Question

1. The insignificant relationship between a firm’s corporate governance mechanisms and performance is only because of the theoretical and methodological choices, and/or demographic data. Critically evaluate the above claim with discussions on the research findings of some recently published research papers in this area.

Answer 1

Corporate governance has been an important research area, which deals with the various governance arrangements used to control the corporation within the objective of maximizing shareholders (owners) wealth. A literature review reveals this importance, and highlights problems with conflict of interest between shareholders and the management (Jensen and Meckling, 1976). When there are asymmetric information problems and imperfect contractual relations between managers and shareholders, managers have incentives to pursue their own objectives at the expense of shareholders. For example, managers might implement financial and investment strategies or may spend more on luxury projects for their own interests rather than increasing the value of the company. Furthermore, this conflict may result in transfer pricing, whereby assets of the company that they manage are sold to another company that they own below the market value.
Effective corporate governance should fundamentally guarantee shareholders' value by ensuring the appropriate use of firms' resources, enabling access to capital and improving investor confidence (Denis and McConnell, 2003). This is related both to internal organisation and external market conditions; firm‘s responsiveness to external conditions is largely dependent on the way the firm is managed as well as the efficacy of the firm‘s governance structure (Gregory and Simms, 1999). Some authors (e.g. Rwegasira, 2000; Nam et al., 2004) have argued that good corporate governance prevents the expropriation of company resources by managers, ensuring better decision making and efficient management. This results in better allocation of company resources and, ultimately, improved performance.   The study of corporate structures has historically been divided into two models: the continental model and the Anglo-Saxon model. In the continental model, there exists an insider system of ownership in the majority of firms. Only a small number of firms are quoted. There are very few hostile takeovers and ownership is highly concentrated (Franks & Mayer, 2001). Long-term debt financing and rather rigid labour markets exist. Family and industrial companies have significant shareholdings either directly or through complex pyramidal shareholding structures.
The Anglo-Saxon model has dispersed ownership; active market for corporate control; equity financing, and; flexible labour markets. There are strong management contract incentives, outside ownership concentration is very low, insider directors are common and there is an active market for corporate control (Bøhren & Ødegaard, 2004). Aguilera and Jackson (2003) have pointed out that the ownership dispersion found in the Anglo-Saxon model is as a result of the 1930s regulatory divide and mergers that occurred in the history of post-war market development of the US and UK. In the case of the US, they suggest that inter-corporate networks restricted inter-firm cooperation because of antitrust laws that encouraged the mergers and diluted ownership. Favourable property rights, bank financing and dense inter-firm networks that existed in continental Europe sustained block holding ownership.
While it has been argued that concentrated ownership controls the free-riding problem (associated with dispersed ownership) within the agency theoretical framework, private benefits are sometimes sacrificed for corporate efficiency to the detriment of minority investors. Ownership concentration therefore does not necessarily lead to good corporate governance or performance growth as the literature will bring out. Franks and Mayer (2001) find no significant difference in how both concentrated and dispersed owners discipline managers as regards to performance in German firms.Jensen and Meckling (1979) argue that the ownership structure is part of a firm’s production function as well as technology and production resources. In this regard, putting ownership as a variable input factor and keeping technology and other input resources constant must lead to different efficiency values for similar sized firms. Because empirical studies have shown that similar sized firms may have differing productivity levels, the issue of agency costs has been given grave importance in the literature. Ownership structures have also been argued to be attributable to regulation of prevailing institutions (institutional approach). There are differences in legislations in different countries. These affect the financial structures and ownership patterns. In the US, banks are not allowed large shares in industrial firms whereas in Germany, France and Spain, banks have significant corporate shares.
Empirical studies have usually compared the Anglo-Saxon and continental types of corporate governance. Other studies however use data from both types in empirical investigations. Table A123 presents a compilation of studies in corporate governance. The compilation of studies by Barca and Becht (2001, see table A13 for results of Belgium, Spain and the UK) indicate variations in the (previously considered monolithic) continental model. Some studies from developed, developing and emerging economies however lend partial support to any of the two typologies. The multi-national studies by La Porta et al. (1997, 1998, 1999, 2000, 2002 and 2006); Claessens et al. (2000), and; Djankov et al. (2008) have indicated that differences in corporate governance exist partly because of the country’s legal origin which shapes its institutional and regulatory environments. Aguilera and Jackson argue that “multiple institutions within a specific country exert interdependent effects on firm-level outcomes” (2003: 448). For this reason, corporate governance mechanisms differ among firms but these differences are lower within a country than between countries. Productivity, valuation, profitability, growth and customer satisfaction are all measures of firm performance depending on the overall objectives of a company. From an economic perspective, firms optimise their objectives with constraints that are subject to a production technology. These constraints therefore represent inefficiencies (technical and organisational) that are consistent with firm optimising behaviour. Firms with greater productivity generally tend to have greater profitability and higher growth rates, but profitability depends on market conditions. Managerial expertise, proprietary technology and firm-specific advantages can also lead to profitable margins.
