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Corporate Governance and Family Business Relationship

Info: 5419 words (22 pages) Example Literature Review
Published: 6th Dec 2019

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Tagged: Business

2.0. Introduction:

This chapter aims at determining the relationship between corporate governance and family businesses. To provide a background on the research topic this chapter reviews previous research literature on the definition of corporate governance and family owned businesses in section 2.1. Following this there is the discussion of the theoretical frameworks of corporate governance from a family owned business point of view in section 2.2. Section 2.3 details the internal mechanisms which drive corporate governance in a family owned business.

2.1. Defining family business and corporate governance:

2.1.1. Defining corporate governance and the need for corporate governance:

Alchian (1950), Stigler (1958) and other neo classical economists indicate that competition and survival are the basic principles which are used to enable firms to acclimatize themselves to product market competition. In order to survive companies minimize the overall expenditure to the company. This leads to evolution of rules and other mechanisms enabling them to raise external source of capital. Based on this theory of evolution of change of economics, there is no concrete role for corporate governance as it is subsumed by the competition promoted in the product market.

Although once the finance capital is available to the entrepreneur the large sums of money is invested into a single bushiness endeavor. This investment needs to get returned as entrepreneurs cannot obtain capital minute by minute. The returns on capital may get reduced by the competition stimulated in the product market. It is also noted that this may affect the amount of money manager can possibly expropriate. However it cannot prevent the mangers or agents in expropriating funds from the competitive return after there is sinking of capital. All of this indicates there is a need for some form of governance within the corporation. Corporate governance measures are often considered as a series of steps which are required to operate firm wherein the ownership and management are found to be separate in nature.

Corporate governance is useful in dealing with specific mechanics which would help provide an investor in any corporation some form of protection for their investment. Corporate governance has been defined by Shleifer and Vishny (1997) that,

“Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment.”

(Shleifer and Vishny, 1997, p. 737)

Corporate governance has also been defined by the ‘Organization for Economic Co-operation and Development (OECD)’ as a series of rules which are useful in the governance of different members of any company. According to OECD,

“Corporate governance involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined.”

(OECD Principles of Corporate Governance, 2004, p. 11)

Corporate governance is considered to be a part of a larger context of a company, when economics are considered. Such an economic context involves the competitive factors of the product market and macroeconomic policies. A framework of corporate governance would involve a number of factors including legal issues, regulatory issues, the environment of the institution, ethics followed in the business and social responsibilities.

No single most effective model of corporate governance has been identified. Corporate governance is found to be influenced by the degree of relationship between the different members of the system of governance (IBID, 2004, p.12). The principles corporate governance are of evolutionary nature. Innovation and adaptation of corporate governance practices of companies is required in order to remain competitive in a changing world to meet the demands and growing opportunities available (IBID, 2004, p.13).

The Centre for Financial Market Integrity of the CFA institute, USA indicates that corporate governance is needed to bring a sense of control and procedure into the firm. They call the presence of corporate governance as a series of controls and procedures initiated internally to manage individual systems. There is the establishment of a framework which provides the responsibilities of the board, management, controlling share holders as well as minority shareholders within a particular organization (CFA Institute, 2005, p.7)

The presence of corporate governance at its core is to bring about a system of checks and balances required in order to cause minimization in terms of conflicts occurring between the shareowners both inside and outside. There is prevention of expropriation of cash flows and assets of one or more members or groups within a company by adopting good rules of corporate governance (IBID, 2005, p.7).

Corporate governance can also be considered from a structural point of view as proposed by Monks and Minow (2004). It is seen that corporate governance can be considered as a structure whose primary responsibility is to pose the correct questions at the correct time to ensure accountability of the firm and its employees. Corporate governance in this case ensures that the answers provided help in the creation of long term and sustainable value (Monks and Minow, 2004, p.2).

The above section clearly indicates there are different ways to define corporate governance. The definitions of corporate governance can be considered along two different schools of thought,

Claessons (2006) indicates that corporate governance can be defined along two different frames of view.

