Corporate governance & innovation

Corporate governance & innovation Mary O’Sullivan University of Geneva mary.osullivan@unige.ch Knowledge dynamics, industry evolution, economic development July 10, 2014

Structure • Theoretical debates on corporate governance • Institutional typologies & institutional change • Capital as a crucial theoretical & empirical blind spot • Historical studies of capital, industrial dynamics and innovation

Why do we care? • Contemporary debates about corporate governance stem from the recognition by economists of the importance of corporate enterprises for allocating resources in the economy • In most economies, corporate enterprises play a critical role in shaping economic outcomes through the decisions they make about investments, employment and trade • How major corporations allocate their vast revenues is a matter of strategic choice and the strategic choices of corporate decision-makers can have profound effects on the performance of the economy as a whole

What is corporate governance? • The governance or control of a corporate enterprise can be understood, in a broad sense, as the distribution and organisationof its decision-making power • A corporation's governance is comprised of the structures and processes, formal and informal, that influence which actors have influence within an enterprise and how they exercise it to determine the corporation's strategic direction • Although it is possible to conceive of the governance of a particular corporation, economists and other social scientists tend to speak of corporate governance in more systemic terms

System of corporate governance The institutions that influence how business corporations allocate resources and returns.

System of corporate governance Specifically, a system of corporate governance shapes: • WHO makes corporate investment decisions • WHAT types of investments and disinvestments they make • HOW the costs of, and returns from, corporate investments are distributed

Multiplicity of perspectives • What makes social sense? What system encourages corporations to act in a way that enhances welfare and equity in accordance with prevailing social values (e.g. soccer balls and child labour)? • What makes economic sense? What system of governance stimulates corporations to participate in a process that creates long-term economic value? • What makes political sense? What system encourages corporations to act in a manner consistent with dominant political values (e.g. democracy versus oligarchy) • What makes philosophical sense? What system encourages corporations to act in a way that is consistent with a particular philosophy (e.g. liberalism and property)

Multiplicity of perspectives • What makes social sense? What system encourages corporations to act in a way that enhances welfare and equity in accordance with prevailing social values (e.g. soccer balls and child labour)? • What makes economic sense? What system of governance stimulates corporations to participate in a process that creates long-term economic value? • What makes political sense? What system encourages corporations to act in a manner consistent with dominant political values (e.g. democracy versus oligarchy) • What makes philosophical sense? What system encourages corporations to act in a way that is consistent with a particular philosophy (e.g. liberalism and property) • etc…

Standard economic theories of corporate governance • Corporations should be run to maximise shareholder value • Corporations should be run in the interests of a variety of stakeholders • Managers need some autonomy from demands of capital and labour

Standard economic theories of corporate governance • Corporations should be run to maximise shareholder value because shareholders bear the risk of the corporation’s earning a residual (shareholder) • Corporations should be run in the interests of a variety of stakeholders because the performance of the corporate enterprise depends on their contributions and not just on the input of the shareholders (stakeholder). • Managers need some autonomy from demands of capital and labour to make strategic commitments of resources to “long-term” investments (managerial/technocratic).

For shareholder theory… • The crucial governancemechanismsare those that influence the relationship between corporate shareholders and managers • “Good” governance depends on creating carrots and sticks that “encourage” managers to maximise shareholder value • These governance mechanisms can be internal or external to the corporation

Internal Mechanisms Capital allocation process e.g. hurdle rates of return Incentive systems e.g. stock options Board composition Company charter External Mechanisms Shareholders’ Meetings Proxy Fights Institutional Investor Activism Hostile Takeovers Legal/ Regulatory Framework that determines rights & obligations of shareholders, directors, executives Mechanisms that (in theory) promote the maximisation of shareholder value

Standard economic theories of corporate governance • Corporations should be run to maximise shareholder value because shareholders bear the risk of the corporation’s earning a residual (shareholder) • Corporations should be run in the interests of a variety of stakeholders because the performance of the corporate enterprise depends on their contributions and not just on the input of the shareholders (stakeholder). • Managers need some autonomy from demands of capital and labour to make strategic commitments of resources to “long-term” investments (managerial/technocratic).

