Corporate Governance Research Paper

1. The Governance Problem

Governance problems arise because corporations are fictional entities, with a legal status that is separate from any of the individuals involved in them. They are not, themselves, actual persons, yet numerous different groups of individuals—investors, employees, man-agers, suppliers, customers—may have interests at stake in them. Often, they are managed by hired executives. Hence, decision-making authority in corporations generally is separated from personal responsibility and liability. Neither managers (the active decision makers), nor other employees, nor investors (who enjoy the protection of ‘limited liability’) necessarily bear the full costs of corporate actions.

Hence, the governance problem to be solved in setting up any corporation is to create a mechanism for selecting and overseeing the firm’s managers that fosters cooperative behavior among multiple participants, protects the investments made by them, discourages abuses by decision makers, and still provides sufficient freedom of action to encourage innovation and risk taking. Such a mechanism should allocate decision and control rights to parties who have the appropriate incentives and the necessary information to make wealth-enhancing decisions for the firm, while at the same time ensuring that the controlling parties are accountable to all of the other participants who are exposed to risk by the actions of the corporation. Most governance arrangements, of course, do not achieve this ideal, and in practice, governance arrangements are responsive to a variety of political, as well as economic, pressures.

Legal rules that influence corporate governance vary from country to country, but generally they include corporate and securities law, as well as rules from contract, bankruptcy, and antitrust areas of law. Other corporate governance practices may be driven by market pressures, or tradition, or by the structure of equity ownership. Observed governance arrangements and practices at a given corporation may be prescribed by specific terms of that corporation’s charter, or they may be merely customary.

2. Goals Of Corporate Governance

The phrase corporate governance came into prominent use in the 1980s, and is often used narrowly to refer to the mechanisms and rules that govern relationships among direct corporate participants in publicly-traded firms, especially shareholders, directors, managers, and sometimes employees. But, historically, questions about social control over corporate behavior have been quite important. Since the corporate form first emerged as the dominant way to organize big business enterprises in the second half of the nineteenth century, policy concerns about corporations have, at various times, focused on antitrust, consumer protection, pollution control, worker and/or investor protection, corporate involvement in the political process, and corporate contributions of resources to charitable causes.

Broadly speaking, there are two schools of thought about the appropriate goals of corporate governance institutions and arrangements. The ‘shareholder primacy’ view, which has been dominant in the US and other English-speaking countries since the 1980s, has focused on the set of governance problems that arise in publicly-traded corporations in which equity shares are held and traded by numerous individuals who have little or no management connection to the firm. This problem has been referred to in the literature as the ‘agency cost problem’ (Jensen and Meckling 1976) resulting from the ‘separation of ownership from control’ (Berle and Means 1932).

By contrast, in Europe and Asia (as well as in the US in the middle of the twentieth century), corporations are more likely to be viewed as institutions with a quasipublic character and role. Hence, the proper goal of corporate governance is more likely to be seen as a balancing of interests among all of the corporate stakeholders. This so-called ‘stakeholder’ view of the firm was widely dismissed by leading legal, economics, and finance scholars in the US in the 1980s and 1990s as not being well grounded in a convincing theoretical model of the firm. However, recent scholarship in the US is providing a stronger theoretical basis for this view.

3. Recent Developments

The explosion of interest in corporate governance since 1980 has been driven by a number of developments. The first was the dramatic emergence in the US of unsolicited and unwanted tender offers, which became a common threat to corporate independence in the 1980s. In these so-called ‘hostile takeover’ transactions, outsiders attempted to buy up enough of the outstanding, publicly-traded shares to gain voting control over a company’s board. Closely related to the rise of hostile takeovers was the development of numerous innovative financial instruments used to finance these transactions.

The threat of hostile takeover became a tool by which investors were able to compel managers to cut staff, close plants, redeploy assets, or take other unpopular actions in order to increase corporate profitability. Initially, corporate directors and man-agers resisted the takeovers, and invented a variety of new mechanisms to prevent the outsiders (whom they pejoratively dubbed ‘raiders’) from gaining control. This led to numerous court challenges and decisions, and an intense legal and policy debate about the appropriate response of corporate directors to take-over threats.

The second development was the rapid increase in the power and influence of financial investors in general, and institutional investors in particular. By the 1980s, institutional investors such as pension funds and mutual funds had grown to become the largest shareholders in many US corporations, and they began to use their new clout to influence corporate agendas. Among the changes institutional investors sought were corporate governance rules and executive compensation plans designed to make corporate executives more sensitive to shareholders’ interests, especially their interest in higher share prices.

