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Definition: corporate governance from Dictionary of Accounting

The way a company or other organisation is run, including the powers of the board of directors, audit committees, ethics, environmental impact, treatment of workers, directors' salaries and internal control

Summary Article: Corporate Governance from Encyclopedia of Business Ethics and Society

In its essence, corporate governance refers to the organization of the relationships between shareholders, board of directors, management, and other stakeholders in a corporation. According to the Cadbury Committee, corporate governance is concerned with the processes by which corporations are directed and controlled. Corporate governance especially deals with exercise of authority over the directions of the company, the supervision of actions of top management, the acceptance of accountability, and the compliance with legal and regulatory frameworks in which the company operates. The term corporate governance is not easy to define, as it can be used differently in different contexts. Several academic disciplines that study corporate governance bring their own distinctive meaning of the term. For example, economic theory emphasizes the mechanisms used by financial suppliers of corporations to assure themselves of getting returns on their investment. The study of law examines the power and duties of various corporate governance actors and discusses the legal instruments by which property rights are organized. The authors from the management and business administration focus on internal governance mechanisms that enhance decision making and improve performance.

Definitions of corporate governance have also changed over time to reflect the shift of the purpose and roles of corporations in modern society. In the 1960s, the main purpose of corporate governance was control of business power and authority. Therefore, corporate governance was dominated by investor predisposed definitions supported by agency theory. The corporate discussion was primarily about the control of managerial self-interest and a board of directors’ monitoring role. More recent definitions adopt a much broader view, contemplating the whole complexity of corporate life. Margaret M. Blair offers one such definition, according to which corporate governance refers to the whole set of legal, cultural, and institutional arrangements that determine what publicly traded corporations can do, who controls them, how that control is exercised, and how the risks and returns from the activities they undertake are located.

National Governance Systems

Although the conceptualization of national differences in corporate governance is often debated, most comparisons categorize countries into three groups: Anglo-American, continental European, and Japanese–East Asian models. The Anglo-American model is characterized in terms of dispersed ownership and corporate financing through equity or short-term debt markets and active markets for corporate control. It is shareholder oriented and perceives the firm as the private property of its owners. This model is prevalent in the United States and the United Kingdom. The continental European model is stylized by concentrated ownership (usually by large blockholders, such as banks and families), long-term debt finance, and underdeveloped market for corporate control. Although it primarily emphasizes the interests of shareholders, it also takes into account the interests of employees. This model is widely adopted in Germany and to a smaller extent in Continental Europe. Japan and East Asian countries follow a model that emphasizes development of longterm relationships among various stakeholders—the main bank, major suppliers, distributors, owners, and employees. In this pluralist framework, employees’ interests take priority. Such an inward-oriented and employee-centered environment of strong and longterm internal relationships, which dominates the firm’s governance structure, also diminishes most chances for hostile takeover.

Differences in national patterns of corporate governance are shaped by a plethora of historical, political, institutional, economic, and social influences and determinants. A large number of studies have shown how historical conditions and political institutions influence certain features of property rights and financial markets and, consequently, ownership concentration and company’s access to external finance in different countries. Furthermore, some authors argue that one of the main political and social factors relevant to understanding corporate governance is the conflict between owners, managers, and workers. For example, where owners and managers have more power, corporate governance institutions tend to favor shareholders over stakeholders. Property rights, financial systems, and network structures are among the major factors accounting for these national differences.