Critiques of Shareholder Value • Theory of shareholders’ contribution: other stakeholders in the corporation also take substantial risks for the economic benefit of corporations • Theory of the firm:“the attempts of the new institutional economics to explain organizational behavior solely in terms of agency, asymmetric information, transaction costs, opportunism… ignore key organizational mechanisms like authority, identification, and coordination and hence are seriously incomplete (Perrow) • Theory of governance mechanisms: all depend for their effectiveness on the stock market’s efficacy in assigning prices to corporate securities. Although the efficient markets’ hypothesis was once described as one of the best-proven facts in the social sciences, it’s taken a bit of a beating recently!

Theoretical debates on corporate governance • Recognition of the importance of the “theory of the firm” that underlies theories of corporate governance • And the limits of dominant theories for understanding how enterprises really operate • Various efforts to develop a theory of the firm that recognises characteristics of innovation as central to process through which corporations allocate resources and distribute returns • Possibilities and problems of these new directions

Theoretical debates on corporate governance • Jensen, M. C. and Meckling, W. H.,1976, “Theory of the Firm : Managerial Behaviour, Agency Costs, and Ownership Structure”, Journal of Financial Economics, 3 (2), 305-360. • Fama, E. and Jensen, M., 1983, “Separation of Ownership and control”, Journal of Law and Economics, 26 (2), 327-349. • Berle, A. and Means, G.,1932, The Modern Corporation and Private Property, New York. • Blair, M., 1999, “Firm-specific Human Capital and Theories of the Firm”, in Blair, M. and Roe, M. (eds), Employees and Corporate Governance, Brookings Institute, Washington, 58-90. • Blair, M. M. and Stout, L. A., 1999, “A Team Production Theory of the Corporate Law”, Virginia Law Review, 85 (2), 247-328. • Zingales, L., 2000, “In Search of New Foundations”, Journal of Finance, 55 (4), 1623-1653. • Chassagnon, V. and Hollandts, X., 2014, “Who are the Owners of the Firm? Shareholders, Employees or No One?”Journal of Institutional Economics. 10 (1), 47-69 • O’Sullivan, M., 2000, “Innovation, Resource Allocation, and Governance”, chapter 1 in Contests for Corporate Control: Corporate Governance and Economic Performance in the United States and Germany, Oxford, Oxford University Press. • Lazonick, W. and O’Sullivan, M., 2000, “Maximizing Shareholder Value : a new Ideology for Corporate Governance”, Economy and Society, 29 (1), 13-35. • Krafft, J. and Ravix, J. L., 2009, “The Governance of the Knowledge-Intensive Firm in an Industry Life Cycle Approach”, in Morroni, M. (ed), Corporate Governance, Organization and the Firm, Edward Elgar, Cheltenham and Northampton, 48-62.

Institutions of corporate governance • A division of labour between scholars interested in understanding institutions that influence • Capital & corporate governance (ownership, finance, profits) • Labour & corporate governance (participation, work, wages & benefits) • In both cases, a great deal of effort devoted to developing typologies of capitalism that highlight comparative similarities and differences in systems of corporate governance across countries • And, more recently, in trying to explain the origins of these comparative patterns of corporate governance

Capital Institutions • Patterns of corporate financing • market-based systems (e.g. US & UK) v. • bank-based systems (e.g. Germany & Japan) • Patterns of corporate ownership • insider systems (most of continental Europe, Japan & ROW) v. • outsider systems (US & UK)

Capital Institutions & Legal Origins • Patterns of corporate financing • Patterns of corporate ownership & their FOUNDATIONS • Patterns of corporate and bankruptcy law • common-law systems (e.g. US & UK) v. • civil-law systems (e.g. Germany & France) Rafael La Porta, Florencio Lopes-de-Silanes, Andrei Shleifer & Robert Vishny, “Legal determinants of external finance”, Journal of Finance, 52 (July 1997), 1131-50; idem., “Law and finance”, Journal of Political Economy, 106 (December 1998), 1113-55.

