King s College London. The Department of Management Research Papers

King’s College London

The Department of Management

Research Papers

An Organizational Approach to

Comparative Corporate Governance:

Costs, Contingencies, and

Complementarities

By Ruth V. Aguilera,

Igor Filatotchev,

Howard Gospel

&

Gregory Jackson

Research paper: 42

Subject area: International Business

Date: May 2006

Further information can be found at the Department’s website:

http://www.kcl.ac.uk/management

An Organizational Approach to Comparative Corporate Governance:

Costs, Contingencies, and Complementarities

Ruth V. Aguilera

Department of Business Administration

and Institute of Labor and Industrial Relations

University of Illinois at Champaign-Urbana

1206 South Sixth St.

Champaign, IL 61820

USA

E-mail: ruth-agu@uiuc.edu

Igor Filatotchev

Howard Gospel

Gregory Jackson

King’s College London

150 Stamford Street

London SE1 9NH, UK

Email: igor.filatotchev@kcl.ac.uk

h.gospel@kcl.ac.uk

gregory.2.jackson@kcl.ac.uk

We would like to thank the UK Department for Trade and Industry with support for the research on which this study was based. The authors are listed alphabetically.

An Organizational Approach to Comparative Corporate Governance: Costs, Contingencies, and Complementarities

ABSTRACT

This paper develops an organizational approach to corporate governance, which assesses the effectiveness of corporate governance and implications for policy. Most corporate governance research focuses on a universal link between corporate governance (e.g., board independence) and performance outcomes, but neglects how interdependences between the organization and diverse environments lead to variations in the effectiveness of different corporate governance practices. We propose a framework to analyze these organizational interdependencies in terms of configurations of costs, contingencies and complementarities of different corporate governance practices. These three sets of organizational factors are useful in comparing the effectiveness of corporate governance in terms of its alignment with diverse organizational environments. We also explore how costs, contingencies and complementarities impact approaches to policy such as “soft-law” or “hard law,” and their effectiveness in different contexts.

INTRODUCTION

Corporate governance relates to the “structure of rights and responsibilities among the parties with a stake in the firm” (Aoki 2001). Effective corporate governance implies

mechanisms to ensure executives respect the rights and interests of company stakeholders, as well as guarantee that stakeholders act responsibly with regard to the protection, generation and distribution of wealth invested in the firm. This effectiveness is also underpinned by various policy approaches to corporate governance that aim to regulate managerial power (Davis 2005, Parkinson 1993). Most of the empirical literature on corporate governance has been rooted in agency theory, and is concerned with linking different aspects of corporate governance with firm performance. The assumption here is that by managing the principal-agency problem between shareholders and managers, firms will operate more efficiently and perform better. Despite the large body of research, the empirical findings on this link have been surprisingly mixed and inconclusive. For example, recent meta-analyses of board composition and financial performance studies did not identify any significant effects (Dalton et al. 1998, Dalton et al. 1999).

One important characteristic of the agency literature is its search for universal relationships between corporate governance and outcomes based on a ‘closed systems’ logic centered on agency costs. Consequently, one reason for the mixed empirical results may be the neglect of patterned variation of corporate governance according to the contexts of different organizational environments. Likewise, recent critiques of agency theory have centered on it being too ‘under-contextualized’ to compare and explain the diversity of corporate governance arrangements across different organizational or national contexts (Aguilera & Jackson 2003). This leads to important shortcomings in terms of rather universalistic policy prescriptions, which often need to be substantially adapted to the local contexts of firms or ‘translated’ across diverse national institutional settings (Ahmadjian & Robbins 2005, Fiss & Zajac 2004). The main theoretical alternative, stakeholder theory (Freeman 1984), comes closer to an ‘open systems’ approach by recognizing a wider set of actors in corporate governance, but in our view similarly

does not analyze the influences of diverse organizational environments. By contrast, an ‘open systems’ logic of studying organizations shifts attention to the environmental context (Scott 2003). Surprisingly, very little corporate governance research has drawn upon the large body of

organizational sociology that more systematically examines the alignment between organizations and their broader environment (Thompson 1967).

We propose an organizational approach to comparative corporate governance that will better account for the interdependencies of corporate governance with diverse technical,

managerial and institutional environments. Our framework starts from universal elements of the agency and stakeholder perspectives, but is concerned with comparing patterned variation that results from interdependencies between firms and their environment. Thompson (1967) argues that the focus on universal elements is necessary, but leads ultimately to a static understanding of organizations. As Thompson (1967, p.vii) suggests, “to get leverage on a topic, we must begin to see some of the universal elements as capable of variation.” Likewise, recent studies in the field of corporate governance have argued the need to better explain the dynamic dimensions of corporate governance over the company life cycle (Filatotchev & Wright 2005, Johnson 1997), as well as the diversity of corporate governance arrangements across countries and over time

(Aguilera & Jackson 2003, Gospel & Pendleton 2005). An important agenda in corporate governance research is to better understand the diversity of corporate governance arrangements, and how the effectiveness of corporate governance relates to its fit with diverse organizations and environments.

In this paper, we develop a framework for understanding the influence of organization-environment interdependencies on the effectiveness of corporate governance in terms of three factors: costs, contingencies and complementarities. Costs refer to the value of inputs to corporate governance, such as compliance with existing regulations or opportunity costs of managing relations with institutional investors. These costs will vary for different firms operating in different sorts of environments, so that cost-benefit analyses are rarely universal.

