheassumptionofapproximately$2bilinliabilities.

6 Takeoverrulesmaynonethelesshavehadadeterrenteffectinreducingthetotalnumberofhostilebids,raisingthequalityofthosebids,andleavingtheactualsuccessratiounchanged(Bratton,2007).

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Still, other economic changes began to catalyse the role of outside directors in theboardroominverysignificantways(Gilson,2006).Anumberof legaldecisionsfo-cusedon the importanceofoutsidedirectors inmonitoring takeoverbids.This rolewasparticularlyclearformanagementbuy-outs,inwhichtheoutsidedirectorsplayedacriticalrole.Forexample,theDelawareSupremeCourtruledtoallowtargetboardsto“justsayno”toahostilebid,aslongasindependentdirectorswereamajorityintheboardandsufficientlyinvolvedinthesedecisions–startinginthe1980scasesofUnocalandMoran,butculminatinginthe1990decisioninParamountCommunica-tionvs.Time(see Appendix A).Insidedirectorsthusbecameevermorevulnerabletoshareholderlawsuits,andexposedthedisciplineofthetakeovermarket.Gilsonarguesthatthesefactorshelpedtriggermoreactiverolefromcorporateboardsmoregenerally.Inparticular,outsidedirectorswereresponsibleforhelpingthediffusionofanumberofnewmanagerialpractices,suchasequity-basedpayschemes,goldenparachutes,M&Aactivity,andboardnominations(Davis&Greve,1997,Westphal,1998,Westphal&Zajac,1995).CEOturnoverincreasedandanumberofhighprofileincidentsemergedwhereCEOswereousted,suchasGeneralMotors.

Inparticular,theriseofequity-basedpaysuchasstockoptionshadgivenmanagersagreaterstakeinpromotingrestructuringandorientatingtheirstrategiestowardthestockmarket.Therealexplosionintherelativevalueofstockoptionscamefromthemid-1990sonward,constituting33%oftotalCEOcompensationamongNewEcon-omyfirmsin1992but83%in2000(Gordon,2003).In1991,theSECchangesrule16(b)makingitpossibleforexecutivestoexercisestockoptionsandselltheirstocksatthesametime,therebyexploitingveryshort-termmovementsinstockpricestotheirownadvantage.Despiteattemptstolimittheamountsoftaxdeductibleexecutivepay(Jensen&Murphy,2004),othertaxincentivesencouragedstockoptions,asdidthefactthatcorporationscouldavoidexpensingoptionsintheirfinancialstatements(Suchan,2004,p.8).Veryfewrestrictionsareplacedontheformofstockoptions,northeper-formancestandardsthatshouldbemet.AsCoffee(2003,p.9)argues,

“…the 1990swas the decade inwhich senior executive compensation shiftedfrom being primarily cash-based to being primarily stock-based. With thischange,management became focused not simply on the relationship betweenmarketpriceandbreak-upvalue(whichtheadventofthebust-uptakeovercom-pelledthemtowatch),butonthelikelyfutureperformanceoftheirfirm’sstockover the short-term. Farmore than the hostile takeover, equity compensationinducedmanagementtoobsessovertheirfirm’sday-to-dayshareprice.”

As lateas1990, theBusinessRoundtable,agroupofchiefexecutivesof the largestfirms,advocatedthenotionthat“thedirectors’responsibility tocarefullyweightheinterestsofallstakeholdersaspartoftheirresponsibilitytothecorporationortothelong-terminterestsofitsshareholders.”Yetby1997,theyarguedthat“theparamountdutyofmanagementandofboardsofdirectorsistothecorporations’stockholders;theinterestsofotherstakeholdersarerelevantasaderivativeofthedutytothestockhold-

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ers”(quotestakefromFourcade&Khurana,2009).Theeraofshareholdervaluehadarrived.

Theriseofshareholdervaluereinforcedthe“downsizeanddistribute”strategyofthepreviousdecade-dividendpayoutratiosremainedhigh,downsizingcontinueddespitethegeneraleconomicrecovery7,andcorporationsremainedfocusedontheircorebusi-nesses.CEOcontinued to increase,whileaveragewages stagnated (Hallock,1998).Ideologically,organizedlabornolongerposedagreatchallengetomanagementandbothunionsandindividualemployeesincreasinglysoughtempowermentthroughthechannelofpensionfundownershiporemployeeshareschemes.Still, theconceptofshareholdervalueevolvedandbecameinfusewithrangeofnewtechniquesof“specu-lativemanagement”designedtoinfluencecompanyshareprices,includingroadshows,stocksplits,namechanges,mergers,spin-offs,changestoincompanypensionplans(Krier,2005).Amongthesetechniques,themostinfluentialwastheexpansionofsharerepurchasesorbuy-backsafter1984(Dittmar&Dittmar,2008,Lazonick,2007).Thevalueofrepurchasesincreasedinvaluefrom13%ofcorporateearningsin1984to35.8%in1999,thuseventuallysurpassingthetotalvolumeofdividendspaidorthevalueofnewsharesbeingissued.ArecentreviewdemonstratesthattherisingearningsofbothCEOsandotherfinancialmarket-drivenoccupationssuchaslawyersandinvestmentbankershavemadeamajorcontributiontotherisinginequalityintheU.S.(Gordon&Dew-Becker,2008).

Thesechangesboth reflectedandcontributed to thewidercontextof“financializa-tion”oftheU.S.economy(Krippner,2005).IntermsofGDPandcorporateprofits,thecentralshiftinthestructureoftheU.S.economyhasbeentowardFIRE(finance,insuranceandrealestate)sectors.Forexample,theratioofprofitsinthefinancialsec-torrelativetothenon-financialsectormorethandoubledsincethemid-1980s.Amongcorporations,theshareofportfolioincome(e.g.incomefrominterest,dividends,andcapital gains) relative to cash flowhas increased roughly three to five times in the1980sand1990scomparedtothe1960sand1970s.LookingatU.S.non-financialcor-porationsovertheperiod1973-2003,Orhangazi(2008)findsasharpriseintheratiooffinancialtotangibleassets(fromroughly30toover100%),anincreaseindividendandinterestincomerelatetointernalfunds(fromroughly20%toaround50%),andagrowingratiooffinancialpaymentsininterest,dividendsandsharebuy-backsrelativetoprofits(fromunder40%topeaksaround100%).

Insum,the1990shadaparadoxicaleffectoncorporategovernance.Whiletheexecu-tivedefencetamedthemarketforcorporatecontrolthroughpoisonpillsand“justsayno”defences,anewsetofmarketmechanismsenteredtheboarditself—newformsofexecutivepay,greaterexecutiveturnover,andgoldenparachutes.Thesemechanisms

7 Forexample,corporatedownsizingremainedpervasive,particularinmanufacturingindustries(foranoverviewseeBaumol,etal.,2003).Aftercontrollingforprofitabilityandgrowth,U.S.firmsremainedtwiceaslikelytocutemploymentlevelsby10%ororerelativetoGermanfirmsduringthe1990s(Jackson,2005).

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shiftedmanagerial interests away from the long-termdevelopmentof the firm, andlinkedtheirowninterestswithshareholdervalue(seealsoGordon,2007).Theseem-ingsuccessofthissystemputcorporategovernanceonthereformagendaworld-wide,culminatingintheOECDprinciplesin1997thatwerelargelymodelleduponastylizedversionofcurrentU.S.practices.

1.4 Enron: 2001

Bytheearly2000s,mostofthekeypillarsintheU.S.“model”ofcorporategovernancewereinplace,andconventionalwisdombegantoseetheseelementsasanormativebenchmarkfor“good”corporategovernancepracticesaroundtheworld.Shareholderengagementwouldbesuppliedbyactiveinstitutionalinvestors.Boardswouldbein-creasinglyindependentandrewardedthroughlong-termequitybasedincentiveslinkedtosharepriceperformance.Theflowofinformationfromtheboardwascertifiedbyoutsidegatekeepers,suchasauditorsandaccountants.Takentogether,theseelementsalsoservedasa foundation foraneffectivemarket forcorporatecontrol.Thestockmarketboomandriseofthe“neweconomy”seemedtodemonstratethesuperiorityofthismodel,bothforestablishedfirmsbutalsoforstimulatinginvestmentinnewentre-preneurialventures.Infact,thewaveofspeculationhadcreatedtoomanyopportuni-tiesforshort-termprofitmakingthroughIPO–softenatthecostofU.S.householdswhowerethe“greaterfools”investinginthestockmarketathistoricallyhighlevels(Lazonick,2007).

ThecrisisandcollapseofEnronsparkedawide-rangingre-examinationofcorporategovernancearoundtheworld.ManydetailedaccountshavebeengivenoftheEnroncaseandnocomprehensivereviewofthesestudiescanbegivenhere(Bratton,2002,CoffeeJr.,2003).IntermsoftheU.S.“model”ofcorporategovernance,Enronexposedthe fact that thevarious elementsof this systemwerenot functioning together in acomplementaryfashion.Infact,theweaknessesorlimitsintheeffectivenessofeachelementseemedtopotentiallyunderminetheother(seeGordon,2002).ShareholdersfailedtorationallyvalueEnron.TheEnronboardfailedtoprotecttheintegrityoffi-nancialdisclosure,despitethepresenceoffourteenmembersofwhichonlytwowereinsiders.Theseboardmembersalsohadhighlevelsofrelevantcompetence,andwereincentivizedbystockoptionsorotherequity-basedincentives.TheexecutivesofEnronwereincentivizedtoadopthigh-riskstrategiesorientedtoearningsmanagementandproppingupanovervaluedstockinordertomaintainthevalueoftheirstockoptions.GatekeeperssuchastheauditingfirmofArthurAndersoncriticallyfailedasaneffec-tiveinterfacebetweenmanagementandinvestors.Akeyaspectofthisfailurewastheaggressiveuseofthemark-to-market(MTM)accountingforEnron’senergycontracts,whichallowedEnrontoreportexpectedbenefitsfromfuturetransactionsintocurrentperiodincome(Dharan&Bufkins,2008).Enronlikewisereportedtheentirevalueofeachtradeonitson-linetradingsystemasrevenue,ratherthanreportingonlyitstrad-

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ingorbrokeragefees.ThefactorsallowedEnrontoreportaphenomenalgrowth inrevenues,fuellingitshighsharepricegrowth.Finally,unlikesituationswerecorpora-tionsunderperform,themarketforcorporatecontrolprovidedlittleeffectivedisciplineorremedyforthe“over-valued”stockpricesatEnron(Jensen,2004).Theagencycostsofover-valuedequityensuewhenmanagerscannotdeliverprofitsinlinewithunreal-isticandinflatedinvestorexpectations.Asaresult,managerswillturntoshort-termmeasurestobolsterstockprices:

“Itbecomesevermorecleartothemanagersofsuchorganizationsthatitisdif-ficulttogeneratetheperformancenecessarytosupportthesky-highstockprice.Andknowingthatthemarketwillhammerthestockpriceifitbecomescleartheexpectedperformancewillnotberealized,managersbegintotakeactionsthatwillat leastappear togenerate therequiredperformance.Theyusethefirm’sovervaluedequityascurrencytomakeacquisitionstosatisfygrowthexpecta-tions.Theyuseaccesstocheapcapitaltoengageinexcessiveinternalspendinginriskygreenfieldinvestments.Theymakeincreasinglyaggressiveaccountingandoperatingdecisionsthatshiftfuturerevenuestothepresentandcurrentex-pensestothefuture.Eventuallywhenthesefailtoresolvetheissues,managers,underincrediblepressure,turntofurthermanipulationandevenfraud.Noneoftheseactionstrulyimproveperformance.Infactwhentheyaretakennottocre-aterealvalue,buttogivetheimpressionofvalue-creatinggrowth,theydestroypartorallofthefirm’scorevalue.”(Jensen&Murphy,2004,p.45)

A Historical Overview of Corporate Governance in the USA

1960s-1970s 1980s 1990s 2000s

Managerial Capitalism

Investor Capi-talism

“Shareholder Value”

Crisis of “shareholder value” para-digm

OwnershipDispersed, individual

Institutional investors

Institutional investors

Institutional investors

Market for Cor-porate Control Weak Strong Medium Medium

BoardsInsider - “ad-vising board”

Insider- “advis-ing board”

Outsider- “monitoring board”

Outsider- “monitoring board”

Executive Re-muneration Fixed Stock options Stock options Stock options

GatekeepersWeakly regu-lated

Weakly regu-lated

Weakly regu-lated

Strongly regu-lated

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2 The Crisis of the Shareholder Value Paradigm: Post-Enron Debates.

Theconceptofshareholdervalue,bothineconomictheoryandasanormativepara-digm,iscloselylinkedtotheagencyviewofthecorporation.Specifically,thisperspec-tivearguesthatthatonlyshareholdersareresidualclaimantstotheactivitiesofthecor-poration,thusshareholdersalonehaveincentivetobearriskinvestinginresourcesthatwillincreasetheeconomicperformanceofthefirm.Alargebodyofworkrelatedtotheso-calledstakeholdertheoryofthefirmnowtakesissuewiththisview(O‘Sullivan,2000).Forexample,earlycritiquesstressedthatemployeeswerealsoresidualclaim-antstotheextentthatfirm-specificinvestmentsaremadeinhumancapital,makingemployeesdependentontheparticularenterprise(Blair,1995).Thisinsighthasbeenelaboratedwithintheoriesofthefirmbasedincorporatepowerandtheasymmetricalnatureoftheemploymentrelationship(Parkinson,1993,Parkinson,2003,Parkinson&Kelly,2001).8Asanalternativetotheprinciple-agentview,the“teamproduction“modellikewisesuggeststhatthecorporationembodiesanumberofstakeholderswhoinvestfirm-specificresources,butjointlyrelinquishcontroloverthoseresourcestoaboardofdirectorsfortheirownbenefitinordertosolvetheproblemofcoordinatingeffortswithintheteam(Blair&Stout,1999).Alongsimilarlines,theconceptofes-sentialityhasbeenusedtoelaboratetheideathatwherehumanassetsareessentialtotheproductivityofthefirm,controlbasedonownershipofthephysicalassetsorlegalentityofthecorporationcannotactasasubstituteforcooperationoremployeevoiceindecisions(Aoki&Jackson,2008).Othershavedevelopedawidertheoryofinnovativeenterprisestressinghowcorporategovernancemayormaynotsupportthestrategic,organizational, and financial perquisites of innovation (Lazonick, 2007,O‘Sullivan,2000).

Ratherthancontinuethesedebates,thissectionwilllookattheshareholdervaluepara-digminitsownterms.TheaimhereistoreviewsomeofthemorerecentU.S.debatesoncorporategovernancethatagree with the normative idea of shareholder value, but critique contemporary corporate governance practices for their failure to deliver cor-porate accountabilityoreconomicefficiency.Theanalysisisbasedonthefivedimen-sionsofcorporategovernance:shareholderactivism,themarketforcorporatecontrol,boards,executiveremunerationandtheroleofgatekeepers.Thepaperwillarguethattheeffectivenessofeachgovernancemechanismhasverysubstantiallimitsinpractice.Perhapsmorecritically,thepaperarguesthattheselimitsmaybemutuallyreinforc-ingsuchthatthelimitsofonemechanismdetractfromtheeffectivenessofotherkeymechanismsofcorporategovernance.Next,wetakeeachofthesepointsinturn.

8 Whilebeyondthescopeofthispaper,theoriesofcorporatesocialresponsibilityalsoarguethatcorporatedeci-sionsmayhavenegativeexternalitiesonstakeholderswhoarenotpartytothosedecisions.Thus,CSRtheoriesargueforgreaterdialogue,participationandresponsibilitytowardstakeholdersincompanydecisionmaking(Vogel,2006).

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2.1 Limits of shareholder activism.

Market-oriented corporate governance is premised upon well-informed and activeshareholders,whoengage incorporategovernanceboth throughexitandvoice.Yetdespite thegrowingsizeandconcentrationofownershipstakesheldbyinstitutionalinvestors,suchaspensionfundsandmutualfunds,numerousstudieshavenowsug-gestedthat thelevelofshareholderengagementhasremainedlowandtheinfluenceoncorporatebehaviourlessstraight-forwardthanoftenhypothesized(Dalton,Daily,Certo&Roengpitya,2003,Gillan&Starks,2000,Wei-Ling&Szewczyk,2003).Forexample,institutionalinvestorsfacedgrowingcriticismfortheiracceptanceofunre-alisticsharevaluationsduringtheITbubble.Institutionalinvestorsheldover60%ofEnronshares,butdidnotseethatEnronwasovervaluedoratleasthadincentivestoengageinherdingbehaviourofholdingthestock(CoffeeJr.,2003).

