The concept of “insider” model and an “outsider” model of corporate governance and critical evaluation of the effectiveness of each model for the governance of a modern corporation.
The world practice indicates that currently there are two predominant models of corporate governance which have emerged as a result of historical and socio-economical development in different countries. They describe main approaches and concepts of decision making and property rights depending on which model of corporate governance is being used. So, the main doctrinal concepts are the shareholder (outsider) and the stakeholder (insider) approach. However, among different scientists the understanding and interpretation of these governance concepts may differ.
In the same time some specialists consider that the “insider” governance systems are characterized with such situations, when property is concentrated in the hands of a few people, which own the largest shares from the corporate property. In this case governance is held by these natural persons or legal entities that have a direct impact upon their companies and other stakeholders. The “outsider” systems are characterized with the joint-stock property that is divided enough and that is why the influence on making decisions and constant corporate control mainly depends on managers.
General characteristic of “insider” and “outsider” models of corporate governance
The insider corporate governance model is based on the activities of the institutional investors which carry out the direct control over internal activities of corporations, while the external control, which is provided by the supervisory councils and the non-executive directors, is slightly subsidiary. The vast majority of specialists consider that in the countries of continental Europe and Japan there is mainly the “insider” model of corporate management, whereas in the USA and Great Britain dominant is the “outsider” approach.
The outsider systems are based on the regulations via non-executive directors and through the securities markets. For example, the peculiarities about the Anglo-American outsider model of corporative governance are directly connected with the features of the corporate ownerships and the lack of dominant investors in English and American corporations.
The Board of Directors in the Anglo-American model consists of men, who work in a corporation (as an executive directors or an employees), or are closely associated with the management of the corporation. Synonymous with the “insider” is the “executive director”, which is a person who at the same time serves as the manager of the company and as an employee. On the contrary, the “outsider” – is an independent director without any personal interests about the company, which is invited to perform certain management functions to operate the company.
The share capital of such corporations is mainly fragmented. A large number of corporations do not have in their registers any individual or institutional shareholders whose shares would be more than one percent of total capital. Thus, any group of shareholders can claim complaints about their representation in the board of directors. Another quite important feature is the fact that the vast majority of the shares that are not owned by the individual investors are concentrated in the hands of different institutional investors – in such forms as pensions and mutual funds. Such investors, which concentrate in their hands more than 50 % of the share capital, rather serve as financial managers. It means that they do not seek representations in the boards of directors and tend to avoid taking responsibilities, which arise from their ownerships in the company in which they have significant stakes.
Such dispersions of share capitals usually facilitate a “flow” of shares from one owner to another. This happens because minor shareholders more easily sell their shares than larger owners. For bigger shareholders selling their packages often means to change their strategic plans and it has a risk to result in losses associated with the changes in market values of shares of a certain company (as a result of significant one-time offers on the market). In such circumstances, the British and American capital markets are characterized by high efficiency and liquidity, which make selling packages of small investors a quick and technically feasible undertaking. Mergers, acquisitions and buy-outs of companies are quite common in these stock markets. However the appearance of corporate management models does not eliminate the existence of the same problems. First is the problem of ensuring the interests of small investors, the conflict between short-term and long-term interests of investors, the conflict between the executive and non-executive directors.
Interpretation of insider and outsider systems develops and acquires a particular meaning in the works of local economists. For example, some of them believe that insiders – are those, which are both shareholders and employees. Meanwhile, the outsiders – are people, who perform their role only with respect to the company shareholders. Insiders may be only workers and managers, who appear to be the company’s shareholders. The outsiders may be represented by legal entities or by the natural persons, which are not the employees of the company. For example, the state can become such a representative. Indeed, such an interpretation is more specific, since it provides a clear definition of insiders and outsiders. By the way, these approaches are also used when appear special issues connected with so-called disclosure of the insider information. However, these definitions are the most accepted in the issues about the acquisition of shares in order to control them. Therefore, combining selected the most appropriate treatments and provides the foundation for the analysis of problems handling equity.
