Does Corporate Governance Affect Firm Value?

Schilling, Sebastian

Leseprobe

ID 6855

Schilling, Sebastian: Does Corporate Governance Affect Firm Value? - Evidence from

Europe

Hamburg: Diplomica GmbH, 2003

Zugl.: Maastricht, Universität, Diplomarbeit, 2003

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Table of Contents

Abstract... iii

Chapter 1 Introduction...1

Chapter 2 An Introduction to Corporate Governance ...6

2.1

The Agency Problem ... 6

2.1.1 Transaction

Conditions ... 8

2.1.2 Incentive

Mechanisms ... 10

2.1.3 Economic

Importance ... 11

2.1.4 Intermediate

Conclusion ... 12

2.2

The Stakeholder Impact on Corporate Governance... 12

2.2.1

Corporate Governance, contractual governance, and work governance... 13

2.3

Culture, ownership concentration and law... 15

2.4

Corporate Governance: A Definition... 18

Chapter 3 The Corporate Governance Rating Framework ...20

3.1

Rights and Duties of Shareholders... 20

3.1.1 Academic

Review ... 21

3.1.2

Key Criteria and Best Practice Recommendations ... 21

3.1.3 Code

Review... 24

3.2

Range of Takeover Defenses ... 24

3.2.1 Academic

Review ... 24

3.2.2

Key Criteria and Best Practice Recommendations ... 25

3.2.3 Codes... 26

3.3

Disclosure on Corporate Governance ... 27

3.3.1 Academic

Review ... 27

3.3.2

Key Criteria and Best Practice Recommendations ... 28

3.3.3 Code

Review... 30

3.4

Board Structure and Functioning ... 31

3.5 Conclusion ... 36

Chapter 4 Statistical Analysis...38

4.1 Data ... 39

4.1.1

Corporate Governance Rating Data ... 39

4.1.2 Financial

Data ... 39

4.1.3

Analysis of Omission Bias... 41

4.2 Research

Questions... 41

4.2.1

How is firm-value best measured?... 42

4.2.2

What is `good corporate governance' and what factors should be taken into

account in its quantification? ... 45

4.2.3

Are there systematic differences between companies in terms of firm value and

corporate governance performance? ... 47

Table of Contents

4.3 Regression

Analysis... 57

4.3.1

Analysis of Multicollinearity ... 63

4.3.2

Further Essential Variables ... 68

4.4

Limitations of the Research ... 74

4.5 Conclusion ... 75

Chapter 5 Practical Insights on Corporate Governance from the Perspective

of Investors and Companies...77

5.1 Introducing

DWS ... 77

5.2

From the Perspective of an Institutional Investor ... 78

5.2.1

Corporate Governance and Shareholder Value... 78

5.2.2

The Weighting of Corporate Governance in DWS' Investment Decisions... 79

5.2.3

The Role of DWS as an Institutional Investor ... 79

5.2.4

Evaluation of the Effect of Corporate Governance on Firm Value ... 80

5.2.5

Comparison of Results between DWS Survey and Chapter Four ... 83

5.2.6

Corporate Governance Viewed in a European Comparison ... 84

5.3

Corporate Governance From a Company Perspective... 85

5.3.1

Incentives for Firms to Improve their Governance Performance ... 85

5.4 Conclusion ... 87

Chapter 6 Conclusion ...89

Bibliography ...93

Appendix...100

Abstract

iii

Abstract

This thesis provides evidence that companies showing stronger corporate governance perform-

ance are on average also valued higher in terms of Tobin's q. This evidence is found using a

dataset of 242 of Europe's largest corporations listed in the FTSE Eurotop 300 index. For each of

these corporations, a dataset of over 300 corporate governance rating variables is provided by

Deminor Rating to establish a detailed overview of a firm's corporate governance performance.

These 300 rating variables result out of a corporate governance standard established by Deminor

in cooperation with the largest European institutional investors and in reference to the respective

national corporate governance codes of the companies in the sample. The standard produces four

rating pillars representing the elements of corporate governance which institutional investors

perceived as most crucial for high governance performance. Aggregation of the four pillars to a

single governance rating variable is avoided to assess the specific effect of each pillar on firm

value as well and because of the risk of subjective weighting. The statistical analysis provides

evidence for a highly significant positive correlation between three of the four governance fac-

tors with Tobin's q as well as strong correlations amongst the governance factors themselves.

The variable `Rights and Duties of Shareholders' is the sole variable to show no correlation with

both the dependent and the independent variables. Employing a Factor Analysis to account for

multicollinearity between the independent variables leads to the creation of one component rep-

resenting a firm's corporate governance performance. This component is highly significant, dis-

plays a positive coefficient and creates a model presenting an R square adjusted of over 12 per

cent. The subsequent addition of the independent score component ROA increases the R square

adjusted of the model to approximately 42 per cent, thereby making the resulting model and the

inherent coefficients highly representative. Whereas an initial analysis shows that company cor-

porate governance performance is strongly dependent on the country it is situated in, this inter-

dependence no longer exists with the created score components, thereby establishing a corporate

governance measurement variable which shows no systematic linkage to either country or indus-

try sector affiliation. The coefficient of the corporate governance score component suggests that,

ceteris paribus, a one point increase in the value of the score component leads on average to a 0.3

point increase in Tobin's q. The created model therefore provides the necessary evidence for a

statistical linkage between corporate governance and firm value.

