Is there an Anglo-American

Corporate Governance Model?

By

Andy Mullineux
(BRiEF, University of Birmingham)

For the Jean Monnet Project

(Financial Integration, Structural Change,
Foreign Direct Investment and Economic
Growth in EU-25)

Andy Mullineux
Professor of Global Finance
The Business School
University of Birmingham
University House
Birmingham
B15 2TT
Email: a.w.mullineux@bham.ac.uk January 2008
Abstract

This paper questions the existence of an Anglo-American model of

corporate governance and capitalism. Significant differences between
the UK and US models of corporate governance are identified. The UK is
a principles orientated system based more on voluntary codes operated on
a ‘comply or explain’ basis, whilst the US system is more rules based and
litigious. The UK focuses more on ex ante protection of ‘outside’
shareholders, whilst the US focuses on ex post protection of share
traders. Institutional investors are expected to play a more prominent
and wide ranging role in corporate governance in the UK than the US,
though the evidence on their voting behaviour and wider ‘engagement’
activity is not readily available. The explosion of private equity led
leveraged buy-out activity in the mid 2000s challenges the efficiency of
both models and could be a harbinger of a ‘new capitalism’; relying more
on incentive compatible remuneration packages and less on public
disclosure and market discipline. Alternatively, it could simply be driven
by the tax advantages currently enjoyed by debt over equity, the special
deferred capital gains (‘carried interest’) tax treatment enjoyed by
private equity, low (long as well as short term) real interest rates (‘cheap
money’), and rising equity prices.

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1. The influence of legal type

In Masulis (2006), corporate governance is seen as a problem of

preventing investor (‘outside’ shareholder) expropriation by managers

and/or controlling (‘inside’) shareholders through self dealing. Following

the pioneering work of La Porta et al’s (1998) Masuli’s contrasts

protection against the self dealing under Civil and Common Law systems

and considers ‘French Origin’, ‘German Origin’ and ‘Scandinavian Origin’

variants of the Civil Law system. Masulis and La Porta et al find

systematic differences among these legal types in the protection of both

minority (or ‘outside’) shareholders and creditors through corporate and

bankruptcy laws.

The Masulis paper concentrates on ‘outside’ shareholder protection, as we

do here. However, the situation with regard to bankruptcy is not as clear

cut as the work of La Porta and its followers suggest. There are

significant differences between the US and the UK. The UK traditionally

favours creditors more than the US, which offers fairly strong

protection to debitors; including ‘Chapter 11’ protection. Recent law

changes in both countries have redressed the imbalances to some extent,

but full convergence has by no means been achieved. Further, France has

enhanced the protection of large debtors by introducing additional

protection against creditors modelled on ‘Chapter 11’ in the US.

Masulis’ paper attempts to develop a (regulation of) Self-Dealing Index

(SDI). The UK is taken as typical of Common Law countries, indeed the

model. Directors in the UK have clear fiduciary duties to shareholders,

as apposed to a wider group of stakeholders, as in Germany for example.

2
In the case of a ‘deal’ involving a potential conflict interest between the

directors and ‘outside’ shareholders, shareholders approval is required in

the UK. In contrast to the US, the UK favours ex ante scrutiny over ex

post litigation by minority shareholders. Disclosure requirements are

generally lower in the US than in the UK and the average of Civil Law

countries. It should also be noted that ex post private control is

relatively high in France, and so is Masulis’ Public Enforcement Index.

The US is in fact not typical of the Common Law group. It does not

require shareholder approval for related party transactions, relying

instead on litigation to protect against ‘self dealing’. Under US Delaware

(State) Law, transactions can be approved by boards of directors without

shareholder approval. In contrast, in France the requirement to seek

shareholder approval for related party transactions is in law easily

avoided, but in practice approval is almost always sought.

The Masulis paper also considers another theme explored by La Porta et

al, namely the relationship between regulation of self dealing and stock

(equity, not bond) market development. It is found that there are wide

differences in stock market development across the legal families, most

strikingly between Common Law and French Civil Law countries. Common

Law countries have larger stock market value to GDP ratios and less

concentrated ownership. It should be noted that the inclusion of the US

in the Common Law group strongly biases this result given that it has the

most highly developed stock markets and is in fact atypical. In addition,

there are some strong econometric issues in the La Porta inspired

methodology - endogeneity issues are not dealt with properly, for

example (Masulis, 2006).

