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
i
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
ii
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
1
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
2
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
1
. 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-
1
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
3
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
2
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.
2
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
4
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
5
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
6
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
7
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
8
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
9
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
10
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
11
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
12
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
13
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
14
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
15
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
16
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
17
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
18
2.4 Corporate Governance: A Definition
A comparison of the numerous national and transnational
3
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)
3
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
19
"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
20
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
4
. 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.
4
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.
Ende der Leseprobe aus 117 Seiten
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- , 2003, Does Corporate Governance Affect Firm Value?, Hamburg, Bedey Media GmbH, https://www.diplom.de/document/222200
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