Chapter 1: Introduction

Chapter 1 Introduction

In the late 1980s, numerous US enterprises began implementing protection mechanisms as a re-

sponse to a vast array of hostile takeovers largely initiated by corporate raiders. Whereas these

mechanisms were designed to protect companies against hostile attacks that were not in their best

interest, they simultaneously protected management from direct influence of shareholders. This

evolution led to the discussion about the roles and responsibilities of management and their

shareholders, with a strong emphasis on the question of how the interests of these two parties

could best be aligned so as to strive for the same goals. Whereas the issue of corporate govern-

ance began as a purely North American problem, it reached Europe in the early 1990s after sev-

eral prominent bankruptcies and fraud occurred as for example the Metallgesellschaft in Ger-

many or Barings in the UK. With the boom of global stock markets in the late 1990s, Continental

Europe experienced a tremendous change in the nature of its capital markets, with the entrance of

a large amount of private investors attempting to reap short-term gains off companies of which

they had only limited structural knowledge. It was only after the crash of global stock markets

and the recent spectacular bankruptcy cases of Enron and WorldCom that corporate governance

has reached the prominence it enjoys today.

Today, there is general agreement by investors that effective corporate governance is crucial for

the long-run success of a company. Institutional investors today agree that corporate governance

must play a prominent role in investment decisions. As James Wolfensohn, president of the

World Bank states: "The governance of the corporation is now as important in the world econ-

omy as the government of countries."

According to a vast array of conducted surveys in recent years, an increasing number of institu-

tional investors are including corporate governance standards and practices by the companies

they invest in into their investment decisions so as to protect their rights and interests as owners.

These investors realize that the financial risk they face may be strongly reduced by the govern-

ance structures implemented by companies. This remains especially valid in times of volatile fi-

nancial markets, as shown by the US examples of Enron and WorldCom mentioned above. Fur-

thermore, as an increasing amount of investors are stocking up on foreign shares, the need for a

Chapter 1: Introduction

detailed corporate governance analysis has reached a global scale. In Europe, this development

has been accelerated by the introduction of the Euro, providing a strong incentive for European

instead of national investment strategies. Nevertheless, governance practice varies strongly be-

tween European countries and companies, making it considerably difficult for investors to com-

pare European companies in terms of governance practice.

Another feature of corporate governance in which investors are strongly interested is its effect on

value creation. Even though corporate governance is not the sole contributor to value creation, its

presence may reduce the downside risk linked to the above problems. According to several sur-

veys performed by McKinsey & Co. (Three Surveys on Corporate Governance, The McKinsey

Quarterly, 2000), investors are willing to pay more for companies they perceive as well gov-

erned, especially in emerging markets. Even in Europe and the United States investors are appar-

ently willing to pay premiums of up to 22 per cent

. As Paul Coombes, a co-author of these sur-

veys states: "First and foremost is the notion that the real value of corporate governance lies not

in satisfying some code of best-practice principles, but rather in actually achieving a lower cost

of equity. If you can establish a degree of confidence in the investing community that the way

you're conducting your affairs is appropriate and sensible, it's likely that they will value your

shares more highly, which thereby reduces your cost of equity" (McKinsey & Co. Website,

26.11.2002). The question whether companies understand that the value for good governance is a

reduced cost of equity remains very much alive.

Whereas much research has been performed on the link between corporate governance and firm

value, mainly weak or non-existent relationships have been established. However, recent re-

search conducted by Gompers, Ishii, and Metrick (2001) establishes a significant negative corre-

lation between the amount of takeover defenses implemented by US companies and firm value.

Research by Byrd and Hickman (1992), Weisbach (1988), and Borokhovich, Parrino, and Tra-

pani (1996), to name just a few, attempt to link board membership and structure to agency costs,

with which they succeed. However, a direct relationship with firm value is either mixed or goes

in the opposite direction of the agency problems. Whereas these studies have all attempted to iso-

This is the average premium investors stated they were willing to pay for well-governed companies in Italy. The

average premium for the remaining countries lies at 19 per cent.

Chapter 1: Introduction

late the effect of certain governance criteria on firm value, there has been no research so far that

investigates overall governance performance in this respect. This aspiration would have repre-

sented an insurmountable project due to the existence of varying and numerous governance crite-

ria across nations. However, due to the increased amount of publications by institutional inves-

tors stating clearly their governance criteria for companies on an international basis, it is possible

to create a benchmark today that is both complete and internationally applicable.

