Who should control the firm? Insights from new and original institutional economics.

Author:Groenewegen, John
 
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Business scandals in the USA, Japan, and Europe have initiated changes in the laws of corporate governance, for instance, the Sarbanes-Oxley Act in the USA, the renewal in the UK on initiative of Derek Higgs, the Cromme-Code in Germany, the Loi de Securite Financiere in France, and the Tabaksblat-Code in the Netherlands. These issues are about the question of who should control the firm and how this can be done efficiently. In this paper an overview of the issues in the field is given and theoretical insights offered by new and original institutional economics are discussed. What are the guidelines offered by institutional economics when changing the laws and codes concerning the governance of firms?

Issues

Corporate governance is about the control of the resources in firms. Corporate governance is concerned with the institutions that influence how business corporations allocate resources and returns. A system of corporate governance determines who makes investment decisions in corporations, what types of investments are made, and how returns from investments are distributed (Lazonick and O'Sullivan 1995). That control should be organized in such a way that investors, managers, employees, and other stakeholders commit resources to the firms on the expectation of a return. The system should discipline management so that objectives of stakeholders are realized.

Systems of corporate governance change. The case of Germany is described by way of example here. In Germany changes have taken place recently in the bank-based system. Post-war Germany developed into a bank-based system with relational contracting between industrial firms and banks and with long-term commitments and trust as the crucial oil in the machine. Banks were important inside shareholders with seats on the board of directors. A second element of the German system is shared decision making; the logic for that is the wish in Germany to create consensus among the participants. A third element is the insider control system of corporate governance with representatives of banks in the supervisory boards of the industrial firms. During the last decade banks changed strategies from commercial banking based on long-term relations to investment banking. This had implications for the interfirm relations between industry and banks, influencing the insider control system. Investment banking implies deal-based transactions with industrial firms demanding flexibility, diversification of the portfolio, and no close ties. So investment banking does not fit well with banks having seats on the boards of industrial firms (Deeg 2001). The networks via the board seats become less dense. It is said that Germany is moving to an enlightened form of capitalism in which labor-management cooperation co-exists with forms of shareholder capitalism.

In most economic systems corporate governance is changing. Japan can also be characterized as an insider system: banks, industrial corporations, and financial institutions are closely linked, and the development of the system follows a specific path. Fundamental changes in parts of the system like in Germany seem to be absent although changes in lifetime employment (LTE), especially among the younger generation, seem to be occurring.

The changes in the USA also seem path dependent: after the scandals of Enron and others in the USA the reaction mainly has been one of tighter legal regulations as laid down in the Sarbanes-Oxley Act.

Changes such as the ones described above raise the question of the most efficient control of the firm. Who should control the firm? How should the board of directors be composed, and what should be the role of that board in relation to management? Below I discuss the insights offered by institutional economics, both the new and the original one.

New Institutional Economics

New institutional economics (NIE) departs from the individual who maximizes his or her utility. The instruments are the institutional arrangements of contracts and organizations. In a competitive environment actors are forced to remedy failures, to apply the fitter type of governance structure. Management of firms is disciplined by the competitive pressure of product markets, the market for managerial labor, and the market for corporate control. Government is responsible for the right formal institutional environment of legal rules. According to such a perspective efficient systems of corporate governance are ex ante created by the actors in contractual arrangements (property rights and agency theory) or emerge ex post (transaction cost economics).

Agency theory builds upon the theory of property rights as developed, among others, by Armen Alchian and Harold Demsetz (1972). The incentive problems arising from a separation of management and ownership should be solved through implicit or explicit contracts, in which individual rights are well specified so costs and rewards are clearly allocated among the participants in the firm. How managers behave depends on the contracts they have with the owners. This general idea is elaborated in agency theory, resulting in the firm as a multitude of complex relationships (i.e., contracts) between the legal fiction (the firm) and the owners of labor, material...

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