Corporate governance has been thought of as ‘a question of performance accountability’ (Mayer, 1996), a question of how to induce managers to run the firm so as to maximize shareholder wealth. In the UK’s Cadbury report (1992), it suggests that managers must be free to drive their companies forward but exercise freedom within a framework of effective accountability.
Therefore, the fundamental issue concerning governance by shareholders today seems to be how to regulate large shareholders so as to obtain the right balance between managerial discretion and small shareholder protection. Corporations need a system that can provide effective protection for shareholders and creditors, so that they can assure themselves of getting a proper return on investment. It should also help to create an environment conductive to the efficient and sustainable growth of the corporate sector. (M.Becht, P.Bolton & A.Roell, Corporate Governance and Control, 2002)
2. Comparative systems
Around the world, one of the most debated topics is the relative merit of two different systems of corporate governance, the Anglo-American market-based system and the bank-based model of Continental Europe and Japan (Allen and Gale, 2000). In the 1980s, the Japanese and German long-term large investor corporate governance perspectives were seen as strengths relative to the Anglo-American market based short-term perspective; and the 1990s, when both minority shareholder protections and the reliance on equity financing are greater, the Anglo-American systems were seen as major advantages.
The classic market-based systems are found in the US and the UK, it also can be characterised as an ‘outsider system’. The distinguishing features of the outsider model are: 1) dispersed equity ownership with large institutional holdings; 2) the recognised primacy of shareholder interests in the company law; 3) a strong emphasis on the protection of minority investors in securities law and regulation; and 4) relatively strong requirements for disclosure. (OECD, 1996)
In countries with outsider systems, the legal framework supports clearly the right of shareholders to control the company and makes the board and the management explicitly accountable to the shareholders (La Porta, 1997). This system of corporate governance appears to be more open and equitable in the distribution of information and corporate governance processes are more transparent, including board elections. The accountability of the board to shareholders as a body is also more clearly recognized.
Indeed, there are significant differences between the systems of corporate governance found in the US and the UK. However, the UK and US markets are also not entirely independent and the increasing level of investment by US institutional investors in non-domestic stock markets and the application to non-domestic markets of corporate governance standards consistent with those developed for US companies is likely to play an increasing role in the development of corporate governance standards in the UK and other economies. (OECD US Survey, 1996)
A Bank-based system can also be called an ‘insider system’, in which a main bank provides a significant share of finance and governance to each firm. In most other OECD countries and nearly all non-Members, ownership and control are relatively closely held by identifiable and cohesive groups of ‘insiders’ who have longer-term stable relationships with the company. These relationships may be purely financial or based on past or current commercial relationships. The interests of large shareholders are often supported by board representation, either directly or through alliances with other shareholders. Thus there is less reliance on elaborate legal protections, and more reliance on large investors and banks. (A.Shleifer & R.Vishny, A Survey of Corporate Governance, 1996)
Insider groups usually are relatively small, their members are known to each other and they have some connection to the company other than their financial investment, such as banks or suppliers. Patterns of equity ownership differ significantly from ‘outsider’ countries. One characteristic of countries with insider systems is that they have generally experienced less institutionalization of wealth than other countries. In addition, patterns of corporate finance often show a high dependence upon banks and high debt/equity ratios. Instead of arm’s length lenders, banks tend to have more complex and longer term relationships with corporate clients. (OECD, 1997)
The investment risks of the inside model include potentially limited accountability to shareholders outside the core insider group and the costs of self dealing if inside shareholder groups make private gains at the expense of other shareholders. These gains may be taken in the form of advantageous commercial relationships, capital or asset transfers, or the pursuit of broader political, economic or corporate agendas than would normally be required by companies in the course of business relationships and their the pursuit of long-term shareholder value. (OECD, Corporate Governance in the UK, 1997)
There is no evidence that the cost of capital is lower in the US or the UK than in Germany or Japan. It is commonly argued that the market-based setting provides a better environment for startups, new technologies and the redeployment of resources into new, more profitable lines of business, while bank-based system are perhaps more suitable for effective management of existing technologies. (M.Becht, P.Bolton & A.Roell, Corporate Governance and Control, 2002)
3. Control of managerial behavior
According the analysis above, the successful corporate governance system, such as those of the US, Germany, and Japan, relies on some combination of concentrated ownership and legal protection of investors. When performance related pay fails to eliminate managerial discretion, other monitoring mechanisms are required. It is the function of corporate governance to devise methods that strengthen the effects of these mechanisms by ensuring that an appropriately constituted and effectively functioned board of directors exists, including shareholder and creditor monitoring (direct or indirect), and various market controls. (M.Moschandreas, Business Economics, 2000)
- Shareholders control
The most important legal right shareholders have is the right to vote on important corporate matters, such as mergers and liquidations, as well as in elections of boards of directors, which in turn have certain rights vis a vis the management (Manne 1965, Easterbrook and Fischel 1983). The right of shareholders to replace managers who are not acting according to shareholder interest is often considered to be one of the most common managerial control mechanisms in many countries. In Britain, this right of shareholder can be exercised either directly through the annual general meeting (AGM), or indirectly through the market in corporate control. (D.Brewster, Business Economics: Decision-making and the Firm, 1997)
In effect, to concentrate shareholdings is the most direct way to align cash flow and control rights of outside investors, which means one or several investors in the firm have substantial minority ownership stakes, such as ten or twenty percent. A substantial minority shareholder has the incentive to collect information and monitor the management, also has enough voting control to put pressure on the management (Shleifer and Vishny, 1986).
