In the corporate world of today, profit margins are shrinking in every industry and it is becoming increasingly difficult to retain one’s customers due to the phenomenal increase in competition levels, employees and their intellectual capital are difficult to retain by satisfying them both monetarily and psychologically, and the investors are becoming increasingly demanding over long-term and short-term gains. In such a scenario, appeasing the three main stakeholders in the firm, namely customers, employees and investors (Zenger et al, 1999) translates to nothing short of a highly complex balancing act.
One area of business management and operation, which directly relates to the inter-relationships between these stakeholders and which has attracted a great deal of attention in the recent past is Corporate Governance. This essay explains Corporate Governance in general, and the specific aspects associated to the American system of Corporate Governance. It goes on to critically assess the economic case for the American system of Corporate Governance, and the extent to which other non-American companies are adopting this form for their respective organisations.
Sir Adrian Cadbury, who chaired the committee on the Financial Aspects of Corporate Governance, defined Corporate Governance as ‘the system by which companies are directed and controlled’ (Cadbury, 2002). Geoffrey Owen (2004) explains Corporate Governance as a set of arrangements that ensure that the managers of a business act in a way that promotes the interests of its owners. It effectively deals with the institutionalisation of a system and a set of processes whereby investors are guaranteed a return on their investment commensurate with what they perceive to be an acceptable level of ROI. With the subsequent recognition of the role of other stakeholders (e.g. customers, employees, suppliers, etc.) in the attainment of organisational objectives, the definition of corporate governance has also been extended to cover these other vital cogs to the wheel.
A number of internal and external control structures exist, especially in advanced economies and markets, which ensure that organisations follow norms of corporate governance and monitor their performance against these norms (Schilhofer, 2003). The internal control systems typically constitute internal audits, effective oversight by the Board, and performance based rewards to managers (Mantsyaari, 2005). The external control systems can be in different forms, controlled by different entities and stakeholders, e.g. banks and other lenders use debt covenants (Hopt, 1998), external auditors and governmental regulations are exercised by regulatory authorities, competition and takeover threats constitute market-imposed controls, while the society at large plays a significant role through media coverage given to lapses in corporate governance (Milhaupt & West, 2004).
Corporate Governance – The American System
When the practices with respect to Corporate Governance across the industrialised countries of the globe are evaluated, two broad schools of thought can be traced. One is the more shareholder-centric form of Corporate Governance, which is the Anglo-American approach, observed predominantly in the US and the UK, and characterised by subordinating all other considerations to the primary objective of maximising shareholder wealth. The other approach is the relationship-based form of Corporate Governance, which is more prevalent across Asian countries and Continental Europe (Grandori, 2004). The main reasons for the emphasis on investors’ objectives over those of other stakeholders are:
Institutional investors: The institutional investors took on a major stake in most of the major American corporations, thereby increasingly exerting considerable influence over the running of the organisation (Hopt et al, 1993). This meant that a major stake in these corporations were in the hands of a few financial institutions, thereby leading to the threat of high quantum offloading of stocks by these institutions if they did not perceive the returns they got on their stakes to be commensurate with their expectations.
Internet Investors: Revolutions in the buying and selling of stocks, the derivative products which are contingent on, and also determine the price of stocks and the rise of the casual participant or the ‘Internet investor’ has also been observed over the past two decades (Morck, 2005). However, most of the stock held by the Internet investor is still in the form of mutual funds or other sophisticated products, as against direct participation in the stock market, which means that the dependency on the institutional investors mentioned above still persisted, with a further increase in market liquidity. This further exacerbated the need to appease the needs of these major shareholders for a company to retain its stock value in the market.
Takeover threats: The emergence of takeover threats by ruthless corporate raiders, who would buy badly performing firms and break them up and sell the constituents in the market, or impose their own systems in a bid to revive the company also poses a cause to ensure that shareholders are satisfied with the company performance and do not sell out to a hostile bidder (Sherman & Chaganti, 1998).
Differences between the two forms of Corporate Governance
The difference between the Anglo-American approach to Corporate Governance and the Asian approach is summarised in the points below:
Shareholder v/s relationship based – The Anglo-American model places a very high premium on shareholder value and the interests of all other parties are subordinated to those of the shareholders. On the other hand, the approach to Corporate Governance in continental European countries like Germany and the Asian countries is much more relationship-based, where organisations are more closely held by families and the lenders forge close relationships with these companies to provide the capital, instead of relying predominantly on the stock markets for infusion of fresh capital. The table in Appendix 1, which indicates ownership gradations of companies across US, UK and other European countries, highlights this difference. As can be observed, most of the UK and US companies are widely held, while family control is fairly widespread among companies in continental Europe (Enrique & Volpin, 2006).
Radical v/s incremental measures – By virtue of being designed to cater primarily to the needs and expectations of the investors, the Anglo-American approach to Corporate Governance tends to call for radical measures, while the relationship based version relies on stability enhancing incremental innovations (Beck et al, 2005). This is also evidenced empirically by the incremental progress made by Japanese companies over the past few decades, as compared to radical measures having been taken by American companies (Ibata-arens, 2005).
