2nd Mitsui Life Symposium on Global Financial Markets: Corporate Governance in Japan and the United States



MAY 11, 1993

(Published in Journal of Applied Corporate Finance, Vol 6:No 4, Winter 1994)

Joseph White, Dean of the Michigan Business School, opened the symposium by extending a welcome to an audience of 600 business leaders, regulators, and academics who filled the main auditorium of the Keidanren Kaiken.
Koshiro Sakata, President of the Mitsui Life Insurance Company, followed with congratulatory remarks directed to the organizers of the conference.
Following the principal presentations, three of
which are printed below, the symposium concluded with a summary and closing remarks by Professor E. Han Kim of the Michigan Business School, and Takaagi Wakasugi of Tokyo University, the co-directors of the Mitsui Life Center.

Joicho Aoi, Chairman of the Board, Toshiba Corporation

Let me begin by congratulating Mitsui Life on sponsoring this second international symposium with the University of Michigan’s Graduate School of Business. I am pleased to see that the event is being held in such a grand manner, and feel honored to be given the opportunity to speak to you today.

The subject of today’s symposium is the governance of corporations in Japan and the United States. There has been a lively debate on corporate governance here in Japan, in the U.S., and in a number of European countries as well. I would like to share with you some of my personal views on the subject. In so doing, I will also discuss what I believe to be the most important consid­erations for corporate management in leading their companies into a new era of technology‑based competition.

The basic issue underlying the corporate governance debate can be stated very simply: To whom does the company belong? That is, should corporate managers view themselves primarily as stewards of their investors’ capital and so aim to maximize shareholder value? Or should they view themselves instead as custodians of their companies’ “human capital,” and thus concentrate more on protecting the interests and developing the knowledge and skills of their employees.

Over the long run, of course, these two perspectives need not be mutually exclusive. Both capital and people are essential to corporate success, and the requirements of both investors and employees must eventually be met. But, as I will argue later, in a world characterized by increasingly global and technology­based competition, the development of human resources has become a much more important corporate function than it was in the past. In the last analysis, moreover, corporate success will depend on management’s ability to satisfy not just its investors and employees, but the entire range of interests that make up our society.


The U.S. corporate governance debate was fueled by the stockholder activism of the 1980s. During this period, U.S. institutional investors such as pension funds became more financially sophisticated and used their expertise to exert more influence on the man­agements of the companies in which they had in­vested. The participation of institutional investors also helped make possible the wave of hostile takeovers that forced the top managers of many U.S. compa­nies out of their jobs. As a result of this takeover activity, the corporate governance issue in the U.S. has been broadly characterized as a “contest for control” between management and shareholders.

Today, there is a widespread perception that the corporate restructuring of the ’80s‑and the adversarial relationship between management and investors underlying it‑was leading to the industrial decline of the U.S. In the ’80s, American companies across a broad range of industries lost market share to global competitors. The rigid shareholder‑based controls exerted by the U.S. governance system have been blamed for enforcing a short‑term profit men­tality on U.S. companiesa mentality that impaired their ability to compete with their more far‑sighted German and Japanese competitors.

In the 1990s, however, the U.S. governance system has undergone significant changes. Although by no means eliminated, the problem of shortsight­edness in many U.S. companies has been mitigated in a number of ways: most notably, by encouraging more active participation by outside directors and establishing longer‑term relationships with institu­tional investors. Some U.S. companies have also made the attempt to build stronger relationships with other important corporate “stakeholders” such as custom­ers, employees, suppliers, financial institutions, and the local communities in which they do business.

Thus, the perspective of U.S. managers on cor­porate governance has broadened considerably in the ’90s from its near‑exclusive preoccupation with share­holders duringthe’80s. Nevertheless, the primary focus of the U.S. governance debate remains the balance of power between managers and shareholders; and thus proposed solutions to the U.S. governance prob­lem focus on means of increasing the effectiveness of corporate boards in transmitting shareholder in­fluence and enforcing shareholder control. They reflect an external approach to the problem, as opposed to the internal one I will propose.


Unlike the U.S. experience, the corporate gov­ernance debate in Japan did not get underway until the 1990s. In this country, the governance discussion has clearly come in response to economic adversity. Since the bursting of its stock market “bubble,” Japan has experienced a sharp and sustained downturn of its economy during the past three years. Corporate earnings, investment, and stock prices have all de­clined significantly, and we are now in the midst of a period of harsh correction and adjustment.

One of the leading participants in the Japanese corporate governance debate has been the Nomura Research Institute, or NRI. NRI recently published a report that came to the following major conclusions:

  • First, the declines in corporate earnings and share prices have by far exceeded those that would have been expected in a purely “cyclical” downturn, and NRI has attributed the severity of such declines to a 44structural” overcapacity stemming from lax invest­ment criteria employed by Japanese companies.
  • Second, the practice of cross‑holdings of shares among Japanese firms has prevented shareholders from exerting sufficient influence on management, with negative consequences for efficiency.
  • Third, in addition to denying shareholders any means of effective oversight or control over their investment policies, Japanese companies also tend to compound the problem by retaining excess capi­tal rather than returning it to shareholders in the form of higher dividends or share repurchases. Failure to pay out excess capital leads to inefficiency.

As you can see from these conclusions, although there are some differences in focus between the U.S. and Japanese governance debates, there is also a common set of concerns. In both countries, there is a perception that corporate management is not suf­ficiently accountable to outside constituencies, and that something must be done about it.

But, in order to evaluate the nature and extent of this problem, we need to examine a few basic questions first: What are corporations in the first place, and how did they originate and develop? And how have their organizational structures and activi­ties changed over the years? Are corporations today doing the right things to prepare for a modem envi­ronment that includes intense global competition, often based on technological superiority? These are the basic issues that confront corporations around the world as they approach the 21st century.

The fundamental aim of corporate activity is to promote technological innovation that leads in turn to value-adding products and services. To the extent such products and services are valued by society, society rewards the corporation—or all its different contributing groups.



The notion that business is conducted primarily by corporations dates back to the 1600s, when the East India Company was established in Great Britain and when similar companies were established in the Netherlands and France. Prior to the formation of these companies, spices produced in Asia were trans­ported overland. The East India Company revolu­tionized world trade by transporting spices and other exotic goods overseas by ship, which led in turn to the establishment of plantations and further devel­opments. It was the form of the “joint stock” corpo­rationin which hundreds of outside investors could each buy fractional ownership interests in a single entitythat allowed such large and risky ventures to obtain the necessary capital.

Between the 1600s and the beginning of the 20th century, corporations were responsible for tech­nological innovations–particularly during the In­dustrial Revolution of the 19th century–leading to greater productivity and higher standards of living throughout the industrialized world. But there was one important difference between those companies and their modern‑day counterparts. Although the East India Company had hundreds of shareholders, most corporations in the late 19th and early 20th century were closely held. Even in the world’s largest corporations, there was a heavy concentration of ownership and owner‑managers were the rule rather than the exception.

But, as a result of the rapid growth of U.S. finan­cial and securities markets in the first decades of this century, the ownership structure of U.S. corpora­tions changed dramatically. In fact, a survey con­ducted as early as 1932 revealed that, in 85% of the largest 200 U.S. public companies, no single stock­holder owned more than 10 percent of the shares. Thus, even in 1932, the separation of ownership from control that U.S. corporate governance critics complain about today was already well advanced. Even then, shareholders had effectively delegated the function of corporate management to a relatively new class of “professional” managersthat is, man­agers who were not also major stockholders.

In the second half of the 20th century, this pro­liferation and dispersion of shareholders spread to all the industrialized countriesand Japan was no exception. Professional managers everywhere com­peted by means not of their own accumulated capi­tal, but on the basis of their knowledge and ability. This worldwide development of professional man­agers in turn enabled corporations to enlarge their operations and achieve significant economies of scale and scope. The result was further increases in pro­ductivity and standards of living worldwide.

In recent years, however, the nature of corpo­rate competition has changed fundamentally. Indeed, I would say that we have entered a “new era” of management. But before describing this new age of competition and the ways companies are adapting to it, let me first offer a brief definition of the corpora­tionone that will allow us to recognize what re­mains the same in corporations even as they are going through continuous change.

In my view, the corporation is an organization of people and resources whose basic purpose is to add value by transforming technological innovation into goods and services demanded by the society. In the process of converting new technology into val­ued goods and services, corporations bring together different kinds of resources‑notably, capital, labor, management skills‑and then attempt to organize themselves in the way that leads to the most produc­tive use of all the resources. And let me elaborate on a few key terms. My definition of “technology” is meant to be comprehensive, encompassing innova­tions not only in products, but in the way services are provided, By “value‑added” I mean the sum total of the benefits deriving from corporate activities that support the upgrading of our society as a whole.

So, the fundamental aim of corporate activity is to promote technological innovation that leads in turn to value‑adding products and services. To the extent such products and services are valued by society, society rewards the corporation‑or all its different contributing groups. Consumers receive valuable products and services, shareholders earn higher returns on their capital, employees receive higher wages and benefits, and local communities prosper. In this sense, the corporate mission is tied firmly to advancement of the social interest. The productive efficiency achieved by corporations in competition with each other yields collective ben­efits to all.

We are in the midst of a transformation from an industrialized to an information  oriented society. For corporations, perhaps the most important consequence of this information revolution is the resulting diversification of consumer tastes and preferences. The increased sophistication of consumers has led to rising demand for both higher‑quality and more specialized products.


This brings me back to my initial statement of the fundamental question of corporate governance: To whom does the company belong? The two most popular approaches to this issue can be summarized very succinctly: Proponents of one view hold that companies are consolidations primarily of capital; proponents of the other that companies are primarily consolidations of people.

Both of these viewpoints, I hasten to say, con­tain an important element of truth and yet both are incomplete. The relative weight that can be assigned to each can also change over time.

Until fairly recently, for example, corporate success throughout the world was based on achiev­ing scale economies from mass production intended for mass consumers. That was the model of industrial society that prevailed throughout the late 19th cen­tury and the first half of the 20th. The primary eco­nomic interest of society lay in the efficient produc­tion of homogeneous products in large enough quantities to achieve significant reductions in prices to consumers. And the principal means of achieving such efficiencies was large‑scale investment in plant and equipment financed by large amounts of inves­tor capital. The ability to raise and redeploy capital, then, was the primary ingredient in corporate suc­cess; people were secondary, interchangeable fac­tors of production.

