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

This careful maintenance of stakeholder power, while seeking to increase shareholder protections, was displayed again as the government appointed two successive corporate governance commissions. This narrative of the German corporate governance commissions is indebted to an interview with Theodor Baums, July 9, 2003, Frankfurt. The first, under the Chairmanship of law professor Theodor Baums, was drawn from representatives of the major interest groups and charged with drafting a comprehensive code of best practices in German corporate governance. Baums successfully insisted that the politically explosive subject of codetermination be excluded from the commission's deliberations on the grounds that it would destroy the consensus required on other important issues. The formation of a second government commission on corporate governance followed the release of the Baums Commission's report. Baums Commission Report (Bericht der Regierungskommission Corporate Governance), July 10, 2001 (complete official German version available at www.otto-schmidt.de/corporate_governance.htm, English summary available at http://www.shearman.com/publications/cm_pubs.html); Cromme Commission (Government Commission of the German Corporate Governance Code), German Corporate Governance Code, adopted February 26, 2002, as amended May 21, 2003 (information and official German version and English translation available at http://www.corporate-governance-code.de/index-e.html). The standing Government Commission on Corporate Governance, once again selected from among the peak associations, major interest groups, respected attorneys, and legal academics. Known as the Cromme Commission, after its chairman Gerhard Cromme (the former chairman of Thyssen-Krupp), the commission made over 150 wide ranging recommendations (substantially following the Baums Commission's recommendations), many of them proposed legislative changes, that would improve disclosure and transparency; strengthen the role, obligations, and independence of corporate boards; improve external auditing; and modernize corporate finance rules. Most important was a proposed “comply or explain” rule (since enacted by Parliament See Transparency and Disclosure Act (TraPuG ) (Gesetz zur weiteren Reform des Aktien- und Bilanzrechts, zu Transparenz und Publizitat (Transparenz- und Publizitatsgesetz), v. July 19, 2002, BGBl. I S. 2681.) that requires firms to comply with the Cromme Commission's Code of Best Practice or else explain in a public disclosure why it had not. Codetermination was the sole major subject conspicuously absent from the Commission report. The Commission's ground rules had placed supervisory board and works council codetermination outside the group's purview.

The works council reform and the refusal of the government's corporate governance commissions to alter existing forms of codetermination suggests the continued significance of labor relations issues in the country's corporate governance regime and the preservation of Germany's stakeholder model. At the same time, these most recent developments reflect two fundamentally important trends in the German political economy. First, they indicate the emergence of a stable political alliance among interest groups and political actors on the center-left to foster development of a market-based finance capitalism. Second, they suggest the increased importance of firm-level corporate governance as an important forum for economic adjustment and the negotiation of conflicts post-war neo-corporatist arrangements, sectoral collective bargaining, and the political and economic power of unions weaken and decline in significance.

4. Politics of Regulatory Reform: Crises, Interests, and Political Actors

Although the logic of path dependence theories and varieties of capitalism scholarship predict the stability of political economics structures and institutional arrangements, developments in the law and policy of corporate governance show that regulatory intervention in the structure and operation of firms and financial markets has undergone remarkable change during the past decade. (See Tables 7 & 8) The narrative accounts of corporate governance reform detailed above highlight a number of important common structural trends in the United States and Germany: regulatory centralization and institutionalization, the displacement of self-regulation by formal prescriptive legal rules, the expansion of market facilitating disclosure and transparency regulation, and the restructuring of the corporate firm through structural regulation. These trends demonstrate not stability but a significant expansion of state power in the economy and its active reshaping of the private sphere.

In both the United States and Germany, institutional failures led to economic crises in both the neo-liberal and neo-corporatist corporate governance regimes and disrupted long settled interests and policy preferences within and among powerful interest groups. Significant changes in the interests of key economic actors, including corporate managers and financiers who play pivotal roles in domestic politics and economic life altered the configuration of interest group politics. Division and/or uncertainty over economic interests and policy preferences within interest groups or their loss of legitimacy under conditions of crisis or scandal prevent them from playing an influential role in the reform process.

