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Course of Study:
(BUS284) Comparative Corporate Governance and International Operations
Title of work:
International corporate governance (2012)
Section:
Chapter 1: Defining corporate governance and key theoretical models pp. 3--24
Author/editor of work:
Goergen, Marc
Author of section:
Marc Goergen
Name of Publisher:
Pearson

PART I
Introduction to Corporate Governance

Defining corporate governance and key
theoretical models
- Chapter aims
This chapter aims to introduce you to the subject area of corporate governance. The
chapter discusses the various definitions of corporate governance, reviews the main
objective of the corporation and explains how corporate governance problems
change with ownership and control concentration. The chapter also introduces
the main theories underpinning corporate governance. While the book focuses on
stock-exchange listed corporations, this chapter also discusses alternative forms of
organisations such as mutual organisations and partnerships.
LEARNING OUTCOMES
After reading this chapter, you should be able to:
1 Contrast the different definitions of corporate governance
2 Critically review the principal-agent model
3 Discuss the agency problems of equity and debt
4 Explain the corporate governance problem that prevails in countries
where corporate ownership and control are concentrated
5 Distinguish between ownership and control
- Introduction
While this chapter will briefly review alternative forms of organisation and own
ership, the focus of this book is on stock-exchange listed firms. These firms are
typically in the form of stock corporations, i.e. they have equity stocks or shares
outstanding which trade on a recognised stock exchange. Stocks or shares are cer
tificates of ownership and they also frequently have control rights, i.e. voting
rights which enable their holders, the shareholders, to vote at the annual gen
eral shareholders' meeting (AGM). One of the important rights that voting shares
confer to their holders is the right to appoint the members of the board of direc
tors. The board of directors is the ultimate governing body within the corporation.
Its role, and in particular the role of the non-executive directors on the board, is
to look after the interests of all the shareholders as well as sometimes those of other
stakeholders such as the corporation's employees or banks. More precisely, the
non-executives' role is to monitor the firm's top management, including the execu
tive directors which are the other type of directors sitting on the firm's board.1

4 C H APTER 1 • DEFINING CORPORATE GOVERNANCE AND KEY TH EORETICAL MODELS
While in the US non-executives are referred to as (independent or outside) directors
and executives are referred to as officers, this book adopts the internationally used
terminology of non-executive and executive directors.
- Defining corporate governance
Most definitions of corporate governance are based on implicit, if not explicit,
assumptions about what should be the main objective of the corporation. However,
there is no universal agreement as to what the main objective of a corporation
should be and this objective is likely to depend on a country's culture and elec
toral system and its government's political orientation as well as the country's legal
system. Chapter 4 of Part II will shed more light on how these cultural, political
and institutional factors may explain differences in corporate governance and con
trol across countries.
Andrei Shleifer and Robert Vishny define corporate governance as:
'the ways in which suppliers of fi.nance to corporations assure themselves of getting a
return on their investment. '2
Basing themselves on Oliver Williamson's work,3 Shleifer and Vishny's defini
tion clearly assumes that the main objective of the corporation is to maximise the
returns to the shareholders (as well as the debtholders). They justify their focus
by the argument that the investments in the firm by the providers of finance are
typically sunk funds, i.e. funds that the latter are likely to lose if the corporation
runs into trouble. On the contrary,-the corporation's other stakeholders, such as
its employees, suppliers and customers, can easily walk away from the corpora
tion without losing their investments. For example, an employee should be able to
find a job in another firm which values her human capital. While the providers of
finance lose the capital they have invested in the corporation, the employee does
not lose her human capital if the firm fails. Hence, the providers of finance, and
in particular the shareholders, are the residual risk bearers or the residual claim
a nts to the firm's assets. In other words, if the firm gets into financial distress, the
claims of all the stakeholders other than the shareholders will be met first before
the claims of the latter can be met. Typically when the firm is in financial distress,
the firm's assets are insufficient to meet all of the claims it is facing and the share
holders will lose their initial investment. In contrast, the other claimants will walk
away with all or at least some of their capital.
In contrast to Shleifer and Vishny, Sarah Worthington argues that there is noth
ing in the legal status of a shareholder that justifies the focus on shareholder value
maximisation.4 Paddy Ireland goes one step further, arguing that corporate assets
should no longer be considered to be the private property of the shareholders but
rather as common property given that they are 'the product of the collective labour
of many generations' (p. 56).5 Marc Goergen and Luc Renneboog suggest a defini
tion which allows for differences across firms in terms of the actors or stakeholders
whose interests the corporation focuses on. According to their definition,
'[a] corporate governance system is the combination of mechanisms which ensure that
the management (the agent) runs the fi.rm for the benefi.t of one or several stakehold
ers (principals). Such stakeholders may cover shareholders, creditors, suppliers, clients,
employees and other parties with whom the fi.rm conducts its business.'6