Focus on cost v/s quality – Focus on the bottom line in order to maximise shareholder returns translates to a higher level of cost-consciousness within American corporations, as any reduction in costs would increase profits, and hence the returns earned by investors. On the other hand, the relationship model is based more on trust and integrity among various stakeholders, including customers, suppliers, employees and the society at large.
Liquid markets – One of the pre-requisites to the American version of Corporate Governance is high levels of market liquidity. This enables the major shareholders, often the financial institutions to get in and out of stock positions, depending on their perception of the company’s performance, thereby exerting an influence over the company’s actions as well.
The economic rationale for the American Corporate Governance
Need for capital to expand operations – Economic growth is interminably linked to enterprise and increase in business activity, which in turn is fuelled by infusion of fresh capital from stakeholders. This presents a highly pertinent case for the American system of corporate governance, glorifying the role of the shareholder and placing their expectations above others.
Development of markets to ensure liquidity – As mentioned earlier, one of the precursors to effective Corporate Governance the American way is to ensure market liquidity within the stock markets. This higher level of liquidity in the markets in turn encourages trading and investment in stocks, thereby further enhancing commercial activities and supporting the economy in general.
Flux of other companies towards the Corporate Governance the American way
Attracting foreign capital – The developing economies of the world are in constant need of fresh capital to maintain and improve their GDP and revenue growth rates. The exceptional growth rates in these countries, mainly the BRIC (Brazil, Russia, China, India) countries as compared to the relatively mature economies where growth rates present unprecedented expansion opportunities to these businesses. However, the limited access to resources that the families owning the prominent businesses have and the prohibitive interest expenses and high leverage associated with taking on too much debt mean that this capital has to be sought from the markets.
As the bulk of the capital that is available for investment across the world is controlled by financial institutions directly or indirectly, i.e. trading on their own or on behalf of their investors and clients (customers of pension, insurance and mutual fund products), the first port of call for these companies soliciting capital is the financial institutions. This makes a case for and explains the ongoing phenomenon of developing countries moving away from relationship-based governance to a more Americanised form.
Ensure safety of shareholders’ investment – Further, the Governments of these countries, especially India and China have acknowledged the need to modernise their financial systems (Owen, 2004), by putting in place standardized rules and regulations protecting the shareholders, overseeing the financial markets and ensuring transparency in sharing financial information. This accords higher power to the investor as compared to other organisational stakeholders, thereby signalling a move towards the American system of corporate governance.
Globalisation – The globalisation of businesses has also reinforced the American form of Corporate Governance. Among historic cases, a striking transition from the relationship-based form to the shareholder-oriented American form of Corporate Governance can be observed in HSBC. Once the biggest bank in Hong Kong, and a proponent of the relationship model of Corporate Governance, it has since taken over the Midland Bank in the UK and shifted its Global Headquarters to London. This has been accompanied by a marked transition towards the American form of governance, which is also evidenced by the fact that the Group Strategy for the five-year period between 1998 and 2003 revolved around ‘Managing for value’ and maximising shareholder value (wikipedia, 2006). A more recent example of globalisation is the India based Tata Group and their bid for Corus, a steel plant in the UK. Such bids could not be successful without the support of the shareholders, thereby elevating the importance of this group against other stakeholders in the organisation.
Employee Stock Options – One of the tools that was used effectively by the American companies to win over employees and managers onto the stockholder bandwagon was Employee Stock Options. Over the past ten to fifteen years, there has been a marked incidence of stock options being used as an effective tool to align the interests of employees to those of shareholders in countries like Singapore, Hong Kong and India as well.
On the other hand, there is a case for not moving towards the more ruthless American form of corporate governance in a number of these countries. To illustrate, in a country like India or China, which are high population areas, the political connotations of a capitalist setup where the shareholder is king could be disastrous. For example, the preference of the shareholders could be gross automation of most of the business processes, thereby retrenching labour and leading to problems of unemployment and increased poverty, which would not be suited to economies with a higher population density. Further, the shareholder orientation would also be in conflict with the protectionist regimes that still exist in a number of industries within these countries, where high import duties and sales restrictions characterise the tendency to protect domestic industries from foreign competition.
Finally, even in case of other developed countries in continental Europe such as Germany, who are proponents of relationship-based governance, there is a marked preference to stick to the conventional form of governance, as it is known to aid managerial decisions that are more beneficial in the long term and stand the company in good stead over a longer time horizon as compared to the American form of governance.
Following a critical analysis of the American form of Corporate Governance and the movement of other economies towards this form of governance, it can be observed that there is a marked convergence towards this form of governance, with especially the new economies of developing countries moving from a relationship-based governance to the American system. However, the existence of country-specific idiosyncrasies means that the transition would be a gradual one and not a radical transformation.