Written By: Richa Buragohain.
Edited By: Christo Sabu.
Corporate governance theory originated in 1932 with the Berle and Dodd debate arising from the separation of shareholder ownership and management control. From the discussion developed the economic model of Agency theory. Today, understanding the role of tradition and culture in corporate governance has become a subject of growing importance. No institutional analysis of corporate governance systems would be complete without considering the traditional environment embedded in such systems. This change is primarily due to the adoption of dimensional models of tradition- an analytical framework developed mainly in social psychology.
INTRODUCTION
Understanding the role of tradition or culture in corporate governance has been a subject of growing importance since the latter concept emerged in the late 1980s and even more so since the advent of research on comparative corporate governance during the 1990s. From the beginning, references to tradition- tended to be impressionistic have been made. Even those references, however, manifested a newly-found awareness of the idea that corporate governance is a complex system whose structure and functioning not only depends on law and economics.
Before discussing tradition, a thumbnail sketch is in place on what corporate governance is and why we care about it. Defined as the institutional framework that regulates the division and exercise of power in the corporation, corporate governance addresses the multiple relations among corporate stakeholders, including shareholders, managers, employees, creditors, and others. Such connections often begin voluntarily using a contractual framework. Hence the widely popular metaphor of the firm as a nexus of contracts has also formed a legal scholarship.
As under corporate governance, the nexus of contracts theory fails. However, this theory fails because corporate governance begins precisely where the contract ends, when the agreement proves incomplete, when information is incomplete, especially when it is unverifiable, or when enforcement of the contract is unlikely. The combination of information and self-interestedness asymmetries results in the centralization of power in the hands of the party who can unilaterally affect the interest of the other party.
THE IMPACT AND RULE OF LAW ON CORPORATE GOVERNANCE
- Relevance:
So, Tradition matters. But (how) does it matter for corporate governance? (How) does it interact with corporate laws to affect corporate governance? According to Beugelsdijk & Maseland, many scholars struggle with the concept of tradition. It is unclear whether the legal origin is seen as tradition or whether there is a relationship between legal origin and tradition.
To get a flavor of how tradition might impact corporate governance consider CEO succession- one of the most significant challenges every company has to face is with respect to its board and its shareholders. Early references to tradition in this regard tended to be highly impressionistic. Granted, the prevailing tradition of some countries may engender somewhat idiosyncratic practices for ensuring the quality of controlling persons.
Tradition has been linked to large-scale variation in such structures at the most general level of analysis of the design of the economic system – sometimes referred to as “varieties of capitalism”. Using the Schwartz dimensions, Frederic Pryor has shown that certain combinations of traditional orientations match the particular economic system of OECD countries and exert a causal effect on this system.
- General Relation between Law and tradition:
The following sections review the relation between traditional orientations and particular subjects of corporate governance. Before that, this section discusses the general relations between tradition and law, especially corporate law. As Williamson’s model of social institution illustrates, tradition and law may interact in a standard-setting. Tradition sets informal constraints and provides motivations for developing the law in a culturally-compatible fashion. In tandem, societal patterns of compliance with, or deviance from, culturally-compatible laws inculcate in societal members the value emphases that these laws reflect.
On a deeper level than formal legal rules, there lies the institution of legality, a.k.a. the rule of law, or more roughly, property rights, or quality of institutions, or simply institutions—a social norm of legality functions as an interface between the informal and formal institutional levels. For any law, including corporate law, to operate as designed, there must be a widely-shared social norm of law abidingness and law enforcement. Such a norm legally means that the legal entitlements of societal members are respected- namely, their personal safety, tangible and intangible property. By definition, every legal system calls on people to obey the law, yet countries vary significantly in the degree to which laws are followed. A social norm of legality can ensure that formal laws are followed by drawing its injunctive force from its compatibility with specific traditional values, particularly values that underscore the legitimacy of personal interests and the moral equality of individuals.
3. The Objectives of the corporation:
The debate over the objectives of the business corporation is one of the oldest and probably the most fundamental in corporate law. The proposition that shareholders are the primary beneficiaries of the corporation and hence directors’ duties run to them is generally interpreted as calling on corporate law. The proposition is that shareholders are primary beneficiaries of the corporate fiduciaries to maximize (long-term) shareholder value. The literature often refers to this proposition in shorthand as the “shareholder primacy norm” or “shareholder wealth maximization norm”. In contrast to shareholder primacy, there stands an opposite view- the” stakeholder approach”- which calls on corporate fiduciaries to consider, in addition to shareholders’ interest, the interests of other constituencies, including employees, creditors, customers, and the community.
