The Regulatory Politics of Corporate Governance Reform and the Foundations of Finance Capitalism

7

Master's thesis

The Regulatory Politics of Corporate Governance Reform and the Foundations of Finance Capitalism

Abstract

During the past decade both the U.S. and Germany have substantially reformed their corporate governance regimes to protect shareholder interests and foster the development of legitimacy of securities markets. Politicians and parties on the center-left in each country took advantage of changing policy preferences within the polity that favored reforms that protected shareholders and curtailed established managerial prerogatives. Policymakers overcame powerful institutional forces of path dependence in ways that have substantially expanded the scope and reach of the regulatory state. Corporate governance reform is central to an emerging paradigm of international finance capitalism, and indicates that new forms of regulatory intervention--not the withering of the state--accompany this form of political economic organization.

1. Introduction

The collapse of the bubble economy of the 1990s in the United States and to a lesser extent in Europe, led to a wave of massive corporate finance scandals in the United States and stock market crashes around the world. The fall of the neo-liberal American economic and corporate governance model from international grace obscures the most important part of the story: a new form of international finance capitalism is emerging and the functioning of highly mobile private investment, securities markets and corporate governance regimes lie at its structural core. Consequently, the politics and institutions of corporate governance loom large in public debate and as a subject of public policy.

The increasing salience and reform of corporate governance reflects the rise of “finance capitalism” as an emerging paradigm of capitalism built on an expanding class of private investors, robust international capital markets, and sophisticated financial services. Although this new form of capitalism has also been referred to as shareholder capitalism, the restructuring of regulation, markets, and industries reflects changes that are far broader than narrow shareholder interests and reflect the growing structural power and influence of financial capital in all its forms. (See Cioffi 2002a, chap. 2) Thus, I use the more general term “finance capitalism.” These features of the economy have begun to take precedence over established institutional arrangements and practices that defined the post-war advanced industrial economies in all their variations. The emergence of finance capitalism, however, present a paradox: the development of financial markets and the increasing prevalence and import of market relations, so often linked to the diminution of state power and authority, have been accompanied by a substantial and ongoing expansion of law and prescriptive regulation governing the structure of and the conduct of parties within these markets and the steady centralization of regulatory authority at the national level. Further, though often neglected in theories of regulation, corporate governance law performs a crucial regulatory function by ordering the authority relationships, decision-making processes, and economic incentives of this most important and ubiquitous economic institution.

This chapter examines corporate governance reform in the United States and Germany during the past decade as an expansion of state capacity and as an indication of how changing social and economic conditions impose new demands on the state and offer state actors opportunities to develop new policies and instruments of state authority and power. To some degree, finance capitalism has begun to inform the public policies and economic structures of all the advanced industrial countries. This financially driven form of capitalism conforms to the long-established neo-liberal institutional structure and policy profile of the United States. Yet the same political push to develop capital markets and the increasing political and economic importance of corporate governance are seen--in more inchoate form--in neo-corporatist political economies such as Germany that have provided a comparative counterpoint to Anglo-American liberalism. This broad emergence of finance capitalism provides a vantage point from which to assess the competing theories of political economic convergence and path dependence that have preoccupied the field of comparative political economy since the early 1990s. Finance capitalism likewise poses difficult and important analytical problems of untangling the influence of economic efficiency in the reform of the foundational institutions of capitalism, more importantly the corporate firm and the markets for finance, and the role of power as channeled through political institutions. This chapter begins to frame and answer this central question.

A comparison of the developmental trajectories of the United States and Germany in the evolution and reform of their national corporate governance regimes, clarifies the common pressures favoring the reform of financial markets and corporate governance across national economies while revealing the political and structural features of the American and German political economies that have propelled them along separate paths of development. On the one hand, we live in an era frequently described as defined by globalization, deregulation, and retrenchment of state power as private actors, interests, and institutions predominate in the organization of the economy. Nowhere is this dynamic more frequently observed or invoked as in relation to the rise of international financial markets and the investors and corporations that utilize them. From this perspective, corporate governance usurps, or privatizes, politics and policy as private interests and institutions predominate in economic decision making and the state retreats under threat of capital flight. Indeed, in some ways the increasing importance of corporate governance as an area of policy and economic practice suggests the devolution of power from the state to the firm and market as the primary mechanisms of economic distribution, innovation, growth, and adjustment. On the other hand, much work in contemporary comparative political economy, particularly that associated with the “varieties of capitalism” literature, maintains that institutional differences among national economies are locked into place by the comparative economic advantages these arrangements confer on domestic firms. Neither description, however, recognizes the intensely political process by which corporate governance regimes are constructed and the state's substantially increased regulatory intervention in the economy that accompanies substantial corporate governance reform.

