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

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

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

4 Income, Antidirector Rights and Rule of Law

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

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

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

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

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

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

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

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

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

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

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

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

17 Large blockholders dominate, with costs though and limited scope for policy

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

19 Scope for policy interventions for other corporate governance mechanisms

20 Scope for policy interventions for other corporate governance mechanisms

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

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