Together with my colleagues Adam Emmerich and Sabastian V. Niles, I have issued a memorandum entitled “Sovereign Wealth Fund Investment in the U.S. - Six Months Later,” which discusses the surprising slowdown in SWF Activity in the U.S. since the end of 2007 and into the opening weeks of 2008 when investment activity by these funds reached new heights. Our memorandum discusses some of the reasons for the slowdown, highlighting the possibility that the uncertain political receptivity to SWF investments and heightened regulatory activity has chilled SWF interest in the U.S. by increasing the costs and risks of investment. The memorandum concludes by calling for continued SWF activity in order to develop a track record of successful investments that will help cause political concerns to recede and by identifying the critical issues for those SWF transactions that get to the negotiation phase.

The memorandum is available here.

My new book, Corporate Governance of Non-listed Companies (Oxford University Press, 2008), which I co-wrote with Erik Vermeulen, examines the set of legal rules and measures needed to improve the governance of non-listed companies. Studies of corporate governance traditionally focus on the governance problems of large publicly held firms, and policymakers’ recommendations often focus on such firms. However most small firms, and in many countries, even many large companies, are non-listed. We provide a comprehensive account of non-listed firms and their particular governance problems.

The book explores current discussions and reforms in Europe, the United States, and Asia providing a state of the art account of the law and the economics. Non-listed firms encompass a vast range, from corporations with the potential to go public through family-owned firms, group-owned firms, private equity and hedge funds, to joint ventures and unlisted mass-privatized corporations with a relatively high number of shareholders. The governance of non-listed companies has traditionally been concerned with protecting investors and creditors from managerial opportunism. However, the virtual elimination of the distinction between partnerships and corporations means that an effective legal governance framework must also offer mechanisms to protect shareholders from the misconduct of other shareholders. Our book examines policy and economic measurements to develop a framework for understanding what constitutes good governance in non-listed companies. We examine how control is gained in the various types of closely held firms and explore the techniques that contribute to the development of a modern and efficient governance framework for these companies. The book concludes with an exploration of how the non-listed firm is likely to stimulate growth and extend innovation and development.

(Editor’s note: For a contrasting analysis of the UN proposal by Guest Contributor Martin Lipton of Wachtell, Lipton, Rosen & Katz, please see here.)

On behalf of our pro bono client Oxfam America, my colleagues, Ira M. Millstein, E. Norman Veasey, Harvey Goldschmid, Steven Alan Reiss, Ashley R. Altschuler, and I have prepared a memorandum that discusses the report, Protect, Respect and Remedy: A Framework for Business and Human Rights, prepared by Harvard Professor John G. Ruggie, the Secretary-General’s Special Representative on Human Rights. Our memorandum is available on the UN Special Representative’s website here.

The Ruggie Report posits three “core principles”: (1) the State duty to protect human rights, (2) the corporate social responsibility to respect human rights, and (3) the need for access to appropriate remedies for human rights abuses.We believe the basic concepts embodied in the Report are sound and should be supported by the business community in the United States. In summary, our reasons are:

• In the first instance, the US and foreign governments have the primary responsibility for defining what human rights obligations are binding legal duties and how those duties are enforced;

• If the Report is taken seriously by foreign government and foreign companies, it will benefit US corporations by leveling the playing field in placing on foreign boards and management the responsibilities to adhere to many of the same fiduciary and binding legal obligations presently applicable to US companies;

• Given the interplay of fiduciary, disclosure, internal control and risk mangement obligations facing US boards and managers today, the Report does not implicate new legal obligations for US companies;

• Violations of human rights may constitute material risks for many US corporations, not only in the US, but also in foreign jurisdictions where they conduct business;

• While the report does not limit the scope of internationally-recognized human rights, each US company must presently determine for itself, what human rights risks may be material to its business;

• Additionally, and beyond the obligation to manage risks, and comply with law, there is a substantial business case in favor of safeguarding human rights wherever the company does business.

The Report is available here, and our memorandum is available here.

The UK has, similarly to the US, deep and liquid securities markets and widely-dispersed ownership of publicly-traded firms. The central problem of corporate governance for publicly-traded firms in the UK is rendering managers accountable to shareholders. My recent paper, entitled Enforcement Strategies in UK Corporate Governance: A Roadmap and Empirical Assessment, provides a roadmap of the enforcement strategies employed in UK corporate governance, and a first approximation of their empirical significance.

Enforcement strategies affect agents’ incentives to comply with substantive rules, and so the effectiveness of a regulatory regime is a function of both substantive rules and the strategies by which they are enforced. While recent scholarship has begun to address enforcement-related issues, no clear consensus has yet emerged, as the results seem sensitive to the way in which ‘enforcement’ is measured. Moreover, those studies that have been done have focused on formal (court-based) mechanisms of enforcement. There are, of course, a variety of other ways in which the agency problems at the centre of corporate governance can be kept in check—from quiet intervention by a regulator to the threat of a shareholder revolt. The impact in practice of a corporate governance regime on agents’ incentives is therefore the sum of all institutions—formal and informal—that may impose a sanction on agents for inappropriate performance. Such institutions vary across countries, and so studies that focus solely on court-based enforcement risk misleading comparisons. Of course, this point isn’t new. The challenge is how to identify these modalities and measure their intensity in a meaningful way. This paper offers a first cut at the problem in the context of the UK.

