Abstract and Keywords
This chapter introduces corporate governance, which has received growing attention and interest over the years. It first looks at the history of corporate governance and the evolution of certain codes and other regulation forms. It then studies the mechanisms and processes of corporate governance, before taking a look at the various life-cycle stages and different forms of governance at each level. The chapter also includes discussions on the types of investor and corporate governance approaches. Summaries of different essays related to these aspects of corporate governance are included.
In recent decades, there has been a substantial increase in interest among policymakers and academics in corporate governance. Since the publication of the Cadbury Report in the UK in 1992, we have witnessed the international diffusion of corporate governance codes and regulations by both individual countries and intergovernmental agencies. Recent legislation, such as the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Act of 2010, and institutional changes, such as the New York Stock Exchange listing rules of 2003, were designed to improve corporate governance practices. A review of corporate governance practices by Walker (2009) reports that the global financial crisis has reduced confidence in the quality of corporate governance. The author even asserts that poor governance systems may have been a root cause of the economic crisis.
As a result, there is also a burgeoning, scholarly literature on corporate governance, as reflected in the numerous conferences and special issues of academic journals on this topic and the development of specialized journals in this area (e.g. Corporate Governance: An International Review and the Journal of Management and Governance). Recent spirited debates in the academic literature regarding executive compensation and the relationship between corporate and environmental social responsibility and corporate governance (e.g. exchanges in Academy of Management Perspectives between Jim Walsh of the University of Michigan and Steve Kaplan of the University of Chicago on CEO Pay (Kaplan, 2008; Walsh, 2009), and Don Siegel of the University at Albany—SUNY and Alfie Marcus of the University of Minnesota on whether top-level managers should engage in “green management” practices (Marcus and Fremeth, 2009; Siegel, 2009)) have stimulated new interest in examining the antecedents and consequences of corporate governance practices. A concomitant trend is the growing number of graduate courses and programs relating to corporate governance in business and law schools. Until now, there has not been a definitive source that integrates and synthesizes academic studies of corporate governance. That is the purpose of our Handbook.
The volume integrates and synthesizes academic studies of corporate governance from a wide range of perspectives, notably, economics, strategy, international business, organizational behavior, entrepreneurship, business ethics, accounting, finance, and (p. 2) law. We also go beyond traditional principal–agent theory to incorporate different theoretical perspectives relating to the numerous stakeholders in the firm.
We consider corporate governance issues at several levels of analysis: the individual manager, firms, institutions, industry, and nation. Critiques of traditional governance research based on agency theory have noted its “under-contextualized” nature and its inability to accurately compare and explain the diversity of corporate governance arrangements across different institutional contexts. This Handbook aims at closing these theoretical and empirical gaps. Thus, in analyzing the effects of corporate governance on performance, we consider a variety of indicators, such as accounting profit, economic profit, productivity growth, market share, proxies for environmental and social performance, such as diversity and other aspects of corporate social responsibility, and, of course, share price effects.
Another unique aspect of the Handbook is that we devote considerable attention to corporate governance practices and issues in emerging industries and nations. It is important to note that much of the extant research on this topic has focused on large companies in the US and Europe that operate in mature industries. Since corporate governance is a global phenomenon, we present a substantial amount of international evidence and our contributing authors have been selected on the basis of their ability to reflect a wide variety of national perspectives on this topic. Finally, besides providing a high-level review and analysis of the existing literature, each chapter develops an agenda for further research on a specific aspect of corporate governance.
Part I: Regulation and History
The purpose of this part is to provide an overview of the history of corporate governance and the development of specific codes and other forms of regulation. It also considers issues relating to the self-regulation, compliance versus legal regulation debate.
In Chapter 2 on the evolution of corporate governance regulation, Aguilera, Goyer, and Kabbach discuss how regulation affects corporate governance. They adopt a comparative perspective and a broad view of corporate governance. The authors consider the classic tension in regulation theory between the interests of policymakers and regulators in influencing governance, and discuss some of the key limitations of this approach. The chapter examines the two main perspectives in studying regulation in corporate governance, namely law and economics and politics. Finally, the chapter explores how regulation has different impacts on corporate governance practices across national contexts. It concludes with a discussion of hard and soft law and the consequences of such for effectiveness in corporate governance around the world.
In Chapter 3, Cheffins provides an historical perspective on corporate governance, taking as his starting point its coming into vogue in the 1970s in the United States. Within 25 years corporate governance had become the subject of debate worldwide by academics, regulators, executives and investors. This chapter traces developments occurring between the mid-1970s and the end of the 1990s, by which point (p. 3) “corporate governance” was well-entrenched as academic and regulatory shorthand. The chapter concludes by surveying briefly recent developments and by maintaining that analysis of the interrelationship between directors, executives, and shareholders of publicly traded companies is likely to be conducted through the conceptual prism of corporate governance for the foreseeable future.