3
The work of La Porta et al focused on ‘anti-director rights’ and

constructed an Anti Self Dealing Index (ASDI). It has been criticised

(Masulis, 2006) for its ad hoc nature and coding mistakes, and its

conceptual ambiguity. Masulis reconstructs the ‘La Porta’ indices, which

aim to summarise the protection of minority shareholders in the

corporate decision process, particularly relating to voting rights and the

ease of exercising them. In his index, the US is an outlier amongst the

Common Law countries, with shareholder protection falling well behind

the UK, but also France! Interestingly, ‘disclosure in the prospectus’ is

highly correlated with the ASDI and when both are used to explain stock

market development, it is disclosure that is significant, not the ASDI.

In sum, to the extent that self dealing is the central problem of

corporate governance, the law seems to play a big part in shareholder

protection and the level of protection varies across countries, seemingly

in relation to legal family.

However, the US is exceptional, given its non-Common Law emphasis on ex

post litigation, rather than ex ante disclosure and approval. Ex ante

transparency in self dealing transactions is taken by Masulis to be the

central difference between Common and Civil Law, and so, the US is more

akin to a Civil Law country and indeed behind France in providing ex ante

protection!

Masulis concludes that the role of ‘the public sector’ is to provide the

‘rules of the game’. These are then enforced by private action with

relatively little reliance on fines or criminal action (pace Section 404 of

4
the 2002 Sarbanes-Oxley Act in the US). More specifically, his findings

suggest that ‘an effective strategy for regulating large self-dealing

transactions is to combine full public disclosure of such transactions

(including potential conflicts) with the requirement of approval by

interested shareholders and strong private enforcement’. The UK seems

closer to this ideal than the US, which is weak on ex ante approval, but

strong on ex post litigation.

2. An Anglo-American System of Corporate Governance?

The Enron, WorldCom and other debacles in the US brought forth the

2002 Sarbanes-Oxley Act (‘Sarbox’), whose infamous Section 404

threatens Chief Executive Officers (CEOs) and Chief Finance Officers

(CFOs) with fines and even imprisonment if a corporation’s ‘internal

controls’ are found to be inadequate. Because private solutions were

found wanting, a public solution had to be put into practice.

In contrast, the UK’s ‘Combined Code on Corporate Governance’ is a set of

principles to which major corporations adhere on a voluntary, ‘comply or

explain’ basis. Further, shareholders have considerable power under the

code to appoint directors, and indeed replace CEOs and Chairmen and to

influence their remuneration. Increasingly this power is exercised

through institutional shareholders, particularly in the UK; where share-

ownership is much more concentrated in the hands of institutional

investors than in the US (despite recent diversification of UK pensions

and other funds away from equity into bonds and ‘alternative’

investments).

5
Bush (2005) contrasts the Turnbull Guidance on Internal Controls1 with

Section 404 of the Sarbanes-Oxley Act and notes that the Guidance has

been approved, by the US Securities Exchange Commission, to be Section

404 compliant. He regards the so called Anglo-American corporate

governance model to be a myth and argues that in Britain, as well as

‘Continental Europe’ and ‘The Commonwealth’, the purpose and focus of

presenting and auditing financial accounts is to serve the interests of the

shareholders, which is not the case in the US.

The US ‘deviation’ is traced back to the 1933 Securities Act. The original

aim was to adopt the British Company Law model, but this could not be

imposed at Federal level by Congress and significant parts of the

legislation had to be enacted at State level; resulting in the ‘Delaware

Law’’, which offers comparatively weak shareholder rights. As a result,

and corporate oversight in the US became focused on assuring accurate

market pricing (for share dealers), rather than financial reporting being

designed to facilitate a share holder oversight. The British model

addresses the question: “do the accounts show how efficiently a company

is run on its capital resources?” The US model in contrast asks: “are the

accounts consistent in showing what a company might be worth when a

share is exchanged?” Bush concludes that “the complete framework of

appropriate internal accounting and external reporting requirements in

the best interests of shareholders, as owners of the company, as distinct

from people trading shares, falls outside the US federal system” Hence

the need for Sarbox!

