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In response to accounting scandals such as Enron and WorldCom, corporate governance has become a highly discussed topic among researchers in the last decade. Some of them argue that laws and regulations need to enforce corporate governance in order to protect shareholders and to improve the functioning of the free market by attracting money. The other view on corporate governance is that other stakeholders, such as employees, should be protected in order to have an equal division of wealth within a nation, which should be achieved by government and other institutions' interventions. This paper will provide an overview of these different views on corporate governance. It can be found that the different views towards what corporate governance should entail are reflected in a division between countries one the one hand that protect shareholders interests and countries on the other hand that protect all stakeholders and the nation as a whole. In this paper, several classifications of corporate governance systems will be provided, ranging from stakeholder vs. shareholder, to market-centered vs. bank-centered, to European vs. Anglo-American corporate governance. Tools will furthermore be presented to classify countries into these different types of corporate governance systems. Finally, implications will be given for potential investors when seeking to invest in countries with different types of corporate governance.
Corporate governance is, since the Enron and WorldCom scandals, a highly discussed and researched topic. While the United States responded to these scandals by the mandatory regulation of corporate governance under the Sarbanes-Oxley act, other countries have not enforced any laws, but rather promote an enabling regime towards corporate governance (Anand, 2005). As with countries, on the one hand there are scholars that stress the importance of the protection of shareholders and the improvement of the functioning of the free market. On the other hand there are scholars that argue for the importance of intervention by the government and the protection of other stakeholders, such as employees. Since corporate governance is a topic that is currently still being researched and academic views on the topic differ, this paper will not be able to identify one conclusive model or one conclusive framework that comprises the 'best' corporate governance system. Rather, this paper will try to provide different aspects of the literature on corporate governance and the critiques and limitations expressed towards these different views. Due to the constantly changing views on corporate governance, this paper will provide a guideline of current and previous views of which an own opinion can be developed by the reader as to what view would be most practical for comparison between countries.
In order to give an overview of corporate governance, a definition has to be provided as to what corporate governance actually comprises. However, there is quite some ambiguity regarding the definition of corporate governance and most definitions provided in academic papers are rather broad or vague. There is furthermore a division between definitions that stress the role of shareholders in corporate governance, assuring to obtain their money, and definitions that relate to the role of institutions in assuring that the money is spent well for the country as a whole. Definitions related to shareholders can be found in the articles by La Porta Lopez-de-Silanes, Shleifer and Vishny (2000): 'Corporate governance is, to a large extent, a set of mechanisms through which outside investors protect themselves against expropriation by the insiders' and Aoki (2001) 'Corporate governance relates to the structure of rights and responsibilities among the parties with a stake in the firm' (as cited in Aguilera, Filatotchev, Gospel, and Jackson, 2008: 475). Definitions that stress the role of institutions can be found in the articles by Judge and Naoumova (2004) 'The term corporate governance is used in a broad sense to refer to all mechanisms used to order and arbitrate the economic interests of shareholders, lenders, managers and employees' (p. 303), Martynova and Renneboog (2010) 'corporate governance system is a broader concept than corporate governance regulation and covers a broader set of institutional settings typically characterized by the quality of legal protection of corporate constituencies, concentration of ownership and control, and the development of capital markets' (p. 7), and Judge, Douglas, and Kutan (2008) 'The corporate governance system refers to one of the means by which a nation channels corporate power for the good of society so that wealth is created efficiently and distributed fairly within a national economy'. García-Castro, Ariño, Rodriguez, and Ayuso (2008) provide two definitions of corporate governance, with which they exactly illustrate this division between the different academic views. 'CG deals with the way in which suppliers of finance to corporations (mainly the shareholders) assure themselves of getting a return on their investment' and 'CG is the design of institutions that induce or force management to internalize the welfare of stakeholders.' This paper will use the following, self-developed, definition of corporate governance, since this seems to be the most complete: Corporate governance is the way in which the behavior of firms is monitored and controlled by the legal system, its shareholders, its employees, and the firms' own sense of 'doing good'.