This changed political context opened opportunities for entrepreneurial politicians and political parties and triggers changes in their strategic positioning and policy agendas. These changes in interest group policy orientations supply the preconditions for substantial regulatory reforms and institutional change. These conditions gave political actors greater autonomy in articulating and imposing their own policy preferences and opened politics to new regulatory approaches and mechanisms. Under such circumstances, political actors could more easily rearrange interest group alignments and alliances in order to engineer institutional change and regulatory innovation. Together, these changes in interests, political strategies, and institutional structures pose a threat to the institutional coherence and complementarities that have defined distinct national variants of advanced industrial capitalism and their comparative economic advantages. This implies that the development of finance capitalism, of which corporate governance reform is a part, portends an extraordinary period of political economic transition.

4.1 The American Case: The Politics of Punctuated Reform

The United States in some ways presents a puzzling case of reform. The country that developed modern securities regulation and shareholder capitalism fell victim to an enormously damaging speculative bubble, serious regulatory failures, corporate and accounting fraud on a vast scale, and systemic problems of poor governance and conflicts of interest throughout the American finance and corporate governance. The governance crisis that began in 2000 exposed the systemic deficiencies and contradictions of the American model in extravagant fashion. The very maturity of the American regulatory regime constrained the process of reform. Consequently, the unprecedented and wide-ranging American Sarbanes-Oxley reforms were intended to reinforce a faltering market-based financial system and corporate governance model.

Proponents of reform relied on public outrage over the scale and scope of the financial scandals of the late-1990s and its effect on the balance of interest group power in American politics and policymaking. The single most important feature of the reform politics of 2001-2002 was the virtual disappearance of corporate managers, accounting firms, and investment banks from the process. Tainted by scandal, these powerful actors and groups were weakened within the legislative process. Business and financial interests were also deeply divided over the reform effort. The blow to the prestige of business and the reputations of managers induced a significant number of leading figures, such as Warren Buffett, Paul Volcker, and Goldman Sachs' Henry Paulson among others, to publicly support legislative and regulatory reform. This division was equally sharp, if not deeper on Wall Street. Leading investment firms understood the depth and seriousness of the scandals and crisis unleashed by the collapse of the bubble economy and they had an enormous stake in ensuring that it was contained--by regulatory reform if necessary.

Likewise, large public employee and union pension funds, long involved in a largely non-regulatory and voluntarist form of corporate governance activism, shifted their policy preferences dramatically in support of increased regulatory stringency and intervention in corporate governance. The increasingly pro-regulatory stance of pension funds highlighted another exceptional aspect of American reform process: organized labor was instrumental in the passage of the Sarbanes-Oxley reforms. The capacity of unions to raise money and mobilize voters gave them far more leverage in the political process than other funds that are constrained by law and by organizational form from political activity. This strong support by organized labor gave a far more powerful voice to shareholder interests. The outrage of diffuse investors is unorganized and inarticulate in the policy process. Limits on campaign contributions and tenuous relations with beneficiaries (whom they cannot effectively urge to the polls) blunt the influence of institutional investors. Labor was comparatively strong in both respects. Although organized labor has not been able to achieve significant labor law reform, Sarbanes-Oxley illustrates its influence where conditions disfavor managers and political alliances are available. Because of their control over pension funds of their own and their reliance on company funds outside their control, unions and the AFL-CIO were intensely interested in and supportive of governance reform. These policy preferences were driven by the reliance of American social welfare policy on private pensions--unlike Western Europe's greater dependence on public retirement benefits. These institutional arrangements, so important to the emergence of finance capitalism in the United States, constituted private interests favoring its reinforcement and development.