1
See “Consultation on draft revised Turnbull Guidance”, June 2005, Financial Reporting Council
(www.frc.org.uk)

6
In the absence of an overriding principle of seeking truthful reporting

for shareholders, the US accounting system has become heavily rules,

rather than broader principles based. Bush finds existing corporate

governance related law in Britain to be closer to that in continental

Europe, than that of the US, and that it is getting closer as a result of

European integration.

There are a number of important issues under debate relating to the

British model. These include auditor accountability, given that auditors

report to shareholders in one capacity but also to company audit

committees and regulators in others. Between them institutional

shareholders, auditors and regulators are supposed to ‘police company’

internal controls. Sarbox cannot be relaxed substantially for large

corporations in the US until alternative means of policing internal

controls and protecting minority shareholder rights are put in place.

After outlining in detail how the US - UK divergence occurred, Bush

focuses on the implications of the different core reporting objectives.

The British financial reporting model recognises in law that there is an

information imbalance between directors, as ‘insiders’, and shareholders,

as ‘outsiders’. This in turn creates a conflict of interest (self serving

bias) amongst directors (and controlling, or ‘inside’ shareholders). Hence

the test for the relevance of information provided is not just absence (or

presence) of fraud (particularly on the secondary market for shares, as in

the US), but also absence (or presence) of self-serving bias.

The federal reporting law in the US addresses the informational

asymmetries between company and secondary markets when a share is

7
exchanged, and also when shares are issued. It is US State Law that is

responsible for covering informational arguments between shareholders

and companies and in most US states this is not addressed by a financial

reporting regime. It relies instead on ex post private litigation. State

enforcement of shareholders’ rights is not strong and so shareholder

rights in the US are relatively weak. One way of looking at the

difference between the UK and US models is to argue that the focus in

the US is on underpinning an efficient capital (equity) market by assuring

that the share price is legally ‘right’ (Bush, 2005). In this sense the US

model is more genuinely one of ‘market based’ corporate governance than

the UK model.

The tendency towards greater disclosure will lead to convergence on a

more market (outsider) based system of corporate governance.

Harmonisation of accounting standards, to the extent that they entail

some compromise by the US accountants, will also force convergence of

practice.

3. Rules Based Vs Principles Based Accounting and Auditing Regimes

Bush believes (2005) the characterisation of the UK as having a

principles-based regime is partly wrong. The key principal in the US

regime is avoidance of scienter (fraud) on the stock market. Overseen by

the Federal Accounting Standards Board, US accounting ‘standards’ have

been developed to try to achieve this. The US GAAP (Generally Agreed

Accounting Principles) essentially created the framework to achieve the

principles of the 1933 Securities Act (US) without any overarching

8
principles of its own. In the context of legal challenges, more and more

gaps had to be plugged.

The US regime applies to listed companies only, whilst UK accounting

standards apply to all companies, supplementing Company Law, but not

creating additional laws. The UK Company Act sets out the key

accounting principles, including the requirement that they show a ‘true

and fair’ view. The emphasis is on ‘substance’, rather the ‘form’. In the

US the audit tends to check for regulatory compliance, not the ‘true and

fair’ disclosure of a company’s financial obligation, as the Enron case

demonstrated. However, in the end, the US courts did not conclude that

the creative overstatement of earnings by Enron had inflated its true

share price.

Bush makes a strong case for convergence on more wide ranging ‘general

purpose’ disclosure requirements consistent with the British model,

rather than a narrower US model. The shareholder relevant information

provided in the UK not only facilitates accurate pricing, but is also used

by the tax authorities; thereby curbing the incentive for earnings

exaggeration.

4. Civil Law Vs Regulation

Bush (2005) observes that the financial reporting framework in the UK is

Civil Law enforced by the general public and protected by the judiciary

and government, whilst in the US it is regulated by the government. Bush

further observes that, the “legal purpose of shareholder accounts and

the auditor duty of care developed across Europe in free markets from

9
the 19th century awards. In almost all of Europe and in the

Commonwealth, financial accounts and the audit share a common purpose,

namely to serve the shareholder”.

In the US, the auditors report to the board with a view to protecting it

from fraud by the managers, rather than serve shareholders interests.

As a result, auditors may get too close to their clients. Further, in both

the US and the UK, auditors are part of accounting firms that also sell

consultancy services to the same client and conflicts of interest result.