The analysis of the Anglo-American “outsider” corporate governance model
The essential features of the model of corporate governance in Great Britain and USA are directly connected with the peculiarities of stock ownerships in the U.S., for instance, with such peculiarity as the absence of investors who obviously dominate over others with the sizes of their shares. Also, Anglo-American model differs from other models with the presence of a number of individual and institutional investors among other shareholders.
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Commonly U.S. and UK corporations are governed by external shareholders. Since the majority of the citizens in these countries are shareholders, there are strict rules regulating the disclosures of corporate activities. For example, all the financial information must be provided quarterly by special public agencies. Moreover, the information about previous activities of the newly appointed directors and the sizes of remunerations provided to senior managers must be also provided. Usually corporations provide information about the shareholders who own stakes in more than 5 % of the share capital.
What is also peculiar about this corporate governance system is that in the Anglo – American system there are no such phenomena as a main central banks (as it is in Japan). Commercial banks provide loans, investment banks may issue shares of corporations and specialized consulting firms provide various consulting services.
Share capitals in the U.S. corporations are mainly divided, so a huge number of U.S. corporations are not allowed in their registries to have individual shareholders whose shares amount is more than 1% of the total share capital. So, as a result, none of the groups of shareholders can bring a claim on a special representation of the company’s board of directors.
Another important feature is that the majority of shares are concentrated in the hands of institutional investors – pension and mutual, while the individual investors can not concentrate their shares. Those institutional investors who have concentrated in their hands more than 50 % of the share capital tend to act rather as financial managers: they do not seek representations on the boards of directors and, as a rule, avoid taking responsibilities for those companies where they have large packages of shares.
The American stock market is characterized with high efficiency and liquidity, which make the sale package of small investors quick and technically easy to implement business. What is interesting about U.S. is the fact that its citizens and corporations own 55 % of all the shares issued in the world.
All the American companies are owned by the shareholders. However, under U.S. law, the right of shareholders to participate in the company’s affairs is reduced by the company’s directors, who run the company from the name of the owners (shareholders). Shareholders are entitled to vote for or against certain changes in the company’s charter, to elect and remove directors and to approve or reject major changes that may lead to the disappearance of the company (in the case of a merger or acquisition). Beyond that, the shareholders of American companies have no rights to impact on the current affairs of the company.
Shareholders do not play a direct role in setting the level of dividends, hiring and firing managers or determination of major investments made by the company. Except for the consideration of pension plans in the private sector, the shareholders are not required to participate in the voting on corporate governance issues.
Concerning the peculiarities of the outsider models, they can be characterized with the separated shareholders’ ownership. In accordance with such specific form of possession, shareholders provide their control through the stock market and by the independent directors. If to be precise, the external directors carry out independent assessments of the managerial staff and provide an inner control. This is the main positive aspect of the outsider model of corporative governance. However, on the other hand, in such a system it is difficult to associate the opinions of various independent investors and directors, manage the conflicts between the executive and independent directors and to create an atmosphere of stability inside the company.
In the UK and U.S. relations in the field of corporate governance are regulated by numerous regulations and laws. In the U.S. at the federal level regulation of corporate law mainly began during the Great Depression during the late 20’s – early 30’s in the 20th century by implementing the laws that governed the movement of corporate securities exchanges. In 1940 a special federal law about companies’ investment was adopted. According to it, when a corporation is registered in a specific state, the state laws form the legal basis and regulate corporate rights and obligations.
Not long ago the United States adopted a large number of state legal acts (especially at the level of separate states), that allowed boards of directors to consider the interests of other members in corporate relations, which are not shareholders (and therefore are not entitled to vote). An example of the laws was in Ohio, according to which the board of directors could take into account by their own: 1) the interests of employees, suppliers, creditors and customers; 2) the state’s interests; 3) the social interests of the local population.
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The U.S. companies continue to have a single dominant opinion according to which the real primary responsibility of the directors in any company is to protect the shareholders’ interests. Creation of joint-stock companies varies widely among states. In the United States at the federal level the Securities and Exchange Commission regulates stock market securities; shareholder relations between corporation and the shareholder; establishes rules for disclosures for corporations. Offices of the Commission act in different states and even at the regional level.