1. Definition of corporate governance in terms of patterns of behaviour including behaviour of the firm, measures of performance of firm like efficiency, growth and financial structure along with treatment of stakeholders and shareholders.

2. Definition of corporate governance in terms of framework of an organization including rules of operation of a firm. These rules are found to originate from the legal system, finance market, labour and production market as well as the judicial system.

The two threads of definition are found to apply to different situations. For example when studies are conducted in terms of single countries or companies studied within a single country the first thread of definition would be the most applicable. When studies are conducted for comparative analysis, or for cross country studies then best choice would be to adopt the second thread of definition (Claessons, 2006, p.93).

Another thread is in terms of fulfillment of investor protection. Rahman (2006) indicates that initially the protection of the investor was not considered to be of vital importance. However over the years the demise of corporations like Enron and Worldcom led to the need to study the relationship between corporate governance and firm value as well as dividend payout.

He indicates that,

“Corporate governance literature has two strands: one sees corporate governance as guiding and improving the performance of managers (Fama and Jensen, 1983b; Hart, 1995) and the other regards it as fulfilling an investor-protection function (Shleifer and Vishny, 1997).”

(Rahman, 2006, p. 362)

This dissertation aims to study the success factors of family firms in Singapore and India. There is both a within the country analysis and a comparative analysis. Therefore a combination of Claesson’s (2006) definitions is considered here. This dissertation primarily follows a semi interview and a questionnaire pattern of methodology without involving any other type of empirical analysis thereby ruling out the second thread of definition of corporate governance.

2.1.2. Family Business

As stated by Sharma (2004) one single definition of family businesses does not exist. Based on the purpose of this thesis, it is important to define family-controlled business. Authors such as La Porta et al. (1999);), Anderson and Reeb (2004), Panunzi et al. (2006) cited in Nordqvist and Boer (2007) described the family-controlled business as a company “where a family (that is one person, or two or more persons related through marriage or blood) owns 20% of the voting stock and this firm is represented in the board and /or the top management”.

These definitional parameters of this thesis, which will be further revisited under the research methodology, are consistent with other recent studies such as the investigation of the ultimate controlling shareholders in 27 large companies around the world (La Porta et al., 1998), or the study of ownership and corporate governance structures of all family controlled firms on the major lists in Sweden (Nordqvist & Boers, 2007).

Family Business is the most frequent form of business organization around the world

Mallin (2004), Melin and Nordqvist (2007), Leach (2007). Furthermore, as Neubauer and Lank (1998) state, there is little doubt that family enterprises are the most complex form of business organization. According to Neubauer and Lank (1998) the contribution of family firms to GDP as well as employment varies from 45 per cent to 70 per cent through the non-communist world. It was mentioned earlier that family firms are the most complex form of organization around the world (Neubauer and Lank, 1998). Therefore a starting point to explain this complexity is, as Nordqvist and Boers (2007) explain, the overlap of the family and the business, where the family concerns impact the business and business concerns impact the family.

Furthermore, Gersick et al. (1997), Ward (1987) cited in Melin and Nordqvist (2007) described the characteristics of family business compared to other categories of organizations through the three-circle model (see Figure 1).

Where the three circles overlap each other the family-business is present. Therefore, they are characterized by three different spheres: ownership, the business and the family itself. These sub-systems are both separated and strongly linked (Poza, 2007). According to Melin and Nordqvist (2007) family businesses are part of a specific category of organizations which show some common characteristics and also face similar problems different from other types of organizations. However, it is possible to find different types of family business within the same category based on the three family business institutions, the ownership, the business and the family.

