Nonprofit Organizations as Investor Protection: Economic Theory, and Evidence from East Asia

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Nonprofit Organizations as Investor Protection:

Economic Theory, and Evidence from East Asia

Curtis J. Milhaupt*

September 1, 2003


Enforcement problems plague shareholder activism and investor protection efforts in many parts of the world. These problems are particularly severe in transition economies, where weaknesses in legal and market constraints are prevalent. The importance of solving this problem has led legal scholars to consider a range of partial alternatives to domestic enforcement regimes. For example, Bernard Black and Reinier Kraakman devised a “self-enforcing” corporate law for Russia, designed specifically to minimize resort to legal authority.1 John Coffee has recently emphasized the role of cross-listings on foreign stock exchanges as a mechanism by which firms in weak enforcement regimes can bond themselves to “good” corporate law by listing on a foreign stock exchange that imposes high disclosure requirements and subjects listed firms to a stringent foreign regulatory and private enforcement regime.2

But there is another partial solution to the problem of weak investor protection and corporate law enforcement, one that has received no theoretical or empirical attention—the nonprofit organization. This partial solution emerges from a puzzle at the center of contemporary East Asian corporate governance. With the possible exception of the government itself, nonprofit organizations3 (NPOs) have emerged as the most important corporate law enforcement agents in Korea, Taiwan and Japan. In Korea, the shareholders’ rights committee of a large, diversified NPO known as Peoples’ Solidarity for Participatory Democracy (PSPD) “has brought the only significant shareholder actions to date,”4 winning two major court victories, including one against the chairman and managers of a leading chaebol firm. In Taiwan, a nonprofit foundation known as the Securities and Futures Institute, established with the support of the government and the financial sector, has organized and filed de-facto class action suits in securities and corporate fraud cases on behalf of thousands of small investors. In Japan, a group of activist lawyers and academics calling themselves the Shareholder [Kabunushi] Ombudsman “dominates the market [for derivative actions], has no recognizable equal, and has litigated several of the more high profile cases in Japan.”5

This brand of shareholder activism is puzzling on several levels. First, the defining characteristic of an NPO is the nondistribution constraint.6 That is, while NPOs are not prohibited from making profits, they are prohibited from distributing profits to their members or others who control them. Why are three organizations operating within the nondistribution constraint--rather than institutional investors or individual shareholders represented by plaintiffs’ attorneys--the principal shareholder activists cum corporate law enforcement agents in the three largest market economies of East Asia? Second, civil society is a comparatively recent development in this region, where the state has traditionally not created much space for the formation of organizations pursuing independent objectives.7 Why isn’t the phenomenon of corporate law enforcement by NPO shareholder activists witnessed more extensively elsewhere, including in countries, which have active nonprofit sectors?8

A partial solution to the puzzle of corporate law enforcement in East Asia, as well as the contours of a possible role for nonprofits in improving investor protection in some other economies, come into focus when we turn from facts to theory. For considerably longer than corporate law scholars have debated the causes of cross-country diversity in corporate structures, social scientists have sought to explain the existence of NPOs, and the vast disparity in the size of the NPO sector in individual countries around the world. While no single theory garners universal support, several influential, related theories help explain the recent phenomenon of NPO shareholder activism in East Asia. By extension, understanding the East Asian experience may suggest ways to improve investor protection elsewhere. One theory views NPOs as a response to unsatisfied demand for public goods—demand that grows as societies become more diverse, opening gaps in supply caused by government and market failures.9 In order to understand how this theory fits the East Asian experience, note that investor protection in the form of corporate and securities law enforcement is a public good: many of the benefits of the enforcement effort accrue to persons who are not required to bear their share of the enforcement costs. Note as well that demand for investor protection and “good” corporate governance have grown rapidly in the region, a result of the Asian financial crisis, domestic corporate scandals, and persistent economic malaise in Japan. Under these circumstances, if the infrastructure for private law enforcement is inadequate and the government is unable or unwilling to meet the increased demand for investor protection, the government failure/market failure theory predicts the emergence of NPOs to supply investor protection, at least where legal and social conditions for the development of an NPO sector are favorable.

A related, “contract failure” theory views the NPO form as a device to economize on the costs of producing public goods, particularly where consumers are unable to evaluate the quality or quantity of the goods provided.10 This theory rests on the premise that the nondistribution constraint inherent in the NPO form makes it a “trustworthy” supplier where such information asymmetries are present, because the owners of such organizations have fewer incentives to take advantage of consumers than the owners of a for-profit firm. As we will see, this theory, applied to the government, helps explain why the Taiwanese securities regulatory agency supports an investor protection NPO, and suggests that government-NPO partnerships have potential to supplement weak state enforcement of corporate and securities laws.