Contingencies refer to a variety of firm and industry-level characteristics, such as the firm’s size, age, industry regulation, or life cycle, that shape the nature of firm’s strategic resources at a given time. Complementarities refer to the overall configurations or ‘bundles’ of governance practices that are aligned with one another to achieve effective corporate governance. For example, the effectiveness of independent board members depends upon the presence of other complementary factors, such as high shareholder involvement and strong legal protection for investors.

Even though these three factors do not comprehensively account for the complexity of interdependence between organizations and their environments, we suggest that costs,

contingencies and complementarities are useful for theoretically understanding why effective corporate governance can be reached through different paths or non-linear trajectories. Consistent with recent configurational approaches to studying organizational outcomes (Fiss, forthcoming), effective corporate governance depends upon the alignment between

interdependent organizational and environmental characteristics. Our understanding of an organizational approach of corporate governance entails equifinality, whereby different initial conditions lead to similar effects or multiple conjunctural causation (Kogut et al. 2004, Ragin 2000), and the coincidence and interaction among multiple factors influence outcomes (Davis & Marquis 2005)2 In short, our framework helps explain why, despite some universal elements, no ‘one best way’ exists to achieve effective corporate governance. Rather, corporate governance arrangements are diverse, but exhibit variation across firms, sectors, and countries.

Grounding corporate governance in organizational sociology has important implications for future study and policy analysis. First, the framework can be applied to the study of

governance processes in diverse forms of organization, such as entrepreneurial firms or

multinational firms, which have been overlooked in the corporate governance literature. It also allows us to compare similarities and differences of corporate governance within and across

2

This approach stresses the study of cases as configurations, rather than isolating the marginal impact of particular variables under the presence of statistical control factors or assumptions of ‘all things being equal.’

industries, as well as in broader sets of national institutions and regulation. Second, it can help explain how different policy approaches based in ‘hard law’ such as US Sarbanes-Oxley Act (SOX) or ‘soft law’ such as the UK Combined Code impact different types of firms.

The rest of the paper is structured as follows. First, we develop a critique of existing corporate governance literature based on its broadly universalistic approach to understanding the effectiveness of corporate governance, and argue for greater attention to the patterned variation in corporate governance drawing on organizational theory. Second, we propose a particular

approach to understanding the organizational aspects of corporate governance based on the costs, contingencies and complementarities of corporate governance in different types of organizational environments. This framework is not based on a typology of such environments, but rather proposes a set of robust concepts for understanding interdependencies between corporate governance and its environment that draws upon classic approaches in organizational sociology (e.g. Thompson 1967). Third, we explore the interactions among costs, contingencies and complementarities by applying our framework to several stylized examples drawn from the corporate governance literature. Fourth, the framework is also applied to understand the

effectiveness of public policy approaches to corporate governance based on how these impact the costs, contingencies and complementarities associated with corporate governance. The

conclusion summarizes our theoretical approach to corporate governance.

FROM UNIVERSALISM TO DIVERSE ORGANIZATIONAL ENVIRONMENTS Principal-agent theory has had a profound impact on organization research in general, and corporate governance theory in particular (Dalton et al. 2003, Jensen 1986, Fama 1983). The central premise of this framework is that managers as agents of shareholders (principals) can engage in self-serving behavior that may be detrimental to shareholders’ wealth maximization. This stream of research identifies situations in which shareholders’ and managers’ interests are likely to diverge and propose mechanisms that can mitigate managers’ self-serving behavior (Shleifer & Vishney 1997). This corporate governance approach identifies several distinct types of

corporate governance mechanisms related to board composition, shareholder involvement, information disclosure, auditing, the market for corporate control, executive pay, and stakeholder involvement {Filatotchev, 2006 #948}. These mechanisms may reduce agency costs within the principal-agent framework and lead to positive efficiency outcomes.

A growing body of empirical corporate governance research has begun to cast doubt on whether there is a direct and universal link between ‘good’ corporate governance, as discussed above, and firm performance. For example, extensive research exists on the performance impact of board composition. Dalton et al. (1998) conducted a meta-analysis of empirical studies on board independence and size, but they did not report any significant effects of board composition on firm performance. This conclusion holds across the many ways in which financial performance has been measured in the literature. The results of other meta-analyses (e.g. Dalton et al. 1999, Rhoades et al. 2000) are also inconclusive. Likewise, neither the joint nor separate board leadership structures have been found to universally enhance firm financial performance (Beatty & Zajac 1994, Boyd 1994, Ocasio 1994, Dalton et al. 1998).

The weak empirical link between corporate governance and performance can also be seen in studies of ownership patterns and agency costs. For example, large-block shareholders have both the incentive and power to assure that managers and directors behave in the interests of shareholders (Daily et al. 2003). Several empirical studies find that firms with concentrated shareholders do outperform firms with dispersed ownership (see Holderness & Sheehan 1988, McConnell & Servaes 1990, Hill & Snell 1988). However, other empirical studies have failed to confirm positive links between ownership concentration and performance (for example, see Demsetz & Lehn 1985, Agrawal & Knoeber 1996, Bethel & Liebeskind 1993). In particular, the meta-analysis conducted by Dalton et al. (2003) found no support to the hypothesized relationship between share ownership by large blockholders and a number of performance proxies that include Tobin’s Q, returns on assets, equity, sales, investment, etc. These mixed findings may results from trade-off’s or

For example, lack of diversification and limited liquidity mean that large shareholders are affected adversely by the company’s idiosyncratic risk (Maug 1998), but may compensate by siding with management (the strategic-alignment hypothesis) (Pound 1988) or using their power to influence by other existing business relationships (the conflict-of-interest hypothesis). Consequently, ownership concentration may negatively affect the value of the firm when majority shareholders have a

possibility to abuse their position of dominant control at expense of minority shareholders (Bebchuk 1994). In the end, the relevance of these potential monitoring and entrenchment roles is likely to differ across firms and different institutional environments.