Property rights define mechanisms through which different groups of shareholders exercise their control and how this control corresponds to managerial discretion. Shareholders rights vary internationally. The outcomes of such a divergence are complex legal and economic arrangements that shape the different mechanisms of corporate control. The Anglo-American system incorporates a liberal market approach. Here, market-oriented mechanisms of control are used to reinforce shareholder rights. Liberal property rights, which postulate relatively high disclosure of company information and establish a one-share–one-vote norm, provide strong protection of minority shareholders. Therefore, this system discourages disproportional control through blocks and favors different dominant interests within corporate governance. The continental European system exemplifies a constitutional model of shareholder control. In this model, shareholders delegate substantial control rights from the general shareholder meeting to a supervisory board. This approach tends to contribute to disproportionate power effects by large blockholders (families, banks, or other corporations). Given the ability of blockholders to secure greater control, they are able to pursue their strategic interests within corporate governance. Empirical research has supported the idea that concentrated ownership increases the external influence over management, whereas in the case of dispersed ownership the shareholders are largely separated from the firm. The Japanese system conforms to a shareholder authority model in which large shareholders hold broad powers. Cross-corporate shareholdings and weak information disclosure predominately protect property rights of majority shareholders and disable minority shareholders from having any influence over the firm.

The second major determinant of governance patterns is the type of financial system on the supply side of the capital market. Financial systems are usually divided into market-based and bank-based systems. The former has greater importance in the United States and the United Kingdom (Anglo-American model). This system promotes equity finance through active capital markets, where suppliers of capital (individuals or institutions) directly or indirectly invest in equity (shares) that is publicly issued by companies. Individual shareholders have little direct influence on management. If dissatisfied with management decision, shareholders have the ability to sell their equity holdings in the firm. In the United States and the United Kingdom, banks typically do not hold company equity and their representatives do not sit as bank representatives on the board, although bank directors as individuals are represented. The bankbased financial system is found to be a dominant investment pattern in Continental Europe and Japan. Banks are the key financial institutions and are closely involved in ownership of the corporate sector. Banks hold shares either in their own right or collect deposits and invest them into companies for others. Their double role as lenders and important shareholders has often been stressed. It has been a historical tradition for this financial system to mobilize capital to the industry. In doing so, it has contributed to the growth of strong relationships between banks, industrial corporations, and other business partners. Dominance of debt finance, through the bank-based financial system, has caused in Germany, for example, the equity market to be relatively undeveloped when compared with equity markets within the Anglo-American system. The German banks have a mechanism for evaluating companies that is not practiced in the banks of the Anglo-American system. In Japan, the same function is covered by large and powerful planning departments of the keiretsu’s main bank and trading company. The differences between these two financial systems are evident in several measures—share market capitalization, the distribution of financial assets, and firm debt/equity ratios. Even though a large number of countries occupy a position between the two opposing models, financial systems have significant impact on corporate governance. This grip is based on their ability to provide different sources of finance and via their capacity to influence relationships between different shareholders.

Variations in governance systems are also a consequence of interorganizational arrangements or network structures. A network structure refers to the quality and quantity of direct and indirect relationships between companies. Research on social networks has shown that the company’s position within the network determines its access to critical resources, diffusion of practices across the companies, and overall power of the company within the network. Interorganizational arrangements of firms that belong to the Anglo-American system of corporate governance are characterized by loosely coupled connections. Their network structure is usually not based on ownership arrangements. Such weak ownership ties, fostered by financial interests of companies, facilitate market-like behavior in their mutual relations. Corporate networks in countries of the continental European system of corporate governance often involve vertical ownership arrangements with various suppliers and the board, thereby interlocking directorates among critical shareholders and creditors. These interorganizational networks are characterized by a high degree of intercorporate cooperation, which strategically promotes long-term relationships between various stakeholders. Codetermination policies in the German model of corporate governance, for example, see large companies as informal partnerships between labor and capital. At the center of the Japanese corporate grouping is a powerful bank or a financially strong company that can provide the other members of the group with capital at low cost. Reciprocal cross-shareholding in the Japanese system strengthens the commitments of organizations within the corporate network/group and weakens the influence of outside entities. This is why hostile takeovers in Japan are virtually unknown. Companies are acquired by other companies only through mutual consent.

The Shareholder Wealth Maximization Model of Corporate Governance

Given an assumed separation of ownership and control in the modern corporation, the shareholder wealth maximization model regards the firm as a nexus of contracts through which various participants arrange their transactions. This theoretical perspective received the strongest support from the “Chicago School” of law and economics. Relationships between shareholders and managers are seen as classical principal-agent relationships with all the difficulties of enforcement associated with such contractual arrangements. The primary responsibility of management is to maximize the value of shareholders’ investment via dividends and market prices of the company’s shares. Thus, according to this model, the major concern of good corporate governance is how to control the behavior of top management and get them to run the company in the interest of shareholders.

