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

These structural flaws were well known to commentators and policy makers prior to 2000 and some earnest attempts to address them failed politically. The post-bubble financial and governance scandals, beginning with the collapse of Enron and spreading to numerous other firms, Wall Street investment banks, and now to the New York Stock Exchange and the mutual fund industry, were the predictable result of these structural flaws and institutional weaknesses. Law and regulation left critical portions of the American corporate governance regime poorly regulated and subject to pervasive and substantial conflicts of interest among managers, boards, accountants, and financial institutions.

The failure to address these brewing problems politics grew out of a combination of fragmented governmental institutions imposing multiple veto points on policymaking, political polarization between the parties, and the influence of interest groups hostile to reform. At the same time, protection of shareholder interests remained the chief preoccupation of the SEC during the Clinton Administration and was backed by investment funds as well as public opinion. As a result, American corporate governance reform during the 1990s swerved between efforts to protect managerial interests and measures increasing shareholder protections. A Congress closely divided between Democrats and Republicans, established structures of federalism, and fragmented pluralist politics produced vacillation in public policy and would continue to discourage programmatic policy reform based on enduring interest group alignments and alliances. This political context precluded major systemic corporate governance reforms during the 1980s and 1990s even as problems of balance sheet manipulation, excessive CEO pay, excessive speculation and inflated stock prices, and inefficient and value-destroying merger and acquisition activity were clear to observers willing to see them.

The American corporate governance regime entered the 1990s still reeling from the legal and political upheaval caused by the hostile takeover wave of the 1980s. Managers had mobilized an ad hoc cross-class coalition with organized labor and grass-roots community groups to fight takeovers and effectively used the courts and state legislatures to erect a wide variety of anti-takeover defenses, ranging from judicially sanctioned “poison pill” defenses to a wide variety of anti-takeover statutes. Together, by the early 1990s, these legal changes had largely eliminated the market for corporate control There continued to be an extraordinarily vibrant market for companies--which reached its apogee during the 1990s boom and stock market bubble. However, the overwhelming majorities of mergers and acquisitions during the 1990s were friendly deals that often richly rewarded senior managers. (See, e.g., Cioffi 2002a, chap. 4) and effectively protected incumbent managers from hostile takeovers. The monumental legal and political battles over hostile takeovers gave way to a series of skirmishes over the proper limits of managerial power and how those limits should be imposed.

These conflicts pitted managerialist anti-regulation business groups, accountants, corporate lawyers, and anti-regulation politicians against pro-shareholder groups, pension funds, unions, regulators, and politicians more favorably disposed towards regulation. The SEC was caught between the opposing forces of managerial and pro-shareholder forces during the 1990s. As a consequence, the SEC suffered a series of political defeats in its attempts to protect shareholder interests. It failed in its efforts to address growing conflicts of interests in the accounting industry. Fearing (correctly as it turned out) that accounting firms acting simultaneously as consultants and auditors would compromise the integrity of their auditing in order to generate and keep lucrative consulting contracts, SEC Chairman Arthur Levitt, a Clinton appointee, wanted to prohibit accounting firms from doing both auditing and consulting work for corporations. Accounting firms enlisted allies in Congress to fight on their behalf and bring legislative pressure on the SEC until the regulatory proposal was withdrawn. The regulation of accounting firms and their conflicts of interest became an especially important issue following a 1994 Supreme Court decision that largely abolished “aiding and abetting” liability under which accounting and law firms could be held liable for fraudulent statements and omissions by publicly traded corporate clients. Central Bank of Denver v. First Interstate Bank of Denver, 114 S.Ct. 1439 (1994). Without the threat of private litigation, SEC regulation was the only enforcement option remaining. Tort reform legislation in 1995 authorized aiding and abetting suits brought by the SEC, but not by private plaintiffs. Likewise, the SEC under Levitt failed in its attempt to require the expensing of stock options in corporate financial statements. In this case “new economy” technology firms dependent on options enlisted bipartisan congressional and executive branch support to quash to initiative.