Today, however, we are in the midst of a trans­formation from an industrialized to an information ­oriented society–a shift that can be expected to continue well into the next century. Increasingly, information networks are being established that will give people everywhere inexpensive access to huge stores of information housed in all variety of data­bases. For corporations, perhaps the most important consequence of this information revolution is the resulting diversification of consumer tastes and pref­erences. The increased sophistication of consumers has led to rising demand for both higher‑quality and more specialized products. And this fragmentation of mass markets has in turn required important changes in production such as flexible manufactur­ing and better inventory controls.

There has also been a major shift in the way information flows. In the past, information was trans­mitted for the most part in one directionprimarily from large corporations to their consumers, suppli­ers, and distributors. Today we are seeing a two‑way street for information between corporations and their major customers and suppliers. Developing such channels of information is critical for corporations attempting to keep up with continuous changes in consumer demand.

Greater demand for customized products also means a larger role for employee initiative and cre­ativity. When we speak of employee “creativity,” we are referring in part to their ability to anticipate con­sumer demands. All companies have employees with highly subjective tastes, idiosyncratic ways of think­ing, and distinctive kinds of know‑how. Corpora­tions should be organized so as to identify and en­courage the development of these human “assets” in such a way that each individual feels challenged and committed to contribute to the company’s success.

And this is perhaps even more true of service industries, where corporate success has always de­pended heavily on the performance of employees. Because service businesses in all industrialized na­tions are expanding far more rapidly than manufac­turing, the importance of employees’ contribution to corporate success is growing.

In sum, the information revolution has elevated the importance of development of human resources relative to capital management. The companies that succeed in the information age will be those organi­zations best able to integrate people, goods, and capital. Those companies that fail to stimulate and harness the creative potential of their employees will be shaken out in the new competitive environment.


But having said this, let me return once again to my original question: To whom does the company belong?

As I suggested earlier, it belongs in part to its shareholders, and it belongs in increasing part to its employees. But neither of these is a complete an­swer. In my view, the complete answer is that the corporation belongs to society. As the economic priorities of society change, so too must corporate priorities. And as a better informed society leads to further diversification of the tastes and values of its citizens, corporations must place increasing empha­sis on investing in and getting the most from their employees.

This view of the corporation as accountable to a broad range of social interests also leads to a dif­ferent way of evaluating corporate performance. In the past, it has been customary to focus on the profits earned by a particular company. But there is another measure of corporate success that may be more rel­evant: namely, the total social benefits derived from a corporation’s activity net of any social disadvantages. For example, in developing internal measures of performance, corporations may choose increas­ingly to capitalize rather than expense their outlays on training, software, and R & D. Such outlays rep­resent investments in the corporate future, and cor­porate internal accounting (and perhaps external accounting, too) should recognize these realities of the new management era.

As another example, measures to reduce the emission of chloro‑fluoro carbons, or CFCs, may impose significant costs on individual companies. By volunteering to bear their fair share of these costs, however, corporations will be contributing to the social welfare. And in the kind of social cost‑benefit analysis by which companies will inevitably come to evaluate their performance, corporate contributions to social problems will increasingly be viewed as “investments” in a firm’s social standing.

Such investments are important because more extreme critics of corporationsthose who subscribe to the “born‑evil” theory of corporationsare con­vinced that all profit‑seeking activities are, by their very nature, harmful to the social interest. All coun­tries have such people, and they tend to have politi­cal influence out of all proportion to their numbers. To combat such misguided criticism, corporations in all nations will have to devote more resources not only to social causes like public health and the en­vironment, but also to educating the public about the social benefits of corporate activities.

Another issue that arises regularly in Japanese discussions of corporate governance concerns the negative consequences of the widespread cross-­holding of shares. Such cross‑holdings reinforce the natural tendency of managers to insulate their com­panies against pressure from “outsiders,” which in­clude shareholders as well as representatives of other social interests. Proposals for reform typically in­clude the appointment of outside directors and im­provements of the auditing system.

I personally believe that outside directors could do much to help companies recognize and respond to the interests of society as a whole. Accordingly, several years ago we at Toshiba set up an advisory board composed entirely of outsiders. The purpose of the board, which meets about twice a year, is to advise top management on broader social as well as economic issues that are typically outside the scope of normal business issues. And my understanding is that many of the largest companies in Japan have introduced similar systems on a voluntary basis.

The information revolution I mentioned earlier makes the function of such a board all the more valuable. With greater access to information, outsid­ers can more easily monitor the activities of compa­niesand the companies themselves can more readily see the interests of those outside the company. As I stated earlier, companies can no longer afford to remain indifferent to the interests of those outside the company. As part of a complex social fabric with conflicting as well as common interests, corpora­tions must seek to win and retain the trust of all the various segments and strata of society.


Further complicating the challenge of the new, more competitive global environment are radical changes in political economy now taking place. After half a century of the Cold War, the world is seeking to create a new order.

Today, we are at a critical turning point in that process. In the 1980s, the world economy experi­enced rapid economic growth, but the 1990s are proving very different. The United States is faced with twin deficits in its fiscal and trade sectors. At­tempts to integrate the European Community are being frustrated by conflicts of interest among vari­ous EC member nations. And, in the former Eastern European nations as well as Russia and the new CIS, there is complete economic disarray. At the same time, some lesser developed countries are saddled with heavy debt burdens, while issues of environ­mental conservation appear to be pitting the eco­nomic interests of LDCs against the social concerns of industrialized nations.

And, as I mentioned earlier, the Japanese economy is now in the midst of a severe adjustment phase. Most Japanese companies, representing vir­tually all industrial sectors of our economy, are moving ahead with severe restructuring efforts aimed at pro­ducing “qualitative” growth in the new era, as op­posed to the “quantitative” growth and expansion that characterized the ’80s and earlier. By “qualita­tive” growth, I mean the formidable task of produc­ing higher‑quality, often more specialized, products in lower volumes for more demanding consumers while still economizing on capital, labor, and other social resources.

In confronting this new challenge, we are faced with the necessity of re‑examining all aspects of Japanese‑style managementa management style that, until recently, was regularly cited as a major contributor to the competitive successes of our com­panies. As I stated earlier, the corporate raison d’etre is the same; it remains the creation of value‑added products and services through technological innova­tion. What demands a radical shift in management perspective, however, is the growing diversification of tastes and values of consumers (and, as I discuss later, of employees). With the advancement of the new information society, companies must invest more heavily in their human resources and place greater emphasis on giving full play to human intellectual creativity within the organization. The competition for technological innovation, productive efficiency, and more sophisticated consumers demands it.

Our basic challenge at Toshiba is to develop products that harmonize our technological advantages with consumer demands and the capabilities of our manufacturing system. The ideal toward which we are striving is a completely flexible manufacturing system in which we can produce a large variety of products in ever smaller quantities, thereby eliminating the need to carry inventory.


(With an Aside on Inventory Management)

Let me say a bit more about technology and human development in corporations, because it’s something that has been much on my mind lately. I have always felt that technological innovation is the most important factor in corporate success. It’s true, of course, that technology per se may be more im­portant in manufacturing than in service businesses. And, as I noted earlier, the growth of the world economy is increasingly moving away from manu­facturing and toward services. But regardless of whether a company belongs to the manufacturing or the service sector, continuous innovationbe it new developments in technology, or valuable changes in organizational structure and processesmust always be critical to competitive success.

During the past two decades, the world has witnessed a transition from an industrial to an infor­mation‑oriented society. During this time, semicon­ductors, computers, office automation, and innova­tions in communication, image, and information technology have all played a central role in eco­nomic growth. But the real force underlying all this change and technological innovation is the human mindhuman brainpower, if you will. Technologi­cal innovation is linked inextricably with changes in the mindset of people—changes which have also expressed themselves in the remarkable prolifera­tion of new consumer tastes and values.

Underlying this diversification of consumer tastes and values is the natural human urge for self‑realization, which means in part differentiating oneself from others. Technological innovation has allowed fuller expression of this urge and, in so doing, has further increased the “demand” for diversity within the cor­porate environment. This means that unless corpo­rations are able to satisfy employee demands for greater opportunity for self‑realization, they will find themselves lagging in the competition for technol­ogy. And if this happens, their products and services will eventually fail to attract consumers, and the organization will lose its justification for being.

Along with this urge toward self‑expression has come increased popular demand for “consumer sovereignty” as a national economic goal. In the past, Japanese companies were remarkably successful in transforming Japan into an economic superpower. This was an appropriate social goal for an industrial society. These days, however, we hear much talk about the need for a better quality of life for the Japanese people. Japan, many observers have sug­gested, ought to seek to become a “lifestyle” super­power as well as an economic superpower.

Such a change in economic goals may require a redefinition of the Japanese concept of “social wealth.” I believe that a society is wealthy only to the extent that it satisfies the demands of its citizens. In the new information age, such demands are shifting from simple material satisfactions to a desire for more sophisticated and higher‑quality goods. Social wealth is thus reflected not in the abundance of physical assets such as oil and land, but rather in the quality of life of its people. A lifestyle superpower is a nation that secures a better quality of life for its citizens.

Corporations must contribute to social wealth by changing their objectives in a way that better meets the demands of consumers. Technological innovation is the key to improving quality of life, in large part because consumer demand is undergoing continuous change. Staying on the cutting edge of technology allows companies to anticipate changes in consumer needsand, in some cases, even to create themrather than responding after the fact.

At the same time, of course, the successful commercialization of technology also requires continu­ous attention to current consumer demands. For example, our basic challenge at Toshiba is to de­velop products that harmonize our technological advantages with consumer demands and the capa­bilities of our manufacturing system. The ideal to­ward which we are striving is a completely flexible manufacturing system in which we can produce a large variety of products in ever smaller quantities. To the extent we can achieve this idealand we have made considerable progress toward it in recent yearswhile also improving our distribution sys­tems, we could conceivably eliminate the need to carry inventory altogether.

Why is inventory management so important? There are directly measurable costs, of course, asso­ciated with warehousing inventory. And, in our present recessionary phase, we often hear about the need to reduce such costs by making inventory adjustments that anticipate the future strength of the economy. But I think that inventory management has a much greater significance than direct costs. Indeed, I would submit that relying on inventory is the greatest source of inefficiency in business. Stocks of inventory effectively block the flow of information between consumers and producers. Such informa­tion in turn provides the basis for other important decisions throughout the organizationin strategy and planning, research & development, and market­ing, as well as production. And, as we progress fur­ther into the new information era, I predict that the ideal of the “stockless” corporation will become a new model for management.