Corporate governance has been linked to several beneficial outcomes for the economy of a country. According to Martynova and Renneboog (2010), 'Corporate governance is found to be beneficial for economic growth, the development of markets, and the governance of firms'. Hillier Pindado, de Queiroz, and de la Torre (2011), argue that 'country-level corporate governance facilitates firm-level investment in research and development' and 'countries with strong governance structures will facilitate the availability of external financing for R&D investment'. Besides this, 'It is important to have a sound corporate governance system, in order to be attractive for foreign, but also domestic, investors. The better protected the rights of the investors are and the more international agreements a country is part of, the higher the relative attractiveness of the country for investment' (Judge & Naoumova, 2005). Besides the fact that there need to be good governance, the information provided should also be transparent and trustworthy, because 'investors need assurance the good governance will oversee the collection and reporting of reliable information' (Starobin and Belton, 2001 as cited in Judge and Naoumova, 2005). A study by Black (2001) furthermore found that a one standard deviation improvement in a firm's governance ratings translated into an eightfold increase in market potential. Martynova and Renneboog (2010) argue that corporate governance is needed because mandatory rules on disclosure will allow for an optimal economic outcome. Since companies cannot profit anymore from expropriation, there will be a higher level of competition and this will cause a better distribution of wealth. Besides that, corporate governance affects to a large extent the availability and cost of capital for a firm, its performance, and the way profits are distributed between the firm's stakeholders: shareholders, creditors, employees, consumers, and suppliers. If a country has a weak legal system and a low level of legal enforcement, money will be allocated inefficiently, firms will be unable to compete internationally and due to a lack of investment, the economic development of that country will be obstructed. For investors it is important to assess the differences between the corporate governance systems, and also the enforcement thereof, because it affects the degree of expropriation risk investors face. If the level of corporate governance or the enforcement of corporate governance is low, the expropriation risk is high, and the chance of losing money increases.
This paper will fist first describe the theoretical framework on which corporate governance is based and address the different classifications there are regarding corporate governance systems. Then, practical tools will be provided that are useful for comparing countries on their corporate governance system in order for investors to make a sound decision as to which country to invest in. Lastly, a conclusion will be provided with recommendations towards investors on how to compare countries on differences in corporate governance systems.
The theoretical framework on which corporate governance is based has changed over the years. Earlier papers focus on the importance of the agency theory in the context of corporate governance. These authors state that corporate governance is necessary to overcome the agency problems corporations face. More recently some critique has been expressed towards the agency theory and new approaches on corporate governance have been developed. Another issue is that previous literature was more focused on the role of the legal system in regulating corporate governance. Recent studies have found forces for the regulation of corporate governance beyond the legal system. This section discusses these movements and provides the different classifications of corporate governance systems as present in the literature.
Agency theory is based on the principle that there are two parties involved and one party acts on behalf of the other party (Otten and Wempe). In the case of corporate governance, the agency problem arises between the shareholders and the management. The problem is that the management acts on behalf of the shareholders, but the management usually tries to pursue its own interests rather than the interests of the shareholders, and due to a lack of information on the side of the shareholders they are unable to notice until it is too late. Martynova and Renneboog (2010) state that the reason corporations face agency problems is because of their separation of ownership and control. The ownership is in the hands of the shareholders, while the control is in the hands of the management. Martynova and Renneboog (2010) thus argue that the main function of corporate governance regulation depends on the degree to which ownership and control are concentrated. In countries where ownership and control are dispersed, the function of corporate governance is to protect shareholders from being expropriated by the management, while in countries where ownership and control are concentrated, the function of corporate governance is to minimize the extent of agency problems between majority and minority shareholders and that between shareholder and creditors. If ownership and control are concentrated, majority shareholders have more power than minority shareholders and shareholders have more power than creditors. Therefore, creditors will have the weakest position and thus the highest risk of being expropriated.
Agency theory furthermore assumes that actors behave fully rational, according to stable risk preferences, and to maximize their self interest (Otten and Wempe). The critiques that have been expressed towards agency theory is that it simplifies, it is predisposed with dominant normative foundations (the before-mentioned assumptions of agency theory), and it shapes the contemporary way of thinking about corporate governance in that it 'neglects the institutional conditions and social relationships in which contracts are made up' (Otten and Wempe). Aguilera et al. express similar critique towards agency theory in corporate governance. They contend that agency theory is 'under contextualized' and thus unable to compare and explain the different corporate governance systems in diverse institutional contexts. They furthermore argue that implications for good corporate governance are too much based on a universal best practice, while the context should be taken into account and these universal best practices need to be adapted to the diverse national institutional contexts. They argue that 'most of the empirical literature has attempted to understand corporate governance in terms of agency theory and explored links between different corporate governance practices and firm performance. This literature assumes that, by managing the principal-agent problem between shareholders and managers, firms will operate more efficiently and perform better.'(Aguilera et al., 2008: 475) According to them, this closed system view does not devote attention to the distinct contexts in which firms are embedded. Therefore, they try to combine the theory on corporate governance with organizational theory. They argue that stakeholder theory or a comparative institutional approach would be a more appropriate foundation for corporate governance.
Corporate government: enforcement through legal system or not?