The results suggest three stylised facts about the UK corporate governance system. First, shareholder lawsuits are conspicuous by their absence. Formal private enforcement appears to play little or no role in controlling managers. Secondly, it is public, rather than private, enforcement which dominates in relation to listed companies. However, the lion’s share of the interventions by the relevant agencies—the Takeover Panel, the Financial Reporting Review Panel, and the Financial Services Authority—is of an informal character, not resulting in any legal action. Suasion, rather than sanction, is the order of the day. Thirdly, a simple divide between public and private enforcement fails fully to take account of the role played by institutional investors in the UK, who have engaged systematically in informal private enforcement activity. Strong informal private enforcement has historically therefore been the flipside, in the UK, of weak formal private enforcement.

The paper is available here.

Ernst & Young recently released its 10th Global Fraud Survey “Corruption or Compliance – Weighing the Costs“.

As the US Foreign Corrupt Practices Act (FCPA) becomes the de facto anti-corruption standard worldwide, over 50% of US executives — and 84% globally — still know little to nothing of its key provisions, according to the survey. Another survey finding with governance implications suggests that companies increasingly rely on internal audit to find and address fraud and compliance risk—but internal audit departments may not have the tools, techniques, or resources to do so. Only 28% of US respondents say their internal audit departments are highly successful at detecting bribery and other corrupt practices.

The results show a marked lack of knowledge and preparedness on the part of C-suite executives and other risk management personnel, including internal auditors, about FCPA, which prohibits bribery of government officials by US companies and US-traded foreign companies. More than two-fifths of survey respondents (43%) say their companies do not have specific provisions in place for dealing with government officials—presenting an enormous risk of FCPA non-compliance.

Another key finding is that companies engaged in M&A may not be conducting necessary due diligence on target companies. Nearly half of FCPA prosecutions in 2007 arose during mergers or acquisitions. But fewer than half of survey respondents report that their companies routinely review the risk of bribery in advance of an acquisition—presenting significant risk of so-called “successor liabilities” that expose the buyer to unnecessary risk.

In sum, Ernst & Young’s 10th Global Fraud Survey demonstrates that corruption and bribery remain a significant exposure for US companies, especially as they conduct business across borders. The survey included senior in-house counsel and chief risk officers, along with other corporate executives from the C-suite to internal audit, and surveyed 1,186 respondents in 33 countries from November 2007 to February 2008.

The survey is available here.

Together with Adam O. Emmerich, David A. Katz, James Cole, Jr. and Sabastian V. Niles, I have recently distributed a memorandum entitled Cross-Border M&A - SEC Proposes Revisions to Cross-Border Transaction Exemptions, which discusses proposed revisions by the SEC to the current regulatory regime for cross-border transactions. The revisions represent a modest advance toward clarifying existing exemptions and, if implemented, would provide US and non-US bidders with somewhat greater certainty and flexibility in structuring deals for non-US targets. The release also requests comments on a number of additional possible changes that could further broaden the exemptions. The proposed revisions do not address a key concern that under existing regulations foreign issuers are subject to potential exposure under the anti-fraud, anti-manipulation and civil liability provisions of the US federal securities laws for transactions with relatively modest US entanglements. The risk of such exposure has persuaded many international issuers to avoid US markets and US investors altogether, to the detriment of global capital markets in general and US investors in particular. The present amendments may thus be a way-station to a more comprehensive future revision of the cross-border rules.

The memorandum is available here.

One of the major findings of the law and finance literature comparing corporate governance across countries is that large-percentage shareholders in public corporations are a response to weak legal protections for investors. Thus, it is reported that common law countries have less concentrated ownership than civil law countries because they afford stronger legal protections for investors. Similarly, it is reported that ownership is less concentrated in countries with strong investor protection laws.

The papers that reach these conclusions analyze country averages of ownership concentration instead of firm-level data. I just released a paper in which I show that this creates omitted-variable and aggregation biases. Aggregation, in particular, eliminates all within-group (country) variation, leading to artificial clustering. Most papers also use small samples of large firms. This makes inferences to country populations problematic because ownership concentration is inversely related to firm size and firm size varies across countries.

I correct for these limitations by analyzing firm-level observations; control for firm-level determinants of ownership concentration, including size; and use a broad sample of firms from 32 countries. When I take these steps there is no support for the widely held theory that large shareholders are a response to weak legal protections for investors. In particular, there is no relation between ownership concentration and whether a firm comes from a common law country. Similarly, there is no systematic relation between ownership concentration and 14 broad indices of investor protection laws. An index is as likely to be positively associated with ownership concentration as it is to be negatively associated with ownership concentration.

Given these findings, I re-examine the theoretical literature that predicts a negative relation between investors’ legal protections and ownership concentration. There are two branches to this literature, and they have diametrically opposed views on the role of large shareholders in public corporations. One branch models external blockholders who monitor management to stop the appropriation of corporate resources. The problem is that around the world blockholders typically are managers. The other branch, in contrast, models internal blockholders who appropriate corporate resources. Although this comports with the reality that most blockholders are insiders, it is inconsistent with evidence showing that in most countries firm value increases with ownership concentration. Both branches of the literature ignore the effects of large shareholders on management decisions. Given how broadly large shareholders can impact management and given that management decisions are not subject to judicial review, even in countries with strong legal systems, there is no reason to expect ownership concentration to vary with investors’ legal protections.

The full paper is available here.