A political institutional perspective is provided in Chapter 4 where Roe argues that for capital markets to function effectively, political institutions must support capitalism and, especially, the capitalism of financial markets. Roe notes that capital markets’ shape, support, and extent are often contested in the polity. Powerful elements—from politicians to mass popular movements—have reason to change, co-opt, and remove value from capital markets. And players in capital markets have reason to seek rules that favor their own capital channels over those of others. How these contests are settled deeply affects the form, the extent, and the effectiveness of capital markets. Investigation of the primary political economy forces shaping capital markets can point us to a more general understanding of economic, political, and legal institutions. A considerable amount of important research has been conducted in recent decades on the vitality of institutions. Less well emphasized thus far is that widely shared, deeply held preferences, often arising from current interests and opinions, can at times sweep away prior institutions or, less dramatically but more often, sharply alter or replace them. When they do so, old institutions can be replaced by new ones, or strongly modified. Preferences can at crucial times trump institutions, and how the two interact is well-illustrated by the political economy of capital markets.
Building on these earlier chapters, Chapter 5, by Martynova and Renneboog provides a comprehensive comparative analysis of corporate governance regulatory systems and their evolution since 1990 in 30 European countries and the US. The authors propose a methodology to create detailed corporate governance indices which capture the major features of capital market laws in the analyzed countries. These indices indicate how the law in each country addresses various potential agency conflicts between corporate constituencies: namely, between shareholder and managers, between majority and minority shareholders, and between shareholders and bondholders. The authors’ analysis of regulatory provisions within the suggested framework enables a better understanding of how corporate law works in a particular country and which strategies regulators adopt to achieve their goals. The 15-year time series of constructed indices and large country-coverage also allows us to draw conclusions about the convergence of corporate governance regimes across countries.
Part II: Corporate Governance Mechanisms and Processes
This part considers mechanisms and processes of corporate governance. The chapters in this part include approaches that review the quantitative empirical literature as well as those that examine the processes of corporate governance, especially the operation of boards. Authors (p. 4) have incorporated evidence from different institutional contexts. The chapters focus first on the role of boards and board processes.
The first chapter in this section (Chapter 6), by Pye, presents insights from the evolution of board processes in large companies over the past quarter of a century. It reflects on a series of three ESRC-funded studies into the people side of corporate governance. Adopting a process-oriented, sensemaking (Weick, 1995) approach to understanding corporate directing across time and context, this longitudinal qualitative research (1987–2011) effectively creates a unique dataset of FTSE 100 directors across a particularly vibrant period of economic history. In order to pay attention to changing context, interviews have also been conducted with selected investors, auditors, regulators, and others who have influence on the process and practice of corporate directing. Based on findings from these studies across time and context, the author highlights key changes in roles and relationships which affect how companies have been and are currently run. The chapter also highlights some paradoxes identified during this series of studies and which underpin corporate directing.
The following chapter, by McNulty, extends our understanding of board behavior and processes. McNulty summarizes qualitative studies on the exercise of board power, influence, and accountability. The chapter discusses studies which model boards as strategic decision-making groups and tests the relationship between board processes and performance. These distinct strands and styles of research provide evidence that the key to understanding the work and effects of boards lies in attention to behavioral processes. McNulty notes that now law and governance codes have substantial influence over matters of board composition and structures. Thus it is ever more important for the theory and practice of corporate governance to get beyond the form and appearance of boards to the substance of board effectiveness.
In Chapter 8, Stiles provides additional insights into the workings of boards. Most significant board decisions are made not within the whole board setting, but within the context of specific committees, yet our understanding of how board committees work remains limited. Stiles examines the three primary board committees—audit, remuneration, and nomination. Research on key aspects of their composition is assessed—chiefly independence and expertise, and also work on the processes by which committees operate. Overall, there is a positive relationship between the independence and expertise of board committees with key effectiveness measures, but process research indicates the tensions committees face in their work. In addition to their role in the inside working of boards, directors can contribute through the networks they bring to the corporation.
In Chapter 9, Renneboog and Zhao point out that director networks have attracted growing attention from finance, management, and sociology. They argue that these networks play an intriguing role in corporate governance. On one hand, networks provide a company with improved information access. On the other hand, networks can be misused by top managers to gain excess power over the board. This chapter first reviews the regulation of director networks in major developed countries. Second, it summarizes the main results from the academic literature on director networks from different disciplines. By means of examples, the chapter demonstrates how director networks can be empirically captured and network information quantified.
(p. 5) In Chapter 10, Brandes and Deb focus on the contentious issue of executive remuneration, which has attracted renewed policy and media interest in the aftermath of the global financial crisis of 2008. Reviewing the now extensive literature on executive remuneration, they develop a framework that integrates the main themes. Their framework highlights how internal governance mechanisms (board power and ownership), institutional governance (regulatory, normative, and mimetic), and market governance factors (labor markets, analysts, product markets, and the market for corporate control) interact with CEO characteristics and firm factors (strategy and reporting choices) to influence the level and structure of executive compensation and the way in which performance measures are defined as the basis for setting compensation. The authors go on to examine the intended and unintended consequences of these interrelationships. They note that, while intended consequences can be positive, negative unintended consequences can involve senior managers’ reluctance to invest in their firms, re-pricing and re-dating option grants, fraudulent reporting in the presence of duality and other governance shortcomings, as well as earnings manipulation where options are out of the money. Concerted actions by groups of concentrated institutional investors can exert pressure on executive remuneration decision-makers but there may also be a need for greater attention to the recruitment of remuneration committee board members with the real expertise to monitor senior managers and set compensation.