The work of La Porta, Lopez-de-Silanes, Shleifer, and Vishny (2000) is an article that has been cited as well as criticized by many authors in the field of corporate governance (Anand, 2005; Bebchuk & Weisbach, 2010; García-Castro et al., 2008; Hillier et al., 2011 Johnson et al., 2010; Judge et al., 2008; Martynova & Renneboog, 2010; Morck & Jeung, 2009; Pendleton, 2009; Pochet, 2002; Veen & Elbertsen, 2008). La Porta et al. emphasize the legal system instead of the financial system in order to explain the deviations in corporate governance systems between countries. As they state: 'Traditional comparisons of corporate governance systems focus on the institutions financing firms rather than on the legal protection of investors' (p. 17). They argue that 'to a large extent, potential shareholders and creditors finance firms because their rights are protected by the law.' The main problem they identify in their study is the principal-agent problem, which means that insiders use the firms' profits to benefit themselves, through for example empire building, while not returning any money to outside investors. They furthermore focus on the expropriation of shareholders by 'insiders' (managers and controlling shareholders) and not by other forces (e.g. political hazards). La Porta et al. have developed a tool that enables investors to compare institutional environments across countries and to assess the different effects of corporate regulation. The tool comprises a country classification by legal origin and indices that characterize the quality of regulatory provisions covering the protection of corporate shareholders and creditors, as well as law enforcement (the tool will be discussed in section 3, practical tools). The main critique that has been expressed towards the work of La Porta et al. is that the indices they developed are static and refer to national legal environments in 1995. Since then, countries have had reforms in their corporate legislations. They furthermore 'opt for the US corporate law as the reference legal system and identify the key legal provisions in the governance of US companies' (Martynova & Renneboog, 2010). They thus measure if legal provisions from the US corporate governance system are present in the laws of other countries. In that way, countries that have legal systems similar to that of the United States will have the best scores for corporate governance. Another issue with the work of La Porta et al. is that it states that the only way of enforcing corporate governance is through the legal system. More recent studies have found that there are other incentives for the adaptation of good corporate governance. Anand (2005) argues that firms have incentives to adopt corporate governance practices without being in place any laws to do so. She states that a corporate governance regime that is not wholly mandatory will yield a higher level of compliance at lower costs. With the agency theory in mind, mandatory corporate governance is essential, because of its protection for investors. Anand, however, argues that if countries adopt an enabling regime with mandatory disclosure of a firm's governance practices, this might be just as effective as and less costly than a mandatory regime. She based her arguments on earlier theories of voluntary environmental compliance. As she states:
'Several studies show that a threat of mandatory environmental regulation can be one reason behind a firm's decision to reduce its pollution levels. For example, Khanna and Damon demonstrate that voluntary programs to control pollution are likely to be successful because firms participate out of rational economic self-interest, seeking to avoid high costs of compliance in the future under a mandatory regime. Voluntary programs can thus be considered a means to forestall more costly mandatory regulation.'
She furthermore argues that in order to attract investors, which is of course the aim of firms as they want their stocks' value to increase, they will have to comply with the level of corporate governance excepted by potential investors and disclose all information to guarantee transparency and risk minimization for investors.
Different classifications of corporate governance
Almost all authors try to make a classification of different types of corporate governance. These classifications are rather similar, even though presented under different names. Overall it can be seen that there are two types of corporate governance present in the literature, mainly based on the type of law existent in the country. The classifications are respectively stakeholder vs. shareholder, bank-centered vs. market centered, and European vs. Anglo-American and the corresponding legal systems are respectively civil vs. common law. Judge et al. (2008) actually shows that countries classified according in the Anglo-American corporate governance system are based on common law and countries classified as having a European corporate governance system had a legal system originating from civil law (see appendix A). The different classifications will be discussed briefly and then the similarities of the systems will be distinguished.
Stakeholder v Shareholder model
García-Castro et al. (2008) argue that corporate governance can be classified into either a shareholder (outsider)-centered model or a stakeholder (insider)-centered model:
'In the outsider or shareholder-centered model of CG, the nature of interactions is transactional. That means that agents' interactions are assumed to be frozen in space and time and isolated from any institutional context. The outsider model of CG relies on the strength of markets - both capital and labour markets - to allocate resources correctly within firms and also on high-powered incentives and external control systems to discipline and align managers' interests. On the other hand, in the internal or stakeholder-centered model of CG, the interactions between the agents are assumed to be defined by formal and informal rules developed over the relationship's history. Some of these rules, given their informal nature, affect the actors' behaviour, not because of extrinsic rewards or punishments but because they have been internalized in a socialization process' (p.262)
Pendleton (2009) argues as well that corporate governance systems can be classified into two types. The first type of system is characterized by market forms of co-ordination between shareholders and managers and the second type of system is characterized by relationships between key actors. These can be compared to respectively the outsider and insider model of corporate governance.
