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CORPORATE GOVERNANCE
Blackwell Publishing LtdOxford, UK
CORGCorporate Governance: An International
Review0964-8410© 2007 The Authors; Journal
compilation © 2007 Blackwell Publishing Ltd
March 2007152262271ORIGINAL ARTICLESTHE
EFFECTS OF REGULATION AND COMPETITIVENESS
COPRORATE GOVERNANCE
Corporate Governance and Firm
Performance: the effects of regulation
and competitiveness
Krishna Udayasankar* and Shobha S. Das
We propose that the extent to which regulation and competitiveness play a role in the country
environment has a complex, interactive effect on the relationship between corporate governance and firm performance. Using an analytical method, we develop an algorithm to express
these effects, and offer proofs to show that our algorithm meets central conditions that are
identified based on extant research findings in this domain. An illustration traces the performance of firms with different corporate governance standards across various environmental
conditions.
Keywords: Government, corporate performance, corporate governance rating/index
Introduction
orporate governance research is characterised by much debate on the performance implications of corporate governance.
While some researchers aver that corporate
governance has a positive effect on firm performance, others find no evidence thereof (e.g.
Dalton et al., 2003). In an attempt to reconcile
the diverging evidence on the linkages between corporate governance and firm performance, we attempt in this paper to ground the
performance implications of firm governance
in the context of the exogenous environment
that firms operate in.
Corporate governance is strongly linked to
the larger environment within which firms
operate (LaPorta et al., 1998, 1999). Corporate
governance is affected by: (i) legislative content, such as shareholder protection laws
(LaPorta et al., 1998); (ii) judicial efficiency
(Klapper and Love, 2002); and (iii) support for
business (Klapper and Love, 2002), which we
cumulatively describe as regulation. In addition, competitive forces can reduce expropriation by managers (Shleifer and Vishny, 1997),
and make monitoring more efficient (Holmstrom, 1982; Nalebuff and Stiglitz, 1983).
However, the question arises whether the
C
*Address for correspondence:
National University of Singapore, NUS Business School,
Singapore, Business Policy, 0204, BIZ 1, 1 Business Link,
117592 Singapore. Tel: +65 6516
3774; E-mail: [email protected]
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regulatory and competitive forces in the environment operate equally upon all firms, or
interact with firm governance practices and
standards to result in idiosyncratic effects on
performance. Towards resolution of this question, in this paper we develop an algorithm
that captures the different effects of competitiveness and regulation as distinct environmental forces, and the implications thereof for
firms with different standards of corporate
governance.
Corporate governance is defined as “the
determination of the broad uses to which
organisational resources will be deployed
and the resolution of conflicts among the
myriad participants in organisations” (Daily
et al., 2003, p. 371). The various mechanisms
of corporate governance that go towards
such deployment of resources and resolution
of conflict as mentioned above, can be
explained by multiple theories of corporate
governance, of which agency, stakeholder,
resource-dependence and institutional theories are primary. Each of these theories contributes to explain the effects of regulation
and competitiveness in different ways. We
therefore bring together principles from these
different theories to propose an algorithm
that captures the interactive effects of re© 2007 The Authors
Journal compilation © 2007 Blackwell Publishing Ltd, 9600 Garsington Road,
Oxford, OX4 2DQ, UK and 350 Main St, Malden, MA, 02148, USA
THE EFFECTS OF REGULATION AND COMPETITIVENESS
gulation and competitiveness on corporate
governance.
Our choice of regulation and competitiveness as the two dimensions of interest in the
exogenous environment is based on recent
developments in the literature which identify
the social and economic context of corporate
governance (e.g. Aguilera and Jackson, 2003;
Kim and Prescott, 2005). We note that this
dichotomous distinction of the environment is
also interesting, in terms of its potential practical use. While regulation and mandate falls
within the purview of policy-makers, competitiveness embodies the context within
which managers may put corporate governance, generally, and our model, specifically,
to use.