Oneconventionalbutimportantexplanationforlowshareholderengagementconcernsmarketfailure(Black,1990).Mutualfundshavediverseportfoliosandstandtogainonly a portion of the value added through investing in shareholder activism,whileothershareholdersmaybefreeriders.Informationsharingandcoordinationofstrate-giesamonginvestorsmaybelimitedsincesuchinformationmayalsogiveproprietaryadvantages in trading.Thus, institutional investors face traditional collective actionproblemsthatmayleadtoasub-optimallevelofengagement.U.S.lawalsodiscour-agescoordinationamongstshareholdersinseveralways.TheSecuritiesExchangeAct§13(d)requiresextensivedisclosuresfromanypersonorgroupthatactstogethertoacquirebeneficialownershipofmorethan5percentofshares.Whileshareholderselecttheboardofdirectors,theyhavelittlepowertodirectlynominatetheirowncandidatestotheboardandhavefewincentivestoengageinproxycontests(Bainbridge,1992,p.1075-84).Despiteliberalizationoflegalrestrictionsin1992,communicationamongshareholdersremainsrelativelylimited(Choi,2000).Ultimately,controllingsharehold-erscanbeheldliableforfailingtoprotecttheinterestofotherminorityshareholders,which therebydiscourages the formationof largeblocks and exercise of control byinstitutionalinvestors(Bainbridge,2008).

Afurtherinstitutionalexplanationforlimitedshareholderengagementislinkedtothedistinctionbetweenpressure-resistantandpressure-sensitiveinvestors(David,Koch-harR.&Levitas,1998,Kochar&David,1996).Pressure-resistantinstitutionalinves-torsarethosewhoareunlikelytohavestrongbusinesslinkswiththecorporatesector.Thus,theseinvestorstheymayhaveastrongerinfluenceonthestrategyandperform-anceofcorporations(Hoskisson,Hitt,Johnson&Grossman,2002).Yetmanyinstitu-tionalinvestorsremainpressure-sensitiveandevenfacestrongconflictsofinterest.Forexample,newstudieshaveinvestigatedthevotingrecordofU.S.mutualfunds,show-ingthemtobehighlypressuresensitiveduetotheirmanagementofcorporatepensionfunds(Davis&Kim,2007).Receivingfundsfromthecorporatesectorgivesrisetoconflictsofinterestwithregardtoshareholderengagement–leadingtotheadoption

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ofpoliciesthataregenerallymorepro-managementthanonemightexpect.Anotherstudyfrom2004-2006showsthatonly13%ofshareholderproposalsonexecutivere-munerationweresuccessful—onaverage,onlyaround17%ofshareholderssupportedtheseproposals,whereas54%rejectedthemand29%abstainedorfailedtovoteatall(Ashraf,Jayaraman&Ryan,2009).Thesamestudyalsoshowsthatmutualfundswithbusinesstiestopensionfundsweremuchlesslikelytosupportsuccessfulproposals.

Meanwhile,themoreactivisttypesoffundsarethosewiththegreatestindependencefromthecorporatesector.Pressure-resistantfundsarelargelylimitedtopublicsectorpensionfunds,suchasCalPERS,orfundswithstrongunioncontrol.Butevenamongthesefunds,thedegreeofactivismvarieswidelyanddoesnotgenerallyextendtocoreissues,suchasnominatingdirectors(Choi&Fisch,2008).Publicemployeepensionfundsincreasedfrom700toatleast2,625by2005.Yetsurveyresultsshowthatwhileamajorityoffundsdoengageinlowcostformsofactivism(e.g.participatingincor-porategovernanceorganizations,writingcommentletterstotheSECorwithholdingvotes),over80%neversponsororsolicitproxyvotesonshareholderproposals,roughly88%havenevercreatedfocuslistsforactivism,and90%nevernominatenamesofdirectorcandidates(Choi&Fisch,2008).Thesamestudyfoundthatonlyaround11%offundsengagedinactivismtofulfillfiduciarydutiesorpursuethepublicinter-est.Rather,fundsengageincorporategovernancetoimproveshareholderreturns,butmoreoftenthannotcitealackofresources(44%)ornegativecost-benefits(31%)asreasonsfornotparticipating.Moreover,evenamongpublicpensionfunds,onlyaroundone-thirdoftrusteeswerememberelectedby2000(Hess,2005).Thestoryisratherdifferentamongprivatepensionfundswithunionrepresentationamongtrustees,whotriedtoremovedirectorsorinfluencecorporatepolicyatover200corporationsin2004andtriedutilizingshareholderproposalstoobtainemployeebenefitsoutsidetherealmofcollectivebargaining(Bainbridge,2006,p.1755).Despitethepotentialpositiveroleofsuchengagement,unionpensionfundshavenotsucceededtoformwidercoalitionswithotheractivistshareholdersorgainsupportfrominstitutionalinvestorsformostoftheirproposals.

Athirdsetofreasonsisthatmanyinstitutionalinvestorslack the organizational ca-pacitytoengagewithalargeportfolioofcompanies.Engagementisexpensive.Smallpension fundsaremuch less likely toengagewith firms than larger funds (Choi&Fisch,2008).Butperhapsmoreimportantly,fundsoftenoperatewithveryhighlevelsofdelegation.Surveyevidencesuggeststhatpublicpensionfundshave84%oftheirassetsexternallymanaged,only15%votetheirownproxies,and42%evenoutsourcethepreparationof theirownvotingguidelines (Choi&Fisch,2008). ISShasapar-ticularlycentralrole,serving69%ofpublicpensionfundsasclients(Choi&Fisch,2008).Infact,Ashrafetal.(2009)foundthatnoshareholderproposalsweresuccessfulwithout receiving favorable ISS recommendations.Other institutional investorsalsooftendelegatemanagementofparticularportfoliostooutsidespecialistsorrelyonex-ternalserviceproviderstoratecompanies,informtheircorporategovernancepolicies,

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ormakevotingrecommendations.Giventhelimitedexpertiseandcapacitytoengagewithcompanyspecificissues,shareholderactivismretainsaquitegeneralized orienta-tion.Eventhemostactiveinstitutionalinvestors,suchasCALPERs,usuallyadvocateacross-the-boardguidelines,andhaveexplicitpoliciesforvotingtheirsharesinlinewithcertainprinciples(Jacoby,2007).However,theinfluenceofthosestrategiesonaparticularfirmisrelativelylimited.Evenwhenacrisisemergesataparticularfirm,in-stitutionalinvestorsstillfacethesubstantialbarrierstocoordinationdiscussedabove.

Amorerealisticpictureofinstitutionalinvestorinfluenceisthatinvestorsrelylargelyoninformal engagement,ratherthanformalexerciseofcontrol.Arecentandinnova-tivestudyofHermespensionfundintheUKfoundsignificantbenefitstoshareholderintervention,butequallystressedthelargelyinformalcharacterofsuchengagement(Becht, Franks,Mayer&Rossi, 2006).Even large shareholders likeHermes rarelyhave enoughvotes to openly challengemanagement, given thatmost investorswillremainpassivesupportersofmanagementapartfromduringexceptionalcrises.Inves-torsmayalsoeschewopenpubliccriticismof firmswhosestock theyown.Rather,institutionalinvestorsmayprefertooperatebehindthescenesthroughinformalcom-municationandpersonalaccesstotopexecutivesbyvirtueoftheirpotentialinfluenceovershareprices,iftheinvestorchoosestosell.Herethethreatofexitconditionsvoice.Indeed,studiesoftheinfluenceofforeigninstitutionalinvestorsonstakeholder-orient-edfirmsincountrieslikeJapandemonstratetheimportanceofgrowingtransparencyandincreasingdialogueofalargelyinformalnature(Ahmadjian,2007,Ahmadjian&Robbins,2005).

Takentogether,institutionalinvestorsfaceseverelimitswithregardtoshareholderen-gagement.Thestockmarketmechanismservicestotransformilliquidinvestmentsintangibleassetsintoliquidclaimstotradablerightsoverinvestmentsthathavealreadybeenmade(Lazonick,2007).

2.2 Limits of the market for corporate control.

One set ofmotivations for takeovers relate to the agency costs associatedwith theseparationofownershipandcontrol(Fama,1980,Fama,1983).9Throughatakeover,shareholdersmay regain control of poorly performing firms and replace inefficientmanagement(Shleifer&Summers,1988).HenryManne(1965)firstdescribedthegov-ernancefunctionoftakeovermarkets:

9 AlargeliteraturedescribesthestrategicmotivationsforM&A,suchassynergyeffects(Chatterjee,1986),gain-ingmarketaccessorpower(Hitt,Hoskisson,Johnson&Moesel,1996,Stigler,1982),diversification(Marris,1964),exitstrategiesforentrepreneurs(Thornton,1999),orrestructuringinresponsetochangesinthetechno-logical,economicorinstitutionalenvironment(Fligstein,1990,Pfeffer,1972,Stearns&Allan,1996).

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“Thelowerthestockprice,relativetowhatitcouldbewithmoreefficientmanage-ment, themoreattractive the take-overbecomes to thosewhobelieve that theycanmanagethecompanymoreefficiently.”

Manneposited a strong relationbetween shareprices andmanagerial performance.Asshareholdersexitpoorlyperformingfirms,lowersharepricescreateincentivesforoutsiders toaccumulatecontrol rights, replace themanagement, and restructure thefirm.Theseoutsiderscanrecouptheirinvestmentthroughasharepricepremium,sell-ingtheirequitystakes lateratahigherprice.Whenexposedto the threatofhostiletakeover,managementmustthereforeimprovereturnstocapitalandstopinvestmentin“underperforming”assets,orelsemanagersrisktheirjobs.Themarketforcorporatecontrol is central tomarket-based systems of corporate governance, since investorsmayretaincapitalliquidityanddiversifiedportfoliosbutbenefitfrommonitoringinthemarket.Takeovers thussubstitutefordirectmonitoringby largeblockholdersorbanks,asakeyfeatureofmarket-basedcorporategovernancesystems(Baums,1993,Höpner&Jackson,2001).

Themarketforcorporatecontrolhasalsofacedstrongcritics.Abroadconsensusex-iststhatsharepricepremiumsfortheshareholders’oftargetfirmsarelarge,perhapsas20-30percent(Bruner,2002).Meanwhile,shareholdersofacquiringfirmshavezeroornegativereturnsboth(Forsyth&Raj,2002,Forsyth&Raj,2003,Gerke,Garz&Oerke,1995,Goergen&Renneboog,2004,Gregory&McCorriston,2002,Higson&Elliot,1998,Sudarsanam,Holl&Salami,1996).Targetfirmsgainsareoffsetbyac-quiringfirmlossestonetastatisticallyinsignificantchangeinperformance(Andrade,Mitchell&Stafford,2001,Draper&Paudyal, 1999,Franks&Harris, 1989,Sudar-sanam,etal.,1996).

Oneinterpretationsuggeststhatwhilenetgainsmaybezero,somecasesofM&Astillproducepositivegainsandthusthereisnoharmtohavingastrongtakeovermarket.YetevenHenryManne(1965)anticipatedtheenormousimpactoftakeoversonthedis-tributionofwealth:“...wecanseehowthismechanismfortakingcontrolofbadlyruncorporationsisoneofthemostimportant‘get-rich-quick’opportunitiesinourecono-mytoday.”Severalcriticismsquestionwhethertakeoversproducenetgainstosociety(Jarrell,Brickley&Netter,1988).Gainstoagivenpartymaybesimplere-distributionsresulting from losses to someone else. The transfer ofwealth from stakeholders toshareholdersmayaccountforalargeproportionoftakeoverpremiums,butleadtonetlossesofefficiencyduetobreachesoftrust(Shleifer&Summers,1988).

Theimpactoftakeoversonemployeesiscentraltothecontroversyoverthemarketforcorporatecontrol.Fromtheagencytheoryperspective,thedisciplinaryroleoftakeo-versshouldreduceexcessemploymentandenhancelabourproductivity.Takeoversarearguedtoshiftassetstomoreefficientuseswhilealsoenhancingtheaccountabilityofmanagerstoshareholders.Alternatively,fromtheresource-basedviewofthefirmorstakeholder theory, takeoversmaydiminishfirm-specifichumancapitalandknowl-

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edge,particularlyinthecaseofhostiletakeovers.Ifemployeesandotherconstituen-cieswithasset-specificinvestmentsarenotadequatelyprotectedbylaw,takeoverswillserve to transferwealth toshareholdersat theexpenseof long-termperformanceoftheenterprise(Deakin,Hobbs,Nash&Slinger,2002).ShleiferandSummers(1988)suggestthat,followingasuccessfulhostilebid,anewmanagementteamcomesinandfindsitselfabletorealizeshort-termgainstomeetthecostsofthetakeoverthroughassetdisposals.Theyarguethat,“Hostiletakeoversareexternalmeansofremovingmanagerswhoupholdstakeholderclaims.Takeoversthenallowshareholderstoappro-priatestakeholders’expostrentsintheimplicitcontracts.Thegainsaresplitbetweentheshareholdersoftheacquiredandtheacquiringfirms.Atleastinpart,therefore,thegainsarewealthredistributingandnotwealthcreating”.Moregenerally,thethreatofhostiletakeovermaydecreasethelevelofinvestmentinfirm-specificassetsbymanag-ers,employeesandotherstakeholders,therebyoffsettinganygainsinthereductionofagencycosts(Schnitzer,1995).Likewise,mergersarealsoassociatedwithanincreasedlikelihoodoflayoffsonanaggregatedindustrylevel(Fligstein&Shinn,2007).10

Theeffectivenessofthemarketforcorporatecontrolmayalsobediminishedbysev-eral factors. First, the stockmarketmayoften fail to effectively value corporations(Kraakman, 1988). Capital markets often take myopic, short-term views of invest-ments,followspeculativetrendsthatmakevaluationsveryvolatile,orfailtorespondtobadmanagementbecauseshareholdersareuninformed(Miles,undated).Second,managementmayreactnegativelytotakeoversthroughcostlydefensivestrategiessuchasgoldenparachutes,poisonpillsandlegalprotections(Bittlingmayer,1998).Third,managementmayadoptshort-termstrategiestobolstershareprices,therebysacrific-ingbeneficial long-termprojectsand investments.Fourth,biddingfirmsmaythem-selvespursueselfishmanagerialinterests,assuggestedbytheso-calledhubristheoryofM&A(Roll,1986).

Inretrospect,theconditionsproducingthewaveofhostiletakeoversduringthe1980sandearly1990sseemquiteunique.Fewtakeoversjustifytheveryhighpremiumspaidtotargetshareholdersinhostiledeals,whichoftenrangefrom30to50%.Suchtakeo-versmustbefacilitatedbyothermacroeconomicfactors,includingstructuremispric-ingofstocks.Whereasinthe1990s,32%ofU.S.firmswithnegativeROAreceived(friendlyorhostile)takeoverbids,thispercentagedeclinedtojust11%intheperiod2000-2005—similartolevelsinGermanyorFrance(seeFigure 1).Still,littledirectlinkcanbeestablishedbetweenthehostilityoftransactionsandtheirlinktopoorper-formance(Bratton,2007).Today,mostdisciplinarytakeoversareachievedbyprivate

10 Awiderangeofotherevidencesupportsthe‘breachoftrust’argument,andgenerallysuggestscastsdoubtontheefficiencyofthemarketforcorporatecontrol.Conyonetal.(2001,2002)examinedhostiletakeoversintheUKbetween1987and1996,reportingsignificantfallsinbothemploymentandoutput.Deakinetal.(2002)conductedcasestudiesof15UKtakeoversin1993-1996,reportingsubstantialjoblossesandshort-termsaleofassets.Theirstudygivesqualitativeinsightsintothemarginalroleofemployeeinterestswithinthedecision-makingprocess,andsubsequentlossesofemployeemorale.

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equityfirmswithouttheneedforhostilebids.Giventhehighcostsofhostiletransac-tions,argumentsforamoreopenmarketforcorporatecontrolseemunwarranted.

2.3 Limits of board independence.

Giventhelimitstoshareholderengagement,akeyelementofmarket-orientedcorpo-rategovernanceisthepresenceofoutside,independentmembersoftheBoardtorep-resentshareholderinterests.Fromtheagencytheoryperspective,boardsofdirectors(andparticularlyindependentoroutsidemembers)areputinplacetomonitormanagersonbehalfofshareholders (Lynall,Goden&Hillman,2003).Theboardofdirectorshastheformalauthoritytoratifymanagementinitiatives,toevaluatemanagerialper-formanceandtoallocaterewardsandpenaltiestomanagementonthebasisofcriteriathatreflectshareholders’interests.Agencytheorysuggeststhataboardcomprisedofindependentdirectors(e.g.,boardmemberswhoarenotdependentonthecurrentCEOororganisation)ismorelikelytoprovideaneffectiveoversightofthefirm’sCEOandotherexecutivedirectors.Theseargumentsseeboardindependencelargelyasapoten-tialsubstituteforformalengagementbylargeshareholders.