There is thus a need for public oversight. In the US this is done, post

Enron, by the Public Accounting Oversight Board (PAOB) set up by

Sarbox. In the UK too, in light of the collapse of Arthur Anderson post

Enron, public oversight by the Financial Reporting Council has replaced

self-regulatory oversight by professional bodies.

Sarbox regulates US auditing, but does not broaden the auditing purposes

to encompass shareholders protection. As such it entrenches the

differences between the US on the one hand and the UK and Continental

European models on the other.

Bush concludes that EU harmonisation initiatives have built on the

existing UK regime without much difficulty because their Company Law

systems have more in common with each other than the US framework of

State (Delaware) Company Law interacting with Federal regulations. He

sees the harmonisation of accounting and auditing standards as a

potential threat and feels that the importation of US standards is not

necessary to support capital market development in Europe, as the

10
success of the London markets and the rapid blooming of the euro

denominated corporate bond markets demonstrates.

5. Capital Market Competition: London Vs New York

Post Sarbox, the London capital markets have attracted an increasing

share of new listings by foreign companies relative to the New York

capital markets. This has raised concerned in the US that London, with

its principles based (‘litigation lite’) regulation under the Financial

Services Authority and ‘comply or explain’ (voluntary) corporate

governance system, might be proving attractive to foreign companies

seeking listings (initial public offering or ‘IPOs’) which are put off New

York by Sarbox’s more rule based litigious system overseen by the

Securities and Exchange Commission (SEC). An alternative view is that

London’s geographical (and hence time zone) position and international

focus makes it attractive as an international market serving Europe,

Africa and Asia. New York is not only naturally more inward looking, given

that it serves the worlds largest economy and there is a well known home-

bias to stock market investment (Bang-Chanko et al, 2006), but also

tainted by attitudes towards the US intervention in Iraq. As a result of

its Colonial past, membership of the EU and the small size of its domestic

economy, London has no choice but to compete for international business.

This is illustrated by its recent success in becoming a centre for Islamic

bond, Sukuk) issuance. The US has a number of committees looking into

the issue, but already some attempt has been made to water down Sarbox

as applied to smaller companies and seems to be leaning towards adopting

a more ‘principles based’ approach.

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Further, the former head of the NYSE (John Thain) alleged that the

success of London’s Alternative Investment Market (AIM), which

competes more directly with NASDAQ, than the NYSE; derives from its

dangerously lax regulatory regime and the weak corporate governance

requirements on its members. To be fair, there has been some concern

about this issue in the UK. The LSE (London Stock Exchange), which

overseas AIM, has proposed some measures aimed at encouraging the

‘nomads’ (‘nominated advisors’) of AIM quoted firms to perform their ‘due

diligence’ roles more assiduously and has increased disclosure

requirements. To some extent, however, such allegations from New York

are seen as ‘sour grapes’. Sarbox cannot, or should not, be significantly

weakened until alternative means of policing internal controls are in place.

As noted earlier, the policing or monitoring is done in the UK by auditors

and institutional shareholders (pension funds, insurance companies,

investment trusts and other collective investment vehicles).

6. Institutional Shareholders and ‘Engagement’ in the US and the UK.

Institutional shareholders (ISs) hold a significant majority of shares in

the UK and their responsibilities are outlined in a statement of principles

updated in September 2005 and overseen by the Institutional

Shareholders Committee; a representative committee of all the major

institutes and associations of collective investors, (including the

Association of British Insurers, the National Association of Pension

Funds, and the Investment Management Association. They are expected

to monitor the performance of companies, intervene where necessary,

report back to clients/beneficial owners and ‘vote all shares held directly

or on behalf of clients where practicable to do so’. ‘Engagement’ with

12
management includes dialogue, as well as voting and they can vote in the

election of members of the Board of Directors (especially the

independent directors), executive remuneration committees and internal

audit committees. They have the power to influence the appointment of

CEOs (Chief Executive Officers) and Chairmen and induce to their

replacement in cases of poor performance. They increasingly encourage

companies to comply with the UK’s ‘Combined Code’ on corporate

governance, which requires the separation of the CEO and Chairman roles,

and that CEOs should not automatically ascend to Chairmanship inter alia.