The rest of this paper is structured as follows. We first review the literature on corporate governance, to restate certain central key
findings that are supported by empirical evidence, as the boundary conditions of our
theorem. We then develop an algorithm that
expresses our theoretical precepts and check
whether the said algorithm satisfies the
boundary conditions established. We illustrate
the efficacy of our algorithm using a hypothetical, but well-grounded, example and then
proceed to outline the implications of our
theory for researchers and managers.
What do we know about corporate
governance research?
Firms tend to comply with legal mandate, as
can be inferred from the plethora of research
that suggests better legal systems have a positive impact on corporate governance. LaPorta
et al. (1998) note the difference in governance
standards perpetuated by common and civil
law systems. The same authors find that firm
value is higher in countries with better protection of minority shareholders (LaPorta et al.,
2002), and that legal rules and quality of law
enforcement with respect to investor protection have an effect on the size of capital markets (LaPorta et al., 1997). Regulatory regimes
also result in a historical, or path dependent
effect on corporate governance (Aoki, 1994;
Berglof and Perotti, 1994). Recent research
suggests that the corollary, deregulation,
would also affect the standards of corporate
governance (Kim and Prescott, 2005). Firms
may also incur certain punitive costs in the
event of non-compliance with such legal mandate, thereby deterring such non-compliance.
All these studies serve to demonstrate the
positive effects of the quality and enforcement
of regulation on corporate governance. These
studies are representative of the institutional
© 2007 The Authors
Journal compilation © Blackwell Publishing Ltd. 2007
263
theory of corporate governance, a key premise
of which is as follows:
Observation 1: Regulation has a positive effect
on firm corporate governance.
Corporate governance could also be considered as a competitive resource, providing
benefits to firms in many ways (see Ho, 2005
for a review), in keeping with both agency
and resource-dependence views. Literature
emphasises the role of a market for corporate
control, whereby firms with poor standards of
corporate governance run the risk of being
acquired. Jensen and Ruback (1983) highlight
the role of comparators and competitors in the
environment, through the mechanism of the
market for corporate control. The resourcedependence view of corporate governance
(Pfeffer, 1972) further supports this notion.
The positive relationship between board capital and firm performance is well documented
(Dalton et al., 1999; Pfeffer, 1972), and literature also suggests that firms with better corporate governance are likely to have better access
to critical resources, including human capital
and relational resources (Hillman and Dalziel,
2003). These resources can be critical in conferring competitive advantage, which enhances
performance and survival. The longer-term
survival and business viability of firms may
therefore be highly dependent on the ability to
reach and maintain above-average standards
of corporate governance.
Observation 2: Under conditions of high competitiveness, above-average firm corporate
governance will be positively associated with
performance.
Going beyond the positive relationship
between regulation and corporate governance
that was proposed by LaPorta et al. (1998),
Pagano and Volpin (2005) suggest a two-way
process, wherein enhanced corporate governance at the firm level also shapes the regulatory environment of governance positively. As
better investor protection leads to a wider
shareholding base, such an increase in the
shareholding base tends to provide more
political support for governance regulation.
Such a two-way relationship is indicative of
the interplay of competitive and regulatory
forces, in the context of corporate governance:
regulatory forces act to engender better governance, while competitive interests also serve
to enhance governance regulation.
As both competitiveness and regulation
work to set overall standards in an environment, firms with lower standards of corporate
governance may also face unfavourable comparisons with firms that meet the environmental benchmarks, or deal effectively with
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various stakeholders. Firms are increasingly
becoming aware of such governance expectations (Mallin, 2005), and as benchmarking becomes institutionalised firms would compete
for legitimacy amidst different stakeholders
through consonance (Arthur, 2003; Hart and
Milstein, 2003; Oliver, 1997; Suchman, 1995)
and benefit from positive comparison, as well
as avoid detrimental comparisons. Peng (2004)
particularly identifies the importance of such
consonance with institutional norms, in the
corporate governance context. Corollary to the
positive role of regulation and competitiveness, in the absence of these environmental
forces, firms may not have much to gain from
maintaining above-average corporate governance standards.
Observation 3: In weak or absent competitive
and regulatory environments, firms will not
benefit from corporate governance.
