The Relevance Of Corporate Government Systems

Published Date: 02 Nov 2017

Individual assignment

Corporate Governance Systems

N.D. Krijnse Locker 2142333

Tutorial group 13

Table of Contents

Introduction

When analyzing or comparing countries for foreign direct investment (FDI) consideration, corporate governance is an important area to consider. Countries differ greatly in the corporate governance area, this is due to a lot of different variables and forces. However, there are two main views in corporate governance, based on the early researches of American corporate governance. You either have market-based corporate governance or relation-oriented corporate governance. This paper will go into detail in both views and will describe the countries applying either one of these views. Also, the different definitions of corporate governance will be discussed, since there are multiple interpretations. Besides that, the different mechanisms associated with this practice will be identified and discussed. Within these different mechanisms also two views arise, both internal as external mechanisms will be debated in detail. Moreover, the issues arising or dealing with corporate governance or that increase the demand of proper corporate governance will be identified and evaluated. Furthermore, the cultural aspect of differences between corporate governance methods will be conferred. What type of corporate governance is preferred or what to take into consideration in a country’s corporate governance environment will be discussed in the conclusion. Also, the relevance of using corporate governance as a primary factor affecting your country comparison or analysis is stated.

Definition

First of all, there are several definitions stated in the academic world on corporate governance. Denis & McConnell (2003) define it as a ‘set of mechanisms’; this already indicates that multiple factors should be considered. They identify the primary issue as the agent-principal phenomenon, widely discussed in business management literature, as they state:

‘We define corporate governance as the set of mechanisms-both institutional and market-based-that induce the self-interested controllers of a company ( those that make decisions regarding how the company will be operated) to make decisions that maximize the value of the company to its owners (the suppliers of capital).‘

Denis & McConnell (2003)

This agency problem is discussed in detail by Shleifer & Vishny (1997) in their ‘An survey of corporate governance.’ This issue will be later evaluated in detail in this paper. Like Denis & McConnell also Shleifer & Vishny identify multiple mechanisms that should be considered. Shleifer & Vishny see corporate governance as a way of protection for money suppliers that supply capital to firms where managers make the decisions as they state:

‘Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment.’

Shleifer & Vishny (1997)

Of course, corporate governance does not solely control the relationship between investors or ‘suppliers of finance’, as Shleifer & Vishny call them , and the firm management. It also controls other parties that the firm encounters. Corporate governance is more generally defined as

‘The system of rules, practices and processes by which a company is directed and controlled. Corporate governance essentially involves balancing the interests of the many stakeholders in a company - these include its shareholders, management, customers, suppliers, financiers, government and the community.’ (Investopdia.com, corporate governance, 2013). As you can see, a lot of different mechanisms are involved. This way, corporate governance is involved in almost all management processes from ‘action plans to performance management’ (Investopdia.com, corporate governance, 2013).

The agency problem

Before I go into detail on the different mechanisms associated with corporate governance systems, the agency problem will be discussed. I consider this problem the main reason why corporate governance systems exist. The story of the principal-agent problem dates all the way back to 1776 when Adam Smith first identified the problem (Denis & McConnell, 2003). The idea is that when ownership and control are not really parallel, conflict of interest appears between these two groups. Shleifer & Vishny (1997) state that ‘the essence of the agency problem is the separation of ownership and control’.

Investors provide the managers with money to invest in company growth and returns. There would be no agency problem if the investors would make a contract with managers that they are allowed to make investment decisions. The problem is, however, that investors usually do not have the required knowledge that managers possess. Therefore, decisions have to made by the manager. Another solution would be stating all possible scenarios that could occur in a contract with the corresponding action that should be taken by the manager ( in favor of the investor). However, as it is impossible to predict what could happen in the future, these ‘complete contracts’ as Shleifer & Vishny (1997) describe them cannot be realised.

Shleifer & Vishny (1997) describe the different ways managers can abuse the control rights, or ‘discretion’ they possess. The first way is that managers could expropriate the capital from the firm. This means that managers e.g. take out money from the company safe, or start a company themselves and sell the output of the company they work for to that company, with discounts of course (Shleifer & Vishny, 1997). This of course can be protected by law in the country the firm is situated in. However, what happens a lot is the usage of firm capital to personal use that does not seem so personal. This is much harder to trace and prosecute by law. A good example, is the purchase of a luxurious company plane, which can be used by the executive managers (Shleifer & Vishny, 1997). A final abuse of managerial discretion is called ‘entrenching’. When managers are asked to leave the company, they can refuse and stay on the job and it will be very costly for the investors to remove them (Shleifer & Vishny, 1997).