The third development was the shifting patterns of corporate performance worldwide. In the 1980s, many US firms lost substantial market share to international competitors, especially in Europe and Japan. In response, scholars and policy analysts asked whether Japanese and European corporate governance systems were somehow better than the US system. The situation reversed in the 1990s. Japanese and European economies slumped, while the US economy, led by a very dynamic high-tech sector, put on one of its best postwar performances. Scholars and policy-makers then began asking what aspect of the US system makes it so much better at fostering and financing business innovation. Toward the end of the 1990s, financial crises in numerous countries, especially the formerly high-growth countries of southeast Asia, again forced policymakers and academics to rethink their beliefs about how corporate governance systems work, and what makes one system work better than another.

The fourth development was the collapse of the former Soviet Empire, and the effort by nearly all communist and socialist countries to convert to capitalism. In the early 1990s, Western advisors rushed into Eastern Europe and Asia to help the governments of the transition countries develop corporate laws and securities markets so that they could convert state-owned enterprises to Western-style capitalist corporations. The effort to create new corporate governance structures and practices in transition economies encouraged these policy analysts and scholars to think more deeply about how the corporate governance systems in advanced economies actually work, and what other legal and institutional infrastructures are needed to support them.

The fifth development has been the continued globalization of capital markets and, closely related, the surge in cross-border mergers and acquisitions, both of which create pressures for harmonization of corporate governance standards across countries.

4. Mechanisms Of Governance

The most important mechanisms of corporate governance in all capitalist economies are boards of directors with fiduciary duties, independent auditors, financial disclosure requirements of securities laws, and the rules determining voting rights. Securities exchanges impose additional disclosure and other governance requirements on firms that list their securities for trading.

4.1 Boards Of Directors

Although statutory requirements and practices differ from country to country, in every country that has incorporation laws, some provision is made for the establishment of a board of directors at the time the firm comes into being. The board then becomes the locus of legal accountability for the corporation. In the US, state-level incorporation statutes generally are ‘enabling’ laws, giving founders of corporations wide latitude to establish almost any governance arrangements they want, as long as they create a board, and set up rules by which directors are to be chosen. It is almost always a requirement under state law in the US that directors are elected by shareholders, and a common practice is for directors to be elected for one-to three-year terms by shareholders, on a one-share, one-vote basis.

Directors have the legal responsibility for making virtually all major substantive decisions about the future direction of the company, and for the distribution of corporate income and assets. They decide whether, when, and how much to pay out in dividends; they are responsible for hiring, firing, and compensation of the chief executive officer; and they are responsible for approving the broad strategy, major initiatives, investments, and transactions undertaken by the firm. Other important duties of boards include responsibility for ensuring that adequate books and records are kept, and, in the case of publicly-traded companies, providing for adequate public disclosure and compliance with other laws.

In the US, the authority of duly elected directors over corporate decisions is nearly absolute. They must satisfy the requirements of their corporate charter and bylaws (which are normally quite general and un-restrictive) and of any external laws and explicit contracts with outside parties. And they must fulfill their fiduciary duties of ‘care’ and ‘loyalty.’ The duty of loyalty is taken seriously by the courts in the sense that directors must not engage in self-dealing trans-actions with the firm (unless such transactions are both substantively and procedurally fair), and must not take advantage of business opportunities that properly belong to the corporation. Beyond that, the courts require little other than that directors must exercise a reasonable amount of diligence in carrying out their duties. If they satisfy these requirements, directors are almost completely protected by the so-called ‘business judgment rule,’ a common law rule that says that the courts will defer to the ‘business judgment’ of directors in strategic, policy, or investment decisions made on behalf of the firm.

In the US, anyone can serve on a corporate board, although in recent years, it has become the accepted wisdom that, in publicly-traded firms, a majority of directors should be outsiders, who are not part of the company’s management structure. In Europe and Asia, it is common for representatives of large investors, such as wealthy families or large financial institutions such as banks or other companies, to sit on corporate boards. European corporate law also often specifies certain aspects of the size, structure, and composition of corporate boards. In Germany, for example, publicly-traded companies (AGs) and large limited liability companies (GmbHs) are required to have two-tier boards, with up to half of the positions on the upper-tier, or supervisory board reserved for employee representatives. (Most German corporations are also required to have ‘works councils,’ which provide another formal mechanism for employee voice in some corporate decisions.)

Nominally, corporate law in Japan is similar to that in the US, and in particular, boards of directors in Japanese firms are chosen in a similar fashion and have a similar degree of control and discretion. But as a matter of custom and practice, Japanese directors typically are chosen from among the ranks of senior employees.