The global convergence of corporate governance standards is a recent, but relatively wellestablished phenomenon (Mar and Young,
2001; Palepu et al., 2002). Attributable to the
development of economies worldwide, global
influences lead to the establishment of similar basic principles of corporate governance
across different countries (Mallin, 2002). As
country environments become better developed, a result of the increasing efficiency of
both regulation and competitiveness, corporate governance standards therein are raised,
and then stabilised, resulting in similar standards globally (Aguilera and Jackson, 2003).
The effects of institutions may also contribute
to a process of isomorphism of corporate governance standards (Udayasankar et al., 2005).
Therefore, as environments increase in the
efficiency of regulation and competitiveness, it
is likely that firm governance standards will
increase, and reach a point of convergence.
Observation 4: In environments with high competitiveness and high regulation, firm corporate
governance standards tend to converge.
Corporate governance and
performance: an algorithm
In the following sections, we propose that
regulation has a strong, independent, effect
until a minimal threshold of corporate governance standards is reached by firms in the environment, after which point both regulation
and competitiveness have an interactive effect.
Beyond a second threshold, competitiveness
alone has an effect on corporate governance.
Since regulation has the coercive effect of law,
it is likely to supersede the effects of other
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forces such as competitiveness, until such a
point that the mandate of law is fulfilled by
firms. Once this point is reached, the effects
of competitiveness become apparent. As the
impact of competitiveness becomes more enhanced, firms are likely to consider not only
the direct competitive benefits arising from
higher corporate governance standards, but
are also likely to find themselves the subject of
unfavourable comparisons with other firms in
the environment, leading to the strong direct
effects of competitiveness, beyond the second
threshold.
We first define the environment within
which our algorithm is operational, as follows.
Let the total number of environments possible
in the global context be represented by the
set G, and any particular environment by E.
Let E[R] represent the actual level of regulation in play in a given environment, where
R takes any value between 0 and 1. Similarly,
E[C] represents the level of competitiveness at
play in a given environment, and also takes a
value between 0 and 1. E[R, C] indicates the
level of regulation and competitiveness in an
environment E.
Assume that we are interested in a particular environment, which includes P number of
firms. It would be possible to identify the firm
with the lowest standards of governance,
amongst P firms, and similarly it would be
possible to identify the firm with the highest
standard of governance amongst P firms. We
symbolise these firms as firm l and firm h
respectively with corporate governance scores
of CGscorel and CGscoreh respectively. Taking
specifically the case of any firm f, from
amongst P firms, we define the distance
between firm f, and firm l and firm h, and the
minimum point of the environment as follows:
1. The distance between firm l (CGscorel) and
the minimum point CGscore = 0, as α.
2. The distance between firm f and firm l
(CGscoref – CGscorel) as β.
3. The distance between firm f and firm h
(CGscoreh – CGscoref) as γ.
The corporate governance standard of firm
f can therefore be expressed as α + β.
Common effects of regulation
Regulation serves to improve corporate governance standards, particularly as firms seek to
avoid punitive costs incurred from noncompliance. However, meeting the standards
mandated by regulation also poses certain
costs for firms, particularly in the light of
recent initiatives such as the Sarbanes-Oxley
Act of 2002. For example, overall spending on
compliance in 2006 is estimated to exceed
© 2007 The Authors
Journal compilation © Blackwell Publishing Ltd. 2007
THE EFFECTS OF REGULATION AND COMPETITIVENESS
$6 billion (Hagerty and Sirikisoon, 2005). In
the event that firms fall short of mandated
standards, expenditure on corporate governance may, in fact, be counterproductive, since
firms would incur expenditure on compliance,
as well as punitive costs. However, should
firms meet such mandated standards, they are
likely to gain benefits relative to other firms
which fall short of such mandated standards,
whether or not such latter firms incur expenditure on corporate governance. That is,
firms complying with mandated standards are
likely to benefit as compared to firms which
do not adequately emphasise or prioritise corporate governance, as well as compared with
firms which do place emphasis on and commit
resources to improving corporate governance,
but fall short of mandated standards in their
implementation.