This thesis therefore attempts to engage in answering the following thesis statement:

Does `good' corporate governance positively influence the value of European firms? Good cor-

porate governance is defined based on a rating standard developed by Deminor International, a

Brussels based consultancy firm, in cooperation with leading institutional investors and also tak-

ing into account national governance codes. The four key pillars by which corporate governance

is defined are:

Rights and Duties of Shareholders

Range of Takeover Defenses

Disclosure on Corporate Governance

Board Structure and Functioning

The thesis will be structured as follows:

Chapter 2 will begin by providing a general overview of what is inherent in the corporate gov-

ernance definition. Part one will discuss the foundation of corporate governance, namely the

agency problem

arising out of the separation of ownership and control by looking at transaction

conditions, incentive mechanisms and by looking at the economic importance of the subject. Part

two of the chapter will then focus on the definition of stakeholders and describe their relationship

with management through the concepts of corporate-, contractual-, and work governance. Part

three will investigate the impacts of a nation's cultural and legal history on corporate governance

practice as well as the effects of ownership structure.

In the course of this thesis, the terms agency problem, principal-agent problem as well as principle-agency theory

will be used interchangeably. All three terms refer to the same phenomenon, namely the problem arising between

principles and agents through the separation between ownership and control of the company.

Chapter 1: Introduction

Chapter 3 will deal with the construction of a governance standard on the basis of which all

companies in the sample are rated in their corporate governance performance. Each of the four

pillars mentioned above are assessed in terms of what they consist of, why they are relevant for

the standard and what recommendations companies must comply with to obtain a high rating

concerning these standards. For this purpose, the description of every pillar is divided into three

sections: first, a review of the academic literature concerning the topic addressed by the pillar is

provided. Next, the description of the pillar and the underlying best-practice recommendations

are discussed. Finally, the third section compares the rating basis of every pillar with several na-

tional and pan-national codes to explore whether significant differences exist.

Chapter 4 will then undertake a statistical analysis of the relationship between the established

corporate governance elements and firm value. More specifically, the objective of the chapter

will be to provide a statistically significant answer to the thesis statement on whether or not

European companies can influence their firm value by improving corporate governance perform-

ance.

Therefore, the first section will give an overview of the financial and corporate governance-

related data that will be employed in the statistical analysis. This overview will include a descrip-

tion of the sources as well as the relevance of the employed data. Then research questions will be

formulated presenting gradual steps in the analysis of the overall thesis question. After the data

has been investigated and specific research steps have been established, an OLS regression

analysis testing the thesis statement will be conducted. In this analysis, four null- and alternative

hypotheses will be formulated and tested. Both regression analysis and further statistical proce-

dures will be employed to determine the statistical influence of corporate governance on firm

value. The focus of the analysis will also include an overview of the interdependence amongst

the independent variables themselves. Finally, additional variables are added to the regression

model besides corporate governance determinants to increase the overall explanatory power of

the model.

Finally, chapter 5 will give insights on how corporate governance is dealt with in practice. More

specifically, a case study of Deutsche Wertpapier Spezialisten Investment Group (DWS),

Europe's largest Mutual Fund, will address strategic and financial issues concerning corporate

Chapter 1: Introduction

governance from both an investor and a firm perspective. The insights provided in this chapter

are based on an interview held with Mr. Christian Strenger, the former CEO and current supervi-

sory board member of DWS, who is also present in several supervisory boards of European

countries. This dual perspective will allow this chapter to not only examine corporate governance

requirements posed on firms by institutional investors, but also their feasibility and implementa-

tion within European companies. The thesis will then be concluded with the conclusion in chap-

ter 6.

Chapter 2: An Introduction to Corporate Governance

Chapter 2

An Introduction to Corporate Governance

This chapter will give an overview of what corporate governance actually is. Considering the

vast array of available academic publication on this topic, it is easy to get lost in details that have

evolved out of a long and tedious academic evolution. This chapter will therefore be structured

as follows:

Part one will discuss the foundation of corporate governance, namely the agency problem arising

out of the separation of ownership and control. First, it discusses transaction conditions, such as

asymmetric information, which are the source of the agency problem. Next, incentive mecha-

nisms will be reviewed that help align the interests of principals and agents. Part one is con-

cluded by putting the economic importance of the agency problem into perspective and giving an

intermediate conclusion.

Part two of the chapter will then focus on the definition of stakeholders and describe their rela-

tionship with management through the concepts of corporate-, contractual-, and work govern-

ance.

Part three discusses the remaining factors described by academia to have an effect on corporate

governance, namely a nation's cultural and legal history as well as the ownership structure

within its respective capital markets.

Finally, the chapter will conclude by providing a definition of corporate governance which will

be valid for the rest of this thesis.

