The Impact of Corporate Governance on Innovativeness

Table of contents

TABLE OF FIGURES

1. INTRODUCTION OF THE TOPIC

2. CONCEPTUAL AND THEORETICAL BASES
2.1. CORPORATE GOVERNANCE
2.1.1. Berle and Means Corporations
2.1.2. Contrasting Approaches to CG: Agency Theory vs. Stewardship Theory
2.1.3. Corporate Governance Systems
2.1.4. Corporate Governance in Germany
2.2. INNOVATIVENESS
2.3. ENTREPRENEURSHIP

3. THE RELATIONSHIP BETWEEN CORPORATE GOVERNANCE AND INNOVATIVENESS
3.1. SOME EMPIRICAL FINDINGS
3.1.1. Ownership Structure
3.1.2. Board Composition - Inside versus Outside Directors
3.1.3. CEO Duality
3.2. CONTROL AND INCENTIVE SYSTEMS
3.2.1. Designing Control Systems
3.2.2. Designing Incentive Systems
3.2.3. The Model of Reinforcing Cycles

4. CULTURAL LIMITATIONS OF CORPORATE GOVERNANCE APPROACHES
4.1. CULTURE AS A SYSTEM OF SOCIAL CONTROL
4.2. CULTURAL TYPES

5. THEORETICAL FRAMEWORK

6. DISCUSSION

7. CONCLUSION

REFERENCES

Table of Figures

Figure 1: The relationship between the topics

Figure 2: Definitions of corporate governance

Figure 3: Contrasting approaches to corporate governance

Figure 4: The differences between entrepreneurial and non-entrepreneurial firms

Figure 5: Reinforcing cycles of collaboration

Figure 6: Reinforcing cycles of control

Figure 7: Cultural typologies

Figure 8: Modified framework of cultural typologies

Figure 9: The relationship between agency/stewardship theories and cultural typologies

Figure 10: The effects of the agency/stewardship theories on cultural typologies

Abstract

Very little empirical research exists that attempts to measure the effectiveness of corpo- rate governance on innovativeness. For this it is crucial to consider the two main ap- proaches (agency theory and stewardship theory) to corporate governance. However, the theory of corporate governance is strongly influenced by agency theoretical considera- tions. This paper, first, attempts to show the relationship between corporate governance mechanisms and innovativeness. Thereby, the agency approach to corporate governance is questioned. Further, the influence of culture as an external variable to the practice of corporate governance is considered. The corporate governance mechanisms ownership structure, board composition and CEO duality have beside control and incentive sys- tems significant influence on a firm’s innovativeness. Furthermore, empirical findings show that stewardship theory is generally more effective in corporate governance in context with innovativeness then agency theory. Finally, an own theoretical framework is developed that shows that the influence of the theoretical approaches to corporate governance is dependent on the organization’s situational culture type.

1. Introduction of the Topic

The theory of corporate governance has been strongly influenced by the Agency Theory, which describes a manager’s behavior as opportunistic and self-serving¹. Both in theory and in practice theoretical considerations of agency are applied to all kinds of corporate relationships revealing an organizational dilemma. On the one hand, this dilemma is forced by today’s highly competitive environment, which demands innovative and progressive firms to sustain and survive in the market. On the other hand, shareholders and governance policies like the Sarbanes-Oxley compliance efforts are demanding tighter controls. Excessive control mechanisms inhibit a firm’s capacity to innovate, because a manager’s discretion to avoid risky strategies is fostered, whereas risk-taking is the principal source of a firm’s innovativeness.

The purpose of this paper is to question the agency approach to Corporate Governance and introduce its theoretical counterpart the Stewardship Theory, which has its origins in sociology and psychology. The most efficient criterion is innovativeness and it stands at the center of this analysis. Besides the effects of the two contrasting approaches to Corporate Governance (Agency Theory and Stewardship Theory) on innovativeness, the effects on entrepreneurship are also regarded, because innovativeness is a behavior that characterizes entrepreneurship. An aspect that is neglected in the Corporate Governance approaches in the academic literature is culture. Therefore, this paper introduces cultural considerations to the debate of the Agency Theory and the Stewardship Theory, which seems to be a fruitful approach to the corporate governance dispute. All together, this paper utilizes Agency/Stewardship Theory and culture to explain the effects of Corpo- rate Governance on innovativeness and entrepreneurship (see figure 1).

