Corporate Governance (CG) is the “system by which companies are directed and controlled” (Cadbury cited in Moschandreas, 2000); therefore it is expected that as a system of governance structure, CG would focus on practical issues including corporate fraud, the abuse of managerial power and social irresponsibility (Letza, Sun and Kirkbride, 2004). However the subject is much more complex and entails the understanding of the different perspectives regarding the scope of an organisation.
The traditional view regards the main purpose of the firm as the maximisation of the profits, hence the maximisation of the shareholder wealth (Shareholding approach). This perspective assumes that pursuing the maximisation of the profits provides the most efficient allocation of resources (Hayek cited in Letza et al, 2004) and that its social action, as put by Milton Friedman (cited in Fisher, 2003), is realised in the mere creation of wealth.
On the other hand, the stakeholding theory argues that the attempt to balance the interests of all its stakeholders (employees, creditors, the local community and everyone who has a stake in its long term; Moschandreas, 2000) provides the means for a superior economic success since all the stakeholders are of strategic importance for the business activity (Freeman cited Letza et al, 2004).
Although the two approaches differ mainly in their vision of the firm’s role in society, the diverse perspectives also result in different analysis and explanation of the problem of corporate governance. In fact, since CG explains the governance structure of a modern organisation as the institutional arrangement of the relationships among various economic actors and corporate participants who may have a direct or indirect interest in a corporation (Letza et al, 2004), a firm’s governance structure represents the solution to how this relationship can produce the desired scope. Hence, whether this relationship should be based on a market system of “check and balance” or built on trust and commitment, results in different governance structures.
The neoclassical view explains the relationship between principals, such as a shareholders, and agents, such as company’s executives with the principal-agent relationship; a relationship that exists when the agent acts on the behalf of the principals (Moschandreas, 2000).
The background of the agency theory (which deals with the principal-agent relationship)can be traced in the development of the Capitalist economy that saw during the 17th, 18th and 19th centuries in England the emergence of corporations as a mechanism of raising capital (Letza et al, 2004). The collective involvement of more individuals in a single organisation creates a dispersion of the ownership and hence the need to delegate the daily business of the firm to a professional manager; however as ownership become more dispersed, the effective control over the firm become more problematic since dispersed ownership may induce shareholders to shrink their monitoring responsibilities (free-riding). Since the classical theory assumes the propensity of the individual to act opportunistically, the consequent more distinctive separation of ownership from control produces the agency problem or rather, a situation where the interests of the owner may diverge from the interests of the managers in charge of the corporation (Berle and Means cited Moschandreas, 2000).
However, that ownership may be dispersed or concentrated in few shareholders is not the relevant issue here; it is instead from the separation of ownership from control that arise the principal-agent relationship and thus the possibility of managerial discretion (agency problem). In fact, shareholders may have not the time or the inclination to effectively monitor managerial behaviour (Moschandreas, 2000) and information about the firm may be asymmetrically distributed at the advantage of the manager; therefore based on the assumption of self-interested human behaviour, this relationship increases the power of the manager that indeed will try maximising its own utility over the shareholders’ interests of profit maximisation.
Agency theory addresses the need to regulate the principal-agent relationship under a form of contract designed in a way that mitigates the opportunistic behaviour of the manager and incentive for him/her to behave in the owner’s interest. However, attempts to ensure that agents act in the principals’ interest incur in agency cost[1], hence the focus is on determining the best efficient form of contract at the lowest agency cost. Indeed, according to Eisenhardt (cited in Letza et al, 2004) such a contract would depends on the trade-off calculation between the cost of measuring behaviour and the cost of measuring outcomes and transferring risk to the agent. Therefore, since corporate governance is the structure that polices the relationship among the principals and the agents, the firm, as a nexus of contracts (Letza et al, 2004) will aim at reducing agency cost with a CG structure that provide an effective monitoring and an appropriate incentive system to reward the managers, so as to achieve the best alignment of the principal-agent’s interests.