There are at least four mechanisms by which shareholders can induce management to adopt an orientation toward shareholder value: (1) a relatively large ownership position, (2) compensation linked to shareholder return performance, (3) threat of takeover by another company, and (4) competitive labor markets for corporate executives. It is expected that a management share ownership option will motivate managers to identify more closely with the shareholders’ economic interest. Though many top executives own a relatively large percentage of shares in their companies, their perspective on risk may differ from that of shareholders. It can be expected that managers have a lower acceptance of risk than shareholders. Where a company makes risky investments, shareholders can always balance this risk against other risks in their portfolio. Managers, however, can only balance an investment failure against the other activities of the company and are, therefore, more affected by investment risk.

The second mechanism that aligns managers’ with shareholders’ interests refers to compensation tied to shareholder return performance. This is the most direct means of influencing management behavior. Here, a variable portion of managers’ compensation is linked to the shareholders’ realized market returns. However, this mechanism is not without limitations. For example, an increase in the price of market share may be the consequence of factors beyond management control, regardless of whether they have worked hard or made good decisions.

The third mechanism is the threat of takeover by another company. Any extensive exploitation of shareholders’ or maximization of managers’ selfinterest should be reflected in low share prices. A lower share price provides a takeover opportunity for another company or investors. The new owners will usually replace existing management. Where such a circumstance is plausible, an active market for corporate control proves to be both an external and ultimate mechanism that has the ability to create a convergence of interests between managers and shareholders.

The fourth and last mechanism of aligning managers’ self-interest with those of shareholders is the competitive labor market for corporate executives. Managers compete for positions within and outside the company. Within this market they are evaluated on corporate performance, both in terms of accountingbased and share market–based measures. As a result, executives leading poorly performing companies will be offered fewer top executive positions within and outside the company.

The shareholder value perspective was dominant both in U.S. and U.K. companies in the 1970s and 1980s. An emphasis on sustaining share price and dividend payments at all costs encouraged the use of mergers and takeovers as mechanisms of corporate control to punish managers who were unsuccessful in improving shareholder value. Such an approach created economic instability and insecurity and was widely criticized by various economic and strategic analysts.

Throughout the years proponents of the shareholder value perspective have become more tolerant toward the interests of other stakeholders. Nevertheless, the main principles, which claim the supremacy of the ultimate owner, have remained the same. Consequently, the focus on shareholder value and stakeholder interests has become a foundation of good corporate governance.

The Stakeholder Value Perspective on Corporate Governance

The stakeholder view of corporate governance argues that all groups and/or individuals with legitimate interests in the company have the right to participate in the company’s activities and gain a share of its economic success. There is no distinct priority of one set of interests and benefits over another. Therefore, a company should be seen as an organizational coalition between numerous and heterogeneous groups who provide their resources (i.e., capital, labor, management, loans, expertise, material, and service) to accomplish multiple, and not always congruent, goals through the company’s activities.

Primary stakeholders are considered to be those with a legitimate claim to participate in the company’s affairs, that is, those who directly participate in the economic-value-creation process and who are directly affected by the company’s policies (e.g., employees, specific customer segments, key suppliers, certain financial institutions, and key governmental agencies). Other interest groups such as local communities, trade associations, and consumer groups, which are indirectly affected by the company’s actions, are regarded as the secondary stakeholders.

According to the stakeholder perspective, the major concern of corporate governance is how to balance the interests of different stakeholders. Shareholders’ legitimate emphasis on share prices and dividends must be balanced against the legitimate demands of other groups. However, these demands are not only financial. Different groups have different values. For example, employees might highly regard education and training support, suppliers of materials might prefer secure demand, and the local community might appreciate minimal air pollution. The balancing of these interests requires constant negotiation and compromise between inside and outside stakeholders and between directors and managers.