A significant role in the Anglo-American model plays stock exchanges, which constantly determine the listing situation and the levels of informational disclosures. In 1988 the U.S. Department of Labor, which was responsible for the private pension funds, decided that these funds can act as attorneys for the shareholders of the corporations. This resolution had a great influence on the performance of different institutional investors and private funds. They became interested in corporate governance, shareholder rights and in the right vote at the annual meeting of shareholders, assuming that it is the part of their “fiduciary obligations.
Compared with other countries, in the United States the rules regulating disclosure of information are the strictest, because there is a system of appropriate regulatory acts, which make the corporate relations between the shareholders absolutely clear. And it is not surprising if you would take into account the size and importance of the stock market in the economy and in the international arena.
All the corporations in the U.S. the must report about themselves quite a lot: for instance, they have to quarterly provide different financial information about the corporation; the capital structure information; information about the activities of the previous directors (including positions that they hold, their relations with the company, company shareholdings); the sizes of total compensations for managers, as well as the dates of remuneration payments for the managers of higher ranks; the information about shareholders whose owning shares exceed 5 % of the share capital; the information about possible mergers or acquisitions; the information about the amendments that were made to the statute and the names of individuals or companies, which were invited to an audit.
In the Great Britain and some other countries with the Anglo-American model, the requirements about disclosures are similar, but they are not such strict as they are in the U.S. However, it should be noted, that the English corporate system is often described as inadequate. It is believed that the civil service, which similar to the U.S. Commission on Securities and Stock Exchanges, must work more efficiently, because the participants of the Anglo-American model are the shareholders, directors, managers, the government, different firms and organizations that consult corporations or shareholders about corporate governance. The mechanism of corporate governance involves active participation of self-regulatory organizations in it. Moreover, in the United States of America an unusually significant role plays the public opinion, the press and television in the state corporate governance.
Since the Anglo-American model was developed in the conditions of a free economy, it assumed that there must be a constant control after the ownership distribution in all the most prominent corporations that was very important for investors who have invested their money from the social activities and business. Commonly such investors are not legally liable for the actions of corporations and this is why they prefer to convey the corporative guidance to managers and pay them as their agents.
Interests of shareholders and managers do not always coincide. Corporate law solves such misunderstandings by creating special executive bodies inside the companies – the Boards of Directors. They are elected by the shareholders and are their representatives. As to the general meetings of shareholders, which are the highest bodies of internal corporate governance, they are usually gathered once a year and they have several features.
The U.S. laws do not distribute functions between executive and independent directors, but only determine the personal liabilities of the companies’ boards of directors. Decision on allocation of functions between the two categories of Directors shall adopt the company’s shareholders at a general meeting. The general tendency of recent years has shown that the number of independent directors in the U.S. Boards of Directors is continuously increasing and that the numbers of their representatives is decreasing. Thus, commonly the boards of directors in the U.S. companies among 13 members have 9 independent directors. However, there are companies where there is a chief executive officer (CEO), in other words a sole representative of the whole managerial staff of the Board of Directors.
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Nevertheless, the issues connected with the board of directors remain the most controversial in corporate governance in the U.S. and UK. Maybe it happens so because different problems concerning corporate governance, for instance disclosure mechanisms between corporations and shareholders are mostly resolved. In fact, in the UK and the U.S. the number of board members is lower than in Japan and Germany. Thus, the results of surveys of some American corporations suggest that the quantitative composition of the board compared to 1998 have significantly decreased. For example, young companies generally have small boards (5-7 people), consisting mainly of investors and managers, while large companies with more extensive system of the ownership, have in their boards up to 10 persons.
In American companies CEO (chief managers) are usually the key figures if the management process. CEOs make all the major decisions based on subordinate managers. Often companies formally have a board of directors, but actually its members are appointed and controlled by the general manager. Such significant role of the chief executive officers significantly distinguishes the outsider and insider models of corporative governance, for example, from the system of corporative governance and control in German.
Furthermore, American executive directors feel sufficiently large distance from the companies’ shareholders. However, despite this fact, the boards of directors in the American companies still retain significant nominal participation in the company’s affairs, which reflects a symbolic participation of shareholders in companies. Moreover, they still rely on the stock exchanges and provide control through voting by the sales of shares. So, the real effectiveness of this model of corporative governess is quite significant for the U.S. and UK due to various historical a socio-political reasons.