4.2 Independent Auditors

One of the most important mechanisms that boards of directors use to ensure that corporations are account-able to their various investors and stakeholders is arranging for audits of records and corporate performance indicators by external, professional auditors. Since the board bears the ultimate responsibility for ensuring the firm’s compliance with the law and for the integrity of its public financial disclosures, the board should arrange for and cooperate with auditors to improve the reporting systems (OECD 1999a). In recent years, investors and professional organizations generally have come to agree that the audit function should be performed by individuals who are unaffiliated with the company, and should be under the control of an audit committee with outside directors in the majority. It is a listing requirement at several important stock exchanges (for example, including the New York Stock Exchange) that listing firms have audit committees dominated by outside directors.

4.3 Financial Disclosure

In the US and other common law countries, publicly-traded corporations are required to make regular and frequent public filings of reports providing detailed financial information about the firm. Key parts of this information must be certified by independent auditors, and must conform to standard accounting practices, as determined by independent standard-setters within the accounting profession such as the Financial Accounting Standards Board in the US. Sanctions for officers and directors of companies that report fraudulent information can be severe, and both securities regulators and private investors participate in policing the disclosures. Moreover, insiders are prohibited from trading on information before it is made public. In general, the disclosure requirements are not as strict in other countries and the restrictions against insider trading not as well enforced. An intense debate is underway in the international community about whether these requirements ought to be brought up to the US standards.

Outside the US, the International Accounting Standards Committee and the International Organization of Securities Commissions are working to develop a core set of accounting standards for use in cross-border financings and for listings in global markets.

One of the controversial questions at stake in the policy discussions about accounting standards is the problem of providing better information about ‘in-tangible’ assets. Intangibles are assets such as intellectual property rights (patents, copyrights, brand names), reputational capital, organizational capital (including, for example, proprietary software or other management systems), and/organizational and intellectual assets, such as the unpatented results of research and development projects or the tacit knowledge and skills of employees. Current accounting rules do not provide a mechanism for such assets to be recorded on the books of firms. Rather, any costs involved in developing these assets are treated for accounting purposes as expenses that, implicitly, do not provide any future return. By some estimates, intangible assets now account for a substantial and growing share of the wealth being generated by the corporate sector, particularly in developed countries. Investors are being provided with very little information about these assets, however, even in countries with relatively transparent accounting systems and strict disclosure requirements.

A related, and equally controversial question at stake has to do with whether corporations should be required to provide public reports on their social and environmental performance. This question links the debate about accounting for intangibles to the debate about shareholder primacy and the social role of corporations.

4.4 Voting Rights

One of the few legal constraints on boards of directors is that the board itself must be elected, and must subject a few important decisions to a vote by affected participants. Generally shareholders must elect directors on a one-share, one-vote basis, for example. In special circumstances, however, other stakeholders may participate in choosing directors. For example, holders of preferred shares or other investors may sometimes have the right to vote for directors if a company fails to pay preferred dividends. Employee representatives to the supervisory boards in Germany are chosen by a process that involves voting both by employees and by their unions. And in a handful of US companies, labor unions have negotiated for the right to choose at least one director.

Shareholders and sometimes other participants often have the right to vote on major corporate transactions, such as a merger or a dissolution. Whatever the formal rules are, however, the voting rules and nomination procedures are easily manipulated so that, in practice, US directors have found they can often get around voting requirements by structuring transactions in different ways. Additionally, control over the nomination process gives existing directors substantial influence over the process of choosing new directors. It is possible for an outsider to wage a campaign to elect an alternate slate of directors, or to amend the charter, or to recommend some other corporate action. Such challenges to boards are called ‘proxy fights’ because the process requires challengers to solicit other share-holders to gain permission from them to vote their shares by ‘proxy.’ Proxy fights happen occasionally in the US, but they are costly, and hence, rare.

Nonetheless, shareholders have other informal mechanisms of influence that in most instances are more useful and effective than proxy fights. Financial investors who own large blocks of shares, for example, have the capacity to transfer a controlling block to a raider by selling out, or to dump shares on the market and thereby drive down the price. This inevitably gives large investors considerable informal influence and market control.

4.5 Listing Requirements

Other important mechanisms of corporate governance are the listing requirements for stock exchanges. If a company wants access to public equity markets, it must not only meet disclosure requirements for issuance of securities to the public, it must also make sure that its securities can be traded in organized securities markets. Stock exchanges typically impose governance requirements on firms beyond the requirements of corporate law. As already mentioned, the New York Stock Exchange requires that listed firms have audit committees composed of outside directors.

