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“The closely argues material is relevant for students studying the subject on undergraduate or post-graduate programmes” (Professional Manager, July 2005)
The decade since the publication of the Cadbury Report in1992 has seen growing interest in corporate governance. This growth has recently become an explosion with major corporate scandals such as WorldCom and Enron in the US, the international diffusion of corporate governance codes and wider interest in researching corporate governance in different institutional contexts and through different subject lenses.
In view of these developments, this book will be a rigorous update and development of the editor’s earlier work, Corporate Governance: Economic, Management and Financial Issues. Each chapter, written by an expert in the subject offers a high level review of the topic, embracing material from financial accounting, strategy and economic perspectives.
“The closely argues material is relevant for students studying the subject on undergraduate or post-graduate programmes” (Professional Manager, July 2005)
Corporate governance, a term that scarcely existed before the 1990s, is now universally invoked wherever business and finance are discussed. The subject has spawned consultancies, academic degrees, encyclopaedias, innumerable articles, conferences and speeches. Almost all the OECD nations are currently revising their corporate governance practices or have recently done so (OECD, 2003), while the establishment of a viable corporate governance system has become a priority objective for emergent economies from Latin America to China. In the midst of so much interest, the underlying issues of the subject are always in danger of being swamped. Moreover, since 'good governance', like 'fair trade' and 'free competition', is an abstraction that commands near-universal respect but diverse interpretation, it has also become the destination board for a bandwagon carrying those who would, in fact, take the corporation in myriad directions.
Not merely does the term corporate governance carry different interpretations, its analysis also involves diverse disciplines and approaches. For example, the behaviour of senior managers is variously constrained by legal, regulatory, financial, economic, social, psychologicaland political mechanisms which are themselves sometimes substitutes and sometimes complements. Academic researchers, predominantly coming from a single subject background, will typically explore the operation of merely a subset of these and then in the context of the priorities of their own discipline. This inevitably means that research on the subject becomes Balkanised and less accessible.
The quantity and variety of material being produced on corporate governance has forced us to be selective in compiling this volume. The book aims to bring together scholars from a variety of backgrounds, particularly accounting and finance, economics and management, to present a series of overviews of recent research on issues within corporate governance and on governance developments within particular countries and institutional regimes. Coverage of the subject has inevitably involved a trade-off between breadth and depth, and in largely restricting ourselves to these business disciplines we have been mindful of the need for coherence. This is not to say that other perspectives, perhaps drawing upon social sciences including politics and sociology, would not have a valid contribution.
Since corporate governance carries such a wide variety of interpretations, it seems appropriate to begin by setting out the approach generally adopted in the volume. Here it is assumed that an effective system of corporate governance has two requirements, one micro and one macro: at the micro level it needs to ensure that the firm, as a productive organisation, functions in pursuit of its objectives. Thus if we follow the traditional Anglo-American conception of the firm as a device to further the well-being of its owner-shareholders, good governance is a matter of ensuring that decisions are taken and implemented in pursuit of shareholder value. Importantly, this involves actions that reconcile the need to protect the downside risk to shareholders (that is, accountability of managers) as well as to encourage managers to take risks to increase shareholder value (that is, encourage managers to act entrepreneurially (Keasey and Wright, 1993)). If the purpose of the firm is modified, perhaps to accommodate the interests of other 'stakeholders', including employees, suppliers etc., the objective changes but the need for mechanisms to further this objective does not.
At the macro level corporate governance, in the words of Federal Reserve Chairman Alan Greenspan: 'has evolved to more effectively promote the allocation of the nation's savings to its most productive use'. Thus in financing corporate activity, whether through equity or debt, savings are channelled into productive activities, the return on which ultimately determines national prosperity. The recent US experience with Enron, WorldCom and other failures is a reminder that if failures at the firm level are sufficiently serious and/or widespread, there will be a misallocation of funds in the short term and systemic consequences for longer-term investment if confidence is damaged. Similarly, a major problem for transition economies has been to create governance systems which engender sufficient trust to allow private savers to supply local entrepreneurs with their funds.
ALTERNATIVE PERSPECTIVES ON CORPORATE GOVERNANCE
Whether success at the micro and macro levels is separable is itself very much part of the debate. It reflects, in particular, the individual's perception of the nature of governance and the degree of confidence held in the efficiency and effectiveness of financial markets. We might broadly distinguish four perspectives in the governance debate: the principal-agent or finance perspective, the myopic market view, the stakeholder view and the abuse of executive power critique.