Political elites in both the United States and Germany have expanded and centralized the regulatory state in the process of reforming corporate governance in order to protect shareholders and the interests of finance capital. These reforms served the interests of political elites by using capital market pressures channeled by corporate governance institutions to constrain managerial autonomy and (arguably) promote corporate restructuring as ways to increase corporate efficiency and improve aggregate economic performance. They reflect the capacity of state actors to take advantage of changing economic conditions and shifts in interest group preferences and public opinion by framing public policy debates and constructing interest group alliances to overcome path dependence. Corporate governance reform belies theories of path dependence and neo-liberal convergence alike. The 1990s witnessed substantial change in institutional arrangements, policy preferences of important political actors, and economic relationships. Substantial reforms have swept through the securities law and regulation, company law, and increasingly in corporate practices and organization. Financial regulators and regulations exist where before there were none. Shareholder rights have developed rapidly in an era in which corporate managers were thought to be gaining power and influence over policy. In both the United States and Germany, regulatory power over corporate finance and governance has become more centralized, hierarchical, and formal as federal law supersedes state law, self-regulation, and unregulated markets. These are not the hallmarks of a stable political economic equilibrium. Nor do these developments herald the wholesale retreat of the state.

In the United States, the ascendance of corporate governance followed the long period of economic crisis during the 1970s and 1980s. American firms lagged behind foreign competitors in international competition. The rise of hostile takeovers, mergers and acquisitions, and financial engineering triggered intense struggles for power within both the public and private spheres by destabilizing established relations among managers, shareholders, and employees. More recently, following the collapse of the stock market in 2000 and of Enron in 2001, massive financial scandals exploding onto the headlines returned corporate governance to a central position in debates over economic policy and the proper role of the state in the economy. In Europe, increased interest of policymakers in corporate governance followed the large-scale privatization of publicly-owned enterprises that began in the 1980s and continued through the 1990s, the sluggish economic growth and innovation of European firms and national economies during the 1990s, and the transformation of financial systems as major financial institutions sought to develop more sophisticated financial services utilizing securities markets. Conditions of economic crisis thus prompted the emergence of corporate governance as a prominent policy area. And these governance policies and reforms constitute an important transformation of the state's role in fostering firm-level adaptation and adjustment to changing economic conditions. The reform corporate governance regimes triggered intense political and economic struggles over power, autonomy, and wealth that were and are ultimately embodied in the structure of legal relations and institutional arrangements. Cioffi 2002c: 2. For a political analysis of the history of the American case in comparative perspective, see Roe 1991, 1993, 1994.

The increasing prominence of the corporate firm and its governance in public policy entails a transformation in the role of the state and regulation in ordering economic relations. In place of state control over finance, public ownership of enterprise, or strong coordinating financial intermediaries, “[t]he use of law and regulation to structure markets and firms . . . is becoming an increasingly important, and perhaps dominant, mode of state intervention in the advanced industrial economies.” (Cioffi 2002c: 2) Corporate governance and its reform exemplify this intertwining of public and private. “The legal mechanisms of corporate governance do not supplant markets; they restructure both markets and the organizational hierarchies of the firm to accomplish policy goals.” (Ibid.)

The rise of corporate governance as a field of law and policy poses the questions of both how the state, through law and regulation, has come to restructure fundamental economic relationships, and why it has done so at this point in time. What drives the political demand for increased regulation of economic activities and institutions modes, and why does this expansion of regulation take the form it does? By examining the process of corporate governance reform in the United States, as the leading neo-liberal political economy, and Germany, as the leading neo-corporatist one, we can begin to see cross-national trends in reform efforts, how the role of the state in the economy has changed, how state actors allocated the costs of policy change and economic adjustment, and the relative trajectories of the German and American corporate governance regimes.