2.1 The Agency Problem

In his book "The Wealth of Nations" (1776), Adam Smith describes the agency problem as fol-

lows: "The directors of such [joint-stock] companies, however, being the managers rather of

other people's money than of their own, it cannot well be expected, that they should watch over

it with the same anxious vigilance with which the partners in a private copartnery frequently

watch over their own" (page 700). Over 150 years later, Berle and Means (1932) describe the

risk of `corporate plundering' by selfish managers at the cost of widely dispersed owners, by de-

scribing that the dispersed ownership of modern corporations leads to relaxed monitoring of

management and thereby lead management to pursue goals that are contradictory to those of the

Chapter 2: An Introduction to Corporate Governance

owners of the firm. It was in the late seventies that Ross (1976) and later Jensen and Meckling

(1976) give a name to the problem identified by Adam Smith exactly 200 years before. Jensen

and Meckling define the agency relationship "as a construct under which one or more persons

the principle(s) engage another person (the agent) to perform some service on their behalf which

involves some decision making authority to the agent. If both parties to the relationship are value

maximisers, there is a good reason to believe that the agent will not always act in the best interest

of the principle." (page 57). For the principle to minimize convergence from his interests, he

must closely monitor management and create incentives so that the agent's interests are in line

with his own. Figure 1 visualizes the basic economics of the agency problem.

Figure 1: The economics of the agency problem

In this figure, it can be seen that that managers provide specialized labor in the form of manage-

rial services, which in turn are remunerated by the firm that employs them. Therefore the manag-

ers are considered agents that act on behalf of principals, who in most cases are equity owners. In

the principal-agent problem, the agents are employed by principals to manage the corporate re-

sources and are represented by top level officers or members of the board. In contrast, the princi-

pals are defined as those who control the agents and vote to employ the board of directors at the

Principals

The people controlling

management. Typically

equity owners

Agents

The administrators of

corporate resources: the

management

Financial Per-

formance

Incentive mechanisms

Such as managerial ownership

Production costs and

related inverse ef-

fects

Other kinds of transac-

tion costs and related

inverse effects

Inverse effects

Managerial transaction

costs

Flow of managerial services

Flow of managerial remuneration

Transaction conditions

Such as asymmetric information and risk aversion

Source: Matthieson (2002).

Chapter 2: An Introduction to Corporate Governance

annual general meeting. However, it should be emphasized that there are numerous examples of

firms in which the owners have practically no voting rights and are therefore irrelevant as princi-

pals in the principal agent concept. For example in Denmark, economically important coopera-

tives may pass on their voting rights to suppliers according to their yearly sales volumes. In this

case, the principal agency problem would be between the managers of the supplier cooperative

and the suppliers.

2.1.1 Transaction Conditions

The principal-agent problem is also characterized by a set of transaction conditions as shown in

Figure 1. For example, many economic models assume asymmetric information between princi-

pals and agents. Principals may not have the insight to assess the quality of managerial service

and therefore may not be able to monitor managers fairly. While the principals can monitor a

firm's financial performance, this is merely an imperfect measure of whether the agents are per-

forming well or not since it is determined by factors that do not necessarily have to do with

managerial effort and talent. It is therefore possible for managers to work less under the condi-

tion of asymmetric information than they would have done if the quality of their services was

fully transparent to both principals and agents. In other words, asymmetric information leads to

imperfect monitoring, which may allow for a lower quality of managerial services which in turn

causes managerial transaction costs. This prevents the firm's performance from being optimal,

which would be the case if information was symmetric.

The principal-agency problem is also characterized by transaction conditions other than asym-

metric information. It is particularly useful to distinguish between environmental and behavioral

conditions. In Figure 2 below, several of these conditions are listed in the box on the left,

whereas the box on the right lists ten relevant incentive mechanisms including ownership struc-

ture, and the middle box lists examples of associated managerial transaction costs. The objective

of Figure 2 is to point out that asymmetric information represents only one of several relevant

issues to the principal-agent problem. Considering the box on the left, it can be seen that the

other potentially important environmental conditions apart from asymmetric information include

the asset specificity of the firms' invested capital or the managers' human capital, the complex-

ity/uncertainty of the relevant incentive mechanisms, the difficulty of measuring the quality of

Chapter 2: An Introduction to Corporate Governance

managerial performance as well as the duration and frequency of the managers' relation with the

relevant principals. References to academic publications addressing the issues mentioned in

Figure 2 are given in Table 33 of the Appendix.

Figure 2: Examples of transaction conditions, incentive mechanisms, and managerial transaction costs

Table 33 also refers to the behavioral conditions mentioned in Figure 2. These behavioral condi-

tions play a key role when explaining the agency problem through economic models, since they

are the core reason for the incentive-misalignment. If for example managers would display a

selfless attitude instead of an opportunistic one, the managerial transaction cost would be negli-

gible. Furthermore, if both principals and agents were not restricted by limited rationality but in-

stead possessed perfect intelligence, contracts covering all contingencies could be written and

Bankruptcy System

Capital Structure

Creditor Structure

Decision System

Market for corporate con-

trol

Market for management

services

Ownership structure

Product market competi-

tion

Remuneration system

Incentive mechanisms

Environmental conditions:

Asymmetric information

Asset specificity

Complexity/uncertainty

Difficulty in measuring

Duration/frequency

Behavioral conditions:

Bounded rationality

Opportunism

Risk aversion

Transaction conditions

Excessive diversification

Excessive growth

Excessive risk taking

Free cash flow dispersion

Hampered capital access

Monitoring costs

Perquisite consumption

Pet projects

Power struggles

Replacement resistance

Resistance to profitable

liquidation or merger

Self dealing transfer pric-

ing

Managerial transaction costs

Source: Schilling (2003)

Chapter 2: An Introduction to Corporate Governance

transaction costs would be trivial. It should therefore be clear that some of these behavioral con-

ditions must be in place for the agency problem to inhibit serious transaction costs.