A recent Rev. of the broader social Science literatures on corporate governance

demonstrates that this ambiguity regarding empirical evidence also applies to many other areas of corporate governance research (Filatotchev et al. 2006), such as executive pay (Bebchuk & Fried 2004) or the market for corporate control (Datta et al. 1992, King et al. 2004). These weak inter-relationships between ‘good’ corporate governance and firm performance cast doubt on several premises of the agency research and suggest a need to re-orient corporate governance research framework. We argue that a central problem in corporate governance research has been the tendency to posit clean, powerful, and universalistic models, yet which abstract away from important environmental complexities. Despite the attempts to ‘control’ for contextual factors in empirical studies, the literature as a whole lacks a systematic focus on how different

organizational environments mediate the hypothesized relationships between corporate

governance mechanisms and firm performance. The ‘under-contextualized’ approach of agency theory remains restricted to two actors (managers and shareholders) and abstracts away from other aspects of organizational context that impact agency problems, such as diverse task environments, the life-cycle of organizations, or institutional context of corporate governance (Aguilera & Jackson 2003). In effect, the exclusive focus on agency problems relies on a ‘closed system’ logic, which neglects broader interdependencies between corporate governance and broader environmental factors.

We suggest that corporate governance research should adopt a more ‘open-system’ approach, which draws more strongly upon existing literature in organizational sociology (Scott 2003, Thompson 1967). Open systems approaches treat organizational features as being strongly interdependent with the fluctuations or uncertainties of their environment, and rejects

universalistic ‘context-free’ propositions. A major advantage of this approach is its ability to capture how organizations buffer, level, adapt to or ration these interdependencies with their environment in ways that influence core characteristics and behavior of the organization. Importantly, such environmental factors moderate the relationship between decision-making structures of the organizations, and outcomes such as strategy, performance or effectiveness. Effective organizational action is one that achieves a certain ‘fit’ or alignment between the organization and its environment. This approach stresses the importance of different organizational configurations, rather than single factors acting in isolation, for explaining

performance (Fiss, forthcoming). Configurational approaches suggest that organizations can best be understood by identifying distinct, internally consistent sets of firms and the relations to their environments, rather than one universal set of relationships that hold across all organizations – a view supported by recent meta-analyses of empirical studies (Ketchen et al. 1997). This stress on interdependencies has also been underlined by work related to strategy (see Hambrick 1984), the co-evolution between organizations and environments (see Lewin & Volberda 1999) and other historically grounded approaches to understanding organizations (Kieser 1994).

This ‘open systems’ approach is particularly suggestive for corporate governance

research because corporate governance itself plays a crucial role in mediating between more open institutional aspects of the environment and the more closed internal aspects of the firm. Despite strong development of contingency-based approaches in other areas of organization theory, similar contextual or environmental factors have largely been ignored within corporate

governance research.3 In the following section, we suggest a framework grounded in

organizational theory that draws upon and synthesizes various empirical findings through a robust, but relatively parsimonious set of concepts.

AN ORGANIZATIONAL APPROACH TO CORPORATE GOVERANANCE

We propose an organizational approach to corporate governance that draws on three specific concepts for understanding the interdependence between corporate governance practices, internal to the firm, and the organizational environment in which these practices are conducted. These specific concepts are costs, contingencies and complementarities. In short, we claim that various configurations of corporate governance mechanisms will lead to greater or lesser effectiveness depending on the costs, contingencies and complementarities associated with different environments as illustrated in Figure 1. An important caveat is that our aim here is not to produce typologies of different sorts of environments, such as technical, managerial and institutional. Nor do we systematically map the dimensions variation within particular sorts of environments, such as the cross-national diversity of corporate governance institutions or industry comparisons. Rather, our emphasis is on how, once various environments are identified, these may impact the potential effectiveness of corporate governance and ultimately measurable aspects of organizational outcomes such as performance. We discuss costs, contingencies and complementarities in turn.

-- Figure 1 about here -- Costs

The potential benefit of various corporate governance practices is at the core of corporate governance research. Most approaches posit that improved company performance results from minimizing agency costs and/or maximizing the firm’s resource base. In addition, however, we consider corporate governance in the context of other potential cost implications related to the

3

One notable exception in economics concerns work linking corporate governance to diverse organizational architectures, where information is bundled and shared in different ways depending on interdependencies among tasks and with external environments (Aoki 2001).

inputs of corporate governance. These often appear as ‘externalities’ or unintended consequences that stem from or are manifest in the broader environment of the organization. These costs will vary across firms to the extent that they operate in different sorts of environments. In that regard, cost-benefit analyses are rarely universally applicable to all organizations.

The implementation of different corporate governance mechanisms may have associated costs of several types, starting with the systemic costs of compliance that are reflected in the firm’s balance sheet and other accounting documentation (e.g., the audit costs, directors’ insurance, etc.). In addition, corporate governance imposes less explicit opportunity costs (e.g., directors’ time spent on governance issues instead of business strategy, changes in managerial risk preferences, etc.), proprietary costs (e.g. costs of disclosure of strategic information), and the reputational costs (e.g., costs of fraud, misconduct or corporate irresponsibility).