2. The Regulatory State, Public Law, and the Corporate Firm

Corporate governance regimes structure the allocation and exercise of power and decision-making authority among managers, shareholders, and employees-- the principal groups involved in corporate affairs. Cioffi 2002a: 1; cf. Gerke 1998 (quoting Schmidt, 1997). This definition of the term corporate governance goes well beyond the narrow confines of the shareholder-manager (principal-agent) relationship that preoccupies the vast majority of scholarship in law and economics. This broader definition more accurately describes the function of corporate governance and its relationship to the broader political economy. A tripartite legal structure of company (or corporate) law, securities regulation, and labor relations law, defines the juridical relationships among these groups and thus establishes the core of national corporate governance regimes as a central feature of national political economies. Cioffi 2002a: 1-2; 2002c. Although the interests of a wide variety of groups arguably may be encompassed within corporate governance (e.g., creditors, customers, local communities, etc.), comparative analysis and a variety of practical considerations in framing a relatively parsimonious analytical framework indicate that a structural model of corporate governance should be limited to these three stakeholder groups and the bodies of law that define their status within the corporation. (See Cioffi 2002a, chaps. 1 & 2; 2002c) This core structure of corporate governance differs substantially across different types of political economic organization. The cases of the United States and Germany demonstrate this variation. The two countries represent distinctive political economic models defined by neo-liberal and neo-corporatist institutional arrangements, respectively. For a classic expression of this typology of political economic types in the study of national financial systems, see Zysman, 1983. An updated analysis of national corporate governance regimes from this typological perspective is presented in Cioffi, 2000 and Cioffi and Cohen, 1999. These divergent political economies deployed very different national corporate governance regimes that configured of the corporate firm and power relations within it is very different ways. In each case, characteristic institutional structures and power relations are replicated at multiple levels of the state, market, and corporate firm. (See Tables 1 and 2 for the basic features of the post-war American and German governance models) Although numerous informal practices are associated with national corporate governance regimes, ranging from managerial compensation to the participation of employees in firm decision-making and implementation, this practices developed within and have been perpetuated by the formal legal and institutional structures of corporate governance. And these formal arrangements are the product of political forces.

The American economy has experienced waves of wrenching crisis and restructuring during the past twenty-five years. The Fordist model of mass production was based on large integrated and oligopolistic industrial firms, managerial autonomy from shareholders, long-planning horizons, stable sources of capital, and predictable product cycles in predictably expanding markets. This form of economic and corporate organization entered a prolonged period of crisis following the oil shocks and stagflation of the 1970s. Deindustrialization, erosion of domestic and export market shares, and the collapse of organized labor represented the collapse of the post-war economic order. In its place, the wave of hostile takeovers, mergers, and acquisitions during the 1980s signaled the arrival of a new, volatile, and financially driven form of economic organization that persisted and began to diffuse across many industrialized countries in the 1990s. Securities markets became more than simply another form of finance, they--or rather the financial, legal, and other professional intermediaries involved in financial transactions--became the drivers of corporate and thus economic restructuring. The United States certainly had a head start in the development of this new paradigm of finance capitalism. Its securities markets were already the most developed and it had among highest rates of stock market capitalization and publicly listed firms in the world. Underlying this economic and financial structure was a well-developed legal and regulatory structure dating back to the New Deal that favored this reliance on markets. The legal and regulatory foundation of American finance capitalism was political in origin, as was its evolution during the past decade.

In Germany, a bank-centered financial system, strong labor unions and codetermination, networks of corporate cross-ownership and interlocking directorates, and consensual neo-corporatist policymaking stabilized economic relations and facilitated long-term skill acquisition, productivity growth, and innovation in production. These institutional arrangements allowed the German industrial economy to weather the crises of the post-1973 era better than its American counterpart. Throughout the 1970s and the 1980s, German firms maintained their comparative advantage in manufacturing by targeting high value-added products and market niches that could finance high wage and highly skilled labor. By the late 1980s, however, the German economy had begun to deteriorate in terms of unemployment, economic growth rates, and technological innovation. These macro-economic problems intensified throughout the 1990s following the reunification of East and West Germany as growth stagnated and unemployment surged to sustained levels of over 9%. This economic malaise fed the perception that Germany was no longer sufficiently economically innovative and dynamic, but that neo-corporatist institutional arrangements within national politics, finance, and the corporate firm now were blocking necessary adjustment and restructuring. Corporate governance reform in Germany is part of a broader and ongoing struggle over the future of these institutional structures. Before delving into the politics of reform, however, a brief sketch of the American and German financial and corporate governance regimes is needed.

2.1 The United States

The structure of American corporate governance encouraged reliance on rapidly shifting arm's length economic relationships over longer-term relational ties among management, capital, and labor. American law tends to preserve an expansive sphere of private organizational and managerial autonomy bounded by a highly developed regulatory framework and formal legal rights. American governance law and economic regulation maintained a relatively hands-off approach to the internal affairs of the corporation in American law and historically allowed managers great latitude in the private structuring of intra-corporate institutions and relationships. The absence of institutionalized representation of and negotiation among countervailing interest groups within the firm concentrates and centralizes of power in the hands of the CEO and other senior managers.