As a solution to the agency problem, Shleifer & Vishny (1997) identify what they call ‘incentive contracts’. This are contracts that contain certain benefits to managers as they pursue the maximization of profit. This way, the interests of ownership and control can be aligned after all.

In the next part, the different mechanisms involved in corporate governance systems will be discussed

Different mechanisms

Corporate governance involves a lot of mechanisms, these mechanisms combined and the distribution of them make up a specific corporate governance system. Denis & McConnell (2003) identify two different mechanism dimensions, namely internal and external mechanisms.

Internal mechanisms

Board of directors

As internal mechanisms they first of all mention the board of directors as an important internal mechanism. In U.S. firms, and in most other countries, a board of directors is there to preserve the ‘rights’ or in other words, representing the interest, of investors and shareholders (Denis & McConnel, 2003). Their main tasks consist of hiring, firing and monitoring managers. Usually, the CEO is also the head of the board of directors, however, except him/her most board members are outsiders in the U.S.. Denis and McConnell identify two key issues relating to the board of directors, namely the composition of the board and the compensation of executives.

The composition of the board issue deals with problems like how many members should be included and if indeed the CEO should be the head of the board or not. The executive compensation issue deals with the extent of compensation (earlier referred to as ‘incentive contracts’) used to make sure that manager interest are the same as the interests of the shareholders. [1] 

Ownership structure

The second internal mechanism Denis & McConnell(2003) identify is the ownership structure. As mentioned above the issue of interest alignment between managers and shareholders is very crucial to corporate governance. One could say that having managers that also own the firm (or at least a significant part) aligns management and shareholders interest, or at least lowers conflicts among these two groups. However, this way a manager could easily do what he wants, without ‘fear of reprisal’ that could ‘entrench managers’ (Denis & McConnell, 2003). Another problem is the involvement of ‘outside blockholders’, this are individuals or groups that have acquired a large, significant amount of the total shares of a firm, thus having a lot of control. A third problem arising from the relationship of control and ownership is that also the government can come into play. In a lot of countries, the government owns a significant part of companies. This gives the government of a country a lot of control over companies. However, the difference with ‘private, outside blockholders’ is that the money of the government on its own is property of the state, this means that ‘not the individuals within the government influence the actions of the firm’ (Denis & McConnell, 2003), but the government in general. As the government usually, when not corrupted, influences firms to act as a benefit to the country and its citizens, the change from state-owned corporations to privatized corporations which are more selfish in a way, also shows changes in corporate performances. (e.g. profit margins)

External mechanisms

In addition to the internal mechanisms, which are firm specific, also external mechanisms are identified. These external mechanisms are of the most importance to country comparisons as they are country specific. When analyzing a country, these external mechanisms could encourage or discourage some types of corporate governance types. The different external mechanisms will be discussed below.

Takeover market

The first external mechanisms Denis & McConnell (2003) identify is the ‘takeover market’, or in other words, the hostility from the outside to take over control of a company. This problem occurs when firms are not performing well, or as Denis & McConnel (2003) put it ‘when the gap between the actual value of a firm and its potential value is sufficiently large’. In the US there is a very active market for these takeovers and thus management is very cautious to make sure that there is no incentive for outsiders to take over the control. This means that managers will always try their best to keep increasing or maintaining the firms value, which is beneficial to the shareholders. But, when a takeover does happen, it usually happens at ‘a premium’ as Denis and McConnell (2003) describe. Therefore, this external mechanism does not seem to have a negative side for shareholders.

Unfortunately, there is a negative side however. As managers are so motivated to keep the firms value high, they might choose to invest in the firm, thus expanding the firm to maintain growth. This seems as something positive, however, the money used to do this normally goes to the dividends or cash returns to shareholders, so now they will not get anything. This indicates that again the principal agent problem occurs.

Legal system

The second external mechanism mentioned is the legal system present in a country. In earlier researches, the legal system was not acknowledged as a fundamental and critical mechanism of corporate governance. (Denis & McConnell, 2003). However, Shleifer & Vishny (1997) do acknowledge this one of the crucial and primary mechanisms of corporate governance. They state that the laws of a country are crucial, especially the rights of investors that invest in firms. The way these laws are enforced in countries determine the evolvement of corporate governance in particular countries. Shleifer & Vishny (1997) identify two ‘most common approaches to corporate governance’. These approaches both involve the share/extent of control power/influence of shareholders.