The pro-shareholder forces were also split among themselves between those favoring expanded disclosure regulation and those seeking to encourage monitoring of management and corporate governance activism by institutional investors. The peculiar vacillations of SEC policy during the 1990s reflected this political and ideological conflict. From 1992 to 2000, the SEC under Levitt initiated a series of reforms to protect shareholders by improving managerial accountability and financial transparency that indicated this conflict over the means of regulation--with mixed political and practical success. In 1992, the SEC amended its proxy rules to encourage corporate governance activism by large institutional investors by making it easier to communicate with each other and with management. The 1992 proxy rule changes appear to have encouraged greater governance activism by institutional investors, but at the expense of transparency in governance. Institutional investors, with some notable exceptions, preferred to voice their concerns and criticisms to management in private communications that would not become public. These communications thus became occasions for managers to disclose significant information to the representative of institutional investors and analysts associated with investment banks and brokerages. In August 2000, the SEC shifted direction with the adoption of Regulation “Fair Disclosure” (“Regulation FD”). Regulation FD prohibited selective disclosure of material information by corporate managers to favored analysts, financial institutions, and institutional investors that is not released to the general public. Another noteworthy feature of Regulation FD is that it expressly failed to create a private cause of action for its enforcement by shareholders. The 1992 proxy rule reforms are structural regulations that were undermined by the prescriptive (or prohibitive) rule of Regulation FD, while Regulation FD is a prescriptive rule without the established effective enforcement mechanism of private litigation. While addressing the problem of informational asymmetries that disadvantage small investors vis-a-vis large institutions, Regulation FD limited the ability of institutional investors to pursue corporate governance activism through their favored approach of private communications with managers and board members. Transparency regulation and institutional activism have always been in tension. The 1992 proxy rule amendments presumed that more intensive communications between institutional investors and managers would benefit all shareholders. By the end of 2000, these two dominant paradigms of corporate governance regulation and reform had collided on the levels of politics, law, and investor relations. This regulatory change ran contrary to both the pro-management stance of congressional Republicans and the SEC's own 1992 proxy reforms.

Moreover, in 1995 and 1998, congressional Republicans--strengthened by the 1994 mid-term elections--spearheaded “tort reform” legislation designed to reduce the incidence of securities litigation. See Private Securities Litigation Reform Act of 1995 (“PSLRA”), Public Law: 104-67 (December 22, 1995), amending Title I of the Securities Act of 1933, 15 U.S.C. 77a et seq. Pub. L. No. 104-67, 109 Stat. 737 (1995) (passed over President Clinton's veto, the PSLRA raised the pleading requirements and authorized the appointment of a “lead plaintiff” in securities fraud suits to curb the power of plaintiffs' attorneys to bring frivolous and allegedly extortionate class actions). Securities litigation reform served a dual political purpose. It strengthened the position of managers, a predominantly Republican constituency, while attacking the financial base of a plaintiffs' bar that overwhelmingly supported Democrats. These tort reform measures contained a grave deficiency: they provided for no alternative mechanisms to protect shareholders from fraud and financial abuses. The laws also had the unintended effect of centralizing corporate governance reform in federal hands. The 1998 law went so far as to preempt state securities fraud laws in order to impose a uniform set of more restrictive federal rules on the filing of securities suits. See Securities Law Uniform Standards Act of 1998 (“SLUSA”), Pub. L. No. 105-353, 112 Stat. 3227 (codified as interspersed subsections of 15 U.S.C. §§ 77-78). At a time when federalism formed a core part of the Republican Party platform, Republicans--with some Democratic allies--pushed through the SLUSA's preemption provisions, which dramatically limited state authority and increased centralized federal control over securities regulation. This legislation had the strong support of some core Republican constituencies, such as corporate executives, the corporate bar, and financial services firms, and belies the notion that the economic conservatives in the United States are ideologically wed to deregulation, devolution, and decentralization of government authority. Unwittingly, the efforts of Congressional conservatives to strengthen managers set the stage for a far-reaching reform and expansion of corporate governance and financial market regulation at the federal level.

The bursting of the stock market bubble and the collapse of the American equities markets in 2000 and the post-bubble corporate finance scandals of 2001-2002 unveiled the vast corruption and fraud that accompanied the economic and investment boom of the late-1990s. The massive corporate finance scandals at Enron, WorldCom, Global Crossing, Adelphia, and other major corporations, along with the loss of over $7 trillion in stock market valuation, stoked popular resentment of corporate and financial elites. Scandal and the perception of systemic crisis and dysfunction inflamed political support for more wide-ranging reform of the American corporate governance regime.

The most severe crisis (at least one of legitimacy) afflicting the American corporate governance and financial system since the Great Depression faced its disrupted the grip of a conservative coalition that had favored minimal regulation and blocked reform through the 1990s. The extraordinary scope, severity, and duration of these financial scandals allowed Democrats in Congress to mobilize support among the public and key interest groups for substantial corporate governance reform while it undermined the legitimacy of managerial and professional elites and their political allies who opposed it. Under these conditions, the Democratic leadership in the Senate, where the party held a short-lived majority prior to the 2002 midterm elections, overcame conservatives in their own party, the opposition of congressional Republicans, the Bush Administration, powerful vested managerial and accounting industry interests, and SEC Chairman Harvey Pitt (who's tenure did not survive the confrontation). Democrats in Congress outflanked and overrode the resistance to pro-shareholder reforms mounted by congressional Republicans and the White House, corporate managers, and accountants. Senate Democrats, although opposed by a Republican-controlled House and presidency, pushed through the most comprehensive corporate governance reform in the United States since the 1930s with the passage of the Sarbanes-Oxley Act of 2002. Though named for both Democratic Senator Paul Sarbanes and Republican Representative Michael Oxley, Sarbanes was the law's chief architect and proponent. Oxley was the chief opponent of reform in the House and only signed onto the Sarbanes bill once it became clear that such opposition by Republicans was beginning to damage the GOP's public support as the corporate scandals continued to spread. Anonymous Interview, March 2003, Washington, DC.