The UK position is somewhat different from that in the US, where share

ownership is more widespread (in part due to tax incentives to develop

private pension accounts), but the dominance of institutional share

holding has been increasing to reach record levels in recent years 61.2%

of the US stock market in 2005, compared to 51.4% at the height of the

dotcom bubble in 2000, and to 37% 25 years or so ago.

IS activism, apart from some prominent exceptions (e.g. Calpers, the

California public employees’ pension scheme) has not been as widespread

and lacks the weight of coordinated IS interventions in the UK. This is in

part because the US market is so large that significant coordination

problems amongst the institutional investors remain.

There is some evidence that increased institutional share ownership is

leading to greater activism, but the extent of it is mitigation by the fact

that a large part of the holdings are in exchange traded index funds.

These have no incentive to beat the market by improving the performance

13
of the companies whose shares they hold. Further, mutual funds, perhaps

the fastest growing ISs, are not traditionally active.

Some large European ISs, including the activist London based Hermes,

are pressing, so far without success, the SEC in the US to allow ISs

access to more company proxies to nominate and elect boards of

directors and to nominate members of remuneration and internal audits

committees and thereby bring the US more in line with the shareholder

rights enjoyed in London and elsewhere in Europe. Indeed they argue

that the lack of proxy access in New York compared to London and other

European stock markets is a stimulus for their growing popularity relative

to New York. They are also pressing for the right to sack directors.

Further, the US gives the CEO a great deal of power relative to

Chairman, and separation is not required, and they tend to sit on, or chair,

remuneration and internal audit committees.

This raises the further concern that the incumbent management, free of

oversight by independent directors and ISs, might be tempted to sell out

too cheaply in response to ‘Leveraged Buy-Outs’ (LBOs) bids led by

private equity firms i.e. as ‘insiders’ the management is tempted by the

promise of significant salary increases to recommend a sale at a price

that sells the wider (outsider) shareholders short.

7. The Rise of Private Equity – The New Model of Capitalism?

In 2007, pressure was increasing to tighten scrutiny of hedge funds and

private equity firms, particularly through greater disclosure

requirements. The US action on hedge funds is motivated by concerns

14
about insider trading, such as warning favoured customers (including large

inside shareholders) ahead of pending trades or management buy-out

(MBO) bids, and more general malfeasance. The G7 meeting in Essen in

February 2007 issued a more general warning of its concerns. Some of

these concerns relate to wider conflicts of interest within investment

banks that have surfaced in the US in recent years. These ‘conflicts’ can

be replicated between the investments banks and management and hedge

and private equity funds, who are major clients of the big investment

banks, both in New York and in London (a major private equity and hedge

fund centres) and elsewhere (‘Sleepwalking into a new investment

scandal’, Financial Times, February 5, 2007, p.17).

The wave of private equity led MBOs in the mid 2000s, have been

leveraged by funds from commercial banks and hedge funds, and

investment banks are also closely involved as advisors. The banks often

make the initial (‘covenant-lite’ or ‘cov-lite’) loans and then securitise

them as structured products (Collateralise Debt Obligations (CDOs)) and

effectively sell them on, often to hedge funds. Further, the hedge funds

frequently build up significant shareholdings in order to prompt changes

in management strategies or LBOs. Further, once an LBO bid is launched,

they can build shareholdings in order to profit from capitals gains and

influence the outcome through their shareholder voting rights.

Concern about such ‘activist investment’ by hedge fund was famously

raised in Germany by Franz Müntefering, then chair of Germany’s Social

Democratic Party, in 2005. He compared them to ‘locusts’, alluding to

their alleged asset-stripping and workforce cutting activities. He

continues to press for action to protect the social market economy in

15
Germany from this rampant form of (‘New Capitalism’). It is notable that

the hedge funds have become more ‘activist’ as shareholders than the

most activist of the ISs. There is a concern that given the more narrow

constituency they represent, they could be more ‘short-termist’ and less

strategic in their investment

As the LBO targets get bigger (e.g. the J. Sainsbury grocery chair in UK

in February 2007), public concerns about the effects on shareholders

other than inside or outside shareholders has grown prompting calls for

more transparency about what is being done and greater disclosure. The

private equity firms are being urged to respond quickly if they wish to

avoid regulation. Some of their managing directors claim that they are

very transparent to their (inside) backers, that they are professional, and

the public equity market has got lazy at monitoring and prompting

enhanced management performance. In other words, the institutional

investors are not ‘engaging’ effectively enough. This is unlikely to assuage

public concern as more and more of the stakeholders are affected by

bigger deals. Nevertheless, the ‘new capitalism’ is a direct challenge to

both the US and the UK models corporate governance systems and the

forms of capitalism they underpin.