The trend toward the stakeholder perspective of the corporate governance is reflected in existing and emerging regulations of many developed countries. The codetermination laws in Germany, which require employee representation on the supervisory board; harmonization of the rules relating to company law and corporate governance in the European Union, which will take into account interests of employees, creditors, and customers; the Japanese well-known legal and customary model of corporations with its interrelated stakeholders including customers, suppliers, financial institutions, and other business partners; and the campaign toward stakeholder law in the United States all demonstrate demand for formal instruments to democratize the governance of corporations.

Board of Directors

The board of directors is a governing body elected by shareholders to direct and supervise the management of the company. The board establishes the strategic direction and objectives of the company and sets the policy framework within which the company operates.

Different countries have different governance practices in terms of the board composition and its functioning. However, in general, members of the board of directors can be grouped into two main categories: (1) executive directors, who also have a management function in the company; and (2) nonexecutive (outside) directors, who have no managerial responsibilities. Nevertheless, they can have executive functions in other companies. Nonexecutive directors are selected to ensure that a broad range of skills and experience is available. In addition, a nonexecutive director can be formally classified as “independent.” An “independent director” has no direct or indirect, current or previous, professional or personal interest or relationship in the company. It is believed that independent directors will empower the board with their ability to exercise independent judgment and effectively monitor management. Increasingly, the corporate governance practice of some countries has required or encouraged representation of formally independent directors on the board.

Within the tradition of the companies that originate in the Anglo-American system of corporate governance, boards can delegate some of their functions to various committees of the board. The purpose of a committee is to address certain issues in a more detailed manner than is possible at board meetings. The board as a whole, however, retains full responsibility. It is a standard practice for nonexecutive directors to establish the audit committee and remuneration committee. The audit committee oversees compliance with statutory responsibilities, thus ensuring that adequate internal controls are in place, advises the board regarding accounting policies and practices, and reviews the scope and outcome of the external audit. The remuneration committee deals with remuneration packages of the executive and nonexecutive directors and other groups of key executive managers. It may also consider succession issues.

Roles of the Board

Board roles can be generally categorized into three groups—control, service, and resource provision roles. The control roles involve the directors’ fiduciary duties of monitoring management on behalf of shareholders. Directors’ responsibilities in this role include appointing and dismissing the chief executive officer (CEO)/president and other top executives, deciding executive remuneration, and monitoring managers to ensure that shareholders’ interests are protected. The services roles consider directors’ advisory functions in formulating strategy and providing guidance to the CEO and top managers in other managerial and administrative issues. The resource roles refer to directors’ assistance in the acquisition of critical resources for the company.

From a legal perspective, the control role is the primary purpose of the board of directors. Directors owe fiduciary responsibility to the corporation and shareholders. Fiduciary duties include the duty of care and duty of loyalty. Essentially, fiduciary duties call on directors to make every attempt to be well-informed before they make decisions, to act in good faith and the best interest of the shareholders, and to be independent in their decisions. From a financial perspective, directors’ control role is primarily grounded in agency theory. That is, directors’ source of power is derived from shareholders. Board members are selected by principals (shareholders) to monitor managerial behavior (agents). By actively monitoring management actions and firm performance, the board can reduce agency costs and maximize shareholder value.

One of the most prevalent roles of the board is its service role, that is, provision of advice and support to the CEO. It is argued that this role is most visible in organizations that experience external monitoring mechanisms, such as product and managerial labor markets. The service role is also stressed in the companies with major institutional shareholders, which decrease the need for active board control. Directors’ involvement in the determination of corporate strategy is an important aspect of their advisory role. A number of studies have shown that directors engage in various stages of the strategic planning process, from the review of strategic initiatives to active involvement in strategy formulation.