The analysis of the German “insider” corporate governance model
In Germany, the outer area of corporate regulation evolved gradually, and some federal traditions had a strong influence upon them. It is important because the companies’ charters, the charters of the stock exchanges, business rules and the rules regulating the supervisory boards of directors are competent to the federal law. However, the regulation of exchanges is the prerogative of local authorities. Federal agency that regulates the securities market was established in 1995.
The stock market in Germany is one of the largest in Europe. A major stock exchange in Germany is the Frankfurt Stock Exchange. Also a significant role in German corporate governance plays the publicity of the country. The press and television are active participants in corporate regulations and they can directly affect on the corporative climate. In Germany, the legislation regarding the limited liability companies (or GMbH in Germany) is considered to be less severe than, for example, in the United States. The disclosure requirements in the German model are such: the corporation must report every six months the financial information; the information about capital structure; the information about each candidate member of the supervisory board (including address and place of work); aggregate facts concerning the members’ remunerations of the supervisory and executive boards; information of shareholders who own more than 5 % in corporations; information about possible mergers or acquisitions; amendments offered to the statute, names of natural persons or legal entities which were invited to an audit.
The disclosure rules require in Germany, unlike in the United States, to report financial information every six months, but not quarterly. Unlike the U.S., there must be submitted only the comprehensive information about the remunerations of directors and managers. In addition, there are significant differences between German and American (GААР) Financial Reporting Standards.
The inner sphere of the corporate governance in Germany differs from the Anglo-American and Japanese models. However, some experts believe that it has some similarities with the Japanese model.
The essential peculiarity about the shareholders in the German (insider) model of corporative governance – is a great role of banks. Banks are long-term shareholders of German corporations and just like in the Japanese model the representatives of such banks are often elected to the Boards. However, if the representatives in the Japanese model are elected to boards of directors only during the economic recession, the German representative office in the board of directors is permanent.
In Germany, the majority of shareholders buy shares through the banks which are eligible to vote and to have deposits. Shareholders of the bank provide the power of attorney under which the bank has the right to vote during the period of 15 months. If a shareholder does not provide specific instructions on voting, the bank would have the right to vote as he considers. Quite often this leads to conflicts between the bank and the shareholders.
Therefore, the German owners and financial institutions that manage their capitals, have closer business relations with their companies than, for example, in the United States. And, as a result, they are much more interested in using their property rights and participating in monitoring the activities of corporations.
The German model has its unique features that distinguish it from other models:
- The boards of directors are bicameral and they consist of executive (managers of the corporation) and supervisory (employees of the company and shareholders) boards;
- Legislated restrictions on voting rights of the shareholders, in other words the companies’ charters limit numerous votes that shareholders can use at the meetings and these votes may not match with the shares that belong to the owner.
The key participants of the German model of corporate governance are the banks and corporate shareholders. Just like in the Japanese model, the bank simultaneously serves as a shareholder, creditor, and issuer of the securities (including debts) and as an agent that shall vote at the annual general meeting.
German banks are also shareholders of German companies and they may have long-term deposits in other non-affiliated corporations. In some way it is similar to the Japanese model, but quite different from the Anglo-American model, where neither the banks nor the corporation can be the institutional investors. The inclusion of employee representatives in supervisory boards is an additional difference between the model of corporate governance in Germany and similar models in U.S. and Japan.
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Regarding the role of general meetings of shareholders in the German model of governance, there is a special list of corporate actions that require shareholders’ approval. There are such actions: the distribution of net income (dividends, use of funds); ratification of decisions of the supervisory body and executive board for the last financial year; supervisory board elections; appointment of the auditors.
Unlike the Anglo-American, in the German model of corporate governance any important issues can be concerned without the shareholders. That means that all the decisions about creating associations with the affiliates, issues about the adoption of amendments to the statute (changes about its activity) and about increasing the size of the upper limit of payments must be approved with the shareholders.
A unique feature of the German model is a bicameral government in corporations, which consists of the executive and supervisory boards. The Supervisory Board is composed entirely of independent directors and the executive is formed by the corporative managers. Also there is a clear division in the German model between the executive and the supervisory functions, so these very two boards have clearly different legal responsibilities and powers. German law draws a clear line between control and direct supervision, and in accordance with it, the executive board in this model is subject to the supervisory board.