Systemic costs of corporate governance are related to the out-of-pocket expenses that are associated with routine compliance with governance rules and regulations. More specifically, these costs include expenditures on recruitment and remuneration of executive and independent directors and costs of setting up and running control and risk-management systems, including board committees. Notably, these systemic costs differ according to different sectoral and national regulatory environments. For example, Aguilera (2005) suggests that US accounting firms are increasingly concerned with being sued, and have developed a voluntary ‘enhanced audit’ that costs companies more than traditional audit services. In addition, new corporate governance rules under the Sarbanes-Oxley Act increase litigation risks, and result in associated increases in the firm’s expenditures on directors’ insurance and indemnity policies (Zhang 2005). An important implication is the differential impact of systemic costs on firms depending on their resource capacities. For example, large firms with sufficient resources can more easily buffer these systemic costs while smaller firms with greater resource constraints may unable to comply and consequently face disproportional additional costs if forced to delist from the stock exchange. The phenomenon of delisting due to higher compliance costs is also more likely among foreign

firms, since this requires greater adaptation to US standards (Aguilera 2005).

Beyond these direct systemic costs, corporate governance also entails less explicit and more indirect opportunity costs, which are often difficult to quantify. These costs relate to how corporate governance impacts strategic priorities and consequently the exploitation of business opportunities. For example, managing relationships with institutional investors can also cause opportunity costs by diverting managers’ attention from strategic and operating decisions associated with running the firm, and toward anticipating short-term expectations about share prices. However, this depends on the specific nature and composition of investors, which set different environment of expectations regarding company behavior. In addition, litigation risks may change management’s risk-taking behavior, and this, in turn, will likely slow down firm growth. For example, the benefits of improving legal protection for shareholders, such as through greater disclosure, auditing and control may be offset by over-regulating the governance

environment in ways that detract from flexibility and risk-taking (Walsh & Seward 1990). A number of studies also find that corporate governance may have a high cost impact on the firm’s proprietary information through requirements of information disclosure (Healy & Palepu 2001, Lang & Lundholm 2000). In market environments where competitive advantage highly depend on proprietary technology or timing of market entry, managers may face high costs to the extent that they are required to disclosure information relevant to their trade secrets or other proprietary information about the firm's R&D in progress, innovations, or recent discoveries (Verrecchia 1983). In addition, where parties face high legal liability for public statements, the extent or content of disclosure may be rationed to offset costs resulting from potential litigation (Beatty & Welch 1996).

Finally, corporate governance influences costs related to the reputation of the firm (Rao 1994, Rindova et al. 2005, Washington & Zajac 2005). Poor or negligent corporate governance practices can have tremendous cost to the firm’s reputation among consumers, investors or other stakeholders thereby raising the cost of capital and damaging other firm assets such as brand

(Rhee & Haunschild 2006). For example, companies misreporting their financial, social and environmental activities may face reputational damage. However, reputational costs and the ability to repair them may depend on the industry environment. Companies in sectors where trust is important for the stakeholders such as auditing firms or food companies are more vulnerable to reputational costs than firms in industries traditionally less stakeholders’ goodwill such as oil and tobacco. Companies may try to level such reputational costs by adhering to voluntary standards developed to assure legitimacy within the industry sector (Bansal & Roth 2000), or national corporate governance codes based on comply or explain principles (Aguilera & Cuervo-Cazurra 2004, Werder et al. 2005).

Costs therefore have a mediating impact on the effectiveness of various corporate governance practices in terms of their organizational outcomes as indicated in Figure 1.

Particular costs, such as costs of compliance with ‘good’ governance standards, are more or less relevant in different environments. Environmental influences impact the degree of costs related to corporate governance by allowing greater opportunities or constraints for leveling or buffering those costs in different environments. In some environments, firms may be unable to buffer against particular types of costs, and lead the costs of particular governance mechanisms to exceed the expected benefits. Consequently, for example, reputation-based governance mechanisms are likely to be more effective in certain environments than in others. Contingencies

Corporate governance must be seen in the light of different contingencies related to the critical resources or capacities for innovation that shape firms’ interdependences with external environments (see Pfefffer & Salancik 1978, O'Sullivan 2000). A growing literature suggests that effectiveness of particular types of corporate governance often depends on a number of important firm- and industry-level contingency factors such as the firm’s size or age, the phases of growth or decline in the company life cycle, the regulatory environment of the industry, or the character of innovation in different markets (Dalton et al. 2003, Dalton et al. 1999, Deutsch 2005, Hermalin

& Weisbach 1998). For example, some corporate governance mechanisms may be more efficient in smaller firms since the scale and diversity of large firms may cloud relationships between corporate governance and performance. However, a small scale of operations and lack of resources may constrain the firm’s ability to introduce effective corporate governance systems, such as diverse and independent boards. While this undermines the notion of universal best practices, it also suggests that policy will be more effective if it takes into account the potential diversity of corporate governance mechanisms, which deal with important contingencies. In short, a ‘one size fits all’ approach may be undesirable.