The board is often seen as a key organizational body that could provide critical resources for the company, protect the company from environmental uncertainties, and reduce transaction costs in managing external relationships. Nonexecutive, outside directors, in particular, play an important role in providing (1) specific resources otherwise unavailable to management (e.g., financial funds, information), (2) access to external institutions and influential organizations (e.g., regulatory bodies, consulting firms, and international organizations), and (3) legitimacy. Resource scarcity prompts corporate boards to engage in interorganizational relationships in an attempt to moderate influences of external pressures on their companies. As capital is one of the key resources, companies often use interlocking directorates with financial institutions as a tool to facilitate access to cash. Contextual factors may moderate the importance of the resource role of the board. For example, small and entrepreneurial companies in which access to critical resources is problematic will benefit from the appointment of a reputable and influential director on their board.

Different Board Structures

In the Anglo-American system, boards of directors are usually unified bodies dominated by management. In a great number of large corporations in the United States and the United Kingdom, the CEO is also the chairperson of the board of directors. CEO duality is often criticized as an undesirable feature of this system, as it may limit the board’s independent decision making. A typical board has between 9 and 15 members, most of whom are nonexecutive, outside directors. All directors are elected by shareholders in a general annual meeting. It is common for many individual shareholders not to attend these meetings. Most shareholders will vote on the election of directors and important policy proposals by “proxy,” that is, by mailing election forms. There is no legal requirement for any specific stakeholder or interest group to be represented on the board. To achieve a greater accountability of directors to shareholders, an attempt is made to restructure the traditional board composition and introduce a majority of nonexecutive directors (i.e., directors not employed by the firm).

The continental European system of corporate governance functions on a two-tier board structure. This model is practiced in Germany, Austria, Holland, France, and Finland. The functions of the board are performed and split between a supervisory board or council and a management or executive board. The supervisory board has three core roles. First, it approves and evaluates the company’s strategy and policies proposed by the management board. Second, it monitors the company’s performance and accounts. Third, it appoints and dismisses members of the management board and monitors and evaluates the performance of the board itself. All members of the supervisory board are nonexecutives and no common membership is allowed between the boards. The supervisory board is headed by a chairperson, whereas the management board is headed by the CEO. The members of the supervisory council are elected at the general shareholders meeting. The management board is responsible for the day-to-day operations and running of the company. A two-tier board structure may work better where shareholdings are not as diversified as in the Anglo-American system and where there is a strong stakeholder concept, as in Germany.

In the German model, which is the most distinctive in this system, the supervisory council (Aufsichtsrat) consists of both employee representatives, appointed through trade unions, and capital representatives, appointed by shareholders. Members of the management board (Vorstand) are professional managers. Although all directors in the supervisory council are nonexecutives, they are seldom truly independent of the company. In enterprises with more than 500 employees, employees are represented in the supervisory council. In such cases, the council can have up to one third of employee representatives.

In the Japanese system, the formal corporate structure is that of a unitary board. Japanese boards are usually very large, with sometimes more than 30 members. Some researchers consider the keiretsu of cross-shareholdings as an informal governing body. It is a common practice that corporate governance takes place behind the scenes, between the corporate executives and representatives of major institutional shareholders. In general, the board of directors does not have external representatives of shareholders (outside directors). The only external person on the board may be a representative of the main bank. The board is composed of the corporation’s own executives and former executives. The majority of directors within Japanese corporations are promoted from within the company and the rest are appointed from parent or affiliated companies. This internal promotion practice is an important component of the lifetime employment policies in Japanese corporations. The advancement to board membership is awarded to employees at the end of their working career for excellent performance during their professional employment. In this way, the boards of Japanese corporations represent the collective interests of the company and its employees rather than its shareholders.

Relations Between the Board and Management

The quality of board-management relationships is an ongoing issue for every board, regardless of the national setting. Both management and the board are responsible for the well-being of a corporation. The main question is how do the board and corporate management strike a balance for sharing these responsibilities?

The CEO is responsible for the day-to-day company operations and is expected to be the bestinformed individual and most committed to the company. The directors are usually not involved in the operational affairs of the company and rely on the information provided by the CEO. In general, the directors should give an overall direction to the company, approve strategic decisions, and propose structural changes. It is believed that the separation of the role of the CEO from that of the chairperson enables a greater balance in board functioning, by way of limiting the power of the CEO to dominate the board.