One of the off-balance sheet structures that has caused substantial losses for a European bank is the so-called “Rhineland Funding”. This structure has resulted in substantial losses for the German bank IKB Deutsche Industriebank. The Rhineland Funding conduit had substantial exposure to U.S. subprime mortgages and was unable to issue asset-backed commercial paper (ABCP) against the conduit and, moreover, was unable to obtain lines of credit from Deutsche Bank and other financial institutions to raise financing. As a result, IKB had to step in and provide liquidity to the Rhineland Funding conduit as a result of various liquidity standby facilities it had earlier provided the Rhineland Funding conduit.

It has been difficult to obtain details on the structures of these off-balance sheet conduits and the various entities affiliated with them. An organizational chart describing the Rhineland Funding structure and affiliated parties is available here.

I have recently distributed a memorandum entitled “A United Nations Proposal Defining Corporate Social Responsibility For Human Rights,” which discusses a report by a Special Representative to the U.N. Secretary-General. The report has broad implications for global business and particularly for companies operating on a global basis, in emerging markets, in underdeveloped countries, or in countries that lack a democratic system. The report, which will be considered in a June session of the U.N. Human Rights Council, proposes that corporations bear the “responsibility to respect human rights,” that the State has a “duty to protect” against human rights abuses by companies, and that both the State and businesses must provide more effective access to remedies for human rights violations. In the memorandum, we explain that the framework recommended to the U.N. could impose on businesses an array of expansive obligations requiring close attention by corporate management and boards. The memorandum sets forth the core principles which the U.N. Human Rights Council may endorse to guide corporate responsibilities for human rights and additionally considers their implications for directors.

The memorandum is available here.

On April 14, my co-author Mark Roe and I presented our paper entitled Public and Private Enforcement of Securities Laws: Resource-Based Evidence at the Law and Economics Seminar here at the Law School.

Recent academic work in finance has generally found that private enforcement for investor protection via disclosure and lawsuits among contracting parties is a relatively more important determinant of financial outcomes than public enforcement via financial, regulatory, and even criminal rules and penalties. However, much legal scholarship has long seen private enforcement of securities laws in the United States as poorly designed, with firms, and hence wronged shareholders, often bearing the cost of insiders’ errors and disclosure failure. Our paper seeks to clarify the discrepancy between these two areas of research.

In our paper, we develop an enforcement variable based on securities regulators’ real resources—their staffing levels and budgets. We then examine financial outcomes around the world, including stock market capitalization, trading volume, the number of domestic firms, and the number of IPOs, in light of these resource-based measures of public enforcement. We find that more intense public enforcement regularly correlates with strong financial outcomes. In comparisons between our measures of public enforcement and the measures of private enforcement prominent in recent finance scholarship, public enforcement is typically at least as important as private enforcement in explaining important financial market outcomes around the world.

The full paper is available for download here.

The General Counsel of the Securities and Exchange Commission and Harvard Law School graduate, Brian G. Cartwright, recently gave the Distinguished Scholar Address at Widener University School of Law. Entitled The Role of the States (Foreign and Domestic), the speech addressed the question of what the increasingly global nature of securities markets and business will mean for Delaware general corporation law. After reflecting on changes in securities investing and commerce in recent decades, Mr. Cartwright envisioned a world in which “a global stockholder base trades the stock of transnational companies in just a few market centers with a global reach.” As greater parts of the world embraced the benefits of free-market capitalism, he predicted, the U.S. might lose the commanding dominance it once enjoyed, although it would likely remain one of the world’s leading capital markets. Mr. Cartwright likened competition for corporate charters in the U.S. to the situation now prevailing in Europe, and questioned how state competition for corporate charters would play out at the international level.

The speech is available here.

(Editor’s note: This post is by Linda McKenzie of Ernst & Young.)

In light of all of the recent market turmoil, the importance of transparency and risk management has certainly been elevated. These issues along with some of the shifts in global capital markets activity are at the center of a speech delivered by my CEO at Ernst & Young, Jim Turley, to a Washington D.C. audience at the U.S. Chamber’s 2nd Annual Capital Markets Summit. The speech describes how the interconnected, complex, and dynamic nature of global capital markets is demanding greater transparency, increased focus on risk management, and development of common standards and practices around the globe. Jim suggested the launch of a sustained multi-party dialogue — some mechanism involving issuers, auditors, and investors as well as governments and regulators — to facilitate a private and public sector dialogue that would monitor, assess, and address the challenges of operating in global capital markets and help to identify best practices. Tackling these issues could set a foundation for higher levels of investor confidence. The full text of the speech is available here.

(Editor’s note: This post by Luigi Zingales is part of the series of posts on corporate governance articles accepted for publication in prominent Finance Journals.)

A forthcoming article in the Journal of Finance titled “The Corporate Governance Role of the Media: Evidence from Russia”, which is co-written by Alexander Dyck, Natalya Volchkova, and myself studies the effect of media coverage on corporate governance. The article focuses on Russia during the period 1999 to 2002 to answer two main questions: Can hedge funds (or shareholders in general) increase the level of coverage received by certain companies? And if so, does this coverage have any effect on corporate governance outcomes? The article develops four main conclusions:

The article notes that an egregious corporate governance violation is more likely to be covered by newspapers regardless of any effort by hedge fund managers, and it is also more likely to generate a reaction. To attempt to disentangle these effects, we employ an instrument—the portfolio composition of the Hermitage Fund, an investment fund that consciously played a media strategy in post-1998 Russia—to provide further evidence that there is a causal link from press coverage to the governance outcome.