The nature and distribution of ownership in a firm is an important dimension of corporate governance. In Chapter 11, Boss, Connelly, Hoskisson, and Tihanyi extend research that tends to focus on the influence of a single form of ownership or type of owner. The authors examine ownership at a broader level, comparing different types of owners and demonstrating how they act both independently and together to influence firm outcomes. They show that, while these different types share some similarities, various forms of internal and external owners differ from each other in terms of preferences, incentives, and motivations. As a result, conflicts may arise among them, leaving top-level managers with competing pressures and difficult choices to make about their firm's strategic direction. The authors draw attention to these conflicts and suggest future research in areas where scholars might explore how to better understand the influence of a portfolio of owners on firm-level actions and outcomes.
Shareholders are not the only investors playing a role in corporate governance. Debt providers are also important. Further, there are interrelationships between different governance mechanisms that may have consequences for corporations. In Chapter 12, Watson examines the interrelationships among corporate performance, business risk, financial leverage, and their impact upon managerial incentives, financial reporting behavior, and the likelihood of costly and unanticipated corporate governance failure. It is argued that the latter will become much more probable because of a systematic board loyalty bias that has resulted in executives being awarded generous and highly leveraged compensation packages that motivate the pursuit of high business risk and high financial risk strategies that are not consistent with shareholder interests. In essence, managers are being unduly rewarded for taking hidden financial risks, i.e. both shareholder and debt holder risk exposures will be underestimated and hence underpriced, and this dynamic transfers wealth from financial stakeholders to managers.
(p. 6) Information, of course, plays a crucial role in the governance process. While firms worldwide are subjected to disclosure regulations, many public and private firms voluntarily disclose more information than required. In Chapter 13, Beuselinck, Deloof, and Manigart discuss the benefits and costs of such voluntary disclosure at the firm and societal levels. They review the empirical literature on the association between a firm's corporate governance and its disclosure policies. They report mixed evidence, concluding that contingencies, e.g. the institutional environment or the type of dominant shareholder, may be important. Besides public corporations, this chapter further explores disclosure by private firms, which has received limited attention so far.
Pursuing the accounting information theme, Mennicken and Power, in Chapter 14, discuss the role of auditors in corporate governance systems, drawing on international comparisons: they emphasize the changing regulatory, institutional, and methodological dimensions of auditing, both internal and external. First, they position auditing within a fluid and evolving corporate governance space as the provision of assurance regarding financial statement and internal control quality. Second, the chapter focuses on auditing knowledge and standards, and related pressures to govern the quality of the market for auditing. Third, auditing is analyzed as a powerful model of governance in its own right and a number of regulatory and research challenges are evaluated.
While the previous chapters in this section focus on internal governance structures and processes, external governance mechanisms may also be important and interact with internal dimensions. The market for corporate control plays a primary external governance role and is discussed in Chapter 15, the final chapter in this section, by Weir. Manne (1965) argues that the market for corporate control can be seen as a response to the managerial discretion afforded in the managerial models that show the consequences of the separation of ownership and control (Berle and Means, 1932). Manne's central argument is that managers are constrained by shareholders, who can sell their shares if they believe that incumbent management is not acting in their best interests. Weir considers the relationship between the market for corporate control and hostile takeovers. He also examines the contribution of the market for corporate control to innovations within the takeover market, for example public to private transactions and leveraged buyouts (considered in more detail in Chapter 24). There may, however, be obstacles to the operation of the market for corporate control, including the free-rider problem, management resistance to bids, and anti-takeover defenses. These impediments to the functioning of the market are analyzed.
Part III: The Corporate Governance Life Cycle
In the corporate governance literature, there has been considerable attention devoted to mature firms. More attention needs to be paid to corporate governance mechanisms and processes involving firms in earlier stages of the life cycle (Filatotchev and Wright, 2005). (p. 7) This part considers the different life-cycle stages and examines different forms of governance at each phase and the problems involved in transitioning from one phase to the next.
To begin, Toms explains the concept of the corporate governance life cycle in Chapter 16. The chapter adopts a framework that shows how the firm's resource base evolves through each stage of the life cycle and how the functions of corporate governance evolve in tandem. At key points in its evolution, the firm is shown to cross a series of thresholds implying fundamental changes in governance arrangements. As the resource base and governance arrangements change, so too do the functions of corporate entrepreneurship and the financial structure of the firm. To explain these dynamic interactions, the chapter presents a four-stage analytical model of the life cycle. Each stage, and each transition between stages, is illustrated with examples from the research literature. Subsequent chapters consider governance in firms which are at different stages.
In Chapter 17 Bertoni, Colombo, and Croce provide a survey of the literature on the role of corporate governance on the innovative activity of high-tech firms. The authors argue that a value protection perspective only allows a partial understanding of the scope of corporate governance in high-tech companies, and that a value creation perspective should instead be used. Following this broader perspective, Bertoni et al. analyze three dimensions of corporate governance: ownership structure, internal governance mechanisms, and external governance mechanisms. They show that the value protection dimension of corporate governance is often curtailed in high-tech companies. In contrast, in high-tech companies corporate governance has a very substantial value creation potential.
