Stock Market Model

Customarily it is believed that corporations in the United States and the United Kingdom (U.K.) operate primarily for the benefit of shareholders. This contrasts with corporations in Japan, Germany, and other Continental European countries, where managers are thought to operate for the common good—for the benefit of shareholders, workers, creditors, and communities. At an abstract level both generalizations are correct, but on closer inspection neither is.

This comparison describes the U.S./U.K. approach as a share­holder stock market model. In it, two internal groups constitute and regulate a corporation: managers and shareholders. Shareholders own the corporation's equity, the value of which fluctuates with the for­tunes of the corporation. Managers consist of both the daily operators of the corporation (the officers) and those who oversee and supervise those operations (the directors).

The key problem in U.S. and U.K. corporate governance is the separation of ownership from control that results from the shareholder-manager dichotomy. Two broad sets of mechanisms address the issues raised by this problem. Monitoring mechanisms either impose duties on managers or empower shareholders to take action against them. Exit mechanisms include, most importantly, the free transferability of ownership interests, which enables shareholders to sell their stock and thus exit the corporation at will; this often is called the Wall Street rule.

Monitoring and exit mechanisms reinforce the financial and stock markets, and vice versa. Shareholders can oust inferior managements because a stock market for managing and controlling corporations exists. The free transferability of ownership interests—an exit mechanism—has contributed to the development of deep, liquid, and ac­tive (if not efficient) capital stock markets. Disclosure laws in the United States, which promote the transparency of corporations' performance, have substantially aided these stock market forces.

Corporate transparency, coupled with the U.S./U.K. tradition of at-will employment, also facilitates reasonably well-functioning stock markets. For example, if managers perform poorly, corporate trans­parency makes it more likely that shareholders will vote to oust them and other corporations will not hire them readily.

At the same time, however, managers can contract and expand the employee base to enhance performance. Of course, labor unions often gain substantial power through collective bargaining agreements which contract and federal labor laws protect. That power does not derive, however, from externally imposed regulation but instead is the product of voluntary arrangements.

Consumer product stock markets also contribute to the discipline of corporate managerial performance by registering preferences which eventually lead to corporate profits. Nonetheless, in the end, labor markets are far from perfect, and it is not uncommon to see senior executives earn staggering compensation despite mediocre or subpar performance.

The great American pastime of litigation reinforces these monitoring mechanisms. Shareholders are equipped with a vast arsenal of legal claims, procedural devices, and legal and equitable remedies to protect their interests. They benefit from a specialized group of lawyers who not only bring direct, derivative, and class action suits under both state and federal law but also identify and communicate the bases for such actions and even finance them.

The rights of other constituencies in a U.S. corporation differ from those of shareholders. Contracts set employee, supplier, creditor, and customer rights. The primary rationale for this treatment is that in bankruptcy, shareholders are last in line after the claims of all the other groups are paid off. This means that when managers act for the shareholders they indirectly protect the interests of all those claimants.

The central finance characteristic of this stock market model is fragmented ownership of equity securities in corporations. An underly­ing cultural aspect of the fragmented ownership structure generates an entrepreneurial spirit which encourages widespread participation in equity of stock investment in terms of both those who demand it (startups and expanding enterprises) and those who supply it (venture capitalists and investors generally).

This ownership structure also rests on a cultural aversion to con­centrations of power. The best examples are the Sherman and Clayton antitrust acts that shut down trusts such as Standard Oil in the climate of Theodore Roosevelt's trust-busting populism. Another is the Glass-Steagall Act, the Depression-era law that segregated the industry of investment banking from that of commercial banking. The repeal of that act in 1999 may reflect a degree of change in U.S. attitudes, though it at least equally likely reflects the globalization of the world economy, in which power is greatly diffused already; the governmental efforts waged against Microsoft under the antitrust laws suggest that such concerns remain prevalent.

Contrast all this with the so-called bank/labor model used to describe Japanese, German, and other Continental European corporate systems. Instead of the shareholder stock market model's fragmentation of ownership, the central finance features of the bank/labor model are ownership concentration and substantial investment intermediation.

