Traditional Corporate Governance - Corporate Governance and Business Ethics

Corporate governance has been understood traditionally as the rules that define the relationship between a firm and its capital providers or financiers. For example, Shleifer and Vishny (1997) write that corporate governance “deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment”. This view is based on a theory of the firm in which a corporation is a nexus of contracts in which every group participating in joint production provides some input in return for a claim on revenues. Since the equity capital providers’ return is the residual revenues or profits, thereby making them residual risk bearers, they have a special contracting problem that is best addressed by the possession of control rights. Although other groups provide needed inputs, these contributions to production are generally not firm-specific and the return, in any event, can usually be secured by other contractual means. Other groups, thus, have little need of the kind of protections, including control rights, that is possessed by the financiers of the firm, and, consequently, these rights are allocated to the party, namely equity capital providers, to whom they are of the greatest value.

The value of control rights in corporate governance to the financiers of the firm derives from the ability of these rights to solve two key agency problems in joint production. First, the problem of monitoring the contribution of every participant in joint production is solved by assigning residual revenues to the group with control right so as to motivate its members to monitor the activities of other groups (Alchian and Demsetz 1972). Second, and more importantly, corporate governance is designed to address the agency problem inherent in the separation of ownership and control in large publicly held corporations ( Fama and Jensen 1983; Jensen and Meckling 1976; Hansmann 1996; Williamson 1985). It is by means of the control rights provided by corporate governance that capital providers can, through the board of directors, ensure that the managers monitor each group’s efforts and maximize the residual revenues or profits.

Since the aim of all production decisions is maximal efficiency, the rules of corporate governance that emerge in a market through a process of negotiation between a firm and its equity capital providers, which constitute the rules of corporate governance, also have the aim of efficiency. In general, the forms of corporate governance that emerge when corporate constituencies are able to contract freely in a market will be efficient. Insofar as corporate law is established by government legislation, as opposed to private contracting, one of its aims some claim its only proper aim is to codify in law the most efficient relationship between firms and its financiers (Easterbrook and Fischel 1991). Indeed, in the Anglo-American system, much of the law of corporate governance is merely default legislation that provides “off the- shelf” rules that codify the kinds of contracts that private parties would write themselves. If these rules do not conduce to efficient production, firms are generally free, especially in the Anglo-American system, to contract differently. Any mandatory rules of corporate governance established by government that cannot be contracted around may be assumed to introduce some inefficiency into corporate operations (otherwise they would be adopted voluntarily by private contract). However, they may be enacted into law by government in the pursuit of values other than efficiency, such as fairness or social welfare.

In this traditional account of corporate governance, firms are understood to operate within a market in which private economic actors exercise their property rights through economic exchanges or transactions. The market is thus a sphere of activity in which every party not only profit-oriented shareholders but other investors, employees, customers, suppliers, and other groups – seek to obtain maximal benefit. The market mechanism is utilized in a capitalist economy, not only to organize production and distribute the wealth thereby created, but also to determine the rules of corporate governance themselves and the assignment of governance rights. The state or government provides the legal structure for market activity for example, by protecting property rights and enforcing private contracts along with making rules for other spheres of civic life through the democratic participation of citizens in the rule-making process. In particular, it is the role of the state to provide public goods and protect individuals’ civil and political rights.

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