The intersection of family and business objectives and values within family businesses give rise to particular corporate governance challenges. In Chapter 18, Uhlaner provides an overview of research on family business and corporate governance—spanning both publicly and privately held companies. An initial overview of the field of family business identifies its prevalence and economic importance globally, as well as key terms (i.e. family business, corporate governance). The chapter is organized according to a framework, represented by nine research questions, which analyzes key findings from the extant literature according to a range of antecedents (but especially family ownership) and consequences of governance (financial performance as well as intermediate outcomes).
While high-tech and family firms are largely privately owned, at least initially, stock market entry through an initial public offering (IPO) represents a subsequent stage in a firm's life cycle. In Chapter 19, Filatotchev and Allcock discuss the context and provide an evaluation of governance issues at an IPO. The chapter provides vital keys to specific governance influences that affect firms at this particular point in their life cycle. Areas of challenge at this time for the firm are changes in the board of directors, the role of the entrepreneurial founder, developing new remuneration schemes, and external governance influences by early stage investors such as venture capital companies. The authors’ analysis indicates that the IPO market is rapidly changing, as are the challenges for companies to develop robust governance mechanisms. As a result, a number of policy issues specific to this stage of a firm's development are raised.
(p. 8) As corporations mature, they may become large multinational firms. Although there is an extensive literature on the internal organization and governance of multinationals, relatively little is known about corporate governance relating to these organizations (Filatotchev and Wright, 2011). As Wu and Tihanyi discuss in Chapter 20, multinational firms are complex organizations, as are their corporate governance mechanisms. The authors begin with a review of the literature on the governance of multinational firms and identify three research streams: coordination and control of foreign subsidiaries, headquarter governance, and knowledge flow within multinational firms. Second, the chapter reviews the literature on the influence of governance on the internationalization process and discusses the governance problems presented by the classic models of international business, including internationalization strategy, mode of entry, and the managerial perception of the internationalization process.
Large business groups, whether multinationals or not, need to develop distinctive governance mechanisms to govern their group affiliates. These issues are addressed in Chapter 21 by Yiu, Chen, and Xu, who identify vertical governance mechanisms (including concentrated ownership, pyramidal ownership, and strategic control) and horizontal mechanisms (including cross-shareholdings, interlocking directorates, and relational governance) that are commonly found in business groups. The authors also point out, however, that business groups also face salient governance problems such as tunneling and propping, cross-subsidization, and mutual entrenchment. Given that business groups vary in ownership structures, they also examine how governance structures and related governance outcomes differ among family-controlled, state-owned, and widely held business groups.
In Chapter 22, Ayotte, Hotchkiss, and Thorburn examine the interplay of formal and informal corporate governance mechanisms relating to firms in distress. First, they outline the framework that determines when and how control rights are exercised. The authors also present extensive empirical evidence, which provides important insights on the evolution of governance involving distressed firms. Their principal focus is on the US, where the key provisions of Chapter 11 of the US Bankruptcy Code influence the behavior of firms even prior to a default.
A central feature of Chapter 11 is that it enables the debtor to remain in possession, thus enabling continuity and removing a disincentive to delay filing. They examine in turn the role of each of the firm's main constituencies who influence a potential restructuring. These constituencies involve shareholders, managers, and boards, on one hand, and senior and junior creditors on the other. Further, the authors also discuss the role of law, courts, and judges. Based on their review of the evidence, the authors conclude that it remains somewhat debatable whether management engages in riskier investment on behalf of equity holders, or whether they act more conservatively as the firm becomes distressed. They also note evidence for shareholder bargaining power in the prevalence of deviations from absolute creditor priority toward equity, although this problem appears to have declined in recent years. The authors also conclude that the idea that bankruptcy provides a safe haven for management is refuted by empirical research, which shows that managers frequently lose their jobs in financial distress. Recent (p. 9) evidence is cited of an ex ante expected median personal bankruptcy cost of $2.7 million (in constant 2009 dollars), or three times the typical annual compensation. They suggest that this high cost will likely have a strong impact on managers’ behavior prior to distress, providing incentives to choose lower leverage or less risky investments. However, given the complicated interplay of formal and informal control rights in bankruptcy, Ayotte et al. suggest that it remains an open empirical question as to whose interests management actually represents when a firm is distressed. The evidence does, however, indicate that senior creditors play an active role in corporate governance and the restructuring of distressed firms outside of bankruptcy.
Of particular relevance to the current financial crisis, recent evidence also indicates that banks are being driven by financial regulations and regulatory policy to push their bankrupt borrowers to sell assets rather than reorganize under Chapter 11. To the extent the assets are sold at fire-sales prices, the suggestion is that this could lead to a suboptimal allocation of corporate assets. Improvement in post-restructuring operating performance of distressed firms is greater when vulture investors (including hedge funds) gain control of the restructured firm or sit on the board, suggesting that these investors bring valuable governance to the target. Labor unions are also found to maintain substantial bargaining power in Chapter 11 and influence the restructuring outcome in terms of the number of lay-offs.
