A systems approach to corporate governance reform: why importing U.S. corporate law isn't the answer.

• Author: Paredes, Troy A.

TABLE OF CONTENTS INTRODUCTION I. THE COMPARATIVE CORPORATE GOVERNANCE DEBATE: DOES LAW MATTER? A. Law Matters B. Transplanting U.S. Corporate Law II. THE U.S. CORPORATE GOVERNANCE SYSTEM A. The Formal Rules of the Game B. Why Do Shareholders Still Invest? C. Overall Coherence and "System Logic" III. Is THE U.S. CORPORATE GOVERNANCE SYSTEM TRANSPLANTABLE? A. Complementarities Critique B. Private Ordering Critique C. Nonshareholder Primacy Critique D. Capital Structure Critique IV. LESSONS FOR DEVELOPING COUNTRIES: A FRAMEWORK FOR CORPORATE GOVERNANCE REFORM A. When Law Really Matters B. "Ground-Level" Benefits of Mandatory Corporate Law C. Some Proposals to Consider CONCLUSION INTRODUCTION

The task is daunting: Spur economic growth in developing countries. Much attention has focused on bringing economic prosperity to transitional economies, including Russia and other former Soviet bloc countries, such as Hungary, Poland, and Czechoslovakia. Developing countries in Asia, Latin America, and Africa have also been the subject of reform programs, many of which have been controversial, designed to promote economic growth through privatization, political change, and other means. Today, all eyes are on Iraq and Afghanistan. A recent article in the Wall Street Journal, titled Taking Iraq Private, summed up what many view as central to promoting economic growth in Iraq and elsewhere: Create property rights, the rule of law, and other institutions that will encourage private investment and foster free markets. (1) While I agree with the article's premise, its title is a misnomer. The goal is less about taking developing countries private than it is about taking them public.

One solution for spurring economic growth in the developing world is to promote securities markets. An established body of empirical studies shows, as one might suspect, a link between the development of capital markets and economic growth. (2) The basic intuition is straightforward: Robust capital markets allow businesses and entrepreneurs to tap into the financial resources needed to increase output, invest in new technologies, fund research and development, build new factories, hire more workers, and exploit business opportunities domestically and abroad. The question, then, becomes: What policies best promote securities markets as a means of economic prosperity in developing countries?

When it comes to promoting equity markets, the question is often rephrased to ask: What accounts for the Anglo-American pattern of finance, characterized by dispersed share ownership and the separation of ownership and control in the United States and the United Kingdom, and how can developing countries replicate this achievement? Suggesting the difficulties of achieving broad and deep stock markets in which shareholders are willing to hold minority stakes in companies, concentrated ownership structures are more typical around the globe. (3)

The "law matters" thesis claims that the law has a central role to play in the development of equity markets. In short, the law is essential to securing the property rights of shareholders. Strong legal protections shield shareholders, especially minority shareholders, from having their investments expropriated by insiders, including directors, officers, entrepreneurs, and controlling shareholders. Unless shareholders are protected from agency problems, such as excessive executive compensation, insider trading, self-dealing transactions, and shirking, they will be discouraged from investing. Those who do invest will pay a discount for shares in order to compensate them for the risk of opportunism they are otherwise forced to shoulder. By protecting shareholders from insider abuses, the law can instill in shareholders the confidence needed to invest, thereby leading to thicker and more highly valued equity markets. The "law matters" thesis is supported by an extensive body of empirical studies, led by the work of La Porta, Lopez-de-Silanes, Shleifer, and Vishny. (4)

Moving beyond whether law matters in concept, the practical question becomes: "What law?" Because the United States by all accounts has the world's thickest equity markets, with over 7500 issues trading on the New York Stock Exchange and NASDAQ alone, (5) attention often turns to the United States when policymakers and others spearheading reform fashion corporate governance agendas for developing countries. Indeed, the "law matters" thesis holds out the possibility that if developing economies craft a corporate law regime like that of the United States, they can achieve developed securities markets. But is the U.S. approach to corporate governance right for developing countries?