The law was the product of a political struggle between Democrats using financial scandals against the Republicans, and Republicans seeking to dilute the legislation in keeping with their loyalty to corporate supporters and their anti-regulation policy agenda. Interest group politics were even more fractious. Corporate managers remained peripheral to the legislative process as result of their loss of prestige and influence in the wake of successive corporate scandals and the popular perception that they, as a class, had looted American corporations and their shareholders that comprised over 50% of American households. The only issue managers fought fiercely was, perhaps revealingly but not surprisingly, the regulation and more stringent accounting treatment of stock options--the mechanism that was supposed to align the interests of managers and shareholders, but which became the most effective meaning of managerial rent-seeking and looting of the corporation ever devised. The development of securities markets, mass shareholding, and the growth and diversity of investment funds in the United States meant that financial interests were divided in their interests and preferences concerning the proper extent of corporate governance reform and government regulation of business and markets. Accounting firms, having perhaps the most to answer for and the most to lose, fought strenuously against the Sarbanes-Oxley reforms--even at the risk of further antagonizing public opinion--but were in no position to stem the tide of popular opinion and political pressures for reform. Financial institutions, such as investment banks, were split over the reforms. They are dependent on public faith in the integrity of the securities markets, but are also privileged insiders that benefited from the status quo and stood to lose from reform. Financial institutions and service providers were also weakened in the political process by their role in numerous scandals of their own--in addition to aiding and abetting dishonest corporate executives.

Institutional investors were a surprisingly impotent political force for reform. They were long committed to an essentially voluntaristic form of corporate governance activism, and the majority of them (particularly mutual funds) espoused a neo-liberal policy stance that was skeptical of, and often hostile to, increased regulation of their affairs. Further, because they are legally barred from contributing to political campaigns and cannot mobilize voters, institutional investors have less political influence than their economic power would predict. An important partial exception to the marginal political status of institutional investors was the active role played by union pension funds. These funds have long been the most activist investors in corporate governance, with ideological and strategic commitments to constraining imperious managers. They were also closely tied to the political operations of their founding unions and the AFL-CIO, which--despite the weakness of American organized labor--remain core contributors and voting constituencies of the Democratic Party.

Ironically, many in organized labor would have preferred that Congress pass no corporate governance reform bill prior to the 2002 mid-term election in order to keep the issue of financial scandal alive for Democratic candidates. By the summer of 2002, however, the politics of reform had taken on a life of its own beyond interest group control. Politicians of both parties scrambled to claim credit for reform or, just as important, to distance themselves from identification with a corrupt corporate elite and blame for the wave of scandals appearing daily in the media. In the words of one organized labor representative involved in the legislative process, “We won Sarbanes-Oxley and lost the election.” Anonymous interview, Washington, DC, March 2003.

Sarbanes-Oxley imposed a host of new regulatory requirements and measures on publicly traded corporations, directors, corporate managers, accountants, and attorneys. Sarbanes-Oxley created an entirely new regulatory body appointed by and under the oversight of the SEC, the Public Company Accounting Oversight Board, to enforce a new set of prescriptive regulations governing accounting standards and the activities of accounting firms in auditing and consulting. The Act also required the SEC, inter alia, to draft new regulations requiring heightened disclosure of the financial condition of corporations that included off-balance sheet transactions, codes of ethics (and their waiver by the board), the reconciliation of “pro forma” financial results with generally accepted accounting standards (US GAAP), limitations on non-audit services performed by the firm's auditor, and real time disclosure of material financial information and developments. The reforms increased civil and criminal penalties for a host of securities law violations and also emphasized increased governmental investigation and enforcement actions rather than private civil suits that had long characterized securities law.

The second path-breaking aspect of the Sarbanes-Oxley Act is its intervention in the internal structure and affairs of the corporation. This represents the first time federal law and regulation has directly penetrated the traditional preserve of state corporation law. Similar to recent German reforms (discussed below), Sarbanes-Oxley strengthened the independence of the board and its auditing function. Public firms are now required to appoint an auditing committee comprised entirely of independent directors and at least one member must be qualified as a financial expert under new SEC rules. The audit committee now has direct responsibility for the appointment, compensation, and oversight of the outside auditors, and approval of all auditor services. The auditors must report directly to the board audit committee, which must resolve any disputes between management and the auditors concerning financial reporting. By encroaching on the traditional subjects of state corporate law, the Sarbanes-Oxley reforms continued the centralizing and federalizing tendencies of corporate governance reform. This unprecedented--and underreported--federalization of corporate law represents a sharp break with nearly two centuries of American federalism and suggests the growing policy import of corporate governance issues and the extraordinary political potency of the financial and governance scandals of 2001-2002. Together, these regulatory reforms represent not only a potentially vast expansion of federal regulatory power, but also a substantial centralization of regulatory authority displacing the self-regulating character of the accounting industry and firm governance.