Part IV: Types of Investors
While the previous part considered the type of firm, this part considers the array of different investors that may be involved in corporate governance. These range from venture capital firms that may be involved in newer firms, to the heterogeneity of traditional institutional investors in mature firms that may have short-term versus long-term objectives. The part also considers newer investors that may play an important role in stimulating the restructuring of mature firms, such as private equity (PE) firms and hedge funds.
As Cumming shows in Chapter 23, corporate governance in the venture capital arena is largely influenced by contractual relationships. Venture capitalists are intermediaries between institutional investors and entrepreneurial firms. As such, there are two main types of contracts: limited partnership contracts (with institutional investors) and term sheets (with entrepreneurial firms). Cummings explains how these contracts are structured, reviews international evidence on the factors that shape the contracts in practice, and discusses the implications of the use of different contractual terms for the governance and success of the venture capital investment process. It is also recognized that contracts are invariably incomplete, so that non-contractual corporate governance plays a vital role in venture capital.
Closely linked to venture capital firms are private equity firms. The terms are sometimes used interchangeably, but private equity has come to refer primarily to the funding of leveraged buyouts (LBOs) of established firms. As Wright, Siegel, Meuleman, and (p. 10) Amess show in Chapter 24, private equity became the subject of considerable controversy and public scrutiny after a flurry of activity between 2005 and 2007. In the light of this attention, this chapter seeks to enhance understanding of LBOs and private equity by providing a review of theory relating to private equity and of the evidence on its impact. The review encompasses a wide range of articles in finance, economics, entrepreneurship, strategy, and human resource management. First the authors outline theoretical perspectives relating to why private equity governance may be expected to have positive or negative effects on financial, economic, and social performance. Second, the authors review the relevant empirical evidence. The evidence from what is now a large number of studies covering both the first wave of the 1980s and the second wave shows that the gains are not limited to cost cutting, but also include benefits from entrepreneurial growth strategies. Active monitoring by PE firms, especially by more experienced firms, contributes to these gains. Nevertheless, questions remain as to whether gains in second-wave PE buyouts will be as great as for those in the first wave.
Hedge funds have emerged as a related but distinct form of active investor and have attracted similar controversy to private equity firms. As Dai shows in Chapter 25, hedge funds have become critical players in the financial market, constituting over $2 trillion in market value at the end of 2011. Dai discusses the development of hedge fund activism and its implications for corporate governance by reviewing the recent key works in this area. Specifically, the chapter describes the nature of hedge fund activism, how and why it differs from activism by traditional institutional investors, as well as by private equity funds and venture capital funds, the tactics commonly applied by hedge fund activists when targeting underperforming firms and distressed firms, respectively; and the short-term and long-term effects of hedge fund activism on corporate governance, firm performance, and value.
Sovereign wealth funds represent another form of investor with novel corporate governance implications. In Chapter 26, Fotak, Gao, and Megginson examine the role sovereign wealth funds (SWFs) play in the global financial system. They argue that SWFs are the result of a process of evolution of state ownership and that their function is to mitigate the governance problems associated with government control of productive assets. The chapter first defines sovereign wealth funds, describes their historical evolution, and details their investment patterns. Next, the chapter describes a model of the role SWFs can and do play in corporate governance in the companies in which they invest. Finally, the model is used to analyze the case of the success that China's SWF has been able to achieve in restructuring the domestic banking system.
Part V: Corporate Governance, Strategy, and Stakeholders
In this final part we examine how corporate governance approaches adapt to the varying objectives and stakeholders in the firm.
(p. 11) In Chapter 27 Harrow and Phillips examine the context of nonprofit organizations. Nonprofit organizations are under pressure to show that they act for the public benefit in transparent ways with demonstrated impact. Consequently, questions of accountability and ownership have infused nonprofit corporate governance. The effect is not necessarily to be more “business-like,” but to address stakeholder relationships and corporate governance systems more effectively when such matters are too easily obfuscated by the wide range of “owners” and players involved. Harrow and Phillips argue that the theories of nonprofit governance represent a kaleidoscope of lenses that can support the environmental contingencies and increased hybridization of corporate forms and business models in the nonprofit sector, whilst still promoting accountability. Accommodation to such innovation has to be squared with the drive for greater homogeneity created by more expansive state and self-regulation and by a consulting industry promoting “best practices.” The second part of the chapter addresses whether increased societal and state regulation will conjoin to enhance corporate governance practices or simply create a muddle which enables governance mediocrity.
The overriding argument of Pendleton and Gospel in Chapter 28 is that there are three main actors in corporate governance: owners, managers, and labor. The chapter focuses especially on the role of labor in corporate governance and the effects of governance regimes and practices on labor. Initially the chapter examines the role of labor in the main corporate governance perspectives and in various strands of political thought. It then turns to perspectives on corporate governance regimes, drawing attention to those in which labor plays an important and direct role and those in which it does not. Various ways are identified in which labor may be involved in governance: representation on company boards and pension funds, ownership of company shares, information provision, and relationships with owners and investors. The chapter concludes by presenting a model of the impacts of corporate governance on labor, and by showing how governance can affect employment, rewards, skills development and work organization, and industrial relations.