2.1.2 Incentive Mechanisms

Figure 1 also shows that the financial performance measures of the company are also closely re-

lated to incentive mechanisms, which again are relevant for the principal agency problem.

Whereas the effect of incentive mechanisms is straightforward, the arrows indicate that the com-

pany's financial performance may also inversely affect incentive mechanisms. Taking the exam-

ple of managerial ownership, it has been argued that increasing the stake of management's own-

ership will increase the incentive to maximize the company's financial performance and there-

fore decrease agency costs. However, the expectation of improved performance might induce

management to increase their ownership share so as to secure more money. Although it is one of

the most prominent aspects of incentive alignment, managerial ownership is only one of numer-

ous incentive mechanisms in the broad field of ownership structures including institutional inves-

tors, block-holder ownership as well as other ownership structures that relate to financial per-

formance. Figure 2 shows that there are many more incentive mechanisms affecting the agency

problem apart from managerial ownership. Although the description of all these mechanisms

would exceed the scope of this chapter, the reader should realize that the portfolio of available

incentive mechanisms is both vast and diverse.

Incentive mechanisms relate to financial performance because of their ability to influence the

managerial transaction costs, since it would otherwise be meaningless to call them incentive

mechanisms. Looking again at the example of managerial ownership, it is clear that if managerial

ownership would have no influence on the behavior of the manager, there would be no use in

terming it an incentive mechanism for the principal agency problem. To put it differently, incen-

tive mechanisms must be capable of influencing managerial economic behavior and thereby in-

fluence transaction costs. Furthermore, transaction costs may not only root in the economic be-

havior of the manager but may also evolve through running and operating an incentive mecha-

nism. A company should always keep in mind the cost-benefit balance between the costs of run-

ning an incentive mechanism system and the costs that are avoided by being able to monitor

managers more closely. Another example of an incentive mechanism that bears transaction costs

in excess of those that are related to better governance of managers is product market competi-

Chapter 2: An Introduction to Corporate Governance

tion (see Figure 2). It is said that fierce product market competition will reduce managerial slack

by making managers realize that without profit maximization, their company may go bankrupt.

Nevertheless, supervision costs of authorities to prevent violations of antitrust laws prevent

product market competition from coming naturally. All other incentive mechanisms apparently

only deal with transaction costs related to the system's ability to monitor the economic behavior

of management. It is for example more difficult to argue that there are significant costs combined

with `operating' the ownership structure of the firm. Although legislation generally governs cor-

porate ownership, authorities apparently do not have to apply significant resources to enforce

obedience.

2.1.3 Economic Importance

To define the economic importance of the agency problem, one must investigate both the fre-

quency of its occurrence within the economy as well as the impact the problem has on economic

performance. Due to the very thin layer of top executives, the principal agency problem cannot

be described as one of the most common agency problems. Agency problems also exist for in-

stance in the relationships between doctors or lawyers (agents) and their clients (principals) with

a much higher frequency. However, the extent to which managers of large multinational enter-

prises can harm the economy makes the principal agency problem on of the most economically

important. Recent examples such as the cases of abuse have shown that managerial misconduct

can lead to the wastage of billions of dollars. These enormous failures could maybe have been

avoided if proper incentive mechanisms had been in place. Less visible cases may also have a

strong negative impact, for instance if managers run a company with positive earnings for years

that are however below the firm's cost of capital. In other words, the potential economic impact

of any single principal-agent problem is much larger than the economic impact of most other

agency problems. Looking back at the case of the lawyer, he could cheat by working less on the

case than would be justified concerning the amount paid or relative to his reputation. Another

example could be that a doctor unrightfully extracts funds from health insurances by performing

unnecessary treatments. However, it seems obvious that the destructive potential of these cases

cannot be matched with that of the managerial agency problem. It is therefore reasonable to sug-

gest that the managerial agency problem is on of the most extensive in modern economies.

Chapter 2: An Introduction to Corporate Governance

2.1.4 Intermediate Conclusion

So far, this chapter has attempted to illuminate the concept of corporate governance by describ-

ing the fundamental problem of management supervision. Similarly, the Cadbury Report (1992)

describes corporate governance as "the system by which companies are directed and controlled"

(page 73). Also Adam Smith raised the question back in 1776 when he argued that the separation

of ownership and control provided poor incentives for managers to operate efficiently in the eyes

of the firm owners. However, because this classic incentive alignment argument has received so

much attention over the years, outsiders may be inclined to presume it is the only relevant argu-

ment concerning the topic of corporate governance. However, if the incentive argument were the

only problem, it would be puzzling to observe that the majority of companies in modern econo-

mies have dispersed ownership. Therefore the next step will be to look at further parties influenc-

ing corporate governance. The next section of this chapter will show that corporate governance is

not merely about shareholders and managers, but that numerous other parties have a significant

impact on corporate governance.