Following the passage of Sarbanes-Oxley, the focus of regulatory politics moved from Congress to the SEC and its troubled ward, the Public Company Accounting Oversight Board. This reflects a longstanding tendency in American regulatory politics: the delegation of difficult and contentious policy problems to administrative agencies. Having resisted calls for reform, the SEC lost influence over the legislative process. In enacting the Sarbanes-Oxley Act, Congress substantially expanded the jurisdiction and powers of the SEC, but placed the agency in the middle of continuing and intense political conflicts among the Executive Branch, Congress, interest groups, and public opinion over the future of corporate governance reform. These conflicts remain unresolved. The scars of these battles still threatens to inflict long-term damage to the legitimacy, morale, and competence of the SEC. SEC Chairman Harvey Pitt, President Bush's appointee to head the SEC, had been a prominent securities lawyer on behalf of major accounting firms in private practice and his efforts to minimize the significance of the corporate scandals and to derail legislative reforms were regarded as suspicious and illegitimate by reformers and, increasingly, by the public at large. The struggle over accounting regulation and appointments to the Public Company Accounting Oversight Board ultimately resulted in the resignations of Pitt and the first Chairman of the Accounting Oversight Board, former FBI and CIA Director William Webster who was found to have been a director of a corporation charged with financial improprieties.

Yet the continuing disclosure of scandal within financial markets and institutions has raised the profile and importance of the SEC, under its new Chairman William Donaldson, to a degree unseen in decades. Recent governance and trading scandals involving the New York Stock Exchange and the mutual fund industry have increased the institutional leverage and authority of the SEC. The question is what the agency will do with this increased power. Already, the SEC is beginning to displace the traditional self-regulation of the stock exchanges and mutual funds with more direct oversight, formal regulation, and structural reform of these institutions. But the political conflicts over corporate governance reform persist. Their culmination may be the battle over reform of proxy voting regulations. Because structural regulation under Sarbanes-Oxley depends on improved functioning of boards, these regulatory amendments go to the very foundations of the recent reforms. However, the SEC's recent proxy rule amendments to allow major shareholders such as institutional investors to more easily nominate and elect directors were modest and met with harsh criticism from shareholder advocates. The proposed rules only allow institutional investors access to corporate proxies mailed to all shareholders after substantial delays and under exceptional conditions. Even then the new rules allow dissident shareholders to elect no more than three directors in this fashion. This is almost certainly insufficient to substantially change the functioning of boards and suggests that corporate boards, however restructured, will remain rather pliant and ineffective as checks on managerial power and misconduct. The Sarbanes-Oxley Act's delegation of rulemaking authority to the SEC over the selection of American directors suggests that the reforms will have less impact than its partisans hoped and its detractors feared. The stage has been set for the next round of political conflict over corporate governance occasioned by the emergence of finance capitalism.

3.2 Germany

The German case presents the rise of finance capitalism as the object of deliberate governmental policy and the product of sustained party and interest group politics. Securities law and corporate governance reform during the 1990s displays the trends of regulatory centralization, the steady expansion of formal prescriptive disclosure and transparency regulation, and the adoption of structural regulation even more clearly than its American counterpart. For a more detailed description and analysis of the German reforms, see Cioffi 2002b. By the late 1980s (and especially after the reunification of East and West Germany), Germany's neo-corporatist institutional arrangements could no longer maintain a high-growth, high-wage, and high-employment economy. During the 1990s this economic crisis intensified as growth slowed to less than 2% annually and unemployment hovered near 10%. Germany was widely regarded as a national laggard in reforming its financial market law and corporate governance regime when compared with other advanced industrial countries such as the United Kingdom and France. In many contemporary accounts, Germany is still regarded as lagging other countries in modernizing its financial and corporate governance systems. These criticisms neglect the substantial legal changes that have changed the foundations of the financial system. They also tend to focus on the perpetuation of codetermination and the low level of equity financing. Although codetermination has remained untouched, largely for political reasons, this has not appeared to affect investment behavior to a significant extent. Hostility to codetermination seems more rooted in ideology than practical economic considerations. The relative failure of Germany equity markets to develop following the reforms of the past decade is a more significant and complicated subject. Continued low levels of equity financing and IPOs suggests both the path dependence of established financial structures and practices, but also the simple fact that the booming German stock markets expansion late 1990s crashed along with the American markets and has not rebounded given the higher risk aversion of German investors. Under current conditions, securities markets do not appear as efficient or attractive to those making real world economic decisions to raise and invest capital. The German pension system remains largely state run, with far less savings flowing into pension funds and mutual funds invested in equities. As this system is reformed to relieve the unsustainable strain on public finances, a huge supply of capital may begin to flow into securities markets and aid in their growth--depending on what type of pensions and pension funds are encouraged by public policy. However, these issues are beyond the scope of this essay. By the late-1990s, large segments of the political elite and the German electorate began to lose faith in the social market economy at the same time they became beguiled by the booming stock market and high-tech sector in United States.