A third theory focuses the supply side, noting that the demand for public good production can only be met by NPOs if there is an adequate stock of individuals (“social entrepreneurs”) to found and operate these organizations.11 This theory recognizes that certain social environments are more conducive than others to the supply of social entrepreneurs. The literature has focused on the role of religious competition in expanding supply, but this is hardly the only environment conducive to social entrepreneurship. For example, a comparatively larger stock of social entrepreneurs would likely exist in societies with a history of organized protest against the government, a circumstance relevant to the East Asian experience.

These theories help explain why NPO shareholder activists have emerged to fill a shortfall in the supply of investor protection-related public goods in the increasingly diverse socio-economic structures of Japan, Korea and Taiwan. This form of law enforcement appears most successful in Korea, where the supply and quality of social entrepreneurs is highest due to its recent history of organized protest against authoritarian governments, and where government policy and the legal environment are conducive to an active NPO sector. The Taiwanese example is also noteworthy, because the government has consciously co-opted an NPO into its public good supply chain. The Japanese NPO, comparatively less prominent than its other East Asian counterparts, reflects both a somewhat more robust corporate law enforcement environment (hence fewer gaps in the supply of public goods), a smaller stock of experienced activists, and a political and legal environment that has traditionally channeled organized nongovernmental activism into highly localized causes.

NPO shareholder activism in East Asia, which has been the focus of virtually no theoretical or comparative analysis,12 has significant implications for ongoing academic debates in comparative corporate governance as well as real-world reform efforts. Academically, two points are well recognized in comparative corporate governance theory, but not thoroughly explored empirically. First, the quality of law enforcement is at least as important to “good” investor protection as high quality statutory law.13 Second, convergence of legal systems at the formal level may not eliminate differences in practice; and conversely, functional equivalents may lead to convergent outcomes even where significant differences remain among corporate governance systems at the formal level.14

The emergence of NPOs as the leading non-state corporate law enforcement agents in East Asia is a novel and important illustration of both points. Despite recent, extensive corporate governance reform in all three countries at the statutory level, the enforcement environment remains problematic. While by no means perfect, the NPOs analyzed here are important—perhaps even the only—aggressive enforcement agents in the corporate governance environments of the three countries in which they are active. All three organizations have found ways to improve the quality of investor protection in their home countries, despite—or perhaps more accurately, because of--shortcomings in public and private enforcement mechanisms.

Moreover, the NPO as a supplier of investor protection is a highly distinctive illustration of functional convergence—that is, the use of strikingly different institutional forms to accomplish a common objective, such as corporate law enforcement.15 In this case, several quite different societies in East Asia have spontaneously generated an NPO substitute for the attorney-oriented incentive mechanisms relied upon in the United States to provide law enforcement-related public goods in the field of corporate governance. Neither the NPO nor the “private attorney general” ensures an optimal supply of investor protection, but these two enforcement alternatives are distinct paths toward the same goal.

Yet the experience of East Asia with NPOs as corporate law enforcers is not an unalloyed convergence story. Even in their common use of the nondistribution constraint to advance the objective of investor protection, Japan, Korea and Taiwan display striking diversity in the organizational form, strategy and success of their NPOs. This diversity can be traced to the distinctive legal, political, and social environments in which NPOs have emerged and exist in the three systems.

At the level of law reform, the lessons from East Asia for other transition economies may be significant, particularly where there is hesitation or inability to replicate the U.S. private attorney general model of corporate law enforcement. While the use of the NPO form as a law enforcement device has its own serious limitations (explored in Part IV below), this innovation is worthy of serious study as a way to improve the corporate governance environments in China, Russia and other transition countries. NPOs may be less effective compared to other functional substitutes for domestic enforcement, such as firms bonding themselves to “good” corporate law through cross-listings on foreign exchanges. However, shareholder activist NPOs are inherently domestic organizations, and that attribute holds out the promise of improvement of local law enforcement institutions. The other alternatives discussed in the literature (save for massive long-term investments in legal infrastructure) generally involve abandoning local legal regimes.

The paper is organized into four parts. Part I presents the puzzling yet significant role of nonprofit organizations in the corporate governance environments of Korea, Taiwan and Japan. Part II outlines several complementary theories from social science literature explaining the existence of NPOs, theories that shed light on the puzzling form corporate law enforcement has taken in East Asia. Part III applies these theories, first to explain the emergence of NPO shareholder activism in Japan, Korea and Taiwan, and second, to explain why substantial diversity exists in the structure and operations of these NPOs despite their common role as corporate law enforcement agents. Part IV draws implications from this distinctive East Asian experience for comparative corporate governance literature, and for corporate law enforcement in transitional economies.

