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In the last quarter of 2015 the emissions scandal at Volkswagen thrust corporate governance firmly back in the spotlight. It is increasingly clear that, in the global economic ecosystem, inhabited by many different types of organizations and a broad range of stakeholders, a one-size-fits-all approach to corporate governance is not appropriate.
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But how do we devise better, more effective governance systems and ensure that organizations are run properly? This is a problem that Xavier Castañer, a Professor of Strategy at HEC Lausanne, University of Lausanne, together with Professor Nikolaos Kavadis at Universidad Carlos III in Madrid, Spain, have been investigating.
Conversation with Xavier Castañer about the influence of agency theory, challenging accepted practices, and the route to better governance.
Has our approach to corporate governance been largely driven by corporate scandal and the need to constrain the actions of senior managers to protect shareholders?
It is partly true that regulation by governments and self-regulation by businesses or business associations has been triggered by corporate crises. In the UK, for example, the Cadbury Report in 1992 was set against a background of governance issues relating to firms such as Polly Peck, Maxwell Communications, and BCCI. Again, in the early 2000s, fraud at companies such as Enron in the US, and Parmalat in Italy, refocused attention on governance matters. And, if anything, the magnitude of possible fraud and manipulation is even greater today, because we have much larger, more multinational, corporations.
We also have the issue of governance and possible fraudulent behavior percolating beyond the business world into the public (governmental) and not-for-profit sectors with cases such as the current FIFA situation.
But the governance debate goes back further than this?
The debate about the separation of ownership and management and approaches to dealing with corporate governance has been heavily influenced by developments in agency theory and the work of US-based academics in the 1970s and 80s, such as Michael Jensen, William Meckling, Stephen Ross, and Barry Mitnick.
As with any economics-based theory, there is an assumption of rationality which means that people pursue their own interests in general. Agency theory, in particular, assumes that CEOs and senior managers may behave opportunistically in pursuing their own interests, even at the expense of the shareholders’ interests.
Agency theory has shaped our attitudes towards corporate governance?
It is not the only theory informing our ideas about corporate governance, but it is the main theory. Created in the US, its practices and its tenets have been diffused throughout the world, wherever you have market economies.
And seminal principles of governance have evolved as a direct response to management behaviors predicted by agency theory. Is that right?
Yes. There is board independence, for example, which is supposed to facilitate the board’s monitoring of the CEO. It is based on the notion that an independent board, where directors have no conflict of interest with the CEO, is able to hold the CEO to account.
And there is alignment of the interests of agent and principal – the CEO and the shareholders, respectively. This includes attempting to tie the interests of the CEO and shareholders together, for example, by making the CEO an owner of the corporation and making CEO remuneration contingent on targets linked to shareholders’ goals (usually assumed to be economic value creation). A common method is through performance-contingent pay – that is, variable compensation which comes in the form of cash bonuses or stock options.
However, some common governance related practices, designed to prevent the kinds of value destroying actions by senior managers that are predicted by agency theory, may be ineffective.
In our 2013 Strategic Management Journal paper, we looked at a situation where CEOs might act in their own interests to the detriment of shareholders. As Jensen noted in his work, when there is money available – free cash flow – the CEO can use it to engage in projects that benefit him or her even if they do not necessarily create shareholder value.
You looked at financial diversification. What is financial diversification?
It’s where a corporation diversifies its scope, for instance, by expanding its portfolio of businesses to even out revenue flows. Often it is to counter the effects of seasonality; a ski-resort company might extend into summer mountain activities or entertainment events off ski season, for example. Revenues in one business increase as revenues in the other business decline – leading to what we call revenue smoothing.
This is potentially good for the CEO. This kind of empire building increases the size of the corporation and enables a CEO to increase their remuneration package as well as securing her or his position in the firm.
But your research shows that financial diversification is bad for shareholder value.
If the company engages in financial diversification, it either creates a new business from scratch, or buys a company that’s already in the business it wants to expand into. But it’s usually more cost effective and efficient for shareholders to diversify their own portfolio directly by purchasing stock in a different company.
You used a large dataset of publically-traded corporations headquartered in France, many of them international firms, to discover how effective monitoring and alignment governance measures are at constraining CEO behavior. In this case at preventing financial diversification given the presence of free cash flow. What did you find?
We found some support for the monitoring role of the board. Although greater ownership concentration had a limited impact, board independence, and in particular the separation of the CEO and chairman role, appears to prevent the use of free cash flow for financial diversification.
What about alignment measures?
Neither the granting of stock options to the CEO, nor the CEO’s ownership of shares had a significant constraining effect on financial diversification. And variable compensation, a very common governance practice, actually leads to more financial diversification.
That’s a surprising (and worrying) finding.
Perhaps not so surprising when you think about it. Agency theory assumes CEOs are risk averse. Yet favored methods of alignment, such as variable compensation, introduce uncertainties about remuneration and thus increase ‘risk’ for the CEO. Predictably, CEOs resort to revenue smoothing to make revenues less volatile and increase their prospects of hitting performance targets.
Another finding that emerges from your work is the importance of considering how the economic cultural norms and values of owners shape their behavior and, therefore, affect governance and strategy.