2.2 The Stakeholder Impact on Corporate Governance

Over a long period of time, the view proposed by Jensen and Meckling (1976) that the firm was

a black box whose sole purpose was to maximize profits (and thereby the present value of the

firm) was widely shared. However, recent academic focus has been more on the interrelationship

of conflicting parties within this black box to achieve value maximization. Jensen and Meckling

(1976) discuss not only the contractual relationships with management as being essential, but

furthermore mention competitors, creditors, customers, employees, suppliers etc. As mentioned

above, agency costs are not limited to the managerial agency problem, but can rather be found

within all these contractual relationships. Alchian and Demsetz (1972) emphasize both the role

of contracts as well as the role of monitoring as important in situations where there is a joint out-

put or team production. Blair (1995) describes all parties holding relationship-specific assets in a

firm which may be at risk as stakeholders. The main mentionable stakeholders are:

Managers:

they are the main decision-makers of the firm

Employees:

human capital providers

Shareholders:

either the owners or the providers of equity financing

Creditors:

suppliers of debt

Chapter 2: An Introduction to Corporate Governance

Suppliers:

providers of intermediate goods

Competing firms:

i.e. in the case of a joint venture

Customers:

i.e. those with long term purchase relationships

Due to the fact that each stakeholder has personally invested in the firm, it is their mutual interest

that the operations of the firm continue prosperously. However, continuity and prosperity are

perceived differently by stakeholders, as they bear conflicting interests. These conflicting inter-

ests arise out of the diverse nature of the relative goals and investments. Figure 3 provides an

overview of the different stakeholder relationships.

Figure 3: Stakeholder relations and governance structures

2.2.1 Corporate Governance, contractual governance, and work governance

As visualized above by Figure 3, there are three main governance structures that control the rela-

tionships between the different stakeholders: corporate governance, contractual governance, and

work governance.

As has been discussed in detail above, corporate governance describes the relationship between

management and financiers, shareholders and creditors, who do not necessarily pursue the same

goals. Creditors aim at being fully reimbursed for their investment, including both their initial

investment and the contractually stated interest. Their interest is for the firm to pursue a low risk

Customers

Management

Employees

Creditors

Shareholders

Suppliers

Competitors

Corporate Governance

Contractual Governance

Work Governance

Source: Gelauff and den Broeder (1997)

Chapter 2: An Introduction to Corporate Governance

strategy to avoid potential bankruptcy. Shareholders are less risk averse and benefit from premi-

ums, in the form of dividends or capital gains achieved through risky projects by the firm. Finan-

ciers must monitor management closely to make sure these act in their respective interests.

Contractual governance describes the relationship between the firm and its purchasers and sup-

pliers (Kester, 1992). The objective of contractual governance institutions is "to enable firms to

invest in bilateral relationships, which are beneficial to both parties, and thus to prevent expro-

priation of relationship-specific investments from one company to another" (Gelauff and den

Broeder, 1997, page 16). Firms can achieve this by investing in horizontal relationships with

competitors and vertical relationships with suppliers and procuring firms. The objective is for

two firms to invest in relationship-specific assets that make them mutually dependant on one an-

other. This mutual dependence will induce the companies to monitor each other to avoid that one

party reaps all the benefits from the investment in relationship-specific assets by cheating on the

other.

Work governance deals with the relationship between the managers and employees of a com-

pany. Once again there is a mutual interest of both parties to monitor one another. While man-

agement needs to monitor the work efficiency of employees, employees are also interested in

monitoring management due to their relationship-specific investment of human capital in the

company. The expected return on this investment by employees is the wage. If management does

not succeed in running the company efficiently, bankruptcy of the company could lead to the loss

of their job and therefore their wage. In contrast to shareholders, who have limited liability and

can diversify their risk by diversifying the portfolio they own, employees have invested all their

human capital in one firm and are completely liable. If the firm goes bankrupt, the employee

loses everything. Therefore employees have a strong incentive to monitor the actions of man-

agement.

In summary, management must adhere to the expectations not only of financiers (corporate gov-

ernance), but also to stakeholders such as suppliers and competing firms (contractual govern-

ance), as well as to employees (work governance). Only in the case where the incentives of all

these parties are aligned will the company be able to perform optimally.

Chapter 2: An Introduction to Corporate Governance

The following section will now take a look at the effects of nations' cultural and legal history as

well as the ownership structure of their markets on the way corporate governance is implemented

differently in different countries.

2.3 Culture, ownership concentration and law

Modern economies display a strong diversity in corporate governance structures, practices, and

participants, originating out of differences in law, cultural history, financial structures, as well as

diverse ownership patterns. This broad variety impedes the comparison of corporate governance

between nations. Nevertheless, a comparison of international corporate governance codes reveals

that the increased reliance on equity financing as well as the broadening international share-

holder structure have led to a common understanding concerning the important role that corpo-

rate governance plays today.