The Democratic Party capitalized on these divisions among the economic elite and the public resentment of corporate managers and financial institutions and did so quickly in case the scandals subsided or public attention began to wane. The continued disclosures of corrupt and improper financial practices throughout 2001 and 2002 finally eroded Republican resistance as they sought to neutralize the scandals in advance of the 2002 November elections. The Sarbanes-Oxley reforms were certainly an exercise in political opportunism, damage control, and the rehabilitation of systemic legitimacy (usually referred to as “investor confidence”). But they are also a substantial step away from the managerial model of capitalism of the post-war era and towards a new form of finance capitalism, engineered by the center-left Democratic Party, that marks a new phase in American regulatory and corporate governance politics.

However, the Sarbanes-Oxley reforms were less systematic and more contested by interest groups and political factions than the far more thoroughgoing German reforms of the past decade. The Sarbanes-Oxley reforms reflect no elite consensus or coherent policy agenda. The political struggle over the Sarbanes-Oxley reforms reveals a policy marked by divisive party and interest group politics within a fragmented political structure that creates multiple veto points. This fragmented structure prevents coordination of complex policy and legislative initiatives, and empowers interest groups to block legislative and regulatory reforms in pursuit of their own narrow interests. When conditions propitious for legislative reform arrived, it had to be carried out quickly. The process was a sudden, reactive, and episodic response to scandal and popular outcry. Delay would likely have spelled the loss of the opportunity.

The fragmented American political system has also generated centrifugal forces in regulatory politics. Growing evidence of substantial enforcement failures by the SEC has led to a partial reversal of centralization of regulatory policymaking and enforcement. State regulators and attorneys general, led by New York State Attorney General Eliot Spitzer, filled a vacuum left by an under-resourced, overworked, and politically hobbled SEC and pursued aggressive investigations and enforcement actions targeting investment banks, firms and managers, and--most recently--mutual funds. These countervailing forces of decentralization and centralization are the product of a federalist structure that allows states substantial concurrent regulatory powers with the federal government. Duplicative institutions and overlapping law enforcement jurisdiction allow decentralization even as the national (and increasingly international) scope of financial markets, recent scandals, and reforms alike has increased pressures for regulatory centralization.

However, powerful political and economic forces favor the restoration of regulatory centralization. The SEC, under its new Chairman William Donaldson, has asked for and received the largest budget increases in its history to buttress enforcement capacities. Centralization is also likely to be reinforced by the flood of rulemaking the SEC is now engaged in as required by the Sarbanes-Oxley Act. The SEC is now in the midst of adopting some of the most important rules in its history, including more stringent regulation of executive stock options, the strengthening of accounting and disclosure regulations, and board independence and qualification rules. The agency is also now considering increased direct regulation and oversight of mutual funds and stock exchanges. Each of these initiatives both expands and centralizes regulatory authority and power in the SEC's hands. In addition, the opponents of regulation and the Sarbanes-Oxley reforms in particular have already begun to attack the Act and related SEC rulemaking as excessively costly and damaging to American business. If history is any guide, American managers will not accept significant governmental limitations of their autonomy and a sustained backlash against corporate governance reform is gathering force. See, e.g., PriceWaterhouseCoopers, “Senior Executives Less Favorable On Sarbanes-Oxley, PriceWaterhouseCoopers Finds,” Management Barometer, July 23, 2003, available online at http://www.barometersurveys.com; Michaels, Adrian, “US Reforms Lose Support of Business Leaders,” Financial Times, July 27 2003. Managers, financial institutions, and political conservatives are already seeking to use federal legislation to centralize regulatory power--if only to achieve a uniform rollback of reform and curtailment of enforcement activities by the states. See Chaffin, Joshua and Adrian Michaels, “Donaldson Warns Against Turf Wars,” Financial Times, September 9, 2003; Masters, Brooke A., “States' Role In Doubt on Wall Street: House to Vote Soon on Bill to Affirm Ultimate Power of SEC,” Washington Post, Wednesday, July 23, 2003; Page E01; Masters, Brooke A. and Ben White, “Donaldson Backs SEC Supremacy Bill,” Washington Post, Wednesday, July 16, 2003; Page E01. The American case is not one of punctuated equilibrium--at least not yet. Reform has redrawn the political battle lines over regulation and corporate power in the United States; it has not brought a truce.