The full article is available here.

Two committees of the American Accounting Association have produced detailed reports evaluating the SEC’s proposal to accept financial statements prepared in accordance with International Financial Reporting Standards (IFRS) from foreign-private issuers without reconciliation to U.S. GAAP (the SEC subsequently voted in favor of the proposal on November 15, 2007). This proposal was also discussed by Carl Olson in his November 28 post. These two papers highlight the difficult nature of this issue. Despite the common background of the members of each group and the common academic research utilized in preparing each proposal, the recommendations of the two committees are distinctly different.

The Financial Accounting Standards Committee report (available here) argues that since there is no conclusive research evidence that financial reports prepared using U.S. GAAP are better than reports prepared using IFRS, the prudent approach is to promote competition among them. This finding supports adopting the SEC’s proposal to permit foreign private issuers a choice between IFRS and U.S. GAAP.

The Financial Reporting Policy Committee report (available here) concludes that the proposed elimination of the GAAP reconciliation requirement is premature. This conclusion is based on research that finds that material reconciling items exist that are relevant to U.S. investors, that there are differences in the implementation of uniform standards and that compliance to IFRS or U.S. GAAP by foreign firms is a concern, that foreign firms benefit from greater access to capital by listing in the U.S., that U.S. investors tend to prefer U.S. GAAP, and that U.S. GAAP - IFRS harmonization might improve the functioning of the U.S. capital markets.

(Editor’s Note: The post below comes to us from Jennifer G. Hill of the University of Sydney, Australia, who is Visiting Professor at Vanderbilt Law School during Spring 2008 and 2009.)

I have recently completed a paper, entitled “The Shifting Balance of Power Between Shareholders and the Board: News Corp’s Exodus to Delaware and Other Antipodean Tales”. The paper is posted on SSRN here.

The abstract to the paper is as follows:

The balance of power between shareholders and the board of directors is a contentious issue in current corporate law debate. It also lay at the heart of a controversy concerning the re-incorporation of News Corporation (News Corp) in Delaware. News Corp has recently been the subject of intense media attention due its successful bid to acquire Dow Jones & Company. Nonetheless, News Corp’s move to the US, which paved the way for this victory, was neither smooth nor a fait accompli. Rather, the original 2004 re-incorporation proposal prompted a revolt by a number of institutional investors, on the basis that a move to Delaware would strengthen managerial power vis-à-vis shareholder power. The institutional investors were particularly concerned about the effect of the re-incorporation on shareholder participatory rights, and the ability of the board of directors to adopt anti-takeover mechanisms, such as poison pills, which are not permissible under Australian law. It was this latter concern, which ultimately led a group of institutional investors to commence legal proceedings in the Delaware Chancery Court in UniSuper Ltd v News Corporation (2005 WL 3529317 (Del Ch)).

The News Corp re-incorporation saga highlights a number of important differences between US, UK and Australian corporate law rules relating to shareholder rights, and provides a valuable comparative law counterpoint to the recent US shareholder empowerment debate. Other recent Australian commercial developments discussed in the article show a tension between legal rules designed to enhance shareholder power, and commercial practices designed to readjust power in favor of the board of directors. These developments are interesting because they demonstrate how some Australian companies have tried to create a de facto corporate governance regime, which mimics certain aspects of Delaware law.

I have just released a working paper on the measurement of shareholder protection around the world, entitled “’Law and Finance’ Revisited” and available on SSRN here. The abstract is as follows:

The “Antidirector Rights Index” from La Porta et al.’s “Law and Finance” (1998) has been used as a measure of shareholder protection in almost 100 published studies. With articles by legal scholars questioning the accuracy of index values for several countries, I undertake a systematic study to verify these values for 46 countries with the help of local lawyers. My emphasis is on accuracy of the data; I do not change the original variable definitions. The study leads to a substantial revision: 33 of the 46 observations need to be corrected, and the correlation of corrected and original values is only .53. With accurate values, the well-known results of La Porta et al. (1997, 1998) no longer hold: accurate index values are neither distributed with significant differences between Common and Civil Law countries nor correlated with stock market size and ownership dispersion. All of the many results derived with the index will have to be revisited.

(NB: This paper is a revision of Spamann (2006).

By way of background, the cited article “Law and Finance” by La Porta, Lopez-de-Silanes, and Vishny (1998) started an entire literature of the same name. I have recently described the current state of this literature on this blog here.

On February 14, the SEC Advisory Committee on Improvements to Financial Reporting presented its interim report to the Securities and Exchange Commission. The report includes 12 developed proposals, conceptual approaches representing the Committee’s initial views on matters, and currently identified matters for further consideration. The key themes of the report are the following: increasing emphasis on the investor perspective in the financial reporting system; consolidating the process of setting and interpreting accounting standards; promoting the design of more uniform and principles-based accounting standards; creating a disciplined framework for the increased use of professional judgment; and taking steps to coordinate Generally Accepted Accounting Principles (GAAP) in the US with International Financial Reporting Standards (IFRS).

Formed by the SEC in July 2007, the Committee was tasked to examine the US financial reporting system and to recommend changes to increase the usefulness of financial information to investors, while reducing the financial reporting system’s complexity. The Committee’s final report is some months away. The Committee includes representatives from the Financial Accounting Standards Board and the Public Company Accounting Oversight Board.

The interim report is available here.