The substantial and comprehensive transformation of the German corporate governance regime reflects a shift in policy preferences and the formation of an enduring and effective political coalition favoring financial modernization dating back to the Kohl era. The EU's single market program of unifying capital and financial services markets contributed to this modernization program as the CDU leadership accepted some degree of liberalism and regulatory reform as the price of European unity. In the early 1990s, the Kohl government's policy veered sharply in favor of capital market reform as part of the EU integration program to which it was committed as internationalists overcame the resistance of more localized domestic interests of the Lander governments, the Lander-based and regulated stock exchanges, and small firms and banks.

But corporate governance reform would not have gone nearly so far since the mid-1990s without substantial domestic support among powerful interest groups and political actors. Prior to the breakthrough of the Second Financial Market Promotion Act in 1994, the German government and financial elites were notorious for resisting EU directives requiring increased transparency, banning insider trading, and other regulatory reforms. With the exception of the fight against the neo-liberal Takeover Directive, this resistance has largely evaporated. Declining profit margins caused by over saturation and excessive domestic competition in traditional bank lending along with and the increasing domestic market penetration by British and American investment banks in higher value-added financial services triggered a shift in business strategies and policy preferences of most large German banks. For a more detailed discussion of the shift in the business strategies and policy preferences of large German banks, see Cioffi 2002b. The Schroder government's political strategy of allying with the banks in support of financial system reform in order to strengthen business support for the SPD and to weaken support for the CDU was confirmed in anonymous interviews conducted in Germany in July 2000 and July 2003. The SPD's interest in pursuing an agenda of economic modernization and corporate governance reform coincided with and complemented the pursuit of financial system modernization and internationalization by many large banks. By the early 1990s, most large German universal banks began to appreciate financial system modernization and the cultivation of new financial services capacities as the route to higher profits, returns to equity, and more lucrative international markets. The elements of the new business model functioned together: more sophisticated market-based financial services would boost bank profits; higher profits would increase returns to equity; these higher returns would raise the price of shares that could then be used to make strategic acquisitions; and these acquisitions around the world would vault German banks into the “bulge bracket” of top international financial institutions. This shift in business strategies altered the banks' policy preferences and mobilized their peak association, the powerful and well-organized BDB, and its political allies in support of securities market and corporate governance reform. Likewise, the globalization of finance and financial markets also reinforced domestic political pressures for financial and corporate governance reform as Frankfurt sought to remain competitive in attracting international capital (and retaining German investment capital).

Corporate managers and the leadership of organized labor were divided over corporate governance reform and the development of finance capitalism. Managers of many large German corporations, such as Daimler Benz and Siemens, backed much of the reform agenda. These firms now had global operations and were increasingly interested in tapping foreign credit and securities markets that were out of reach so long as the German financial and corporate governance model remained insular and dominated by domestic insiders. Shareholders, however, played virtually no political role in the reform of securities and company law--even though these reforms were ostensibly undertaken on their behalf. Quite simply, given Germany's historically undeveloped securities markets and lack of an equity culture of mass shareholding, shareholders were to few and too poorly organized to wield significant influence in policy debates. Reforms were almost entirely a top-down process. Union leaders, including those of IG Metall, Germany's leading industrial union, realized that the German economy had slipped into a structural crisis requiring the adoption of reforms to increase growth by increasing restructuring and competitiveness. Despite some skepticism, labor leaders were largely willing to accept financial system and corporate governance reforms so long as they did not disturb codetermination and collective bargaining arrangements, and did not shift the costs of restructuring onto employees who would lose their jobs. German welfare state policy has played a critical role in facilitating corporate restructuring despite countervailing union power. Organized labor has been accommodated by the extension of generous unemployment and early retirement pension benefits to ease the impact of restructuring on the workforce. Germany has effectively socialized the risk and costs of restructuring, but at increasingly enormous costs in terms of pension outlays and structural unemployment. (See Streeck 2003)

