The recent $1.4bn settlement between Wall Street's top investment houses and the US Securities and Exchange Commission (SEC) epitomizes the distorted incentives and regulatory failures that underlay the string of spectacular corporate failures seen in America in recent years. The admission that securities analysts deliberately skewed their research to attract investment-banking customers shows how easily the proper functioning of checks and balances in corporate governance can break down-even in the most advanced system-leaving minority shareholders at risk.
Managers, after all, are imperialists by nature, inclined to undertake massive investment projects, mergers, and acquisitions. So investment banks are only too willing to play along. Rising share prices facilitate managerial empire-building and imply a massive windfall for insiders with stock options. So managers are quick to embrace "aggressive" or "creative" accounting methods that flatters earnings projections, conceals risks, and portrays a smooth record of profit growth. Finally, managers, not distant shareholders, control access to well-paid appointments and lucrative consulting jobs. So internal and external auditors are often co-opted.
To be sure, the US corporate and securities scandals exposed regulatory gaps-insufficient enforcement of disclosure requirements, for example, or excessive reliance on peer review for auditors and on so-called "Chinese Walls" to keep brokerage and investment-banking activities separate. Moreover, US accounting standards have been unable to cope with bookkeeping's uncharted frontiers of off-balance sheet transactions, structured financing methods, and Byzantine contract valuations.
The deeper question is whether these problems are limited to the US, and whether they reflect America's characteristic diffuse structure of corporate ownership. Diffuse ownership, with a large number of relatively small shareholders entrusting day-to-day company operations to independent managers, prevails in the US and the UK. Concentrated ownership, with one or more controlling shareholders, prevails in continental Europe (and, indeed, in the rest of the world).
In the past decade, it became fashionable to extol the superiority of the Anglo-Saxon model, with its supposed virtuous circle of diffuse ownership and strong protection for distant shareholders. But it was the US economy's rapid growth and booming stock market that made American-style ownership look so good in the 1990's, just as impressive growth once had everyone cooing over the German and Japanese models of corporate ownership and governance. Some of the few European corporate failures similar to those in the US have occurred in American-style companies-Vivendi in France or Marconi in Britain-with no controlling shareholder to monitor the company.
Of course, European-style concentrated ownership carries its own costs for investors. Control enables the majority shareholder to extract revenues and wealth from the company at the expense of minority owners. Even leaving aside perks and privileges, majority shareholders can appropriate private benefits through transactions with other companies that they own, such as transfer pricing and privileged credit relations. Moreover, concentrated corporate ownership impedes the growth of equity markets, making it difficult for smaller shareholders to sell.
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But the ownership structure prevailing in a country depends largely on factors other than the legal regime of investor protection: it may be endogenous to the country's industrial structure. More importantly, there is no single optimal corporate ownership model that lawmakers and regulators should strive to achieve.
Convergence on a particular model of corporate ownership and governance is a myth. Instead, lawmakers and regulators should focus on providing better protection to minority investors, whether the threat comes primarily from managers, as in diffuse ownership systems, or from controlling shareholders, as in concentrated ownership systems.
The reaction to the wave of corporate scandals in the US-and hence to the blatant failure of self-regulation-has been admirably swift. Within a few months, the US Congress enacted the Sarbanes-Oxley Act, the most comprehensive securities legislation since the SEC's establishment in 1934.
Moreover, the SEC itself has been redrafting and updating its regulations, while equities markets have revisited their listing rules. Regardless of whether the Sarbanes-Oxley Act and other initiatives prevent new types of financial excess, they will almost certainly strengthen shareholder protection and set higher standards for other jurisdictions.
Where concentrated ownership prevails, as in Europe, regulators should pay particular attention to companies' transactions with related parties, ensuring full disclosure and setting stringent limits on controllers' insider dealings. Similarly, when there is a controlling shareholder, a certain number of seats on boards and audit committees should be explicitly reserved for directors representing minority shareholders.
On the other hand, before the Sarbanes-Oxley legislation, European regulation was ahead of the US in some areas. The principles enshrined in the International Accounting Standards-to be adopted by all EU listed companies by 2005-being more general, with substance prevailing over form, are more easily adaptable to financial innovation than US accounting standards. In some European jurisdictions, regulators supervise and sanction internal and external auditors, and disclosure of price-sensitive information is mandated as a general principle rather than as a response to specific events. There have even been efforts to regulate analysts' reports.
The corporate failures of recent years provide a sobering lesson for all-a brutal public reminder of problems that political leaders forgot or conveniently ignored. Renewed awareness that even seemingly strong protections for minority shareholders can be illusory has created a window of opportunity for undertaking necessary reforms. To accomplish this, in Europe no less than in the US, our focus must remain squarely on maintaining the confidence of minority investors.
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The escalating war in the Middle East must be understood in a broader context. The fact that the Iranian regime felt emboldened to risk a direct strike on Israel attests to a changing world order in which Western power is increasingly open to challenge.
considers the implications of Iran’s unprecedented decision to launch a direct strike on Israeli territory.