The paper starts with a brief description of the theoretical bases by defining the term Corporate Governance. Further, Corporate Governance’s historical origin is examined and the theoretical assumptions of the two contrasting approaches are described. A short insight is given to the Corporate Governance system in Germany to show that there are differences in national governance systems, especially between the Anglo-Saxon and the German one. For theoretical clarity, the terms innovativeness and entrepreneurship will be defined after.

Figure 1: The relationship between the topics

illustration not visible in this excerpt

Source: Own construction

In chapter three, the main part of the paper, empirical findings between the relationship of Corporate Governance mechanisms and innovativeness are examined and the design of control and incentive systems is also discussed. A psychological model, which shows the effects of overemphasizing control or collaboration tensions to Corporate Govern- ance, is then introduced. In the following chapter, the mediating role of culture to Cor- porate Governance is shown. Additionally, a model of a cultural type is presented, thus making the classification of an organization into four different culture types possible.

Finally, my own contingency theoretical framework is constructed, which makes the application of the right theoretical approach to Corporate Governance dependent on the type of culture. The main findings of the paper are that Corporate Governance systems are correlated with innovativeness and that the stewardship approach to Corporate Governance is superior to the agency one in revealing innovativeness.

2. Conceptual and Theoretical Bases

2.1. Corporate Governance

Corporate Governance (referred to from now on as CG) turned into one of the most popular business terms after several business scandals like Enron and WorldCom. Doz- ens of academics, institutions, and practitioners started to consider it a crucial issue. In the past decades a numerous variety of definitions has emerged. One example is the very simple but apposite Cadbury definition that sees CG as the “…system by which companies are directed and controlled”². Figure 2 shows further examples of definitions used in codes which emanate from both the EU Member States and pan-European and international sources.

Researchers have focused their attention primarily on the control of executive self- interest and the protection of shareholder interests to avoid business scandals. The economists Holmstrom and Kaplan started, in turn, to warn of the dangers of excessive CG through a specific system that is designed to eliminate excessive behavior of execu- tives and managers³. According to them, this poses far greater risks than the behavior itself through its stifling risk taking behavior which is necessary for economic growth.

For this paper, the following two definitions are relevant: “Corporate governance is con- cerned with the institutions that influence the ways in which business corporations allo- cate resources and returns”⁴. This definition from O’Sullivan, a leading researcher, is helpful to set CG in context with innovation, which, in turn, depends on a firm’s re- sources and returns. Monks and Minow give the second useful definition describing CG as “…the relationship among various participants in determining the direction and per- formance of corporations”⁵, where the internal relationships of the corporate are high- lighted. There are several types of CG relationships in corporations, i.e., between corpo- rate owners and corporate stakeholders, corporate owners and corporate directors, cor- porate directors and corporate managers, and as well between corporate managers and corporate employees.

Figure 2: Definitions of corporate governance

illustration not visible in this excerpt

Source: European Commission (2002), pp. 28-29.

The focus of this paper will lie in the internal CG relationships, which describe the in- terplay between all actors in the corporation that are in the academic term characterized as principal-agent relationships. This thesis does not revive CG in context with misman- agement and corruption, as mentioned before, and for what CG got famous. The pur- pose is to show that CG’s primary focus is to make companies more efficient. For that, the impact of CG on corporate innovativeness will be analyzed. Innovativeness, thus leads to improvements of a corporations’ performance and reveals efficiency. First of all, the origin and the meaning of CG are described. For this, it is important to regard the Berle and Means corporations and investigate if they are in keeping up with the times.