Bank-centered vs. market-centered corporate governance
In bank-centered corporate governance, one main bank finances and governances a firm, while in market-centered corporate governance, a firm is financed by a large number of investors and takeovers play a key corporate governance role. Aoki and Patrick (1993) and Porter (1992) argue that bank-centered corporate governance allow firms to make long-term investment decisions. Banks furthermore avoid major financial distress, because they provide finance to firms with low liquidity. Besides this, there will be no expensive takeovers when things go wrong, instead the bank performs an intervention. However, in need of larger reorganizations, banks are not able to solve the problems that firms face with large loans.
Thus, in case of an economical downturn, market-centered corporate governance is better able to deal with insolvent firms (La Porta et al., 2000).
European vs. Anglo-American corporate governance
Judge and Naoumova (2005) define two types of corporate governance. The first is Anglo-American in form, which means that the state has minimal involvement, while the rule of law and market govern private enterprises. The problem with this approach is, according to them, that there is a lag between the legal system and the actual practices. The second type they define is the Western European governance form, which implies that there is more government control, with a higher level of protection for other stakeholders, such as employees and not just shareholders as is the case in the Anglo-American governance form. The Anglo-American form of corporate governance is similar to the shareholder and market-centered model and the European governance form is similar to the stakeholder and bank-centered model.
According to Clarke (2007) the diversity in corporate governance comes from differences in cultures, ownership patterns and law. He classifies the types of corporate governance into firms that are controlled through equity or controlled through debt. He distinguishes more than just the two types of corporate governance (Anglo-American and European). Instead he argues that Anglo-American is split into two types. Anglo bases its corporate governance on principles and voluntary compliance with the relevant corporate governance code or explaining why the code is inappropriate, while the American type bases its corporate governance on rules and mandatory compliance with the law or else they will face penalties. Next to the European type of corporate governance, which is similar to that of other authors, he distinguishes an Asian-pacific type of corporate governance, which in other models is included in the European type of corporate governance, but the difference he distinguishes is that in the Asian-pacific region, large businesses are often family-owned or state-owned and therefore corporate governance is more complicated. An in-depth discussion of this type of corporate governance is beyond the scope of this paper, but it should be mentioned that Clarke is one of the few authors that takes into consideration the Asian-pacific, because most authors focus solely on the Anglo-American and the European models.
In conclusion, it can be stated that stakeholder-based, bank-centered, and European corporate governance have, even though based on different institutions (respectively labour, financial, and legal institutions), similarities in that they are all based on informal rules, rather than the law, and there is more government and institutional intervention and less reliance on the working of the market for the enforcement of corporate governance. This type of corporate governance is furthermore more often present in countries with a civil law origin. Shareholder-based, market-centered, and Anglo-American corporate governance are similar on the fact that they rely on the legal system and the functioning of the market. This type of corporate governance is more often present in countries that have a common-law origin. The tools to assess which country belongs to which type of corporate governance, can be found in the next section.
This section will outline different tools in order to be able to compare countries on their type of corporate governance system. It will provide an overview of different tools that might be used complementary to each other or the reader can pick the tool that is best suitable for the countries he wants to compare, since none of the tools provide numbers for all countries in the world and especially developing countries are underrepresented.
The first tool comes from La Porta et al. (2000). They stress the importance of the role of the legal system in corporate governance and therefore divide countries into different legal families, as appendix B shows. These legal families, Common law, French civil law, German civil law, or Scandinavian countries, all have different levels of legal protection for investors. Common law countries have the highest protection for investors (both shareholders and creditors) and French civil law countries have the lowest protection. The quality of the law enforcement (as measured by efficiency of the judiciary, level of corruption, and the quality of accounting standards) is also an important aspect in appendix B The quality of the enforcement of law is, unlike legal rules, related to the level of economic development in a country and of high importance to investors, because if the regulations regarding corporate governance will not be enforced, the level of corporate governance in itself will be useless.