A vastly increasing amount of academic literature investigates the impact of national cultures on

corporate governance systems. Most noticeable is the distinction between markets seeking coop-

erative relationships and consensus versus corporate governance structures emphasizing market

processes and competition. The predominant examples for countries representing these structures

are the USA and the UK versus Germany and Japan. The former two countries are often de-

scribed as more market-oriented, with a higher emphasis placed on competition, whereas the lat-

ter are often described as co-operative and consensus seeking systems. Table 1 compares charac-

teristics of these two systems.

Table 1: Factors affecting corporate governance systems

USA, UK

Germany, Japan

Market culture

Market-oriented

Short-term strategy

Relatively more reliance on equity

Large stock exchange

Relatively smaller influence of con-

trolling shareholder(s)

Consensus culture

Network-oriented

Long-term strategy

Relatively more reliance on debt

Small stock exchange

Relatively larger influence of control-

ling shareholder(s)

Source: Fraser, Henry, and Wallage (2000)

Chapter 2: An Introduction to Corporate Governance

Ownership concentration is another factor strongly influencing both the characteristics of equity

markets as well as the contents of national corporate governance codes (Barca and Brecht, 2001).

In markets with widely dispersed ownership, managerial monitoring becomes more complicated

through the strong separation of ownership and control. These markets tend to be relatively liq-

uid, but the power, incentive, and capacity of small shareholders may be too small to effectively

monitor management. In theory, supervisory boards are introduced to bridge this gap between

ownership and control and monitor management. However, these supervisory boards must pro-

tect themselves against too strong influence of managers both because of their access to critical

information and/or domination of the boards themselves. Therefore, corporate governance codes

in these systems tend to focus on the capability of supervisory boards to maintain independence

and to encourage shareholder participation through voting.

On the other hand, in systems where certain rights of ownership are dispersed but control rights

are not completely separated from ownership, as when large shareholders or consortiums hold a

controlling stake, corporate governance codes shift their attention towards the fair treatment of

minority shareholders.

Finally, academic literature suggests that investor protection may be correlated with the origin of

a country's legal system (La Porta, Lopez-de-Silanes, Schleifer, and Vishny, 1998; Reynolds and

Flores, 1989). They base their theory on the `law and economics' perspective initially introduced

by Jensen and Meckling (1976). This perspective states that entrepreneurs bear the costs that in-

vestors place on them if they fail to contractually disclose information about themselves and treat

investors well, and are therefore willing to bind themselves through contracts with investors.

However, these contracts must be legally enforced, and this is where they see large differences

between countries. They continue by categorizing countries on the basis of four distinct legal

origins: the English, French, Scandinavian, and German origins. Countries with their legal roots

in the English legal system, such as the USA and the UK, run a common law system, whereas

the other legal origins have led to the implementation of the civil law system.

All these differences in financial, legal, and cultural attributes are catalogued in an attempt to

describe national approaches to governance. Table 2 gives an overview of the most common dis-

Chapter 2: An Introduction to Corporate Governance

tinctions in this aspect. These distinctions have also been used to distinguish different evolution-

ary stages of corporate governance. However, these overly broad distinctions risk having a blur-

ring effect as corporate governance continuously evolves. Whether describing models in opposi-

tion to one another, such as insider vs. outsider or Anglo-Saxon vs. Continental is valuable in a

dynamic discussion of corporate governance is questionable, since they tend to polarize this very

distinct topic.

Table 2: Typical Descriptions of Corporate Governance Models

Market-oriented

Outsider-dominated

Shareholder-focused

Anglo-Saxon

Bank-oriented

Insider-dominated

Shareholder-focused

Continental

According to Hansmann and Kraakman (2000, p. 443), "despite the apparent divergence in insti-

tutions of governance, share ownership, capital markets, and business culture across developed

economies, the basic law of the corporate form has [...] achieved a high degree of uniformity

and continued convergence is likely." Whether or not one agrees with this prediction, there is

observable uniformity concerning the basic elements of corporate governance and company law.

In summary, one can conclude that the internationally valid goal of corporate governance is to

equally protect all stakeholders so as to maximize a firm's economic potential.

It has been described in this last section that different cultural and legal backgrounds as well as

diverse capital market structures amongst countries have led to different developments in the

stakeholder and shareholder structures of these nations. The next section will go into detail on

how national corporate governance codes deal differently with their national differences and will

conclude by giving a definition of corporate governance, which will be valid for the remainder of

this thesis.

Chapter 2: An Introduction to Corporate Governance

2.4 Corporate Governance: A Definition

A comparison of the numerous national and transnational

corporate governance codes reveals

that the term is liable to both broad and narrow definitions. Most codes refrain from attempting

to articulate what is encompassed by the term. Table 3 below gives some examples of definitions

provided by corporate governance codes from both national and transnational sources.