2.1.1. Berle and Means Corporations

The economists Adolf Berle and Gardiner Means put forth a fundamental and influen- tial theory to characterize the nature of corporate management. Contrary to smaller companies, which are mostly owner-managed, Berle and Means corporations are larger companies that separate ownership and control and where managers and boards play a powerful role. The idea of separation of ownership and control is revealed in Berle and Means pioneering work in 1932 about the modern firm⁶. As further mentioned they gave the basis for the theory of the firm to researchers for the last 70 years.

They paid attention to the prevalence of widely held firms, in which ownership of capi- tal is dispersed among small shareholders, and control is concentrated in the hands of managers⁷. Today, it is questionable, if the archetypical Berle and Means corporations fit the current business environment due to the changes in the nature of competition and enterprise government. The vertically integrated conglomerate, although, still describes the typical corporation of Berle and Means. According to Van Ees and Postma these firms are asset-intensive, and are characterized by tight control over employees. Control is concentrated in the top management level. The competitive advantage comes primar- ily from the economies of scale and scope. Furthermore, the economic boundaries of the enterprise coincide with the legal boundaries of the corporate one⁸. Finally, the size of these firms requires massive outside-investment, and as a result dispersed outside- owners delegate control to the manager, revealing the principal source of the Berle and Means problem which has provided the basis for the emergence of the Agency Theory.⁹

Through several changes in the environment the conditions of the typical Berle and Means corporations have to be revised. First of all, nature of competition has changed dramatically. The liquidity of markets has increased through the effects of deregulation and globalization. This has lead to an increasing competition and has shifted the exter- nal balance towards the markets. In output markets the competitive pressure has in- creased the need for differentiation and innovation. Product-life cycles have become shorter. As a result, the importance of economies of scale as a major source of competi- tive advantage is declining. While the lead-time of innovations is shrinking and the time to get to the market is becoming essential, non-technical innovations involving intangi- ble assets and human capital are becoming more and more important to foster innova- tiveness.

Furthermore, the nature of enterprise governance has also changed. As large conglom- erates have been braking up, looser forms of corporation between independent firms have become more and more important. Control is distributed among contributing com- ponents, i.e., the formal relationship between a subsidiary and parent board is that of shareholder. Global outsourcing strategies shift power from the top management levels of the organization to the lower levels of the organization or even outside of the organi- zation¹⁰.

La Porta et al. showed in their analysis of the ownership structure of 27 large corporations that the Berle and Means corporation is far from universal, and that it is quite rare for some definitions of control. Therefore, they claim that the typical Berle and Means firm is practically non-existent, outside the UK and US¹¹. In Germany, concentrated ownership is predominant, and in a general sense, it can be said that Berle and Means corporations are more the exception than the rule.

After this short review it does not seem appropriate to take the Berle and Means corpo- rations as the basis for creating CG systems. Other factors like culture and management philosophy are becoming more and more important than just the separation of owner- ship and control. Consequently, the importance of those factors is increasing in young and entrepreneurial corporations and branches and within a highly dynamic environment where innovations are crucial to business performance.

2.1.2. Contrasting Approaches to CG: Agency Theory vs. Stewardship Theory

As stated before, the focus of this thesis is set on the internal governance structure, which describes the interplay between owners, directors, managers and employees. Those are i.e., the ownership structure, the organization of boards (Vorstand in Ger- many), the role of the CEO (Vorstandsvorsitzender), and the director-manager and manager-employee relationships. The paper uses Agency Theory and Stewardship The- ory to hypothesize the relationship between CG and innovativeness. In this context, it is important to know which theoretical approach to CG is more efficient and fosters risk- taking and entrepreneurial behavior of all actors. Risk-taking and entrepreneurial behav- ior are necessary conditions for innovativeness. Both theories provide the bases for the whole thesis and especially for the analysis of governance mechanisms in chapter 3 and culture in chapter 4. Furthermore, they determine the construction of CG systems. First, the Agency Theory, which is the dominating theoretical approach to CG in the literature and in practice, is described.