The reform of securities law and regulation quickly became a consensual policy among German political and economic elites and it has proceeded apace since the mid-1990s. The landmark Second Financial Market Promotion Act of 1994 transformed securities regulation in Germany. Second Financial Market Promotion Act (Gesetz uber den Wertpapierhandel und zur Anderung borsenrechtlicher und wertpapierrechtlicher Vorschriften, Zweites Finanzmarktforderungsgesetz) of 26 July 1994, Federal Law Gazette, Part I, p. 1749. The Act replaced the decentralized system of state-level exchange regulators and largely self-regulating stock exchanges with a centralized federal regulator, German Federal Securities Supervisory Office (Bundesaufsichtsamt fur den Wertpapierhandel, or “BAWe”), for the first time in German history and transformed substantive securities law. The BAWe's creation represented an extraordinary change in the legal and institutional foundations of German finance. Over the remainder of the 1990s further legislation and regulatory rulemaking steadily expanded the agency's powers and jurisdiction and increased the stringency of disclosure rules and other regulatory standards. From late 1997 through 1998, another series of Financial Market Promotion Laws and other legislative changes markedly expanded the agency's role in regulating and policing German securities markets. The BAWe came to oversee the filing of prospectuses, the financial disclosure by public companies, insider trading, and the reporting of voting rights and ownership stakes. It now also supervises financial services providers, stock brokers, the stock exchanges, and cooperates with other national securities regulators. (See Cioffi, 2002b) In April 2002, following the election of Schroder's SPD-Green coalition in late 1998, the process of regulatory centralization reached its peak as the German Parliament consolidated all financial market and services regulation, including the regulation of securities markets, banking, and insurance, and folded the BAWe within one massive agency, the German Financial Supervisory Authority (Bundesanstalt fur Finanzdienstleistungsaufsicht, “BAFin”). Law on Integrated Financial Services Supervision (Gesetz uber die integrierte Finanzaufsicht (“FinDAG”)), April 22, 2002 (effective May 1, 2002). With this reform, Germany surpassed the United States in the centralization the administration of financial services regulation.

But consensus was far harder to find when policy debate turned to more contentious issues of company law reform and managerial power within the firm. The CDU-CSU led coalition balked at more substantial corporate governance reform. Corporate managers nestled within the protective network structure of the German economy were--and remain--both a core constituency of the center-right Christian Democrats and divided over corporate governance reform. Opposition was particularly intense among owners and managers of many small and medium sized firms within the Mittelstand, often referred to as the backbone of the German economy, who feared that financial system reforms would favor large publicly traded firms over their financial needs for stable sources of credit. Because they were tied to the CDU-CSU led coalition, the Free Democratic Party (FDP), was hamstrung on governance and financial system reform to which it was otherwise favorably disposed as Germany's sole liberal party with historically close relations to major banks and the financial sector.

This reform agenda was taken up by the center-left Social Democratic Party, first in opposition in the Bundestag and then as the governing party under Chancellor Gerhard Schroder, rather than by the recalcitrant political conservatives of the CDU under the Kohl government. Since the late 1990s, the SPD used corporate governance reform to claim economic modernization as the centerpiece of its own policy agenda to counter the traditional perception of the CDU as the party of business and economic stewardship. See Cioffi 2002b; Hopner 2003. For an excellent account and analysis of the ways in which the Schroder government sought to create a shareholding culture in Germany during the late 1990s, see Ziegler, 2000. Schroder's faction came to appreciate the reform of capital markets, securities law, and ultimately the entire corporate governance regime as a strategy to improve corporate and macroeconomic performance along with the party's electoral fortunes. Centrist SPD and Green Party leaders confronted resistance from more traditional left-wing members who were suspicious of Anglo-American “casino capitalism.” However, Schroder's centrists were able to overcome these objections from segments of organized labor (particularly the rank-and-file) and traditionalist left-wing factions. Indeed, Schroder's rise within the SPD and his victory in this policy debate indicates the decline of these traditional powers within German social democracy. In part, the centrists prevailed because the corporate governance policy agenda appealed to long-standing ideological concerns of the German left. Both the SPD and Green parties have been antagonistic towards the traditional insularity of Germany's economic elite, with its associations with conservative hierarchy and corporatism. For an excellent account of this ideological aspect of German social democracy in historical perspective, see Hopner 2003; see also Cioffi 2002b. The Greens, the SPD's coalition partners have revealed themselves to be economic liberals in many respects. Corporate governance reform as formulated by the SPD leadership appealed to the Greens' ideological preferences for economic decentralization and devolution--even as this necessitates regulatory centralization. By 2002, following the election of Schroder's SPD-Green coalition in late 1998, policymakers would thoroughly reformed the country's securities and company law to favor shareholder interests over those of incumbent managers and banks, and the development of securities markets in place of established bank-centered financial and ownership networks. (Cioffi, 2002b)

In 1998, the SPD took advantage of shifting policy preferences among interest groups to engineer the first major overhaul of company law since 1965. While still in the opposition, the Social Democrats' successful campaign for company law reform played upon popular resentment of “bank power” among their core constituents while casting themselves as business-friendly economic problem solvers. For a detailed discussion of the SPD's pseudo-populist strategy to gain left-wing support for governance reform, see Cioffi 2002b. The proposed legislation put the CDU on the defensive and forced the Kohl government to support a compromise version of the Control and Transparency Act (“KonTraG”), which moderated the anti-bank provisions while retaining more important governance reforms. Corporate Control and Transparency Act (Gesetz zur Kontrolle und Transparenz im Unternehmensbereich, “KonTraG”) of 27 April 1998, Federal Law Gazette, Part I, p. 786 (Gesetz vom 27.4.1998, BGBl. I, S. 786 vom 30.4.1998). For a political analysis of the KonTraG, see Cioffi 2002b. This had been the SPD leadership's strategy from the start: they could claim credit as modernizing reformers, maintain credibility with their left wing while painting the CDU as beholden to corporate interests, and still continue to cultivate closer relations with the financial sector.