However, many scholars and corporate governance experts also believe that effective functioning of the board depends on the quality of individuals and their ability to interact among themselves, and with the CEO and other managers, rather than only on the structural composition of the board. The fact that shareholders, management, and other stakeholders have changing expectations about the directors’ knowledge and contribution to and involvement in the company’s strategic affairs have led boards around the world to redesign themselves and their relationships within and outside corporations. Boards are expected to be more proactive in seeking information, in challenging the CEO in a constructive manner, in working together as a team, and in getting a deeper understanding of the company’s business.

Some proponents of board redesign emphasize the importance of the dynamic balance between control and collaboration approaches in the board-management relationship. According to this view, a control approach protects a corporation from self-serving behavior and reduces goal conflict, whereas a collaborative approach encourages cooperation between the board and management and fosters trust and goal alignment. Acceptance, understanding, and management of control-collaboration tensions promote learning and improve governance. Other authors stress the role of the CEO and called to attention the evolution of the CEO-board relationship. Following the evolutionary perspective, these authors argue how the advisory role of board has a relatively higher significance in the early period of CEO tenure while the controlfocused approach is emphasized more in the later CEO tenure.

The Changing World of Corporate Governance

The emerging research on corporate governance has extensively considered new developments in national corporate governance systems, the increase of institutional shareholders activism, and the changing role of boards in knowledge-based organizations.

Changes in National Governance Systems

The Asian financial crises in the late 1990s and the U.S. corporate scandals at the beginning of this century have fuelled debate concerning the current models of corporate governance. Market failures and corporate collapses have urged the need for radical reforms in corporate governance and regulation. In the last decade, corporate governance transformation has become a major concern of national governments, stock exchanges, international organizations, and corporations themselves. More than 40 countries published corporate governance codes; the OECD has issued the principles and World Bank and IMF released the guidelines. In the United Kingdom, Sir Adrian Cadbury’s final report on “The Financial Aspects of Corporate Governance” in 1992 and the final Hampel Report in 1998 were influential in setting in motion corporate governance reforms in the United States and in the United Kingdom. The Cadbury Code became a framework for international standards of governance. The main recommendations related to (1) the clear separation of responsibility at the corporate level, (2) involvement of nonexecutive directors, (3) the role of committees formed by nonexecutive directors, and (4) the formation and functions of audit and remuneration committees.

The most current major initiative to radically improve the corporate governance system in the United States came in the form of the Sarbanes-Oxley Act of 2002. The act was formed in response to a series of corporate collapses, including the Enron, WorldCom, and Tyco International financial scandals. It is designed to protect shareholder value and the general public from corporate wrongdoing. The Sarbanes-Oxley Act dealt with four major issues in corporate governance of public corporations. First, the act created an oversight board to set and enforce auditing standards and discipline public company auditors. Second, the act intended to foster auditor independence. For example, the corporate members with a financial reporting supervision role should not be employed by the external auditor. Third, the act increased corporate responsibility, by requiring that CEOs and CFOs certify all periodic reports containing the company’s financial results. Having knowledge of the certification of false statements is subject to criminal liability. Finally, the act enhanced financial disclosure with regard to the off-balance-sheet transactions and obligations with consolidated entities and individuals. These key provisions of the Sarbanes-Oxley Act have significantly strengthened the role of the board of directors and have made managements more accountable.

The cooperative, inward-oriented and employeecentered model of the Japanese corporate governance system was usually portrayed as a source of competitive strength for the Japanese economy. However, since the beginning of the Japanese recession in the 1990s, many studies have shown that some of the reasons for the economic downturn in large Japanese companies originated due to a lack of effective monitoring of managers by shareholders and weak accurate disclosure of companies’ financial conditions and business performance. To improve the state of the economy, Japan has embarked on the modernization of the corporate governance system emphasizing better protection of shareholders rights, increased responsibilities of directors, and regular disclosure of information. In 2003, the Corporate Governance Forum in Japan established guidelines and defined best-practice corporate governance principles. The forum proposed the adoption of specific elements of the Anglo-American system. These included appointment of nonexecutive directors on the board, introduction of an executive officer system, and enforcement of auditor power.