Agency Theory

In their 1976 classic, The Theory of the Firm, Michael Jensen and William Meckling revolutionized the fundaments of the Agency Theory. Their paper describes the rela- tionship between managers and owners, which is shaped by the separation of ownership and control ¹² . The Agency Theory is further applied to the interplay between directors, managers, and employees within a corporation. In economics, it is used in nearly all kinds of order relationships. The agency problem in corporations bases on Berle and Means previous described work about The Modern Corporation and Private Property.

Owners as principals hire executives to manage their firms for them. The capital re- quirements of the modern corporation¹³ cause owners not to be able to manage their own companies. Owners want to minimize their costs and reap the maximum profits for themselves. The executives as the agents of the principals are morally responsible to maximize shareholder wealth.

The assumptions are that the Agency Theory underlies the model of an economic man who is a rationale actor seeking individual utility maximization¹⁴. The underlying model of this man is individualistic, and represents a conflict of interests between the owner and the manager, as well as, in all other principal-agent constellations. Therefore, this leads to the assumption that the agent will not always act in the best interest of the prin- cipal, which, in turn, will possibly lead to a self-serving behavior of the agent. The non- alignment of interests between the principal and the agent, furthermore, fosters distrust in their relationship.

The major problems of the Agency Theory are caused by asymmetrical informations between the agent and the principal. The agent has a significant information advantage which makes it impossible for the principal to monitor him. This can lead to opportunis- tic behaviors like hidden information or hidden action. Hidden information problems can arise when the agent misrepresents his abilities. It is possible that the agent hides information regarding his skills and abilities which are relevant to the principal. This leads usually to adverse selection because the principal cannot accurately gauge the quality of managers¹⁵. Hidden action emerges when it is not possible to clarify manag- ers’ success to their own actions or to external effects. This can reveal the threat of a shirking behavior of the manager, which is also known as moral hazard. For example, an executive may expend effort on activities that maximize personal utility but such efforts may add no value to the firm. A further problem is that managers have bounded rationality¹⁶ (meaning the limitation of mind and the structure of the environments in which the mind operates) which also limits the efficacy of applied control mechanisms significantly.

Principals are described as risk-neutral because they can own shares in multiple and diverse companies. Agents are risk-averse because they have a need for a stable envi- ronment and do not have the option of risk diversification. The objective in agency the- ory is to reduce the agency costs, which are determined by principals, by imposing in- ternal controls to keep the agent’s self-serving behavior in check¹⁷. Researchers advo- cating the Agency Theory prescribe specific governance structures and incentive schemes to protect shareholders interests, minimize agency costs, and ensure agent- principal interest alignment. Such incentive schemes are based primarily on financial rewards. The impact of such alternative governance mechanisms is crucial on perform- ance and innovativeness.

The Agency Theory informs a control approach aimed at cutting self-serving behaviors of managers that may negatively affect owners’ wealth. According to the economists Sundaramurthy and Lewis, control advocates the “…challenges of individualism and the value of extrinsic motivation”¹⁸.

The theory described above underlies a lot of limitations and boundaries. The assump- tion of an opportunistic, individualistic and extrinsic motivated model of man seems to not be appropriate to describe human behavior in today’s world. Jensen and Meckling criticized this model of man as being a simplification for mathematical modelling and an unrealistic description of human behavior eighteen years later¹⁹. Furthermore, the adoption of the Agency Theory to director-manager relationships is more problematic, because directors, here as the principals of managers, also act as the agents of the own- ers. The Agency Theory is only applicable when there is identifiable goal incongruence between the agent and the principal. The use of such an extremely pessimistic theory in practice should be utilized very carefully, because it can lead to a self-fulfilling proph- ecy or motivational crowding-out effects, which are described in section 3.2.3.