One approach they identify is the same as Denis & McConnell (2003) identify with their internal mechanism ‘ownership structure’. Shleifer & Vishny (1997) argue that ‘ownership by large investors’ is a major approach of corporate governance. This enables these large investors to achieve concentrated ownership, giving them ‘control rights with significant cash flow rights’. They include other mechanisms like ‘large share holdings, relationship banking and takeovers’ as part of these large investors, that are also using these previously stated rights.

The second main approach they state is the giving of power to investors by protecting them with laws and regulations. This is what Denis & McConnell (2003) see as an external mechanism, since it is country specific. These laws should thus be carefully analysed before considering FDI to a specific country. This is because these regulations greatly influence the evolvement of corporate governance and enable some types of corporate governance systems to be used, and disables other types. What different types of corporate governance systems go with what characteristics is dealt within the next part of this paper.

Different types

The different mechanisms discussed in the previous part are combined, altered and present in different significances in different corporate governance systems. Kaplan (1997) identifies two major streams, or types for that matter, of corporate governance present all over the world. He identifies the U.S. corporate governance system as a ‘market-based’ system. He also identifies more ‘relationship-oriented’ systems that he categorizes and finds in two major countries, Germany and Japan. Germany and Japan both differ from the American system but also differ among each other on certain aspects. In the following part these differences will be highlighted and analysed.

Market based

First up is the U.S. system of corporate governance. This system is categorized as an ‘market-based’ system, which entails several specific characteristics or, now known as, mechanisms. First of all, the U.S. capital market is seen as ‘liquid’, this means that a lot of different players are present and is not steady; investors ‘go with the flow’ and not necessary stick to one specific company. This also means that the ownership of companies is not highly concentrated, but spread among multiple investors (Kaplan, 1997). However, the internal mechanisms of board control, earlier described are high in the U.S.. Managers are closely watched. Mostly, the board of directors of U.S. firms consist of outsiders to the firm. Secondly, the previously mentioned external mechanism ‘takeover market’ in which external control groups are seeking for incentive to intervene and take over control of a country is high on US markets.

Relationship oriented

The second type of corporate governance system is the ‘relationship-oriented’ system of both Germany and Japan. Contrary to the U.S. capital market, the capital markets in both Japan and Germany are defined as ‘illiquid’ (Kaplan, 1997), thus meaning that investors stick more to the firm they are already investing in. Moreover, the ownership of firms is highly concentrated in the Japanese and German systems. Also, these systems have long term relationships and it are these relations that monitor the managers. These relations consist of ‘a combination of banks, large corporate shareholders and other intercorporate relations’ (Kaplan, 1997). Furthermore, the external mechanisms ‘takeover market’ is not so much an issue in Japan and Germany, it is either small or nonexistent (Kaplan, 1997).

Comparison

Kaplan (1997) looked at several mechanisms associated with corporate governance systems to compare the three systems and see which one is best. His statements are summarized in table 1 below.

Table . Source: Kaplan, S. N. (1997). Corporate governance and corporate performance: A comparison of Germany, Japan, and the US. Journal of Applied Corporate Finance, 9(4), 86-93.

As described above, Japanese and German systems are more ‘relationship-oriented’, this can be found back in several mechanism comparisons. Kaplan (1997) states that the main view is that ‘the close ties and relationships in Germany and Japan reduce agency costs and allow investors to monitor managers more effectively than in the U.S.’ This has several implications for the differences among these systems.

The U.S.

First of all, the ownership concentration in Germany and Japan is higher than in the U.S.. Relationships concerned with the firm, like family ties or corporate relationships with banks are the cause of this. For example, because a typical firm in Germany has close ties with the banks, these banks have better information on the firm and its activities and are therefore more keen to supply money for long-term projects. This is contrary to the U.S. banks and investors, that are highly dispersed and therefore have less information and therefore are more hesitant to invest in long-term ‘value-increasing projects’ (Kaplan, 1997). This also implicates that U.S. firms are more concerned with investments that provide short-term returns than with long-term projects. This, together with the mechanism ‘takeover market’, which is considered ‘major’ in the U.S. by Kaplan (1997) means that the U.S. markets are more competitive than German or Japanese markets. Therefore, more pressure lies on the managers of U.S. firms, that must ensure the company’s growth is maintained, without being able to easily invest in e.g. expansion of the firm by investing in long-term investment projects.

To link back to the previously discussed mechanisms, these managers also have to deal with a different kind of board of directors, the first internal mechanism identified by Denis & McConnell (2003). Namely, the typical U.S. board of directors consists of 13 or 14 members of which two third are outsiders (Kaplan, 1997). In comparison, a typical Japanese board has 21 members of which nearly all members are insiders (Kaplan, 1997). The ownership concentration is, as discussed above, lower in the U.S. compared to Japan or Germany. However, the share that U.S. managers own of the company they work for is higher than in Japan and Germany (Kaplan, 1997) as can be seen in figure 1.