A substantial number of empirical studies try to verifywhether independent direc-torsperform their governance functions effectivelyby linkingboard structurewithperformance(Bhagat&Black,1999).Whileanumberofstudiesfindapositiverela-tionshipbetweenoutsidedirectors’representationandfirmperformance(Baysinger&Butler,1985,Pearce&Zahra,1991),otherstudiesfindanegativerelationshipbetweenboardindependenceandfirmperformance(Baysinger,Kosnik&Turk,1991,Kesner,1987).Someauthorstriedtoverifytherelationshipbetweenboardindependenceandperformanceusingmeta-analyticalmethodology(Dalton,Daily,Ellstrand&Johnson,1998,Dalton,Daily,Johnson&Ellstrand,1999,Rhoades,Rechner&Sundaramurthy,2000).Forexample,Daltonetal.(1998)used54empiricalstudiesofboardcomposi-Daltonetal.(1998)used54empiricalstudiesofboardcomposi-(1998)used54empiricalstudiesofboardcomposi-tionandfinancialperformance,anddidnotidentifyanysignificanteffectsofboardcompositiononperformance.Thisconclusionholdsacross themanyways inwhichfinancialperformancehasbeenmeasuredintheliterature.Theresultsofothermeta-analyses(e.g.,Daltonetal.1999;Rhoadesetal.2000)areinconclusive.Anotherdif-ferent streamof research suggests that, rather thanexaminingaboard’smonitoringeffectivenessbyusing the firm’s financialperformanceasaproxy,amoreaccurateevaluationcanbegainedbyexaminingdiscretionarydecisionsor“criticaldecisions”thatinvolveapotentialconflictofinterestbetweenmanagementandshareholders.Forexample,Deutsch(2005)reviewed16differentstudiestoshowthatindependentboardshaveahigherprobabilityoftheCEOturnover.Still,theevidenceremainsinconclu-siveorevensometimesnegativeregardinghowboardstructureinfluencesothercriti-caldecisionsaroundexecutivepay,earningsmanagement,R&Dinvestment,orM&Astrategies(Beasley,1996,Bryd&Hickman,1992,Core,Holthausen&Larcker,1999,Gordon,2007).

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Theweakevidenceregardingthebenefitsofindependentboardsraisesaquestionofwhytheireffectivenessappearstobelimited.Indeed,thefailureoftheEnronboardtoheedthewarningsignsasthecompanysliddeeperintotroubleremainssomethingofamystery.Atleasttwoissuesareimportantinthisregard.First,boardmembersmaynotbesufficientlyindependentfromtheCEO(Bhagat&Black,1999).Gilson(2006)describesthesituationinthe1980sasfollows,

“Thechiefexecutiveofficer,ratherthanbeingselectedbytheboard,effectivelyselectedwhowouldbeadirector,andtheshareholderspassivelyendorsedthechoice.Theresultwasthatdirectorssawthemselvesasadviserstoseniorman-agement,nottheirmonitors.IfadirectordisagreedwiththeCEO’sstrategy,theproperresponsewastheresignationofthedirector,ratherthanthatthereplace-mentoftheCEO”.

Morerecently,Bebchuk(2005)finds thatonlyasmall fractionofpubliccompaniesintheUSAfacedcontestedboardelectionsthatweredesignedtooustexistingdirec-tors.Oneofthebarrierstocontestedboardelectionsisassociatedwithfinancialandorganisationaldifficultiesshareholdersfacewhentryingtoplacetheirowndirectorsonacompany’sproxystatement.Bearingthisinmind,Bebchuksupportssuggestionsthatcompaniesshouldbeabletochoosetoprovideshareholderswithproxystatementsvia theInternet.Thisargumentsuggests theproblemis thatoutsideboardmembersmay remain insufficiently independent, particular since outside directors have littledirectmandatetorepresentkeyshareholderorbroaderstakeholderconstituencies.Inotherwords,independenceshouldbeseenashavingcomplementaritieswithstrongershareholderengagementorrepresentationofcorporatestakeholders,ratherpurelythanasasubstitute.Consequently,intheestimationsofLangevoort(2007),“…entrenchedCEOsfinditeasytopopulatetheboardwithoutsideswhomeettheformaldefinitionofindependence,butremainloyaltothemforsocialorpsychological,ifnoteconomic,reasonsorwhoareinsufficientlyinformedormotivatedtoupsetthestatusquo”(p.11).Intheabsenceofstrongercontrolsonthenominatingprocess,mostindependentdirec-torsmaintainastanceof“dysfunctionaldeference”totheCEOthatlimitstheircontri-butionofeffectivecorporategovernance(Sharfman&Toll,2008).

A second issue concerns themore inherent limits of independence per se.Outsidedirectorsmaysimply lack theamountandqualityof informationthat insidershave.Theinformationavailablemaybetoodependentonformaldisclosure,toofocusedonfinanceratherthanstrategyandoperations,andundervaluelong-termfutureprojects.Conversely,otherstudieshavefound thatamajorityof insidedirectorsmay lead tomoreeffectiveevaluationoftopmanagers(Hill&Snell,1988,Hoskisson,Johnson&Moesel,1994).TheresultisalsoborneoutbystudiesregardingcodeterminationinGermany (Addison, Schnabel&Wagner, 2004). For example, financial economistshaveshownthatemployeerepresentationonGermanboardsisassociatedwithhighercapitalmarketvaluationduetothefactthatemployeeshavestronginsideknowledgeofcompanyoperationsthataidinthemonitoringofmanagement(Fauver&Fuerst,2006).

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Insum,thelimitsofindependentdirectorsmayalsorelatetodifferencesamongfirmsintheircapacitytoabsorbcostsormakeuseofboard-levelresources(Aguilera,Fila-totchev,Gospel&Jackson,2008).Still,whenviewedinahistoricalcontext,thechang-ingstructureofU.S.boardsfroman“advising”toa“monitoring”boardhasbeenpartofalong-termshiftincorporategovernancetowardshareholdervalueasadominantcorporateideology(Gordon,2007).

2.4 Limits of board incentives.

ThegrowthinexecutivepayintheU.S.sincethe1990siswellknown,andhassparkedawide range of public debate.Changes in executive compensationwere ostensiblyintroducedtocreatemoreappropriateincentivesforexecutivestoactintheinterestsofshareholdersthroughstockoptionsandotherequity-basedincentivemechanisms.TheaveragesalaryofCEOofS&P500firmsincreasedfrom$3.7millionin1993toapeakof$17.4millionin2000(Bebchuk&Grinstein,2005).Forthesesamefirms,theproportionofequitybasedcompensationincreasedfrom41%to78%.Onaggregate,thevalueofstockoptionsheldbyU.S.executivesgrewfrom$50billionin1997to$162billionin2000,representingaroundfifteenpercentofallsharesoutstanding(CoffeeJr.,2003).

Criticismofexecutivepayisnotnewinitself,butanewwealthofevidencehasaccu-mulatedtosuggestthatexecutivepayisitselfacoreproblemofcontemporarycorpo-rategovernance(forthemostcomprehensivecriticalassessment,seeBebchuk&Fried,2004).Thecoreargumentisthatexecutiveshaveasubstantialinfluenceovertheirownsalaries,andhaveusedthispowertoweakenthelinkbetweenpayandperformance.Forexample, recent studieshaveshown thesizeof stockoptionsoutstandinghadaverystronginfluenceontheprevalenceofearningsrestatements(Efendi,Srivastava&Swanson,2004){Dennis,2006,page1564}.Thus,anumberofauthorsnowcloselylinktheproblemssurroundinggatekeeperfailuretothegrowingincentivesofmanag-erstoinflateearnings.Evenadvocatesofshareoptions,suchasMichaelJensen,havestartedtellingexecutivesto“justsayno”toWallStreet,andcriticizedmanagers’focusonshort-termearningsgames(Fuller&Jensen,2002).

Anumberoffactorscontributedtothisshift inexecutivepay.Executivecompensa-tionissetbytheBoardofDirectors.Forreasonsdiscussedabove,thelackofgenuineindependenceofoutsidedirectorsgives themavarietyof incentives toacquiesce tothe compensation packages of theCEO.Directors also typically have low levels ofequityholdingsinthefirm,andthuslittleincentivetoactivelyinterveneagainstnega-tivepolicies.Empiricalstudieshavenowshownthatweakboardsarecorrelatedwithhigherexecutivesalaries,suchaswhereboardsareverylargeorahighproportionofDirectorshavebeennominatedbytheCEO(Bebchuk&Fried,2003).Butevenwherecompensation committees are formally independent, theuseof consultants remainspervasiveandcreatespotentialproblems.ConsultantsmayfeelbeholdentotheCEO

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whohiredthem,thusfearingthatunfavourablerecommendationsofpayincreasetheirriskofnotbeingrehiredinthefuture.Thisfearmayfurtherincreaseifconsultantssup-plymultipleservicestothefirm,suchasotherconsultingonhumanresourcepractices.Benchmarkingtechniquesusedbyconsultantsalsomakeiteasyforfirmsto“ratchet”upexecutivepaytryingtobeatperceivedmarketrates.Recentstudiesconfirmthattheuseofconsultantsisassociatedwithhigherlevelsofexecutivepay,andgreaterrelianceoflargeequity-basedincentives(Conyon,Peck&Sadler,2009).

Butcanmanagerssimplydiscounttheinfluenceofsocialnormsorthepotentialdisap-provalofoutsiderstowardtheirpaypackages?Bebchuk(2003)arguesthatanotherfac-torfacilitatingthegrowthofCEOpayistheabilityofexecutivestocamouflagetheirpay increases, drawing upon shareholder-oriented ideologies and hiding behind therapidgrowthinstockmarketcapitalizationduringthe1990s.Existingaccountingrulescreatemisperceptionsofthetruecostsofstockoptions(Jensen&Murphy,2004).Al-thoughaproposalformandatoryexpensingofoptionwasremovedfromSOX,amongfirmswhereshareholdersintroducedresolutionstoexpensestockoptionsinthecom-pany accounts in 2003CEOpay declined and stock optionswere smaller (Ferri&Sandino,2009).Thisfindingsuggeststhatlackoftransparencyregardingtheexpenseofoptionsmaybeonefactordrivingpayrises.Meanwhile,thestockmarketboompro-videdaconvenientjustificationforpayrises–evenwhentheseincreaseswereoutstrip-pingstockmarketgrowth(Bebchuk&Grinstein,2005).Moreover,theenthusiasmofinvestorsforperformance-basedincentivesprovidedanopportunitytointroducenewpayelementsontopofexistingschemes,yetdesigningthemtoavoidmanydownwardrisks.Takentogether,theshiftinpaymentschemesandthelackofcriticalmonitoringbyboardsovertheseschemessignificantlyalteredtheincentivesoftopU.S.managerstowardshort-termsharepricesandassociatedeffortstomanageearnings.

Whilemany thus see thegrowth in executivepay as reflecting theopportunismofmanagers,thisinterpretationisnotundisputed.Inahotlydebatedarticle,StevenKap-lan(2008)hasdefendedCEOpay,arguingthatthehighsalariesofCEOsarenotuniqueandhavemovedinlinewithincreasesinbothCEOturnoverandstockmarketvalueinwaysthatestablishclearlinksbetweenpayandperformance.Kaplancitesseveralimportantfactsinsupportofhisargument–averageCEOhasdeclinedsinceitspeakin2001,paymentlevelsarelinkedtostockmarketperformance,andaveragetenureofCEOshasdeclinedfromovertenyearstojustaroundsixyearsasCEOturnoverhas increasedin thefaceofgreaterperformancepressures.Thesefactorsaremeanttosuggestthatexecutivecompensationisdrivenbymarketforcesratherthaninsidercollusion,andhencenotunlikeotherhighlypaidoccupationslikelawyers,hedgefundmanagersandinvestmentbankers.CEOpayishighlycorrelatedwiththesizeoffirm,asmeasuredby stockmarket capitalization– the600% increaseofU.S.CEOpaybetween1980and2003isarguedtobelinkedwiththeidentical increaseinmarket

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capitalizationduringthisperiod(Gabaix&Landier,2008).11Criticssuggest,however,thatthesepointsaremisleading.First,Table 6showsthat(accordingtoKaplan’sowndata)althoughaverageCEOpayhasdeclinedsincethestockmarketbubbleof2001,medianpayhasactuallybeenincreasing,doublingfrom$4millionto$8millionperyear.Paylevelshaveincreased400%since1993.Second,arecenthistoricalstudyhasshownthatCEOpaywasnotlinkedtostockmarketcapitalizationduringthe1950sand1960s,butafter1976 this relationship isveryclosely linked(Frydman&Saks,2008).Thischangeisduetothetransformationofmanagerialpaytowardstockop-tions,buthasnotactuallyincreasedtherelativesensitivityofpaytoperformance(seealsoWalsh,2009).Third,otherstudiesshowthattherelativetalentsofCEOshavelittleinfluenceofstockmarketcapitalization,whicharedrivenbyfirmsizeandmarketsen-timent(Kolev,2008,Tervio,2008).Themoneypaidtoattract“top”executivesdoesn’timprovemarketreturnsrelativetothe“lesstalented”andcheaperexecutives(Wyld&Maurin,2008).Fourth,eventherelationshipbetweenpayandperformancefoundbyKaplanexistsforthesmallestfirmsinhissample,butthiseffectisnearzeroforthelargestfirms.

Thesedebateshavebeenvery important inpolicydiscussionsaround“sayonpay.”ManyscholarsarguethatCEOs’fiduciarydutiesplaceamorallimitregardingtheircompensation,whichshouldnotgobeyondtheminimumeffectivecompensationtoat-tractandretainmanagers(Moriarty,2009).Mostconventionalpolicysuggestionsstressfurtherincreasingtheinvolvementofindependentboardmembersandimprovingthedesignonequity-basedplans(foraverythoroughdiscussion,seeJensen,2004).Thepolicyideabehind“sayonpay”,however,revolvesaroundshareholderinvolvement.Thepolicywouldallowanon-bindingup-or-downvotebyshareholdersonexecutivecompensationpackages. In2006,sevenproposalscametoavote, receivingaveragesupportof40percent.Butinvestorsvotedon51proposalsin2007,gaininganaverageof43percentsupport(Tse,2008).Congresspassedlegislationcallingforashareholdervoteonpay,butthebillstalledintheSenate.In2008,resolutionswenttoavoteatover80companiesandaveraged42percentsupport,butonlyreceivedamajorityat11com-panies.However,thefinancialcrisisofbanksandresultingAmericanRecoveryandReinvestmentActofFebruary2009hasledto“sayonpay”forroughly400companiesreceivingfundsundertheTroubledAssetReliefProgram(TARP).Asmallbutgrow-ingnumberofothercompaniesarealsovoluntarilyagreeingtoholdshareholdervotes.TheSEChasalsoexpressedsupportofwideradoptionof“sayonpay.”Mostrecently,SenatorDonaldSchumerannouncedhisintentiontointroducetheShareholderBillofRightsActof2009,whichwouldrequirealllistedcompanies:

11 TheconsultingcompanyTowersPerrinreports thatCEOsalaryamongasampleofFortune500companiesdeclinedby2% in2009as a result of the economiccrisis. http://www.towersperrin.com/tp/showdctmdoc.jsp?country=global&url=Master_Brand_2/USA/News/Spotlights/2009/April/2009_04_30_spotlight_exec_comp.htm

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Toholdannualstockholderadvisoryvotesonexecutivecompensation,facilitateafederalrequirementthatstockholdersbegrantedaccesstoeverycorpo-ration’sproxytonominatetheirowncandidatestoboardsofdirectors,endstaggeredboardsatallcompanies,requirethatalldirectorsreceiveamajorityofvotescasttobeelected,andorderthatallpubliccompaniessplittheCEOandboardchairpositions

2.5 Limits of gatekeepers as informational intermediaries.

Gatekeepersarereputationalintermediarieswhoprovideservicesrelatedtothecerti-ficationofcorporateinformationtoinvestors(CoffeeJr.,2003),includingindepend-ent auditors, debt rating agencies, securities analysis, or investment bankers.Whilethesegatekeepersareoftenpaidbythecorporationtocertifytheirinformation,theirindependence is supportedby theirownreputationalcapital.Gatekeepers shouldbeunlikelytosacrificetheirreputationforthebenefitofanysingleclient.However,thecorporategovernanceliteraturepaidlittleattentiontogatekeepersuntilrecently.Dur-ing the1970s, theprofessionsbecame largelyderegulated and intertwinedwithin alarge internationalnetworkof the“BigFive”auditing firms (Windsor&Warming-Rasmussen,2009).