Considering these three different spheres, as it is argued by Ward (2004), family members will have a different perspective depending on the role they play. For instance they can be owners, managers and family members at the same time and they should be able to balance these three roles. Therefore, we can find a combination of roles, where some individuals can be managers but not owners or others can be simultaneously owners and managers leading to a situation where different people in the family business see things different depending on their perspectives (Ward, 2004). This implication of family members having different or multiple roles is supported also by Mustakallio et al. (2002) cited in Nordqvist and Boer (2007). Consequently, members of the family in family firms can hold different positions.

Neubauer and Lank (1998), the inclusion of the family dimension and the inevitable overlapping of the family with the three circles (see figure 2) leads to challenges that no completely publicly held corporation has to face. Thus, this is the conception of family controlled company, where the family has influence in the three circles and therefore, as argued by Neubauer and Lank (1998), this conception begins to explain some of the negative dynamics commonly associated with such organizations.

According to Hall (2001) there is a strong interrelation between the sub-systems as a consequence of the overlap when some individuals are part of the different systems at the same time. This situation brings conflicts because the individual who acts and has a role in different sub-systems will perceive the business differently. Thus, as indicated by Hall (2001) probably the most difficult situation is to combine the roles of family member, owner and working in the business. This complexity can increase depending on how many roles the same individual holds.

2.2. Theoretical framework of corporate governance in family businesses:

The problems arising due to separation of ownership and control of the resources of the firm lead to the rising of specific issues of corporate governance. The business activity conducted by a firm helps in the growth of a market economy. As early as 1989, Eisenhardt indicated that there are a number of problems which arise due the asymmetry between the principal i.e. the shareholders of the firm and the agent i.e. the manger of the day to day business of the firm. She indicates this asymmetry occurs due to,

  1. Difference in goals of the agent and the principal.
  2. Inability to determine if the actions of the agent reflect the best interest of the principal.

The importance of this asymmetry has been studied in terms of corporate governance theories over the years. Ho (2005) has indicated the presence of different perspectives of corporate governance. This dissertation focuses on two main perspectives: agency theory and stakeholder theory.

2.2.1. Agency Theory:

The agency theory has been used to explain corporate governance effectively across all disciplines of social sciences. The agency theory has been used to study corporate America to determine the relationship between the principle and the agent. The evolution of the principal versus agent conflict is traced to the debate of American scholars like Edwin Dodd, Adolph Berle and Gardiner Means immediately after the Wall Street crash of 1929. Clarke (2004) has indicated that Berle and Means were concerned with the growth of economy and the increae of stock ownership diversification which makes it difficult to separate ownership and control in public corporations (Clarke 2004, p.3).

Clarke indicates that Dodd’s argument clearly puts forth the asymmetry which existed. Eisenhardt (1989, p. 71) points out the relevancy and the application of the agency theory. She indicates that the agency theory helps in the provision of an unique and testable perspective of the problems which arise due to lack of co operative effect within a firm.

Following this extensive research has been conducted in this school of thought. Fama and Jenson (1975) influenced the Claessens et al (2000) view in terms of ownership and control in East Asian Corporations. Other studies mirroring the concepts of agency theory include the ownership structure and contract analysis by Alchain and Demsetz (1974, p794), contractural nature of firm and the costs involved in undertaking a business venture by Jensen Mecking (1976, p 311-357).

In order to understand the greater complexity of agency theory’s application the problems associated with the agency theory have become more apparent with the increasing use of this theory over the last few decades. It is seen that in the recent past the concentration of ownership is one of the major factors which drive the separation of control in terms of principal and the agent. This theory often holds good in developed countries like America wherein the widely dispersed ownership does not give rise to a dominant owner-principal.

Limitations of the Agency theory in family owned businesses:

In countries where there are a large number of family owned corporations the basis of the agency theory with regard to expenditure is found to be nonexistent as more often than not there is uniformity in terms of decisions taken up strategically. Einsenhardt (1989, p 64) indicates that the control of a clan on a corporation reflects a congruence of goals between the different parties involved thereby decreasing the need to monitor the behaviour and outcome of the research.