A growing body of empirical research now explores how the effects of various governance mechanisms differ based on contingencies related to interdependencies between organizations and their environment. This is evident in recent studies on information and disclosure patterns. For example, Meeks et al. (1995) find different patterns of disclosure contingent on firm size, debt-equity ratios, country of incorporation, and international listing. Other UK research suggests that disclosure is not only positively related to firm size, but varies significantly across industrial sectors, and that companies whose future earnings are poor are likely to disclose more information (Abraham & Tonks 2004). Holland (2005), for example, has suggested that disclosure, both public and private, increases when performance declines and during take-over battles.

Contingencies also play a growing role in research on boards. Recent meta-analysis has found that the relationship between board size and firm performance relationship is stronger for smaller, as compared to larger firms (Dalton et al. 1999). Filatotchev and Toms (2003), and Hambrick and D’Aveni (1992) argue similarly that board diversity and external ‘interlocks’ may play an important role in crisis situations, since, from a resource-dependency view, these board configurations may provide more diverse networking links to resource providers. IPO research (Certo et al. 2001, Sanders & Boivie 2004, Filatotchev & Bishop 2002) shows that newly listed companies with more diverse and independent boards achieve better performance. On

the other hand, Luoma and Goodstein (1998) focus on the representation of stakeholders, such as employees, public officials, suppliers and customers, on company boards, and find that such representation is more likely when companies are larger or in highly regulated industries.

An emerging body of research on the life cycle of corporate governance (Filatotchev & Wright 2005, Johnson 1997, Lynall et al. 2003) suggests the notion of a number of stages in the firm where different ‘bundles’ of corporate governance characteristics are most effective.

Corporate governance should thus be viewed as a dynamic system whereby corporate governance may address changing sets of environmental interdependencies throughout the different stages of the life cycle. For example, previous research has identified different roles of corporate

governance within the firm, including accountability (‘wealth protection’) and resource/service (‘wealth creation’) roles (Filatotchev & Wright 2005, Talaulicar et al. 2005). Wealth creation role is also often associated with entrepreneurship and business venturing in young and mature firms. As firms change over the life cycle from establishment, growth, maturity, to decline, we argue that the effectiveness of corporate governance undergoes shifts in the roles and balance of accountability vs. enterprise and entrepreneurship. Contingent environmental interdependencies, such as internally and externally available resources, impact the salience of accountability with regard to (changing) groups of external stakeholders and resource providers, etc. (Filatotchev & Toms 2003). Therefore, firm and environmental contingencies should moderate the impact of ‘good’ governance on organizational outcomes, such as performance. Firms may respond to changing interdependencies, such as resource dependence, through changes in their governance such as ownership structure, board composition, or the degree of founder involvement.

In the early stages of the life cycle, the entrepreneurial firm has a narrow resource base. It is, as a rule, owned and controlled by a tightly knit group of founder-managers and/or family investors, and the level of managerial accountability to external shareholders is necessary low. In this context, for example, the resource and knowledge contribution of boards may be more important than in firms facing more mature markets (Podolny 2001). As the firm grows, it

requires access to external resources and expertise, which may fuel and support this growth. Consequently, the board may be opened to external investors, such as ‘business angels’ and venture capital firms. At this stage, the balance between resources and accountability starts to shift towards greater transparency and increasing monitoring and control by external providers of resources. An initial public offering (IPO) provides the firm with a higher legitimacy and enhanced access to financial resources, but is also accompanied by an increase demand for accountability and scrutiny from investment community and other stakeholders.

Bearing in mind these changing strategic and operating conditions of the firm, its dynamic interdependence of the firm with its changing organizational and industry environment may impose different demands on corporate governance. Therefore, in order to be effective, corporate governance needs to adapt to very different monitoring, resource and strategy roles depending on a particular stage of the firm’s life cycle. The most effective configuration of corporate

governance practices will display patterned variation over the life-cycle, rather than conform to a universal model. Contingencies underline the ‘open’ nature of organizational interdependence, such that whereas mature firms may be concerned with reducing agency costs, new

entrepreneurial firms face different challenges in terms of anticipating future technological developments and buffering environmental uncertainties through long-term venture capital investments.

Complementarities

A growing literature has sought to develop a configurational approach to corporate governance by exploring how corporate governance mechanisms interact and substitute or complement each other as related ‘bundles’ of practices. Just as with the contingencies literature discussed above, corporate governance mechanisms here are not seen as being universally applicable. Rather than isolated ‘best practices’, corporate governance mechanisms become effective only in particular combinations. Complementarities concern such interactions between corporate governance mechanisms, and how these interdependencies align corporate governance

to potentially diverse organizational environments.

The notion of corporate governance as a system of interrelated elements having strategic or institutional complementarities has been proposed within the economics literature (Aoki 1994, Milgrom & Roberts 1994, 1995). Here complementarity is usually defined as situations where the difference in utility between two alternative institutions or practices U(x’) - U(x”) increases for all actors in the domain X, when z’ rather than z” prevails in domain Z, and vice-versa. If conditions known as ‘supermodularity’ exist, then x’ and z’ (as well as, x” and z”) complement each other and constitute alternative equilibrium combinations (Aoki 2001, Milgrom & Roberts 1990). This view suggests interaction effects or ‘clustering’ of characteristics into particular combinations in line with work on configurational approaches to organization that have become vital in business studies (Fiss, forthcoming), the comparative sociology of organizations (Maurice et al. 1986), and comparisons of national business systems (Aguilera & Jackson 2003, Whitley 1999). An important implication is that efficiency does not result from a universal ‘one best way’, but suggests different patterns of comparative institutional advantages for different sorts of

business strategies or industry environments (Hall & Soskice 2001, Aoki 2001).