The responsible for the daily management in the company is the executive board. It consists exclusively from employees of the corporation. What is also differs the German model from Anglo-American, is the fact that the criteria for evaluation for the executive boards in German companies are different from American ones. This is probably because the status of the company on the stock market is not the main subject of attention for the German boards, and the information about short-term performance results of the company are of limited interest.
The analysis of the Japan “insider” corporate governance model
The Japanese legislation that regulated corporate governance issues and the stock market was practically copied from the U.S. during the World War II. Despite various amendments and changes, the base of Japanese legislation is almost the same as the U.S. legislation, except, of course, the role of state law.
The government and all the state ministries have traditionally had a huge impact on industrial and other policies in Japan, although in recent years a number of factors that influence Japanese industry have reduced.
There were several reasons:
- Firstly, into the regulation of the industrial policy became involved several ministries led by Ministry of International Trade and Industry and the Ministry of Finance in connection with the increasing influence of Japanese corporations abroad and domestically.
- Secondly, the Japanese corporations’ internationalization has made them less dependent on the Japanese market and less connected with the domestic industrial policy.
- Thirdly, the growth of the Japanese capital market has led to a partial liberalization of Japanese financial markets. However, despite the fact that these and others factors somehow separated single economic policy, it still remains an important factor in Japanese corporate governance, especially compared to the Anglo-American model.
- On the other hand, the independent regulation of the Japanese market is constantly made by state agencies of a specific competence. These organizations are key regulators: the Securities Bureau of the Ministry of Finance and the Committee for the Supervision of stock exchanges, which initiated the foundation of the Bureau in 2002. This regulatory agency is responsible for compliance with the applicable corporative legislation and considers the committed offenses.
Japan has a fairly well-developed stock market, which is a significant factor in corporate regulation. Tokyo Stock Exchange is the biggest in Southeast Asia, and its role is constantly increases. Japanese publicity has a slightly smaller impact on the corporate sector, for example, than in the United States. This happens so due to the national characteristics of the Japanese model of corporate governance.
Also, the corporate governance model in Japan is specialized by the high percentage of affiliated banks, companies as the shareholders. The banks and the corporations have strong ties. To tell the fact, the national legislation, publicity and the industrial structures together support “keiretsu”. Keiretsu appears to be a group of companies united by a mutual ownership and control. In the same time the percentage of unaffiliated shareholders is relatively low and therefore it is rather difficult to vote inside the corporations. The Japanese model of corporate governance is multilateral and it is based around a central bank and the financial and industrial networks, or keiretsu.
In the Japanese model of corporative governance there are four main participants: the central state bank, affiliated companies (main domestic corporative shareholders), managers and the government. Interaction between participants rather aims at the establishment of the business contacts, rather than on the balance of powers, as it is in the Anglo-American model.
Unlike the Anglo-American model, the independent (non-affiliated) shareholders are actually incompetent to influence the affairs of the corporation. Consequently, the number of really independent directors in the boards is extremely low.
In the Japanese model, just like in the German, banks are the crucial stakeholders and they develop strong relations with corporations. This is the main difference between these two models and the Anglo-American, where such relations are prohibited by the antitrust laws. However, general meetings of shareholders in the Japanese corporative governance model are objectively not as important as they are in American or German models. The main distinctive feature of the Japanese model is the mechanism of interaction between key stakeholders, which improves their relationship.
Boards of directors in Japan perform management functions between the general meetings. They have significant role in connection with the affiliated bank representatives and other members of the keiretsu. A common board of directors in Japan consists almost entirely from affiliated persons, such as the executive directors, heads of departments of companies and the government. If the company’s profit is constantly falling for a long period of time, the central bank and keiretsu members can remove some directors and appoint different from their candidates.
Contrary to the Anglo-American model, the representatives of non-affiliated shareholders appear very rarely in the boards of directors in Japanese corporations. Thus, despite the similarities in the sphere of foreign corporate regulations with the American model, the model in Japan differs significantly from it. An as a result, this corporate governance system has become a role model for the formation of corporate standards in other countries in the Southeast Asia.
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