The following two chapters address developments in corporate governance that extend the traditional principal–agent approach that is typically applied to listed corporations in developed Anglo-American countries. There is increasing recognition that the principal–agent framework is too simplistic, as it envisions a homogeneous set of shareholder and manager relationships. Peng and Sauerwald in Chapter 29 examine the problem of principal–principal (PP) conflicts between controlling shareholders and minority shareholders, which give rise to major governance problem in many parts of the world. They address the antecedents of PP conflicts and discuss potential remedies in the form of internal and external governance mechanisms. They highlight important organizational consequences of PP conflicts in four key areas: managerial talent, mergers and acquisitions, executive compensation, and tunneling/self-dealing. They suggest that to enhance corporate governance in the context of PP conflicts there is a need for further understanding of informal institutions, transition from family management to professional management, and collaboration among shareholders.
(p. 12) In contrast, Hoskisson, Arthurs, White, and Wyatt address the problem of multiple agent conflicts in Chapter 30. They assert that a majority of ownership is derived from institutional investors who are themselves agents to ultimate principals (those investing funds with the institutional investors). Many of these institutional investors, or “agent-owners,” have dual identities, transcending outside relationships, and investment time horizon differences that lead to new and sometimes unexpected agency problems. The authors expand agency theory by analyzing the potential conflicts and ramifications caused by agent-owners and other important governance actors in several contexts, including initial public offerings, mergers and acquisitions, alliances and joint ventures, leveraged buyouts, and firm bankruptcy.
The 2008 financial crisis has raised fundamental questions regarding the extent to which large-scale corporate governance failures have undermined the basis of the global economy. The literature on financialization suggests that the decline of the managerial revolution and its replacement by a supposedly shareholder dominant paradigm has been little of the sort; rather, both ordinary investors and traditional managers have been emasculated through the rise of financial intermediaries. In Chapter 31, Wood and Wright critique the financialization perspective on corporate governance. They argue that the process of financialization is not a coherent phenomenon, and does not constitute a new epoch. Rather, it suggests that socio-economic change is a process of continual evolution (with uncertainty regarding ultimate direction), and one that embodies continuities going back to preceding eras. Institutions are not likely to be perfectly aligned with and follow what is done at firm level. At the same time, this diversity may make for different strengths and weaknesses than those encountered in Chandlerian managerial capitalism. Hence, much of the literature on financialization seems to be at some variance with the evidence.
The final chapter, by Brammer and Pavelin, examines the nexus between corporate governance and corporate social responsibility. Although there is growing interest in both issues, the academic literatures on these topics are somewhat disjointed. The authors review recent theoretical and empirical studies on the relationship between these two phenomena. They conclude that there is no consensus, either theoretically or empirically, on the nature of this relationship. They also lament the fact that there is little yet in the academic literature of major practical significance to managers or policymakers. To aid in this effort, the authors provide some guidance for additional research on this topic.
Conclusions: Corporate Governance in the New Financial Landscape
This Handbook covers numerous governance topics and provides considerable international evidence, based on quantitative and qualitative methods. The continuing financial crisis and disasters, such as BP's oil spill in the Gulf of Mexico, have focused greater (p. 13) attention on corporate governance, which has been stretched to the limit and found to be wanting on a number of occasions. Some of the symptoms of the stress within the current regimes of corporate governance are:
• It would seem that the pressures on businesses to perform in the short term are such that risks are taken that are detrimental to the long term.
• Directors (especially non-executive directors (NEDs)) now face almost unlimited responsibilities, but very limited time and resources to meet those responsibilities.
• The financial crisis has cast a long, dark cloud over the efficacy of the external audit.
While poor corporate governance is not the sole cause of the current crisis, it has been a contributing factor. Furthermore, the balance between risk taking and risk avoidance, which is key to sustainable innovation and performance, has gone out of kilter. One aspect of this imbalance is the risk and reward culture which developed into “extreme asymmetric forms” over the past decade.
Executive Remuneration and Bonuses—Compensation Remains a Contentious Issue
The recent Wall Street bailout raised concerns and anger regarding executive pay. This anger reached its peak in March 2009 when the public learned that many AIG (a bailed-out insurance company) employees would receive multi-million dollar bonuses. At the time, legislation was proposed that would have taxed bonuses at a rate of 90 percent for all financial managers. Although this legislation was never enacted, executive compensation continues to be subject to greater scrutiny.
A comprehensive review of the literature in this volume indicates that Congress was wise not to intervene. However, some actions are required to address some of the systematic abuses. These include aggressive actions by institutional investors and a much greater focus on choosing the best remuneration committee board members. These board members should have the appropriate expertise to design the appropriate compensation structure and monitor the performance of senior managers.
Overarching Regulatory Framework—Especially for Financial Firms
After the heightened policy and media debate in 2006–8, especially about the alleged impact of private equity and hedge funds on asset stripping and short-termism, and that the financial and economic returns achieved were down to adverse implications for R&D, investment, managerial practices, and employment, a number of attempts are being made to change the regulation of these firms. Although private equity firm activity has declined sharply since this peak period, the area remains one where controversy is (p. 14) not far below the surface. In the US, the role of private equity and its managerial implications assumes particular importance in an election year. Recent research has pointed to differences in private equity activity in Republican and Democrat states (Gottschalg and Pe’er, 2011). The Republican presidential candidate, Mitt Romney, had a career background in private equity that was the subject of scrutiny (<http://nymag.com/news/politics/mitt-romney-2011-10/>).
