Different System for Disciplining Management Corporate Governance

In the system we have described thus far, stockholders bear the burden of replacing incompetent management; we can call this a market-based corporate governance system, where investors in financial markets govern how corporations are run. There are some who believe that this is too much of a responsibility to put on investors who, as they see it, often operate with poor information and have short time horizons. Michael Porter, a leading thinker on corporate strategy, has argued that firms in the United States are hamstrung by the fact that investors are short term and demand quick returns. He contrasts them with Japanese firms, which he argues can afford to adopt strategies that make sense in the long term, even though they might not maximize profits in the short term. He suggests that investors should form long-term relationships25 with firms and work with them to devise long-term strategies. His view of the world is not unique and is shared by many corporate executives, even in the United States.

25 There is some movement towards "relationship investing" in the United States, where funds such as Allied Partners (run by Dillon Read), Corporate Partners (run by Lazard Freres) and Lens (run by activist Robert Monks) have attempted to create long term relationships with the managers of firms.

These executives argue that there are alternatives to the market-based corporate governance systems, where stockholders act to discipline and replace errant managers and stock prices measure their success. In the German and Japanese systems26 of corporate governance, firms own stakes in other firms and often make decisions in the best interests of the industrial group they belong to, rather their own. In these systems, the argument goes, firms will keep an eye on each other, rather than ceding power to the stockholders. In addition to being undemocratic - the stockholders are after all the owners of the firm -- these systems suggests a profound suspicion of how stockholders might use the power if they get it and is heavily skewed towards maintaining the power of incumbent managers.

While this approach may protect the system against the waste that is a by-product of stockholder activism and inefficient markets, it has its own disadvantages. Industrial groups are inherently more conservative than investors in allocating resources and thus are much less likely to finance high risk and venture capital investments by upstarts who do not belong to the group. The other problem is that entire groups can be dragged down by individual firms that have made bad decisions27. In fact, the troubles that Japanese firms have had dealing with poor investments in the 1990s suggests to us that these alternative corporate governance systems, while efficient at dealing with individual firms that are poorly run, have a more difficult time adapting to and dealing with problems that are wide-spread. These problems, consequently, tend to fester and grow over time. For instance, while financial markets pushed corporate banks in the United States to confront their poor real estate loans in the late 1980s, Japanese banks spent much of the 1990s denying the existence of such loans on their books28.

26 There are subtle differences between the Japanese and the German systems. The Japanese industrial groups called keiretsus are based primarily on cross-holdings of companies and evolved from family owned businesses. The German industrial groups revolve around leading commercial banks, like Deutsche Bank or Dresdner, with the bank holding substantial stakes in a number of industrial concerns.

27 Many Korean industrial groups (called chaebols), that were patterned after the Japanese keiretsu, were pushed to the verge of bankruptcy in 1990s because one or two errant firms in the group made bad real estate loans.

28 Kaplan, S.N., 1997, Corporate Governance and Corporate Performance, A Comparison of German, Japan and the United States, Journal of Applied Corporate Finance, v9(4), 86-93.. He compares the U.S.,

Is there a way in which we can measure the effectiveness of alternative corporate governance systems? One suggestion is that corporate governance systems be measured on three dimensions - the capacity to restrict management's ability to obtain private benefits from control, easy access of firms that want capital to financial markets and the ease with which inefficient management is replaced. It can be argued that corporate governance system in the United States does a better job than alternative systems on all three counts.29

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