A recent report by Credit-Suisse (FT, January 30, 2007, P30) found that

stocks with a significant family interest (in which the founding family or

manager retains a stake of more than 10% of the company’s capital

enjoyed), have since 1996 achieved a superior performance than their

respective sectoral peers. A similar result is found in the US. Credit-

Suisse has used these findings to construct a ‘Family Value Index’ made

up from 40 such companies, including BMW and Ericsson. Three key

16
reasons for the superior performance are proposed by Credit-Suisse.

Firstly, ‘long termism’ engendered by the desire to pass on holdings to the

children in the family. Secondly, avoidance by costly acquisition and

associated leverage (debt). Third, strong alignment of manager and

shareholder interests.

In the latter respect there is a strong similarity with formerly public

firms taken private by private equity firms through MBO. There are,

however, sharp contrasts too. Private equity firms usually look to exit

(sell their shares) after three to five years and are thus more medium

term in outlook and less patient. They need quick results and must often

act ruthlessly. They also take on large amounts of debt to leverage the

capital in their funds and those provided by hedge fund participants in

the bids by issuing bonds and taking on bank loans.

LBO’s effectively remove outside investors from the picture, thereby

resolving at a stroke the core of the ‘principal agent problem’ and the

underlying corporate governance problems (asymmetric information

between insiders and outsiders and the coordination problems faced by

outside shareholders). The ‘leveraging’ is effectively subsidised by the

bias towards tax deductable debt, relative to equity, which faces double

taxation of profits and dividends. Admittedly, publicly traded firms

could also take on more debt and indeed may do so to fund share buy-

backs inter alia, but is this desirable?

In a world where tax competition between countries pushes corporate tax

rates downwards it is debatable whether debt interest deductibility can

be sustained. Both the UK and Germany economics and finance ministries

17
have mooted withdrawing its deductibility, but have faced strong

opposition from the corporate sector (and SMEs, which tend to be more

dependent on bank loans for external finance). A trade off between

reduced corporate tax and reduced deductibility can be envisaged.

Private equity funds however, enjoy even greater tax concessions relating

to their capital gains tax treatment and the fairness of these have been

questioned in the UK and the US and are under review.

8. The End of Stock Markets?

How far can the privatisation of equity go? If it is so superior, then will

all publicly traded companies disappear and the stock markets close?

There is certainly a long way to go before this happens - the total value

of assets under private equity management is approximately 2.2% of

equity market capitalisation in the US and 1.3% in Europe! It is also to be

noted that the most common exit for private equity is trade sales to

publicly quoted companies. This is followed by ‘floatation’s’ (IPOs) on

AIM in the UK or Nasdaq in the US. The LBO targets only stay private

temporarily (normally for three to five years). Further, many

‘Mittelstand’ companies (in Germany and elsewhere) face ‘succession

problems’ and choose to sell the company as a going concern (with ‘good

will’ or ‘intangibles’ intact), rather shut them down and liquidate the

assets . Private equity may have a medium term role to play in the

process, but they too will want to exit before too long.

Perhaps most ironically, some of the large private equity firms (e.g.

Blackstones) have recently floated themselves on New York Stock

18
Exchange in response to the pressure for more disclosure and to enable

the founding managers to ‘exit’; rather than pass the ‘goodwill’ they have

built up onto their successors. This would perhaps not have been the

choice they would have made if the management was likely to be kept in

the family, as in the pre-Big Bang days of the merchant and private

banking associations in London and New York. Such family run banks still

trade successfully in continental Europe; but increasingly they describe

what they do, as ‘private banking’ or ‘wealth management’ and private

equity and venture capital, or more generally, ‘alternative investment’.

This, of course, not very different from what they have always done.