I. A Puzzle: The Role of NPOs in East Asian Corporate Governance

As noted in the Introduction, a puzzling feature of contemporary East Asian corporate governance is the presence of an organization operating within the nondistribution constraint as a major corporate law enforcement agent in each of the three largest market economies in the region. This part introduces the puzzle by describing the three shareholder activist/investor protection NPOs operating in Korea, Japan, and Taiwan, respectively.

A. Korea

The People’s Solidarity for Participatory Democracy (PSPD) was founded in 1994. Legally, it is a nonprofit organization registered with the Seoul Metropolitan government. Its membership has grown rapidly, from 200 at its founding to over 12,000 in 2002, so that today, 80 percent of its monthly budget is funded out of membership fees.16 It has a professional staff of fifty, but its activities rely heavily on voluntary participation of lawyers and other experts. PSPD is actually a nonprofit “holding company” for several “action bodies” engaged in a wide variety of advocacy efforts, including judicial oversight and a taxpayer’s movement. One of these action bodies is the Participatory Economic Committee, which launched a Small Shareholders Rights Campaign in 1997. The aim of this campaign is to protect minority shareholder rights and improve corporate management by mobilizing small shareholders to act collectively against the chaebol, conglomerates dominated by a controlling shareholder, typically the founder or his family.17 The complexity of intra-chaebol firm relationships, the history of close, if at times contentious relations with the government, and above all, the use of pyramidal and circular shareholding structures by founding families to maintain control over group firms despite relatively low cash flow rights, gave rise to some acute corporate governance problems in Korea.18 Through the activities of the PEC targeting these problems, PSPD has become the leading shareholder activist,19 and indeed, the most influential civic movement in Korea.20 (For simplicity, hereafter I will refer only to PSPD.)

PSPD consciously targeted the leading chaebols for its initial activism efforts, seeking to make them good role models for other firms.21 While it engages in a variety of non-legal activities to promote corporate governance, PSPD has utilized the legal system as its principal tool of reform.22 Toward this end, it holds a portfolio of stock so that it has standing to exercise shareholders’ rights. By participating in shareholder meetings, PSPD has obtained disclosure of information and managerial acceptance of corporate governance reform at a number of major chaebol firms, including SK Telecom, Hyundai Heavy Industries, and Daewoo Corporation.23 It has also successfully sued to nullify resolutions passed at a shareholders meeting at which irregularities occurred. PSPD has also launched several proxy solicitations aimed at attracting foreign institutional investors to its cause, sought injunctions against illegal managerial conduct, and filed administrative complaints against lawyers and accountants for aiding in such conduct. 24 In addition, it has successfully proposed a series of reforms to the Commercial Code and Securities Exchange Act. Most recently, PSPD has been instrumental in initiating an investigation of fraud and insider trading at the SK Group, Korea’s third largest chaebol. The investigation resulted in the prosecution and conviction of ten senior executives within the group.

Most importantly, PSPD has achieved two major victories in shareholder derivative suits.25 The first—indeed the first shareholder derivative suit in Korean history--was a suit against the former directors of Korea First Bank, filed on behalf of sixty one minority shareholders. The claim alleged that the directors had accepted bribes in return for the extension of credit to a failing conglomerate, while instructing staff to proceed with the loans despite knowledge of the borrower’s poor financial condition. A 40 billion won ($44 million) decision was rendered against the directors in 1998, making directors aware, for the first time, of their fiduciary obligations to their shareholders.26 In 2001, PSPD won a judgment in a shareholder derivative suit brought on behalf of twenty two shareholders against the controlling shareholder and nine directors of Samsung Electronics. In the case, which bears a resemblance to Smith v. Van Gorkom, the court held the directors liable for failing to exercise business judgment in the acquisition of a failing target company. As in Van Gorkom, the court found the directors’ conduct to lie beyond the protective confines of the business judgment rule where negotiations proceeded with undue haste and inadequate diligence by the board. In addition, the chairman of the firm was found liable for making an illegal political contribution, and six directors were held liable for approving a related- party transaction on unfair terms. According to Korean corporate law experts, the Samsung Electronics case sent an even more powerful message to the business community than the Korea First Bank case, indicating that even managers of Korea’s most profitable and well known firms are legally accountable to their shareholders.27 Reinforcing the public goods quality of PSPD’s activities in these cases, the NPO itself was not paid any damages since these were shareholder derivative suits, and the PSPD attorneys who handled the litigation volunteered their services without compensation.

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