In applying complementarities to corporate governance, various works have stressed that the simultaneous operation of several corporate governance mechanisms are important in limiting managerial opportunism (Rediker & Seth 1995, Walsh & Seward 1990, Hoskisson et al. 2002). Anglo-Saxon corporate governance systems are based around broad interdependencies between performance incentives within executive remuneration, board independence, and the market for corporate control. These corporate governance mechanisms serve to align incentives within and outside the organization, and make corporate governance more effective in environments of dispersed share ownership. In addition, even these interdependent mechanisms of corporate governance would remain quite ineffective without further complementary mechanisms, such as high information disclosure to investors, which allow the market to price shares accurately, and a rigorous system of auditing to assure the quality of that information. For example, information

disclosure is demonstratively higher in the presence of corporate governance mechanisms such as takeover bids (Brennan 1999), independent directors (Cheng & Courtenay 2004), and in firms where audit committees are independent and have financial expertise (Mangena & Pike 2004). These interdependencies help explain the sensitivity of U.S. corporate governance during recent scandals, whereby the complementary elements of this system failed to work in a reinforcing manner and gradually broke down as gatekeepers, such as auditors and even non-executive directors, became increasingly co-opted by managers (Coffee Jr. 2003), executive pay decoupled from performance (Bebchuk & Fried 2004), and the market for corporate control tamed (Useem 1996). Indeed, the lack of factual independence of directors may remain a weak link within this system, as institutional investors largely rely on exit rather than a strong voice in acting

responsibly to promote effective boards.

Meanwhile, these elements common in Anglo-Saxon corporate governance often remain absent in other countries. Here other corporate governance mechanisms may effectively

substitute and display different sets of complementarities. Where one specific mechanism is used less, others may be used more, resulting in equally good performance (Agrawal & Knoeber 1996). For example, in German and Japanese corporate governance, monitoring by relationship-oriented banks may effectively substitute for an active market for corporate control (Aoki 1994, Baums 1993). Jensen (1986) also suggests that when the market for corporate control is less efficient, the governance effects of debt holders may play particularly important role in restraining managerial discretion. The long-term nature of bank-firm relationships may also display important complementarities with a more active role of stakeholders, such as employees, as employees investments in firm-specific capital are protected from ‘breaches of trust’ (Aoki 2001) and employee voice helps to make managers more accountable internally by more thoroughly

justifying and negotiating key strategic decisions (Streeck 1987).4

The number of potential combinations of corporate governance characteristics, and hence complementarities, is very large. These configurations remain to be systematically theorized, let alone investigated empirically. While such a task is beyond the scope of this paper, the important analytical point here is that the effectiveness of corporate governance mechanisms cannot be seen in isolation. Moreover, a particular corporate governance mechanism, such as the market for corporate control or independent board members, may have opposite effects in different contexts. Whereas the market for corporate control may help exert discipline in the context of dispersed ownership and high transparency, the same may undermine the effective participation of

stakeholders. Analytically, it is also important to take into account different aspects of economic exchangethat have potential trade-offs. Strong employee participation may increase agency costs but lower transaction costs. Take-overs may lower agency costs, but increase transaction costs. Inferences about the overall complementarity between particular institutions remain challenging, and we cannot tell a priori which dimension will drive overall performance (Jackson 2005a). At the level of institutions, corporate governance embodying conflicting principles may also allow for more heterogeneous combinations of corporate governance characteristics and maintaining requisite variety for future adaptation in an population of firms (Stark 2001).

INTERACTION OF COSTS, CONTINGENCIES AND COMPLEMENTARITIES IN DETERMINING THE EFFECTIVENESS OF CORPORATE GOVERNANCE

Costs, contingencies and complementarities do not exist in isolation, but jointly mediate the relationship between corporate governance practices and effectiveness or ultimately

performance outcomes. Here a configurational understanding is particularly important, since these three factors may add to, subtract from, or multiply each others’ effects. Often policy or corporate governance practices that raise costs may be beneficial to the extent that they help firms

4

The recent experience of Germany suggests that employee representation in the board has important effects on the design of executive stock option plans, leading to adoption of more and qualitatively stricter performance conditions than similar U.S. companies (Buck & Shahrim2005).

adapt to particular contingencies or increase effectiveness by complementing other aspects of corporate governance. Conversely, attempts at saving marginal costs by rationing inputs to corporate governance may undermine potential complementarities and render corporate governance ineffective.

In Table 1, we provide a set of stylized cases that exemplify how costs, contingencies and complementarities may interact in influencing the effectiveness of particular aspects of corporate governance. For the sake of illustration, we have selected three key aspects of corporate

governance: board independence, information disclosure and employee participation. For each of these aspects, we compare two stylized cases that are ‘most similar’ in terms of broader national corporate governance systems, but show distinct sets of interdependencies with their

organizational environments reflected in different patterns of costs, contingencies and

complementarities. To provide an initial stylized application of our framework, we operationalize each of these three variables in terms of their degree of salience. Since we cannot analyze all potential contingencies or complementarities, we focus on specific examples related to the level of uncertainty with regard to the firms’ resources and the strength of complementarities among stylized corporate governance mechanisms. Finally, we posit whether each configuration will have a positive or negative impact on the effectiveness of corporate governance overall.