Banks act as financial intermediaries by accepting individual deposits and compiling them for investment in corporations. Only a relatively small number of these investing entities exist. This concentration of ownership and debt holdings reduces the pressure for the development of actively functioning, deep, and liquid capital stock markets. Moreover, nothing like the Glass-Steagall Act has prevented the commercial and investment bank unity that mitigates this concentration of investment ownership.

This centralization results in a small and powerful body of share­holders and debt holders whose dual position requires few regulatory governance mechanisms compared to the array of tools used to define the rights of various interests in U.S./U.K. corporations. Because a single bank acts as both primary shareholder and debt holder, there is less pressure to choose between models that favor either shareholders or other constituencies of the corporation.

Also, less need exists for regulating governance mechanisms because of traditions that have put labor at the center of the gover­nance structure rather than as a participant with contractually defined interests. European nations are deeply committed to worker protection, as evidenced by wage-setting policies and laws that make firing workers difficult (in contrast to U.S./U.K. at-will employment). These sorts of forces also explain why the disparity in compensation levels between senior executives and ordinary laborers is relatively narrower under the bank/labor model than it is under the stock market model.

In terms of formal governance, the German and Dutch version of this model formally elevates labor as a third key participant in the leadership of a corporation. These corporations operate with worker councils which management must consult on a variety of matters concerning corporate policy. German corporations generally have a two-tiered board system which consists of a management board and a supervisory board.

The management board (Vorstand) manages the corporation, represents it in third-party dealings, and submits regular reports to the supervisory board. The supervisory board (Aufsichtsrat) appoints and removes the members of the management board and oversees the management of the corporation. Under German law, employee- elected and shareholder-elected representatives are represented on the supervisory board in equal shares. While it cannot make management decisions, the supervisory board may determine that certain actions or business measures contemplated by the management board require its prior approval.

The German dual-board structure is based on the concept of codetermination (Mitbestimmung). According to this view, because labor and capital codetermine a corporation's future, labor should protect its interests from within the corporate governance system through formal representation on the supervisory board rather than through contract or governmental regulation. Banks, which occupy the unique positions of debt holder and shareholder, constitute the other half of the supervisory board. Consequently, the separation of ownership from control, a defining characteristic of the shareholder stock market model, is expressly absent in the bank/labor model.

In the bank/labor model, even sole shareholders may lack the power to remove or replace management. This lack of power is especially pronounced under the two-tiered board structure prevalent in Germany and the Netherlands, in large part as a result of the work council regulations that have been adopted across Europe. The European Union (EU) mandates that all members except the United Kingdom require most of their corporations to establish procedures for employee consultation and worker council formation.

Many Continental European countries have gone beyond the EU mandates to require that virtually all corporations establish and maintain worker councils. Management must consult with these councils on major corporate policies affecting labor interests, including layoff proposals and in many cases potential changes of control. Galvanizing this labor element in the corporate governance model, the EU also requires that employment contracts follow business assets when sold as a going concern so that a buyer of such assets remains subject to those agreements by operation of law.

Compared to the European model, the Japanese variation deepens the roles of both labor and lender banks in the governance struc­ture. As in Europe, banks tend to own the vast bulk of the debt and equity of industrial companies. The distinguishing factual charac­teristic is the Japanese production model that is called horizontal coordination. Workers are generalists when it comes to the production process and engage in a substantial amount of information shar­ing and training throughout production. Limited specialization, however, requires high corporate investment in labor markets to develop the necessary human capital.

Japanese corporations thus face a higher risk of loss on investment from worker defection than do European and American cor­porations. However, workers face the risk of acquiring nontrans- portable, firm-specific skills. Corporations and workers have addressed these risks by developing a system of lifetime employment. This policy provides workers with permanent job security and affords corporations a concomitantly restricted labor market.

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No binding contract guaranteed this mutual security system, and so the Japanese model turned to corporate cross-ownership to provide the necessary structural protections. Industrial corporations in Japan own substantial percentages of the securities of other industrial corporations. The resulting ownership concentration is even more centralized than it is in the European model, and it causes a commensurate dilution of capital stock market disciplining power.