However, Corporate Governance is also an intrinsic result of the political, legal, and social environment of a country (Moschandreas, 2000), so cultural differences can explain different approaches to the principal-agent relationship. The objectives of business organisations differ from one country to another (Witt, cited in Yoshikawa and Rasheed, 2009) so, for example, social obligations are important in countries such as Germany and Japan whereas the interests of shareholders are considered paramount in the US and UK (Dore cited in Yoshikawa and Rasheed, 2009).
In fact, given that the assumption of self-interested human behaviour is typical of an individualist ideology such as Capitalism, in UK and US, where entrepreneurship and free-market principles have had a major contribution to their cultural history this difference results in a diverse control mechanism in the governance structure of the firm. Indeed, in line with the neoclassical view, a principal-agent model of corporate governance (or finance model; Letza et al, 2004) in UK and US will aim to achieve an optimal structure in the belief that market efficiency will provide the best solution to the lack of shareholders’ control.
In fact, in these two countries, share ownership is much more dispersed, a circumstances that certainly hinders an effective monitoring of the firm’s management but even more, it implies that the shareholders are more often like investors (“only there for the money” ; Handy,2002). In this case, the market price becomes the best indicator of the management effectiveness, on the basis of the efficient market hypothesis (EMH) that the price fully reflects all the information available[2] and the value of the future profits and growth of the firm.
Although, the agency theory, as a shown by Hill and Jones (1992), holds whether there is a shareholding or a stakeholding approach in countries such as Germany and Japan, very often the manager is deemed to be trustworthy because of the intrinsic belief that a “social pax” is preferable to individual success. Therefore, corporate governance will be more consistent with the interest of a broader body of stakeholders (Moschandreas, 2000) and oriented toward long-term objectives.
Therefore, in Japan and Germany power relationship are considered as a more effective instrument for limiting the agent’s discretion; a diversity that derives from a different contractual relationship in use. In fact in US and UK transaction contracts tend to be at “arm’s length”, or rather that relationships are more likely to be short-term, with lower expectations, and less frequent. On the other hand, in Germany, but especially in Japan more time is spent in building long-term relationships with other parties in order to establish a reciprocal trust, thus as a consequence, deviations from this system results in a reputational loss that indeed is used to check on opportunistic behaviour.
Moreover, property rights institutions can also be the principal source of diversity among national governance systems (Milhaupt cited in Yoshikawa and Rasheed, 2009). The fact that British and American shareholders enjoy the right to trade their shares without major restraints, and at a much lower cost than of obtaining precise information about the firm in which they are investing, acts as an efficient form of control of manager’s discretion; as a result the agent will be seeking profit maximisation in order to avoid the shareholders moving their capital elsewhere. This mechanism based on the assumption of market efficiency, other than allowing for other forms of shareholder control such as the corporate market (takeovers) and the managerial market, it also paves the way for the proposition of appropriate incentives to the managers based on performances values easily measurable such as share price and return on equity.
When property rights regimes are weak such as in Germany and Japan, smaller firms, family ownership and very little dispersion in ownership would typically be observed (Yoshikawa and Rasheed, 2009). Thus, the more concentrated share-ownership allows for the formation of power groups that effectively act as trustees of the stakeholding community; a position earned thanks to their laborious commitment to construct long-term relationships. Therefore, reputation and political capital will play a major role in limiting the activity of share trading that indeed is restrained by the fear of eroding that relationship, hence rendering ineffective forms of shareholder control based on price signal or on takeover bids.
Also, banks play a minor role in monitoring corporations in the US and UK compared with Japan or Germany. For example, in Japan, in line with the perspective that bank monitoring reduces agency cost and encourages long term orientation, the main bank plays the role of manager of a loan consortium when a group of banks extend major long term credit to the company and it is responsible for closely monitoring the business affairs of the company (Aoki, 1990)
The broader objective of maximisation of stakeholding wealth of German and Japanese firms is also reflected in the organisational structure. The German system has two boards, a supervisory board and a management board, which by law must include workers’ representatives (Moschandreas, 2000). In fact, the power that labour unions enjoy in Germany does not have a parallel in other developed economies and reflects the comparatively higher power enjoyed by this stakeholder group in Germany (Yoshikawa and Rasheed, 2009). In Japan, instead, long term employment and consensus-seeking behaviour is enough to grant a seat on the board; as to reflect how the extent of the internal relationships is important to guarantee that the management acts in the stakeholder’s interest.