Law & Corporate Governance • Legal rules that protect minority investors and the quality of their enforcement determine patterns of corporate finance and ownership • Legal systems differ systematically in the quality of protection they provide minority investors • Common law is more protective of minority investors than German and Scandinavian civil law which is more protective than French civil law • And so countries’ legal families explain comparative patterns of corporate finance and ownership • Corporate finance: in countries with better legal protections, companies will have easier access to external finance from capital markets • Corporate ownership: countries with poor protections have more highly concentrated ownership of shares

Institutional typologies & institutional change • Typologies may be useful for capturing comparative patterns in corporate governance at a point in time • However, they tend to ignore institutional change or treat it in highly simplified terms (capital markets develop or do not if a key factor (e.g. legal family) is present)* • Recent evidence suggests that there is considerable change over time in main characteristics of systems of corporate governance • And that it is not related in any simple fashion to “key” causal factors that have been identified in literature * O’Sullivan, Mary, “A Fine Failure: Relationship Lending, Moses Taylor & the Joliet Iron & Steel Company, 1869-1888,”Business History Review, forthcoming

Public Share Issues proceeds as a % of GFCF* * Gross fixed capital formation Source: Rajan and Zingales, 2000, p. 38

Public Share Issues proceeds as a % of GFCF* * Gross fixed capital formation Source: Raghuram Rajan and Luigi Zingales, “The Great Reversals: The Politics of Financial Development in the 20th Century,”Journal of Financial Economics 69 (July 2003), p. 16.

Institutional typologies & institutional change • Growing body of historical research on origins and evolution of institutions of corporate governance • With a particular focus on historical evolution of • ownership of corporate shares • markets for corporate securities • As well as efforts to propose explanations that account for historical & comparative patterns • Political Dynamics (Mark Roe; Peter Gourevitch & James Shinn) • Trends in Economic Openness (Raghuram Rajan and Luigi Zingales) • Dynamics of Economic Development (Mary O’Sullivan, Dividends of Development, forthcoming, 2015)

Institutional analysis & economic dynamics • Empirical links between institutional analysis and economic dynamics usually drawn in loose terms e.g. shareholder value orientation of U.S. corporate sector makes Silicon Valley innovative! • Even in the most careful institutional analyses, there is typically little connection between institutional patterns of corporate governance and the behaviour of corporate enterprises • It is not surprising, therefore, that we know little in empirical terms about the links between institutions of corporate governance, innovation and economic dynamics

Capital as a blind spot • The theoretical murkiness of capital’s role • standard theories of the firm (financing capital formation?, waiting? risk-bearing?) • heterodox traditions (Schumpeterian innovation versus Keynesian speculation) • And very little empirical research that would allow us to distinguish among more or less plausible arguments • A survey of historical research reveals just how little we can say with confidence about the role that capital played in the process of economic development • Canonical example is Britain’s Industrial Revolution but even if we focus on capital-intensive industrialisation (e.g. steel) Source: O’Sullivan, Mary, 2004, « Capital: The Blind Spot of Capitalism”, a review ofCapital in the 21st Century by Thomas Piketty, American Historical Review, forthcoming

Motor Cars on the U.S. Securities Markets, 1907-1929

Corporate governance & innovation • The links between corporate governance, innovation and economic dynamics are promising • From a theoretical perspective (dynamic theories of the firm as basis for conceptualisation of corporate governance) • And an empirical perspective (links between institutional patterns and economic dynamics) • Crucial blind spots to be overcome but research strategies to do so • Already apparent from new studies that standard theories of corporate governance are lacking • But still an open question of how much we can generalise about links between corporate governance & innovation

Corporate governance & innovation