Corporate Governance (Finance)

The firm is a nexus of contracts, and the corporation is a firm whose equity claims have limited liability and are generally traded on li quid markets. Corporate governance refers to the rules, procedures, and administration of the firm’s contracts with its shareholders, creditors, employees, suppliers, customers, and sovereign governments. Governance is legally vested in a board of directors who have a fiduciary duty to serve the interests of the corporation rather than their own interests or those of the firm’s management (see Clark, 1985).

The apparent simplicity of this description disguises two key problems which have stimulated most popular and academic interest in corporate governance. First, what exactly is meant by the interests of the corporation, given that corporation is not an individual? Second, the courts’ ability to enforce the vague notion of fiduciary duty is limited at best (Romano, 1991). What other forces exist to motivate self-interested directors and managers to serve corporate interests?

One way in which financial economists have answered both questions is to maintain that corporate interests are identical to the wealth of shareholders, and that directors and managers are motivated to serve these interests by incentive pay, by their own shareholdings and reputational concerns, and by the threat of takeover. This approach must, however, be supplemented by the recognition that in some firms the costs and benefits of corporate decisions are also borne by parties such as creditors and long-term employees. We conclude that the most promising areas for further research are based on the recognition that the optimal governance structure varies widely across corporations, depending on the relative importance of these various claims on its cash flows; see Garvey and Swan (1994) for a more extensive survey.


Governance and Performance

The question of most immediate relevance to researchers and commentators is how governance affects firm performance and, in particular, whether firms perform better when shareholders’ interests are likely to be dominant. Such firms are identified in the empirical literature either by the proportion of outsiders who serve on the board of directors, or by the linkage between chief executive officer (CEO) wealth and the wealth of shareholders. Evidence on the role of outside board members is provided by Rosenstein and Wyatt (1990) who find that the appointment of outsiders to the board is associated with a stock price increase and by Weisbach (1988) who finds that outsider-dominated boards are more likely to dismiss the CEO for poor share price performance. Evidence on the performance effects of CEO incentives can be found in DeFusco et al. (1990), who document an increase in the share price of firms which introduce stock option or ownership plans, and in McConnell and Servaes (1990) who find a positive relationship between the percentage of shares owned by managers and board members and firms’ market-to-topic values.

This type of evidence is not as useful as it might appear. In particular, it does not establish that firms should increase outside board membership or CEO incentive pay as advocated by the American Law Institute (1982). First, an i ncrease in the stock price could be driven by wealth transfers rather than efficiency gains. Indeed, DeFusco et al. (1990) found that the increase in share price was also associated with a decline in the value of the firm’s outstanding debt. Second, even if the share price were a reliable guide to performance, compensation and board structures are not chosen randomly as required by the performance studies. A recent study by Agrawal and Knoeber (1994) attempts to account for the endogeneity of compensation and board structure, and comes to the provocative conclusion that many firms have too many rather than too few outside members on their boards. To disentangle these effects, we need to understand more about the effects of various governance mechanisms and how they relate to a firm’s unique environment and strategies.

Governance and Behavior

A less obvious but arguably more useful research strategy is to examine how different governance mechanisms affect the firm’s behavior rather than its performance. While this approach cannot tell us whether actions such as the dismissal of a CEO or rejection of a takeover bid is optimal for the firm in question , it is an essential input into any understanding of optimal governance structures.

The most robust finding is that changes in control due to takeover or insolvency bring dramatic changes in firm personnel and strategy. Gilson and Vetsuypens (1993) document that CEO and board member turnover increases radically in the event the firm goes into financial distress. Martin and McConnell (1991) present similar findings for a hostile takeover. These findings suggest if nothing else that incumbent managers and board members will take steps to avoid takeover or insolvency, either by increasing the firm’s cash flows or by some less productive avenue.

The importance of the takeover threat depends not only on the slack to be found in the target firm, but also on the premium that must be paid by a bidder. Grossman and Hart (1980) show that collective choice problems between target shareholders can greatly increase this premium, thereby deterring many takeovers. Stulz et al. (1990) find evidence that the severity of this problem differs across firms, and is miti gated when a firm’s shares are concentrated in the hands of financial institutions. Brickley et al.’s (1994) study of voting on antitakeover amendments provides further evidence of the rich differences that exist between firms. They find that only those institutional shareholders who have no obvious business ties to the firm are willing to oppose management-sponsored anti-takeover amendments. Such heterogeneity leads naturally to our final question; how are these differences adapted to the different environments of firms?

Governance Structures and Environments

Governance mechanisms are not cost free. Any party who would oversee management must bear the direct costs of monitoring and the indirect costs of bearing firm risk. Demsetz and Lehn (1985) were the first to explicitly recognize these costs and ask how governance characteristics vary with the attributes of each firm’s environment. They found that shareholdings were less concentrated in larger firms, in regulated firms, and in firms whose profits were more predictable. Garen (1994) finds that such firms also tend to exhibit less incentive pay for the CEO, because the benefits of oversight and incentive-alignment are smaller relative to their costs for such firms.

Areas for Further Research

The ambiguous results of the performance studies summarized above suggest that corporate performance cannot be reliably increased simply by adding outsiders to the board of directors or by increasing the CEO’s stock-holdings. Future research efforts are better devoted to understanding why and how governance structures differ across firms. Studies such as Kaplan (1994) provide useful evidence on how Japanese and German firms differ from their US counterparts. Other differences that merit further study include the liquidity of the stock market (e.g. Bhide, 1993) and the importance of employee claims on the firm’s future cash flows (see Garvey and Swan, 1992).

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