6.2  Corporate governance

Establishing a firm reduces the informational and contracting costs faced by resource owners in the open market. However, it does not eliminate costs, as the firm structure introduces some within-firm information, monitoring and uncertainty costs of its own (i.e., agency costs). Owners cannot be certain that their agents will pursue the objectives they wish them to, i.e., profit maximisation. Saleh notes that bargaining costs will be lower within the firm (for example, an employer need not negotiate with employees about undertaking specific tasks) but the costs of monitoring employees and obtaining information about aspects of the production process are not necessarily insignificant. There are a number of mechanisms that can mitigate these costs, including corporate governance, the market for corporate control and bankruptcy.

There are many conflicts of interest in firms with separation of ownership and control and where managers/shareholders are not liable for losses. La Porta, Lopez-de-Silanes, Shleifer and Vishny (1998) suggest that the legal system itself is a mechanism that allows investor rights to be protected. Furthermore, the legal system has a fundamental impact on the structure and functioning of the market which also acts as a discipline on managers.

More formally, the corporate governance system is a mechanism by which shareholders provide a discipline on management in order to maximise the value of the firm. Corporate governance mechanisms involve reporting and disclosure on matters related to management and board members, such as remuneration and responsibilities, declaration of relevant interests, provisions to limit insider trading, risk management processes, audit arrangements and relationships with stakeholders. Corporate governance mechanisms, while costly themselves, may reduce the prevailing agency problems and the induced agency costs. In other words, according to Shleifer and Vishny (1997: 737), “Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investments.”

External agents other than shareholders may also effectively monitor and constrain managerial behaviour outside the corporate governance structure, for example through the stock market, bankruptcy or regulation.

The market for corporate control, including takeovers and mergers, also acts as a discipline on managers by external agents. A firm that is not performing up to expectations is an attractive target for a takeover. Where a firm is underperforming, its profits will fall and then its share price will fall. Shareholders will be more open to a takeover offer if a company is not performing well.

The threat of a takeover is a pressure external to the firm that provides a discipline on the activities of managers. The threat of takeover acts as an incentive on managers to perform well as management typically lose their jobs after a takeover. This is true whether or not a takeover offer has been made to shareholders because there is always the potential for an offer to be made. The threat of takeover aligns the interests of managers and shareholders by encouraging managers to maximise the returns to shareholders, which in turn encourages shareholders to resist takeover offers.

The market for corporate control can be seen as the “glue” that holds together the nexus of contracts that is the firm. When a firm is taken over, parts of the organisation may be sold off or established as stand alone entities. This implies that the agency costs associated with retaining resources within the firm had become too high and the new owners find it more cost effective to acquire those resources through the open market.

The degree to which the institutions governing the market for corporate control allow for takeover will influence whether the threat of takeover can place an effective discipline on management to perform. Regulation of takeovers and mergers can often focus on equity rather than efficiency objectives. Equity objectives involve the protection of consumers, minority shareholders, employees and other stakeholders. These considerations can affect the value of a takeover transaction to the acquirer and therefore reduce the extent to which takeovers contribute to improving management performance.

Other institutions may affect the capacity for changes in corporate governance. For example, competition law may prevent mergers and takeovers where a company is selling products in a non-competitive market. The prospect of corporate control providing greater discipline for firms operating in such markets would be particularly valuable, given management in such firms face less pressure than their counterparts in more competitive industries to operate efficiently. However, mergers or takeovers of these firms is unlikely to improve these conditions and if anything will worsen them. Bittlingmayer (2000) notes that during most of the twentieth century, mergers, acquisition and control of corporations in the United Statements has been related to problems of monopoly and concentration of economic power.

6.2.1  Resource allocation, innovation and human capital

Resource owners will attempt to maximise their productivity and profitability through the method of coordinating resources that they adopt, either contracting in the open market or using the firm structure. Which method provides the greatest returns will depend on which delivers the greatest efficiencies. This in turn will depend on the relative imposition of transaction costs in the open market compared with the agency costs within the firm. This will be influenced by institutions governing corporate governance and market transactions.