The KonTraG complemented the prior massive overhaul of securities law by addressing issues of bank power, the function of the supervisory board, auditing, share voting rights, stock options, and litigation rules. The law sought to reduce the power of Germany's universal banks in voting shares and supervisory board representation while strengthening their disclosure and fiduciary obligations to shareholders. If the bank's holdings in a listed firm exceed 5% of the corporation's stock, it can vote their own equity stakes or vote the proxy votes of the shares deposited by its brokerage customers--but not both. The rules on the voting of shares by banks in corporate decision making were designed to use the traditional bank-centered proxy voting system while allowing alternative mechanisms of proxy voting to emerge (e.g., shareholders' associations). Policymakers feared that banks would make good on their threat to withdraw completely from the practice of voting depositors' proxies if more onerous rules were imposed on them, resulting in fewer shares voted and managers even less constrained by this limited exercise in shareholder democracy. (See Cioffi 2002b) The KonTraG also imposes limited prescriptive rules on banks that require them to disclose all board mandates held by their representatives, their ownership stakes in firms, and alternative ways for their share depositors to exercise their votes. (Ibid.) However, in the end, the law's restrictions were measures acceptable to the large banks and fit with their emerging business strategies that diverged from the relational banking model of the past. The KonTraG also uses law to shift information and power to the supervisory board as a means of protecting shareholder interests. More than four years before the passage of the Sarbanes-Oxley Act, German law required the supervisory boards of listed firms to hire and oversee the external auditor instead of the management board. The law contains additional auditing reforms to ensure the independence and reliability of auditors. An auditor may not auditing a firm if it has earned more than 30% of its revenues from the client over the past five years and must change the signatory of the audit if the same person has signed the report more than six times in ten years. The KonTraG also raised the limitation on auditor liability from 500,000 DM to 8 million DM for listed corporations (2 million DM for unlisted companies).

An equally important regulatory reform introduced by the KonTraG mandated shareholder democracy through a “one share, one vote rule” that prohibits unequal voting rights and abolished voting caps among shares of common stock for the first time. In contrast to the general principle of one share-one vote, the KonTraG prohibits the voting of cross-shareholding stakes above 25% (a blocking minority under German company law) in supervisory board elections. This provision was designed to prevent managers from wresting control from shareholders by engaging in reciprocal voting with the managers of other firms involved in cross-shareholding relationships. However, by weakening their defensive ownership structures, this new structure of voting rights exposes some German firms to unprecedented threats of hostile takeover--a fact underappreciated at the time but one that would soon prove politically contentious. The KonTraG also partially embraced Anglo-American financial practices and litigious enforcement mechanisms. The law allowed stock repurchases and the use of stock options as executive compensation for the first time (though with stricter limitations than in the United States to prevent excessive executive compensation and abuse). In the area of shareholder rights and enforcement mechanisms, the KonTraG contained modest reforms of shareholder litigation rules. However, the KonTraG did not alter the substance of fiduciary duties, nor did it otherwise alter the mechanisms and procedures for enforcing shareholder rights (e.g., class actions, contingency fees) to make them more effective in practice. The German ambivalence towards litigation continues.

The modernization of securities markets took an additional leap forward in July 2000 when the Schroder government pushed through a major tax reform law (Steuerreform), over strenuous opposition from the Christian Democrats, that abolished capital gains taxes on the liquidation of cross-shareholdings. By seeking to encourage the unwinding of cross-shareholdings, the Social Democratic government deliberately chose to undermine the network ownership structure of corporate Germany that insulated German corporations from takeovers and to encourage the German financial sector to replace its bank-centered model that retarded the use of capital market financing with a market form of organization. In doing so, the tax reform of 2000 may become, in retrospect, the most important corporate governance reform in German history. (See, e.g., Holloway, 2001) The reform was simultaneously a generous benefit to the financial services sector (which held a disproportionate share of these cross-shareholdings), a means to improve the liquidity of domestic stock markets (by increasing the proportion of shares actively traded--the “free float”), part of a longer-term strategy to subject firms to capital market pressures to restructure.