Nonetheless,duringthe1990s,growingevidencesuggestedagrowingprevalenceofconflictsof interest andgatekeeper failure.Thequalityof auditsdeclined from themid-1990s,whilethemarketingofnon-auditservicesbyauditingfirmsincreasedinparallel.12Forexample,thenumberofearningsrestatementsissuedbylistedcorpora-tionsmore than tripled (Coffee Jr.,2003,p.17), andhascontinued toclimb through2002.Moreworryingwas the fact that themagnitude of earnings restatements in-creasedgreatly,revealingthatincomesmoothinghadgivenwaytomuchmoreaggres-siveaccountingpracticesaimedattheearlierrealizationofincome.Thisfactisargu-ablyrelatedtothelooseningoflegalliabilityofauditorsfollowingtheSupremeCourt’sCentralBankdecisionin1994andsubsequentPrivateSecuritiesLitigationReformin1995(Langevoort,2007).Butperhapsmoreimportantforexplainingthisphenomenonis the explosionofnon-audit income throughconsulting services (Coffee Jr., 2003).Themainissuehereisnotnecessarilythedesireofauditorstoretainthelargershareofconsulting-relatedincome,butthefactthatmixingthesetwoservicesgiveclientfirmsalowvisibilitywayoffiring(orreducingtheincome)toauditingfirms(Gordon,2002).This factorwas reinforced by the fact that the auditmarketwas very concentratedaroundtheBigFivefirms.

12 Empirically,thelinkbetweennon-auditfeesandauditqualityremainscontested.Publishedstudieshaveuseddatafromdifferenttimeperiodsanddifferentempiricalmethodologies,leadingtoconflictingresults(seedis-cussioninLangevoort,2006).

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2.6 Absence of Employee Voice

Astrongbodyofevidencenowlinksemployeevoiceincorporategovernancetoim-provedoutcomesforemployeesandhighproductivityforcompanies(forareviewofthestatisticalevidence,seeFilatotchev,Jackson,Gospel&Allcock,2007).Whiletheissueofstakeholderinvolvementremainscontroversial,theshareholder-orientationofU.S.orUKcorporategovernancehasbeenwidelycriticizedbystakeholdertheorists.Whatislesswellknownarethesetofargumentslinkingincreasedemployeeinvolve-ment in theU.S.with improved functioningofvarious shareholder-orientedmecha-nismsofcorporategovernanceinthelong-term.Afewexamplescanbementioned.

Intermsofshareholderengagement, unionrepresentationonpensionfundshasbeenassociatedwithstrongengagementoncorporategovernanceissues.Unionrepresenta-tionisnotonlyavehicleforpromotingemployeeinterests,butalsohelpsprogressanumberofagendaswhereemployeeshareholdersandothershareholderhavecommoninterests–avoidingexcessivemanagementpay,promotingtransparency,assuringin-dependentaudits,etc.

Intermsoftakeovermarkets,employeeprotectionmayhelplimitthescopeofoppor-tunisticstrategiesduringtakeovers,wherenewownersengageinbreachesoftrusttocreateshort-termgains.

Intermsofboards,Europeanexperiencehasshownthatemployeerepresentativesontheboardofdirectors,eitherthoseelectedviatheworkforceorappointedbyunions,tendtoberelativelyindependentoftopmanagement.Employeeboardmembersdirect-lyrepresentindependentstakeholdersandhaveaccesstoinformationandknowledgeoftheemployees,ratherthanbeingsolelydependentondisclosurefrommanagement.While employees areoftendiscussed asbeing company “insiders,” they are in factquite independent relative tosome“outside”boardmemberswhoareessentiallyre-cruitedbythetopmanagement.Similarly,debatesoncorporatesocialresponsibilityintheU.S.havelongadvocatedtheideaof“constituencydirectors”electeddirectlybyshareholderstogiveweighttostakeholderinterests(Brudney,1982).

Intermsofmanagerialpay,employeerepresentationonboardsseemtohavebothmoremodestpay,butalsomorestrictlydefinedlong-termperformancecriteriathanincoun-trieswithout employee representation (Buck&Shahrim,2005,Fiss&Zajac,2004,Sanders&Tuschke,2006).Employeesdonothaveaninterestinavoidingincentivizedorvariablepay,butdohaveastronginterestinmakingsuresuchincentivesarelong-term,consistentwiththestrategicgoalsoftheorganization,andcompatiblewiththesocialnormsofotheremployeesinthefirm.

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2.7 A Complementary System?

CorporategovernanceintheUnitedStateshasnotbeenastaticsystem.Despitetherelativelyfewlegalreformstotheformalsystem,theevolutionofcorporategovernancepracticeshasbeenverydynamic,inpartduetothefactthatverylittleintheformalstructure shields firms from the economic changes inmarkets (Gilson, 2006). Theslowchangesinownershippatternsstartinginthe1970sand1980screatedanewmar-ketforcorporatecontrol,andtherebycalledforthfurtherchangesinthestructuresofboards,executivecompensationandtheroleofgatekeepers.Mostobserversagreethatthissystemhasdisadvantagesintermsofsupportinglong-termcommitmentsamongstakeholdersand thus supporting incremental formsof innovation.Yet thedynamicandmarket-orientatednatureoftheU.S.systemisarguedtobesuperiorincopingwithmorediscontinuousformsofeconomicchange(Gilson,2006,p.158).

Initspositiveform,theresulting“model”ofcorporategovernanceintheU.S.iscon-sideredtohaveanumberoftightlycoupledandmutuallyreinforcingelements—strongshareholderengagement,independentboardmembers,strongfinancialincentivesformanagers,gatekeepersaskeyinformationalintermediaries,andultimatelyaneffectivemarketforcorporatecontrol.Atamoretheoreticallevel,theU.S.paradigmrelieslarge-ly on three tools ormechanisms–market incentives, disclosure and independence.Marketplayersarethoughttoactefficiencyaslongascorporationsdisclosesufficientinformation.Thequalityanddepthofthisdisclosureis,inturn,enhancedbythein-dependenceofboardmembersandgatekeepers.Theselinksassurethattheincentivesfromthemarketenterintothefirm,butalsothatinformationexitsthefirmtoshapemarketexpectations.Yetmuchhingeshereonindependenceasacrucialelementofchecksandbalancesfortheinterfacebetweenfirmsandmarkets.Forexample,Gordonargues(2007,p.1563):

“Stockpricesaretakenasthemeasureofmostthings.Inthisenvironment,in-dependentdirectorsaremorevaluablethaninsiders.Theyarelesscommittedtomanagementanditsvision.Instead,theylooktooutsideperformancesignalsandarelesscapturedbytheinternalperspective,whichasstockpricesbecomemoreinformative,becomelessvaluable…IntheUnitedStates,independentdirectorshavebecomeacomplementary institution toaneconomyof firmsdirected tomaximizeshareholdervalue.”

Similarly,Gilson(2006)arguesthattheincentivizingofmanagerswithstockoptionsand growing independence of directorswere complementary developments – sincegreater incentivesmay lead tobothhigherperformanceormorecheating, the inde-pendentscrutinyofdirectorsbecameincreasinglyimportant.However,independenceis equally intended tooperatenot just asaconduit,but alsoasacounterbalance toshareholderdemandsasamoreenlightenedversionoftheshareholdervalueapproach.AsGorden(ibid)continues:

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“…italsoopensupspaceforadistinctiveroleoftheindependentboard:decid-ingwhenprevailingpricesmisvaluethefirmanditsstrategies.Inlightofim-perfectlyefficientcapitalmarkets,sucharolemaybeefficiencybased…Foraparticularfirm,adisfavouredstrategymayinfactmaximizeshareholdervalueoverareasonabletimehorizon.Ifthemarketgotitwrong,rejectingitssignalsmayleadtoputtingthefirm’sassetstohighestandbestuse.”

Analternativeinterpretationsuggeststhattheselinkagesmay,infact,bequiteweak.Alargebodyofsocialscientificevidencenowsuggeststhatunderconditionsprevail-ingthroughthe1990s,shareholdersarenotveryengaged,outsideboardmembersfacedangersofcapturebytheCEO,theincentivesforexecutivesareverybiasedtowardhigh-poweredshort-termgains,andgatekeepersarecomplicitwiththissituationduetotheirownconflictsofinterest.Thelimitedeffectivenessofeachelementindividuallymayhaveknock-oneffectsthatreducetheeffectivenessofotherinterrelatedcorporategovernancemechanisms.Thissituationcanbedescribedintermsofcomplementari-tiesbetweencorporategovernancemechanismsorinstitutions,butinanegativesenseofmutualreinforcementtowardasub-optimalequilibriumpattern.13Forexample,thescandalofEnroncanbeinterpretedasanimbalancebetweenmanagementincentivesanddirectormonitoring,wherebyindependentoutsiderswereinsufficienttocounter-balance thepowerofequity incentives(Holmstrom&Kaplan,2003).Thissituationwas,inturn,drivenbytheover-valuationofU.S.equitiesbyinstitutionalinvestorsdur-ingthestockmarketbubble,whichgeneratedmassiveshort-termpressuresonfirmstomeetunrealisticshareholderexpectations(Jensen,2004).SomepreliminaryevidencesuggeststhatstockmarketvaluationsaresystematicallyhigherintheUSandUKrela-tivetoGermanyforfirmsofsimilarsizeandperformancelevels–althoughfurtherresearchisneededonthispoint(Höpner&Jackson,2001).14

Ratherthancreatingpositivecomplementaritiesthataremutuallyreinforcing,theinter-actionsamongthevariouselementsofU.S.corporategovernancecreatedcomplemen-taritiesinamorenegativesense ofexternalitiesthatmutuallyreducedtheeffective-nessofthesepracticesbutlockingactorsintothesechoices.Weaknessinshareholderengagementcontributedtothelackofdirectorindependence.Complacentoutsidedi-rectorscontributedtoproblemsofexecutivecompensation.Executiveshadstrongin-centivestomanageearnings,andutilizedgatekeepersinwaysthatledtokeyconflictsofinterest.Viewedinthissystemicway,thecrisissurroundingEnronwasnotmerelyalocalcrisisorisolatedphenomenon.Rather,thecrisisbecamesystemicandchallengedthebasiclinkagesbetweenkeycorporategovernancepractices.

13 Fromatechnicalperspective,thiscaseistheinverseofstrategiccomplementarities.ComplementaritiessuggestthattheefficiencyofAisenhancedbythepresenceofBandviceversa.ThisideacanbeextendedtoarguethattheefficiencyofAisnegativelyinfluencedbytheabsenceofB.

14 Forexample,aquickinspectionofsharepricesattheendof2008amongasampleoffirmswithover10,000employeessuggeststhatU.S.firmshadprice-bookvalues27%higherthanGermanfirmsaftercontrollingforfirmsizeandreturnonassets.

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ThenextsectionshalldealwithSOXlegislationasareactiontothiscrisis.Asshallbearguedbelow,SOXcorrectlytriestoaddressthesystemicfailuresincorporategovern-ancebystrengtheningthelinksfromauditorsandtosomeextenttheroleofdirectors.SOXrulesdomuchlesstoaddressissuesaroundshareholderengagementorexecutivecompensation.Assuch,SOXdidlittle toalter thebasicunderlying“model”ofU.S.corporategovernanceandleavesanumberofweaklinksuntouched.

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3 Sarbanes-Oxley and its Influence on Corporate Governance

The legislativeprocess leading toSOXwasa reaction to thescandalsatEnronandWorldcom,andhassincerisetoaheateddebateoveritsmeaningandlegitimacy.Thehastylegislativeprocesslastedjust29days(Haller,Ernstberger&Kraus,2006;Cioffi,2010).WhiletheSarbanes-OxleyActof2002wasenactedbyaRepublicancongressandPresident,SOX isgenerally seenasapieceof“progressive” regulation (Baker,2008).Commentatorshaveseenitbothasabriefwindowfornecessaryreformsthathavefar-reachingpotentialtobringaboutpositivechange(Mitchell,2003),orasanill-consideredoverreaction leading the“quack”corporategovernance(Romano,2005).TheSOXreformundoubtedlyrepresentsafundamentalchangeinthepatternofU.S.regulation,replacingtraditionaldisclosurerequirementswithdirectregulatoryman-datesforcorporategovernance.TheFederalgovernmenthastakenonagreaterrole,since theSEChasnowmovedintoareas thathadbeenexclusivelyregulatedbythestates.Andfinally,theroleoflargelyself-regulatedorunrelatedprofessionalgroups(e.g.accountants,auditors,analysts,middlemanagers,etc.)hasbeenbroughtintotheforefrontofthecorporategovernancediscussion.

Table 7providesasummaryofthemajorprovisionsofSOX(CoatesIV,2007).Thelawhasfivemainobjectives(AmericanBarAssociation,2004):1)tostrengthentheindependenceofauditingfirms,2)toimprovethequalityandtransparencyoffinancialstatementsandcorporatedisclosure,3)toenhancecorporategovernance,4)toimprovetheobjectivityofresearch,and5)tostrengthentheenforcementofthefederalsecuri-tieslaws,includingtheuseofcriminalpenalties.15

AmajorelementofSOXwastoreformtheauditprocess.Abanwasplacedonnon-auditfees.AnewregulatoryagencyPublicCompanyAccountingOversightBoard(PCAOB)wascreatedtoincreasepublicsupervisionofauditors.PCAOBisnowinvolvedintheregistrationofaccountingfirms,theinspectionofthosefirmswithrelationtoaudits,thesettingofstandardsfortheaccountancyprofession,andenforcementofviolationsthroughdisciplinarysanctions.Therelationshipbetweenthecompanyandtheauditorswasalsoplacedundertheoversightoftheboard’sauditcommittee.Theauditcommit-teemustalsobecomposedentirelyofindependentdirectors,andfirmsmustdisclosewhetheratleastonememberofthecommitteehasfinancialexpertise.TheprovisionsofSOXthuslargelystresstheroleandindependenceofauditors,whilegivingsomebutrelativelylessattentiontohowboardsoperate(Fogel&Geier,2007).

15 AlthoughSOXgreatlyincreasedthemaximumcriminalpenaltiesforwhitecollarfraud,nostepsweretakentostandardizeactualsentencingapplication. Thus, thenumberofwhite-collarcrimeprosecutionsincreasedfromsome6,000annuallybeforeSOXtoover8,000in2007—suggestingthatSOXhaslittledeterrenteffectasjudgesrefusetoimposehighpenaltiesandengageinsubstantialpleabargaining,asinthecaseofJeffSkillingatEnron(2009).

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Anotherkeyareafornewrequirementsconcernsinternalcontrolsystems.Section302ofSOXrequirestheCEOandCFOtoattesttotheeffectivenessofinternalcontrols,andreportanydeficienciestoboththeauditorsandtheboardauditcommittee.Section404alsorequiresmanagementtoreportontheeffectivenessofinternalcontrols,andtheauditormustattesttoandreportontheirassessment.TheSEChassubsequentlyissuedanumberofrules to interpret theserequirements,particularlywithregard toreportingof“materialweaknesses” in the internalcontrols.PCAOBhasfurtherde-finedtheseweaknesseswithregardtotheobligationsforauditors.Theseruleswerewidelycriticizedasbeingverycostlyoreventhesourceofrentseekingbehaviourbyauditorsandlawyersinvolvedintheirimplementation(Langevoort,2006).Since2007,however,theSECandPCAOBhaverevisedtheserulestobemoreprinciples-basedandorientedtofirm-specificriskfactors.

One interestingaspectofSOXhasbeen theabsenceofany increase in shareholderrightsandresponsibilities,eitherintermsofvotingrights,abilitytonominatedirec-tors, or legal liabilities. SOXhas been less about redistributing private power frommanagers toshareholders,andmoreaboutdiffusingprivatepowerintoamorepub-licsystemofchecksandbalances(Langevoort,2007;Cioffi,2010).PublicregulationhassoughttocounterbalancethehighpowerincentivesandresultingriskfactorsthathavebecomebuiltintotheU.S.systemofcorporategovernance.Theregulationsonaudit firms, independent directors, and top corporate executives have all sought tomake theseactorsmorepublic-regardingandcurtail theirprivatepower.Practition-ersthereforesometimesdistinguishtheshareholder-orientedmodelintheUK,whichleavesgovernancetotheinteractionsbetweeninvestorsandmanagers,andthemoreregulator-orientedmodelintheU.S.,wheretheSECplaysamoredirectroleofcorpo-rategovernancebyenforcingdisclosurerules(InstituteofCharteredAccountantsofEnglandandWales,2005).Althoughthesereformsmaybenefitshareholdersorreducecapitalmarketrisks,onelegacyofSOXmaybetointroduceasubstantialpublicinter-estelementintotheU.S.corporategovernancesystemsthatisoftenassociatedwiththe‘stakeholder’modelsofContinentalEurope.