One danger of transplanting U.S. corporate law to developing economies is that it might not fit with the "importing" country's economic structure, political system, social order, or cultural values. To be sure, the resulting "transplant effects" of any such misfit are important. My focus, however, is the other side of the transplant coin--namely, whether a market-based system of corporate governance, like that found in the United States, adequately protects shareholders in developing countries so as to promote equity markets there. Posed differently, to what extent should the government displace private ordering with more substantive regulation of corporate governance in developing countries?

U.S. corporate law, and Delaware corporate law in particular, reflect an enabling approach to corporate law made up largely of default rules that parties can opt out of to privately order their governance affairs. The law on the books is supplemented by the judge-made law of fiduciary duties, designed to ensure that directors and officers, who are charged with managing the corporation's business and affairs, exercise their authority over the business with due care, in good faith, and in the best interests of the corporation and its shareholders. While far from trivial, Delaware corporate law provides shareholders relatively few protections from insider abuses. (6) Indeed, Delaware corporate law affords directors and officers a great deal of discretion in managing the business free from the interference of shareholders and judges. The gaps in the law are filled by a host of other formal and informal mechanisms that hold management accountable. The market for corporate control and incentive-based compensation, such as stock options, are frequently cited as examples of the nonlaw components that contribute to the U.S. corporate governance system. At bottom, instead of depending primarily on substantive corporate law to protect shareholders, the market-based approach of U.S. corporate governance relies on markets, contracts, and norms, supported by a host of other institutions, to discipline directors and officers.

Not every country has the institutional makeup that allows it to eschew a more heavy-handed corporate law regime and still develop thick equity markets. Most developing countries lack the institutional mix that makes a market-based corporate governance system, with an enabling corporate law, workable. For example, the U.S. governance model presupposes that developed capital markets already exist, but they obviously do not exist in developing economies. The bottom line for most developing countries is that importing a corporate law regime along the lines of the U.S. model, or otherwise depending on a market-based model of governance, is not a viable option. More to the point, importing U.S. corporate law falls far short of replicating the U.S. system of corporate governance in developing countries, leaving many of the most important parts behind.

The alternative I recommend for developing countries is a mandatory model of corporate law that fixes key features of corporate governance--such as banning self-interested transactions, capping executive compensation, requiring shareholder approval for significant acquisitions, mandating the payment of dividends, and granting shareholders a limited put right and the right to make proposals that bind management--in order to protect shareholders from insider abuses and mismanagement. As compared to the U.S. governance system, the mandatory governance model I envision further restricts directors' and officers' discretion in managing the enterprise and allocates to shareholders additional authority, allowing shareholders to hold management more accountable and to exert more direct control over the business and how it is run. (7) Law matters in developed countries, but it really matters in developing countries where the institutional infrastructure that otherwise protects shareholders is nascent or simply nonexistent. Having said this, a caveat is in order. To the extent that corporate governance reform is part of a larger privatization effort and move toward free markets, the more visible hand of the government in corporate governance matters should not extend further into the private sector to steer capital flows, prop up businesses, or favor certain industries or companies through subtle or not-so-subtle forms of industrial policy.

Although my focus is on corporate governance reform, and even more narrowly on the transplantability of the U.S. model of corporate governance to developing countries, the analysis offers several broad lessons that can promote successful reform of all types. First, a country's legal regime, including the law on the books and formal enforcement mechanisms, is simply one part of a much more complex set of formal and informal institutions. The law must fit with a country's broader institutional mix, and legal reform should therefore be considered in its larger context. Second, conduct can be shaped in lots of ways. When market mechanisms are inadequate, such as when market or contracting breakdowns occur, there is a strong argument for more state-sanctioned law. On the other hand, as institutions develop, it might be...