(Editor’s Note: The post below comes to us from Peter Moon of Universities Superannuation Scheme, Phil Spathis of the Australia Council of Super Investors, and Keith Johnson of Reinhart Institutional Investor Services.)

Verizon, Par Pharmaceutical and Aflac became the first US companies over the last year to adopt policies requiring an advisory vote of shareholders on company executive compensation practices. A network of over 70 institutional and individual investors lead by AFSCME and Walden Asset Management announced in January that adoption of this ’say on pay’ policy is expected to be put on proxies at more than 90 US companies this year. With majority shareholder votes having been cast for similar resolutions at seven companies during 2007, say on pay will be one of the hottest issues in the upcoming US proxy season. In their article, Global Investors Laud Shareholder Votes on Executive Compensation, Peter Moon from the $65 billion Universities Superannuation Scheme pension fund in Britain, Phil Spathis from the $200 billion Australia Council of Super Investors and Keith Johnson from the University of Wisconsin Law School’s International Corporate Governance Initiative describe the impact that say on pay has had in other markets and discuss the benefits it could produce for both companies and shareholders in the United States.

With my co-authors Reena Aggarwal (Georgetown), Isil Erel (Ohio State) and Rohan Williamson (Georgetown), I have recently completed a revision of the paper “Differences in Governance Practices between U.S. and Foreign Firms: Measurement, Causes, and Consequences.” The paper is available at SSRN. The paper is now forthcoming at The Review of Financial Studies. The paper shows that foreign firms invest less in firm-level governance and that this lower investment is associated with lower valuations.

Using the well-known definition of Shleifer and Vishny (1997), governance consists of the mechanisms which insure that minority shareholders receive an appropriate return on their investment. Governance depends both on country-level as well as firm-level mechanisms. The country-level governance mechanisms include a country’s laws, its culture and norms, and the institutions which enforce the laws. Firm-level or internal governance mechanisms are those that operate within the firm. Firm-level governance mechanisms that increase the power of minority shareholders to receive a return on their investment are costly, so that the adoption of such mechanisms by a firm is an investment. The payoffs from that investment differ across countries and across firms.

The U.S. is recognized to have extremely high financial and economic development, to have strong investor protection, and to protect property rights well. Consequently, we would expect the internal governance of firms in the U.S. to come as close as possible to what the optimal internal governance of a firm would be in a foreign country if it were not constrained by weaker institutions and lower development than in the U.S. The internal governance of firms in the U.S. therefore provides a benchmark that can be used to evaluate the impact of different institutions and different development from the U.S. on governance choices and, through these choices, on firm value.

On theoretical grounds, it is not clear whether the characteristics of the U.S. make firm-level investment in governance mechanisms that increase the power of minority shareholders more or less advantageous for U.S. firms relative to firms from countries which do not have the same high level of development and investor protection. One possibility is that foreign firms would invest less in firm-level governance if they were in the U.S. because firm-level governance and country-level investor protection are substitutes. An alternative possibility is that investment in firm-level governance is less productive in countries with poor economic development and weak investor protection than it is in the U.S., implying that firm-level governance and investor protection are complements.

We find strong evidence that foreign firms invest less in internal governance mechanisms that increase the power of minority shareholders than comparable U.S. firms do. In other words, investment in firm-level governance is higher when a country becomes more economically and financially developed and better protects investor rights. Further, to the extent that institutional and development weaknesses reduce a foreign firm’s investment in corporate governance compared to a U.S. firm, we would expect the value of the foreign firm to be lower. As expected, we find that the value of foreign firms is negatively related to the magnitude of their governance investment shortfall relative to U.S. firms.

To conduct our investigation, we need information about firm-level corporate governance attributes that increase the power of minority shareholders for a large number of firms across a large number of countries and we would like individual governance attributes to be assessed similarly across all these firms. We use the corporate governance attributes recorded by Institutional Shareholder Services (ISS). By doing so, we can analyze 44 common governance attributes for 2,234 non-U.S. firms and 5,296 U.S. firms covering 23 developed countries. We create a governance index making sure that the governance attributes included are relevant both for U.S. firms and foreign firms. We call it the GOV Index.

To evaluate the governance a foreign firm would have if it were in the U.S., we use a propensity score matching method in order to match each foreign firm with a comparable U.S. firm. We then show that foreign firms generally have a lower GOV index, so that they give less power to minority shareholders, than if they were U.S. firms. We define the governance gap to be the difference between the governance index of a foreign firm and the governance index of a comparable U.S. firm. A firm with a positive governance gap has a higher value of the GOV index than its matching U.S. firm. Only 12.7% of foreign firms have a positive governance gap. Strikingly, 86.1% of these firms come from Canada and the U.K., so that firms from countries with similar investor protection as in the U.S. are the ones that are the most likely to invest more in governance than comparable U.S. firms. Such a result is inconsistent with the hypothesis that investor protection and internal governance mechanisms are substitutes.

Having compared the governance of foreign and U.S. firms, we turn to the question of whether the governance gap helps explain a firm’s valuation. We find that the value of foreign firms is increasing in their GOV index. More importantly, perhaps, the lower the GOV index of a foreign firm compared to its matching U.S. firm, the lower the value of that foreign firm. We find that this result holds controlling for firm characteristics known to affect q and controlling for the endogeneity of the choice of governance mechanisms.