Stewardship Theory

As a stark contrasting approach to the Agency Theory, the Stewardship Theory has its origins in psychology and sociology and was first introduced in an economic context by Donaldson and Davis. They picked up the concept of Herzberg et al., who conceived organizational role-holders as being “…motivated by a need to achieve, and to gain in- trinsic satisfaction through successfully performing inherently challenging work…”²⁰ Furthermore, they argue that the role-holders are motivated to exercise responsibility and authority, and thereby to gain recognition from bosses²¹. Based on these theoretical considerations, Donaldson and Davis argue an alternative and contradicting view of managerial motivation to the Agency Theory. Thus, the Stewardship Theory depicts subordinates as collectivists, pro-organizational, and as trustworthy²².

The utility function of the steward according to Davis et al. can be described as following: A steward perceives greater utility in cooperative behavior and behaves accordingly. Therefore, he perceives strong satisfaction by the success of the organization and the increase of the principals’ wealth. By protecting and maximizing shareholder benefits, the steward’s utility function is maximized²³.

The Stewardship Theory informs a collaborative approach to enhance board- management ties and decision making by empowering managers of the firm²⁴. The ex- ecutive’s motivation must fit the model of a man underlying the Stewardship Theory. Consequently, this leads to a high alignment of interest between the principal and the steward where, in turn, a high nonalignment of interests is found between the principal and the agent. The steward’s tendency to opportunistic behavior is constrained by his utility function where a “trade-off” between personal needs and organizational objec- tives does exist²⁵. Like the Agency Theory, it is applicable to all possible internal gov- ernance relationships.

However, contrary to the Agency Theory, it is not the primary focus of the Stewardship Theory to motivate executives, managers, or employees. Instead, it wants to generate facilitative, empowering structures that will enhance effectiveness and produce superior results to principals. The structure of a corporation inhibits or fosters information flow, and has a further significant effect on strategy and performance. Already in 1962, the influential economist Chandler emphasized the crucial importance of strategic manage- ment decisions for a corporations’ structure when he observed that “structure follows strategy”²⁶.

Figure 3 compromises the results of the comparison between the Agency and Steward- ship Theory. The main difference lies in the assumptions about human nature. However, the Agency Theory is still the dominating theory in CG research and practice. Its effi- ciency must be questioned. One important aim of this paper is to show that the use of the Agency Theory as an approach to CG is not appropriate in some situational con- texts, especially not in incompatible CG systems or in autonomous cultures that foster innovativeness and creativity. There is also no one-best-way approach to CG as claimed before in Donaldson and Davis’ paper²⁷ and as will be shown in the following chapters.

Figure 3: Contrasting approaches to corporate governance

illustration not visible in this excerpt

Source: Based on Sundaramurthy/Lewis (2003), p. 398.

An effective CG system is one that bridges the gap between the principals who provide incentives and the stewards or agents who provide managerial skills and effort for a firm. The use of an appropriate approach to CG will be a critical success factor to real- ize entrepreneurial behavior and therefore innovativeness. Not only the relationship of owners and mangers remain a principal agent/steward relationship, but all other entre- preneurial relationships in a corporation as well, which are based on the delegation of decision-making power over the allocation of corporate resources and returns.

Both theories additionally construct the bases in the analysis of the empirical results between governance mechanisms and innovativeness. The psychological effects on the performance of managers and employees will be discussed afterwards, when both theories are linked directly to innovativeness and entrepreneurship.

2.1.3. Corporate Governance Systems

In the preceding sections, the definition and the origin of CG, and the main theoretical approach, which is applied to CG were clarified. In this section, the paper investigates the complex construct of CG in depth to explain CG systems.

CG systems determine the structure and the legal boundaries of a corporation, and they differ significantly, even among advanced economies. They depend on the national law systems and they are not easy to change. Generally, a country’s system of CG is em- bedded in the idiosyncratic national institutions and ideologies of a country²⁸. Neverthe- less, this does not mean that it is not possible to transfer national CG systems across boundaries. Hoskisson et al. assume that there is no institutional barrier for doing that²⁹. According to O’Sullivan, a system of CG “…shapes who makes investment decisions in corporations, what types of investments they make, and how returns from investments are distributed”³⁰.