Those approaching corporate governance issues from a principal-agent or finance perspective, following Jensen and Meckling (1976), see governance arrangements, including the apparatus of non-executive directors, shareholder voting etc., as devices that the suppliers of finance require to protect their interests in a world of imperfectly verifiable actions. Jensen and Meckling (1976) consider the case of a 100% owner-manager considering the sale of an equity interest to outsiders. As the original owner's share falls, so does the incentive to exert effort to generate shareholder wealth. In the absence of any controls on the owner-manager's anticipated post-float behaviour, the issue price of outside equity would fall to reflect the corresponding threat to shareholder wealth. Therefore, with full anticipation of the consequences of the manager-shareholder relationship the total ex ante cost falls on the would-be issuer of outside equity, that is, the owner-manager. This generates a corresponding incentive to introduce devices to control and monitor managerial behaviour - that is, to establish corporate governance arrangements - at least up to the point where the marginal cost of so doing equals the marginal benefit. On such a view, an efficient capital market will generate effective governance arrangements without the need for external intervention.
It follows that those adopting this principal-agent perspective tend to see unrestricted capital and managerial labour (Fama, 1980) markets as the most effective checks on executive malperformance. On such a view, well-functioning capital markets will tend to solve both the micro-level governance problem and, by directing funds to the use of those managers that appear to offer the best risk-return combinations, ensure compatibility with the macro-level objective of efficient funds allocation.
Conversely, those who view the capital market as fundamentally flawed and myopic in its concern for short-term returns, argue that purely private bargaining between a firm's owners and the supplier of funds will not produce effective governance. On this view, a myopic stock market encourages managers to underinvest in long-term projects. Effectively a higher cost of capital is applied than is strictly economically justifiable, thus screening out many longer-term investments. This problem is intensified in environments where a hostile takeover threat - see below - further restricts managerial discretion.
Adherents to the myopic market position unlike, say, supporters of the stakeholder view do not necessarily question shareholder value maximisation as an objective. What they do conclude, however, is that in the presence of a myopic capital market there is likely to be a macro failure of corporate governance in that there will be systematic distortions of investment in the economy to the detriment of long-run growth. On such a view insulating managers from stock market pressures will also benefit shareholders in the longer term. Thus some myopic market critics would endorse the involvement of other stakeholders - for example, employees - in governance not necessarily to further the interests of the latter themselves, but where these might have interests that favoured long-term projects.
Proponents of the stakeholder perspective contend that the traditional Anglo-American view of the firm's objectives is too narrow and that it should be extended to embrace the interests of other groups associated with the firm, including employees, community groups etc. These stakeholders are considered to have interests that depend, in part, on the continuing development of the firm. Therefore, a governance process that offers no explicit voice to such groups is unlikely to take sufficient account of their interests. On this view, it is the firm objective of unalloyed shareholder value-maximisation that leads primarily to a micro failure of governance arrangements.
Finally, there is a view that corporate governance reforms should be used to restrict, if not prevent, the pathologies that arise from the abuse of executive power. Supporters of such a position may variously hold to shareholder value or stakeholder interests as the optimal objective for the firm, but they suggest that the pursuit of any such objective may be flawed if dysfunctional behaviour by senior executives emerges. On such a view executives may be able to exploit situations that were simply unanticipated or even inconceivable at the time of share flotation. Governance arrangements can be created to reflect principles of transparency, representation and a division of responsibility, but there will be a need for a periodic reform of procedures to reflect evolving circumstances in the firms themselves. While the misuse of power by the CEO of firm A is primarily a micro failing, perhaps hurting firm A's shareholders, bondholders, pensioners or employees, if the As are too big or too numerous the problem develops into a systemic macro one.
BACKGROUND TO CORPORATE GOVERNANCE REFORM
In the early 1990s much of the debate on corporate governance concerned the alleged weaknesses of the Anglo-American corporate form (see Charkham, 1994). In economies such as the USA and UK, with liquid stock markets in which the overwhelming proportion of shares were held by financial institutions, it was widely assumed that monitoring of managers would be deficient. Shareholders, whose investments were held in diversified portfolios, were considered to have weak incentives to involve themselves in information collection and participation in company AGMs etc. Here the dominant strategy for individually dissatisfied investors was to utilise the opportunities generated by a liquid stock market and exit. In the face of diffused shareholder power the divorce of ownership from control, long ago identified by Berle and Means (1932), was assumed to be the norm. Managers thus had considerable discretion to further their own interests in ways that included diverting cashflow to preferred investments, often involving unnecessary diversification or the undertaking of entrenching activities, and in giving themselves overly generous salary and bonus rewards.