4.2 Germany and the Logic of Systemic Reform

In Germany, the reforms necessary to develop a more market based financial system required a thoroughgoing overhaul of corporate governance law. As in the United States, the corporate governance reform reveals the political effects of divisions among business interests and elites in policy debates and outcomes. Institutional change on the order of magnitude of the 1990s corporate governance reforms entails fierce political and economic conflict among elites and social groups, and within the business community itself. As already seen in the American case, “business” is not a homogenous collective entity. Nor does the business community necessarily have a political or ideological “center of gravity” that represents its aggregate political positions and policy preferences. Numerous conflicts and cleavages the pit business interests against one another. In Germany, the most fundamental division is that between the financial sector and the rest of business. Corporate governance reform implicates the inevitable conflict between these two groups over corporate rents and the autonomy of corporate managers. While managers of financial firms may be ambivalent about rules that enhance their accountability to shareholders, the financial sector also benefits from the development of securities markets these rules are designed to promote. The managers of the German universal banks generally supported corporate governance reform, often over the opposition of many other corporate managers. A second politically salient division within business opened between large public corporations with international operations and smaller, mostly privately held, firms far more reliant on domestic markets. The former have an interest in developing securities markets as part of a global financial strategy. In contrast, smaller and family-owned firms, such as those comprising the German Mittelstand, may have an interest in maintaining a bank-based financial system of long-term relational lending. The realignment of interests and alliances among large banks and publicly listed industrial firms fundamentally altered the political terrain in favor of reform and the development of an infrastructure for finance capitalism in Germany.

The SPD took advantage of the opportunity presented by these shifting interests to claim a strategic centrist policy position on financial system and corporate governance reform. The party's realignment of its political support to include major financial institutions created the political foundation of corporate governance reform. This placed the conservative CDU-CSU and their neo-liberal allies in the Free Democratic Party in a difficult position. They have long relied upon the support of business and financial elites, but now these elites and interest groups were splitting over financial market and corporate governance reform. The SPD outflanked the CDU-CSU and cast the conservative alliance as the defender of managerial interests and Germany's economic aristocracy who ran an economic model that had become outmoded and increasingly dysfunctional. The conservative and liberal parties had to follow the SPD lead--but at a distance to avoid alienating prominent managers who were antagonistic towards neo-liberal reforms.

Ultimately, the SPD-Green coalition has been forced to confront its own political constraints and was caught in a dilemma similar to that previously faced by the CDU as their union and more left-wing supporters became hostile towards further liberalization of corporate governance policies. In the domain of corporate governance policy and extending to those of labor relations, pension, and social welfare reform, the Schroder government has been fighting an increasingly tense two-front battle, not only against the CDU and FDP opposition parties, but also against the left wing of its own SPD and industrial unions hostile to reforms designed to promote the development of German finance capitalism along Anglo-American lines. In the area of takeover law, the perceived threats to German corporate and socio-economic interests produced both greater unity among managers and political alliances with labor and the opponents of neo-liberal reform prevailed. Concern over the social and political legitimacy of the emerging corporate governance regime led the Schroder government and the SPD to maintain the balance of power between shareholders and employees within the firm and even buttress the existing institutions of the stakeholder model. Intra-party politics constrained policymakers to leave supervisory board codetermination untouched and to modestly strengthen works council codetermination. In the area of securities regulation, where these conflicts over economic power did not exist, pro-market regulatory expansion and centralization proceeded with astonishing speed to exceed that of the United States in some respects.