American corporate law is distinctive in that it has been the responsibility of state, not federal, law. State company laws function as general enabling statutes that create the bare minima of the corporate form-- limited liability, the “corporate personality” (the capacity to enter into contracts and to sue and be sued), a board of directors, and basic fiduciary duties and shareholder rights. Otherwise, corporate law gives managers and directors wide discretion in how to structure the firm, its finances, and decision-making processes and gives shareholders comparatively few rights to vote on important corporate decisions. In fact, American proxy rules give management control over shareholder proxy votes. (See, e.g., Kubler, 1987: 215) In theory, the fiduciary duties of corporate directors and officers partially counterbalanced the resulting weakness of shareholders in corporate governance. These legal duties obligate them to run the corporation for the benefit of the shareholders in a loyal and reasonably attentive and competent fashion. Fiduciary duties in American corporate law are an enormously complex subject far beyond the scope of this chapter. For a leading treatise on the subject, see Block, Barton, and Radin, 1994. For an incisive overview and provocative theory of fiduciary duty law, see Allen, 1998. In practice, however, the “business judgment rule” substantially dilutes fiduciary duties by exempting from liability those decisions taken in good faith in the ordinary course of business. Still, American law endows shareholders with unusually well developed substantive and procedural rights that has made the American regime highly litigious and has made the courts and attorneys important actors in corporate governance. Shareholders may enforce these rights through private lawsuits brought under a set of favorable procedural rules, including derivative suits, class actions, and contingency fee retainers. However, the business judgment rule reveals the structural inadequacy of fiduciary duties as a mechanism of governance. The potential liabilities of corporate fiduciaries are so enormous that no rational individual would agree to act as a director if not granted a very broad safe harbor from personal liability. Likewise, in the absence of a business judgment rule, insurers would refuse to write “directors' and officers'” insurance policies at acceptable rates.

American federalism's long-standing allocation of corporate lawmaking to the states and this concentration of power in corporate management increased the incentive for federal policymakers to use market-reinforcing securities market regulation as a principal means of constraining managers and protecting shareholders from fraud, misappropriation, and abuse. Accordingly, with the rise of the modern regulatory state in the 1930s, the American governance regime pioneered modern securities regulation and came to rely on the Securities and Exchange Commission--a strong centralized regulatory agency--to relieve information asymmetries and to improve the efficient functioning of securities markets. In short, the SEC's mission was to make the markets work--and it did so by using regulation to redress informational asymmetries that plague securities markets. The SEC was charged with drafting and enforcing elaborate and mandatory registration, disclosure, and securities fraud rules, and with overseeing the administration of stock exchanges (and their listing and disclosure rules). As a result of this institutionalization of securities regulation, the United States possesses comparatively strong transparency, disclosure, and insider trading laws and regulations designed to protect minority shareholders, facilitate market transactions, and buttress the perceived legitimacy of the country's securities markets. Within this regulatory framework, the "external" capital markets in the United States became among the most developed and liquid in the world with a high proportion of publicly traded firms, a sophisticated financial services industry, and an extraordinary range of debt and equity financing options.

Both the emphasis on transparency and disclosure regulation and weak institutional position of shareholders within the legal structure of the American corporation encouraged individual and institutional investors to respond to governance and management problems through exit by selling their stakes rather than participate more actively through voice in firm governance. See, e.g., Roe, 1991; Coffee, 1991. For the classic analysis of the use of exit and voice in governance relationships, see Hirschman, 1970. There arose a mutually reinforcing relationship between the market-driven American financial system and a legalistic, transparency-based regulatory regime. The weakening of shareholders within firm-level structures of corporate governance through ownership fragmentation increased the importance of and reliance on prescriptive disclosure regulation to protect shareholder interests. This corporate governance and regulatory model formed an important underpinning of the Fordist model of production and the managerialism that defined American capitalism after the Second World War. When this disclosure and transparency regulation failed during the bubble market of the late 1990s, so did the broader system of corporate governance and finance.