5. Patterns Of Shareholdings

Apart from the formal governance mechanisms, the factor that may have the greatest influence on how decisions get made in publicly-traded corporations, and on the weight given to the interests of various corporate constituencies in those decisions, is the pattern of ownership of equity shares. There is a significant difference between the pattern that prevails in the US and other English-speaking countries, and the pattern that prevails in continental Europe and Asia. In the US, there are thousands of publicly-traded corporations with shares that tend to be very widely held. Typically, no single institutional or individual shareholder controls more than 50 percent of the voting shares, and even 20 percent blocks are relatively uncommon. When no large investor holds a substantial block, it may be hard for shareholders to monitor boards and managers. Moreover, as already noted, it is costly for shareholders to organize them-selves in order to wage a proxy fight. These factors tend to make corporate officers and directors quite autonomous and independent. On the other hand, the fact that shares are widely held usually means that there is a liquid market in the shares, and dissatisfied shareholders can easily sell. The market price of the shares provides a constant signal about how well investors think the company is doing.

By contrast, in continental Europe and Japan, there are many fewer publicly-traded companies (even relative to the size of their economies), and companies that are publicly-traded often have very concentrated shareholdings. In German firms, for example, more than half of all publicly-traded companies have a large shareholder with 50 percent or more of the shares. In Japan, groups of industrial companies hold substantial amounts of each others’ shares, and in Italy, pyramidal groups headed by families, coalitions, or the state often hold controlling interests in firms. The large shareholders in these firms often have seats on the boards of directors, and inevitably exercise consider-able influence on the boards.

Corporate governance scholars have debated the reasons for this pattern. One theory holds that financial institutions in the US were prohibited from becoming large shareholders in industrial companies for political reasons (Roe 1994). The result has been that shares are widely held, and shareholders have tended to be passive in the US. Managers and directors, in turn, generally operate with much greater impunity than they could if there were more large-block shareholders actively involved in governance. But the fact that shares are widely held and actively traded on deep markets also creates the possibility that outsiders can get control of companies, even against the wishes of boards and managers, by engaging in tender offers. Hence, the ‘market for corporate control’ may be an effective substitute for direct monitoring.

An alternative theory holds that shareholdings are unconcentrated in the US and other Anglo-Saxon countries because, all else equal, investors would prefer to diversify their risks and make their investments more liquid by holding only small amounts of many different companies in their portfolios. Since their holdings in any one company are typically small (both relative to the size of their portfolios, and relative to the size of the company), investors would prefer to be passive (Black 1990). However, investors could not afford the luxury of being passive if they were not confident that they would be protected from exploitation both by managers and by controlling share-holders. Advocates of this theory note that common law countries have the deepest, most transparent financial markets and the best protections for minority shareholders in the form of strict securities laws. Consequently, these same countries tend to have widely-dispersed shareholders. By this theory, share-holding is more concentrated in European and Asian countries because those countries do not provide sufficient protection for minority shareholders to encourage small investors to hold equities (Coffee 1999).

6. Supporting Institutions

These arguments suggest an overarching issue, which is that corporate governance arrangements must be seen as imbedded in a larger set of social and political institutions. In the early 1990s, many of the Western scholars and policy analysts who advised transition economy governments about transforming their economies into capitalist-style free market economies recommended ‘shock therapy’ approaches. These advisers believed that if productive enterprises could be taken out of the control of governments and placed under the control of private investors, and if subsidies and cross-subsidies could be ended, market pressures would come into play and quickly drive private actors to reorganize themselves into much more efficient configurations. In fact, this had rather conspicuously failed to happen in Russia by the end of the 1990s, and the results were spotty, though generally less disastrous, in other Eastern European countries. As a result, scholars are now turning their attention to the important role played by supporting institutions

such as the development of accounting standards; independent and professional accounting firms; court systems that can adjudicate complex contracts and enforce fiduciary duties; professional norms and standards; well-regulated financial institutions; and securities laws with effective systems of enforcement. Empirical studies have shown that in countries without these institutional supports, the corporate sector tends to remain small, and the corporations that do exist tend to be closely held and controlled by families or other networks of economic elites.

7. Which Way Works Best?

While the corporate governance systems that have emerged in modern developed economies are obviously superior to the systems in developing and transition countries, scholars are still debating the relative merits of the various systems in developed countries. Is the common law system in the US and other English-speaking countries, with its scattered shareholding, deep and transparent financial markets, and relatively autonomous boards and managers, better in any sense than the large-shareholder dominated, civil code systems of continental Europe and Asia? Each may be an internally consistent system with its own advantages and disadvantages. Where supporting institutions, such as an independent ac-counting profession and courts that can adjudicate complex contracts and enforce securities disclosure rules, are weak, it may be impossible to provide adequate protection for minority investors. In such circumstances, outside equity investors may only be willing to put capital into firms in which they can get seats on the board and exercise some control. On the other hand, if the legal and social system can effectively limit or discourage self-interested transactions by insiders, then the advantages of widespread share-holding and fluid capital markets can be realized.