Legal doctrine regarding the objectives of the corporation varies among jurisdictions. Although common law and civil law jurisdiction often have been characterized as shareholder-oriented and stakeholder-oriented, even a cursory analysis challenges such a clear distinction. Thus, the laws of Delaware in the United States and of the United Kingdom endorse the shareholder-oriented approach. In Delaware, the ruling in Gheewalla underscored shareholder primacy and dispelled any possible ambiguities in the wake of Credit Lyonnais. The U.K. law authorizes board members to consider the interests of non-shareholder constituencies but subordinates the latter to a primary objective of promoting “the success of the company for the benefit of its members as a whole”. Civil law tradition things are pretty ambiguous. Finally, Indian law is a chimaera requiring directors to promote the company’s objects for the benefit of its members as a whole and in the company’s best interests, its employees, the shareholders, the community, and the protection of the environment.
4. Relations with Investor (and other stakeholders):
Defined as the institutional framework that regulates the division and exercise of power in the corporation, corporate governance addresses the multiple relations among corporate stakeholders, including shareholders, managers, employees, creditors, and others. This section demonstrates the role that tradition may play concerning crucial issues in the relations with investors and other stakeholders- namely, earning managements, as a fact of the informational regime that governs public companies and dividend policy, as a facet of firms’ financial relations with its stakeholders.
- Disclosure: Earnings Management:
Earning Management is the practice of exercising judgment in financial reporting to mislead some stakeholders about firm performance or to influence contractual outcomes. Corporate insiders may want to manage earnings numbers to be eligible for contingent remuneration, meet financial covenants in debt instruments, or meet analysts’ expectations to avoid embarrassment, and so forth. Earnings can be managed to reduce intertemporal variability in reported earnings or meet specific targets.
- Distribution: Dividend policy:
Several theories purport to explain dividend policies. Agency theory holds that dividends may serve to discipline insiders from behaving opportunistically by denying them free funds that could be extracted as private benefits or allow for managerial slack. In this view, discretionary dividend payouts may substitute for legal rights that ensure investor protection. LLSV has documented a positive relationship between shareholder rights and dividend payouts around the world. This finding arguably supports an outcome theory of dividends- namely, minority shareholder rights support pressures to release free cash to shareholders. Dividend payout increases default risk and might limit future investment such that it affects additional stakeholders like creditors and employees.
5. Executive compensation:
Few corporate governance issues trigger heated debates and regulatory intervention as executive compensation does. Executive compensation is a complex issue, and corporate governance is only one aspect of it. Whether one subscribes to the “managerial power” theory of executive pay or the “optimal contracting” theory, there is no denying that executive compensation is set by corporate insiders who enjoy discretionary power. This may call for institutional regulation. This section focuses on the role that culture may play in the setting.
In a speech given by the Governor of the Bank of England, Mark Carney, at the World Economic Forum’s annual meeting in Davos, Mr. Carney stated “[W]hile regulators … can determine the appropriate split if remuneration between fixed and variable elements to limit risks to financial stability, only society, not regulators can determine whether the absolute and relative levels of compensation are acceptable”.
6. The Board of Directors:
The board of directors is the epicenter of power relations in any corporation. It is, therefore a key component in firms’ corporate governance. At first glance, the board is a universal phenomenon. Companies that invariably have had boards at least since the East India Company were chartered in 1600. Doctrinally, the board of directors holds the power to manage or direct the management of the company’s business. With various secondary differences, this is the law in virtually all common law jurisdictions and other legal systems.
Corporate Governance provides a modern rendition of the board’s dual mission-namely, to provide strategic advice and monitor the management. Although they lack legal force and may not precisely reflect the corporate laws of all countries, the OECD Principles do reflect a universal consensus on the board’s responsibilities.
This image of universality may be misleading. However, when one examines national laws in more detail, numerous differences emerge, especially with regard to the structure of the board. Recent research indicates that formal legal differences may form just the tip of the iceberg, regardless of whether they are consequential or not. Both the functioning of the board and its structure may also be shaped by informal, traditional orientation. This section reviews current evidence on these issues:
- Operation: Board-CEO Relations
- Composition: Board Diversity
- Structure: Director Networks
CONCLUSION
Thus, it has surveyed the literature on tradition, law, and corporate governance, intending to establish the importance of considering both formal (legal) and informal (tradition) institutions in the analysis of corporate governance systems. It also hopes that the goal has been met with some success. In one of my papers that called for adopting the traditional value dimension framework for such analyses I referred to tradition as “the mother of all path dependencies”. The body of scholarship that has since accumulated seems to support the contention made at that time. “At the risk of stretching the mother metaphor a little bit, it can be argued that tradition may indeed be perceived as an old mother. It knows a lot, but some of this knowledge might be obsolete today; it is sometimes nagging; it will resist change unless absolutely required. Most importantly, it must not be ignored.”
More work can be done toward revealing additional facets of the relations between corporate governance and tradition. Institutional environments in Asia and even Europe differ markedly from those that prevail in English- speaking countries. Understanding these environments will help policy – and lawmakers to develop corporate governance systems more effectively. To achieve this goal, we will need to advance our knowledge beyond observing correlations of the sort that was reviewed here toward a more detailed understanding of the relations between law and tradition. Looking at the road ahead, it is fitting to conclude this with a contemporary quote from Michael Bond, who, together with Hofstede and Schwartz, is among the founder of modern cross-cultural research.