Colombian cartel launches bid for Japanese firms.

• Author: Ramseyer, J. Mark
• Position: Response to article by Mark J. Roe in this issue, p. 1927 - Symposium: Economic Competitiveness and the Law

INTRODUCTION

Or so one would argue. With one of the brightest and most productive corps of corporate law scholars in the country, the Columbian cartel dominates much of the debate over American "corporate governance." Now Mark Roe--among the brightest and most productive in the cartel--extends that analysis to governance patterns in Japan (and Germany). The Japanese (and German) practice may even, he suggests tentatively, solve some of the problems the cartel finds in American governance.(1)

In tying Japan to this debate over "corporate governance," Roe does a brilliant job. Along the way, he raises two loosely related questions: whether the concept of "corporate governance" adequately explains the shareholding practices of Japanese banks and, more broadly, why the concept has become so prominent in recent corporate law scholarship. To explore these issues, I first review Roe's argument (Part 1). I then demonstrate why "corporate governance" may not explain the Japanese phenomena he describes (Part II). In the process, I suggest that Japanese banks buy stock in their clients to exploit the inside information they acquire in the course of researching potential borrowers. I reach this conclusion by elimination; none of the explanations that either Roe or anyone else has advanced fits the facts observed. I conclude by asking why so many corporate law academics seem so obsessed with "corporate governance" (Part III). For many academics (including some Columbians but notably excluding Roe), the answer lies in a desire to promote mandatory terms-terms of the corporate contract that investors and managers cannot agree to circumvent.(2) By focusing attention on the notion that something is radically "wrong" with American corporate governance, these scholars seem to justify their attempts to dictate these terms. However much they cite Japan to buttress their proposals, though, Roe nicely shows why the Japanese example does not justify mandatory terms.

1. LEGAL INFLUENCE

   Roe argues that many of the differences in the ways Japanese and Americans organize their firms result from regulatory differences.(3) In this, he is surely right. Absent regulatory differences, competing capitalist firms will often resemble one another. Significant differences will sometimes remain, to be sure. We have only begun to learn how different any two firms can be, yet both stay competitive. Nonetheless, we should not miss the basic commonalities. Given similar product markets (most men in most developed countries crave Lethal Weapon videos), competing firms will tend to sell similar products. Given similar worker preferences (most workers everywhere want more money and shorter hours), competing firms will tend to adopt similar manufacturing practices. Given porous capital markets (most sophisticated investors can arbitrage international differences), competing firms should develop similar capital structures. And given similar investor preferences (all investors prefer more money to less), many firms that did anything else would eventually go broke.

   In stressing the importance of regulatory differences, Roe shows the flair for sophisticated analysis that he has demonstrated in a variety of other contexts. He first contrasts the capital markets in the two countries: Japanese banks dominate domestic financial markets; American banks do not. He then explains the regulatory origins of this result. First, American banks face a variety of geographical and other legal restraints that Japanese banks escape. Second, American banks face fierce competition from other capital sources. Although Japanese banks face competitors too, Japanese regulators crippled the securities markets. Consequently, securities-based competitors do not pose the same threat in Japan that they pose in the United States.

   Roe also contrasts the basic financial structures of Japanese and American firms. Most crucially, he notes that Japanese banks tend to buy stock in the firms to which they lend money. As a result, Japanese managers often find large blocks of stock in their firms owned by banks. These blocks, according to Roe, reduce the managers' discretion. The shareholding patterns shift monitoring from the boards of directors to the institutional shareholders (the banks), in other words, and with the monitoring goes significant control. All this, Roe claims, largely follows from the regulatory constraints in place: Japanese regulators allow banks to buy stock; American regulators do not. But for the regulatory restrictions, American banks too might have become organizations that buy stock in their debtors.