Yes. We are currently working on a project looking at the effect of owners’ country of origin on board independence. But we have already concluded and published a couple of research pieces which look at how an owners’ country of origin influences strategy.
First, there is this well-established idea that you can classify owners into: pressure-sensitive, such as banks and insurers, meaning they are likely to be close to the CEO and less able to resist a CEO’s demands; and pressure-resistant, more independent of the CEO and firm and more able to resist the pressure to engage in activities suggested by the CEO that are not beneficial to shareholder value maximization.
Moreover, past research has assumed, probably because it has looked at US investors taking ownership positions in companies abroad, that foreign owners are more oriented towards shareholder value than domestic owners.
However, we argue that it is not an issue of foreignness vs domesticity, foreign ownership is very diverse, nor is it just about the owner type (pressure-resistant vs pressure-sensitive).
More specifically, we claim that the country origin of an owner is going to shape their position regarding the desirable objectives, practices and strategies of the corporations they own elsewhere. After all countries may differ considerably in terms of their political economic and legal institutions, for example, pluralist versus corporatist political economy systems, and common versus civil law systems.
And you look at this in the context of unrelated diversification?
In a paper published in Advances in Strategic Management we look at unrelated diversification as the strategy. A firm’s portfolio of businesses is unrelated if there are few or no similarities or complementarities in the resources that the firm’s different businesses use. ‘Resources’ might include technologies or other inputs – including people – or distribution channels, for example. Empirical evidence shows that, on average, unrelated diversification creates less value for shareholders than related diversification or specialization.
Agency theory suggests that, given free cash flow, a CEO might engage in unrelated diversification for a number of reasons including the potential for empire building, increased prestige, and better remuneration. We find that the greater the presence of Anglo-American investors in the ownership of a French corporation, the less the amount of unrelated diversification. This shows that owner category (pressure-resistant here) matters, but that the country of origin also matters.
Actually, institutional origin seems to have a greater effect than the pressure-sensitive/pressure-resistant classification. We found that the presence of pressure-sensitive Anglo-American owners significantly led to less unrelated diversification. Whereas with a pressure-resistant (institutional) owner from France, the cultural background – being less focused on the maximization of shareholder value – seems to prevail, and we find a positive effect on unrelated diversification.
Your work on business restructuring and family ownership also produces some surprising findings. Especially given the notion that family business owners, particularly continental European owners, are perhaps less inclined to engage in restructuring activities in the pursuit of value.
Indeed. Restructuring means different things. For example, it can cover layoffs, spin-offs, getting rid of unrelated businesses. In our paper published in Corporate Governance: An International Review, we measure restructuring costs, which are related to all of those things. As these actions – exits, rationalizations, reductions in workforce, realignment, and so on – are often driven by the pursuit of greater efficiency and profitability, it is reasonable to assume that owners from a shareholder value maximizing culture will be more prone to this than owners from more corporatist environments where the considerations of broader stakeholders are considered important. But actually we find that, contrary to what we would expect, the greater the ownership by a French family, the greater the subsequent restructuring costs.
Your work goes to the very heart of the purpose of corporate governance. It challenges some strongly held beliefs about the subject, and reminds of the importance of challenging our assumptions about governance. A one-size-fits-all approach to corporate governance doesn’t appear very effective. But how do we go about constructing better corporate governance systems?
Well, we need a more diverse understanding of organizations, because organizations don’t just have one type of owner, they have diverse ownership. In some cases, the very notion of ownership is tenuous or merely absent.
Take some of my current research with Professor Lluís Bonet from the University of Barcelona, for example, where we look at the non-profit sector, which contains, along with corporations, organizations with other legal forms such as associations, cooperatives, and foundations. How can we improve governance in these entities? The ownership and the management structures are very different from listed corporations. Agency theory is not that useful here. We need different approaches; different solutions. My research with Nikolaos on French publicly-traded corporations shows that even not all corporate shareholders have the same objectives or strategy preferences.
We know that different actors, whether they are owners, or different companies in an alliance, or different associations in a federation, have different interests. The issue is how we model those different interests and how we understand their effects on decisions and performance. We need to recognize the different interests, and begin to understand how they come into play. How they translate into and influence decision making. How you can organize the board discussion to reconcile the different interests and agree on a strategy.
If we understand these things we can devise more effective governance.
Relevant publications on this topic:
- Castañer, X. and Kavadis, N. (2013). Does Good Corporate Governance Prevent Bad Strategies? An Empirical Analysis of Non-Value Creating Financial Diversification in French Companies, 2000-2006. Strategic Management Journal, 34: 863-876. Early view January 2013, published on-line May 2013.
- Kavadis, N. and Castañer, X. (2014). Ownership Effects on Unrelated Diversification: An Institutions’ Perspective. In B. Villalonga (ed), Finance and Strategy issue of Advances in Strategic Management, vol. 31, Emerald Group Publishing Limited: 253-288.
- Kavadis, N. and Castañer, X. (2015). Who Drives Corporate Restructuring? Co-Existing Owners in French Firms. Corporate Governance: An International Review, 23 (5): 417–433. Early view online since March 31, 2015.