Effective contracting institutions contribute to economic growth by improving the efficiency of transactions. They reduce the costs to firms of transacting with each other and provide an environment where firms can be confident about entering into contracting arrangements, undertaking innovations and investing in human and physical capital.

Effective corporate governance institutions contribute to economic growth by exerting discipline on management to maximise profits. Takeover, or the treat of takeover, can increase productivity and profitability if it increases management efficiency in resource allocation and encourages managers to look for innovative opportunities. Bittlingmayer (2000) notes that recent studies on firm productivity find that transfers of control over firms raise productivity and profits. Nicoletti and Scarpetta (2003) find that corporate governance and competition boost productivity growth. Effective corporate governance will encourage investment in human capital where this will enable management to improve profitability.

6.2.2  Productivity

Corporate governance is increasingly seen as a mechanism that promotes economic growth. However, while the relationship between corporate governance and growth is clear in theory, the relationship is difficult to establish empirically at the macroeconomic level, partly because the effect is difficult to measure and isolate (OECD 2004). Laws that protect investors differ significantly across countries, in part because of differences in legal origins and these differences in laws and their enforcement affect the ownership structure, dividend payout, availability and cost of external finance, and market valuations of firms (La Porta et al 1998).

Gugler Mueller and Yurtoglu (2001) analyse the impact of corporate governance institutions, ownership structures and external capital market constraints on company returns on investment and they conclude that differences in firm performance are related more to the legal system than the firm’s corporate governance arrangements.[20] Companies in countries with common law legal systems based on the earn returns on investment that are at least as large as the cost of capital. At the same time, strong external capital markets and creditor protection improved the investment performance of firms.

Klapper and Love (2002) examined governance arrangements in emerging markets and conclude that firm-level corporate governance matters more in countries with weak legal environments exhibiting little shareholder protection and poor judicial efficiency. In other words, the legal environment matters less for well-governed firms, which have less need to rely on the legal system to resolve governance conflicts.

At the firm level, the empirical evidence suggests that corporate governance is an important determinant of firm performance (see for example Gugler 2001). La Porta, Lopez-de-Silanes, Shleifer and Vishny (2000) find that that strong investor protection is associated with effective corporate governance, as reflected in valuable and broad financial markets, dispersed ownership of shares, and the efficient allocation of capital across firms. Gompers, Ishii and Metrick (2003) found that firms with strong shareholder rights yielded annual returns that were 8.5% higher than those with weak rights.[21] They also showed higher valuations, higher profits, higher sales growth and lower capital expenditures.

The impact of corporate governance on firm performance has been shown in a number of studies outside the US. Denis and McConnell (2003), in a survey of international corporate governance, conclude that strong investor protection permits the development of strong financial markets necessary for economic growth. A study of Korean firms showed that improving corporate governance practices can have a significant impact on the value of a company (Black, Jang and Kim 2003).[22] Drobetz, Schillhofer and Zimmermann (2004), in a study of German firms, found a positive relationship between good governance arrangements in firms and firm value.

6.2.3  New Zealand corporate governance institutions

The practice of corporate governance is seen to be of a good standard in New Zealand, although ongoing consideration is given to how these can be improved to increase the information available to owners and the market more generally. The New Zealand Security Commission recently developed a set of principles for corporate governance to guide boards of directors related to ethical standards, board composition and performance, use of board committees, reporting and disclosure, remuneration of directors and executives, risk management, external audit processes, stakeholder relations and stakeholder interests. The New Zealand Stock Exchange recently reviewed its legal and regulatory framework to ensure the arrangements balanced the protection of market integrity with compliance costs. As part of upcoming reforms to securities trading law, changes will be considered for provisions related to insider trading, market manipulation, disclosure and penalties.