A Search for New Foundations - Corporate Governance and Business Ethics

Fortunately, it is possible to understand the development of the new governance in a way that explains how the new roles and responsibilities of present-day corporations are an efficient adaptation to a changed competitive environment for business. Such an explanation, furthermore, does not raise any normative problem about legitimacy that would require discarding the fundamental conception of corporations as economic actors. However, this explanation does alter the underlying theory of the firm in ways that lead to significant changes in corporate governance. The main outlines of this explanation are sketched by Luigi Zingales in his article “In Search of New Foundations”. The foundations in question are those for corporate finance: needed, in his view, is a new theory of the firm to support the empirical research, practical applications, and policy recommendations of corporate finance. However, the new foundations that he describes can be applied with equal fruitfulness to corporate governance and the new governance. Many of the features of present-day firms described by Zingales are also present in what Post et al. (2002a, 2002b) call the “extended enterprise”, although these writers do not explore its implication for the theory of the firm or corporate governance.

The world has changed dramatically in the past several decades. The changes noted by advocates of the new governance concern primarily what Mathews (1997) calls the rise of “global civil society”, in which national governments have lost autonomy and now share power with corporations and nongovernmental organizations (NGOs). In political theory, this change represents the end of the Westphalian system and the beginning of a system of “global governance” (Kobrin 2008; Wolf 2008). By and large, scholars of the new governance have drawn on the immense political theory literature on global civil society and global governance. However, equally significant changes have occurred in business organizations that are not reflected in this literature.

The visible signs of changes in present-day corporations are, first, the breakup of large conglomerates with their standardized forms of organization in favor of smaller, more nimble companies, which have taken a wide variety of original and still-evolving organizational forms. Second, corporations have abandoned their rigid and closed vertically-integrated structure to adopt more flexible, open forms of collaboration in networks. Both of these developments lead to a blurring of organizational boundaries, which are constantly in flux. Third, corporations are ceasing to be hierarchical with extended formal chains of command and are becoming more flattened with multiple, informal reporting relationships. Fourth, corporations are being driven to innovate constantly with new produces and services and improve quality rather than merely reducing costs and expanding output of a standard product line. Innovation and quality improvement have replaced the traditional emphasis on economies of scale and market share as the drivers of corporate strategy.

Behind these visible signs are some less obvious changes with profound implications for corporate finance and government. The optimal strategy for a company in any competitive environment is to identify and exploit opportunities for value creation. In the traditional firm, the key elements have been to employ large fixed tangible assets and realize economies of scale to reduce prices and enlarge market share. In such a firm, control over inputs through vertical integration of natural resources and hierarchical command structures for labor are critical. The most critical input or resource is capital. Because large amounts of capital are needed in a traditional, capital-intensive firm, firms must turn to outside investors who can bear the risk of providing capital through diversification. Since these diversified investors still bear considerable residual risk, it is necessary to offer them strong ownership rights. With outside ownership, however, comes the separation of de jure ownership and de facto control, which leads to the agency problems that corporate governance is designed largely to solve.

The changed competitive environment of the past several decades has radically altered the strategy that companies must pursue to continue to create value. In his presidential address to the American Finance Association, Michael Jensen (1993) terms the years after 1973 “the modern industrial revolution”. In his account, a combination of increasing productivity, technological innovation, declining capital costs, more varied sources of financing, reduced regulation, and the globalization of commerce made the traditional model of growth through expansion and economies of scale counterproductive. Corporations could now create value only by seizing new opportunities that arose mainly from technological innovation and globalization. New and better products were the key to value creation rather than cheaper, more abundant ones.

In this new era, fixed tangible assets are less important than skills and knowledge. Since financial capital is less essential and, in any event, easier to obtain in many different forms, human capital has become more crucial and in demand. At the same time, corporations find that they have less control over employees and other sources of innovation and competitive advantage. Not only can employees easily leave to work for competitors anywhere in the world, but some valuable skills and knowledge are possessed by outsiders in all parts of the globe who cannot be brought inside the firm. As a result, the resources needed for value creation cannot be owned and controlled in a hierarchical organization as in the past, but need to be mobilized in a collaborative network of people and institutions, both inside and outside the organization. Consequently, Post et al. (2002a) observe that “it is relationships rather than transactions that are the ultimate sources of organizational wealth” (original emphasis; citing Leana and Rousseau 2000).


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