We therefore suggest that all firms are likely
to benefit equally for a certain minimal level
of compliance, in the form of absence of punitive costs. This minimal level of compliance is,
in effect, likely to be the same as the corporate
governance standards of firm l. The common
effects of regulation, for all firms can be
expressed therefore as α × R and is the
same for all P firms in a given environment,
until the minimum levels of compliance, in
that environment. We therefore propose as
follows.
Proposition 1a: The moderating effects of regulation, on the relationship between firm corporate governance, and firm performance is as
represented by the expression:
α × R,
where all terms are as previously defined.
Interactive effects of regulation and
competitiveness
However, firms are likely to be subject to both
positive and negative comparisons with the
other (P-1) firms in the environment, on the
basis of their corporate governance standards.
The most beneficial comparison that may be
made, in the context of any firm f, would be
with the corresponding firm l, for the said set
of firms. That is, the most complimentary comparison possible for any firm would be a
comparison with the firm that has the lowest
governance standards in that environment.
This distance is represented by β, as has been
stated earlier. In general, the higher the value
of β, the more positive the effects on firm performance, given that a favourable comparison
on the basis of governance standards is made
to the benefit of firm f. However, the competitive and regulatory nature of the business
environment can serve to enhance or diminish
this relationship. Particularly, standards of
© 2007 The Authors
Journal compilation © Blackwell Publishing Ltd. 2007
265
governance beyond mandated levels can have
a positive impact, from reduced agency costs.
This however is dependent on the competitiveness of the environment. The specific
benefits that are likely to accrue to a firm,
given its standards of corporate governance,
and the competitiveness of the environment
can be expressed as β × C.
Firms may also use corporate governance as
a means to attract positive attention to themselves, in a bid to compete for resources. However, this is most likely under conditions
where access to resources is restricted, and
firms aim to attract the attention of various
market intermediaries, particularly when market institutions are weak (Khanna and Palepu,
2004b). The positive benefits of corporate
governance in competitive environment may
therefore be affected by the presence or
absence of market intermediation. Since the
existence of market intermediaries is strongly
linked to the absence of a regulatory environment that creates a level playing field, by
facilitating access to resources, we propose
that the specific benefits of corporate governance, as a means to attract the attention of
intermediates, is stronger in environments
with low regulation. Firms in countries with
inadequate regulation may also view corporate governance as a means to compensate for
the perceived lack of business efficiency and
transparency in the country, and actively
exhibit high standards of corporate governance in a bid to attract positive attention
(Khanna and Palepu, 2004a). Given that the
highest possible regulation in any environment is denoted by a score of 1, we express the
effects of a given regulatory environment, in
the particular context of market intermediation, as 1 − R.
For example, in a country like India, which
is characterised by average levels of regulatory
efficiency,1 but is nevertheless undergoing a
process of economic transformation and liberalisation, the information technology leader,
Infosys is known for its high levels of
corporate governance. However, a comparative firm, Tata Consulting Services (TCS) does
not exhibit the same levels of governance
(CLSA, 2001). Khanna and Palepu (2004b)
identify Infosys as facing an “institutional
void”, or inadequacy of institutional development in support of the business environment.
TCS on the other hand is associated with a
large family business group, which compensated for this institutional void, particularly
through the availability of an internal market
for capital and labour. TCS would also enjoy
increased legitimacy through its association
with such a leading business group. Thus, in
a market environment where regulation is
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moderate, the competitive reasons for increasing corporate governance standards are highlighted, and firms like Infosys may use
corporate governance as a means of garnering
legitimacy and positive attention.
Based on this, we express the effects of
positive comparisons based on corporate governance, in the context of both regulatory and
competitive environments, for a firm f as
β × C × (1 − R). However, this expression takes
into account only a comparison between firm
f and firm l, in the given environment. While
this comparison is likely to be the most beneficial for firm f, given that it captures the highest positive difference between the corporate
governance standards of this firm, and other
firms in the same environment, it is nevertheless possible that this firm f may be subject to
multiple positive comparisons, with all firms
that have lower corporate governance scores
than itself. For ease, we assign the term βa to
refer to the average effect of these multiple
comparisons of firm f, with any firm from firm
l to firm f, and rewrite the expression for the
cumulative effects of positive comparisons
based on corporate governance, for firm f as
βa × C × (1 − R), to propose as follows.