In the past two decades, the Japanese economy has weathered two major oil crises as well as the competitive problems stemming from the apprecia­tion of the yen. In each case, we have overcome these problems by giving full play to the creativity of our people in confronting technological challenges. I am confident that technological advance also holds the solution to our current problems. To remain competitive, companies in all nations must continue to develop their technological capabilities.

The key to developing such capabilities lies in developing and making the best use of corporate human resources. In the new “intelligent informa­tion‑oriented society,” as we refer to it at Toshiba, it is human capitalintellectual value‑added, if you willthat will increasingly differentiate successful from unsuccessful companies. The slowing of world­wide economic growth rates combined with the diversification of values of the various segments of the society is now forcing companies to draw upon and give full expression to their intellectual resources.

And just as diverging consumer tastes are forc­ing companies to differentiate themselves by producing goods and services with more originality, employees are also changing their views of the com­panies. Unlike the past, Japanese employees are no longer married to their companies; they view their jobs as only a part of their lives. Moreover, they are seeking workplaces in which they are able to de­velop their talents and perform work they find chal­lenging and worthwhile. In meeting such new de­mands from employees, Japanese companies will benefit from encouraging greater individual initia­tive and entrepreneurial spirit.

To achieve this goal of greater employee self-­realization, however, reform of the present Japanese education system is essential. While our companies are seeking people with varied skills and interests, our education system, continues its attempt to pro­duce only “genius people” by emphasizing test scores and instilling uniformity of approach. For this rea­son, our school system is failing to prepare our young people to help Japanese corporations compete in the new world economy.

In closing, let me state once more my conviction that there are two critical requirements for corporate success in the 1990s and beyond: continuous techno­logical innovation and a firm commitment to devel­opment of human resources. We have entered into a new era in corporate managementone that is being driven fundamentally by advances in informa­tion technology. Largely as a result of cheap access to information of all kinds, consumer tastes have become much more diverse, specialized, and so­phisticated. To compete effectively, companies must not simply respond to changes in consumer de­mand; they must also anticipate and even “create” them through imaginative product innovation.

In responding successfully to such change, companies perform an important social mission by contributing to the vitality and growth of all aspects of society. Through their ability to create products and services valued by global consumers, compa­nies enrich not only their shareholders and employ­ees, but an entire network of corporate constituen­cies that includes suppliers, local communities, and government. Nations around the world today are faced with formidable challenges: the global envi­ronment, conservation, industrial waste, the aging of society, expanding the role of women in the workforce, and addressing the shortage of skilled labor. As important members of society, corpora­tions must participate in devising solutions to these problems.


Are the investment horizons of U.S. firms too short? Yes, was the conclusion of Capital Choices, a report published, in August 1992 by 25 academic scholars under the leadership of Professor Michael Porter of the Harvard Business School. The Porter Report was widely acclaimed not only by the U.S. financial press, but by many Japanese observers. Mr. Katsuro Umino, for one, Vice President of the Osaka‑based Kotsu Trading Company, was quoted in the Chicago Tribune of August 24, 1992 as saying:

It’s interesting to see that somebody in America is finally waking up to the real culprit behind the decline of American corporate competitiveness. I think many of us in Japan have known for a long time that America’s capital allocation system is inherently flawed.

The flaw seen by Messrs. Porter and Umino and ever so many others is the overemphasis on stock prices and shareholder returns in the Ameri­can system of corporate governance. By contrast, a survey of 1,000 Japanese and 1,000 American firms by Japan’s Economic Planning Agency, reported in the same Chicago Tribune story, finds that on a scale of 0 to 33 being most importantJapanese firms give “Higher Stock Price” a rating of only 0.02. “Increasing Market Share” gets a reported rating of 1.43 in Japan, almost twice its rating in the United States.

Surveys must never be taken too literally, of course. Japanese managers surely cannot believe that increasing market share is the overriding corpo­rate goal. Achieving a 100 percent market share for your product is too easy: just give it away! Profitabil­ity must also and always be considered. And, indeed, the Japanese firms surveyed did give a rating of 1.24 to Return on Investmentfar less than the 2.43 rating given by the American firms, but still much much more than the virtually zero weight given to Higher Stock Prices.

For all its technical limitations, however, the survey does, I believe, accurately reflect differences in managerial behavior in the two countries. Ameri­can managers are more concerned with current movements in their own stock prices than are Japanese managers. And rightly so. The emphasis American managers place on shareholder returns is not a flaw in the U.S. corporate governance system, but one of its primary strengths.

Some of my academic colleagues believe, in fact, that American big‑business management has been putting put too little weight on stockholder returns, leading to massive waste of both shareholder and national wealth. Their argument has not, in my view, been convincingly established. The billion‑dollar losses of companies like IBM and General Motors in recent years, offered by such critics as evidence for their case, testify less to failures in the U.S. gover­nance system than to the vigorously competitive environment in which U.S. firms must operate.


Let me begin my defense of U.S. corporate governance by emphasizing that managerial con­cern with shareholder value is merely one specific application of the more general proposition that in American society the individual is king. Not the nation, not the government, not the producers, not the merchants, but the individualand especially the individual consumeris sovereign. Certainly that has not been the accepted view of ultimate economic sovereignty here in Japan, though the first signs of change are beginning to appear.

The connection between consumer sovereignty and corporate governance lies not just in the benefits customers derive from the firm’s own output. The customers are not the only consumers the firm serves. The shareholders, the investors, the own­ers however one chooses to call them are also consumers and their consumption, actual and poten­tial, is what drives the shareholder‑value principle.

To see how and why, consider the directors of a firm debating how much of the firm’s current profits, say $10 million, to pay out as dividends to the shareholders. If the $10 million is paid as dividends, the shareholders clearly have an additional $10 million in cash to spend. Suppose, however, that the $10 million is not paid out, but used instead for investment in the firmbuying machinery, expand­ing the factory, setting up a new branch, or what have you. The stockholders now do not get the cash, but they need not be disadvantaged thereby. That will depend on how the stock market values the pro­posed new investment projects.

If the market believes the firm’s managers have invested wisely, the value of the shares may rise by $10 million or even more. Stockholders seeking to convert this potential consumption into actual con­sumption need only sell the shares and spend the proceeds. But if the market feels that the managers have spent the money foolishly, the stock value will rise by less than the forgone dividend of $10 millionperhaps by only $5 million, or possibly not at all. Those new investments may have expanded the firm’s market share; they may have vastly im­proved the firm’s image and the prestige of its managers. But they have not increased shareholder wealth and potential consumption. They have re­duced it.

Japanese stock prices, even at current levels, are still hard to take seriously because they are not completely free‑market prices. Japanese managers can be pardoned for wondering whether the stock market may be just a Bunraku theater, with the bureaucrats from MOF backstage manipulating the puppets.

Current Market Values and Future Earnings

Using the stock market’s response to measure the true worth of the proposed new investments may strike many here in Japan as precisely the kind of short‑termism that has led so many American firms astray. Let it be clearly understood, therefore, that, in a U.S.‑style stock market, focusing on current stock prices is not short‑termism. Focusing on current earnings might be myopic, but not so for stock prices, which reflect not just today’s earnings, but the earn­ings the market expects in all future years as well.

Just how much weight expected future earnings carry in determining current stock prices always surprises those not accustomed to working with present‑value formulas and, especially, with growth formulas. Growth formulas, however, whether of dividends or earnings, rarely strike my Japanese friends or my Japanese students as very compelling. Many Japanese firms, after all, pay only nominal dividends, and the formulas don’t make sufficiently clear what investors are really buying when they buy a stock.

Let me therefore shift the focus from a firm’s rate of sales or earnings growth to where it ought to be­ namely, to the competitive conditions facing the firm over meaningful horizons. And let me, for reasons that will become clear later, measure the strength of those competitive conditions by the currently fash­ionable market value‑to‑book value ratio (also known as the “market‑to‑book” or “price‑to‑book” ratio). The book‑value term in the ratio, based as it is on original cost, approximates what management actu­ally spent for the assets the market is valuing. A market‑to‑book ratio of 1.0 (abstracting from any concerns about pure price inflation) is thus a natural benchmark, signifying a firm with no competitive advantage or disadvantage. The firm is expected to earn only normal profits in the economists’ sense of that term, that is, profits just large enough to give the stockholders the average, risk‑adjusted return for equities generally.

To sell for more than an unremarkable market-­to‑book ratio of 1.0that is, to have a positive “franchise value,” as some put ita firm must have long‑term competitive advantages allowing it to earn a higher than normal rate of return on its productive assets. And that’s not as easy to do as it may seem. Above‑normal profits always carry with them the seeds of their own decay. They attract competitors, both from within a country and from abroad, driving profits and share prices relentlessly back toward the competitive norm. Investors buying into a firm, are thus making judgments not only about whether, the firm and its managers have produced a competitive advantage over their rivals, but also about how far into the future that competitive advantage can be expected to last.

Some specific numbers may help to fix ideas.[1] Consider a U.S. firm with a market‑to‑book ratio of 3.0and there still are many such. And suppose, further, that it will be plowing back its entire cash flow into investments expected to earn twice the normal competitive rate of return. By paying three times book value for the shares, investors are in effect anticipating that the firm will expand and stay that far ahead of its competitors for the next 20years!

That’s really forward‑lookingmuch too for­ward looking, some would say, in this highly uncer­tain world. And perhaps that’s why so many Japa­nese managers are instinctively skeptical about using the stock market to guide or evaluate managerial decision‑making. They don’t really trust the prices in theJapanese stock market where, at the height of the stock market boom of 1989, market‑to‑book ratios were not just 3.0 but, even after adjusting for real estate and for other corporate shares in cross­holdings, ran routinely to 5.0 or even 10.0. Such ratios implied that investors saw opportunities for these companies to earn above‑normal, competitor-­proof returns for centuries to come!

Prices and market‑to‑book ratios have fallen substantially since then, but are still hard to take seriously because they are not completely free­market prices. The values are not only distorted by the pervasive cross‑holdings of nontraded shares, but the prices of the thinly‑traded minority of shares in the floating supply often reflect the heroic scale of market intervention by the Ministry of Finance (MOF). Japanese managers can be pardoned for wondering whether the stock market may be just a Bunraku theater, with the bureaucrats from MOF backstage manipulating the puppets.