The conflicts generated by the reform agenda and chronic deadlocks within the established neo-corporatist bargaining processes led not only to regulatory centralization, but also to political centralization of the policy making process. The SPD government has relied increasingly on the use of expert commissions to formulate policies and frame legislative initiatives. Once it attained power and began pursuing a reform agenda that often antagonized the left wing of the SPD, the unions, and many German corporate managers, the Schroder government deliberately and shrewdly manipulated neo-corporatist policy processes to push through regulatory reforms while avoiding bargaining impasses. In contrast to corporate governance policy, the German Constitution circumscribes governmental intrusion into negotiations among the “social partners” in the area of labor relations. Accordingly, the government could not circumvent neo-corporatist gridlock through commissions or the tripartite negotiations under the Alliance for Jobs (Bundis fur Arbeit). (See Streeck 2003) The Schroder government has used this technique of political governance to appropriate (or manipulate) the existing framework of neo-corporatist interest representation by handpicking a groups of representatives from peak organizations as well as experts, academics, and professionals likely to reach a consensus on a given policy area close to the government's own position. As a result, party and interest group realignments and extant institutional arrangements permitted sustained systemic and systematic reforms. This “neo-corporatism by commission” thus allows the government to increase its control over policy processes and outcomes, by circumventing traditional neo-corporatist bargaining that increasingly tended to produce not consensus but impasse. For discussions of the German government's increasing use of commissions as a means of formulating policy, forging consensus, and avoiding deadlock among interest group and peak associations, see The Economist, “German Reform and Democracy: The Exhausting Grind of Consensus,” The Economist, August 28, 2003; Baums, Theodor, “Reforming German Corporate Governance: Inside a Law Making Process of a Very New Nature, Interview with Professor Dr. Theodor Baums,” German Law Journal, vol. 2, no. 12 (16 July 2001); Zumbansen, Peer, “The Privatization of Corporate Law? Corporate Governance Codes and Commercial Self-Regulation,” unpublished paper, July 2003 (on file with the author); cf. Heinze, Rolf G., and Christoph Strunck, “Contracting out Corporatism: The Making of a Sustainable Social Model in Germany,” paper delivered at the Progressive Governance Conference, Hilton London Metropole, July 11-13, 2003. More controversially, some critics have accused the government of using expert commissions to circumvent Parliament in the process of policy formation. Government defenders counter, accurately, that Parliament still must pass all legislation and that the commissions have not impaired democratic lawmaking. See The Economist, “German Reform and Democracy,” op cit.; Baums, German Law Journal, 2001, op cit. However, this style of governance contains a potentially damaging contradiction: it relies on neo-corporatist organizations for representational legitimacy while cutting them out of actual policy discussions. Neo-corporatism and the entrenchment of well institutionalized peak associations made the use of expert commissions possible, but this policymaking ultimately may cause peak associations to whither as their real influence and representational function wanes.

5. Conclusion: The Regulatory Politics of Corporate Governance and the Implications of Structural Change

The comparison of the American and German cases suggests that the neo-liberal American model has remained more resilient than the Germany's neo-corporatist arrangements. Sarbanes-Oxley does not represent a fundamental break with the established institutional arrangements and power relations of American corporate governance (as did the New Deal reforms of the 1930s). In comparison, the series of securities, company, and tax law reforms in Germany do represent a critical juncture in corporate governance and finance. The German reforms constitute a major episode of institution building and structural change that reflects a fundamental realignment of domestic political forces. The prospect of labor market, pension, and social welfare reforms in Germany further reinforce the impression that the German social market economy is now at a critical juncture that will substantially recast the economy and polity. These differences in the significance of reforms in the United States and Germany stemmed from the very different political motivations underlying them and the two countries' different starting points. German elites sought to systematically restructure their financial and company law systems in order to address pressing economic problems. American politicians had no such systemic reform agenda and merely sought an immediate response to the political and economic threats posed by pervasive corporate scandals. As the politics of reform differed, so did the policy outcomes and their significance.

