Saturday, 5 April 2014

CONTRACTUAL CORPORATE GOVERNANCE – OR WHY CORPORATE GOVERNANCE IS NOT JUST ABOUT COMPLIANCE

Sometimes following so called best practice in corporate governance is just not good enough. Or what is currently best practice at the national level could not even be deemed to be good. This might be the case for firms based in emerging markets where corporate governance regulation is weak and the regulation that exists is not necessarily enforced. However, even some firms from developed economies, with relatively stringent regulation and good law enforcement, may feel that their national corporate governance standards are not good enough. 

In 2007, while holding a chair in finance at Sheffield University, I organised a conference on contractual corporate governance with the help of Prof. Luc Renneboog from Tilburg University. We defined contractual corporate governance as
The ways and means by which individual companies can deviate from their national corporate governance standards by increasing (or reducing) the level of protection they offer to their shareholders and other stakeholders.
The best papers from the conference were published in a special issue of the Journal of Corporate Finance. This special issue focused on three ways by which firms could deviate from their national standards. These included:
  • cross-listings,
  • cross-border mergers and acquisitions, and
  • reincorporations.
A cross-listing consists of a firm being listed on a foreign stock exchange, in addition to its domestic stock exchange. Within that context, Prof. John Coffee advanced the so called bonding hypothesis. According to this hypothesis, firms from countries with weak corporate governance cross-list on a stock market with stricter regulation (typically a US stock market) to commit themselves not to expropriate their (minority) shareholders. Why would firms want to do that? Well, one of the consequences from weak corporate governance is that firms will be charged a higher cost of capital by their providers of finance, including their shareholders. In other words, firms that are perceived to have weak corporate governance (possibly due to weak national law and weak law enforcement) will have to pay a premium to their shareholders, compensating them for the greater risk they incur by investing in such firms. For firms that operate in highly competitive product (or service) markets an above-average cost of capital may effectively be their death sentence. Hence, a way forward would be for such firms to opt voluntarily into a better corporate governance system. This could be achieved via a cross-listing. A study, which I conducted with my colleague Dr Wissam Abdallah and which was published in the special conference issue, finds that firms with large shareholders from countries with relatively weak law are more likely to cross-list on markets with better law. This suggests that these large shareholders make a conscious effort to show their minority shareholders that they are safe from being expropriated.

Another way for a firm to go beyond its national standards would be a cross-border merger & acquisition (M&A). Without going into too much detail, the firm could be the bidder or the target in the cross-border M&A. More importantly, the two papers on cross-border M&As published in the special issue of the Journal of Corporate Finance suggest that the better corporate governance of one of the counter-parties typically spills over to the counter-party with the weaker corporate governance. Hence, alongside cross-listings cross-border M&As seem to be one way for firms to exceed their national standards of corporate governance.

Finally, firms may reincorporate in a country with better corporate governance. However, this is not always the case as the example of the USA suggests. Indeed, the vast majority of US firms that reincorporate in another US federal state do so in Delaware. Delaware is known for favouring managers over shareholders by e.g. offering anti-takeover devices which may shield the former from the disciplinary role of hostile takeovers. Hence, as reincorporations are concerned, the jury is still out there as to whether they will result in a race to the bottom (whereby firms would all move to countries with weaker corporate governance and law) or a race to the top (whereby firms would all move to countries with better corporate governance and more efficient law).

Returning to contractual corporate governance, it is important to realise that for some firms best practice is not good enough and that they may want and need to do better than that. More generally, investors should be very suspicious about firms that follow the herd. Every firm is different and is likely to suffer from particular corporate governance problems and conflicts of interests. Firms can only gain from having a grown-up approach to corporate governance rather than a boiler plate approach. To put it bluntly, good corporate governance is about spelling out one's firm's potential weaknesses and then putting in place mechanisms that mitigate these weaknesses. Let us stop reducing corporate governance to compliance. Indeed, some firms need to do more than just to comply. This also calls for rethinking how corporate governance is taught in business schools.

Note: See also chapter 13 of my book 'International Corporate Governance' which provides an introduction to contractual corporate governance.



Legal disclaimer: This blog reflects my personal opinion and not necessarily that of my employer. Any links to external websites are provided for information only and I am neither responsible nor do I endorse any of the information provided by these websites.