The recent $1.4bn settlement between Wall Street's top investment houses and the US Securities and Exchange Commission (SEC) epitomizes the distorted incentives and regulatory failures that underlay the string of spectacular corporate failures seen in America in recent years. The admission that securities analysts deliberately skewed their research to attract investment-banking customers shows how easily the proper functioning of checks and balances in corporate governance can break down-even in the most advanced system-leaving minority shareholders at risk.
Managers, after all, are imperialists by nature, inclined to undertake massive investment projects, mergers, and acquisitions. So investment banks are only too willing to play along. Rising share prices facilitate managerial empire-building and imply a massive windfall for insiders with stock options. So managers are quick to embrace "aggressive" or "creative" accounting methods that flatters earnings projections, conceals risks, and portrays a smooth record of profit growth. Finally, managers, not distant shareholders, control access to well-paid appointments and lucrative consulting jobs. So internal and external auditors are often co-opted.
To be sure, the US corporate and securities scandals exposed regulatory gaps-insufficient enforcement of disclosure requirements, for example, or excessive reliance on peer review for auditors and on so-called "Chinese Walls" to keep brokerage and investment-banking activities separate. Moreover, US accounting standards have been unable to cope with bookkeeping's uncharted frontiers of off-balance sheet transactions, structured financing methods, and Byzantine contract valuations.
The deeper question is whether these problems are limited to the US, and whether they reflect America's characteristic diffuse structure of corporate ownership. Diffuse ownership, with a large number of relatively small shareholders entrusting day-to-day company operations to independent managers, prevails in the US and the UK. Concentrated ownership, with one or more controlling shareholders, prevails in continental Europe (and, indeed, in the rest of the world).
In the past decade, it became fashionable to extol the superiority of the Anglo-Saxon model, with its supposed virtuous circle of diffuse ownership and strong protection for distant shareholders. But it was the US economy's rapid growth and booming stock market that made American-style ownership look so good in the 1990's, just as impressive growth once had everyone cooing over the German and Japanese models of corporate ownership and governance. Some of the few European corporate failures similar to those in the US have occurred in American-style companies-Vivendi in France or Marconi in Britain-with no controlling shareholder to monitor the company.
Of course, European-style concentrated ownership carries its own costs for investors. Control enables the majority shareholder to extract revenues and wealth from the company at the expense of minority owners. Even leaving aside perks and privileges, majority shareholders can appropriate private benefits through transactions with other companies that they own, such as transfer pricing and privileged credit relations. Moreover, concentrated corporate ownership impedes the growth of equity markets, making it difficult for smaller shareholders to sell.
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Access every new PS commentary, our entire On Point suite of subscriber-exclusive content – including Longer Reads, Insider Interviews, Big Picture/Big Question, and Say More – and the full PS archive.
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But the ownership structure prevailing in a country depends largely on factors other than the legal regime of investor protection: it may be endogenous to the country's industrial structure. More importantly, there is no single optimal corporate ownership model that lawmakers and regulators should strive to achieve.
Convergence on a particular model of corporate ownership and governance is a myth. Instead, lawmakers and regulators should focus on providing better protection to minority investors, whether the threat comes primarily from managers, as in diffuse ownership systems, or from controlling shareholders, as in concentrated ownership systems.
The reaction to the wave of corporate scandals in the US-and hence to the blatant failure of self-regulation-has been admirably swift. Within a few months, the US Congress enacted the Sarbanes-Oxley Act, the most comprehensive securities legislation since the SEC's establishment in 1934.
Moreover, the SEC itself has been redrafting and updating its regulations, while equities markets have revisited their listing rules. Regardless of whether the Sarbanes-Oxley Act and other initiatives prevent new types of financial excess, they will almost certainly strengthen shareholder protection and set higher standards for other jurisdictions.
Where concentrated ownership prevails, as in Europe, regulators should pay particular attention to companies' transactions with related parties, ensuring full disclosure and setting stringent limits on controllers' insider dealings. Similarly, when there is a controlling shareholder, a certain number of seats on boards and audit committees should be explicitly reserved for directors representing minority shareholders.
On the other hand, before the Sarbanes-Oxley legislation, European regulation was ahead of the US in some areas. The principles enshrined in the International Accounting Standards-to be adopted by all EU listed companies by 2005-being more general, with substance prevailing over form, are more easily adaptable to financial innovation than US accounting standards. In some European jurisdictions, regulators supervise and sanction internal and external auditors, and disclosure of price-sensitive information is mandated as a general principle rather than as a response to specific events. There have even been efforts to regulate analysts' reports.
The corporate failures of recent years provide a sobering lesson for all-a brutal public reminder of problems that political leaders forgot or conveniently ignored. Renewed awareness that even seemingly strong protections for minority shareholders can be illusory has created a window of opportunity for undertaking necessary reforms. To accomplish this, in Europe no less than in the US, our focus must remain squarely on maintaining the confidence of minority investors.