   2. BANK SHAREHOLDING

   In positing this historical might-have-been, Roe may be right. Absent regulatory limits, American banks might have become institutions that buy their borrowers' stock. If legal restrictions more drastically circumscribe bank investments in the United States than in Japan, one reason American banks do not buy their clients' stock is easy. They do not buy stock because regulators do not let them. The harder question--and the one Roe may not satisfactorily answer--is why Japanese banks do buy their clients' stock and whether American banks would if they could. More abstractly, the question is the following: Why might the equilibrium in an apparently unregulated market be one where banks buy stock in the firms to which they lend money? To answer this question, I first consider a variety of unsuccessful hypotheses and then turn to a hypothesis that differs from the one Roe and other scholars advance.

   A. Unsuccessful Reasons

1. Controlling the Borrower

   Perhaps Japanese banks buy their clients' stock in order to influence or control those clients. Although Roe suggests this possibility,(4) he never identifies the reasons banks want to influence or control their debtors. Consider four possibilities. First, a bank may believe it can help a firm better compete in the product market. If the bank simply has better information about suppliers or buyers, however, it need not buy stock to induce a firm to use the information. Rather, the firm's managers will use the information gladly, whether or not the bank owns stock. The bank would need to buy stock to force the firm's managers to take its advice only if it wanted to replace them with its own staff. Although bankers know how to lend money, they seldom know how to run factories. If a firm's managers are so inept that bankers can run the firm more efficiently, rational bankers will not lend the firm money. Prudent bankers only lend to people who show they can compete effectively in the product market on their own.(5)

   Second, a bank may want to induce firms to borrow inefficiently large amounts of money or to borrow at supra-market rates.(6) Because a bank makes money on its loans, it may hope to use its control over stock holdings to induce the firm's managers to borrow more money. The bank would then bear a small share of any resulting losses to the firm and earn 100% of the profits on the debt. If so, such a strategy might seem to pay.(7) In fact, it seldom would; it would pay only to the extent capital markets were not competitive and bank reputations did not matter. All else equal, firms will avoid banks that induce debtors to incur inefficient loans. All else equal, banks will respond by cultivating reputations for supplying only efficient amounts of debt and only at market interest rates.

   Third, a bank may want to ensure that a firm's managers do not pay themselves supra-competitive wages. Nonetheless, it is not clear either why a bank would much care about CEO salaries, or why managers would borrow from such a bank. CEO salaries are rarely large enough to lower significantly the value of a bank's loan. And if managers want to pay themselves high sums, they will not want to borrow from a bank that would constrain their salaries. Conversely, if they want to bind themselves to low salaries, they can write long-term contracts and dispense with special banking relationships. Whatever the case, we should not observe banks restraining managerial salaries.

   Last, a bank may simply want enough potential control over a firm that--should the firm's managers ever adopt bad strategies--it can force those managers to change course.(8) This possibility works no better than the others. First, rational banks will recognize a cheaper and more effective way to protect themselves: either lend money short term and refuse to renew loans if managers adopt poor strategies or negotiate protective loan covenants. These measures Japanese banks regularly take.(9) Second, by becoming a 5% shareholder, a bank does not decrease the risks it faces--it increases them. Although holding a 5% stake may make the bank the firm's largest shareholder, if the managers want to ignore its demands, they can do so at will.(10) By buying a minority equity stake, a bank simply increases its exposure.

2. Insulation from Takeovers

   Perhaps Japanese banks buy stock in their debtors to help insulate those debtors from hostile takeovers. Other observers have made this argument often, and Roe mentions it too, though he does not make it a major part of his story.(11) He does well to avoid it. Managers may want to protect their jobs, but banks want debtors well-run. An acquiror will usually find it profitable to buy a firm only when it can improve the firm's performance.(12) If a firm is well-run already, an acquiror cannot raise the price of its stock, and without a way to raise its stock price, will lose money on the purchase. If a firm is poorly run, however, an acquiror may be able to increase its efficiency. If so, a bank will want the acquiror to buy it; after all, it gains a better run client in the process.(13)

   If a bank competed for customers by promising to help them avoid hostile acquirors, it would invite classic problems of adverse selection. Because the firms that face the most severe threat of a hostile acquisition are the most...