Proposition 1b: The moderating effects of regulation and competitiveness, on the relationship
between firm corporate governance, and firm
performance is as represented by the expression:
βa × C × (1 − R),
where all terms are as previously defined.
Negative effects of competitiveness
Firms are equally subject to unfavourable
comparisons on the basis of corporate governance, as they are to beneficial ones. Particularly, unfavourable comparisons are likely to
hold more weight in environments that are
very highly competitive. Such environments
are likely to have higher levels of information
flow, facilitate the dissemination of effective
business practices, and raise expectations that
firms are managed diligently, in general. In
highly competitive economies, such as the
United States, while firms may not be recognised often for their above-average standards of governance, the market repercussions
of violation or non-compliance with corporate governance standards can have serious
repercussions, as was seen in the case of Enron
Corp.
In such environments, a singular comparison between firm f and the firm with highest
standards of corporate governance, firm h, is
given by the distance between these two firms,
expressed by the term γ. The combined effects
of unfavourable comparisons, in the context of
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a specific competitive environment, can be
expressed as γ × C. However, for similar
reasons as discussed in the preceding section,
the expression would capture only one of the
possible unfavourable comparisons in an environment. The average effect of the multiple
comparisons possible is given by the term γa.
The expression for the cumulative effects of
unfavourable comparisons can therefore be
rewritten as γa × C, and leads us to the following proposition.
Proposition 1c: The moderating effect of competitiveness, on the relationship between firm corporate governance, and firm performance is as
represented by the expression:
γa × C,
where all terms are as previously defined.
We summarise the various notations used in
this section in Table 1.
So far we have identified the effects of
rewards for compliance and of beneficial and
unfavourable comparisons, on the basis of
corporate governance. Since the effects are
expressed as positive effects on corporate governance, we subtract the negative effects from
the summation of the two components of
beneficial effects, to arrive at the net performance effects of corporate governance. The
total performance implications of corporate
governance, contextualised in the larger business environment, would be a simple combination of the three components, as follows:
Proposition 2: The total performance implications of a firm’s corporate governance standards,
in the context of the firm’s competitive and
regulatory environment is as represented by
the expression:
PerformanceCG = α × R + βa × C × (1 − R)
− γa × C,
where all terms are as previously defined.
In keeping with previous literature (Doidge
et al., 2004) that describes the relationship
between the business environment, firm corporate governance and firm performance, we
assume that the costs of corporate governance
are fixed across all firms. We therefore do not
include a cost of corporate governance component in our algorithm.
Theoretical validation
In order to substantially establish the theoretical validity of our algorithm, and support
our propositions, we take the extant findings
identified in the earlier section as boundary
conditions, and test the proposed algorithm
against the four established empirical findings
that were stated. By doing so, we are able to
integrate the strong empirical evidence in the
© 2007 The Authors
Journal compilation © Blackwell Publishing Ltd. 2007
THE EFFECTS OF REGULATION AND COMPETITIVENESS
267
Table 1: Key notations and symbols
Symbol
Definition
E
R
C
P
Firm f
Firm h
Firm l
α
Any environment with levels of regulation R and levels of competitiveness C
Levels of regulation in environment E, expressed on a scale of 0 to 1
Levels of competitiveness in environment E, expressed on a scale of 0 to 1
Total number of firms in environment E
Any identified firm in environment E
The firm with the highest standards of corporate governance in environment E
The firm with the lowest standards of corporate governance in environment E
The minimum standards of corporate governance in environment E, also the same
as the corporate governance standards of firm l
The difference between the corporate governance score of firm f and the corporate
governance score of firm l
The difference between the corporate governance score of firm h and the corporate
governance score of firm f
The average effect of all possible comparisons between firm f, and any firm
between firm l and firm f
The average effect of all possible comparisons between firm f, and any firm
between firm h and firm f
β
γ
βa
γa
domain of corporate governance, into a comprehensive expression as captured by the proposed algorithm. Our standard to test the
expression is that it must satisfy each of the
four boundary conditions, or observations,
identified on the basis of prior empirical findings, individually and cumulatively.