3.1 The Influence of SOX and Related SEC Regulations on U.S. Firms

TheinfluenceofSOXispotentiallywideranging.Inthissection,wefirstlookattheexternalaspectsof this influencerelatedtotheinteractionsbetweencompaniesandinvestors.Heretheevidenceisatleastsomewhatpositive,suggestingimproveddisclo-sure,lessearningsmanagementbycompanies,andimprovedinvestorconfidence.WealsolookattheinfluenceofSOXontheinternalorganizationofcorporations,includ-ingtheissueofcompliancecosts.Heretheevidenceconfirmstheverysubstantialcostsincompliancethatmustbeweighedagainstthebenefitsdiscussionabove.Intermsofbothinternalandexternalaspects, theeffectofSOXdiffersgreatlyacrossdifferenttypesoffirmsmakingauniformanalysisproblematic.

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3.1.1 External aspects: Disclosure, Earnings Management and Investor Reactions.

Intermsofdisclosure,SOXhelpedtoincreasethelevelofdisclosure,suchasinthereportsbyauditcommittees (Pandit,Subrahmanyam&Conway,2006).Firmshavebeenmorelikelytoreportdeficienciesintheinternalcontrolsystems(Stephens,2008).Likewise,auditorapproved improvements to internalcontrol systemshavebeenas-sociatedwithmorefavourableriskassessmentsbyinvestorsandlowercostsofequitycapital(Ashbaugh-Skaife,Collins,KinneyJr.&Lafond,2009).Firmshavealsobeenmore likely touseethical terminologywithin theirdisclosures,althoughsuchfirmsweremorelikelytobeinhighimpactindustriesandscorelowofcorporategovernancemeasures(Loughran,McDonald&Yun,2009).

In termsofearningsmanagement, someempiricalevidencesuggests that followingSOX,thedegreeofearningsmanagementhasbeenreduced,ashopedforbypolicymakers(Chang&Sun,2008,Li,Pincus&Rego,2008,Lobo&Zhou,2006).Thesestudieslookatthedegreeofdiscretionaryaccrualsbyfirms,showingthatfirmsarelessaggressiveinreportinggainsandmovemorequicklytoreportlosses.Thesere-sultssuggestthatgreaterauditorindependenceandtheincreasedpersonalliabilityoftheCEOandCFOfortheearningsstatementsoflistedcompanieshaveledtomoreconservativeaccountingpractices.Forexample,Cohenetal.(2008)showthetotallevelofdiscretionaryaccrualsofU.S. firms increasedcontinuously from the1990suntiltheEnronscandal.However,theseaccrualsdeclinedfollowingthepassageofSOX.AnumberofadditionalstudiesalsolinklowerlevelsofearningsmanagementwithsomeofthespecificmeasuresintroducedbySOX.First,whilestockoptionswereassociatedwithincreasedearningsmanipulationbeforeSOX,thisincentiveseemstohavedisap-pearedfollowingSOXperhapsduetotheincreasedliabilityoftheCEOandCFOact-ingasapositivesignal(Cohen,etal.,2008,Zhang&Wiersema,2009).16Conversely,formerCFOsoffirmsrestatingtheirearningsfacehigherpenaltiesinthelabormarketfollowingSOX,suggestingthatCFOsarenowbeingheldmoreaccountable(Collins,Masli,Reitenga&Sanchez,2009).Second,otherpost-SOXstudieshaveshownthatfinancialexpertiseofdirectorshelpstocurbearningsmanagement(Hoitash,Hoitash&Bedard,2009).SOXrulesrequiringgreateraccountingexpertisewithintheauditcommitteehaveledtomoreconservativeaccountingpractices,althoughthisresultiscontingentonfirms’havingstrongboardswithmoreindependentdirectors(Krishnain&Visvanathan,2008)anddoesnotruleout the importanceofalternativecorporategovernancemechanisms(Carcello,Hollingsworth&Klein,2006).Finally,anumberofstudieshaveshownsomeevidencethatthenumberofindependentmembersoftheaccounting committee is associated with lower earnings management (Agrawal &Chadha,2005,Chang&Sun,2008,Klein,2002).

16 ProvisionsinSections302and304ofSOXmandatethereturnofanyincentivecompensationowingtomaterialnoncompliancewithanyfinancialreportingrequirement.

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Whilethepictureofearningsmanagementseemspositive,Cohenetal.(2008)findthatfirmshavebecomemore likely to undertake real earnings managementthroughabnor-malchangesincashfromoperations,productioncosts,ordiscretionaryexpensessuchasR&D.Asaccountingruleshavetightened,discretionaryshiftsinearningshavebeensubstitutedbyrealshiftsinearnings.Executiveswithunexercisedstockoptionsweremorelikelytomanagerealearningspost-SOX.Consequently,theexistingrulesmayassistincurbingfraudulentreporting,butmaydolesstoaddressbroaderissuessuchasshort-termism.Hence,lookingataccountingpracticesinisolationisinsufficientun-lesscomplementedwithothercorporategovernancepracticesthatworkinconjunction(Aguilera,etal.,2008).

Intermsofinvestorconfidence,anumberofempiricalstudieshaveexaminedhowfi-nancialmarketsreactedtoSOXusingeventstudymethodologies.Whilesomestudiesshowapositivereaction(Jain&Rezaee,2006,Li,etal.,2008)andgreatersensitivityofinvestorstofirm-specificrisks(Akhigbe&Martin,2008),otherstudiesshowthatnegativereturnsfollowingSOXthatmayberelatedtotheincreasedcostsofcompli-ance(Zhang,2007).Thesemixedresultscanbeexplainedinpartbystudiesthatdif-ferentiatebetweendifferent typesof firms.FirmswithweakshareholderprotectionexperiencedpositivereturnsafterSOX,whereasfirmswithstrongprotectionhadnopositivebenefit(Choi,Frye&Yang,2008).Smallfirmsmayhaveahardertimeshoul-deringthecostsandhencefacedmorecostsandrecoupedfewerbenefitsfrominves-tors(Small,Ionici&Hong,2007).LargerfirmswithmoreindependentdirectorspriortoSOXwereabletoactmorequicklyandreapgreaterbenefitsfrombeingperceivedascompliant(Akhigbe&Martin,2006).

3.1.2 Internal aspects: Corporate Boards and Employee Whistleblowers

SincethetimeofEnron,thestructureofU.S.boardshasundergoneanumberofre-forms introduced throughSOX.Inorder toavoidfurther legislation, theNYSEandNASDAQalsoundertookparallelreformsinthelistingrequirementsin2002.First,theboardofdirectorslistedfirmsmusthaveamajorityofindependentdirectors.Moreover,thecompensationandthenominatingcommitteesmustconsistentirelyofindependentdirectors.Therequirementsofbothexchangesarelargelyidentical,butNASDAQisslightlymoreflexibleincertainaspects.Second,independentdirectorsmustnowmeetadefinitionofindependenceaccordingtoFederallaw.Inparticular,SOXdefinesan“independent”directorassomeonewhomaynot“acceptanyconsulting,advisory,orothercompensatoryfeefromtheissuer;orbeapersonaffiliatedwiththeissueroranysubsidiarythereof”(SOXArticle301).Similarly,NYSElistingrulesdefineindepend-enceas someonewith“nomaterial relationshipwith the listedcompany…includinga partner, shareholder or officer of an organization that has a relationshipwith thecompany”(Gordon,2007,p.1483).Third,theauditcommitteemusthaveaminimumof threemembers fromamong the independentdirectors. Inaddition,eachmembermustbefinanciallyliterateandonememberan“auditcommitteefinancialexpert”or

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thecompanymustdisclosewhyitdoesn’thavesuchanexpert.Thedutiesoftheauditcommitteealsogobeyondthegeneraldutiesofcarewithinstatecorporationlaw.Tak-entogether,theserequirementsmakeasubstantialsteptowardgreaterindependence.Yetnotably, thesereformshavenot introducedanyrulesonregardingboardsizeorseparationoftheCEOandChairpositions.CEOsalsosuccessfullyblockedproposalsfromtheSECin2003thatwouldhavegivenshareholdersgreateraccesstonominatingindependentdirectors.

Thechiefexecutiveofficerandchieffinancialofficermustalsonowtocertifythefi-nancialstatementofthecorporation.Therequirementimposesanewsubstantialdutyoftheseofficers,andlinksthefulfilmentofthesedutieswiththepublicauditprocessinanewway.TheSECmaythusrequirethattheCEOorCFOreturntothecorporationanybonus,incentive,orequitybasedpaymentpaidduringthe12monthsfollowingtheissuanceofanyrestatedfinancials.Similarly,SOXalsoplacedabanonloanstodirec-torsforthepurposesofbuyingshares,ascompanieswhomakeloanstoboardmembersaremorelikelytorestateearnings(Cullinan,Du&Wright,2006).

Thesemeasuresnotonlyintroducestricterrules,butintroduceanewlayeroffederalregulationofdirectors’duties thatdisplacestatecorporation law(Bainbridge,2003,Mitchell,2003).Theaimof these reformshasbeen to reaffirm the importance,butredefinetheroleof independentdirectorswithintheboard.Thereformsdonothingtoincreasethedirectaccountabilityofdirectorstotheshareholders.Rather,theboardhasbeengivenabroaderroleinpromotingexternaltransparencyinthepublicinterest.SOXhasledindependentdirectorstotakeonanumberofadditionaltasksthatpromotetransparencytooutsideconstituencies,aswellasbearinggreaterliabilityfortheinfor-mationdisclosedbythecompany.

WhateffecthasreformhadonthestructureofU.S.boards?Asnotedintheprevioussection,thetypicalstructureofU.S.boardssincethemid-1990srevolvedaroundama-jorityofoutsidedirectors,butarelativelyweaklegaldefinitionofindependenceandalackofseparationbetweentheroleoftheCEOandChairmanoftheBoard.SincethepassageofSOXandnewlistingrules,thehistoricaltrendtowardindependentdirec-torshascontinued(Valenti,2008),particularlyamongsmallcompanies(Linck,etal.,2008).WhereasshareownershipbytheCEOdecreasedthesizeandindependenceoftheboardpre-SOX,thiseffectseemstohavedisappearedpost-SOX.WhileSOXandrelatedreformsseemtohavehadabroadeffectof increasingboardindependence17,somenotablelimitsexist.LookingatTable 4suggeststhatasof2005,thedegreeofseparationbetweenCEOandChairoftheBoardhadincreasedbutremainsrelativelylow.Variousestimates show that the roles remaincombined in some70%of largelistedfirms(Linck,etal.,2008,Valenti,2008).

17 Moregenerally,Linck(2008)hasshownthatpost-SOXboardshavebecomeslightlylargertoincorporateagreaternumberofoutsidersandreflectvariousrequirementsforcommittees.Fewercurrentexecutivesweredirectors,andmoredirectorswereretiredexecutives,directorswithfinancialexpertise,lawyers,andacademics.

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Theseremainingproblemsregardingindependenceofboardmembersarefurtherre-flectedinthefactthatSOXdidnothingtoincreasetheaccountabilityofboardmem-berstoshareholders(seealsoCioffi).Hence,fewconclusionscanbedrawngiventhefactthatthescopeforCEOcaptureofindependentdirectorsmayremainthroughin-formalmeans.Morepositively,independentdirectorsnonethelessfacegreaterchecksandbalancesfromgatekeeperssuchasauditors,whotakeaninterestinindependentdirectorsdevotinggreaterresourcestoprocessessuchasinternalcontrolsandauditing.Whetherornotthisinteractionwillgraduallyredefinetheroleofindependentdirec-torsmoresubstantiallyremainsanopenquestion.Thekeyissueisnotjusttherelativebalancebetweenactingintheinterestsofshareholdersorcompanyinsiders,butalsowhetherdirectorswillseethemselvesasactingasanewsortof“publicdirector”(Lan-gevoort,2007).

Thedevelopmenttowardamoreindependentandpublicregardingboardhasalsofacedanumberofsubstantialcriticisms,particularlywithregardtothe“onesizefitsall”ap-proachreflectedinthesereforms.Criticsnotethattheserulestakenoaccountistakenof the diversity and variance among firms (Bainbridge, 2003).Much research nowshowsthatfirmschoosetheirboardstructuresinwayscontingentupontheirstrate-giesandcriticalinternalandexternalresources(Aguilera,etal.,2008).Firmsmaytrytobalancethebenefitsandcostsofexternalmonitoring,butalsothefunctionsoftheboardinprovidingcriticalknowledgeandresourcesrelativetothemorearm’slengthcontrolandmonitoringrole.Forexample,smallerfirmsmaybelessabletoshoulderthehighcostsofmoreoutsideboardmembers.Alongtheselines,Wintoki(2007)findsthat the increase in independentdirectors afterSOX led tohighermarketvaluationamonglargerandolderfirmsinmatureindustries,butledtolowerreturnsforfirmswithhighgrowthopportunitiesandmoreuncertainoperatingenvironments.Thisevi-dencedoessuggestsomepotentialopportunitycostsassociatedwithauniformboardstructure.

Beyondtheboard,SOXaimedatfacilitatingsomeinternalmechanismsofaccountabil-itythroughprotectionsforemployeewhistleblowers.Indeed,employeeshaveapoten-tiallystronginterestinpublicinterestsaspectsofSOX.Limitingthecapacityforfraudandincreasingthetransparencyofriskstothecompanyisconsistentwiththeinterestsoflong-termemployees.Asnotedabove,theissuehereisnottheincreaseinshare-holdercontrolbutapublicinterestintransparencythatcouldserveboththeinterestsofemployeesandinvestors.18Intermsofitsprovisions,SOXhadonlyaverylimitedinfluenceonthedirectinvolvementofstakeholderssuchasemployeesinU.S.corpo-rategovernance.Oneaspectexplicitlyrelatedtoemployeesconcernstheprotectionsforwhistleblowers.AnalysisofthedetailedregulationsandinitialapplicationbytheDepartmentofLaborsuggestthattheprotectionofferedislimitedandfallsshortofthe

18 Anumberofrecentworksdiscussthecommoninterestsofinvestorsandemployeesinpromotinggreatertrans-parencyandaccountabilityoftopmanagers(Aguilera&Jackson,2003,Gourevitch&Shinn,2005,Höpner,2003).

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idealsenvisionedbyCongress(Watnick,2007).Arecentstudyofwhistleblowercasesshowsthatthepercentageofemployeesamongthemdeclinedfrom20%beforeSOXtojust15%(Alvarado,2007).AnotherchannelforemployeevoicerelatestoCodesofEthicsrequiredbySOX.YetinitialstudiessuggestthatSOXhasmadetheircontentandstructuremoreorientatedtowardlegalcompliancethanpreviously(Canary&Jen-nings,2008).Thus,aninitialconclusionisthatSOXprobablyhasalimitedinfluenceoncorporatecultureandthepowerofemployeesinpromotingresponsiblepractices.

3.1.3 Costs of Compliance

AfrequentlymentionedaspectoftheSOXlegislationisthehighcostsofcomplianceassociatedwiththelaw.Itshouldbementionedthat theactualcostsandbenefitsofthelegislationareveryhardtocalculateonascientificbasis.However,itseemsclearthatthecostofcompliancewithSOXhasfarexceededtheinitialestimatesbytheSECofroughly$91,000percompanyininternalpersonhours,hourlychargesforexternalauditors,andauditingfees(Janson&Scheiner,2007,Orcutt,2009).Onestudyfoundthepersonhoursinvolvedinassessmenttobe12timeshigher,andthemonetarycostofattestationinauditorfeestobesome1.4timeshigher(Sneller&Langendijk,2007).Onesurveyof217firmsregardingthefirstyearofcompliancewithSection404ofSOXreportedcostsof$4.3millionU.S.dollars in2005distributedroughlyequallybetweeninternallaborcosts,externalconsultingexpenses,andadditionalauditfees.Over time,however, thesecostshavedecreased (FinancialExecutives International,2008).ItremainstoberesearchedastowhetherthiseffectistheresultofnewrulesfromtheSECandPCAOBsince2007.Itmayalsobethecasethatfirmsbecamebetterateliminatedrent-seekingbyauditfirmsandlawyers,whoseektousethenewrulestoincreasetheirownfees.

ThehighcostofcompliancewithSOXhasanumberofsources.First,thecontroversialrequirementofSection404hasmandatedanauditoffirms’internalcontrolsystems,whichhasprovenverycostlyintermsofincreasedauditfeesandinternalpreparations.Whilefirmshavebeenrequiredtohave“reasonable”internalcontrolsystemsinplacesincethe1970s,thesewereinterpretedquitenarrowlybytheSEC.Thenewrequire-mentsofSOXandsubsequentsetofrulesissuedbytheSECandPCAOBhavegivenrisetoaveryintensivesetofrequirements(Langevoort,2006).Asnotedabove,newrulesin2007havesoughttomaketheseprocessesmorefocusedandlesscostly.Butitwillbesometimebeforethelong-termeffectsareclear.Second,thebaninsomenon-auditworkhasgivenrisetoastrongincreaseinauditfeesamongtheremainingBig4firms,whohavetriedtoshifttheirsourceofincome(Pandit,2007).Third,firmsfaceadditionalcostsfromattractingandretainingagreaternumberofqualifiedindepend-entdirectors.