Similarly to the US system, the UK board of directors consists of a chairman and a number of executive and non-executive directors (NED). However, differently from the United States where CEOs are given a free rein, in the UK, an extra layer of control is given by the structure of the board. In the UK public companies often separate the role of chairman and CEO while the board has in effect the dual function of being responsible for executive decision making and for monitoring the executive function (Moschandreas, 2000). More importantly, the UK “unitary board” system, aiming at preserving shareholders’ wealth and thus the accountability of the management, allows the presence on the board of independent NEDs. In fact, since the role the board of directors is to minimize agency costs arising from the separation of ownership and control and to preserve shareholder value (Williamson cited in Rebeiz and Salameh, 2006), in line with the agency theory of the firm, a more independent boardroom configuration would mitigate the agency cost of the firms due to the detachment of the independent directors from the management team (Rebeiz, 2008).
Indeed, the Cadbury report represented a seminal development of the UK governance structure since its main recommendations were directed to strengthen the independence of the board of directors to improve the disclosure of information to shareholders and thus the accountability of the board (Keasey, 2005). However, even allowing for an increase in the number of non-executive directors (NED), this does not solve the main flaw in the UK system that is the conflict of interest which lies in the board’s dual role of being responsible for executive decision making and for monitoring the executive function (Moschandreas, 2000); indeed, NEDs are often put in the awkward position of evaluating and setting the compensation of the CEO who has after all nominated them.
In the UK, the evolutionary trajectory of the governance system has often been driven by the increasing effort of the governments to influence governance corporations on the back of public opinion concerns (Keasey, 2005). In fact, as the Sarbanes-Oxley legislation in the US was a public response to a breakdown in the system caused by the Enron and WorldCom accounting scandals, the publication of the Cadbury Committee report in UK in 1992 was a response to the numerous corporate problems in the late ‘80s (Keasey, 2005).
However, the need to address problem of the conflicting role of the board has often met the resistance of timid British regulators to impose further procedures and rules; an opposition to some extent reasonable since the market would undoubtedly do a better job than meddling politicians and populist arguments. Yet, the recent financial crisis and the successive backlash against the disproportionate remuneration of the executives at the helm of the same banks blamed for the global recession have again shown the limits of this system. Indeed, if “executive pay is the litmus test of effective corporate governance” as stated in the Financial Times (2009a) the UK model has failed to properly monitor greed and correctly reward performances[3].
Hence, the failure of an effective system of accountability risks depriving businesses of the necessary social legitimacy[4], indeed the danger is that shareholders and the public may lose trust in a system in which the managers seems to take care only of themselves (Handy, 2002).
Although the UK regulators could try to be more incisive in imposing a clear division of the roles within the boards instead of just recommending procedures, the required leadership to overcome this problem should at least come from the same shareholders. They should assume more responsibilities of their ownership and pursuing a longer-term view of their investments instead of just speculating on the share-prices; in particular, as suggested John Plender in the Financial Times (2010b) institutional shareholders could undertake more monitoring responsibilities, such as having a majority of the seats on remuneration committees.
However, the key is not moving towards a German or Japanese system. Although, globalisation may become the main force behind an apparent convergence of governance structures across the world[5] (Yoshikawa and Rasheed, 2009) and thus driving national corporate governance systems towards an ideal global normative structure, it would be wrong to compare governance structures in terms of which one works better and thus to believe that a dogmatic and static approach produces superior economic performances. As exposed in the Toyota’s recent problems, the preference for consensus-based decision-making and the rigid system of seniority and hierarchy have made Japanese firms resistant to change and vulnerable to mishandling a crisis (The Economist, 2009) while excessive regulations have contributed to the lack of dynamism of European firms and sclerotic economies in the continent (Handy, 2002). Instead the regulators in the UK should focus more on ethical and professional standards of the managers while shareholders ought to abandon their gambler’s approach and taking more pride of their ownership’s responsibilities.