Table 3: Definitions of Corporate Governance by National and Transnational Codes

"Corporate Governance is the system by which companies are directed and controlled"

(Cadbury Report, UK)

"`Corporate Governance' refers to the set of rules applicable to the direction and control of the

company"

(Cardon Report, Belgium)

"[Corporate governance is] the organisation of the administration and management of compa-

nies..."

(Recommendations of the Federation of Belgian Companies, Belgium)

"[Corporate governance is] the goals, according to which the company is managed, and the major

principles and frameworks which regulate the interaction between the company's managerial bod-

ies, the owners, as well as other parties who are directly influenced by the company's dispositions

and business (in this context jointly referred to as the company's stakeholders). Stakeholders in-

clude employees, creditors, suppliers, customers and the local community." (Nørby Report &

Recommendations, Denmark)

"Corporate governance describes the legal and factual regulatory framework for managing and

supervising a company"

(Berlin Initiative Code, Germany)

"Corporate Governance, in the sense of the set of rules according to which firms are managed

and controlled, is the result of norms, traditions and patterns of behaviour developed by each

economic and legal system..."

(Preda Report, Italy)

"The concept of Corporate Governance has been understood to mean a code of conduct for

those associated with the company ... consisting of a set of rules for sound management and

proper supervision and for a division of duties and responsibilities and powers effecting the satis-

factory balance of influence of all stakeholders."

(Peters Report, The Netherlands)

Transnational refers to codes produced by non-governmental and non-national interest groups such as the OECD,

the International Corporate Governance Network (ICGN) or the European Association of Securities Dealers, also

know as "Euroshareholders".

Chapter 2: An Introduction to Corporate Governance

"Corporate Governance ... involves a set of relationships between a company's management, its

board, its shareholders and other stakeholders. Corporate governance also provides the structure

through which the objectives of the company are set, and the means of attaining those objectives

and monitoring performances are determined."

(OECD Principles)

"Corporate governance comprehends that structure of relationships and corresponding responsi-

bilities among a core group consisting of shareholders, board members, and managers designed to

best foster the competitive performance required to achieve the corporation's primary objective."

(Millstein Report to OECD)

A common theme found in the majority of these definitions relates corporate governance to con-

trol, in the context of the company, corporate management or of managerial conduct. The Cad-

bury Report gives the simplest definition relating to control, as can be seen in Table 3.

Another common theme is that of supervision of the company or management. Corporate gov-

ernance is also frequently related to a legal framework, rules and procedures and private sector

conduct. Finally, the transnational codes tend to emphasize codes of good conduct between

shareholders, supervisory boards and managers.

For the remainder of this thesis, the definition given by the OECD principles code will be used to

describe corporate governance. The reason why the author has explicitly decided for this defini-

tion is it's independence of national influences and the fact that it mentions both shareholders

and stakeholders as key players in the concept of corporate governance.

"Corporate Governance [...] involves a set of relationships between a company's management,

its board, its shareholders and other stakeholders. Corporate governance also provides the

structure through which the objectives of the company are set, and the means of attaining those

objectives and monitoring performances are determined."

OECD Principles, Preamble, 1999, p. 2

Chapter 3: The Corporate Governance Rating Framework

Chapter 3 The Corporate Governance Rating Framework

The objective of this chapter is to establish a link between chapter 2, which discussed the general

economic theories behind the topic of corporate governance, and chapter 4, which will attempt to

quantify and subsequently value mechanisms companies have implemented to avoid the agency

costs discussed in chapter 2. The chapter will therefore be structured as follows:

As mentioned in the introduction, four key areas are identified as essential to bridging the gap

between principles and agents: the rights and duties of shareholders, the range of takeover de-

fenses implemented, the disclosure of specific information to shareholders, and finally the struc-

ture and functioning of a company's board. For each one of these categories, an overview of the

results of academic research is given. Furthermore, best practice recommendations by large insti-

tutional investors are given based on published codes by these investors as well as on continuous

surveys performed by Deminor Rating

. Finally, a summary of recommendations as spelled out

by national European corporate governance codes is given for every key area. As the chapter

proceeds, it will become clear to the reader that workable best practice recommendations for

corporate governance, which provide for a clear quantification of the often rather intangible cor-

porate governance criteria, can only be found in the best practice suggestions by institutional in-

vestors. The rating framework in chapter 4 will be based on all of the criteria discussed in this

chapter and will therefore not be biased due to specific subjective preferences of any sole institu-

tion.

3.1

Rights and Duties of Shareholders

This category within the corporate governance rating framework refers to the equal and unre-

stricted treatment of shareholders. The key issues discussed within this section will be the `one

share-one vote-one dividend principle', access to- and voting procedures at general meetings,

and the maintenance of preemption rights.

Deminor Rating is an independent institution specialized on the analysis of investor corporate governance require-

ments and the subsequent rating of European companies in terms of these requirements. The best practice recom-

mendations in this chapter have been formulated by the author on the basis of the rating data and the relative weight-

ings of these criteria within the rating framework provided by Deminor Rating.