If firm-level governance is more costly for foreign firms than for U.S. firms, we expect that the foreign firms comparable to the U.S. firms that benefit the most from investing in internal governance will find it optimal to invest less in governance than matching U.S. firms do and will suffer a loss of value as a result. We can therefore use regression analysis to investigate whether a foreign firm’s q is negatively related to the governance index value it would have in the U.S. We find that this is the case. Such a coefficient is not subject to an endogeneity bias because we are measuring the governance of a U.S. firm and the valuation of a foreign firm.

In addition to investigating the value relevance of differences in the aggregate governance index between foreign firms and comparable U.S. firms, we also consider the value relevance of specific governance provisions. We focus on provisions that have attracted considerable attention in the literature and among policymakers. We find that firms that have an independent board, auditors that are ratified annually, and an audit committee comprised solely of outsiders, have a higher value when their U.S. matching firm has these governance attributes. In contrast, neither board size nor separation of the chairman and CEO functions are value relevant.

Recently, in Reinier Kraakman’s Corporations course here at Harvard Law, Justice Jack B. Jacobs of the Delaware Supreme Court treated students to a highly insightful talk on Delaware’s Takeover Law. Justice Jacobs’s talk provided a rare insider’s perspective on the evolving standards of international takeover law–and the Delaware cases that govern most American acquisitions.

Justice Jacobs gave a detailed analysis of the institutions that regulate takeovers in the United Kingdom, continental Europe, and elsewhere, providing fascinating context for the relative dominance of the common law in Delaware. In the course of his talk, Justice Jacobs noted that the choice among regulatory institutions has had critical, and often overlooked, implications for the substantive approach to takeovers in each jurisdiction: the importance of defenses, the role of directors, and the rights of shareholders. The discussion also provides a striking perspective on Delaware’s leading takeover cases and their relevance to contemporary merger practice.

An audio recording of Justice Jacobs’s talk is available online here.

Cross-border M&A nearly doubled from 2006 to 2007 as a percentage of total activity, and some observers see it as the savior of 2008. Here is a quick checklist of critical issues for US/non-US deals.

And sometimes less really is more: here is a one-pager on M&A in 2008.

Recently, in the Mergers, Acquisitions, and Split-Ups course here at Harvard Law, co-taught by Professor Robert Clark and Vice Chancellor Leo Strine, Jr., two expert practitioners shared their insights on the complex cross-border transactions that increasingly define the M&A landscape. While the panelists provided guidance on the economic reasoning underlying cross-border deals, the discussion also featured fascinating perspectives on the social and political considerations that accompany most major international mergers.

The panelists included Richard Hall of Cravath, Swaine & Moore along with Scott V. Simpson of Skadden, Arps, Slate, Meagher & Flom, each of whom have served as counsel on some of the largest cross-border deals ever to close. The panelists took students through case studies of two recent cross-border deals that illustrate the sensitive issues that corporate counselors face in a major international merger: Mittal Steel’s acquisition of Arcelor, and Basell’s acquisition of Huntsman. The panelists offered an insider’s view of the negotiations in both transactions–and the social and political matters that inevitably arise when a foreign acquirer pursues a large target.

A video of the discussion can be accessed online here.

The Program on Corporate Governance has recently issued as a discussion paper my piece, co-authored with Zvika Neeman, entitled Investor Protection and Interest Group Politics. We develop in this paper a framework for analyzing how interest group politics influence investor protection levels. Our analysis identifies factors that impede desirable corporate governance reforms, and can help explain the ways in which investor protection levels vary around the world and over time. The abstract of the paper is as follows:

We model how lobbying by interest groups affects the level of investor protection. In our model, insiders in existing public companies, institutional investors (financial intermediaries), and entrepreneurs who plan to take companies public in the future, compete for influence over the politicians setting the level of investor protection. We identify conditions under which this lobbying game has an inefficiently low equilibrium level of investor protection. Factors that operate to reduce investor protection below its efficient level include the ability of corporate insiders to use the corporate assets they control to influence politicians, as well as the inability of institutional investors to capture the full value that efficient investor protection would produce for outside investors. The interest that entrepreneurs (and existing public firms) have in raising equity capital in the future reduces but does not eliminate the distortions arising from insiders’ interest in extracting rents from the capital public firms already have. Our analysis generates testable predictions, and can explain existing empirical evidence, regarding the way in which investor protection varies over time and around the world.

The full paper is available for download here.

I recently presented my new discussion paper with Mark Roe, Public Enforcement of Securities Laws: Preliminary Evidence, at the Conference on Empirical Legal Studies at the New York University School of Law. The paper develops a measure of securities-enforcement intensity and examines financial outcomes worldwide in light of enforcement activity. The abstract of the paper follows:

The legal consequence of economic actors ignoring their legal obligations, such as laws that protect outside investors in firms, is a recurring issue. Recent scholarship examines the relative importance of private enforcement for investor protection on the one hand–via disclosure and lawsuits among contracting parties–and public enforcement on the other–via financial, regulatory, and even criminal rules and penalties. Recent financial work has seen the former to be more important than the latter. Yet much recent legal scholarship has seen private enforcement of securities laws in the United States as poorly designed, with firms–and, hence, wronged shareholders–often bearing the cost of insiders’ errors and disclosure failure. To better understand the relative importance of public and private enforcement, we here develop an enforcement variable based on securities regulators’ staffing levels and budgets. We then examine financial outcomes around the world–such as stock market capitalization, trading volume, number of domestic firms, and number of IPOs–in light of these measures of public enforcement and find that more intense public enforcement regularly correlates with strong financial outcomes. In horse races between our measures of public enforcement and the measures of private enforcement prominent in recent financial scholarship, public enforcement is typically at least as important as private enforcement in explaining important financial market outcomes around the world.