Books
Fisher, C. M. (2003) Business ethics and values. Harlow, England, New York: FT Prentice Hall.
Keasey, K., Thompson, S., Wright, M. (2005) Corporate Governance. London: Wiley
Moschandreas, M. (2000) Business Economics. 2nd ed. London: Thomson
Journal Articles
Aoki, M. (1990).Toward an economic-model of the Japanese firm. Journal of Economic Literature 28 (1): 1-27 mar 1990 [online]. Available from: Business Source Complete:
Hill, Charles W. L., Jones, Thomas M. (1992). Stakeholder-agency theory. Journal of Management Studies Mar92, Vol. 29 Issue 2, p131-154[online]. Available from: Business Source Complete:
Letza, S., Sun, X., Kirkbride, J. (2004) Shareholding versus Stakeholding: a critical review of corporate governance. Corporate governance –Oxford.vol. 12; number 3 242-262 [online] .Available from: Business Source Complete:
Rebeiz K. and Salameh Z. (2006). Relationship between governance structure and financial performance in construction. Journal of management in engineering 22 (1): 20-26 Jan 2006 [online]. Available from: Business Source Complete:
Rebeiz, K. (2008). The optimum boardroom composition and the limitations of the agency theory. Journal of the Academy of Business and Economics Vol. 8 Issue 1 [online]. Available from:
Rieke, R.D. (1975).The Efficient Market Hypothesis and the Value of Traditional Security Analysis. The Journal of Financial and Quantitative Analysis, Vol. 10, No. 4, 1975 Proceedings (Nov., 1975), p. 537 Published by: University of Washington School of Business Administration [online]. Available from: < http://www.jstor.org/stable/2330594>
Yoshikawa, T., Rasheed, A. A. (2009) Convergence of Corporate Governance: Critical Review and Future Directions. Corporate governance -Oxford- vol. 17; number 3 388-404[online]. Available from: Business Source Complete:
Online Articles
Financial Times (2009a) Executive pay. Financial Times [online]. Published: December 28 2009. Available from:
Fox, J. (2010b). Cultural change is key to bank reform. Financial Times [online]. Published: March 25 2010. Available from:
Handy C. (2002).What is a business for. Harvard Business Review; Dec2002, Vol. 80 Issue 12 [online].Available from: < http://hbr.org/2002/12/whats-a-business-for/ar/1>
Hill, A. (2009b) Lord Turner's pay provocation deserves proper hearing. Financial Times [online]. Published: August 27 2009. Available from:
Plender, J. (2010a). To avoid a backlash, executives must act on pay. Financial Times [online]. Published: April 2 2010. Available from:
The Economist (2010).Accelerating into trouble .The Economist Feb 11th 2010 [online]. Available from:
[1] The deviation from the ideal situation in which the interests of the principal and the agent coincide (Moschandreas, 2000)
[2] The efficient market hypothesis implies that the issuance of market information is quickly reflected in prices changes (Rieke, 1975).
[3] In fact, according to Income Data Services (cited in Financial Times, 2010a) the chief executives of the UK’s 100 largest companies will have earned 81 times the average pay of full-time workers in 2009, an increase of 47 times the average wage in 2000 than hardly justify the business’ performances over the same period.
[4] As also highlighted by Lord Turner, chairman of the Financial Services Authority, the UK regulator, which provoked controversy when he questioned the social value of much investment banking activity (Financial Times, 2009b)
[5] In fact, the need for an comprehensive normative auditing system to better compare businesses’ performances and continuous cross-countries’ operations undertaken by firms have certainly contributed to minimize the distinction between the “market based” Anglo-American system and the “relationship oriented” or stakeholder based model found in such countries as Germany and Japan.