In the UK, self-regulation was introduced in 2007 in the form of The Walker Guidelines, which brought greater transparency to the private equity industry's largest investments and investors. These guidelines require that private companies report the same kind of information to the public that would be provided if the companies were publicly traded, covering ownership, board composition and key executives, and a business review of the same type as publicly traded companies. Compliance with the guidelines is monitored by the Guidelines Monitoring Group, consisting of a chairman, two independent representatives from industry and/or the trade unions, and two representatives from the private equity industry. The guidelines reinforce existing practice in reporting to investors and reiterate that valuations should follow existing international guidelines. This reflects the argument that current communication practices have generally been seen to be satisfactory by both limited partners and general partners. The new element is the requirement to communicate more broadly with any and all interested parties. The information required is included in an annual review published on the private equity fund's website. Compliance has been increasing, with the third report published in 2010 noting a higher standard of compliance than in previous years and that reporting was in line with, and in some cases better than, FTSE350 companies. The Monitoring Group issued a guide providing practical assistance to companies to help improve levels of transparency and disclosure, and which included examples of portfolio company reporting reviewed by the Group over the last two years.
Perhaps reflecting the more heated debate in Europe, The Alternative Investment Fund Management (AIFM) Directive was passed by the European Parliament in November 2010. The Directive applies to relatively few Alternative Investment Fund (AIF) managers who are based in the European Union (EU) or market funds, or invest in the EU, with total funds under management above €500 million. Funds falling under the directive are restricted in the people to whom they may market their funds. Initial proposals designed to stop asset stripping would have prevented leveraged buyouts where the loan was secured on the assets of the target company, which would effectively have removed the business model used in leveraged buyouts. The measures included in the Directive have been significantly diluted from these original proposals.
The Directive contains provisions to limit the levels of leverage that can be used by AIFs within funds. However, leverage at the portfolio or holding company level used by private equity firms is not included in the definition of leverage in the Directive. This recognizes that loans secured on the assets of the portfolio company do not create a systematic risk. There are requirements for AIFMs to have minimum capital related to (p. 15) the size of the underlying funds. Arguably these are misguided where the funds are inherently illiquid, as in most private equity funds. The Directive requires AIFMs to introduce a remuneration policy, including carried interest, consistent with, and which promotes, sound and effective risk management. An AIFM must prepare an annual report which must be provided to the relevant EU competent authorities, as well as to investors on request. An AIFM must notify its voting rights to its relevant regulator when it acquires voting rights of 10/20/30/50/75 percent of a non-listed company, with additional disclosures being required at ownership levels above 50 percent. The PE firm needs to disclose to regulators the chain of decision-making regarding the voting rights of investors in the company; and practices to be put in place to communicate to employees. In changes to the original draft, there is no longer a need to disclose detailed information on the PE firm's strategic plans for the company. Overall the directive represents a significant increase in regulatory disclosures and regulatory burden, but does not materially impede any private equity fund manager from continuing their business.
Governance and Risk Management
It is clear that boards have a role to play in ensuring better governance and risk management practices. Below we consider a number of arguments regarding risk management which revolve around a greater commitment of the board to engendering a culture of better practice. This, however, raises the issue of what needs to be done at board level to lead such improvements. In addition to ensuring that directors are selected with the appropriate skills and experience, the following aspects need to be considered if boards are to be kept up to date, offer a range of challenging perspectives, and be independent in their judgment: namely, the rotation of committee members, board diversity, independent chairmanship, lead independent director, and auditor rotation.
The turbulence in the financial markets and the recent BP oil spill disaster in the Gulf of Mexico have raised many questions over the governance of organizations and more importantly how risk management aligns with broader governance principles.
In terms of the financial crisis, many papers have outlined the basic causes, including innovation, complexity of structured products, the originate and distribute model, an inability to measure tail risk, the role of the credit rating agencies, and the role of fair value accounting. Against this set of causes, there is also a need to consider how more mundane matters had a role to play—i.e. risk concentrations, maturity mismatches, high levels of gearing, inadequate and opaque risk management processes and procedures. Keeping a focus on the financial crisis for the moment, who owns the risk and how risk is measured are two issues of risk management that need further consideration.
Risk management and governance have tended to be seen as separate entities/activities within organizations with their own individual committees and processes. The problem with this approach is that it can give rise to box ticking, instead of an integrated embedding. The BP oil spill disaster has clearly shown that the board has to own (p. 16) both the general governance of the organization and its many and varied risk activities—it is not good enough to assume that risk management is being tackled within parts of the organization and there is no need for board ownership and oversight of the issue. As is the case with governance, while a separate committee might give profile to the topic, it also runs the danger of directors assuming that the matter is being handled elsewhere and is not a key part of their duties. While specialist committees and processes are laudable, the topics of governance and risk management are so important that they have to be embedded in the organization so that they are the responsibility of every stakeholder.