The full paper is available for download here.

(Editor’s Note: This post comes to us from Shann Turnbull, Principal of the International Institute for Self-Governance.) 

I have recently released a new paper, entitled Correcting the Failures in Corporate Governance Reforms, in which I argue that constructive governance reform will require regulators to recognize and address the shortcomings of existing reforms. I invite readers to respond to one of the central claims of the paper: that regulators and stock exchanges cannot responsibly permit directors to retain absolute power over corporate affairs.

Among other proposals, the paper recommends that regulators prohibit corporate charters from granting directors the sort of “inappropriate powers” described by Bob Monks and Allan Sykes in Capitalism Without Owners Will Fail. For example, Directors typically are provided absolute power to manage their own conflicts of interest. As power tends to corrupt and absolute power tends to corrupt absolutely, how can regulators and those overseeing the various stock exchanges responsibly allow directors to possess such powers?

One explanation may be that regulators and exchanges have become captive of corporate interests. Monks articulates this claim in a short video available here. In my 2004 paper, Agendas for Reforming Corporate Governance, Capitalism and Democracy, I described a series of policy reforms that would give shareholders and stakeholders alike an incentive enhance the political and social legitimacy of large corporations.

Correcting the Failures in Corporate Governance Reforms posits that a contributing cause of the failure of corporate governance reforms is a knowledge gap with respect to how corporate constitutions can be designed both (1) to improve the control of complex firms to enhance their competitiveness and (2) to introduce self-enforcing co-regulation. In The Governance of Firms Controlled by More Than One Board, I offered a series of design criteria for such constitutions, based in part on case studies of self-governing, stakeholder-controlled firms.

The knowledge gap described in Correcting the Failures in Corporate Governance Reforms was pointed out by Al Gore in a 1996 speech in which he described “the growing disconnects between science and democracy.” “Page through a directory of members of Congress,” Gore noted, “and you’ll find well over 150 lawyers, but only six scientists, two engineers, and one science teacher among the 535 people in the House and the Senate. As a result, scientific concepts sometimes elude the vast majority of our elected officials.”

As I argued in The Science of Corporate Governance, the design of governance controls in modern firms is itself a scientific inquiry, requiring careful observation of the science of information and control. Yet those fields are generally ignored in the education of corporate and constitutional lawyers–as well as in the training of social scientists in schools of government, public administration and business.

One of the most fundamental principles of information science is that regulation can only be amplified indirectly through co-regulating agents. This, of course, explains the current failure of top-down regulation of corporate governance, which has taken place largely without bottom-up co-regulation by stakeholders.

Scientific analysis of corporate governance controls offers a methodology that will permit corporations to become self-governing and thus reduce the role of government in corporate affairs. Regulators would do well to incorporate that methodology as they address the failure of corporate governance reforms around the world.

Correcting the Failure in Corporate Governance Reforms is available for download here.

(Editor’s Note:  This post comes to us from Till Immanuel Lefranc at Harvard Law School. Till invites comments at till.lefranc [at] gmail.com.)  

The French Commercial Code was amended in 2006 in order to make poison pills possible in France. Only two months after the amendments were enacted, the general meeting of fifteen large companies gave its board authority to adopt a pill. Comparing French and American poison pills is interesting for two main reasons:

(1) France is likely to face same problems that the Delaware courts have been dealing with for more than twenty years. Corporate directors may have legitimate reasons for refusing an acquisition, such as finding time to obtain a higher price from a third party. But directors may also be acting out of self interest, and use the pill to entrench themselves–to the detriment of shareholders. How will French institutions regulate the pill to prevent this type of conduct from happening?

(2) On the other hand, the French pill has been carefully designed to mitigate those risks. A new pill must be approved by a general meeting of shareholders, and rights can only be issued by the board with shareholder consent. If shareholders do give the board authority to issue rights, that authority is valid for a maximum of 18 months.

I have prepared a Memorandum that sets forth a comparative analysis of the French poison pill and its implications. The Memorandum is available for download here.

Jay W. Eisenhofer, a partner in the law firm Grant & Eisenhofer P.A., recently presented his paper Investor Litigation in the U.S.–The System is Working here at Harvard Law School. Co-authored by Gregg S. Levin, the paper is critical of efforts to “discredit” the “long-established mechanism” of investor class actions.

Investor Litigation in the U.S. discusses the reported decline in the international competitiveness of U.S. capital markets, considers recent evidence on the listing premium enjoyed by firms cross-listing in the U.S., confronts the so-called “circularity argument” often levelled at the securities litigation system, and canvasses corporate governance reforms said to have directly resulted from shareholder litigation. The paper concludes that the “current system of investor rights has resulted in lower costs of capital and higher valuations” and that no case can be made for radical litigation reform.

The full paper is available for download here.

Recently, in the Law School’s Seminars in Law & Economics and Law, Economics, and Organization, Florencio Lopez de Silanes presented his latest work with Rafael La Porta and Andrei Shleifer (LLS) on legal origins. Over the last ten years, LLS and different co-authors collected data on various sets of legal rules in up to 129 countries. They covered areas of law ranging from civil procedure to military conscription, but mostly focused on legal rules particularly relevant to corporate finance. In all their studies, LLS invariably found that common law countries had “better” laws than civil law countries, particularly those of the French legal family. In particular, it appeared that common law countries were much better at protecting investors, and hence developed larger and more liquid financial markets.