More broadly, the market-driven American corporate governance model is more consistent with the growth and integration of transnational markets for finance and financial services, and arguably with the emerging paradigm of finance capitalism. Accordingly, the political and economic implications of corporate governance reform and finance capitalism are very different in United States and Germany. Corporate governance reform raises the possibility of more far-reaching and potentially destabilizing structural political economic change. State actors' deployment of new modes and mechanisms of regulation alters the institutional environment that defines the institutional complementarities that link financiers, managers, and employees. It follows that alteration of one element of a complex institutionally complementary system without corresponding changes to the other institutional elements will produce systemic dysfunction and intensified political and economic conflict. The vaunted institutional complementarities of the German model--high-skill, high-wage, high-value added production financed by supplies of “patient capital”--and the comparative economic advantages they confer may be fatally disrupted by the reform of the financial system and by tensions between this new market-driven financial system and the established labor relations system and the conflicts these tensions may generate within the firm.

In the corporate governance area, these conflicts come in two general variants. First, intensifying conflicts may arise between interest groups and state. Legalistic prescriptive regulation encourages more intensive lobbying of state actors and adversarial regulatory relations than self-regulation and consultative or neo-corporatist policymaking. See generally Kagan, 2001, 1997. Second, regulatory reform may spark greater conflict among interest groups. Consensual, cooperative, and negotiated policymaking is displaced by more formal, and contentious policy processes mediated by the state through lobbying legislatures and agencies rather than negotiations among and within private groups. Neo-corporatist bargaining tends to screen out zero-sum policy outcomes, at the expense of slowing or preventing reform. The expansion of regulation and the channeling of lobbying directly towards state actors in place of sectoral and peak association bargaining encourage more pluralistic interest group fragmentation that makes consensus among interest groups harder to achieve. The paradoxical increase in the centrality of the state in neo-liberal regulation allows reform to proceed by striking divisive political bargains during moments of crisis, setting the stage for a new round of political and economic conflicts. In both the American and German cases, corporate governance reform favors the displacement of relational governance practices by shorter-term contractual arrangements and arm's length economic transactions that sharpen conflict, reduce trust, and increase economic insecurity.

The incorporation of American-style securities regulation and corporate law principles poses a potentially substantial threat to the consensual German neo-corporatist system and social market economy. Over the medium to long-term, Germany's adoption of transparency regulation and company law rules favoring shareholder interests may sharpen conflicts among managers, shareholders, employees, and other stakeholders that the post-war political economy ameliorated by institutional design. The corporate firm is becoming a more important institutional forum for the negotiated adjustment of economic conflict as these functions devolve from the levels of sectoral governance and peak associations. Hence, the most striking difference between the American and German corporate governance regimes, the powerful position of labor and employees within politics and firm governance in Germany in contrast with the virtual exclusion of employees and labor interests from the American structure, has become an even more important institutional feature of the German political economy.

In contrast, the United States is more likely to absorb the regulatory innovations of the Sarbanes-Oxley Act without destabilizing the established market-driven corporate governance system. However, unintended consequences may flow from the recent American reforms. Congress may have crossed a threshold that makes further federal incursions into the traditional sphere of state corporate law more likely over time. Yet, as a general matter, shareholders historically have been the beneficiaries of federal legislation, as opposed to managers, labor, or other stakeholder interests. The Sarbanes-Oxley reforms fit comfortably within this historical pattern. The new federal politics of corporate governance reinforce the shareholder-centered character of the American model rather than dilute it. Even if a managerial and conservative backlash against corporate governance reform and Sarbanes-Oxley intensifies, as seems likely, the fragmented and veto-ridden American political system will also likely constrain attempts to deregulate corporate governance.

Finally, corporate governance and its reform have increasingly clear international repercussions. In the wake of the scandals that laid bare the structural flaws of the American corporate governance regime, the American model appears less efficient, less appealing, and thus less influential in informing policy overseas than at any time in decades. International and domestic confidence in American capital markets and corporate governance has plummeted along with the public's regard for federal regulatory efficacy. If the 1990s was the decade of speculative booms and faith in neo-liberal financial markets, this decade has ushered in a new and more sober era of regulatory politics. Finance capitalism is already a reality in many respects, both at the national and international levels, but it is less likely than ever to take a single homogenizing form. Instead, this new paradigm of capitalism is developing in nationally distinctive ways, driven by varying political forces, and embodied in national regulatory structures generated through national political and legal institutions.

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