The variables used in the relationship between corporate governance and performance are varied. Renneboog (2000) argues for lagged data of ownership, performance and debt policy to be used to address endogeneity problems while correcting over or underperformance with industry peers. In Yeh and Woidtke’s (2005) empirical study on shareholder commitment and entrenchment and their effect on firm valuation (by way of Tobin’s Q derived as market value of equity plus its book value of debt, all divided by total assets), they use the following variables to control the relationship: prior fiv-year performance (an average of a firm’s EBIT over total assets for the previous five years); the book value of total assets to control for firm size; the ratio of R&D and advertising expenditures over sales to control for risk; total debt over total assets (for leverage); adjusted industry firm value (a firm’s Tobin’s Q less the average Tobin’s Q for firms in the same industry), and; ownership dummies (for >10%, >20%, >30%).
In testing for entrenchment and expropriation hypothesis of the effect of ownership on performance, Mørck et al. (1988) and De Miguel et al. (2004) use such variables as market value of share to replacement value of fixed assets as the dependent variable, firm size (logarithm of the replacement value of total assets), debt ratio, and (book value of) intangible fixed assets/ replacement value of fixed assets) in one of alternative model specifications. The shareholding value used is the percentage of all shareholders with significant shares and the square of this value.
The literature review in table A12 (which comprises 51 studies) reveals several measures of performance and governance. The control variables that moderate in this relationship are extensive and depend on data availability (or perhaps which of these support the relationships one is investigating). This section examines the variables that have been used so as to select the appropriate ones for the context of this study’s empirical aspect.
A shortcoming of most of the papers on corporate governance and performance is the use of financial performance mostly stock valuation data. Lee (2004) argues that they are indirect measures of firm productivity. Demsetz and Lehn (1985) argue that accounting data might reflect yearly fluctuations in underlying business conditions, influenced by past investments, better than stock returns as the latter captures future developments that tend to obscure business fluctuations (cases in point are Yahoo’s refusal for the hostile takeover bid by Microsoft and the 2008 global stock market crashes and consequent economic recessions). One cannot therefore conclude that stock returns have a superior measure despite its statistical advantage. The use of valuation measures often lead to the exclusion of financial firms since valuation ratios cannot be compared to non-financial firms (La Porta et al., 2002). Gascón et al. (2002) for example has established a strong positive relationship between pure technical efficiency and market valuation. Traditional financial ratios can be included in the measure of productive efficiency. Feroz et al. (2003) decompose return on equity into measures of sales, net income, total assets and common equity. Though these measures give an indication of productive efficiency in revenue generating organisations, net income can be in the form of losses and it is difficult to model with traditional DEA (unless some further restrictions are imposed like in hyperbolic models or directional distance functions) and hence Feroz et al. use total assets, costs, and common equity (which are non-negative) as inputs and total revenues as output to indicate the use of minimum resources to generate maximum outputs.
Optimisation constraints that are imposed on a production technology by firms produce varying levels of inefficiencies. Some of these inefficiencies are due to agency problems of human activity that bedevil the production process. To place the concept of DEA in the main agency theoretical framework, some authors such as Bogetoft (1994, 1995) and Agrell et al. (2002), have modelled relationships between DEA and agency theory by assuming that the best production function of a firm is not a priori certain, although the production possibility set is known. DEA is therefore a useful tool of solving this problem based on firms that use a similar production function to minimise the extent of uncertainties.
Technical efficiency relates the success of firms to produce maximum outputs from a set of inputs under a given production technology. Technical efficiency measures are rare in governance studies. In a later section to this chapter, some studies that have utilised technical efficiency are reviewed. The concept of technical efficiency and its relation to some other similar concepts are also explained. Both parametric and non-parametric methods are discussed. The notion of productivity growth and how it is derived is also covered. Variables used in DEA input and output specification are also reviewed, and then limitations and advancements in the use of DEA models are also summarised.