MOF’s notorious market support activities also interact in other ways with the issue of corporate governance in Japan. Many academic observers in the U.S. (myself, in particular)[2] have attributed MOF’s famous P.K.O. (Price Keeping Operations, and a Japanese pun on the country’s participation in the U.N.’s Peace Keeping Operations in Cambodia) to its role as cartel manager for the Japanese brokerage industry. Another motivation traces, however, to the Japanese banking industry. Japanese banks, unlike those in the U.S., can hold equity positions in the companies to which they are also lendinga dual role that, in turn, has often been cited as the real key to Japanese managerial success. The bank connection is said to reduce corporate agency costs, provide better monitoring of corporate decisions, and, above all, allow management to undertake profitable but risky long‑run ventures while confident of having the continued financial support needed to carry projects through to completion.

But any gains to the Japanese economy on the governance front have come at a substantial cost on other fronts. Corporate equities can be great assets for banks when the stock market is booming as it was in Japan in the 1980s. The price appreciation then provides the banks with substantial regulatory capi­tal to support their lending activities. But when the stock market collapses, as it did in Japan after 1989, the disappearance of those hidden equity reserves can threaten the solvency of the banks and the integrity of the country’s payment system.

The prospect becomes even more frightening when we remember that shareholdings in Japan run in both directions. Not only do banks hold the firm’s shares but the firmsagain, presumably with a view to better governancealso hold the banks’ shares. The result is a classic, unstable, positive‑feedback asset pyramid. No wonder MOF must keep support­ing stock prices and always seems to be running around, like the proverbial Dutch boy on the dikes, plugging holes and leaks in its regulations.


Stock Prices and Information

To say that the stock market in the U.S. is much closer to the free‑market ideal than the Japanese stock market is not to suggest that valuations in the U.S. are always correct. But at least those investors with bearish opinions about particular stocks or the market as a whole can express their pessimism by selling, even selling short, without encountering the kind of anti‑selling rules and taboos for which MOF has become notorious. Those pessimists may well be wrong, of course. And so in their turn may be those who are optimistically anticipating a rise in future earnings and prices.

No serious student of stock markets has ever suggested that stock prices always “correctly” mea­sure the true “fundamentals,” whatever those words might mean. The most claimed is that the prices are not systematically distorted, like those in Japan where MOF’s heavy thumb often tilts the scales against selling. Nor are the prices in the U.S. just some artificial numbers driven by whims and fads, as some academics have argued (and quite unsuccessfully so, in my opinion). The evidence overwhelmingly sup­ports the view that prices reflect in an unbiased way all the information about a company that is available to the investing public.

The word “available” is worth stressing, how­ever. Stockholders and potential outside investors can’t be expected to value management’s proposed investment projects properly if they don’t have the information on which management has based those plans. And management may well hesitate to dis­close that information for fear of alerting competi­tors. This inevitable “asymmetry” in information, to use the fashionable academic jargon, is what many see as the real flaw in the shareholder‑value prin­ciple. Projects with positive net present values, pos­sibly even with substantial net present values, may not be undertaken because outside investors cannot value the projects properly and will condemn man­agement for wasting the stockholders’ money. That, essentially, is the Porter position. As one way to deal with it, the Porter study recommends that U.S. gov­ernance rules be changed to permit firms to disclose proprietary, competitively‑sensitive information se­lectively to that subset of the stockholders willing to commit to long‑term investing in the company.

Can investment be discouraged by inability to disclose selectively? Possibly. Has it happened? And on what scale? That is much harder to say. The main evidence cited for its pervasiveness in the U.S. is the supposedly superior earnings and growth perfor­mance of bank‑disciplined Japanese manufacturing firms relative to their impatient American stockholder‑disciplined counterparts. Note that I stress Japanese manufacturing firms. No one has ever suggested that Japanese market‑share‑oriented firms were superior in the service industries, notably retailing, or in commercial banking.

And I should say that manufacturing was the main evidence for Japanese governance superiority cited before the current recession hit Japan. That recession, painful as has been and still is its impact on the Japanese economy, has at least served to remind us that myopia is not the only disease of vision afflicting business managers. They may suffer from astigmatism (distorted vision) or even from hyperopia or excessive far‑sightedness. Looking back over the last 20 years, one may well find cases in which American firms facing strong stockholder pressures to pay out funds invested too little in some kinds of capital‑intensive technology. But many Japanese firms, facing no such pressures, have clearly over-invested during that same period in highly capital‑intensive plants that will never come close to recovering their initial investment, let alone earning a positive rate of return. And I won’t even mention the trillions of yen poured into land and office buildings both at home and abroad.

No form of corporate governance, needless to say, whether Japanese or American, can guarantee 20‑20 vision by management. Mistakes, both of omission and of commission, will always be made. My claim is only that those American managers who do focus on maximizing the market value of the firm have a better set of correcting lenses for properly judging the trade‑off between current investment and future benefits than those who focus on maxi­mizing growth, market share, or some other, trendy, presumed strategic advantage.


Glasses help you see better, of course, only if you wear them. And the complaint of at least one wing of American academic opinion, especially in the field of finance, is precisely that U.S. managers don’t always wear their stockholder‑corrected lenses to work. Because ownership of American corpora­tions is so widely dispersed among a multitude of passive individual and institutional investors, U.S. managers, so the argument runs, are left free to pursue objectives that may, but need not, conform to those of the stockholders.

Shareholders, however, are not powerless. Al­though neither able nor willing to perform day‑by-­day monitoring of management operating decisions, shareholders do have the right to elect the company’s Board of Directors. And the Board, in turn, by its power to unseat management, and even more by its power to design the program for executive compen­sation, has command over important levers for aligning management’s objectives with those of the shareholders.



Myopia is not the only disease of vision afflicting business managers. They may suffer from astigmatism or even from excessive far sightedness. Looking back over the last 20 years, one will find cases in which American firms facing strong stockholder pressures to pay out funds invested too little. But many Japanese firms, facing no such pressures, have clearly overinvested during that same period.




Compensation Packages and Management Incentives

The Board of Directors has a tool‑box full of levers but not, alas, any simple or fool‑proof set of instructions for using them. In fact, academic “agency cost” theory suggests that no all‑purpose optimal schemeno “first‑best” as opposed to, say, second-­best or even lower‑best solutionreally exists for aligning interests when success depends on luck as well as skill.

To see why, ask yourself how the directors could make the managers accept the stockholders’ attitudes toward risk. Suppose, to be specific, that the directors try what may seem the obvious perfor­mance‑based compensation strategy of giving the managers shares in the company. Will that make managers act like the shareholders would? More so, probably, than if the directors just offered a flatand presumably highsalary supplemented with gener­ous retirement benefits. Managers so compensated are more likely to be working for the bondholders than for the stockholders. Salaried managers clearly have little incentive to consider projects with serious downside risk.

Giving managers stock at least lets them partici­pate in the gains from their successful moves, but still does not solve the problem of excessive managerial timidityexcessive, that is, relative to the interests of the outside stockholders. Those stockholders are, or at least in principle ought to be, well diversified. They can thus afford risking their entire investment in the company even for only 50:50 odds because their stockholding is only a small part of their total wealth. That, after all, is a key social benefit of the corporate form with fractional and easily transferable ownership interests: more efficient sharing of the business risks. But the managers are typically not diversified. A major fraction of their personal wealth and their human capital is tied to the corporation. Caution, not boldness, inevitably becomes their watchword.

The executive stock option was invented in the U.S. in the 1950s precisely to offset the play‑it‑safe tendencies of underdiversified corporate managers (though tax considerations and accounting conven­tions have since blurred the original incentive‑driven motivation for options).[3] Stock options, suitably structured, work by magnifying the upside potential for the manager relative to the down. A bet paying $1,000 if a coin comes up heads and losing $1,000 if tails would hardly be tempting to the typical risk-­averse manager. But tossing a fair coin might well seem attractive if heads brought $5,000 and tails cost only $500.

Options and their many variationsincluding option‑equivalents like highly leveraged corporate capital structuresnot only can reduce management’s natural risk‑aversion, but may overdo it and tempt managers into excessively risky ventures. If these long‑odds strategies do happen to pay off, the managers profit enormously. If not, the bulk of the losses are borne by the shareholders, and probably the bondholders and other prior claimants as well. Many observers feel that a payoff asymmetry of precisely this kind for undercapitalized owner‑man­agers was the root cause of the U.S. Savings and Loan disaster.

The inability to align management interests and risk attitudes more closely with those of the stock­holders shows up most conspicuously, some aca­demic critics would argue, in the matter of corporate diversification. Corporate diversification does re­duce risk for the managers. But because stockhold­ers can diversify directly, they have little to gainexcept perhaps for some tax benefits, large in some cases, from internal offsetting rather than carryforward of losseswhen a General Motors, say, uses funds that might otherwise have been paid as dividends to buy up Ross Perot’s firm, Electronic Data Services (EDS). In fairness, however, let it be noted that the stockholders, by the same token, would have little to lose by such acquisitions unless the acquiring firm were to pay too high a price for controlwhich certainly has been known to happen.


Stockholders could also lose if diversification predictably and consistently means sacrificing the efficiencies from specialization. Some evidence sug­gests that it doesalthough hardly enough, in my view, to justify claims by some academic critics of corporate diversification that loss of corporate focus and related failures of governance by GM or IBM or Sears in recent years have destroyed hundreds of billions of dollars of their stockholders’ and, by extension, of the nation’s wealth.

For those firms, certainly, aggregate stock mar­ket values have declined substantially. But to treat such declines as a national disaster like some gigantic earthquake is to overlook the distinction between social costs and private costs. Consider, for example, the story told in Figure 1, which pictures an IBM‑type firm about to be hit unexpectedly with an anti‑trust suit (and let it be clearly understood that this is an illustration, and not necessarily a recommendation). The company’s initial demand curve is d1d1, and its long‑run marginal cost is BJ (assumed, for simplicity, to be constant and hence equal to its average cost). Because the firm had “market power,” it set its product price at OC (i.e., above average and mar­ginal cost), earning thereby the above‑normal profits indicated by the rectangle BCDF. Those above­-competitive profits will be capitalized by the stockmarket and the company will sell for a high market-­to‑book value premium.

Now let the government win its anti‑trust suit against the company and immediately force the company’s price and output to their competitive levels (OB for price and OK for quantity). The abnormal profits will vanish, the stock price will fall, and the market‑to‑book value premium will disap­pear. Yet no net loss in national wealth or welfare has occurred in this instance. Wealth and economic welfare have simply been transferred from the company’s shareholders to its customers; producer surplus has been transformed into consumers’ sur­plus. In fact, in the case pictured, society is better off on balance, not worse off. Because output increases to the competitive level, consumers gain additional consumers’ surplus in the form of the (”Harberger”) triangle DFN.