Proof 1. Assuming that the environment E
has the highest level of regulation and lowest
level of competitiveness, E [1, 0], we can
restate the CG algorithm as:
(a ¥1) + (b a ¥ 0 ¥{1 - 1}) - (g a ¥ 0).
The expression is simplified to suggest that
performance arising from corporate governance, PerformanceCG = α. Under these conditions, performance benefits arise only from
firm compliance with regulation, thereby
reaffirming the positive effects of regulation,
on performance, in the context of corporate
governance, and satisfying the conditions of
Observation 1.
Proof 2. Our second condition involved the
effects of competitiveness on corporate governance, and stated that corporate governance
was essential to firm performance, and eventually survival, in highly competitive conditions. Such a highly competitive environment
E, is best represented as exemplifying the lowest level of regulation and highest level of
competitiveness, E [0, 1]. The CG algorithm
expressing this condition is therefore
(a ¥ 0) + (b a ¥1¥{1 - 0}) - (g a ¥ 1).
This is simplified into βa − γa, which takes on
a positive, and meaningful, value only if
© 2007 The Authors
Journal compilation © Blackwell Publishing Ltd. 2007
(βa > γa). The simple inference that becomes
possible therefore, is that any firm f, for which
the value of βa is greater than the value of
γa, the firm corporate governance score or
CGscoref must also be higher than that of many
other firms in the environment. That is, on
average, more firms have lower corporate
governance scores than that of firm f, and by
comparison, fewer firms have higher scores. In
this way, the conditions of Observation 2 are
therefore also satisfied.
Proof 3. When we assume that the environment E has the lowest level of regulation and
lowest level of competitiveness, E [0, 0], we
can restate the CG algorithm as:
(a × 0) + (b a × 0 × {1 − 0}) − (g a × 0 × 0)
The simplification of this expression gives
us a value of zero. The algorithm therefore
satisfies the boundary conditions inherent in
Observation 3, since firms will have no performance benefits from corporate governance in
conditions where both competitiveness and
regulation are absent.
Proof 4. Finally, our last condition captures
the convergence of corporate governance standards, as environments become highly developed. In a highly developed environment E,
level of regulation would be the highest, and
so would levels of competitiveness, E [1, 1],
and the CG algorithm takes the form:
(a × 1) + (b a × 1 × {1 − 1}) − (g a × 1 × 1)
This expression will yield a non-negative
result only if α > γa and a non-zero result only
if α = γa. Consequently, variation in corporate
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−20
−5
5
20
20
40
60
80
30
30
30
50
60
50
60
80
10
5
10
35
60
50
60
80
−10
−10
10
35
40
40
60
80
40
40
60
80
G Inc.
A
B
C
20
40
60
80
0
0
0
0
20
40
60
80
10
10
10
10
20
40
60
80
−10
0
7.5
20
5
5
15
27.5
CG
score
PerfCG
CG
score
PerfCG
CG
score
PerfCG
CG
score
PerfCG
CG
score
PerfCG
CG
score
PerfCG
CG
score
PerfCG
CG
Score
E [1, 1]
E [0.5, 1]
E [0.5, 1]
E [0.5, 0.5]
E [0.5, 0.5]
E [0.5, 0.0]
t2
t1
t0
Firm
Table 2: Governance Inc.: an illustration
The firm Governance Inc. (G Inc.) is incorporated in, and has business operations in a
given country environment E, which, being a
new developing economy, has the least possible regulation and competitiveness levels of
E [0, 0]. We assume, for the purposes of illustration, that G Inc.’s industry has no effects on
corporate governance, nor does the industry
have in operation any unique regulatory or
competitive forces other than the nationally
operational levels of regulation and competitiveness. Being the nascent economy that
country environment E is, all the firms operating in the environment are domestic firms.