Asaconsequenceofthesecosts,oneofthestrongestcriticismsofSOXisthatitcre-atesexcessiveexpensesforpubliccompaniesandtherebydisadvantagessmallerfirms,

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aswellasdeterringforeignfirmsfromlistingtheirsharesintheU.S.Someevidenceexistsforthesepoints.First,morefirmshavedelistedfromU.S.stockexchangesafterSOXtoavoidtheincreasedcostsofregulation.Second,therateofU.S.firmsgoingprivatehasincreasedfollowingSOX(Engel,Hayes&Wang,2007).Third,thenumberofIPOshasdeclinedsinceSOX,althoughtheperformanceofthesefirmsisbetteronaverageandthussuggeststhatSOXmayhasimprovedthequalityofcompaniesoratleast reducedsome informationasymmetriesamong investors (Johnston&Madura,2009).Last,smallerfirmsmayhavechangedtheirbehaviourtoremainsmalltotakeadvantageofpostponedcompliancewithSOXthrough2008(Gao,Wu&Zimmerman,2009).Overall,asurveyin2005reportedthat94%ofsurveyfirmsreportedthatthecostsofSOXoutweighthepotentialbenefits(Glaum,Thomaschewski&Weber,2006,p.42).

3.2 The Influence of SOX on Foreign Firms

SOXhadanindirectbutprofoundinfluencetheagendaforEUrulesandGermancor-porategovernancereform–leadingtonewrequirementsforauditorrotation,disclo-sureofnon-auditfees,andincreasedpublicoversightofauditorsthatdepartswithsomenationaltraditionsofprofessionalself-regulation(foradetailedcomparison,seeHaller,etal.,2006).19ButSOXhasadirectinfluenceonforeigncompaniesbecauseitsprovi-sionshavebeenincorporatedintothelistingrulesandcorporategovernancestandardsoftheNYSEorNASDAQ.Hence,therulesalsoapplydirectlytoforeignfirmslistedonaU.S.stockexchange,aswellasindirectlytoforeignsubsidiariesofU.S.firmsthataresubjecttoSOXrequirements.TheSEChasalonghistoryofgrantingexemptionstoitsrulesforforeigncompanies.Consequently,observerswereparticularlysurprisedattheinitialinsistencethatSOXwouldbeapplieduniformlytoforeigncompanies—althoughexemptionswerelatergrantedafterall(Hollister,2005).Forexample,Ger-mancorporationswrotetotheSECin2002requestingexemptionsandwerebackedbywarningsfromtheGermanFederationofIndustry(BDI).TheregulationsinSOXgobeyondthetraditionalemphasisoftheSECondisclosureandimposemoreprescriptivesubstantive requirementson the internal structureof companies (e.g. audit commit-tees),whichmayconflictwithrulesinothercountries(Ribstein,2003).HerewewillbeconcernedwiththedirectinfluenceofSOXonforeigncompanies.

ForeignfirmsoftenlisttheirsharesonU.S.stockexchangesinordertoenjoyincreasedliquidity, greater access to capital, and “bond” themselves to shareholder-orientedcorporategovernancepractices(Baily,Karolyi&Salva,2006,Coffee,1999,Gilson,2000).Itnowseemsundisputedthatforeignfirmshavealsobeguntoderegisterfrom

19 Somedifferencesremain(Suchan,2004). InGermany,professionalself-regulationstillplaysagreaterrole,somenon-audit legal servicesare less restricted, and rulesonauditor rotationdisqualifyauditors certifyingfinancialstatementsmorethansixtimesintenyears(ratherthanabadafterfiveconsecutiveyears).Likewise,onlySOXrequiredthepre-approvalofauditandnon-auditservicesbytheauditcommittee,aswellasusinglessflexiblemandatoryauditingstandards.

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U.S.stockexchangesfollowingSOX,oftencitingtheincreasedcompliancecostsun-derSOX,suchasdisclosure(Leuz,Triantis&YueWang,2008,Marosi&Massoud,2008).Smallerfirmswithlessshareholder-orientedcorporategovernancecharacteris-ticshavebecomemorelikelytolistontheUKAIMmarketthanNASDAQfollowingSOX,althoughlargerfirmsseemunaffected(Piotroski&Srinivasan,2008).Likewise,publicfirmsbecamelesslikelytotargetU.S.underthejurisdictionofSOXthanprivatefirms,whocouldessentiallytaketargetfirmsprivateandavoidcompliancewithSOX(Kamar,Karaca-Mandic&Talley,2009).Otherstudiesshowthatfirmswithhighcostsforcompliance,suchasauditrelatedexpenditures,andlowprofitabilityhaveagreaterpropensitytodelist,asdofirmswithhigherlevelsofinsiderownership(Khan,2008).Insum,SOXhasreducedthenetbenefitsofaU.S.listing,particularlyforsmallerfor-eignfirmswithlowertradingvolumeandstrongerinsidercontrol(Marosi&Massoud,2008).

Still,SOXhasasimilarbenefitatleastsometypesofforeigncompanies,justasithasonU.S.domesticfirms.Forexample,disclosuresandrequirementsforauditcommit-teeindependencehavebeenassociatedwithlowerlevelsofearningsmanagementfol-lowingSOX(Chang&Sun,2009).SomestudiesfindthatforeignfirmsutilizinghighdisclosurebeforeSOXexperienceddeclinesinmarketvalueafterSOX,butthathighgrowthfirmsfrompoorlyregulatedcountriesbenefitedintermsofincreasedinves-torconfidenceandhighermarketvaluation(Litvak,2007/Litvak,2008).OtherstudiesshowthatforeignfirmswithhighriskfactorsbeforeSOXexperiencedlowerlevelsofriskafterwards(Akhigbe,Martin&Nishikawa,2009)

Table 8 shows the recentdevelopmentof listed firms in theNYSE,NASDAQ,andLondonstockexchange.ForeignlistingsinNewYorkhavedeclinedinabsoluteterms,andwentfromnearly20%ofalllistingsin2002toaround14%in2008.TotallistingsonNASDAQhavedeclined,butforeignlistingshaveactuallyincreasedverymargin-allytoaround11%offirms.Takentogether,102fewerforeignfirmswerelistedinU.S.exchangessixyearsafterthepassageofSOX.Meanwhile,thenumberofforeignlistingsinLondonincreasedbyaround300firmsinthesameperiod.

3.3 Compliance with SOX and Compatibility with German Corporate Governance

SOXcreated a numberof policy issues inGermany, regarding the audit process inparticular.Germanauditorsplayaslightlydifferent role,bothasgatekeepersof thepublic (investor) interest andas anassistant to the supervisoryboard in its internalcontrolovermanagement(Suchan,2004).Forexample,SOXimposestheregistrationofauditorswiththePCAOBconflictwithGermanrulesondataprotectionandclientconfidentiality(Haller,etal.,2006,p.112).Likewise,theindividualliabilityofthechiefexecutiveandchieffinancialofficerunderSOXrunscontrarytothecollectiverespon-sibilityofthemanagementboardunderGermanlaw(Hollister,2005,p.479).Thus,de-

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spitesomeoverlapinGermanandU.S.regulations,GermanfirmshadtosubstantiallyalteranumberofpracticesinordertocomplywithSOX,particularlyintheareaofinternalcontrolsandriskmanagement(Stadtmann&Wissmann,2005).

Initially,SOXauditcommitteeruleswerethoughttoconflictwithGermanlawinatleastthreeways(Ribstein,2003,p.10-11).First,auditorappointmentbytheauditcom-mitteeunderSOXconflictswiththepowersofappointmentoftheAGMinGermany.Second,SOXSection301makesineligibleanyonewhoreceivesanysortoffeefromthecompany, thuspotentiallyexcludingcertainsupervisoryboardmemberssuchasemployees. InApril2003, theSEC issued further rules to resolve thisproblemandextended theperiod for complianceof foreigncompanies anotheryearuntil2005.20The SEC explicitly recognized labor representatives in Germany as “independent”onthegroundsthattheyserveasacounterweighttomanagementpower(Glaum,etal.,2006,p.21).Moreover,exceptionswereissuedtoexplicitlyaccommodatetwo-tierboardstructuresprovidedtheirelectionisindependentfrommanagement,aswellastheallowcontrollingshareholderswithintheboard.Still,eveniftheGermansupervi-soryboardstructureisrecognizedunderSOX,thecompositionoftheauditcommitteeisonlygoverned inGermanyby thecorporategovernancecode, and thusmight inpracticechangethebalanceofpowerawayfromlaborrepresentatives.

Someempirical informationexists in the formofasurveycarriedoutby theDeut-schesAktieninstitut(DAI)in2005,whichcollectedinformationfrom15outofthe18GermanfirmslistedonU.S.stockexchanges(Glaum,etal.,2006).MostofthebasicrequirementsofSOXwerealreadyimplementedbyGermanfirms,oftenincompliancewiththeGermancorporategovernancecode.Oneexceptionwastheareaofinternalcontrolsystems,whereSOXrequirementsunderSection404arefarmoredetailedandprescriptive thanGermanrules.100%ofsurveyedfirms reported takingmeasurestodocumentinternalcontrolprocessesand62.5%offirmsreportedmakingsubstan-tialchangestotheirriskmanagementsystems.Meanwhile,fewerchangesweremaderegardingotherregulations–only3firmsreportedmakingchangestotheirwhistleblowingprocedures(Stadtmann&Wissmann,2005).

ThecostsofSOXcomplianceforGermanfirmsareveryhigh.Whilehalfofthefirmsreportedlessthan25,000person-hoursofworktocomplywithSOXSection404,onequarteroffirmsreportupto50,000personhoursandanotherquartermorethan50,000person-hours.Theaveragecostofcompliancetotaledover7millionEuro(Glaum,etal.,2006,p.76),althoughthecostsvarywidelybetween555,000Euroand11millionEurodependingonthesizeofthefirm.Morethanhalfofallfirmsspent2.5millionEuro ormore on compliance costs.Roughly three-quarters of firms reported someimprovementtotheirinternalcontrolsystems,althoughhalfofallfirmsreportedonlyamediumratherthanhighlevelofimprovement.Germanfirmsviewedmostpositive-lytherequirementsconcerningreportingofoff-balance-sheetentities(Glaum,etal.,

20 TheSECrulesarefoundhere:http://www.sec.gov/rules/final/33-8220.htm

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2006,p.33).Still,theoverallevaluationofSOXwaslukewarmatbest–mostfirmsnei-therfavorednordisfavoredmostoftheSOXmeasures(Glaum,etal.,2006,p.37).Morethan80%offirmsreportednopositiveinfluenceontheirabilitytoidentifyrisks,norreductioninthecostofcapital.Onthewhole,60%offirmsreportedthattheattrac-tivenessoftheU.S.capitalmarkethaddeclinedfortheirfirmafterSOX(Stadtmann&Wissmann,2005).Still,noGermanfirmshavedelistedasaresultofSOX,althoughthenumberofnewlistingshasdecreasedtoanearstandstill.Onthebalance,GermanfirmsstillperceiveanumberoftangiblebenefitsofU.S.cross-listings,particularlyintermsofbrandnamerecognitionamongconsumersandtheabilitytoissuesharestoemployeesintheirU.S.operations.

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4 Conclusion and Implications for Understanding Corporate Governance

ThisreporthasarguedthattheU.S.corporategovernanceshouldbeseenasasystemofinteractingelements.Butunlikethestylizedshareholder-orientedmodelfoundineco-nomictheory,theactualpracticesinU.S.firmshaveamorecomplexandconflictingrelationship.Justaseachmechanismofthesystemdependsuponsupportfromothermechanismsasacomplementarywhole, the limited implementationofeachmecha-nismmayundermineorleadtodysfunctionallinkageswithinthesystem.Thesedys-functionallinkagesaremanifestintherecentthebubbleandscandalssurroundingtheEnronandWorldcomcases.Despitethestrongalignmentofmanagerstoshareholdervalue,thesolutiontoagencyproblemsoftheU.S.corporationistoooftenbasedonex-cessiveincentivesformanagers,toolittleresponsibilitybyinvestors,andtoolittlegen-uinescrutinybyindependentboards.GatekeepersreceivedmostoftheblameduringthetimeoftheEnroncrisisandSOXrepresentedanalmostunprecedentedlegislativereformtargetedattheauditprocess.Perhapsironically,theauditfirmsthemselveshavebeenoneofthemainbeneficiariesofthisprocess.WhileSOXhassomedemonstra-blepositiveeffectsonimprovingdisclosureandrestrictingearningsmanagement,thisregulatoryapproachhadonlyalimitedinfluenceontheoverallsystemofcorporategovernance.TheSOXreformhasdonelittletoaddressthefundamentalissuesregard-inginvestorresponsibility,executivecompensation,andthetenuousroleoftheboardwithinthisconstellationofactors.

FromthismoresystemicperspectiveofU.S.corporategovernance,thecurrentfinan-cialandeconomiccrisisisnotsurprising.Indeed,thecurrentcrisishasmuchincom-monwiththe“controlfrauds”ofthepastcrisissuchastheSavingsandLoanScandalorEnron,wheremanagersusetheircontroloverfirmstocreatefictionalaccountingprofitsandrealeconomiclossesinaself-reinforcingbutultimatelyunsustainableway(Black,2005).Thesecuritizationofmortgagesandpackagingintocollateralizeddebtobligations(CDOs)gavebankstheabilitytoseparatecreditrisksfrommarketrisks,thus allowing them to take bigger betswith less security (Lim, 2008).While indi-vidual riskswereat leastpartially tradedaway, the levelof system riskgrew toanintolerablelevel.Newpatternsofagencywerecreatedbetweenborrowers,lendersandcreditratingsagenciesbythisnewmodelof“generateanddistribute”loans,wheretheoriginatorsof financedonotbear long-termresponsibility formonitoringdebtcov-enants.Thesesystemicrisksremainedinvisible,coveredbythemisleadingappearanceofgrowingprofitabilitydespitethegrowingpressureforararebutsevereadjustment.

Whiletheoriginsofthefinancialcrisisareatopicofgreatcomplexity,itislegitimatetoaskwhatrolecorporategovernancehasplayed,ifany?Whilethisquestionwillre-quiredetailedfutureresearch,afewpointscanbementioned.First,accountingstand-ardswereproventobeinadequateandso-called“fairvalue”accountingthatbenefits

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shareholdersthroughrisingassetpricesontheupsidealsoclearlyamplifiedthedown-side risks tonegativeadjustments inequityvaluations.Second, a strong linkexistsbetweenthehighpowerincentivespromotedbyCEOsandtherisktakingbehaviourofbankexecutives,aswellaslowerlevelemployeesandtraders.The“bonusculture”ofbankshascomeunderseverescrutiny.Fromacorporategovernanceperspective,theoverallremunerationpolicyisaresponsibilityoftheboardandshouldhavebeenmonitoredwithaviewtopotentialriskstothelong-termvalueoftheenterprise.Third,riskmanagementpracticesproved insufficient togetboards tomonitorandpreventexcessiverisktaking(seeOECDreportinparticularbyKirkpatrick,2009).Giventheclearresponsibilitiesoftheboard,thisareawillclearlyneedtobeaddressedinfutureresearchandpolicyconsiderations.Finally,theroleofcreditratingagenciessuggeststhatgatekeepersremainveryconcentratedandstillfacesubstantialconflictsofinterest(CoffeeJr.,2006).Clearly,theseissuesconcerningtheroleofcorporategovernanceinthefinancialcrisiswillemergeasanimportantareafornewresearchanddebate.

Meanwhile, what future does the shareholder-valuemodel of corporate governancehaveafterthefinancialcrisis?Certainlythisquestionismoreinterestingandmeaning-fulthanitwasjustoneyearago.ItishighlyunlikelythattheU.S.modelwillevolveinthedirectionofContinentalEuropeanstylestakeholder-orientedcorporategovernance–norwerethesesystemsimmunetothecurrentcrisis.Yettheperiodisonewhereamore‘enlightened’approachtoshareholder-valueseemspossibleandhenceopportuni-tiesexisttoaddresssomeoftheshort-termnatureofthecurrentsystem.Theanalysisinthisreportsuggests,however,thatsuchamoreenlightenedapproachtoshareholdervaluewouldneedtogobeyondthetraditionalemphasisonmarketdisclosureandsys-temsofriskmanagement.Rather,investorswouldhavetobeencouragedtoactmorelikeownersthantraders.Independentdirectorswouldhavetofeelstrongerobligationstostakeholderconstituents.Andthehigh-powerincentivesinthenameofshareholderinterestswill need to be fundamentally addressed. In the long run, such amarket-orientedandshareholder-centredsystemcoulddevelopmanymorecommonalitieswithstakeholder-orientedsystemsbydemocratizingfinancialmarketsandmakingfinanceitselfaccountabletothepublicinterest.