The most famous and common perspectives of CG systems are the shareholders and the stakeholders view. According to the shareholders view, shareholders are the “owners” or “principals” in whose interest corporations should be run. They both have incentives to monitor managers and the influence to bring about changes they feel will be profit- able. The shareholders view is more common in Anglo-Saxon countries than in other developed economies. Shareholders perspectives are characterized by a market-based CG system. In a market-based system, an effective governance system is one that can achieve a more optimal allocation of capital, thereby creating benefits for the economy as a whole³¹. Managers are monitored by an external market for corporate control and by a board of directors that are usually dominated by outside directors³².

The stakeholder’s view, which is common in other countries like continental Europe and Japan, sees stakeholders as the main group management accounts for. Stakeholders are employees, owners, customers, suppliers, and the society. The stakeholders’ view is characterized by a relationship-based CG system. Under a relationship-based system, investment in the development of human capital, through which cooperation is fostered, is essential for a firm’s survival in the long run³³.

The Anglo-Saxon CG system is criticized for its short-sightedness, whereas the Japanese and German systems are characterized by their willingness to invest in long-term capabilities³⁴. The German CG system is described briefly in the next section, and is of particular interest because of its exceptional components.

2.1.4. Corporate Governance in Germany

As stated before, the national systems of CG differ from country to country. Germany has a “two-tier” system, which is mandated by the law for all public corporations with over 500 employees. It promotes a stakeholder system, in which various groups of employees in addition to its owners are given a strong voice in the management of the firm. Employees elect half of the members of the supervisory board (Aufsichtsrat) and the shareholders elect the rest. The chair of the board is elected by the shareholders and the chair has a casting vote in the case of a stalemate.

Therefore, this reflects a strong consensus orientation of the German system. The supervisory boards main task is to control and monitor the board of executives (Vorstand) of top managers. The German supervisory board is comparable with an insiderdominated board of directors in Anglo-Saxon countries. The management board performs the same function as the CEO in the unitary Anglo-Saxon board system. The management board has the exclusive right and responsibility to manage the business of the company and to represent the company to third parties.

Power in the German system is not only given to owners and this makes it difficult to identify the typical principal-agent relationship between the owners and the managers.

[...]

---

¹ Jensen/Meckling (1976), p. 308.

² Cadburry Report (1992), p. 1.

³ Holmstrom/Kaplan (2003), p. 96.

⁴ O ’ Sullivan (2000), p. 394.

⁵ Monks/Minow (2001), p. 12.

⁶ See Berle/Means (1932).

⁷ La Porta et al. (1999), p. 471.

⁸ Ees/Postma (2002), p. 6.

⁹ See Jensen/Meckling (1976).

¹⁰ Ees/Postma (2002), p. 6.

¹¹ La Porta et al. (1999), p. 511.

¹² Jensen/Meckling (1976), p. 309.

¹³ Berle/Means (1932), p. 32.

¹⁴ Jensen/Meckling (1976), p. 308.

¹⁵ See Williamson (1985).

¹⁶ Simon (1955), p. 129.

¹⁷ See Jensen/Meckling (1976), p. 309.

¹⁸ Sundaramurthy/Lewis (2003), p. 389.

¹⁹ Jensen/Meckling (1994), p. 5.

²⁰ See Herzberg et al. (1959).

²¹ See Herzberg et al. (1959).

²² Donaldson/Davis (1991), p. 51.

²³ Davis et al. (1997), p. 25.

²⁴ Sundaramurthy/Lewis (2003), p. 398.

²⁵ Davis et al. (1997), p. 25.

²⁶ See Chandler (1962).

²⁷ See Donaldson/Davis (1991), p. 51.

²⁸ See Pauly/Reich (1997).

²⁹ Hoskisson et al. (2004), p. 294.

³⁰ O ’ Sullivan (2000), p. 394.

³¹ Hoskisson et al. (2004), p. 295.

³² Kaplan (1995), p. 23.

³³ Hoskisson et al. (2004), p. 296.

³⁴ See Porter (1990).