Understanding the Corporate Governance Quadrilateral

Understanding the corporate governance quadrilateral

Introduction

The recent splurge in corporate governance literature has veered the way the corporations work. Firm behavior was earlier modeled on the “black-box” argument of the neo-classicists who asserted that firms are nothing more than production counters. All activities of the firm were so geared to maximize profits. Finance literature has come a long way in explaining the various theories of firms and the behaviors associated with them. However, with the increasing understanding that mere economic and production based explanations do not describe the motivations for governance, researchers have focused on the behavioral side of firm performance to justify the economic rationale of the typical behaviors of the managers or the controllers.

Ronald Coase’s seminal work in 1937 on the nature of the firms, where he emphasizes the importance of authority and direction that characterize the boundaries of the firm, has revolutionized the way researchers perceived firm behavior. His work was further strengthened by Alchian and Demsetz (1972) who viewed the firm as a web of contractual relations. Monitoring team production could only be possible if the firm was characterized by contractual obligations. Subsequent development of agent-theoretic models following Jensen and Meckling’s (1976) seminal article “Theory of the firm: managerial behavior, agency costs and ownership structure,” has focused on the behavioral motivations of individuals who run corporations. However, the basic argument of corporate governance as it is seen today by both academic as well as other independent researchers, can be traced back to the pioneering work of Berle and Means (1932) who observed, as early as the 1930s, that the modern corporations have acquired colossal size. This growth thus led to the separation of control from ownership. Promoters, who till then ran the corporations, now needed specialized skills if they were to run them. Professionals with the required skill-sets were to be hired. Berle and Means’ observation of the departure of the owners from the actual control of the corporations led to a renewed understanding of the behavioral dimension of the theory of firm.

The modern day ruckus of insider trading, excessive executive compensation, managerial expropriation of shareholders’ wealth, false reporting, non-disclosure of certain accounting and governance practices, self-dealing, and such other practices – all of which are native to current corporate governance problems, are assumed to be related to the theory of separation of ownership and control. Earlier, researchers have modeled all corporate governance practices and their associated problems to the Berle and Means theory. Today, with four different types of governance mechanisms prevailing across different economies of the world, modeling firm behavior on the US style of governance for all corporate governance anomalies seems anachronistic.

This paper tries to posit the four different governance mechanisms in currency and the attendant implications that they have on the governance of corporations.

The quadrilateral

Shareholders of a corporation are its ultimate owners. However, not all shareholders do actively participate in the day-to-day operations of the firm. In a majority of firms, the majority owners control the organization and take decisions on behalf of the minority owners. In some other firms, which are characterized by manager control, the managers make all firm-level decisions that are supposedly conceived to be beneficial to the owners at large. However, there are firms where the financial institutions too involve themselves in the decision-making process. Hence, the tactical running of the firms is largely governed by the power equation the corporation nurtures as a part of its culture.

Given the multiplicity of governors, a fundamental question arises: do all the different types of decision-makers aim at maximizing shareholder value? Related to this question is another question. To what degree are the decision-makers aligned with the interests of the shareholders at large, and how are they influenced by the corporate governance systems in place? By corporate governance systems I mean the influence of the market-centric models, the transition economies and the relationship-based governance styles. Market centric models are essentially US and UK based models that are characterized by diffusion of ownership. They are the classic Berle and Means firms where ownership is separated from control; capital markets are strong and liquid; there exists a ready market for corporate control and ready access to managerial labor markets. Transition governance