Managerial dominance over corporate affairs subordinated both finance capital and labor. While American corporate governance law weakened shareholders within firm governance, it wholly excluded employees. No representational structures exist in American law at the state or federal levels to incorporate employees into firm decision making or provide for ongoing consultation processes, such as that provided by board representation or works council structures in Germany (see infra). In fact, labor law, as interpreted by the National Labor Relations Board and the federal courts, impedes the formation of alternative forms of employee representation under a broad prohibition of company unions that protects employee organization at the expense of organizational experimentation. These restrictions have led the NLRB and courts to hold that workplace committees dealing with safety and productivity issues are illegal. See Electromation, Inc., 309 N.L.R.B. 990 (1992), enforced sub nom, Electromation, Inc. v. NLRB, 35 F.3d 1148 (7th Cir. 1994); E.I. du Pont de Nemours & Co., 311 N.L.R.B. 893 (1993); see also Estreicher, 1994; Hyde, 1993; Summers, 1993. These rulings reinforced the sharp distinction between the spheres of state corporate law and federal labor law. American labor law strictly separates labor relations and firm management. In short, labor law protects managerial prerogatives from encroachment by collective bargaining or other forms of union power. American labor law maintains this strict separation by limiting “mandatory subjects” of collective bargaining to a highly circumscribed range of “bread and butter” issues concerning the terms and conditions of employment. NLRB v. Borg-Warner Corp., 356 U.S. 342 (1958); Fibreboard Paper Prods. Corp. v. NLRB, 379 U.S. 203 (1964); see also First National Maintenance Corp. v. NLRB, 452 U.S. 666 (1981). Matters such as investment, marketing and production strategy, design and production plans, and financial strategies are considered within the “core of entrepreneurial control” and not subject to collectively bargaining, Fibreboard Paper Prods. Corp. v. NLRB, 379 U.S. 203, 223 (1964) (Stewart, J., concurring); see also Ford Motor Co. v. NLRB, 441 U.S. 488, 498 (1979) (quoting Fibreboard). although these issues may have decisive importance for the future of the workforce.

Together, the combination of corporate law managerialism, strong transparency and disclosure regulation under securities law, and labor marginalized through comparatively weak labor laws constitute the basic structural features of the American corporate governance regime. The American corporate governance regime also relied to a striking extent on the substantial use of highly formal and prescriptive regulation and formal litigious enforcement mechanisms. These legal-institutional arrangements encourage risk taking, organizational restructuring, and technological innovation, but at the cost of chronic “short-termism” that often elevates financial speculation and quick returns over long-term maintenance and growth of production and productivity. The American corporate governance regime reinforces both the comparative strengths of the American economy in terms of sophisticated financial services, high tech, and rapid corporate adjustment and reallocation of capital, and its systemic weaknesses: lagging competitiveness in production and manufacturing, a consistent failure to capitalize on technological innovations, and a combination of high levels of economic insecurity and inequality. As the varieties of capitalism literature accurately argues, these attributes are hallmarks of the liberal market economic model. Yet this legal framework pits managerialism against “shareholder primacy” (the principal that the maximization of shareholder value over any other stakeholder interests justifies managerial decisions) as the fundamental tension in corporate governance. During the 1980s and 1990s this tension would break out into increasingly bitter political conflict.

2.2 Germany

The post-war German political economy and corporate governance regime stands in sharp contrast to the neo-liberal American model. The German governance regime relied on law and regulation to structure the firm as a largely self-regulating entity situated within a consensus-based social market economy with its neo-corporatist interest representation, centralized wage bargaining, and networks of relational finance and corporate ownership. It led in the development of a stakeholder model of governance that incorporates and protects the interests of non-shareholder constituencies, particularly labor, within the corporation. For an early and classic article comparing the German and American corporate governance regimes and their legal and political histories, see Vagts, 1966. For more recent comparative treatments, see, e.g., O'Sullivan, 2000; Roe, 1994, 1993b; Charkham, 1994. Like the United States, Germany is often described as highly legalistic country. However, German legalism more frequently uses law to fashion representational structures and institutional frameworks that channel opposing interests into negotiation rather than formal enforcement processes. The German political economy, in contrast to the United States, makes substantial use of centralized interest group representation in the formulation of policy. This ordering of opposing interests into long-term bargaining relationships replicated on the level of the firm and workplace through the distinctive institutionalization of German finance and labor codetermination.

The framework of German securities and company law corporate governance was the mirror image of the American structure. The American corporate governance regime was defined by centralized federal securities regulation and the dispersion of corporate law among the states. In Germany, a uniform federal company law and the fragmentation of securities regulation among the Lander (states) and local self-regulating exchanges defined the legal framework of German corporate governance until the mid-1990s. Disclosure regulations, and accounting rules remained weak and company finances opaque. Moreover, the law provided few effective avenues for private litigation to enforce shareholder rights.