The takeover vulnerability created by these reforms, along with the fear instilled in managers by Vodafone's hostile takeover of Mannesmann in early 2000, triggered a backlash against the further liberalization of German corporate governance. One curious aspect of this backlash against takeovers is that the Mannesmann takeover preceded the enactment of the July 2000 tax reform law. At the time Mannesmann was taken over, corporate Germany appeared unruffled by it. Interviews conducted by the author, as well as journalistic accounts, indicate that the fears of German managers grew when they considered the combined effects of the KonTraG and the tax reform and the unequal playing field this might create against firms from countries that allowed more potent anti-takeover defenses--including, ironically, the United States. For an excellent analysis of the Mannesmann takeover, see Hopner and Jackson, 2001. The growing domestic political conflict over takeovers spilled over into the EU's attempt to adopt a EU Takeover Directive that would have liberalized Europe's market for corporate control. Realizing that the proposed EU directive would render German firms asymmetrically vulnerable to takeover by foreign corporations with stronger anti-takeover defenses, German managers, unionists, conservatives, and left-wing Social Democrats alike mobilized to block the directive in the European Parliament. They succeeded in blocking the directive in July 2001--the first major defeat ever suffered by the European Commission in its pursuit of a single EU market. For an extended discussion of the relation between the politics of German corporate governance and the failure of the EU Takeover Directive, see Cioffi, 2002b.

A week after the collapse of the EU Takeover Directive, the German Bundestag passed the Securities Acquisition and Takeover Act (the “Takeover Act”), which replaced a voluntary self-regulatory takeover “codex” widely derided as ignored and ineffective. See Ashurst Morris Crisp, 2002 (translation); Strelow and Wildberger, 2002; Osborne & Clarke, 2002; Rissel, 2002; Zehetmeier-Mueller and Ufland, 2002; Williamson, 2001; BBC, July 11, 2001; Wood, 2001 The domestic politics of takeover law were largely identical to the battle against the EU Directive. As originally drafted, the law was identical to the proposed EU Takeover Directive. Opponents of takeovers ranged across the political spectrum, from corporate managers backed by the CDU-CSU to the leaders of organized labor supported by the left-wing of the SPD. This disparate ad hoc coalition drove the government to appoint a nineteen member blue-ribbon commission comprised of corporate and financial institution managers, securities market officials, labor representatives, and leading legal academics. (See Braude, 2000a, 2000b) Through the appointment of the commission, the government simulated the interest group array of established neo-corporatist bargaining, while granting the government greater control over an increasingly divisive policy area. The government ultimately diffused the controversy surrounding the Takeover Act by diluting the liberal approach to takeovers and shareholder rights in the draft law. (See Braude and Hong, 2001, Barbier, 2001)

For the first time in Germany, the Takeover Act subjects takeover bids Offers by one or more parties acting in concert to acquire 30% or more of a public firm's voting stock. to mandatory procedures and disclosure rules (under BAFin regulation and supervision) to facilitate and ensure the fairness of bids and takeovers. The Takeover Act does not transform the core of the stakeholder corporate governance scheme. Codetermination and fiduciary obligations remain undisturbed. The law imposes a mandatory bid rule triggered when an ownership stake reaches a 30% threshold. The details of takeover bids an ad the offeror's business plans must be fully disclosed in a filing with the BAFin. More controversially, the Takeover Act also contains a general “duty of neutrality”--one of the most controversial features of the EU Takeover Directive--that prohibits the management board from taking action to frustrate a hostile bid. At the same time, however, the statute expanded the latitude of management to adopt defenses in advance and thereafter to deploy defensive tactics against a hostile takeover Securities Acquisition and Takeover Act, § 33.1 & .2; see also Braude, 2001a--similar to the reallocation of legal authority to the boards of American corporations during the 1980s. However, “poison pill” defenses common in American practice remain illegal under German company law.

In contrast to the American case, the Germany government sought to maintain the balance of stakeholder power within firm governance. First, rather than enshrining the primacy of shareholder interests in law, the Takeover Act does provide some protection for employee stakeholders. The Act obliges both the offeror and the target's management to disclose information to either the works council or directly to the employees concerning the terms of the offer and its implications for the firm, its employees, and their collective representation. Organized labor is also entitled to two representatives on the government's thirteen-member “advisory board” on takeovers created under the Act. Thus, the Takeover Act makes use of and may reinforce the institutions of works council codetermination even as it expands the supervisory board's power and liberalizes takeover law. Codetermination may have actually served a crucial legitimation function that made the pro-shareholder liberalizing elements of the Takeover Act palatable enough for passage. This hypothesis, however, remains speculative without further research. Second, codetermination legislation passed with government support in 2001 marginally expands the competence of works councils and makes them somewhat easier for employees to form. The legislation also had a political motivation: the Social Democratic government used it to compensate the unions and left-wing Social Democrats that had supported or acquiesced in the far more important and influential pro-business reforms of securities, company, tax, takeover, and pension laws.