The German model of corporate governance has also been pressured to undertake reformative changes. The publication of the official “German Corporate Governance Code” in early 2002 marked a milestone in the development of good governance in Germany. The code addresses all major criticisms, especially from international investors, that point against German corporate governance—namely, inadequate focus on shareholder interests, insufficient independence of supervisory boards, the two-tier board structure, the limited independence of financial statement auditors, and inadequate transparency of the German corporate governance system. The main purpose of the code is to make Germany’s corporate governance rules transparent for both national and international investors.

In Europe, the EU Commission’s role in corporate governance has increased in recent years but is limited due to major differences in national and company laws. In May 2003, the EU Action Plan was set up to define minimum governance standards for European companies. The idea of the EU Action Plan is not to legislate for all EU member states but to achieve convergence of the many different governance regimes within a well-defined timeframe.

The Rise of Power of Institutional Shareholders

In the 1970s, individual shareholders held almost 80% of the equity in the United States. By the end of the 1990s, however, their holdings had decreased below 45% while institutional shareholding had increased to 53%. In 2002, individual ownership declined further to just over 37% while institutional ownership reached over 55%. Corporate governance is highly affected by changes in power of different categories of shareholders. Controlling shareholders, such as families, individuals, or other corporations, can have significant influence over corporate strategic behavior. Small individual shareholders, on the other hand, do not exercise governance rights as they usually do not have knowledge, power, and incentive to control corporations. However, they are concerned about fair treatment from majority shareholders and management. Institutional shareholders have emerged as a distinctive and demanding voice in corporate governance within the Anglo-American system. Institutional investors, such as large pension and mutual funds, have the power to directly influence managerial decisions in many corporations. Their activism has led to a greater emphasis on shareholder value and directed management to place greater priority on their interests rather than those of stakeholders. The board of directors meets regularly with representatives of institutional and large investor groups to actively communicate corporate developmental strategies. It is expected that such groups have higher knowledge and long-term interest in the company. In this situation, management interests are more likely to be aligned with those of shareholders. Some observers of institutional investor activism assume that this development is bringing the Anglo-American model of corporate governance closer to those of the continental European and Japanese models.

Corporate Governance in Knowledge-Intensive Firms

The context of increasing technological intensity creates additional challenges for corporate governance. A boards’ legal and moral authority has always been derived from their representation of shareholders of the firm. This authority, legally translated into accountability for the key strategic assets of the firm, guides deployment of these assets toward the most productive and shareholder-approved uses. However, the nature of strategic assets that needs to be accounted for in a knowledge- or technologyintensive company is significantly different. It is not only that these assets are intangible but also there is difficulty in agreement over who owns them and who is responsible for them. Specific assets, such as human capital, producer’s tacit learning, or complex networks of interorganizational interactions, create a governance problem that standard models of control in corporations do not explicitly address. Due to lack of knowledge and inability to evaluate information, a traditional board of directors, for example, may be an ineffective governance mechanism.

The competitive advantage of knowledge-intensive firms comes mainly from nonphysical and nonfinancial assets, which can include employee know-what and know-how, training and development processes, and intellectual property. These companies offer different organizational cultures that thrive on ambiguity and offer an antithesis to control approaches that are more amenable to traditional industries. Such cultures reflect changes in power relations between financial and human capital. In these organizational environments, greater attention is paid to human resource issues because of an increased importance of technical and scientific personnel. As some authors suggest, human capital—the assets that each day go home and which are readily moveable—should be treated with care. Therefore, corporate governors should more explicitly affirm the rights of nonshareholders by allowing them formal involvement in governance processes. This formalization may be initiated through special compensation schemes or other arrangements that align the employees’ interests with those of shareholders. Thus, if knowledge is the immanent resource and a critical asset of new companies, are individual employees becoming residual claimants in the changing world of corporate governance?


