This is Part II of a two-part series on the World Bank’s Doing Business Report. In this entry, I discuss the extent to which the World Bank imposes a one-size-fits-all corporate governance regime and penalizes deviations from it with lower scores on the “Protecting Minority Investors” index. For Part I, see my earlier post.
“Protecting” Minority Investors
The second major problem with the World Bank’s Doing Business Report is reflected most clearly in its “Protecting Minority Investors” category. Here, the index implicitly mistrusts the power of spontaneous private-ordering.
Countries construct their corporate law regime along a rough continuum, from a contractarian and enabling approach to a mandatory and statutory approach. The former (prevalent in common-law countries) says: “here are some basic default rules, feel free to opt-out of any but the most basic of them (such as the “good faith” requirement) and thereby customize your corporate charter as you see fit.” The latter, more prevalent in civil-law countries, says “Your charter must look like this, you may customize around the edges but the basic template is not up for negotiation”.
The World Bank has very much embraced the mandatory approach in its “Protecting Minority Investors” index. Any corporate governance arrangement that does not reduce a firm’s management to supine figures groveling at the feet of shareholders is penalized with a lower score. The balance of power between management and shareholders in a hotly contested issue in the academic corporate governance literature, with top scholars exchanging salvos in the pages of law reviews and economics journals as we speak. As I have written elsewhere, I believe that restrictions on shareholder power, such as insulation provisions or representative quotas for the board of directors, are inefficient and misguided (for further reading, see Lucian Bebchuk’s work, the indefatigable Harvard champion of shareholder rights). Yet this is not a justification for their proscription by the state. Let Bebchuk’s work persuade businessmen on its own merits. Likewise, statutes and regulations which impose costs or restrictions on management and the board of directors which the relevant contracting parties might not have agreed to in every instance similarly reduce the potential bargaining range and leave mutually beneficial deals on the table. If a prospective corporation were so inclined to tap the insights of the ivory tower for guidance as to how to efficiently structure its charter, shouldn’t it be permitted to emulate what it believes to be the better of the academic arguments, as applicable to its particular niche in the larger corporate ecosystem? Instead, we have the World Bank declaring Bebchuk the winner, in all circumstances, by fiat.
Ironically, restrictions on the management and the board are tantamount to restrictions on the shareholders themselves, the principals who now possess fewer degrees of freedom along which to command their agents. When the “Protecting Minority Investors” index awards a score of 1 if “shareholders elect and dismiss the external auditor” and a 0 otherwise, this can be translated as “shareholders are never allowed to delegate this particular responsibility to management or to the board.” Translated further, we arrive at the assumption implicit in this scoring scheme: “We [the philosopher-kings] foresee, ex ante, no scenario at any company in any country in which shareholder delegation of power X would be the efficient outcome arrived at by the contracting parties to the corporate charter.”
If management’s selection of the external auditor (is having an external, as opposed to an internal, auditor always the efficient outcome? The World Bank thinks so) is inefficient for a given firm, two things will happen: 1) That firm’s shares will be discounted accordingly. The fatal conceit baked into the World Bank’s scoring approach is that if it wasn’t for the state’s wise contractual parameterization serving as guardrails, ignorant shareholders would be robbed blind by asymmetrically informed insiders.
But shareholders opt in to buying a firm’s shares after assessing not just the firm’s financial fundamentals but its corporate governance structure as well. What if insiders then simply fail to disclose this information? Shareholders will then ding the share price for this lack of transparency. 2) The firm will suffer not only a lower share price for failing to accommodate this shareholder preference, but also the undetected managerial rent-seeking that results from having a compromised auditor with a conflict of interest. All else equal, this firm will be at a competitive disadvantage in the market and we would expect this maladaptive provision to disappear except in situations in which it proves efficient. No need for the state to render certain contractual evolutions stillborn ex ante when we can simply observe ex post those efficient arrangements which survive in the market for corporate governance strewn amongst the fossils of thousands of (mostly defective) iterations.
The less information one has about the particular, idiosyncratic nature of the business that a corporation will be engaged in, the less one is able to prescribe efficient rules for that corporation ex ante. When prescribing efficient rules for all corporations across all business environments, parsimony is key. Beyond a few basic, universally adaptive rules (e.g. the “good faith” requirement, or, “mammals should have relatively sturdy spines and thick skulls), blindly prescribing more specific rules may well prove maladaptive (all mammals should have flippers).
The World Bank is not short on characteristics that a country’s corporate law must prescribe:
- Extent of Disclosure Index (5 provisions)
- The index envisions an extremely robust, mandatory disclosure regime for related-party transactions that falls upon the shoulders of management. But of course, any mandatory diversion of managerial resources (in this case, complying with disclosure requirements) imposes opportunity costs suffered by the firm writ large, including its shareholders. Management’s inclination to engage in related-party transactions indeed poses a classic agency problem for shareholders (which they can simply price-in to the cost of capital!), but it is far from clear that every firm in every country would find the precise disclosure measures codified in the World Bank index to be the value-maximizing conditions in every instance. In many economies, informal relational networks predicated on reciprocity and reputation are invaluable. Shareholders may intentionally be investing in firms with a CEO who’s tapped into such networks.
- Extent of Director Liability Index (7 provisions) + Ease of Shareholder Suits Index (6 provisions)
- Allocates liability, ease of bringing a lawsuit, who can bring the lawsuit, who must pay transaction costs and legal fees, etc. Many of these might be efficient. Some might be transfers. Some might be inefficient. Anyone familiar with the law and economics tradition recognizes that every one of these provisions entails tradeoffs, whereby costs are redistributed amongst the parties. The contractiarian approach assumes that the negotiating parties will be able to arrange for the costs to fall on the party most capable of preventing them. The greater the number of non-negotiable tradeoffs imposed ex ante, the less likely this is to be the case.
- Shareholders’ Rights in Corporate Governance (30 provisions across multiple sub-indexes)
- Finely prescribes the balance of power between management, the board and shareholders, between majority owners and minority investors, thresholds for agenda control amongst shareholders, auditing and disclosure requirements, etc.
Once again, it’s one thing to recommend the foregoing provisions as generally efficient default conditions which corporations may opt-out of in designing their charters if they so choose. Shareholders may then freely choose amongst various charters, pricing them accordingly. It’s entirely another thing to require, a-la the World Bank, that:
The change must be mandatory, meaning that failure to comply allows shareholders to sue in court or for sanctions to be leveled by a regulatory body such as the company registrar, the capital market authority or the securities and exchange commission… include[ing[ amendments to or the introduction of a new companies act, commercial code, securities regulation, code of civil procedure, court rules, law, decree, order, supreme court decision, or stock exchange listing rule.
The state can’t trust private entities to manage their own affairs. It must take them gently by the hand.