Regulators and governments around the world are rewriting the rules for the governance of corporations. Most of these initiatives focus on increasing board vigilance and minority shareholder protection. In the United States, these efforts have culminated in the passage of the Sarbanes-Oxley act, while in the European Union this has led to the talk of a possible European code of conduct on corporate governance.
While some academic research supports the hypothesis that shareholder rights and board vigilance stimulate the growth of financial markets and economics (for instance, see La Porta, Lopez-de Silanes, Shleifer, and Vishny (1998)), the hypothesis remains to be conclusively established. First, the ability of shareholder rights to explain financial market development in the time series is weak. In the United Kingdom around the turn of the last century a legal precedent, Foss vs Harbottle (1843) stripped minority shareholders of virtually all legal protection.
The flowering of diversified public equity ownership in the U.K on soil “poisoned” by Foss vs Harbottle seems difficult to square with essential importance of shareholder rights (see Franks, Mayer, and Rossi (2005)). Second, nor do outside shareholder legal rights appear essential for capital market development. In fact, some researchers (e.g., Bainbridge (2002)) as well as legislators have expressed concern that excessive outside shareholder rights can even be harmful because outside activist shareholders will use their rights to pursue private or politically motivated agendas at the expense of overall shareholder welfare.
Indeed, a reaction to the increased demands for board and shareholder formal control seems to be currently building in both policy making and business circles as evidenced by the SEC’s April 4, 2007 decision to revisit the Sarbanes Oxley act, the recent explosive growth of lightly regulated AIM market in London, and, perhaps, by the expanded role of private equity financing. From these developments, it is clear that that many firms, financiers, and policy makers doubt the value of the recent reforms empowering outside investors and board members.
Surprisingly, both the initial adoption of reform and the subsequent reaction have occurred in the absence of an integrated theory of governance. While many researchers have examined particular aspects of governance, this research has proceeded in the absence of a comprehensive theory of governance that examines the relation between the key determinants of governance board vigilance, the market for corporate assets, executive compensation, and shareholder activism.
While the focused approach to research on governance has generated important insights into the effects of several factors on the governance of corporations, it suffers from several drawbacks. First, the effect of any one factor on firm governance may well depend on how the other governance parameters are set. Because of jurisdictional variations in legal and institutional factors, many components of governance policy are exogenously fixed at disparate levels for different firms. For this reason, the results of studies verifying the optimality of one governance choice in a specific jurisdiction may not extend outside that jurisdiction. Second, because a number of the components of the governance mechanism are choice variables, a sample of firms selected based on usage of a particular governance mechanism may not be random. Further, the choice of one component of the governance mechanism depends endogenously on other choices. For this reason, predictions based on the examination of a single component of the governance mechanism may be misleading. Given these problems, what is needed is a model of governance that incorporates all of the key components of governance structures.
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