These findings had an enormous academic and real-world impact–and generated a good deal of controversy. In The Economic Consequences of Legal Origins, written for the Journal of Economic Literature and presented at the Law and Economics seminar, LLS provide a synthesis of the academic debate that has taken place over the last ten years. Here is their abstract:

“In the last decade, economists have produced a considerable body of research suggesting that the historical origin of a country’s laws is highly correlated with a broad range of its legal rules and regulations, as well as with economic outcomes. We summarize this evidence and attempt a unified interpretation. We also examine the effects of legal origins on resource allocation and economic growth. Finally, we address a broad range of objections to the empirical claim that legal origins matter.”

The paper’s survey of the existing literature is outstanding. Yet the paper’s main contribution is its articulation of a “unified interpretation” of the empirical results. LLS “develop the Legal Origin Theory, namely that legal origins represent fundamentally different strategies of social control of economic life.” A big advantage of this theory is that it can explain why legal origins also seem to matter in areas dominated by statutes, such as military conscription or the regulation of entry of new businesses. These subjects had eluded previous attempts at explanation; earlier hypotheses had usually focused on the differences between judicial and legislative law-making.

One may wonder, however, what is specifically “legal” about the “Legal Origins Theory” as now articulated by LLS. To be sure, the theory predicts differences in legal rules as found in the data collected by LLS and others. But the theory seems to locate the root cause of these differences in the cultural and political inclinations of countries’ populations or elites rather than in institutional differences (even though LLS argue vigorously against competing cultural and political explanations in the paper). Among the many questions raised by the theory, then, is how these inclinations could have been so profoundly influenced by the identity of the colonizing power–which is ultimately what legal origins refers to (where a country chose its legal family, as in the case of Japan, legal origin is endogenous and hence does not have explanatory power). Likewise, one might ask how these inclinations could be so stable over time, especially through the many and often profound changes in local political climate.

…continue reading: The Economic Consequences of Legal Origins

Ever since Berle and Means published The Modern Corporation and Private Property in 1932, diffuse ownership has been considered the norm for U.S. public corporations.  And at least since La Porta et al.’s Law and Finance (1998) and Corporate Ownership around the World (1999), this aspect of US corporate governance has been considered exceptional from a global perspective–with only the U.K. and some other developed, common-law countries showing similarly low levels of ownership concentration.

In The Myth of Diffuse Ownership in the United States, Clifford Holderness challenges this view.  Using a more representative sample of U.S. firms than have previous studies, Holderness finds that ownership concentration in the US is about the same as the world average.  Moreover, in Holderness’s data, U.S. blockholding does not look qualitatively different from the world average in terms of blockholders type (as demonstrated in Table 5) and board representation (Table 6).  These results are robust to controlling for certain firm attributes relevant to ownership concentration, such as firm size. Given the amount of research that has been based on the assumptions that Holderness challenges, his article is bound to have considerable impact.  Here’s his abstract:

This paper offers evidence on the ownership concentration at a representative sample of U.S. public firms. 96% of these firms have blockholders; these blockholders in aggregate own an average 39% of the common stock. The ownership of U.S. firms is similar to and by some measures more concentrated than the ownership of firms in other countries. These findings challenge current thinking on a number of issues, ranging from the nature of the agency conflict in domestic corporations to the relationship between ownership concentration and legal protections for investors around the world.

The full paper is available here.

(Editor’s note: This post was authored by Guest Contributor Rene M. Stulz of the Fisher College of Business at The Ohio State University.)

In a paper entitled Has New York Become Less Competitive in Global Markets? Evaluating Foreign Listing Choices Over Time, Craig Doidge, G. Andrew Karolyi, and I show that Sarbanes-Oxley (”SOX”) cannot be blamed for the decrease in foreign listings on the New York Stock Exchange and NASDAQ.  A recent revision of the paper, posted here, provides additional supporting evidence for our conclusions.  Before reviewing that additional evidence, I summarize the main results of the paper below.

A popular explanation for the decrease in foreign listings on the exchanges in New York is that the passage of SOX has made U.S. listings significantly less attractive to foreign companies–so much so, it is argued, that many listed firms would delist and deregister if it were easy to do so.  (That explanation, among others, is set forth in a recent report entitled Sustaining New York’s and the US’s Global Financial Services Leadership, prepared for Senator Charles Schumer of New York.)  The argument is that SOX makes a U.S. listing less advantageous because it imposes severe costs on companies and their managers, especially through the compliance requirements of Section 404.  (Section 404 aims to reduce the market impact of accounting “errors” by assuring effective management control over reporting; and, in turn, creates significant legal exposure for companies as well as executives.)

For this popular explanation to be correct, it would have to be that firms that would have chosen to list in the U.S. before SOX are no longer willing to do so.  Our paper shows that:

…continue reading: Has SOX Made New York Less Competitive in Global Markets?

This year’s meeting of the American Law and Economics Association, hosted here at Harvard Law, wrapped up today with three different panels featuring the latest scholarship on corporate governance.  Today’s panelists offered papers on hedge funds, stock market efficiency, and executive pay, all cutting-edge subjects for those interested in corporate governance.  For those of you who couldn’t join us here in Cambridge, I provide below a brief summary of the authors’ presentations as well as links to the excellent papers we discussed today.

…continue reading: ALEA Conference Goes Out In Style