Bong-Chanko et al (2006) find that, notwithstanding home bias, US

investment funds are more attributed to markets that offer (outside)

investor protection, than to markets perceived to be insider driven. The

globalisation of finance is thus likely in the end to encourage more

disclosure (by private equity funds) and to favour markets that offer

greater (outside) investor protection. To the extent that London is doing

so, New York should take note. But the Sarbox rules may in the end

(perhaps following a scandal involving in an AIM. or an LSE quoted

company) prove superior to London’s principles based, voluntary ‘comply or

explain’ regime. Further, New York could help itself by enhancing the

proxy voting rights of institutional investors, whose role as outside

monitors should be enhanced as a means of reducing dependence on

auditors and rules backed by law; thereby requiring less resort to costly

litigation.

19
The private equity model dramatically raises risk compared to the public

equity model, which is why the returns are on average higher. The higher

risk is a result of the higher debt levels and much more concentrated

share ownership. There is more risk of illiquidity and a lack transparency.

Liquidity and transparency are the underpinnings of the public stock

markets. Lack of transparency can lead to cost escalation through fees

paid to advisors and generous management remuneration packages.

Finally, the model works against widespread share ownership and makes

informed portfolio diversification more difficult for pension and other

fund managers. If it progresses too far, it could undermine confidence in

the public markets, especially if the firms with the most upside potential

have been taken private.

The backlash against private equity is also linked to concerns about

foreign ownership of formerly domestically owned firms. There is a

suspicion that the new foreign owners, whether private equity or public

equity funded, may asset strip or ruthlessly cut costs (and jobs) and that

the boards sell out too easily due to aforementioned conflicts of interest

between them and outside shareholders,

Under US securities laws, companies that are taken private must file

reports on exactly how executives and investment banks come to be

involved in bids for the companies they manage or advise subsequent to

the introduction of the managers to the private equity firms. In the

interest of greater transparency, such reports would be useful in the UK

and so too would similar reports for other mergers and acquisitions

involving domestic or foreign public equity backed companies.

20
9. Conclusions

This paper questions the existence of an Anglo-American model of

corporate governance and capitalism The UK model relies heavily on

institutional shareholder ‘engagement’ and regulatory principles, the US

much more on regulatory rules and ex post litigation. There is some

suggestion that competition between the capital markets in London and

New York and thus of the UK and US models of capitalism, is inducing

convergence on a more principles and less rules based system.

The rise of private equity driven LBOs has introduced a new model of

capitalism to compete with the US and UK models. This development is

driven in part by advantageous treatment of deferred capital gains made

by partners of the private equity firms (‘carried interest’), the ‘fairness’

of which is being reviewed by the tax authorities in both the US and the

UK.

More fundamentally, the ‘new capitalist’ model relies on high leveraging

(debt to equity ratios) and generous performance focussed remuneration

packages for managers aimed at aligning their interests with those of the

(private) shareholders; who intend to sell out in the medium term to

secure their profits and make payments to the investors in the private

equity funds they manage.

The question thus arises, why the US or UK corporate governance models

do not adopt similar strategies involving (involving high leverages) and

incentive compatible management remuneration packages. If a highly

leveraged capital structure is genuinely advantageous (and not simply a by

21
product of the tax deductibility of debt servicing, but not dividend

payments and abnormally low (real) interest rates, such as those

prevailing since post 2001, and rising stock prices), then why have the

institutional investors in the UK, for example, not required the managers

of the companies in which they invest to adopt such a structure. And why

have they also not imposed incentive compatible management pay

structures? Is this simply a failure of UK’s corporate governance model?

Corporate finance theory suggests (distortions aside) that the capital

structure or degree of leveraging should have a neutral effect (the

Modigliani and Miller, 1958). Against this, however, Jensen (1989) argued

that the public company had outlived its usefulness due to, in part, to the

inherent conflicts of interest between managers (‘agents’) and

shareholders ‘principals’ (i.e. the principal-agent problem) and the wider

Berle-Means (1932) coordination (of dispersed shareholders) problem.

The ‘conflict’ of particular relevance to Jensen’s argument relates to the

use of retained profits. Higher debt levels impose more discipline by

reducing free cash flow in order to meet higher interest payments. As a

result, there should be less unprofitable investment. Institutional

investors that fail to assure that retained profits are invested at least as

profitability as they might be elsewhere are failing in their duty to

investors.

