New Foundations and Corporate Governance - Corporate Governance and Business Ethics

This account of changes in the competitive environment of corporations explains developments in the strategies adopted by companies in recent decades as well as in their organization, management, and financing. What are the implications, though, for corporate governance? Can corporate governance still deal only with “the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment” or must it address a broader ranger of groups and their interests? The traditional account holds that only investors are the subject of corporate governance, not because the interests of other groups are not affected or unimportant, but because of three related propositions.

First, only shareholders bear residual risk. Other constituencies bear some risk from corporate operations, but given that the returns for their investment in a firm are fixed amounts that can be secured with complete, legally enforceable contracts, they do not bear residual risk – which is the risk that comes from having a return based on residual revenues or profits. Corporate governance, moreover, is a solution for residual risk bearers, so that its protection is appropriate only for investors with residual claims. For other groups with different kinds of risk, different protections are more effective. The crucial point here is that every group should receive an appropriate level of risk protection, but the safeguards for non-residual risk bearers may properly be different from those for residual risk bearers and hence need not be the subject of corporate governance.

Second, only shareholders and not other groups are affected by corporate decision making as long, of course, as a firm remains solvent. Since all no shareholder constituencies have fixed claims that are negotiated in the process of forming a firm’s nexus of contracts, their return is determined by the prices that their inputs command in the appropriate markets for labor, products, commodities, and so on, which are independent of the performance of a firm. By contrast, the return of equity capital providers, who have claims on the firm’s residual revenues or profits, depends directly on the decisions made by management. Management decisions affect the level of profits, but not necessarily the solvency of the firm, which is the major source of firm risk for non-shareholder groups. Only shareholders have an interest that a firm be more than solvent, and corporate governance is the means by which this interest is protected.

Third, only explicit contracts form the basis of each group’s claim on corporate revenues. Corporate governance constitutes investors’ claims, and the claims of every other group are backed by the agreements that occur in the market transactions for their inputs. However, firms also make implicit contracts that induce input providers to commit firm-specific assets that are not guaranteed by a legally enforceable contract. Zingales observes that a firm with a reputation for fair treatment, for example, may be able to induce employees to make a firm-specific contribution that they would not make in a market.

He continues,Thus, any theory of the firm that captures all sources of value in a firm must onside implicit as well as explicit contracts. However, the standard economic theory of the firm pays scant attention to these implicit contracts.

It is easy to see that these three propositions, which are central to the traditional account of corporate governance, are called into question by the developments that have taken place in present-day corporations.

First, residual risk is now borne by many groups other than shareholders. With the declining importance of large, tangible assets and economies of scale and the new emphasis on innovation and quality, human capital becomes central to a company’s strategy. However, employees can no longer be commanded in a hierarchical structure but must be induced to make firm-specific investments with promises that their contributions will be rewarded and not exploited (Blair 1995). Put differently, the value of human capital in modern production leads to greater quasi-rents due to firm-specific investments, which makes employees vulnerable to exploitation by other groups, specifically shareholders. Moreover, the human capital that is valuable to a firm is held not only by employees inside the corporation but also by many groups on the outside who are part of a firm’s network of resources. These sources of human capital must also be induced to cooperate with promised rewards. Thus, the residual risk of firms is spread further as strategic alliances are formed with partners and suppliers and the organizational boundaries of firms become blurred and porous.

Second, non-shareholder groups are now more affected by corporate decision making than before. The sharp line that once existed between the effects of managerial decisions, which extend only to the level of profits, and those of markets, which determine the prices of inputs, has broken down. As human capital becomes more important, employees are no longer merely sellers of labor, the return for which is determined by the labor market. Management decision making now has a profound impact on the value of the employees’ contribution and hence their return. Moreover, as relationships replace transactions, employees operate less in a labor market, merely selling their labor for wages, and more in cooperative enterprises, helping to create value by making firm-specific investments that could not be obtained in a market alone. Similarly, other groups have been drawn into the sphere of corporate activity, not merely as market participants or bystanders, but as resources that constitute part of the value or organizational wealth of a firm. Because they share in the production of wealth and also its distribution, the return to these groups is not determined merely by the market price of their inputs but is directly affected by management decision-making. Again, as firm boundaries become more blurred and porous, the once sharp distinction between being in a relationship with a firm and merely participating in a transaction with one breaks down.

Third, implicit contracts are now as important, if not more important, to business enterprises than explicit contracts. Explicit contracts are central to market transactions but are less crucial to relationships, which are built more on trust and mutual interests and goals. Implicit contracts are also more important in networks, especially with people and organizations outside a firm, than they are in firms with a hierarchical command structure and the vertical integration of resources. The value of relationships and networks to a firm reflects the fact that it is human capital the utilization of the skills and knowledge of people and not financial capital which can be used to secure fixed, tangible assets that is now they key to wealth creation. And the input of human capital, as opposed to financial capital, is better obtained and employed through implicit rather than explicit contracts.

If traditional corporate governance is built on the three propositions that only shareholders bear residual risk, that only they are affected by corporate decisions, and that only explicit contracts are at issue and if these propositions no longer apply, then obviously there is a need to rethink the prevailing allocation of control rights and the processes for their exercise. Zingales (2000) admits, “I am not aware of any formal development of the consequences of this approach [that is, the new foundations] for corporate governance”. It is beyond the scope of this article to attempt any such development, although a few writers have suggested new directions (Bainbridge 2008; Blair 1995; Blair and Stout 1999; Bottomley 2007). What remains to be shown, though, is how this new foundation is related specifically to the main features of the new governance, namely rule making and the administering of rights. More precisely, how can these developments be understood as a part of the changed competitive environment that motivates the search for new foundations?


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