We assume, for simplicity, that there are a total
of four firms, including G Inc. in the environment, and that these firms have the following
corporate governance scores: G Inc: 20; Firm
A: 40; Firm B: 60; and Firm C: 80. At this time,
t0, applying the CG algorithm developed, we
calculate PerformanceCG for each of these firms,
and observe that, as given in Table 2, all the
firms have PerformanceCG of zero. That is, no
firm has any performance benefits arising
from corporate governance, even though these
firms have various standards of corporate
governance. This can be attributed to the total
absence of competitiveness and regulation, in
the environment.
At the next point in time in our illustration,
t1, the policy makers of country E decide to
introduce legislation, in order to facilitate efficient business, and one of the consequent
pieces of regulation focuses specifically on cor-
t3
Governance Inc.: an illustration
E [0, 0]
t4
t5
t6
t1a
governance scores, amongst firms is highly, if
not completely, reduced. The minimal levels of
corporate governance tend to be very high
since α is greater than, or equal to γa. For the
same reasons, the inter-firm variation in corporate governance, that occurs over and above
the minimal threshold value of α, is reduced.
This leads us to conclude that under conditions of the environment E [1, 1], corporate
governance standards tend towards convergence, thereby satisfying the conditions of
Observation 4.
The algorithm derived satisfies all the four
boundary conditions that we identified based
on important findings in corporate governance research, thereby offering analytical
evidence that supports our propositions. We
therefore offer the proposed algorithm as a
comprehensive, yet parsimonious expression
of the effects of regulation and competitiveness on corporate governance. We further
illustrate the operation of our algorithm over
multiple contexts, through the use of a hypothetical illustration.
PerfCG
CORPORATE GOVERNANCE
E [0.0, 0.5]
268
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THE EFFECTS OF REGULATION AND COMPETITIVENESS
porate governance. Under this condition of E
[0.5, 0], since firms would respond to regulatory pressures alone given the absence of
competitiveness, all firms derived the same
performance benefits from corporate governance (PerformanceCG = 10), despite their varying corporate governance standards.
Subsequently, at the point in time t2, competitiveness in the environment also increased
to moderate levels, facilitated particularly by
the better regulation of the business environment, E [0.5, 0.5]. Initially, none of the firms
respond to this move, resulting in varying performance benefits. As seen from Table 2, G Inc.
specifically suffers a loss of performance from
corporate governance, with a PerformanceCG
value of −10, since it has the lowest corporate
governance scores in the environment. Firms
A, B and C, have PerformanceCG values of 0, 7.5,
and 20, respectively.
Eventually by the point in time t3, G Inc.
raised its scores to 40 in response to the legislation, while all the other firms continued to
maintain their previous scores. G Inc. was able
to benefit from its increased corporate governance standards and its PerformanceCG moved
from a negative value, to a positive value of 5.
It is interesting to note that the PerformanceCG
values of all the other firms also increased
(Firm A: 5; Firm B: 15; and Firm C: 27.5),
despite the fact that they did not raise their
corporate governance scores individually. This
phenomenon is a result of the increase in the
lower threshold of corporate governance
standards in the environment as a whole.
Continuing with our example, the policy
makers of country E found that with legislation in place, many foreign investors seemed
to express interest in investing in country E.
The policy makers therefore allowed foreign
direct investment and liberalised international
trade at this time, t4, thereby increasing the
overall competitiveness in the environment to
high levels, E [0.5, 1]. Like all the firms in the
environment, G Inc. continued to maintain the
same standards of corporate governance. Not
only were the performance implications of G
Inc., Firm A and Firm B reduced, but also, the
performance implications of G Inc. and Firm
A were negative (PerformanceCG = −10). The
firm with the highest corporate governance
benefited substantially. Firm C had gained
from an increase in the performance implications of their firms’ corporate governance
standards (PerformanceCG = 35), despite having
the same governance scores as before. The
strong emphasis on competitiveness, in this
environment, highlights not only the benefits of corporate governance, for firms with
high standards, but also highlights the negative effects of unfavourable comparisons, for
© 2007 The Authors
Journal compilation © Blackwell Publishing Ltd. 2007
269
firms with lower standards of corporate
governance.