-
1.2 DEFINING CORPORORATE GOVERNANCE 5
While Shleifer and Vishny's definition largely reflects the focus of the typi
cal American or British stock-exchange listed corporation, managers of most
Continental European firms also tend to take into account the interests of the
corporation's other stakeholders when running the firm. Although this statement
dates back more than 40 years and may now appear somewhat stereotypical, it nev
ertheless is a good illustration of what is frequently still managers' attitude outside
the Anglo-American world. The chief executive officer (CEO) of the German car
maker Volkswagen AG stated the following.
'Why should I care about the shareholders, who I see once a year at the general meet
ing. It is much more important that I care about the employees; I see them every day.17
Further, in Germany corporate law explicitly includes other stakeholder interests in
the firm's objective function. Indeed, the German Co-determination Law of 1976
requires firms with more than 2,000 workers to have 50% of employee representa
tives on their supervisory board (see Chapter 10). In a questionnaire survey sent to
managers of German, Japanese, UK and US companies, Masaru Yoshimori asks the
question as to whose company it is.8 While 89% of both UK and US managers state
that the company' belongs to the shareholders, only a minority of French, German
and Japanese managers do so (see Figure 1.1). In fact, 97% of Japanese managers
believe that the company belongs to the stakeholders rather than the shareholders.
Hence, while Anglo-American firms tend to - or at least are expected to - pursue
shareholder value maximisation, firms from the rest of the world tend to cater for
multiple stakeholders. However, over the last two decades, the two camps have
moved closer to each other. For example in the UK, the recent Company Law
Review resulted in the Companies Act 2006 which now states in its Section 172 that:
Figure 1.1 Whose company is it?
71 United Kingdom 1- ------ ---,--
2
-
9- - ---- --- �
76 United States >--------------------� 24 1------�
22 France 1-- - ----'-- - ------- - --- � 78
!------------------------'
17 Germany 1----�-------------------, 83
3
Japan ........... ------- - -- ------------- �9 7
D Shareholders D All stakeholders
Notes: The number of firms surveyed is 50 for France, 100 for Germany, 68 for Japan, 78 for the UK and 82
for the USA. l Source: Yoshimori, M. (1995), 'Whose company is It? The concept of the corporation in Japan and the West',
Long Range Planning 28, p. 34
-- -

6 C H APTER 1 • DEFINING CORPORATE GOVERNANCE AND KEY TH EORETICAL MODELS
'Directors should also recognise, as the circumstances require, the company's need to
foster relationships with its employees, customers and suppliers, its need to maintain its
business reputation, and its need to consider the company's impact on the community
and the working environment.'
Nevertheless, company directors must act bona "fide in accordance to what would
most likely promote the success of the company for the benefit of the collective
body of shareholders. In other words, while directors are expected to take into
account the interests of other stakeholders, they should only do so if this is in the
long-term interest of the company, and ultimately its shareholders, i.e. its owners.
Hence, the principle of shareholder primacy is still pretty much intact in the
UK and also the USA. At the same time, Continental Europe has moved closer to
the shareholder-oriented system of corporate governance. In particular, European
Union (EU) law has moved the law of its 27 member states closer to UK law. An
example is the 2004 EU Takeovers Directive which was largely modelled on the
UK City Code on Mergers and Takeovers (see Chapter 7 for details). In turn, recent
pressure on (large) corporations to behave socially responsibly has moved stake
holder considerations to the forefront.
A more neutral and less politically charged definition of corporate governance is
that the latter deals with conflicts of interests between
• the providers of finance and the managers;
• the shareholders and the stakeholders;
• different types of shareholders (mainly the large shareholder and the minority
shareholders);
and the prevention or mitigation of these conflicts of interests. This is the defini
tion which is adopted in this book. Another important advantage of this definition
is that it can be applied to a variety of corporate governance systems. More pre
cisely, this definition does not assume that problems of corporate governance are
limited to the failure of the management to look after the interests of the firm's
shareholders, but it also covers other possible corporate governance problems ·
which are more likely to emerge in countries where corporations are characterised
by concentrated ownership and control. These corporate governance problems nor
mally consist of conflicts of interests between the firm's large shareholder and its
minority shareholders.
One of the first codes of best practice on corporate governance, if not even the
very first one, was the Cadbury Report which was issued in 1992 in the United
Kingdom.9 The Cadbury Report defines corporate governance as 'the system by
which companies are directed and controlled'. However, in the following sentences
the Report then goes on to mention what it considers to be the crucial role of
boards of directors in corporate governance:
'Boards of directors are responsible for the governance of their companies. The share
holders' role in governance is to appoint the directors and the auditors and to satisty
themselves that an appropriate governance structure is in place. The responsibilities of
the board include setting the company's strategic aims, providing the leadership to put
them into effect, supervising the management of the business and reporting to share
holders on their stewardship. The board's actions are subject to laws, regulations and
the shareholders in general meeting.'