---Table 1 near here--- Case 1: Board Independence

To compare the potential effectiveness of board independence, we compare the case of a large and mature public U.S. Fortune 500 firm with a small U.K. post-IPO venture firm. We suggest that for the U.S. firm, the systemic costs of compliance with requirements of board independence entail high out of pocket expenses, but these large firms have a high capacity to absorb such costs and receive strong benefits in terms of enhanced reputation among investors. Still, substantial opportunity costs may arise if the overall board lacks strategic ‘inside’

of costs for this sort of stylized firm. On the other hand, the U.K. venture firm faces high systemic costs by appointing independent directors, which may be hard to bear for small companies. Moreover, independent directors may increase risks of proprietary costs when strategically sensitive information is shared with company outsiders. In this case, the overall cost of board independence is generally high.

In terms of contingencies, the large U.S. firm is likely to operating in a mature or even declining industry context. Meanwhile, the resource base of the firm is broad. The stability of industry environment and large size of the firm both generally reduce the overall level of contingencies facing the firm. Consequently, board independence may contribute to greater accountability to external stakeholders, who provide the key resources to the firm (O´Sullivan 2000). On the other hand, the IPO firm is likely to operate in an emergent or growing industry characterized by greater uncertainty regarding technologies and market position. This smaller and younger firm is also likely to have a narrower resource pool, and hence lower demands from external stakeholders for accountability. In cases where environmental contingencies are high, the contribution of independent directors would largely consist of anticipating environmental change. However, the traditional role of promoting accountability would be less salient. Rather, boards take on a variety of important strategic functions (McNulty & Pettigrew 1999). In such situations, the boundaries between learning and monitoring often become blurred (Sabel 1994).

Board independence may display complementarities with other elements of corporate governance. For the mature U.S. firm, board independence is likely to more effective due to the presence of other corporate governance elements common in the U.S. such as the existence of board committees, which structure and enhance the influence of independent directors within the board. Likewise, independent directors are argued to play an important in setting executive pay and assuring appropriate incentive alignment between executives and shareholder interests. At a broader institutional level, the factual independence of directors is enhanced by the existence of comparatively strong legal protection of shareholder rights. For the U.K. IPO firm, board

independence may be less effective due to the lack of similar complementary corporate governance mechanisms. Venture firms tend to have large block shareholding by venture capitalists or entrepreneurs, who hold seats on the board and provide a strong monitoring role without the presence of independent ‘outside’ directors. Institutionally, the stock market segment for U.K. IPOs (e.g., the Alternative Investment Market, or AIM) have relatively less demanding disclosure requirements, which may impair the effectiveness of independent directors and their accountability to the generally fewer outside shareholders.

This illustrative discussion suggests that board independence will have a positive

influence on the effectiveness of corporate governance in the U.S. firm, but a potentially negative influence in the U.K. firm. In the U.S., costs are only moderate, contingencies are relatively low and the boards monitoring role is buffered from environmental uncertainty, and

complementarities with other corporate governance mechanisms are high – all of which align the role of board independence with the broader organizational environment. Meanwhile, the U.K. IPO firm faces higher costs, greater environmental contingencies that disrupt the monitoring role of the independent board members, and fewer complementary corporate governance mechanisms. Taken together, board independence is less well aligned to the organizational environment of the UK firm.

Case 2: Information Disclosure

We draw on two stylized cases from the Latin model of corporate governance (Aguilera 2003, Hoskisson et al. 2004, Rhodes & van Apeldoorn 1997) to explore how the information disclosure contributes to the effectiveness of corporate governance. In particular, we compare information disclosure patterns for a large publicly traded, but family-owned Italian firm and a large recently privatized French firm. In terms of cost of information disclosure, the family firm is likely to face high systemic costs due to the complex pyramidal structures used to maintain corporate control, which thereby secure voting rights for families that are disproportional to their cash flow rights (Becht & Roel 1999). The close knit nature of family ownership may lead

families to resist disclosing information to outside parties such as the government and other non-family members firm, due to the particular implications or costs for the reputation of the non-family. Alternatively, a recently privatized French firm will experience benefits from disclosure and be willing to shoulder such systemic costs, and will also need to increase disclosure in order to assure their good reputation. During the transition from state-owned to privately owned enterprise, developing elaborate information and disclosure practices are essential to making operations transparent and managers accountable, and thereby attract the new investors.

Regarding contingencies, both the Italian and the French firm are large and most likely in mature industries characterized by relatively few environmental uncertainties. The degree or effectiveness of information disclosure will be positive in these environments, due to the low danger of disclosing important strategy and proprietary information to competitors. Finally, information disclosure may interact with quite different sets of complementary institutions between these two cases. In Italy, disclosure is likely to display only weak complementarities with other corporate governance elements, since the type of ownership structure is concentrated and pyramidal, which gives these owners the power to monitor management effectively without high public disclosure requirements. Likewise, the demand for external sources of financial capital tends to be low, and hence fewer institutional investors exist that benefit from disclosure. On the contrary, in the French firm, information disclosure is essential for effective corporate governance, since new dispersed owners, such as foreign institutional investors, rely heavily on public information disclosure in order to fulfill their corporate governance roles through extensive shareholder engagement with company policy.

Information disclosure will thus have different influences on the effectiveness of corporate governance depending on the local environment of the firm. In the Italian example, because of the high cost of disclosure and low complementarities with other corporate

governance practices, information disclosure is likely to have a negative effect on corporate governance effectiveness. In the French firm, information disclosure is likely to influence

positively the effectiveness of the corporate governance because the costs of disclosure and the contingency effects are low, and this practice is reinforced by other existing practices.