In place of American-style transparency regulation, Germany's corporate governance regime long relied on mandatory rules to structure the corporation and its governance processes and on the power of large banks to monitor managers. Germany's bank-centered financial system defined a set of stable, interlocking ownership and governance relationships based on concentrated ownership, extensive cross-shareholding networks, and long-term relational finance ties between banks and corporate borrowers. These financial structures reinforced the stakeholder model. Relational finance by banks ameliorated pressures for maximizing short-term financial returns and encouraged the adoption of long-term adjustment and growth strategies by industrial enterprises that could balance the competing demands of capital and labor. The major banks' central role in securities underwriting, brokerage, and trading gave them significant power in corporate affairs. Large German “universal banks” combined the lending and securities services at the core of financial system. Consequently, these banks were simultaneously important lenders to and major shareholders in publicly traded firms. Further, under German law, the banks may vote "deposited share voting rights" (“DSVRs”) if authorized by their brokerage clients. Thus, in addition to their own equity holdings, the banks wield disproportionate voting strength and substantial leverage when it comes to board nominations or influencing key strategic decisions. Charkham, 1994: 37-38; Vagts, 1966: 53-58. Even where German management attempts to maintain autonomy by diversifying sources of bank debt, Deeg, 1992: p. 208, banks have adopted a practice of designating a "lead bank" to monitor the corporation, vote their aggregate DSVRs, and maintain supervisory board representation. Vitols, 1995: p. 6. Bank representation on the supervisory board frequently cemented the combination of voting power with long-term relational lender and shareholding relationships. The corporate structure organized stakeholder interests into self-regulating relationships within firm governance. In theory, the banks' status as shareholders aligned their interests with those of other shareholders; and the banks' power within firm governance presumably protected these other investors. In fact, banks did not play the active monitoring role assumed by conventional wisdom and the contradictory status of the banks as lenders first and shareholders second generated conflicts of interest that law and regulation did not police or remedy. In the absence of strong shareholder protection or strong incentives for major banks to cultivate equity finance, relatively few German firms were publicly traded, equity was not an important form of finance, and securities markets remained far less developed than in the United States.

Under German company law, public corporations (Aktiengesselschaft or “AG”) have a dual board structure in which the supervisory board (analogous to the American board of directors) is completely separate from the management board (a more collegial version of the CEO and senior management of the American firm) with no overlapping membership between them. The supervisory board (“Aufsichtsrat”) appoints and supervises the managing board (“Vorstand”) and formulates (or at least approves) major corporate policies and strategies. German company law also gives the shareholders' meeting (Annual General Meeting, or AGM) the right to receive relevant information and vote on a broad range of issues, including mergers, major acquisitions, capital increases, and major changes in business strategies. Shareholders may bring a private action to nullify any corporate decision taken in violation of their informational and procedural rights. Because these decisions often concern important and time-sensitive strategic issues, managers usually seek to settle these suits quickly. Thus, German company law created a disclosure and transparency regime outside of securities regulation--though it functions only when an AGM is held, not continuously as under securities law. This litigation has also created all the problems allegedly excessive litigation and frivolous lawsuits that dodge the far more litigation prone American governance regime and legal system. In the absence of stringent securities regulation designed to improve the efficiency and disciplinary function of stock markets, German company law relied on the internal corporate institutions, the board and AGM, to constrain managerial power. However, these institutional constraints were not designed to protect shareholders alone, as in the United States, but also to safeguard the interests of creditor banks and employees as important stakeholders of the firm.

Codetermination, the incorporation of employees into the firm's governance processes, embodies the stakeholder vision of the corporation as an institutional and organizational entity. For discussions, see Katzenstein, 1987: Chap. 3; Wiedemann, 1980. Company and labor relations law interpenetrate under codetermination to create “microcorporatist” Cf. Assmann, 1990; Streeck, 1984 (use of the term “microcorporatism” in relation to firm structure and organization). structures that facilitate negotiation, compromise, cooperation, and consensus within firm governance. Supervisory board codetermination under the Codetermination Act of 1976, perhaps the most striking feature of German company law, requires most corporations with over 2,000 employees appoint equal number of shareholder and employee representatives to their supervisory boards. Wiedemann, 1980: 79. Firms with 500 to 2,000 employees must set aside only one-third of the board seats for employee representatives. Wiedemann, 1980: 80. “Montan” codetermination, the third (and original) variant, only applies to firms in the coal, mining, and steel sectors employing more than 1,000 workers, provides for full parity of shareholder and employee representation. The decline of the mining and steel sectors in Germany has reduced the importance of Montan codetermination. However, the chairman of the supervisory board is elected by the shareholders and wields a second tie-breaking vote. (Wiedemann, 1980: 79; Charkham, 1994: 26) Thus, the structure of the board preserves shareholder formal (or managerial) dominance, but alters the bargaining dynamics on the board by allowing managers to ally with employee representatives to resist shareholder pressures for higher returns. It does so, however, at the expense of well-defined fiduciary duties. Fiduciary duties under German company law protect the corporation's interests, rather than the interests of shareholders alone. Codetermination institutionalizes the recognition of the “interests of the corporation” as the interests of multiple stakeholder groups, including labor. Board codetermination has become enormously important as a symbol of the country's neo-corporatist and social democratic consensus-driven “social market economy.” Works council codetermination provides a second and more important form employee representation in firm governance. The product of the center-right Adenauer government's 1952 attempt to break the unions' monopoly over representation of employees, works councils wield substantial influence within the workplace, and often over entire corporate groups, through their ability to use informational, consultation, and codetermination or codecision rights to substantially impede the implementation of managerial decisions and through their authority to demand compensation for economic injury caused by changes in corporate policy. Wiedemann, 1980: 80-82. The Works Constitution Act of 1972 provides for the election of works councils in facilities or plants of business organizations with five or more permanent employees. Wiedemann, 1980: 80. However, many large firms voluntarily instituted enterprise (or Konzern) works councils covering an entire corporate group to ensure stable and cooperative labor relations. For general discussions of the political origins and impact of codetermination, see, e.g., Vagts, 1966: 64-78; Streeck, 1984; Katzenstein, 1987: Chapter 3; Muller-Jentsch, 1995. For the role of works councils in German labor relations, see Thelen, 1991; cf. Turner, 1991.