But there are tradeoffs. Civil code systems may be more stable in the short run because it is harder in these systems for financial investors to move capital out of companies in search of higher returns. For the same reason, it may be easier to impose ‘social’ regulations and requirements (to protect jobs, for instance, or to clean up the environment) on companies in civil code countries.

In contrast, capital is extremely mobile in common law countries. In the US in the 1980s and 1990s, the mobility of capital made it easier for financial interests to force corporations to restructure and downsize, a development whose costs and benefits to society as a whole are still being debated (although it seems pretty clear that the restructuring of the corporate sector enhanced wealth for the shareholding class). In other words, capital may, counter intuitively, be more powerful in the long run in countries where share-holdings are relatively small, dispersed, and mobile, than in countries where large block shareholders have much more direct influence over managers.

The mobility of capital in common law countries has probably made it easier for start-up firms to get new capital, thereby contributing to the dynamism of the high-tech sector in the US in the 1990s. However, increasing the rate of growth and technological change quite possibly reduces social and income stability, and widens the disparities in income distribution—effects that may not be politically acceptable in all societies. Hence, there may be an unavoidable trade-off of social goals, and which path a society chooses is partly a matter of politics and ideology.

On a theoretical level, numerous scholars and commentators, especially in the US, approach corporate governance questions from the perspective of a ‘principal-agent’ view of the firm, in which share-holders are understood to be the ‘owners’ of firms, and directors and officers their ‘agents’ (e.g., Easterbrook and Fischel 1991, Shleifer and Vishny 1997). Analysts who have adopted this point of view tend to be more libertarian and more comfortable with the social ordering that emphasizes private property and limited role for government. The normative implications of this perspective are that corporations should be run solely for the purpose of maximizing value for share-holders, and that corporate governance systems should support this goal alone, and not other social agendas. Hence, the relative impunity with which directors can control the nomination and voting process and resist takeovers is often viewed as a flaw in the US system because shareholders are not given sufficient control to enforce shareholder primacy (e.g., Jensen 1993). However, the freedom with which capital moves is viewed as a strength offsets this weakness. Meanwhile, the legal rules and practices in Japanese and German firms that have made them much more protective of employee interests relative to shareholders’ interests are viewed as flaws by scholars and policy analysts who adopt this point of view.

On the other side, a small but growing body of scholarship has argued that the principal-agent perspective is misleading both as a matter of law and of economic theory. Under US law, the role of corporate directors is unique, but is much closer to that of ‘trustees’ than that of ‘agents.’ Outside the US, shareholders rarely are referred to as ‘owners’ of corporations (as if corporations were merely pieces of property). An emerging theoretical perspective emphasizes that the productive activity undertaken by corporations is a form of ‘team production,’ in which numerous parties in addition to shareholders are involved in the productive activity of corporations and have assets (whether tangible or intangible) at risk in the enterprise. This alternative view has somewhat different normative implications. For example, it suggests that corporate governance should not just be about maximizing value for shareholders. Rather, it should be about creating structures that foster and encourage wealth creation for all of the ‘team’ members. One mechanism by which this may be achieved in the US is the very mechanism so maligned by agency cost theorists: board independence. Mechanisms that insulate directors from pressures from all stakeholders, including shareholders, may serve to protect minority shareholders (seen as important even by shareholder primacy advocates) and to protect the interests of stakeholders other than shareholders (Blair and Stout 1999, Coffee 1999, Hansmann and Kraakman 2001). Even though shareholders do not exercise tight control over directors or managers of publicly-traded corporations, they enter into the relationship freely, thereby yielding legal control rights to the board. This allows them to make a credible commitment not to use their control over capital to unfairly squeeze out other stakeholders who may make irreversible investments in the enterprise. Hence, shareholders in firms where directors are relatively autonomous are more likely to win the co-operation of other stakeholders in the first place (Blair and Stout 1999).

The question is more than a theoretical exercise. As financial investors have grown in influence, the voices of shareholder primacy advocates have been quite prominent among those who want to see corporate governance standards harmonized worldwide. These voices have clout because capital has become so mobile internationally. Thus, the political question of whether corporate governance rules and standards should be harmonized across countries, and if so, whether international standards should be made to look more like the US or another model, is caught up in powerful economic forces, making it hard for countries to resist financial market pressures to move to a US standard.

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