The topic of corporate governance has attracted a lot of attention and has become a subject of enormous debates in the recent years. Corporate scandals and collapses taking place in most countries have prompted regulatory reforms in all national governance systems. The issues of corporate governance are complex and deeply embedded in specific historical conditions and economic and political circumstances. Corporate governance researchers and professionals all agree that there is no one best way to design a governance system. In the modern world, an emerging perspective on corporate governance goes beyond the conventional emphasis on financial aspects of corporate control and takes into account interests, constraints, actions, resources, and influences of all constituencies in the corporate governance system. This entry has attempted to present some of the key building blocks, major perspectives, and the most recent developments and challenges of corporate governance.

    See also
  • Agency, Theory of; Chicago School of Economics; Chief Executive Officer (CEO); Fiduciary Duty; Keiretsu; Minority Shareholders; Property and Property Rights; Sarbanes-Oxley Act of 2002; Shareholder Model of Corporate Governance; Shareholders; Shareholder Wealth Maximization; Stakeholder Theory

Further Readings
  • Aguilera, R. V.; Jackson, G. The cross-national diversity of corporate governance: Dimensions and determinants. Academy of Management Review, 28(3), (2002). 447-465.
  • Berle, A. A.; Means, G. C. (1932). The modern corporation and private property. New York: Macmillan.
  • Blair, M. M. (1995). Ownership and control: Rethinking corporate governance for the twenty-first century. Washington, DC: Brookings Institute.
  • Cadbury Committee. (1992). Report of the committee on the financial aspects of corporate governance. London: GEE.
  • Carpenter, M. A.; Westphal, J. D. The strategic context of external network ties: Examining the impact of director appointments on board involvement in strategic decision making. Academy of Management Journal, 44, (2001). 639-661.
  • Clarke, T.; Clegg, S. (1998). Changing paradigms: The transformation of management knowledge for the 21st century. London: HarperCollins Business.
  • Demb, A.; Neubauer, F. F. (1992). The corporate board: Confronting the paradoxes. New York: Oxford University Press.
  • Donaldson, T.; Preston, L. E. The stakeholder theory of the corporation: Concepts, evidence, and implications. Academy of Management Review, 20(1), (1995). 65-91.
  • Fama, E.; Jensen, M. C. Separation of ownership and control. Journal of Law and Economics, 26, (1983). 301-326.
  • Fligstein, N.; Choo, J. Law and corporate governance. Annual Review of Law and Social Science, 1, (2005). 61-84.
  • Fligstein, N.; Freeland, R. Theoretical and comparative perspectives on corporate organization. Annual Review of Sociology, 21, (1995). 21-43.
  • Government Commission. (2002, February 26). German corporate governance code. Retrieved March 22, 2006, from
  • Hampel, R. (1998). Committee on corporate governance: Final report. London: GEE.
  • Hansmann, H. (1996). The ownership of enterprise. Cambridge, MA: Belknap.
  • Hillman, A. J.; Cannella, A. A.; Paetzold, R. L. The resource dependence role of corporate directors: Strategic adaptation of board composition in response to environmental change. Journal of Management Studies, 37, (2000). 235-255.
  • Japan Corporate Governance Forum. (2001). Revised corporate governance principles. Retrieved March 22, 2006, from
  • Johnson, J. L.; Daily, C. M.; Ellstrand, A. E. Boards of directors: A review and research agenda. Journal of Management, 22, (1996). 409-438.
  • Keenan, J.; Aggestam, M. Corporate governance and intellectual capital: Some conceptualizations. Corporate Governance, 9(4), (2001). 259-275.
  • Organisation for Economic Co-operation and Development. (2004). OECD principles of corporate governance. Paris: Author.
  • Pfeffer, J.; Salanick, G. R. (1978). The external control of organizations: A resource dependence perspective. New York: Harper & Row.
  • Rappaport, A. (1986). Creating shareholder value: The new standard for business performance. New York: Free Press.
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  • Ljiljana Erakovic
    Copyright © 2008 by SAGE Publications, Inc.

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