An integrated and embedded approach to risk management and governance will depend on at least the following aspects being balanced: the balance between the need to conduct business and achieve/meet performance expectations and the appetite for/acceptance of risk; how far senior management see themselves as being responsible for the identification and understanding of material risks and the mitigation thereof; how much effort senior management put into the flow of information within and across the business; and the extent to which open discussion of risk matters is encouraged across the business.
The segregation of risk and governance within the firm creates at least two major issues. First, there can be no appreciation of the overall risk of the organization and, second, there can be no cross-learning of risk understanding, risk mitigation, and how these two should be integrated into broader governance structures. An obvious point for consideration is how managers and owners can be better aligned in terms of risk activities, performance, and executive remuneration. This is clearly a topic that is receiving substantial media attention (see above), especially in the bailed-out banks/insurers which continue to make losses and pay large bonuses to the management.
In terms of the measurement and disclosure of risk, the Senior Supervisors Group (2011) report offers a number of insights into the measurement and disclosure of risk. First, better performing firms had greater management involvement in stress testing and had a greater selection of tools. There was a greater sharing of qualitative and quantitative data across the firm. Second, some firms were able to use the integrated data to give them an earlier warning of significant risk. Third, firms which suffered from risk problems seem to depend on a small number of risk measures and were unable to give them sufficient critical evaluation and challenge. Finally, the risk-prone firms were unable to get management to give sufficient time and attention to future-looking risk scenarios.
Essentially, good risk management should avoid an overreliance on single risk measures and specific models; instead having an open mind and a broad range of methodologies is essential. Encouraging challenge and avoiding silos of thinking/approach are key to good risk management; and it goes without saying that these are essential qualities of a healthy governance environment.
In summary, existing risk management practices, in general, are insufficient to deal with the risks and turbulence many companies are encountering in the current economic environment. Most of the guidance is too high level, wedded to too few (p. 17) methodologies, and not sufficiently grounded in the business. Risk management has to be a culture deeply embedded in the actions of the business and not overly process driven. Management needs to encourage a broad-based risk management culture that traverses traditional organizational boundaries. This would be a culture where the board stresses the benefits of good governance, strong ethical principles, and ongoing monitoring, management, and mitigation of risk. Boards need to be encouraged to take a broad-based view of their responsibilities, which includes a detailed understanding of the risk management of the business; in essence, they have to understand the totality of their roles.
Corporate Governance and National Institutions
Despite the enormous influence of agency theory, extending this approach to cross-nationally comparative work on corporate governance remains problematic. Although the pioneering efforts of agency theorists contributed to understanding goal incongruence among principals (shareholders) and agents (managers) as a function of contractual relationships set up within the firm, the subsequent empirical corporate governance research has failed to fully contextualize how different sets of institutions modify this basic relationship by creating different sets of incentives or resources for monitoring. The problem setting for the vast majority of studies reflects a basic separation of ownership and control, as well as emphasis on individual incentives and active external markets for capital and labor that characterize the corporate economy in the US. But one cannot assume that theories and empirical evidence developed in the US apply to other institutional settings in a universal fashion. These conditions of the “Anglo-Saxon model” constitute the exception rather than the rule when looking at corporate governance in Continental Europe, East Asia, India, and emerging economies in other regions. In most countries, ownership is substantially more concentrated. Legal institutions also differ widely, as do managerial career patterns and the salience of social norms around shareholder value.
Given the “under-contextualized” nature of most theories of corporate governance, a challenge remains to more explicitly understand and compare how corporate governance operates effectively in different organizational environments and institutional contexts. The literature in organizational sociology has argued that different corporate governance practices may be more or less effective depending upon the contexts of different organizational environments and is related to the institutionalization of different legitimate values across societies and over time (see Aguilera et al., 2008). This literature stresses a shift away from the focus on principals and agents as a universal phenomenon and looks more at the patterned variation of organizational forms under different settings. Rather than economic efficiency, these theories seek to understand external factors that shape the effectiveness and legitimacy of corporate governance practices.
While institutional approaches are well-established within the social sciences, institutional theory has had an important but limited influence on agency theory. More (p. 18) generally, one major strand of the literature examines the role of legal origins (La Porta et al., 2000). This literature argues that, in common law societies, investors are willing to take more risks and use “arm's-length” control mechanisms, since they have legal remedies such as the ability to sue in the courts if board members and managers do not act in their best interests and maximize firm profitability. In civil law countries, weaker legal protection for investors has led to the persistence of more concentrated forms of ownership, albeit with different roles for families, governments, banks, or other types of blockholders across countries. Thus, the role of various types of investors may be different in civil law environments, where fewer legal remedies are available compared with common law countries. While this approach acknowledges the role of institutions, the perspective is also limited by seeing institutions in relation to a single universal principal–agent problem. Furthermore, the less contextualized categorization of common law versus civil law systems in examining the role of legal origins has been questioned, and a better comparative understanding of corporate governance around the world requires a more developed institutional view of corporate governance that goes beyond the agency theory paradigm. In essence, corporate governance research needs to pay closer attention to how the effectiveness of well-known corporate governance practices differ across institutional environments due to broader sets of complementarities within the social and political environment.
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