As a consequence of this situation, Firm C
realised that the huge discrepancy in corporate governance, in their favour, presented an
excellent opportunity to acquire G Inc. and/
or Firm A. As the governance standards of
these firms were relatively very low, the possibility of mismanagement, and the consequent undervaluation of their shares posed a
lucrative acquisition opportunity for Firm C.
The managers of G Inc. realised that the firm
was the object of a potential takeover, and
also of unfavourable comparisons by foreign
investors. These investors were concerned
about the efficiency and reliability of domestic companies as potential investment opportunities, and these negative comparisons were
detrimental to G Inc.’s performance. In a
bid therefore to establish a better standing
amongst investors and thereby also enhance
its image amidst shareholders and consumers
at this time, t5, G Inc. intensively committed
its resources to enhancing its corporate governance standards, until these standards
reached a score of 60, the second lowest score
in the environment. Firm A also increased its
scores, but only to 50, thereby taking the
lowest scores position (E [0.5, 1]). Both firms
found that the performance implications of
their corporate governance standards had
moved from negative to positive (10 and 5,
respectively).
Finally, in t6, the policy makers of country E,
in a bid to maintain the new levels of competitiveness in the environment, further increased
the regulation required to facilitate business, resulting in the condition E [1, 1]. The
high levels of regulation and competitiveness
resulted in a trend towards convergence, and
though the spread in actual corporate governance scores is also low; the spread in PerformanceCG of the firms is relatively lower. In
fact, all three firms, G Inc., Firm B, and Firm
C, derived the same performance benefits
(PerformanceCG = 30), despite having different
corporate governance standards in operation.
Being an illustration, the preceding sections
cover only a few, main instances of the effects
of the environment, and changing governance
standards, on firm performance. Also, in this
example we have assumed that initially, an
increase in the levels of regulation in country
E is likely to precede an increase in the levels
of competitiveness. We do so, since this is,
more often than not, likely to be the case, as
policy-makers try to create an environment
that is more appealing to both domestic and
foreign firms. However, should the converse
also take place, our theory would still hold
good. For example, in t1a, should competitive-
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CORPORATE GOVERNANCE
ness precede regulation, resulting in a condition E [0, 0.5], G Inc. would still suffer a
strong loss from corporate governance standards (PerformanceCG = −20), since G Inc.
would be subject to strong unfavourable comparisons, as well as potential loss of legitimacy
from market intermediaries. This loss would
decrease somewhat with the introduction of
regulation, since such a move would facilitate
access to resources, and reduce dependence on
intermediaries.
Conclusion
Our algorithm captures the performance
effects of corporate governance across different conditions of competitiveness and regulation. When the focal firm fails to meet the
levels of governance mandated by regulation
it suffers losses, while firms which respond
quickly gain in comparison with other firms.
The potential uses of our algorithm include
comparison of a given firm with comparators
and/or competitors. However, the proposed
theory is limited since we do not consider the
role of firm-level attributes specifically, though
admittedly such variables may impact the corporate governance–performance relationship.
Some assumptions were necessary to arrive at
a simplified, yet accurate expression of the
performance effects of corporate governance,
yet we are vindicated in making these
assumptions by the strong utility of the algorithm that is proposed.
Note
1. As per the World Competitiveness Yearbooks.
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Krishna Udayasankar is an Assistant Professor (Visiting Fellow) at the NUS Business
School, National University of Singapore. She
obtained her PhD in Strategic Management
from the Nanyang Business School, Nanyang
Technological University, Singapore. Her
research interests include corporate governance, institutional theory and competitive
strategy.
Shobha Das is an Associate Professor in the
Strategy, Management, and Organization
Division of the Nanyang Business School in
Singapore. Her research interests are in examining corporate governance at the firm, industry, and country-levels. She obtained her Ph.D.
in Strategic Management from the Carlson
School of Management, University of Minnesota, USA.
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