Martynova and Renneboog (2010) have developed a corporate governance index to assess the degree of protection for shareholders, minority stakeholders, and creditors, based on the work of La Porta et al. (2000). This index is based on several dimensions that can be found in appendix C. This tool can be useful for investors, because it can compare two countries easily. This is, of course, if the data on the countries is available, because the downside is that the numbers are only given for the United States and 30 European countries (for the data see appendix D). This implies that for any other country, the numbers still need to be calculated. This calculation might be difficult to perform, because if a country has a dimension that balances more or less in the middle, the calculated numbers will be subject to the interpretation of the investor and might not allow for an objective measure. The tool might also be unsuitable for non-Western countries, because the dimensions included might be biased towards the Western way of doing business. In other non-Western countries other aspects might also have an influence in the protection of investors. For example, the level of corruption (or political hazards) is not taken into account when indicating the level of protection of shareholders, while this might be an important aspect to take into mind in less developed countries, because of its implications of increased risk for investors. If corporate governance has to be enforced by the government, but the government is highly corrupted, the possibility of financial statements not being correctly represented is high, and therefore the corporate governance in itself is unreliable. If there are laws and regulation on corporate governance, but they are not enforced, then the corporate governance in itself is useless. A study that does take into account the limitation of the study by Martynova and Renneboog is the research by Judge et al. They indeed state that 'most studies of corporate governance are largely ethnocentric and predominantly Anglo-American'. They furthermore do take into consideration the level of corruption a country faces. They found that corruption was negatively correlated with governance legitimacy.
A study that also takes into account data on the corporate governance of other countries besides Western countries is the work of García-Castro et al. Their work provides a tool to assess whether a country has a stakeholder or shareholder-based corporate governance system. In order to assess whether a country was shareholder or stakeholder centered countries were plotted on a matrix with on one side the corporate governance index and on the other side the labour management index, the scores for the countries on the labour management index and the corporate governance index can be found in appendix E. The final overview matrix of the countries and their classification into either an insider or an outsider model of corporate governance can be found in appendix F.
This paper has tried to develop an overview of corporate governance and its differences between countries. The different views on corporate governance presented in this paper could be divided into two distinctive groups. One group represents scholars that base their theory of corporate governance on agency theory. They argue that the main problem investors face is expropriation due to a separation of ownership and control. Investors have no control over how their money is spent and therefore the role of corporate governance is to minimize this expropriation risk as much as possible, for example through legal regulations. These academics view the optimal corporate governance system as the systems that have been classified by scholars as shareholder-based, market-centered or Anglo-American. The other group of academics bases their theory of corporate governance not only on agency theory, but they try to look beyond that and take context into account. They argue that corporate governance's main goal is to divide wealth equally within the nation in order to increase overall economic development for a country. They stress the role of the government and institutions to provide more informal regulations in order to protect all stakeholders. This group furthermore contends that firms adopting corporate governance will eventually have a comparative advantage, because they will be better able to attract investors. For this group, the optimal corporate governance system is the system that has been classified as stakeholder-based, bank-centered, or European.
As this paper shows, there is no conclusive answer to the question which corporate governance system is preferred for an investor. It seems as if investors are better protected by a shareholder, or Anglo-American system of corporate governance, because in those countries laws are enforced to protect shareholders. However, countries that have a stakeholder based corporate governance system are more concerned with the nation as a whole and in wealth maximization for the entire country. Eventually, this will also be profitable for the investment made, because the whole country is profiting from an increase in wealth and not only a few powerful players. Therefore, there is no optimal corporate governance system, but more important is the enforcement of the corporate governance system in a country. Laws will not have much effect if they are not enforced due to for example corruption. It is furthermore important to assess who have an interest in having a weak corporate governance system. La Porta et al. (2000) for example argue that in order to reform corporate governance, legal, regulatory, and judicial reform is needed. They state that governments are often reluctant to introduce laws to protect investors, because it will decline their own regulatory control over large corporations. Families that control large corporations also show intense opposition to increased investor protection, because it will decrease their possibilities to expropriate. Of course, in absence of legal regulations regarding corporate governance, individual contracts can be made. However, as La Porta et al. indicate, individual contracts between the investor and the firm may not work, because the courts that have to enforce those contracts are often subject to political pressures and corrupt. Conversely, governments, once realizing the importance of good corporate governance for the economy of a country, can also have a major influence on the way corporate governance is transformed into a sound system. This sound system can mainly be recognized by financial transparency, effective methods for violations of corporate law and the enforcement of the resulting judgments (Judge and Naoumova, 2005). This thus has not much to do with how the corporate governance systems are classified, but rather with how they are enforced.
Since this paper only deals with the corporate governance system of countries, it is suggested to also consult papers that deal with for example institutional differences and the level of corruption in different countries, since this affect to a large extent whether and how corporate governance systems are executed properly. According to Judge and Naoumova (2004), 'the more corrupt the country is, the more attention it pays to protectionist laws', which means that a country will try to avert foreign investment and interference. Besides this, only a combined analysis will provide a potential investor with a full picture of the market and environments in different countries and therefore it is suggested to look at other papers that develop tools to compare countries on more dimensions.