While the takeover threat was always present for underperformers - and probably remained quite potent for the more egregious examples - the takeover is a blunt and costly instrument and the probability of being acquired falls with size. Indeed critics pointed to the high apparent failure rate among takeovers to suggest that the market for corporate control was as much a part of the problem of inadequate monitoring as it was a solution. Value-destroying mergers were interpreted as evidence of managers furthering their own aspirations for growth at the expense of the shareholders. Furthermore, in the UK at least, a series of high-profile corporate failures involving the apparent misuse of executive power by domineering CEOs such as Robert Maxwell and Asil Nadir pointed to the absence of effective checks and balances.
Nor did the Anglo-American corporate form escape criticism at the macro level. It was widely noted by its supporters and critics alike that executives were ultimately constrained by the ease of shareholder exit, employing the term of Hirschman (1970). Dissatisfied shareholders would sell and if they did so in sufficiently large numbers the share price would fall and the firm's assets would ultimately become attractive to some rival group of managers who would thus bid for them, perhaps via a hostile takeover. Supporters saw this 'market for corporate control' (Manne, 1965) as a key check on managerial malfeasance or incompetence. Critics complained it engendered perverse incentives. They pointed out that even a poorly performing target firm's shareholders could usually expect some recompense for past underperformance via a bid premium, thus further eroding their incentives to participate in the monitoring of management. The principal losers appeared to be the target's senior management, many of whom would lose their jobs. Critics (for example, Charkham (1994)) argued that such a fear, coupled with perceived myopia in the capital market, encouraged a short-termist attitude in the Anglo-American corporate form. This was contrasted with lending-based systems such as those in Japan and Germany, countries where stakeholder representation is also more pronounced and where finance is typically supplied by a bank in a long-term relationship with its client firm.
Thus it was argued that in firms financed by debt and/or retained profits managers could afford to take a longer-term perspective and invest in physical and human capital without day-to-day concerns about the consequences of share price falls. While this short-termist charge remained highly contentious, not least because it implied serious capital market inefficiency, it became quite influential. This was not least because its supporters could point to the superior performance of the German and Japanese economies in the 1970s and 1980s, in comparison to the sluggish growth in the US and UK.
GOVERNANCE REFORMS: THE EARLY DAYS
The modern process of corporate governance reform can be said to have started in the UK with the establishment of the Cadbury Committee (on the Financial Aspects of Corporate Governance) in 1991. It was set up in response to three inter-related areas of concern in the existing arrangements: first were anxieties over the use of 'creative accounting' devices, which were believed to be obfuscating the calculation of shareholder value (Whittington, 1993). Second were concerns over a string of corporate failures, particularly those associated with high-profile, domineering CEOs who were apparently able to conceal financial weaknesses through the opacity of their control mechanisms. Finally, there was a growing public unease over the rapid growth of executive remuneration, especially an apparent failure to relate increases more strongly to firm performance (Keasey and Wright, 1993).
Cadbury's recommendations, which are explored in detail by Keasey, Short and Wright in Chapter 2, centred on ways to increase the accountability of executives. Thus the Committee proposed a series of reforms designed to decentralise power within the firm and to increase the role and independence of non-executive directors in the monitoring of executives. These included the splitting of the functions of chair and CEO and the establishment of a series of main board committees, to be dominated by non-executives, which would take responsibility for organising the audit function, executive remuneration and the nomination of future nonexecutive directors.
In the UK and elsewhere Cadbury has been followed by further moves to strengthen the indirect voice of shareholders by enhancing further the role and independence of non-executives. There is a growing realisation that independence is compromised where directors remain in-post for too long, spend too little time on their duties to understand the complexities of their firm's activities or where the executives remain in de facto control of non-executive appointments. Thus successive corporate governance reviews have introduced limited terms of appointment (Greenbury, 1995), redefined responsibilities and suggested still more independent recruitment procedures (Higgs, 2003).