This stakeholder system both legitimated the post-war capitalist order and conferred the comparative advantages of incremental innovations in industrial production that enabled German industry to focus on high quality and high value-added market niches that rationalized high wages and investment in skill formation. But these benefits came at an increasingly steep price during the 1990s, as export markets became increasingly unstable, international competition became fiercer, bank profits declined as the domestic market for corporate finance became increasingly saturated, and German reunification required more rapid and thoroughgoing restructuring of the country's corporate economy. By the early 1990s, these pressures and declining national economic performance made the need for structural reform ever more obvious. German politicians then faced the twin problems of what form the reforms should take and whether Germany's well-developed structure of interest representation would block them.

3. Politics and Policy Reform

Corporate governance reform reflects systemic crises in both the American and German political economies and their approaches to economic policy. Declining national economic performance, the internationalization of financial markets, and fiercer competition within the financial sector spurred the pursuit of higher returns to capital by investors and financial institutions while policymakers sought ways to encourage corporate restructuring through market pressures. These changes increased the political and economic leverage of investors, investment banks, and institutional investors in the United States and of universal banks in Germany. Recurrent corporate financial scandals in each country also mobilized popular support for the reform of the corrupt insider-dominated dealings of corporate and financial elites--even as these elites shaped and benefited from the reforms of the past decade. (Cf. Moran, 1991)

However, financial scandals do not occur in a legal, institutional, or political vacuum and they alone do not produce far-reaching reforms. Scandal and economic crisis spread within a legal and institutional context that only trigger the political dynamics of reform. Crises and conflicts merely provide the necessary preconditions for substantial change in policy and institutional structures. Politics drives the reform process itself and predominates over market forces and economic logic. Crises, whether of economic performance or legitimacy, alter the balance of political power by strengthening and weakening interest groups, parties, and policy positions. Entrepreneurial politicians and political parties are presented with strategic opportunities to mobilize and cultivate supporters, alter interest group alignments, and take up issues that improve their prospects in electoral competition.

Significantly, the political proponents of reform in both the United States and Germany came from the center-left--the Democratic Party in the United States and the Social Democratic and Green Parties in Germany. The more conservative Republicans in the United States and the Christian Democrats (the CDU-CSU) in Germany were generally far more resistant to pro-shareholder reforms. The prospect of the political left advancing the cause of shareholders and finance capital appears counterintuitive. However, the politics of corporate governance indicates the power of finance capital and capital markets to destabilize and threaten the interests, power, and positions of established managerial elites represented by center-right parties and opened strategic political avenues to center-left parties.

First, under the pressures of economic crisis and an eroding working class base, center-left policymakers came to embrace corporate governance reform as a means of appealing to voters resentful of economic elites while claiming the banner of reform and economic modernization. The Democratic Party in the United States used the post-bubble scandals and the collapse of share prices to attack the Republican Party's most conservative and pro-manager leadership since the 1920s and as a well-placed appeal to middle class voters (with significant savings invested in stocks) who believed in free but fair markets. The German SPD government's corporate governance reforms satisfied left wing and populist constituencies by targeting managerial and (to some extent) banking elites and formed part of a strategy to lure political and electoral support from the middle class and financial sector by promoting policies that would encourage efficiency in capital allocation, higher rates of growth and innovation, and economic restructuring. Governance reform also has the advantage of blame avoidance with respect to the inevitable economic pain inflicted of workers in the process of corporate restructuring. The state would not be directly responsible--market forces would. Further, the SPD has been careful to leave much of the welfare state intact to cushion the impact of restructuring to shore up support of its base constituencies and to insulate itself from criticism over the results of pro-finance and pro-shareholder policies.