The social and private consequences are easily distinguished in this anti‑trust scenario. But what if the decline in stock‑market value is a self‑inflicted wound? IBM, after all, did not lose its anti‑trust case. Its market value was eroded by the entry of new firms with new technologies.

That kind of value erosion, however, surely cannot be the national disaster to which the gover­nance critics are pointing. Why, after all, should society’s consumers care whether the new products were introduced by IBM or by Intel or Apple; by Wal‑Mart or by Sears; or, for that matter, by General Motors or by Toyota? The complaint of the critics may be rather that the managements of those firms have failed to downsize and restructure fast enough even after the new competition had penetrated the market. Entrenched managements, unchecked by the hand‑picked sycophants on their Boards, kept pouring money into the old, money-losing lines of the firm’s business rather than letting their stock­holders redeploy the funds to better advantage elsewhere.

But continuing to make positive investments in a declining industry”throwing good money after bad,” as the cliche would have itcannot automati­cally be taken as evidence of economic inefficiency, and certainly not of bad management. Nothing in economic logic or commonsense suggests the best exit path is always the quickest one. A firm with­draws its capital by making its net investment nega­tive, that is, by holding its rate of gross investment below the rate of depreciation. The marginal rate of return on that gross investment may well be high even though the average rate of return on the past capital sunk in the division or the firm as a whole is low or even negative. When the direct costs of exit (such as severance payments) are high, and when the firm is at least covering its variable costs (unlike many in Russia, so we are told), investing to reduce a loss can often be a highly positive net‑present-­value project indeed.

Suppose, however, for the sake of argument that some entrenched managers were too slow in downsizing. The losses reported by their firms still cannot be equated dollar for dollar with the social costs of bad governance. To see why, turn again to Figure 1, which can also be used to show the new condition of our original firmthat is, after the entry of the new competition attracted by its earlier high profits. The firm’s demand curve is now the rnuch more elastic demand curve d2 d 2 and its new long-­run equilibrium level of output will be OL, smaller than its earlier equilibrium output level OH.

Should the firm seek to maintain its earlier market share of OH, however, net losses of ABFG will be incurred, exactly as the critics insist. But only the triangle MFG represents the social cost of the failure to downsize. The rest, given by the area ABMG is, again, merely a transfer to consumer surplus. How much of the reported loss goes one way and how much goes the other cannot be settled, of course, merely from a schematic diagram. That requires specific empirical research of a kind not yet found in the recent academic literature so critical of U.S. corporate governance.

That the losses suffered in recent years by firms like IBM or Sears or General Motors may not be social losses will be of little comfort, of course, to those stockholders who have seen so much of their retirement nest eggs in those companies vanish. One can hardly blame them for wishing that the directors had somehow prodded management to abandon their formerly successful strategies before the suc­cess of the newer competitive strategies had been so decisively confirmed. Fortunately, however, share­holders whose personal stake is too small to justify costly monitoring of management have another and well‑tested way to protect their savings from management’s mistakes of omission or commission: diversify! A properly diversified shareholder would have the satisfaction of knowing that his or her loss on IBM shares or Sears or General Motors was not even a private loss since it was offset in the portfolio by gains on Microsoft, Intel, Apple, WalMart and other new‑entrant firms, foreign and domestic, that did pioneer in the new technologies.

There is no permanent or systematic bias for U.S. firms in the aggregate toward myopia or hyperopia, toward underinvestment or overinvestment, because market forces are constantly at work to remove control over corporate assets from managers who lack the competence or the vision to deploy them efficiently.





Summing up, then, we have seen two quite different views of what is wrong with American corporate management. One view, widely accepted in Japan and by the Michael Porter wing of academic opinion, is that American managers pay too much attention to current shareholder returns. The other view, widely held among U.S. academic finance specialists, is that American managers pay too little attention to shareholder returns.

Which view is right.? Both. And neither. Both sides can point to specific cases or examples seem­ing to support their positions. But both are wrong in claiming any permanent or systematic bias for U.S. firms in the aggregate toward myopia or hyperopia, toward underinvestment or overinvestment relative either to the shareholders’ or to society’s best inter­ests. There is no inherent bias because market forces are constantly at work to remove control over cor­porate assets from managers who lack the compe­tence or the vision to deploy them efficiently.

We saw those forces most dramatically perhaps in the takeover battles, leveraged buyouts, and corporate restructurings of the 1980s and, more recently, in many well‑publicized board‑led insurgencies. But, for all their drama, those events (which often seem little more than struggles over how the corporate franchise premium is to be shared between the executives and the shareholders) repre­sent only one partand by no means the most important partof the process of allocating society’s productive capital among firms. The ultimate discipline for the managers of one firm in the U.S. will always be the managers of other firms, including foreign firms, competing with them head to head for customer business. As long as we continue to have plenty of that kind of competition in the U.S., I, for one, can’t become terribly concerned about the supposedly fatal flaws in our governance system.

* MERTON MILLER is the Robert R. McCormick Distinguished Service Professor Emeritus at the University of Chicago’s Graduate School of Business. Professor Miller won the Nobel Prize in Economics in 1990.

C. K. Prahalad, University of Michigan*

Accounts of the much‑publicized troubles of CEOs at companies like IBM, General Motors, Kodak, and Sears have focused almost exclusively on the balance of power and struggle for control between top manage­ment and investors. Boards of directors are caught in the middle of such control “contests,” and when and how they should perform their mediating function is now being widely debated. Large pension funds such as CAPERS and other investor advocates are viewed as saviors by some and villains by others.

But, in spite of all the emotion and energy behind the debate, the real problem has not been correctly identifiedand so the recommended cures are often worse than the disease. We may need to rethink what we mean by “corporate governance.”

The popular understanding of the U.S. corpo­rate governance problem is grounded in financial economists’ theory of capital markets, This theory, which begins with the assumption that stockholders are the owners of the firm,[4] is preoccupied with the efficiency of the market in allocating capital among firms. In this view of the world, the efficiency of firms in general is maintained by investors’ ability to move their capital and, by denying capital or mak­ing it expensive, to punish errant managers. The theory offers managers little guidance, however, about the means of increasing the efficiency of specific firms witbin that market.

The capital market focus also leads to an easily understood and readily communicated scorecard of corporate performancethat is, a company’s market value as measured by its current stock price. Using stock price as their yardstick, financial economists profess to be able to tell us which companies are “winning the game” and which are losing. Almost no attention is paid, however, to the process by which wealth is created in a large firmthat is, how the game is played. Financial economists, analysts, and investors have all, for the most part, been content to treat the internal process of wealth creationwhat I think of as the game itselfas a “black box.”

In my talk today, I approach the corporate governance issue from the perspective of the indi­vidual firm; that is, I concentrate on the game itself, as opposed to the capital market’s latest pronounce­ments on winners and losers. This focus provides an alternative to the “control‑oriented” perspective pro­vided by financial economistsone that I believe will lead to more effective crisis avoidance, fewer unpleasant surprises for shareholders, and, over time, greater wealth creation for investors and soci­ety at large.

I begin by arguing that the reality of capital markets in the 1990snotably, the changing pat­tems of share ownership and the slowdown of the takeover marketis very different from that which existed during the development of capital market theory, and that some of the critical assumptions on which this theory rests are no longer tenable. I then go on to demonstrate that the quality of internal governance depends critically on the nature of stockholder activism. In brief, my message here is that greater information‑sharing and cooperation among boards, managers, and major investors are more likely to lead to sustained wealth creation than the adversarial relationships that prevailed during the 1980s.

In closing, I present my conception of the process of wealth creation as a balancing act that attempts to meet simultaneously the demands of various corporate “stakeholders”customers, em­ployees, suppliers, as well as investors. This is quite different from the financial economist’s prescription that managers attempt single‑mindedly to maximize shareholder value. in place of shareholder‑value maximization, I offer my own concept of corporate value added a corporate objective more attuned to the economic and competitive realities of the 1990s.


Although we may continue to debate the effec­tiveness of the takeovers and LBOs of the 1980s, these capital market solutions to corporate ineffi­ciency are no longer as readily available today. Managers now have at their disposal a wide variety of anti‑takeover measures. Poison pills, shark repel­lants, state anti‑takeover laws, and other such road­blocks to control transactions have sharply increased the costs of imposing the discipline of the capital market on poor performers.

The activity of the “corporate control” market during the 1980s was not an indication of the success of the U.S. corporate governance system, but rather a clear sign of its failure. The stockholder activism of the ’80s was a response of last resort, and it therefore functioned as a very blunt instrument of corporate reform.[5] Although large shareholder gains were achieved through takeovers in the short run, much longer‑term corporate value‑which consists, as I will argue, in no small part of the quality of manage­ment relations with employees, suppliers, and inves­tors‑was lost in the process.

Efforts to discipline inefficient managers using market mechanisms during the 1980s followed a predictable sequence. The first sign of investor unrest was often triggered by persistent, typically unanticipated, profit declines that led in turn to sharp stock price declines. If things deteriorated far enough, a hostile takeover bid emerged.

One major problem with this capital market “solution” is that, by the time outsiders intervene, it is often too late to take meaningful corrective action. In any large diversified firm, profit declines are typically preceded by several years of inefficient management. Sheer momentum in such firms can insulate profits for quite some time before clear evidence of managerial inefficiencies begins to show through the veil of corporate size and scope. (The opposite is true as well; it generally takes several years for even the best managers to turn around the financial performance of badly run firms.) For ex­ample, when did the impending crisis first become apparent to investors in firms such as IBM, DEC, Wang, Philips, and General Motors?

The most sophisticated observers of corporate behavior are those able to distinguish strategic vulnerability from financial results. Such people pay attention to not only profit and cash flow numbers, but also to changes in product portfolios, productivity, cycle times, and quality of products and services. In many of the cases of corporate decline just cited, sophisticated corporate strategists were expressing doubts about the efficiency of top man­agement long before sharp declines in stock prices and financial performance exposed the extent of the problem to all. Consider that, as recently as 1987, IBM’s stock, now under $60, was selling for $175; at the same time DEC, now trading for less than $35, was adjudged by the stock market to be worth $200.

After stock prices decline and the extent of managerial inefficiency is revealed, shareholders have two basic choices. One, they can sell their stock and move on to better‑managed alternatives (al­though, as we shall see, this option is less feasible today for large institutional holders than it once may have been). Or two, they can attempt to replace the top managers. But this is a very costly process, especially since managers have found many ways to use the legal and regulatory system to set up roadblocks. And even if managers are replaced, there is no guarantee that efficiency will be restored soon.