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6 Appendix A: Statistical TablesTa

ble

1: O

wne

rshi

p of

Cor

pora

te E

quiti

es in

the

Uni

ted

Stat

es

1945

19

55

1965

19

75

1985

19

95

2001

20

02

2003

20

04

2005

20

06

2007

Indi

vidu

als

93.1

%

88.1

%

83 .8

%

69.6

%

54.2

%

52.3

%

41.6

%

38.1

%

35.9

%

32.9

%

30.0

%

27.7

%

25.4

%

Gov

ernm

ent

0.0%

0.

0%

0.0%

0.

0%

0.0%

0.

3%

0.6%

0.

7%

0.5%

0.

5%

0.5%

0.

5%

0.5%

Fore

ign

inve

stor

s B

anks

2.

3%

0.2%

2.

3%

0.4%

2.

0%

0.3%

4.

0%

0.5%

6.

0%

0.2%

5.

7%

0.2%

10

.3%

0.

2%

11.2

%

0.3%

11

.8%

0.

3%

12.2

%

0.3%

12

.6%

0.

3%

13.5

%

0.3%

13

.0%

0.

3%

Insu

ranc

e 2.

4%

3.2%

2.

9%

5.0%

5.

8%

5.2%

6.

4%

7.2%

7.

1%

7.2%

7.

5%

7.8%

8.

0%

Pen

sion

fund

s 0.

0%

2.2%

5.

9%

15.8

%

28.0

%

23.2

%

21.0

%

22.4

%

22.9

%

23.2

%

23.3

%

23.3

%

22.8

%

Mut

ual f

unds

0.

8%

2.4%

4.

2%

4.0%

5.

0%

12.1

%

18.5

%

18.4

%

19.5

%

21.2

%

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%

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%

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%

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er

1.2%

1.

3%

0.9%

1.

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9%

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7%

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4.4%

Sou

rce:

U.S

. Fed

eral

Res

erve

, Flo

w o

f Fun

ds A

ccou

nts.

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Table 2: Board Composition, 1950-2005

Year Inside (%) Affiliated (%) Independent (%)

1950a 49 26 22

1955 47 30 23

1960 43 31 24

1965 42 33 25

1970 41 34 25

1975 39 31 30

1980 33 30 37

1985 30 31 39

1990 26 14 60

1995 21 15 64

2000 18 15 67

2005 15 11 74

Source: (Gordon, 2007) collected from various sources.

Table 3: Hostile Takeover Attempts in 1991-2005, by Outcome

Hostile Attempts

Sold to Raider

Sold to Alter-native Bidder

Remained Independent

Germany 6 5 0 1

83 % 0 % 17 %

United Kingdom 176 74 34 68

42 % 19 % 39 %

United States 332 73 103 156

22 % 31 % 47 %

Source: (Jackson & Miyajima, 2007)

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Table 4: Board Structure of Large U.S. Companies

1997 2005

Percentage of Independent Board Members 73.4 % 81.4 %

CEO on Nominating Committee 23.3 % 0.8 %

Separation of CEO and Chair 15.8 % 30.3 %

Source: (Valenti, 2008). Based on a sample of 120 Fortune 500 companies.

Table 5: Selected Forms of Non-Litigation Related Activism among U.S. Public Pension Funds

Activity Never Done Occasionally Frequently

Writing Letters to Management 53.9 % 30.8 % 15.4 %

Meeting with Management 64.1 % 20.5 % 15.4 %

Soliciting Support for Activities from Other Institutions (Building Coalitions) 47.5 % 35.0 % 17.5 %

Sponsoring Shareholder Proposal 82.5 % 15.0 % 2.5 %

Soliciting Votes on Shareholder Proposal 85.0 % 10.0 % 5.0 %

Formally Nominating Director Candidate in Opposition to Man-agement 100.0 % 0.0 % 0.0 %

Participating in Proxy Contest in Support of Other Non-Manage-ment Nominees 71.8 % 28.2 % 0.0 %

Submitting Names of Director Candidates to Nominating Com-mittee 90.0 % 10.0 % 0.0 %

Withholding Votes from Manage-ment Director Candidate 42.5 %

22.5 % 35.0 %

Publicly Announcing Vote Prior to Shareholder Meeting

85.0 % 10.0 % 5.0 %

Lobbying Congress (Formally or Informally) with Respect to Corpo-rate Governance 72.5 % 27.5 % 0.0 %

Creating Focus Lists for Activism 87.5 % 2.5 % 10.0 %

Writing Comment Letter to SEC 50.0 % 35.0 % 15.0 %

Source: (Choi & Fisch, 2008)

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Table 6: Trends in Actual CEO Pay

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Table 6 Trends in Actual CEO Pay

Table 7: Sarbanes-Oxley Act of 2002: Summary of Provisions

Sections Topics

101-109PCAOB’s creation, oversight, funding, and tasks

302, 401-406, 408-409, 906New disclosure rules, including control systems and officer certifications

201-209, 303Regulation of public company auditors and auditor-client relationship

301. 304, 306, 407Corporate governance for listed firms (audit committee rules, ban on officer loans)

501 Regulation of securities analysts

305, 601-604, 1103, 1105 SEC funding and powers

802, 807, 902-905, 1102, 1104, 1106 Criminal penalties

806, 1107 Whistleblower protections

308, 803-804Miscellaneous (time limits for securities fraud, bankruptcy law, fair funds)

Source: (Coates IV, 2007)

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Table 6 Trends in Actual CEO Pay

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Table 8: Number of Listed Companies, 2002 and 2008

Total Domestic Foreign

2008

NASDAQ 2,952 2,616 336

NYSE 3,011 2,596 415

London 3,096 2,415 681

2002

NASDAQ 3,649 3,268 381

NYSE 2,366 1,894 472

London 2,272 1,890 382

Source: World Federation of Stock Exchanges

Figure 1: Number of Hostile Takeover Bids in the USA and UK

Source: Own calculations, Thomson Banker One database.

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Table 10: Proportion of Firms with Negative Return on Assets Targeted in M&A

1991-99 2000-5

France 22 % 13 %

Germany 13 % 10 %

Japan 5 % 21 %

UK 18 % 11 %

USA 32 % 10 %

Source: Own calculations, Thomson Banker One database.

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7 Appendix B: The Contrast in US and UK Approach to Takeover Regulation

Countriesdifferintermsoftherightsofshareholdersandthescopeofdefensiveac-tionsallowedbymanagementduringatakeover:

Shareholderrightsrelatetoprinciplesofequaltreatment,mandatorybids,squeeze-outandsell-outrulesanddisclosureofanti-takeoverdefenses.Pre-biddefensesconcerndeviationsfromone-share-one-voteprinciples(e.g.dualclassshares,votingcaps,goldenshares,preferenceshares),breakthroughrules,reg-isteredshares(e.g.sharescanonlybetransferredwithdirectors’approval),defen-siverecapitalizations,shareissuanceormergerwithawhiteknight,repurchaseofshares,anddefensiveacquisitionordisposalofassetswiththeaimofreducingcash,raisingregulatoryobstacles,orimplementpoisondebtprovisions.Post-bidrulesconcernissuesofboardneutrality(e.g.prohibitsactionfrustratingthebidwithoutshareholderapproval),goldenparachutes,andthepotentialforpre-bidauthorisationtoadoptcertaindefensemeasures.

Iftheboardisallowedtomountpost-biddefenses,theboardmaytakeactiontowardthebiditself(e.g.seekingawhiteknight,defensiverecapitalization,tacticallitigationormakingrecommendationtotargetshareholders),thetargetfirmvotingrights(e.g.shareholder rightsplans, issuanceofauthorisedcapital, authorised share repurchaseandstaggeredboards)ortowardthetargetcompanyassets(e.g.crownjeweldefensesuchasdisposalofimportantassetsordefensiveacquisitionordisposalstrategy).

Evenamong the twomarket-orientedsystemsofcorporategovernance, theUKandU.S.followtwoverydistinctapproachestotakeoverrules(Kenyon-Slade,2004).Aswillbediscussedindetail,theUKstressesmandatorybidrulesandboardneutralitytowardbids,whiletheU.S.essentiallygivestheboardagreaterroleinthebiddingproc-essesandusesothermechanisms,suchasanti-takeoverrules,toassurefairoutcomes

United KingdomTheUKtakeoverrulesincludeamandatorybidruleandstresstheprincipleofequaltreatmentofshareholders,whichclearlyprohibitsdefensivemeas-ures,suchaspoisonpills,whichengagetheboardanddiscriminateagainstthehostilebidder.ThekeyprincipleunderUKtakeoverrulesistheequaltreatmentofallshare-holderswithinaclass.The PrincipleofEqualTreatmentisoutlinedasGeneralPrinci-ple1oftheCityCode,whichstipulatessimilartreatmentforshareholders.Specifically,anacquirermustofferminorityshareholdersthechancetoexitontermsthatarenolessfavorablethanthoseofferedtoshareholderswhosellacontrollingblock.Existingshareholdersalsohaveapre-emptiverightofpurchaseanynewsharesissued.Equaltreatmentisenshrinedinmandatorybidrules,whichofferprotectionagainstpreda-torybiddingtechniques,suchasbuildinghostilestakesandpressuringforchangesincontrolorcoercivelysqueezeothershareholders.UnderRule9oftheCityCode,an

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acquirermustmakeatenderoffertoallshareholdersonceathresholdof30percentoftheshareshasbeenacquired.ThemandatorybidrulesalsorestrictspartialacquisitionsexceptwhereexplicitlyallowedbytheUKTakeoverPanel.21

AfurtherkeyaspectoftheCityCodeintheUKregardsboardneutrality,whichre-stricts frustratingactionsby theboard (“boardneutrality”).Englishcase law in the1960/70sandthe1968CityCodegiveshareholderstheessentialpowerofdecisionovertheoutcome.Theroleoftheboardislimitedtomakinganinformedrecommendationtotargetshareholders(rule25)toarguewhywhetherpriceofacashofferisadequate(orrecommendahigherofferfromawhiteknight)orarguewhyshareholdervalueishigherifthecompanyremainsindependent,inthecaseofashareswapoffer.Inkeep-ingwiththeprincipleoffairtreatmentforshareholders,theboardofhasanobligationnottotakeanyaction,whichcouldfrustratetheoffer(rule21).Likewise, theboardmustnottakeanyactionwhichmaydepriveitsshareholdersoftheabilitytodecideonthemeritsoftheoffer,unlessitsshareholdersapproveotherwiseingeneralmeeting.Examplesof‘frustratingaction’aresetoutinrule21,includingissuingnewshares,grantingoptionsoverunissuedshares,creatingsecuritiescarrying rights toconvertinto(orsubscribefor)targetshares,selling(oracquiring)assetsofamaterialamount,andenteringintocontractsotherwisethanintheordinarycourseofbusiness.Forex-ample,defensiverecapitalizationisonlypermittedwithapprovalthroughanordinaryresolutionoftheshareholdermeetingorcompanyarticles.TheCompaniesActof2006furtherstrengthensboardneutralitybyrequiringthatanypaymentsmadetodirectors,inrelationtotransfersofcontrol,shouldbeapproveddirectlybytheshareholdersofthetargetfirm.The“dutyofneutrality”imposesrulesthatarefarstricterthantheU.S.statute.

United States.TheU.S. approach to takeoversdiffers from theUKregardingbothmandatorybidsandboardneutrality.Inimportantrespects,U.S.rulesdelegatepowertodirectorstodealwiththehostilebidderonbehalfofthetarget’sshareholdersandpotentiallyallowamuchwiderrangeofdefensiveactions.AnotherimportantaspectconcernsFederalism,andthefactthatmanyaspectsoftakeoverrulesfallunderthejurisdictionofstatecorporatelaw.However,competitionamongstatesforincorpora-tionsismuchlessvigorousthanoftenassumed(Kahan&Kamar,2002).Mostpubliccompaniesincorporateinthestateoftheirheadquarters,whereasDelawareistheonlystateattractingsubstantialnumbersofoutofstatefirms.

NomandatorybidruleexistsintheU.S.AsubstantialbodyofFederalSecuritieslawaddressestheproblemsofcoercivebiddingtactics.Particularlyinthe1960s,concerngrewover aggressive bidding tactics that gave target firm shareholders insufficienttimetoconsider,withtoolittledisclosure,andnoobligationtopayfairpricesformi-

21 Inlieuofamandatorybid,purchasersacquiringastakegreaterthan15percent,butlessthanthe30percentaresubjecttoSubstantialAcquisitionRules(SAR)enforcedbytheTakeoverPanel.Importantly,theserulesdiscouragetwo-tiertakeoverattemptsand“greenmail”practices,wherebiddersmightusecontrolofaninitialstaketogainconcessionsfromothershareholdersingainingfurthercontrolofthetargetcompany.

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norityshareholders‘frozenout’duringadeal.TheWilliamsActof1964amendedtheSecuritiesExchangeActfrom1934toprotecttargetfirmshareholders.Thespiritofthelegislationwas‘neutral’ towardbids,andprevailedagainstothermoremanager-friendlyproposals.TheActheighteneddisclosureofstakes(settinga5%threshold),andregulatedtheprocessoftenderoffersbygivingaminimumtimeperiodof20days,settingoutcertainconditionsforsuchoffers,andrequiringaresponsefromthetargetcompanies’boardwithin10daysoftheoffer.22However,theserulesdonoteliminatepartialbidsforlessthan100%ofshares,nortwo-tieroffers.Assuch,thepotentialtofreezeoutatargetfirms’minorityshareholderswithlessfavorableconditionsremainsapossibility.Thisgapwasfilledbystateanti-takeoverrules,whichessentiallyseektoregulatetheconditionsunderwhichahostilebiddermaypurchasesharesoreffectbackendmergerfreeze-outsoftargetshareholders.

State anti-takeover rules first emerged as a response to coercive bids in the 1960s.Thefirststate takeoverstatutewasenactedbyVirginiain1968.By1981,a totalof37Statesenactedtheselawsaimingtoprotectcorporationsresidentintheirparticularstate(Romano,1987).Theselawstypicallyimposeddisclosurerequirementsonbid-dersintendingtopursueatenderoffer,andoftenrequiredanadministrativeapprovalforabidtoproceed.WhilecorporatelawintheU.S.isthedomainofindividualstatesadoptingtheselaws,securitieslawfallsunderFederalregulation.23However,thisfirstwaveofanti-takeoverlawswasvulnerabletolegalchallengeforpreciselythisreason.ThebroadjurisdictionoftheselawsledtoconflictswiththeCommerceClauseandtheSupremacyClauseoftheU.S.Constitution.Forexample,somelawsrelatednotonlytocorporationsregisteredwithinthestate,buttoanywithsubstantialeconomicactivities,suchthattheselawswerejudgedasplacinganexcessiveindirectburdenoninterstatecommerce,inviolationoftheConstitution.SomelawsalsoconflicteddirectlywiththeWilliamsActbyseekingtodirectlyregulatethetakeoverprocesses.Inparticular,somestatelawsgavegovernmentofficialsdirectpowertointerveneintakeoverbids,whichpreemptedbyFederalpolicyoftheWilliamsActthatinvestorsremainfreetomaketheirowndecisions.In1982,theSupremeCourtcaseEdgar vs. MITE CorpledtotheIllinoisanti-takeoverlawbeingdeclaredunconstitutional(Kenyon-Slade,2004,p.173-175).Federalcourtstosubsequentlyoverturnotherfirstgenerationanti-takeoverrules.

Asecondandmoredurablegenerationofstateanti-takeoverlawsemergedfollowingalandmark1987SupremeCourtcaseCTS Corp. vs. Dynamics Corp. of America.ThecourtjudgmentupheldIndiana’sControlShareAcquisitionStatute,andtherebyestab-lishedalegalbasisfornewtypesoftakeoverrulesthathavesurvivedlegalchallenge.TheIndianalawisaso-called“fairprice”statute,whichprohibitsamergerbetweenthebidderandthetargetcompanyunlessasupermajorityshareholdervoteapprovesthe

22 SomeoftheseruleshavebeenamendedthroughtheSEC’sM&AReleaseof2000.Inparticular,theserulesfacilitatetheuseofshareexchangesasconsiderationduringtenderoffers.

23 ManycommentatorshavesuggestedthatthisaspectofFederalismhasmaderegulatorsmorevulnerabletothedemandsof largecompanies indifferentstatesandpaved thewayfor themoremanager-friendlysystemoftakeoverrules,whichcontraststotheUK.