Figure . Source: Kaplan, S. N. (1997). Corporate governance and corporate performance: A comparison of Germany, Japan, and the US. Journal of Applied Corporate Finance, 9(4), 86-93.

This, of course, is an incentive for managers to not waste money on long-term investment when it also can be used for cash returns to shareholders, of which the manager is a member.

In sum, the general remark that can be made about the U.S. system is that it can be defined as short-term oriented (Kaplan, 1997). The fact that ownership concentration is low and thus means that investors have less control and information, discourages U.S. firms to invest in long-term projects since the investors are hesitant to provide capital. Secondly, the fact that the typical US board of directors consists of outsiders for the larger part means that more pressure is present on the managers to increase, or at least maintain, growth without wasting money to long-term investments. Finally, the fact that U.S. managers own more shares than Japanese managers, they are more likely to invest in short-term return projects.

Japan

The biggest difference of the Japanese system, when comparing it to the U.S. system is the small size or absence of the control market, or as Denis & McConnell(2003) describe it ‘the takeover market’. Also, the board of directors consists of mostly insiders, not outsiders that represent the shareholders. The question that then arises is how Japanese managers are pushed to come up with good performance and high cash returns, since the control market will not seize control nor will the board of directors intervene, as is the situation in the U.S.. You would think that Japanese managers are thus much more safe on their position because no real pressures from either the board or the takeover market exists. However, the thing is that Japanese, and also German, managers are ‘twice as likely to lose their jobs in a year with loss than in a year with positive earnings’ (Kaplan, 1997) than U.S. managers.

So there must be another force driving the Japanese managers to maintain growth and cash returns to shareholders. As stated earlier, most members of Japanese boards of directors are insiders, however, one or two members are ‘appointed outsiders’ (Kaplan, 1997). Usually, these outsiders are linked to the banks investing in the company, or are outsiders that are not employees of the company but have a history in banking (Kaplan, 1997). These outsiders are appointed in times of lower returns, loss on earnings and more borrowings from particular banks (Kaplan, 1997). These ‘appointed outsiders’ take over the role of the ‘takeover market’ mechanism to some extent. They are not really intending takeovers like in the U.S., but function more in a ‘monitoring and disciplinary’ role.

Germany

The role that ‘appointed outsiders’ fulfill for Japanese managers, is fulfilled by the supervisory board for German managers. The supervisory board is an extra board, acting together with the management board. The supervisory board consists of representatives of the shareholders and of representatives of the employees (Kaplan, 1997). Like in Japan also this supervisory board acts as an monitoring and disciplinary body. Considering the other mechanisms, the corporate governance system is similar to the Japanese corporate governance system. Other than then the supervisory board, the German system has one more difference. It is more flexible to poor sales growth in comparison with Japan and the U.S. systems (Kaplan, 1997).

Which one is the best?

While these three corporate governance systems differ a lot among each other, the results they produce are very similar. Kaplan (1997) explains this by stating that these ‘three countries have successful market economies’. So, although the systems are very different, sometimes these differences do not matter when certain market characteristics are present. Kaplan (1997) identifies two dimensions that can be used to explain this concept better, namely the maturity of a industry and the competitiveness of the market. Table 2 below summarizes his view on this.

Table . Source: Kaplan, S. N. (1997). Corporate governance and corporate performance: A comparison of Germany, Japan, and the US. Journal of Applied Corporate Finance, 9(4), 86-93.

First of all, sometimes firms have to choose between maximizing their value or failing. Of course, when this is the case, all managers will try to maximize value unrelated to any corporate governance system. This is especially the case when markets are competitive. (Kaplan, 1997) Secondly, when industries are growing or changing, firms should change as well. The managers will have to invest capital effectively in expanding the firm in order to survive. As stated previously, a manager can choose between adding value to the firm in the long term or invest in short-term growth and use remaining capital for cash returns to shareholders. The latter option is favored by shareholders, who strive for short-term growth and cash returns. Kaplan (1997) states that managers that invest in ‘unprofitable growth’, so the expensive long-term investments, will fail. So, in these two cases the difference in corporate governance system do not matter.

What can be concluded ,considering this literature, is that in the most capitalist economies different corporate governance system types will not matter. However, differences in corporate governance systems will ‘matter most in companies operating in mature industries or in noncompetitive industries where firms can survive for substantial periods without maximizing, and waste substantial resources in the process’ (Kaplan, 1997).