The severity of the corporate governance prob­lem confronting investors today can be seen, in part, as an after‑effect of the “vicious cycle” of the 1980s. In that period, stockholder activists and top manag­ers alike devoted more time and energy to legal maneuvers designed to outwit one another than to improving the long‑run prospects of the business. And while the issue of corporate governance be­came mired in legal debates, attention was diverted away from the substantive economic issuesnota­bly, the process of continuous corporate renewal and sustained wealth creation.


It is my contention that the underlying assump­tions of financial economics are neither appropriate nor adequate for dealing with the wealth‑creation process and its demands on corporations in the 1990s. As a consequence, the finance literature offers at best partial explanations of the corporate gover­nance issues that now confront us. To see why the current governance debate misses the mark, and why the proposed solutions are inadequate, let’s examine the assumptions themselves.

The interests of owners and managers are divergent. The theory of “agency costs” that per­vades the finance literature suggests that the relation­ship between shareholders and management in large public companies is inevitably adversarial. There is thus a need to align the interests of owners (investors) and managers, primarily by creating appropriate financial incentives for top managers. In practice, this means tying the pay of CEOs and other top managers more strongly to financial measures of performance, especially share price. The underlying assumption is that changing incentives will cause the firm to increase its market value or, in my terms,, to become more effective in “playing the game.”

As I suggested earlier, however, very little attention is paid to the actual wealth creation pro­cess; in effect, the firm is still treated as a black box.

Very large firms and widely distributed owner­ship leads to “powerless shareholders.” The popu­lar image of shareholders as “poor old men and women in tennis shoes” unable to rein in CEOs who fly around in Lear jets and enjoy country club mem­berships is difficult to dispel. The reality, however, is not nearly as one‑sided. Today, more than 60% of the shares of the Fortune 200 are held by institutional investors.[6] Moreover, many individual institutional investors are increasingly likely to hold concentrated blocks in large companies. CalPERS, for example, held almost 2% of Kodak throughout most of 1993.

This evolving pattern of more concentrated shareholdings has created a new problem for insti­tutional investors. They cannot sell such large holdings in a company without significantly reducing the price of the stocks being sold. Such illiquidity in turn creates a two‑way dependence between managers and large investors. Top managers depend on the goodwill of institutional investors who evaluate their performance through their portfolio choices. At the same time, investors depend on managers to pro­duce the superior operating performance necessary for them to show adequate investment returns.

Given such mutual dependence, one wonders why a more cooperative relationship between the two groups has not evolved. Institutional investors, for example, should play a much larger role in crisis prevention than they now do; they should intervene long before the problems escalate to the point where companies like IBM and General Motors are report­ing billion‑dollar losses. Institutional investors have the resources and sophistication necessary to play such a role.

Boards are protectors of shareholder inter­ests. While the ownership and management debate goes on, corporate boards are seen as providing the necessary checks and balances to make the system work. In practice, however, the capacity of boards to perform this function is debatable. The sympathies of most board members are much more closely aligned with the interests of top managers, whom they know, than with those of stockholders, who are faceless. Even when boards have acted, as in the cases of GM and Kodak, the action has come only after huge losses in value. GM’s problems were obvious to sophisticated outsiders by the mid‑1980s. Why then wait until 1992? Whose interest was the board protecting? Clearly not the shareholders’.

All three of the above assumptions limit our ability to think clearly about the role and reform of U.S. corporate governance. In reality, the relation­ship between investors and managers is far more complex than these simple assumptions would suggest. Nevertheless, most academics and other experts appear to cling to them with the same fervor that a captain holds onto a sinking ship.

The solutions to the corporate governance problem endorsed by financial economists are, in effect,”crisis‑driven”they are means of dealing with crises in profitability that have already happened. A better approach would aim at crisis prevention, in part through more open and regular communication among managers, boards, and major investors.


The investor control‑oriented solutions to the corporate governance problem endorsed by finan­cial,economists are, in effect, “crisis‑driven”—they are means of dealing with crises in profitability that have already happened. A better approach would aim at crisis prevention, in part through more open and regular communication among managers, boards, and major investors.

Large corporations are confronted with three interrelated challenges that are all essential to the corporate process of creating value:

The Performance Gap

Most companies evaluate their performance by “benchmarking” themselves against their competi­tors along a set of dimensions that include product quality, cycle time, costs, head count reductions, productivity levels, and administrative costs. Their aim in so doing is generally to put themselves at least on a par with the “best in their class.” Eliminating the performance gap has been the focus of the reengineering and restructuring efforts of most firms.

It is common knowledge, however, that most firms that have focused only on the performance gap are forced to revisit the restructuring issue every two or three years. Focusing on the performance gap allows firms to get the obvious waste out of their operations, buy some time, and hopefully create an investment pool. But no company should depend only on this approach. The limitation of this ap­proach is that, while firms strive to achieve par, the “best” of their competitors have already moved on. To keep up, companies focused totally on perfor­mance‑gap measures must repeatedly force them­selves on crash diets in which corporate muscle is very likely to be mistaken for fat.

Clearly, then, focusing on the performance gap is a necessary but not a sufficient condition for wealth creation.

Adaptability Gap

Most, if not all, the performance problems in large firms are a combination of “under‑managing” the performance parameters and not responding in a timely way to structural change within the industry. Structural changes are continually taking place in most industries. Such changes can be attributed to a wide variety of forces: deregulation (in telecom­munications, for example), global excess capacity (earth‑moving equipment), mergers and acquisi­tions (financial services), reduced protectionism (state‑owned enterprises all around the world), changing customer expectations (consumer elec­tronics) and technological discontinuities (PCs).

As a result of such continuous change, large firms are often confronted by the dilemma of canni­balizing existing businesses or having the world move on without them. IBM, for example, stayed with its vertically integrated system and commitment to mainframes too long (and the same was true of the large Japanese computer makers, Fujitsu and Hitachi). In the meantime, however, the industry was effec­tively “de‑verticalising.” The emergence of dominant specialist suppliers such as Intel and Microsoft, together with a wide variety of new distribution channels, led to the fragmentation of the industry. Ironically, many of these trends were initiated by IBM; but once they were launched, IBM watched the industry pass them by.

In Europe, the cases of Siemens, Daimler Benz, and Philips are much the same. Each of these companies failed to prepare itself fully for an “open” European market.

The challenge of responding to structural change is made much more difficult because management must also continue to address the performance gap at the same time. That is, the firm must continue to seek out new sources of growth even while cutting out inefficiencies in existing ones. This dual task is particularly formidable because of the tendency of stock analysts to focus primarily on the performance gap. And such a tendency is not difficult to understandafter all, information about corporate suc­cess in managing the performance gap can be readily identified, quantified, and communicated through the simplistic medium of brokerage research reports.

But management’s job, as suggested, is much more complex than squeezing out inefficiencies through cost‑cutting. No amount of performance improvement will help if management fails to antici­pate structural changes and adapt its strategy and organization to meet the new demands. Neither IBM nor GM can simply restructure its way to health. They must undertake a fundamental rethinking of their “business model” or “profit engine.”

In sum, although failure to anticipate industry transformation results in a “performance gap,” cor­porate restructuring provides only a surface solution to such problems. An effective long‑run corporate governance system must provide timely and reliable signals that indicate how well management is antici­pating and responding to continuous structural change in industries.

Opportunity Gap

While structural changes force a redeployment (and, in some cases, a reduction) of firm resources, they can also present new opportunities. Indeed, the potential for growth is limited, in some sense, only by the imagination of management. Current devel­opments in multimedia, for example, have opened up major investment opportunities for industries as diverse as retailing, publishing, office equipment, and consumer electronics. Those companies with the vision to invest in such opportunities will reap huge profits. Hewlett‑Packard and Motorola are good examples of companies whose continuous commitment to new markets and opportunities has paid off richly.

Publicly available information can tell us only so much about what is really going on inside companies and generally only with a significant lag In time. For this reason, we need to explore alternative, non-financial indicators that would help reduce the time lag between actual declines in managerial performance and their confirmation by financial statements.






Summing Up

The process of value creation, then, requires that firms simultaneously manage three dimensions: performance in the existing businesses (”the perfor­mance gap”), adaptation to structural changes in the industries in which they operate (”the adaptability gap”), and growth in new directions based on their resource and competence endowments (”the oppor­tunity gap”). As illustrated in Figure 1, sustained competitiveness requires that top managers focus ion all three aspects of value creation.

This view of the wealth creation process, more­over, has considerable import for the current debate on corporate governance. As stated earlier, the fi­nance literature tends to focus primarily on the per­formance gap. As I will now go on to argue, however, this traditional finance‑oriented focus must be ex­panded to consider the quality of the relationship between management and investors, and its poten­tial for increasing companies’ effectiveness in iden­tifying and making the most of growth opportunities.

Such an expansion of focus means that manage­ment should put current stock prices in proper perspective; that is, it should not be overly influ­enced by short‑term stock price fluctuations. At the very least, management should give more consider­ation to limitations on outside investors’ ability to detect underlying changes in long‑run corporate profitability before they are confirmed by changes in reported earnings. As financial economists them­selves have recently begun to emphasize, there is an inevitable information gap (or “asymmetry”) be­tween management and outside investors. Publicly available information can tell us only so much about what is really going on inside companies and, as mentioned earlier, generally only with a significant lag in time. (This information problem is made worse, moreover, by SEC regulations that restrict selective corporate communications with investors.)

This expanded view of value creation also raises a more fundamental question: Is the governance crisis in large firms an internal governance crisis? Public debate on corporate governance has focused on the nature of the relationship among shareholders, boards, and top management. But what about the quality of management inside the large firm and conventional methods for evaluating it? Does the internal governance system provide investors with useful early warning signals to alert them to what is likely to happen to financial performance?

Investors must spend as much effort in attempt­ing to understand and monitor the quality of internal governance as they do in poring over financial statements. As I have said several times nowand this message cannot be insisted upon too strongly­a crisis in profitability is too late for active stock­holder intervention. For this reason, we need to explore alternative, non‑financial indicators that would help reduce the time lag between actual declines in managerial performance and their con­firmation by financial statements. Adopting a new performance scorecard (for which Figure 1 could serve as a model) could be an important first step in this undertaking.