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mergerorthebidderprovidesa“fairprice”fortheremainingshares.24Thisruleelimi-natesthepossibilityoffreezingoutremainingminorityshareholdersatalowerprice.Otherstatesenacted theseorother similar secondgenerationstatutes.Forexample,“controlshareacquisition”statutesrequireashareholdervoteapprovinganacquisitionofcontrolbyaparty.Suchruleswererobusttolegalchallenge,sinceitclearlyfellinthedomainofState’sauthorityovercorporatelawandoperateswithintheboundsoftheWilliamsActbymaintainingshareholders’sovereignty.Notably,whileEdgar vs. MITE Corpprotectedthefreemarketprincipleacrossstateboundaries,thejudgmentinCTS Corp. vs. Dynamics Corp. of America rejected the idea that theCommerceClauseprotectsaparticularstructureofthemarket:

“Theverycommoditythatistradeinthesecuritiesmarketisonewhosecharac-teristicsaredefinedbystatelaw.Similarly,theverycommoditythatistradeinthe‘marketforcorporatecontrol’—thecorporation—isonethatowesitsexist-enceandattributestostatelaw.Indiananeednotdefinethesecommoditiesasotherstatesdo;itneedonlyprovidethatresidentsandnonresidentshaveequalaccesstothem.ThisIndianahasdone”(CTS Corp. vs. Dynamics Corp. of Amer-ica,95L.Ed.2d,67,89(1987)).

Overall,23statesadopted“fairprice”statutes,and25statesadopted“controlshare”statutes.Thesesecondgenerationdefensesinfluencetheabilityofbidderstolaunchtwo-tiered coercive bids that pressure shareholders to tender by discriminating onprice.However,theydolesstoprotecttargetfirmsfrombecomingvulnerabletobidsperse.Asaresult,23statesadoptedafurtherthirdgenerationofverypowerfulanti-takeoverlawsknownas“businesscombination”statutes(Bebchuk&Hamdani,2006),includingthestatesofWisconsin,Delaware,andNewYork.TheselawsprohibitanAcquirorwithalargepercentage(e.g.10or20%)fromundertakingpost-acquisitionbusinesscombinationstransactionswiththeTargetforaspecifiedperiod(e.g.threeorfiveyears),unlessthecombinationisapprovedbytheboardofdirectorsorasuperma-jorityof‘disinterested’shareholders.Theserulesgivesubstantialnegotiatingpowertothetargetcorporation’sboard,andhavebeenupheldbyhighercourtdecisions.25ThestateofDelaware,whichistheregisteredhometothehighestnumberoflargecorpora-tions,enactedabusinesscombinationstatutein1988prohibitingAcquirorswithover15%stakesfromengaginginbusinesscombinationsforathree-yearperiodwithouttheapprovaloftheboardorasupermajorityof‘disinterested’stockholders.

Theapplicationofstateanti-takeoverrulesisinfluencedbyalargeandsophisticatedbodyofjurisprudence.Directors’dutiesofloyaltyandcarearedefinedinrelationto

24 Inparticular,ifanAcquiror’svotingrightsexceedacertainlevel,theirvotingrightsaresuspendeduntilex-presslyconferredbyavoteofamajorityoftheTargetcorporations’‘disinterested’shareholders(Kenyon-Slade,2004,p.178).Ifthetargetshareholdersconfersuchrights,theyareguaranteedapriceequivalenttothatofthepreviouslyacquiredstake.

25 Inparticular,thecaseofAmandaAcquisitionsCorp.vs.UniversalFoodsCorp.in1989upheldthevalidityoftheWisconsinlaw.

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thecorporationanditsshareholders,butthemeaningofthosedutiesisusuallysubjectto theBusiness JudgmentRule thatgives substantial prerogative tomanagement inbusinesscontexts.Inthespecialcontextoftakeovers,however,thebusinessjudgmentrulewasseenasgivingmanagerstoomuchfreereignsothatU.S.courtshavesoughttodevelop specific standardsunderwhich theusual ‘safeharbor’ofbusiness judg-mentcanbeapplied.TheDelawarecourtcaseofUnocalin1985wasmostinfluentialinestablishingatest(so-calledUnocaltest)basedontwoconditions(Kenyon-Slade,2004,p.248-255).First,directorsmustdemonstratethatreasonablegroundsexistforbelievingthatadangertocorporatepolicyandeffectivenessexisted.Thelawrecog-nizes several typesof threats, such aswhere shareholders aredenied a superior al-ternativetransaction,unequaltreatmentofshareholdersunderabid,orwhenabidisunder-pricedduetomanagementmisrepresentation(Gilson&Kraakman,1989).Courtdecisionssurroundingthesetwotestshavecometorejecttheapplicationofmechani-calrulesbasedonthepriceofbidscomparedtootheralternativebids,andmaintainedflexibilityinapplyinglegalrulessuchthatmanagementmaintainpotentialscopefora‘justsayno’defensepolicy.Second,thedefensiveactiontakenbythemmustbereason-ableinrelationtothethreatposed.Reasonablenessmaydependonmanagementnottryingtoforceanalternativedealonshareholders,orprecludeahostilebidaltogether.Quiteunlike theUKapproach, theDelaware courts expressly acknowledged in theUnocalcasethatitislegitimatetomakedistinctionsamongtypesofshareholders,suchasshort-termspeculatorsandotherstableshareholders,inusingsharerepurchasepro-gramsasdefenses.Thesamestandardsapplytoanticipatoryandresponsivedefenses.

Rather thangranting the protection of business judgment, theUnocal test cruciallyshiftsthelegalburdenshiftsbacktothedirectorstojustifytheiractions.ThediscretionisalsolimitedbyRevlonduties,introducedbytheDelawarecourtsrulinginRevlon Inc. v. MacAndrews & Forbes Holdings, Inc.in1986.TheRevlondutyimpliesthatifthesaleofthecorporationisinevitable,theboardhasadutytoauctionthecorporationatthehighestprice.Inparticular,onceRevlondutiesaretriggered,theconsiderationofnon-shareholderconstituenciesisnolongerappropriate.WhiledefensivemeasurescanbemaintainedunderUnocal,ifthesemeasuresareusedtoselltoanewcontrol-lingshareholder,suchasthroughawhiteknightoralternativebid,Revlonsubstantiallyshifts thedutiesofdirectors to require theBoard tomaximize thecompany’svalueinanauctionforthebenefitofshareholders.Inotherwords,Revlondutiesimposeafiduciarydutyontheboardtoevaluatecompetingproposalsandrefrainfromimple-mentingdefensivemeasuresthatdepriveshareholdersoftheopportunitytoconsidercompetingproposals.

GiventhedualsetofprinciplesunderUnocalandRevlon,defensivemeasuresdonotusuallyprevent takeoverbids.Seeninconjunction,Unocalessentiallyhelpsmanag-erstostrengthentheirnegotiatingpositionvis-à-visabidder,andthereforebettertakeintoaccountshareholderintereststhatbecomeparamountunderRevlon.Anumberofdefensesareknowwellestablishedunderexistinglegalrulesandhavemadetakeo-

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versmoreexpensive.Underthissystem,USfirmshavenowwidelyadopteddefensivemeasures such as poison pills, golden parachutes and staggered boards. In 2003, amajorityoflistedfirmshavesuchoneormoresuchmeasuresinplace,despitethefactthattakeoverdefensescontinuetobeseennegativelybyinstitutionalinvestors(Gilson,2006).

Takeover Defenses.

WithintheboundariesoftheRevlonandUnocalrules,U.S.corporationshavewidelyadoptedanumberoftakeoverdefenseswiththeaimofdiscouraginghostilebids.Thesedefensesdonotmakehostiletakeoversimpossible,butmayhavetheeffectofslow-ingtheprocessdownandbuymanagementtimefornegotiationthatleadstofriendlymergers.

Intermsofpre-biddefenses,USlawhasbeenfairlypermissive.Delawarelawpermitsdual classesof shares (Art102(a)(4), 151(a)DEGCL), aswell as contractual restric-tionsofvotingandtransfer(Art202DEGCL).Theserulesgivemanagerstheabilitytoengageindefensiverecapitalizationefforts,wherebynewsharesareissuedtoman-agement(orthirdpartywhiteknights)withexcessvotingrights.U.S.boardsaregivenconsiderablylegalpowertoactinthisregard,whereassimilaractionsareonlyallowedintheUKfollowinganordinaryresolutionoftheAGMorpriorauthorizationwithinthecompanystatutes.However,aoneshare-onevoteprinciplewasinitiallyadoptedthroughSECRule19c-4in1988,butlateroverturnedincourt.Subsequently,theone-share-one-voteprinciplewasadoptedvoluntarilybyNYSEandNASDAQin1994aspartoftheirlistingrequirementssoastoprotectexistingshareholders’rightsfrombe-ingdiluted(Bebchuk&Hamdani,2006).26

ThemostcentralandpowerfultakeoverdefenseundertheDelawareLawremainstheabilitytoadopta“poisonpill.”Poisonpillsorshareholderrightsplayaremechanismswherebynewsharesmaybeissued,ataheavilydiscountedprice,toshareholdersotherthanthehostilebiddersoastosubstantiallydilutethehostilestake.Thepillmustfirstbetriggeredbyanacquirerpurchasingacertainthresholdamountofvotingshares,ormakingahostiletenderoffer.Tworegulatorypreconditionsareimportanthere.First,apoisonpillcanbeadoptedbythetargetfirmboardwithoutashareholdervote,andtypicallytheboardalonehasthepowertoredeemtherightsissuedinconnectionthere-with.Second,shareholdersunderDelawarelawhavenopre-emptiverighttopurchaseshares,unlessprovidedforunderthecorporatecharter(Kenyon-Slade,2004,p.377).Thepoisonpillissoeffectivebecauseitgoesbeyond“fairprice”and“supermajority”anti-takeoverdefensesbecause itcompletelyblocks thebidder fromacquiringmorethanasmallstake,regardlesswhetherapremiumpriceispaidtoallshareholdersand

26 Someexceptionsarepermittedwithregardtoinitialpublicofferingsofsecuritieswithdisparatevotingrightsorsubsequentpublicofferingsoflesservotingstock.

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regardlessofthefactthatasupermajorityofshareholderswouldliketoacceptthebid-der’soffer(CoatesIV,1999).Inpractice,nohostilebidderhaseverboughtthroughapoisonpill.

Poisonpillsbecamewidespreadafter theDelawareSupremeCourtrulinginMoran v. Household International Inc.Whilethecaseupheldthepoisonpillasalegitimatetakeoverdefense,othercaseshaveinvokedfiduciaryobligationsandrequiredboardstoredeempoisonpillsandpermitshareholderstodecideforthemselveswithregardtoahostilebid.However,theboardmustsatisfyitsdutiesofcareandloyaltyinadoptingapoisonpill.CourtshavethusappliedtheUnocaltesttoevaluatepoisonpillsandalsotheRevlondutieswherepoisonpillscanbeusedasanauctiongavelinordertofieldhigheroffersorpreparealternative transactions.Thisscrutinydoes limit theabilityformanagerstousepoisonpillsaspartofa‘justsayno’strategy,althoughcourtsmaysometimesupholdthisposition(Kenyon-Slade,2004,p.351-354).Furthermore,biddingfirmsmaytrytocircumventthepoisonpillthroughaproxycontest,whereinahostilebidiscombinedwithaproposaltoreplacetheboardwithitsownnominees,whowillredeemthepoisonpill.Insuchcases,takeoverdefenseswillbemoreeffectivetotheextentthatthetargetalsohasa‘staggeredboard’sharkrepellent,stipulatingthatonlyone-thirdofthedirectorsmaybereplacedperyear.Staggeredboardshavecontinuedtogrowinpopularitytoaroundone-thirdofalllargefirmsbytheendofthe1990s,althoughthesehavesincebecomeincreasinglyhardtoimplementduetooppositionofinstitutionalinvestors(CoatesIV,1999).

Intermsofpost-biddefenses,theU.S.boardhasnodirectlegalobligationtoactneu-trallytowardabid.Asnotedintheprevioussection,defensivemeasuresmayonlybetaken in response toa threat tocorporatepolicyandeffectiveness,provided the re-sponseisproportionatetothethreat(Unocalrule)anddirectorshaveafiduciarydutytoevaluatecompetingproposalsandtorefrainfromimplementingdefensivemeasuresthatdepriveshareholdersoftheopportunitytoconsidercompetingproposals(Revlonrule).Shareholdersmayalsoauthorizetheboardtoundertakeparticulardefensiveac-tions,subjecttoa“sunsetclause”ofvalidityfor36months.Onceahostilebidhasbeenlaunched,twodefensivestrategiesarecommon:searchforawhiteknightordefensiverecapitalizationefforts,includingcrownjeweldefenses(e.g.disposingofcrucialcom-panyassets)orengaging indefensiveacquisitions thatmay raise thebarriers to theoutsidebid.

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Shareholder rights in takeover regulation

Germany UK US

Equal treatment, particularly during bidding period (EU) Yes Yes No

Disclosure of anti-takeover provisions (EU) Yes Yes Yes

Mandatory bid rule (EU)

Yes, threshold 30 % of all outstanding shares

Yes, threshold 30 % of all outstanding shares No

Squeeze out rule (EU)

Yes,95 % threshold; minimum price

Yes,90 % threshold; minimum price8.64 et seq, 8.82 et seq

Yes, but accep-tance and minimum price can be altered in statutes

Sell out rule (EU) Yes Yes No

Selected pre-bid takeover defenses

Germany UK US

Deviations from one share- one vote principle No, extremely rare.

Yes, but restrictions are discouraged by the stock ex-change.

Yes, but not at the detriment of exist-ing shareholders

Dual-class shares (multiple voting rights) No

Yes, although dis-couraged by LSE

Yes, permitted in Delaware company law; but prohibited by NYSE and NAS-DAQ listing rules

Voting right ceilings (voting caps)

No (except for Volk-swagen Law)

Yes, but hardly ap-plied

Yes, supermajority voting requirements

Breakthrough rule (EU)

No, but companies can opt-in individu-ally

No, but companies can opt-in individu-ally No

Restricted reg-istered shares (shares can only be transferred with directors’ approval)

Yes, but only ap-plied in few compa-nies

Yes, but only in un-listed companies

Yes, but only volun-tary lock-up agree-ments

Pre-bid defensive recapitalisation, share issuance to white knight, repur-chase of shares

Yes, but may re-quire shareholder or supervisory board approval

Yes, but requires ordinary resolution of AGM

Yes, possible with-out shareholder approval

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Scope of Post-bid Action of the Board

Germany UK US

Board neutrality (prohibits action frustrating the bid without shareholder approval)

No, several excep-tions to general board neutrality principle Yes No

Golden parachutes Yes, but rare.

Yes, but less im-portant in takeover context

Yes, common means to align board and share-holder interests

Pre-bid authorisa-tion to adopt de-fence during the offer period

Yes, reserve au-thorisation delegat-ing any shareholder competence to the management board; valid for 18 months No

Yes, sunset clause valid for 36 months

Board action with regard to the bid

Germany UK US

White knight or defensive recapi-talisation (search for an alternative friendly bidder; maximise the ul-timate takeover price) Yes Yes Yes

Tactical litigation (judicial review and civil litigation be-tween parties) Yes

No, expressively discouraged by all judicial and legisla-tive actors Yes

Board recommend rejection of bid to target shareholders Yes Yes Yes

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Board action with regard to target shares and voting rights

Germany UK US

Shareholder rights plan (Delaware style poison pill; share issuance to shareholders other than the hostile bid-der; applied without any shareholder approval)

No, inconsistent with shareholder equality.

No, shares issu-ance into friendly hands to frustrate an offer is im-proper; any board action that could frustrate the bid re-quires shareholder approval Yes

Issuance of author- author-ised capital

Yes, with super-visory board ap-proval, valid for five years

No, would require shareholder ap-proval Yes

Authorised share repurchase

Yes, with super-visory board ap-proval, valid for 18 months

No, would require shareholder ap-proval

Yes, subject only to fiduciary duties of the board

Staggered board

Yes, supervisory board and man-agement board may be staggered; members can be removed only with cause

No, directors can be removed in any shareholder meet-ing with or without cause Yes

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Board action with regard to target assets

Germany UK US

Crown jewels de-fence (decision during the offer period to dispose of important assets)

Yes, with super-visory board ap-proval; shareholder approval is only required if concrete action involves more than 80 % of the company’s assets or changes the company’s core business focus (Holzmüller doc-trine)

No, transfer of more than 10 % or other material as-sets not permitted Yes

Acquisition/disposal strategy defense (continuation of any extraordinary board action which has been started before the offer period)

Yes, shareholder approval is only required if concrete action involves more than 80 % of the company’s assets or changes the company’s core business focus (Holzmüller doc-trine)

No, acquisition or disposal of more than 10 % or other material assets not permitted Yes

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Über die Hans-Böckler-Stiftung

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Über die Hans-Böckler-Stiftung

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Über die Hans-Böckler-Stiftung

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Über die Hans-Böckler-Stiftung

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November 2009

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