Case 3: Employee Participation

Finally, we compare two stylized cases from ‘stakeholder’ models of corporate governance in Germany and Japan (Dore 2005, Jackson 2005b) to explore how employee participation contributes to the effectiveness of corporate governance. In particular, our stylized examples concern large automobile companies that are integral to the strong export performance of these two countries. Despite their overall similarities in terms of corporate governance models and sectors, our framework is useful for illustrating how effective corporate governance may be achieved in different, but equivalent ways.5

In terms of the cost of employee participation, Germany has a strong legal regime of codetermination that imposes strong requirements of firms for the election of employees to the Supervisory Board and works councils, whereas Japan as a less formalized system rooted largely in collective bargaining agreements. Besides these higher systemic costs, the German firm may risk proprietary costs related to disclosure of strategic information to employee representatives. In terms of contingencies, the context of the automobile industry suggests large, mature firms within established markets. In this context, incremental innovation and quality-based product competition is critical (Hall & Soskice 2001). Here, employee participation may be particularly well-tailored to assuring smooth coordination of production, getting workers involved in raising quality, and reducing transaction costs (Streeck 1987). A large literature of Japanese production methods suggest that employee participation is an important governance factor in mobilizing the commitment and cooperation of shop floor workers engaged in lean production (Sako 1992). Given the low level of environmental contingencies, employee participation can help give these firms a strong capacity to buffer environmental uncertainties related to complex, modular production and smooth central resource inputs.

5

Despite these similarities, the effectiveness of employee representation rests upon rather different sets of complementary institutions in Germany and Japan (Aoki 2001). In Japan, employee voice is linked with enterprise-based unions, long-term employment guarantees, seniority wages, and internal training and job rotation to assure the flexibility and commitment of this stable labor force (Dore 2005). In Germany, unions are industry-wide and settle uniform wages on a sectoral basis. Likewise, training occurs through an occupational-based

apprenticeship system that involves public-private partnership in training according to standard, national profiles for each occupation. In this context, employee participation serves as a critical and complementary link to implement and enforce institutionalized obligations imposed from outside the firm in ways completely absent in Japan (Streeck 1987).

DISCUSSION AND POLICY IMPLICATIONS

Our framework has highlighted the importance of ‘contextual factors’ based on different organizational environments. An important implication of our argument is that these should not be treated, in methodological or theoretical terms, simply as ‘control variables’ in understanding otherwise universal relationships. Rather, we suggest that theory and empirical research should progress to a more context-dependent understanding of corporate governance and that this, in turn, will prove very useful for practitioners and policy makers interested in ‘applying’ corporate governance to particular situations. In this regard, recent methodological advances in studying configurations through set-theoretic methods represent a very fruitful avenue for further research. A potentially more contentious argument is that understanding effectiveness or performance requires greater sensitivity to how corporate governance affects different aspects of performance in different contexts. For example, whereas return on equity may be relevant for the corporate governance of mature firms, younger entrepreneurial firms’ performance may be better measured by innovation. Likewise, the existence of diverse stakeholder relationships implies that corporate governance should be associated with different distributive outcomes.

implications for public policy. In the light of corporate governance scandals and perceived advantages in reforming governance systems, debates have emerged over the appropriateness of different policy approaches based on hard law or alternatively regulation that draws upon soft law, such as codes of good governance based on comply or explain principles. The hard law approach to regulation, such as the US Sarbanes-Oxley Act passed in 2002, seeks to strengthen corporate governance through legal rules that cover all companies operating in a particular jurisdiction. Such an approach mandates high minimum standards and failure to meet these results in severe legal penalties. Soft law, such as the UK Combined Code, is based on an alternative approach of comply-or-explain principles. This approach has been criticized for its weaker degree of

enforcement and inability to mandate uniform minimum standards, but also has potential benefits in dealing with costs, contingencies and complementarities. Namely, the flexibility for firms to adapt or mix various corporate governance mechanisms under soft-law may help firms tailor corporate governance to diverse organizational environments.

The jury is still out on the two policy approaches to regulating corporate governance practices. However, we suggest that the trade-offs involved can be better understood by

analyzing the implementation of policy in terms of costs, contingencies, and complementarities. For example, Sarbanes-Oxley has been criticized for being too rigid and imposing excessively high costs, whereas the UK codes need to be strengthened by greater legislative underpinnings to assure enforcement. However, the fact that the UK approach is arguably the less universalistic and more contextualized of the two, may also help explain why, as other countries look to the US and the UK as early pioneers in the field, they have adopted some aspects of the US approach, but on the whole they have tended to follow more the UK Codes approach (Aguilera and Cuervo-Cazurra 2004).

CONCLUSION

This paper has developed a critique of corporate governance research within the agency theory and stakeholder traditions based on its lack of systematic attention to ‘contextual’ factors

grounded in diverse organizational environments. While the ‘open systems’ approach to understanding organizations and their environments has been a staple of organization theory, similar lines of inquiry remain surprisingly underdeveloped within the corporate governance literature. We have suggested a framework for looking at environmental interdependencies of corporate governance in terms of costs, contingencies and complementarities related to various well-known mechanisms of corporate governance. In order to take systematic account of these factors in future empirical studies, research on corporate governance must explore the patterned variation of corporate governance in terms of diverse configurations of factors, and attempt to understand effectiveness in terms of alignment of organizations with a more contextualized view of organizational environments.

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