The finance literature assumes that the primary market discipline on top managers comes from the capital market. As providers of equity capital, share­holders are the “residual claimants” who bear most of the risk, and they accordingly receive the lion’s share of the reward for corporate success. Other corporate “stakeholders”customers, employees, suppliers, local communitiesshould be adequately compensated, but no more. Finance theory says, in effect, that corporations should devote resources to such stakeholders only to the point where the marginal dollar spent yields at least a dollar in return to the shareholders.

Implicit in this view is thus a clear hierarchy of objectives. The primary objective of management is to maximize shareholder value, and the ultimate scorecard for managers becomes the current stock pnceor, more precisely, stockholder returns over a definite time horizon.

As we approach the 21st century, however, this view may no longer be appropriate. Shareholder priority was clearly a valid view of a large enterprise when the scarce resource was capital. In the days when access to capital was essential to achieve large economies of scale in manufacturing, the ability to raise and allocate capital effectively were the defining characteristics of superior top management. At this time in our history, there was a plentiful, undifferentiated supply of labor, customers, and suppliers; capital was the resource in relatively short supply.

But the world has changed. Capital, of course, is still essential for growth, and capital markets will continue to impose a certain discipline in the form of required rates of return on firms that make use of it (although investor time horizons may require some adjustment). What is relatively new, however, is the intensity of the global competition for other key stakeholders. While capital remains a necessary ingredient, access to specialized talent (labor) and to a specialized supplier infrastructure (including tech­nology) have become much more important factors in corporations’ ability to compete in increasingly sophisticated and global consumer markets.

And, just as capital has long been viewed by economists as trading in a distinct “market,” I will argue that the services of stakeholder groups such as consumers, employees, and suppliers now each deserve to be regarded as trading in a separate “market” in its own right, each with its own distinc­tive set of characteristics and internal dynamics. Of course, there are important differences in the stages of development and level of efficiency of each of these marketsparticularly across national bound­aries (some of which will be discussed later). The point of viewing non‑investor corporate stakehold­ers as markets is to encourage recognition that key stakeholders, like capital markets, also impose a unique set of internal disciplines on firms. To create long‑run value and social wealth, firms must com­pete effectively in all of these markets.

The Product Markets

That consumers constitute a distinct market has, of course, long been recognized by economists. Through the operation of product markets, consum­ers impose their own kind of discipline on firms­one that operates even in the absence of capital market pressures. Consider a state‑owned enterprise such as Thomson of France, which produces elec­tronic equipment. Even though relatively insulated from capital markets by government funding, Thomson must ultimately meet the demands im­posed on it by the consumer electronics market if it is to survive.

Consumers worldwide have become more so­phisticated, and the discipline of global product market competition far more demanding, in recent years. For example, in the past, large multinationals expanded by employing a concept known as the “product life cycle.” In practice, this meant achieving growth by marketing mature, lower‑quality, or less sophisticated products to consumers in developing countries. Today such a strategy is bound to fail. Any firm that has tried to sell low‑quality or previous­generation products in the emerging markets of southeast Asia has learned this lesson the hard way. Consumers of TVs, camcorders, PCs, and cellular telephones everywhere demand the same level of quality.

Much, then, as capital markets have become globally integrated, advances in technology are also bringing about a single worldwide market for many products and services.

The Market for Technology

The intensity of global competition has elevated the importance of technological capability. In today’s world of increasing specialization, technology is often effectively bundled and sold by specialist “suppliers” to a global set of customers. Sharp, for example, makes liquid crystal displays (LCDs) for products such as laptops and PDAs manufactured by Apple Computer. Sharp also competes with Apple in the same markets, thus making Sharp at once a supplier and a competitor of Apple. As a result of such relationships, the fine lines between customers, competitors, and suppliers are blurring. Even the closed system of the Japanese keiretsu is giving way to “cross‑sourcing” between competitors.

The central challenge in accessing technology, then, is not just in building effective internal R&D capabilities, but in establishing access to a supplier network around the world. Such access is critical in developing competitive advantages such as “im­proved time to market” and “new business develop­ment.” Access to core product specialists such as Intel, Sony, and Kyocera may be as critical to competitive success as access to capital was during the earlier growth period. As a result, there is intense corporate competition to gain access to supplier networks.

The Market for Labor

To meet the new demands of global product markets and the worldwide competition for suppliers, corporations have also been forced to step up the intensity of their search for specialized talent. In high‑technology businesses such as financial ser­vices and computing, firms have long recognized that the real currency is talent. The same is true of the emerging multi‑media businesses.

There are also signs that the corporate compe­tition for talent has become global. To offer just one example, companies such as Citicorp, DEC, Texas Instruments, and Motorola have located computer programming operations in Bangalore, India, where high‑quality programmers command much lower wages than their California counterparts. As this example suggests, the market for talent is as yet relatively undeveloped; it has the most distortions­the highest transaction costs and greatest “informa­tion asymmetries” between buyers and sellersand hence is the least “efficient” of the four markets mentioned. But, as this case also suggests, the distortions inherent in this market create opportuni­ties for “arbitrage” by opportunistic firms.

Although such price differentials will ultimately be eliminated by companies seeking to benefit from them, much of the advantages of diversifying the corporate talent search will remain. Competition for talent is not just about price, but about access. A large number of high technology firms are busy setting up programs designed to gain access to highly trained people. The ability to collaborate at a distance will be a key factor in the development of a market for talent. If effective, such collaboration will represent a successful “arbitrage” of labor markets across countries.

In sum, all companies effectively compete in at least four distinct markets. Success in any one of these markets is not enough to meet the competitive demands placed on firms. Creating wealth for inves­tors through efficient use of capital depends critically on management’s ability to manage the disciplines of the product market (imposed by sophisticated cus­tomers around the world), the labor market (special­ized talent), and the technology market (specialist suppliers).

Because investment in the product, technology and talent markets requires time to generate returns, the hidden cost of the traditional modus operandi of U.S. firms will become visible only in the longer term. By continuing to treat all other markets as subordinate to capital markets, most U.S. companies are falling years behind the firms that are already attempting to balance the demands of the four markets.


Over the long run, of course, the interests of each of these four corporate constituencies are united. A firm’s consumers, suppliers, employees, and investors all benefit from sustained superior performance. In the short run, however, serving all four markets simultaneously inevitably involves making some trade‑offs among them. Top managers in the U.S., Europe, and Japan have traditionally shown systematic differences in making trade‑offs among the four markets.

The U.S.

For example, most firms in the U.S. have responded most directly to capital market pressures while placing less emphasis on the other markets. Because this near‑exclusive capital market focus reduced the competitiveness of U.S. firms during the 1970s and 1980s, many U.S. firrns today are currently refocusing their energies on product markets. With. out customers, they have been forced to recognize there is no business and no prospect of wealth creation. The number of corporate initiatives de­signed to address quality, time to market, new product development, and customer responsiveness is a sign of a fundamental change in the perspective of many U.S. top managers.

Relationships with specialist suppliers have also become a major concern of some U.S. companies. Toyota’s ability to outperform the Big Three U.S. automakers throughout the 1980s had as much to do with their privileged access to suppliers (which had a vested interest in improving Toyota’s quality) and new product development capability, as it did with their efficiency in employing capital. The lessons have not been completely lost on U.S. auto and other manufacturing firms.

U.S. top managers have also become more concerned today with engaging people in the tasks of competitiveness. Corporate programs for improving the quality of work life, encouraging greater employee involvement, and promoting “empower­ment” have become commonplace. Such programs are part of a concerted effort by many companies to make their organizations more attractive to talented peoplenot only to improve their performance, but simply to retain them. Corporate accommodation of dual careers, the introduction of “flextime,” and allowing greater choice of location (in part by long­-distance collaboration) are all signs of a talent market that is imposing its discipline on companies.

But if recognition of the imperatives of mar­kets other than the capital markets is gradually developing within many U.S. firms, the rhetoric and the reality do not fully match. For all the talk about these relatively new concerns, most U.S. managers remain focused on the capital market disciplines, often to the exclusion of the demands of the other markets.

There are, of course, a number of U.S. firms that have achieved extraordinary success by managing all four markets at oncenotably, Motorola, Hewlett Packard, Intel, Microsoft, Sun, and General Electric. GE, for example, has professed its commitment to creating a “boundary‑less organization”one that “stretches” its people by giving them a say in the development of the business. While this kind of rhetoric must always be discounted somewhat, it is nonetheless a far cry from the old U.S. managerial tradition of viewing people as interchangeable fac­tors of production. It explicitly recognizes the “hard” or measurable impact on competitiveness of attend­ing to the “soft” side of management.

But, again, firms like GE represent the excep­tion to rule in the U.S. And because investment in the product, technology, and talent markets requires time to generate returns, the hidden cost of the traditional modus operandi of U.S. firms will become visible only in the medium to long term. By continu­ing to treat all other markets as subordinate to capital markets, most U.S. companies are falling years behind the firms that are already attempting to balance the demands of these four markets.

Japan and Europe

Japanese firms, by contrast, pay significant attention to the labor market. This is evident in their college recruiting efforts, their emphasis on internal training, and their policy of lifetime employment for a selected talent pool. Japanese firms have also long cultivated strong relationships with captive “house” suppliers (in the forrn of keiretsus), but are now also increasingly developing supplier networks with outsiders to gain access to new technologies. These actions have allowed them to compete very effec­tively in the global product market, setting new world standards in product quality, customer re­sponsiveness, and time to market. Indeed, Japanese firms across a variety of industries have succeeded in rewriting the rules of competition to their own advantage.

At the same time, however, Japanese managers have not paid sufficient attention to their investors­in large part because Japanese capital markets have long been distorted by regulatory controls and intervention.[7] The current recession, a strong yen, and competition from overseas are now forcing Japanese managers to reassess their traditional ap­proach to the talent market. They are even reconsid­ering their policy of lifetime employment.[8] Until now, Japanese firms could pursue lifetime employ­ment not only because a growing economy ab­sorbed the costs, but because of a hidden source of flexibility in the Japanese labor market: While the largest firms held onto their talented employees during hard times, employees of the suppliers and sub‑contractorsas well as women and contract workers in the large firmsprovided the much needed cushion (as much as 20% to 30% of the workforce).

Japanese managers are also being forced to reexamine the concept of a captive supplier base and the efficiency of long‑term relationships generally. The need for privileged access to the supplier base has become more important, but sourcing only from internal house suppliersas in the traditional keiretsuis no longer considered essential or even valuable. Many Japanese managers are also discov­ering that goals such as reducing time to market, product proliferation, and increasing market share have been pursued at excessive cost to investors. With Japanese stock prices at roughly half their 1989 levels, and corporate profits sharply depressed, Japa­nese firms are being forced to come to a recognition that investors must be adequately compensated.