- Creditors control
Like shareholders, creditors have a variety of legal protections. These include the right to grab assets that serve as collateral for the loans, the right to throw the company into bankruptcy when it does not pay its debts, the right to remove managers in bankruptcy, and the right to vote in the decision to reorganize the company.
Significant creditors, such as banks, have large investments in the firm and receive a variety of control rights when firms default or violate debt covenants (Smith and Warner, 1979). As a result, large creditors combine substantial cash flow rights with the ability to interfere in the major decisions of the firms. Moreover, in many countries, banks end up holding equity as well as the debts of the firms they invest in, or alternatively vote the equity of other investors (OECD 1995).
- Takeover constraints
Managers who perform poorly must always fear that their company can be taken over. If a corporation performs badly because of the managers, the market price of that company’s stock will decline, and a determined outsider can try to acquire a majority of the shares at a low price. There is a market not only for individual shares, but also for whole corporations. In other words, there is a market for the rights to manage corporations. Competition between management teams in the market for corporate control increases the pressure on managers to perform well. (S.Douma &H.Schreuder, Economic Approaches to Organizations, 1998)
A particular mechanism for concentrating ownership has emerged in Britain and the US where large shareholders are less common, namely the hostile takeover (Jensen and Ruback 1983, Franks and Mayer 1990). In a typical hostile takeover, a bidder makes a tender offer to the dispersed shareholders of the target firm, and if they accept this offer, acquires control of the target firm and so can replace, or at least control, the management. Takeovers have been widely interpreted as the critical corporate governance mechanism in the US, without which managerial discretion cannot be effectively controlled (Easterbrook and Fischel 1991, Jensen 1993).
- The Managerial labor market
The market for managers can play an important role in disciplining managers through the establishment or destruction of ‘reputations’. The top position in a large company usually gives a manager more power, more prestige, more money, and more job satisfaction than the top position in a smaller company. Hence every manager has to worry about his reputation for competition between managers to obtain those few top position in the largest firms. If manager acquires a reputation for pursuing his personal interests instead of actively pursuing profit opportunities, it is likely that his chances to get a better position are small.
On the other hand, in order to attract the best new managers and to keep the best of the existing ones, the firm offer performance related rewards. Even if the corporate managers of a company do not own shares in their company, their pay package may still include a bonus related to annual profits, an option to buy stock at a later date, etc. This can also bring the interests of top managers more in line with those of the shareholders. (S.Douma &H.Schreuder, Economic Approaches to Organizations, 1998)
- The Product market
Competition in the product market may also act as a restraint on managerial discretion. The more intense the competition in those markets, the less opportunity there is for managers to pursue their own interests. If they do so, the company will have higher unit costs than its competitors or it will turn out products of a lower quality than that of its competitors. It will lose market share and exit the market. Managers have no choice but to profit maximize. Therefore competition in product markets also restricts managers from pursuing their own interest. (M. Moschandreas, Business Economics, 2000)
Conclusion
We have seen from the above discussion that corporate governance is concerned with the resolution of collective action problem among dispersed investors and the resolution of conflicts of interest between various corporate claimholders. The control of management and legal protection of investors can be as potentially useful ways of thinking about corporate governance in different systems, whatever market based or bank based.
A fundamental problem of corporate governance emerges from this overview: regulating large shareholder intervention appears necessary, but limiting the power of large investors can also result in greater managerial discretion and scope for abuse. In fact, the patterns of ownership and control should ultimately correspond more to the needs and characteristics of a particular enterprise than to the ‘system’ prevalent in the country. Firms should have the possibility to move smoothly from one regime to another as they grow and their needs and constituencies change.
We should not expect uniform corporate governance institutions in the world; the arrangement of ownership and control are still a part of a society’s core characteristics and will remain in a considerable long term. We need to know a great deal more about these questions to objectively analyse the argument of corporate governance.
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