However, high debt levels have serious implications for other

stakeholders since higher leverage is associated with higher default risk

and thus threatens the job security of current workers and the security

of their pensions schemes as well. During the ‘restructuring’ of a firm

after a LBO, there is also a threat to the job security of current

22
employees (although the private equity firms claim that they are on

balance net job creators). Hence, as larger firms become involved in

LBOs, the private equity firms have come under greater scrutiny, in line

with the actual or potential social impact of their intervention.

Further, there may be wider implications for financial and macroeconomic

stability. Higher leverage ratios could well be associated with greater

instability since the interest on debt must be paid whether profits are

being made or not, whilst dividends only have to be paid when profits are

being made. Thus, there they may be a trade-off between ‘efficiency’ and

stability.

In the UK, the Private Equity and Venture Capital Association responded

to public criticism by commissioning Sir David Walker to make proposals

for a voluntary code of conduct with regard to disclosure of information

by private equity firms. At the end of July 2007 he proposed a ‘model

template’ that should include details of how an LBO transaction will be

financed, the strategy behind the deal, including any factory closures or

job cuts, and a description of who will take over as management and board

members. It is hoped that the media will police the system by ‘naming

and shaming’ firms that do not respect the voluntary code. A watered

down version of the proposal, which applies to larger LBOs, was finally

reluctantly accepted by the profession in the UK in late November 2007.

Another committee was working on voluntary codes for Hedge Funds, but

had not reported at the time of writing.

It seems unlikely that the UK Treasury Select Committee, which has also

been investigating the industry, will be happy with the recommendations

23
given that the threat to pensions funds is not addressed. It also seems

unlikely that Trades Unions, who have been lobbying hard against private

equity, will be satisfied by the implied lack of worker consultation; even

though the unpaid income and profits/capital gains issues they have

raised are partially addressed.

In the UK, mergers and acquisitions are covered by the ‘takeover code’ of

practice overseen by the Takeover Panel. The proposed disclosure

requirements for private equity led LBOs, or an enhanced version of

them, might reasonably be brought within this framework. The UK

government has also been urged to review the powers of the Pensions

Regulator and pensions trustees so that the viability of pensions funds

are not threatened by LBOs

In sum, there is no common Anglo-American system of corporate

governance or capitalism. Capitalism itself evolves in response to

competitive forces (‘globalisation’) within the context of institutional

structures that currently differ between the US and the UK (and more

widely). The competition between the systems is likely to lead

(eventually) to convergence on a hybrid system. The emergence of the

Private Equity (LBO) challenge to the public company governance

structures and Hedge Fund activism seems likely to influence the

convergence path, if not the destination.

24
References:

Berle, Jr. A and G. Means (1932). “The Modern Corporation and Private

Property”. Chicago Clearing House.

Bush, Tim (2005), “Divided by a Common Language where economics

meets law: US Vs non-US financial reporting models”, Dialogue in

Corporate Governance: Beyond the myth of Anglo-American Corporate

Governance; Institute of Chartered Accountants in England and Wales

(ICAEW), June 2005.

Bang-Chanko, René. M. Stulz and Francis. E. Warnock (2006), “Financial

Globalisation, governance and the evaluation of home bias”, BIS Working

Paper 220, December, Basel, Switzerland.

Bush, Tim (2005), “Divided by a Common Language where economics

meets law: US Vs non-US financial reporting models”, Dialogue in

Corporate Governance: Beyond the Myth of Anglo-American Corporate

Governance; Institute of Chartered Accountants in England and Wales

(ICAEW), June 2005.

Jensen, Michael “Eclipse of the Public Corporation”, Harvard Business

Review, Sept-Oct, 1989.

La Porta, Rafael, Florencio Lopez-de-Salinas, Andrei Shleifer and Robert

Vishy (1998), “Law and Finance”, Journal of Political Economy, 106, 1113-

1155.

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Masulis, Ronald, W. (2006), “The Law and Economics of Self-Dealing”,

Keynote Speech, The 19th Australian Finance and Banking Conference, The

University of New South Wales, Sydney, December 2006.

Modigliani, F. and M. Miller (1958), “The Cost of Capital Corporate

Finance, and the theory of Investment”, American Economics Review, 48:

261-297.

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