The European situation is somewhat more complex. For example, legislation requires Euro­pean firms to be concerned about employment, but the competitive consequences of such legislation are unclear. On the one hand, this could make European firms more willing to invest in developing their existing talent. In practice, however, such legislative constraints on hiring and firing may well interfere with the effective development of human resources. Perhaps partly as a result, European firms have not converted this built‑in protection of labor into a means of achieving greater understanding of their customers or building relationships with suppliers. Like many of their Japanese counterparts, moreover, European managers in general have not focused on providing returns to capital markets.

Such a situation could be tolerated as long as European markets remained sheltered from compe­tition (although a completely protected economy, which creates distortions in all four markets, cannot last forever). But, now that barriers to competition are falling with the prospect of a united Europe, leading European firms are being forced to make progress along all dimensions of corporate success. They are becoming more investor‑driven, more con­cerned with global product market competition, and more focused on gaining access to networks of sup­pliers. Even European governments are reexamining the wisdom of legislation that, while protecting some workers, effectively denies opportunities to others.


Although U.S., Japanese, and European firms thus have different starting points and are traveling different roads, their paths are converging and their destination is more or less the same. Despite impor­tant differences in historical roots and institutions, corporations around the globe are all being forced to respond to the demands of the four markets.

Complicating this story are differences among nations in the stage of development, and thus in the level of efficiency, of some of these markets. U.S. capital markets, for example, exert a much more powerful (if sometimes short‑sighted) discipline than do Japanese markets although the Japanese system will change somewhat. And labor markets worldwide are clearly less efficient than product markets, at least at present. But, as firms seek to profit from such disparities and inefficiencies, the forces of global competition will reduce them.

Just as more and more firms are consulting their key customers and suppliers, outlining their strategies and inviting their counsel in shaping future directions, top managers should encourage institutionaliInvestors to become partners with management in the enterprise by sharing its strategies and its understanding of the risks underlying them.


As top managers reflect on the wealth creation process, it will become obvious that there are important differences among the disciplines im­posed by the four markets. In thinking about such differences, management must address the follow­ing issues:

Time horizon. Developing competence and access to a specialist supplier base could take as long as five to ten years. For example, if an auto supplier participates in an advanced car program, the per­spective ought to be at least five to seven years. Participation in a new airframe development takes even longer; for the first three to five years of such a development program, there may in fact be no revenues at all.

Adjustments will have to be made both by the firm itself and by its first‑tier suppliers as they learn to relate to each other in new ways. These relation­ships must be both competitive and cooperative at the same time. The same is true of key customers; it may take years to gain privileged access to customers to build up brand loyalty.

The key question here, of course, is whether the time horizons of institutional investors are sufficient to accommodate corporate investment in non‑inves­tor stakeholders. If the time horizons of capital markets are considerably shorter than the payoff period required for investments in the other three markets, are there steps managers can take to stretch them?

Transaction‑Specific vs. Relationship‑Specific Costs. While significant attention has been paid to transaction costs in these four markets, little attention has been paid to relationship‑specific costs. Corpo­rate dealings in the markets for technology, talent, and customers are often premised on not just a single transaction, but rather on an expected sequence of transactions. Repeated transactions lead to the de­velopment of a relationship, whether contractual or implicit. The goal in such cases is not just to minimize the costs of a specific transaction, but to minimize costs (or maximize total efficiency) over the entire sequence of transactions.

This has important implications for corporate policy. For example, a first‑tier supplier involved in co‑developing a critical sub‑assembly should not be treated in the same way as another supplier selling a commodity component. And, indeed, a two‑tier system now appears to be evolving in each of the four markets. Firms increasingly tend to distinguish between:

a. key suppliers and others
b. key accounts and channels and others
c. key employees and others
d. key institutional investors and others

Although near‑term cost minimization is likely to be the appropriate goal in dealings with “others,” the establishment of relationships with “key” stake­holders demands an investment mentality. Managers may also find it valuable to share more information in key relationships. They will thus not be able to treat these relationships as totally competitive, but instead seek to achieve a balance between compe­tition and cooperation. The nature of these interac­tionsthe collective learning that takes place be­tween the firm and its key stakeholdersis what leads to wealth creation over the long term.

Control or Value Added? The implicit assump­tion of financial economists in the governance debate is that investors, as owners, ought to control managers. Further, investors are urged to put pres­sure on boards to rewrite management incentive contracts so as to elicit the desired (”shareholder-­wealth‑maximizing”) behavior. The principal prob­lem with such a control orientation is that it discour­ages managers from sharing information with inves­tors. When combined with constraints imposed by the SEC and the rest of our legal and regulatory system, a control‑oriented system ensures that the information investors receive from managers will relate only to past events.

To address the heart of the U.S. corporate governance problem, this control orientation must give way to a more constructive, value‑adding relationship between management and investors. In this sense, corporate relations with investors should attempt to learn from the collaborative develop­ments now taking place between firms and their main customers and suppliers. Just as more and more firms are consulting their key customers and suppli­ers, outlining their strategies and inviting their coun­sel in shaping future directions, top managers should encourage institutional investors to become partners with management in the enterprise by sharing its strategies and its understanding of the risks under­lying them.

A value‑added relationship must continue to have a control component, but it must amount to something more mutually productive than an arm’s length “yes or no” relationship. The process must encourage continuous informative dialogue between management and investors that aims to produce a shared understanding of the firm’s strategyof the critical assumptions underlying the strategy, the competitive challenges facing it, the yardsticks (fi­nancial as well as non‑financial) by which progress toward strategic goals is evaluated, and the time period over which it is expected to play out. In short, a value‑added orientation must focus on crisis pre­vention rather than crisis management.

Top managers must also recognize that the process of sustained wealth creation is a continuous act of balancing the demands of the four markets. If managers seek to optimize in any single marketbe it talent, technological competence, suppliers, or investorsthey are likely to fall behind in the wealth-creation process. Achieving the optimal balance among the four markets involves making the appropriate tradeoffs among them. To make the right tradeoffs (and to explain them most effectively), managers should develop communication channels and procedures that encourage active dialogue with key participants in each of the four marketsinvestors, suppliers, customers, and critical talent. By encouraging information‑sharing, such dialogue should generate valuable longer‑term commitments.

In sum, the economic and political realities of the 1990s demand the active participation of each of these four main corporate constituencies. Corporate managers are likely to be surprised by the value added that can result simply from allowing the players in these markets a greater voice in setting the broad direction of the firm.


Corporate governance is not, as capital market theory suggests, simply a matter of giving investors more control over top management. The real governance crisis in the U.S. is an internal crisis. It is the failure of many top managers to address simultaneously the performance, adaptability, and opportunity gaps now evident in many of our largest public companies. If our internal governance system can be strengthened, there will be much less need for intervention by capital markets.

Unfortunately, the remedies currently proposed by financial economists tend to focus on the symptoms rather than the cause of the problem. Crisis-oriented, highly selective, and sporadic intervention by shareholder activists is not the solution. Indeed, it may provide the wrong signals to the CEO. Managing the stock price in the short term is not the same as building the capacity for sustained wealth creation. To add value, top managers must consistently balance the demands of and be subject to the disciplines of four distinct marketsproduct markets (consumers), labor markets (specialized talent), the market for technology (suppliers), and capital markets (investors).

In the past, the orientations of top management in the U.S., Japan, and Europe toward these four markets have been quite different. Whereas U.S. management has focused primarily on meeting investor requirements, Japanese managers have devoted more attention to building relationships with employees and suppliers. In the 1990s, however, convergence among the world’s best firms in their approach to these markets is inevitable, irrespective of national origin and history. For Japanese and European managers, such convergence implies greater concern for investors. For U.S. managers, it means a new, pragmatic, value‑added approachone that seeks to establish long‑term relationships with investors based on mutual interest and effective sharing of information.

C.K. Prahalad is the Harvey Fruehauf Professor of Corporate Strategy at the Graduate School of Business Administration of the University of Michigan.

[1] . The calculations to follow are adapted from the finite growth model presented in Merton H. Miller and Franco Modigliani, “Dividend Policy, Growth and the Valuation of Shares, ” Journal ofBusiness, Vol. 24, No. 4 (October 196 1), pp. 411‑433. 1 have taken the value of rho (the risk‑adjusted cost of capital) as 10 percent (whatelse?)and the value of k (the investment‑to‑eamings ratio) as 1.0. A firm with a market‑to‑book ratio of 1.0 corresponds to a “no growth‑premiurn firm” with average internal rate of return (rho‑star) just equal to the cost of capital.
[2] For an account of how MOF systematically  uses its regulatory powers to sustain the Japanese brokerage industry cartel and to support the level of stock prices, see my articles, “The Economics and Politics of Index Arbitrage in the U.S. and Japan,” Pacific‑Basin FinanceJournal, Vol. 1, No. I (May 1993), pp. 3‑11; and “Japanese‑American Trade Relations in the Financial Services Industry,” Working Paper, Graduate School of Business, University of Chicago (September 1993).
[3] See Merton Miller and Myron Scholes, “Executive Compensation, Taxes and Incentives, ” in Financial Economics, Essays in Honor of Paul Cootner, William Sharpe and Catheryn Coomer (Eds.), Prentice‑Hall, Englewood Cliffs, NJ, 1982.
* The author gratefully acknowledges the research assistance provided by Ms. Karen Schnatterly, Ph.D. student, at the University of Michigan.
[4] More precisely, finance shareholders are the “residual claimants” entitled to all earnings and assets once all other prior claimants are fully compensated.
[5] While the process allowed for some rationalization of efficiency, it came at a significant cost. I estimate the costs of restructuring in the U.S. to have exceeded $400 billion during the 1980s.
[6] SEC filings, form 13‑F, data processed by spectrum.
[7] See Merton Miller, “Is American Corporate Governance Fatally Flawed?”, Journal ofApplied Corporate Finance (Vol. 6 No. 4), which appears immediately before this article.
[8] Although lifetime employment in Japan is often described as a cultural trait thepractice is actually quite recent. It evolved around late 50s and early 60s. Given the paucity of talent at that time, it made good economic sense to hold onto talent. Lifetime employment was the result. Although continuous growth insulated firms from having to deal with the negative consequences of this “blanket commitment,” the “real cost” of this approach is now becoming apparent.