Objectivity, Control, and Adaptability in Corporate Governance
Posted: 23 Sep 1998
Date Written: January 1998
In this article we maintain that corporate governance systems can be evaluated by the degree to which they accomplish three objectives: (1) lowering contracting costs by providing default rules and reliable enforcement of such rules; (2) lower agency costs by providing mechanisms for controlling managers; and (3) protect specific human capital investment. Differences in corporate governance systems reflect the fact that different systems accomplish these three objectives in different ways. Differences in corporate governance systems also reflect the fact that different societies impost different cultural and legal constraints on the ways that firms are financed and governed.
Different corporate governance systems also reflect local adaptations to local legal and cultural constraints on financial contracting. In other words, differences in corporate governance systems reflect the different ways that investors have "contracted around" restrictions in their own legal and social orders in order to make the most efficient investments possible under a given set of constraints.
These insights have implications for regulatory reform. In particular, we argue that making improvements in one aspect of a corporate governance system, in order, for example, to improve the way that a corporate governance system reduces agency costs, can weaken that system in other ways, for example by reducing the ability of the system to protect human capital investments.
Despite the rich differences among various systems of corporate governance, two basic paradigms of corporate governance, the U.S. paradigm and the German paradigm, dominate the literature. The U.S. paradigm is that of strong capital markets but weak institutional constraints on management. The German paradigm is of strong institutional (bank) controls on management to compensate for weak capital markets. In addition to the trade-off in corporate governance between the characteristic of liquidity, which provides investors with a ready *exit option,* and the characteristic of *voice,* policymakers face another, related tradeoff when designing a corporate governance system. This is the tradeoff between objectivity and proximity. In systems such as those that exist in Germany, the Netherlands and elsewhere, there is finely textured monitoring by sophisticated, institutional investors. However, in these systems, the monitors often do not respond to the signals they are receiving because they have become *captured* by the firms they are monitoring. This happens because the monitors have become co-opted into adopting the perspective of the firms they are ostensibly monitoring. Thus the informational advantage enjoyed by the insiders in certain corporate governance systems is mitigated by the fact that these investors may lack the ability to evaluate the performance of the firms they are monitoring in an objective manner.
By contrast, in a corporate governance system like the one that exists in the U.S., where there is considerable distance between investors and management, investors face an obvious problem in obtaining detailed, reliable information about the firms in which they are investing, since management will have incentives to withhold information or to provide inaccurate information. Even where there is disclosure, rational ignorance and free-riding prevent investors from benefitting from the information they receive. On the other hand, the distance that U.S. investors have from the firms in which they are investing brings with it a degree of objectivity lacking in corporate governance systems in which investors enjoy large degrees of control.
We argue that this tradeoff between objectivity and control is systemic and intractable. As a result, corporate governance systems that take steps to improve one vector of corporate governance performance, for example by improving the quality of capital markets in order to reduce contracting costs or agency costs, will weaken other aspects of their system, for example by weakening protections for investments in human capital.
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