Second, in each case, scandal and crisis weakened opponents of reform. In the United States, managers, accounting firms, corporate attorneys, and anti-regulation conservative (of both parties) were almost completely sidelined from active political participation during policy debates over governance reform at the peak of the post-bubble scandals. German managers, and to some extent labor, reached a low point of their legitimacy in economic governance as stagnation and high unemployment wore on through the late 1990s. Bankers were already seeking a more market driven financial model and therefore largely (if quietly) supported the reforms and offered little resistance.

Third, in both the United States and Germany, governance reform fit surprisingly well within the contours of the center-left ideology. The Democratic Party and the SPD have both been committed to the development of the regulatory state as a counterweight to managerial power, concentrated corporate power, and market distortions. Both parties had a practical and ideological interest in shoring up the perceived fairness and equity of markets that absorbed increasing shares of working and middle class pension and retirement savings. Governance and securities law reform thus appealed to both the egalitarian and welfare state components of center-left ideology and policy agendas. This is a highly simplified sketch of complex inter-party and intra-party dynamics in both countries. Yet the general point is valid. Corporate governance reform is largely a project of the political left--not the ostensibly pro-business or neo-liberal right.

These reforms do not fit into simple theories of convergence or path dependence. Although the resultant institutional developments display some important convergent tendencies, they also reveal substantial differences in structural and policy outcomes. In part, these reform trends indicate convergence on the American SEC transparency and disclosure model of securities regulation. (See Cioffi 2002c) More broadly, the current reform of corporate governance regimes reflects the ascendance of a new paradigm of finance capitalism defined by increasingly market-driven national and international financial systems. Because financial markets and financially driven firm strategies tend to produce spectacular market and governance failures--much in evidence in recent years, but not by any means a new historical phenomenon--finance capitalism requires a bulwark of strong legal rules and an institutional foundation of active regulatory authorities. Yet this broad rubric of finance capitalism does not erase national differences in institutional structures and economic practices, just as the broad contours of Fordist mass production admitted numerous institutional and regulatory variants during the post-war era.

3.1 The United States

The American governance regime contained a set of structural flaws that would together produce the systemic corporate governance crisis that peaked in 2000-2002. This crisis continues to spread, most recently to the New York Stock Exchange and the mutual fund industry. Two central components of the American financial system are now ripe for substantially increased regulation displacing and self-regulatory model that has governed both for decades. First, the transparency-based system of American securities regulation was weakened by the largely self-regulating character of the accounting industry (the intermediaries responsible for external corporate audits) that had long since come to treat auditing as a loss leader to sell more lucrative consulting services. The weaknesses of accounting and auditing as mechanisms of transparency were compounded by highly detailed, prescriptive, but loophole-riddled accounting rules (Generally Agreed Accounting Principles, or “US GAAP”) drafted by the Financial Accounting Standards Board (“FASB”), a private body comprised of accounting industry representatives. Second, American law virtually ensures management domination of the board of directors. State corporate law and federal proxy voting regulations together give managers almost complete control over the nomination and election of the directors who nominally monitor and oversee the firm's management. Within the single board structure of the American corporation, the CEO typically doubled as chairman of a board dominated by insider-managers. Consequently, CEOs and senior managers largely dominated the very governance institutions and processes that were supposed to render them accountable to shareholders. Third, institutional investors were not willing or able to fulfill the active governance monitoring role that many commentators, corporate governance activists, policymakers, and academic theorists envisioned for them--nor were many of them willing to become more active in corporate governance. Federal law had long segmented the financial services industry and mandated portfolio diversification that precluded the use of concentrated equity ownership as a means of checking the power of management.The Glass-Steagall Act severed investment banking from commercial banking and traditional lending; the Investment Company Act of 1940 and the Employee Retirement Income Security Act of 1974 placed limits on the size of the stakes investment firms and funds could hold as a percentage of their own capital and of outstanding corporate equity. Under these market conditions, shareholders cannot solve the collective action problem of coordinating and defraying the costs of monitoring efforts. See generally See Roe, 1998, 1994, 1993b, 1991, 1990. These rules inadvertently strengthened managers by mandating fragmented ownership structures. In contrast, rules that mandate institutional structures within the firm deliberately modify power relations by design. Federal regulation did not substantially depart from the voluntarist involvement in corporate governance advocated by even the most activist institutional investment funds and thus did not solve the fundamental collective action problems of monitoring by fragmented institutional shareholders.