So when corporate governance system differences do matter, you need to make sure you use the best one. Although the systems have a lot of variations amongst each other, the U.S. system prevails in two different aspects (Kaplan, 1997). The previously described larger amount of shares held by American managers in respect to the Japanese and German managers, is a good incentive for American managers to not ‘overinvest or waste the extra cash that a successful firm generates’ (Kaplan, 1997). Secondly, there are some benefits dealing with cash returns to shareholders in the U.S. system. Note that this is an external mechanism because now the legal system of the particular country comes into play. In the U.S., dividends are paid to shareholders and the firms are allowed to buy back stocks sold, this is tax advantaged in the U.S. (Kaplan, 1997). In Germany, the buying back of shares is illegal, however dividend payments are allowed with tax advantages. Japan, on the contrary, makes it very unattractive to pay dividend since it is tax disadvantaged (Kaplan, 1997). Like Germany, it was forbidden to buy back shares, but since 1995 it is allowed, but still mostly restricted (Kaplan, 1997). This tax advantage is an example of what Shleifer & Vishny (1997) identify as one of the common approaches of corporate governance, namely the giving of power to investors by protecting them with laws and regulations.

In sum, the U.S. corporate governance system is the preferred choice considering this literature. It is not that it is more beneficial to bad performing companies, but it is ‘more effective than Germany’s and, particularly, Japan’s, in discouraging successful companies from overinvesting’ (Kaplan, 1997).

International corporate governance

The above discussed three different corporate governance systems, namely the American, German and Japanese corporate governance systems are the most discussed systems in the academic literature. The differences that surfaced in this analysis can be found all over the world, since different countries use either one of these three systems or slightly altered versions of these three systems. There can be stated a general rule of thumb, that in developed countries usually having capitalist markets, the U.S. corporate governance system is the most effective in keeping firms from wasting money. However, this U.S. corporate governance system is based on the rules and laws of the USA. There can be argued, with respect to the huge amount of literature on the topic, that culture of a country influences the development of laws and regulations, since it is an representation of norms and values. Like Licht (2000) states: ‘A nation’s unique set of cultural values might indeed affect—in a chain of causality—the development of that nation’s laws in general and its corporate governance system in particular.’

Knowing this, it is the culture of a country that prescribes the use of one of the three systems to some extent. This is because the evolvement of corporate governance systems in developing countries can only go so far, since in the end, it will be limited by the culture of the country. In this context, I refer to the laws and regulation with the word ‘culture’. It are these laws that e.g. make it illegal in Germany to repurchase stocks, giving a manager more incentive to use the money available to invest in unprofitable long-term investment.

Conclusion

In conclusion, the agency problem is a real issue in the performance of firms. In order to solve this issue to its best ability, corporate governance systems were created. These systems consist of several mechanisms. Denis & McConnell (2003) identified two different types of mechanisms; internal and external mechanisms. It are the external mechanisms that should be considered when comparing countries, since these external mechanisms are the ones that are country specific.

Shleifer & Vishny (1997) see corporate governance systems as protection for investors and this protection is realized by established laws and regulations. The way these laws are enforced in a country deals with the external mechanism ‘legal system’. This legal system present in a country is crucial to the type of corporate governance system that can be realized.

Kaplan (1997) identifies two different streams of corporate governance; market-based and relationship-oriented governance. He finds three main countries in which these two streams manifest themselves, namely the U.S., Japan and Germany. A different set of mechanisms is present in each different system, however which system is the best depends on the economy of a country. Sometimes differences do not even matter. There can be concluded that in the most capitalist economies different corporate governance systems will not matter. However, firms operating in mature industries or in noncompetitive industries will benefit or suffer the most from differences in corporate governance systems.

Overall, the U.S. corporate governance system is the preferred choice in most cases. It is not that it is more beneficial to bad performing companies, but it is effective in keeping managers from overinvesting and thus wasting money.

Moreover, when comparing or analyzing countries you have to consider that the cultural differences also influence the type of corporate governance system, even when this is not so obvious at the surface. However, after considering all aspects and mechanisms discussed in this paper, there must be concluded that corporate governance is greatly influenced by the presence of certain legislation (investor protecting regulations), which in the end is rooted in the culture of a country.

So, in the comparison and analysis of countries, corporate governance is a primary factor that should be considered. As a manager considering FDI you have to think about the legislation present in a country that might be useful or just might work against your company. Cultural differences is again a key term in country comparisons and should not be overlooked when analyzing the corporate governance systems in a country. Again, with whatever purpose you are analyzing a country, the corporate governance system might give away a lot of important details hidden in the roots of a culture.