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About the contributors xi
1 Introduction (Kevin Keasey, Steve Thompson and Mike Wright).
Alternative perspectives on corporate governance.
Background to corporate governance reform.
Governance reforms: the early days.
New perspectives from the 1990s.
The volume’s contents.
2 The Development of Corporate Governance Codes in the UK (Kevin Keasey, Helen Short and Mike Wright).
Corporate governance in the UK – definitions and framework.
The evolution of policy recommendations – from Cadbury to Hampel.
The evolution of governance policy – from Combined Code I to Combined Code II.
Overview of policy evolution.
3 Financial Structure and Corporate Governance (Robert Watson and Mahmoud Ezzamel).
Capital structure and financial risk.
Does capital structure matter?
The agency costs of debt.
Employees as residual claimants.
4 Institutional Shareholders and Corporate Governance in the UK (Helen Short and Kevin Keasey).
Institutional shareholdings in the UK.
General overview of the objectives and incentives of institutions.
The willingness and ability of institutions to intervene in the governance of corporations.
Methods of intervention.
Governance by institutional shareholders: empirical evidence.
Summary and conclusions.
5 Boards of Directors and the Role of Non-executive Directors in the Governance of Corporations (Mahmoud Ezzamel and Robert Watson).
The corporate form, governance and the board of directors.
The UK’s governance by disclosure.
6 Executive Pay and UK Corporate Governance (Alistair Bruce and Trevor Buck).
Executive pay and corporate governance in the UK: an overview.
The empirical analysis of executive pay.
Executive pay evolution in the UK.
Further discretionary elements in LTIP design.
Mix of remuneration components.
7 Compensation Committees and Executive Compensation: Evidence from Publicly Traded UK Firms (Rocio Bonet and Martin J. Conyon).
Compensation committees and executive pay.
New data and results.
Discussion and conclusion.
8 The Governance Role of Takeovers (Noel O’Sullivan and Pauline Wong).
Takeovers and company performance.
The likelihood of takeover success.
Management turnover subsequent to takeover.
The consequences of takeover failure.
9 Governance and Strategic Leadership in Entrepreneurial Firms (Catherine M. Dalton, Patricia P. McDougall, Jeffrey G. Covin and Dan R. Dalton).
Governance and strategic leadership do matter.
Top management teams.
Boards of directors.
Discussion: an opportunity lost.
10 Corporate Governance: The Role of Venture Capitalists and Buy-outs (Mike Wright, Steve Thompson and Andrew Burrows).
11 Explaining Western Securities Markets (Mark J. Roe).
The argument: corporate law as propelling diffuse ownership.
Corporate law’s limits.
Data: political variables as the strongest predictor of ownership separation.
Conclusion: politics and corporate law as explanations for securities markets.
12 International Corporate Governance (Diane K. Denis and John J. McConnell).
First generation international corporate governance research.
Second generation international corporate governance research.
Convergence in corporate governance systems.
Conclusion and directions for future research.
13 Corporate Governance in Germany (Marc Goergen, Miguel C. Manjon and Luc Renneboog).
Ownership and control.
Internal corporate governance mechanisms.
External corporate governance mechanisms.
The recent evolution of corporate governance regulation and stock exchange structures.
14 Network Opportunities and Constraints in Japan’s Banking Industry: A Social Exchange Perspective on Governance (William P. Wan, Robert E. Hoskisson, Hicheon Kim and Daphne Yiu).
Japan’s main bank system.
A social exchange approach to Japan’s banking networks.
Opportunities and constraints in Japan’s banking networks.
Implications and conclusion.
15 Analysing Change in Corporate Governance: The Example of France (Mary O’Sullivan).
Understanding systems of corporate governance.
The ownership and financing of French corporations.
Implications for French corporate governance.
The role of structure in corporate governance.
16 Ownership and Control of Chinese Public Corporations: A State-dominated Corporate Governance System (Guy S. Liu and Pei Sun).
Overview of the Chinese corporate governance system.
Ultimate ownership, intermediate shareholding classes, and their relation to corporate performance.
The evolution of ownership and control and its determinants.
17 Corporate Governance in Transition Economies (Mike Wright, Trevor Buck and Igor Filatotchev).
Corporate governance and differing privatisation approaches in transition economies.
Corporate governance in transition economies.
Studies of the effects of different ownership and governance forms.