The studies of corporate governance have been carried out internationally thereby broadening the scope of the theory as well as its audience. Despite the presence of anomalies in the agency theory there are instances where it is used in studies where the ownership and the control is the same (Schulze et al., 2001). This section examines the effectiveness of the agency theory in Asia wherein there is dominance of family owned businesses.

Tsai et al (2006) applied the agency theory to two Taiwanese firms. One firm was owned by a family while the other was non family owned. They observed that turnover of the CEO of a family firm is half that of non family CEO. They also observed that corporate values are more easily observed and enhanced by family CEOs. This result is against the general consensus that better corporate performance is observed when the ownership and control are separate. This led them to indicate that the agency theory cannot be implemented to family owned firms as there are no asymmetry factors in terms of principal and agent. The control of a family is found to serve as monitoring factors instead of CEO bonding. They drive home the view that the agency theory is applicable to non family firms but not the family firms (Tsai et al., 2006, p 23-26).

The failure of privatization in emerging economies has been studied from an agency theory point of view by Dharwadkar et al (2000). They indicate that the lack of recognition in terms of rights of property and the weak structure of corporate governance in the emerging economies results in an agency problem unique to emerging economies i.e. that of expropriation. They indicate that,

“Traditional agency problems of based upon principal-agent goal incongruence are supplanted by unique agency problems arising from principal-principal goal incongruence.” (Dharwadkar et al., 2000, p. 660)

The above section thus clearly indicates that while the agency theory is a powerful and effective theory to study corporate governance it is problematic to apply this theory in countries where there is concentration of ownership in most firms.

2.2.2. Stakeholder theory:

This theory is based on the foundation that there are a number of other groups to whom the firm is responsible to in addition to the stockholders (Freeman and Reed, 1983). This theory is based on the school of thought that firms are required to pay equal attention to all parties of a company including employees, customers, suppliers and creditors alike rather than considering the view point of the stockholders alone. Stakeholders of any corporation include a group of individuals on whom the organization is completely dependent in order to survive. Therefore stakeholder list would include employees, suppliers, consumer market, government agencies and financial institutions (Freeman and Reed, 1983, p 91).

Freeman and Evan (1990) indicated that the firm is best conceptualized in terms of a number of overlapping contracts among all the stakeholders. They also indicate that it is not enough to look at the firm from only the contractual view and there are other concepts needed to strengthen the stakeholder theory.

Donaldson and Preston (1995) have clarified that the stakeholder theory can be studied from four main aspects:

  1. Descriptive aspect: This involves the functional aspect of the theory wherein there is description of the co operation and competitive interests of the corporation.
  2. Instrumental aspect: This helps in the identification of the connection between the management of stakeholders and obtaining growth and profitability in the organization.
  3. Normative aspect: This aspect is used to interpret the functions of the corporation and identify the moral guidelines to manage any company.
  4. Managerial aspect: This aspect is used to determine the attitude, structure and the practices which would run the stakeholder management of a corporation.

(Donaldson and Preston 1995, p.72).

It is observed that the stakeholder management therefore requires attention to the interests of all stakeholders of the firm (Jones, 1995). Jenson (2002) is against the stakeholder theory indicating that any corporation paying attention to all the constituencies of the firm is unassailable. This is as indifferent as maximization of value. He finds a fundamental flaw in the stakeholder theory because he feels that it violates the proposition that any organization requires the need for a single valued objective in order to achieve a rationale or a purpose.

Advantages of Stakeholder theory in family owned businesses:

The rising stages of corporate governance research in Asia indicate that the stakeholder relationships are not well understood in Asia. However the stakeholder theory is more applicable when compared to agency theory. Stakeholder theory in Asia has been studied by Reed (2002). He indicates that the differences in terms of cultural, institutional, legal and managerial factors in Western and Asia economies makes it important to apply the stakeholder theory in Asia from a different context. He indicates that three important principles are required to apply the stakeholder theory in Asia.

  1. There is a need to respect acts of public autonomy. This is required even when absence of a democratic process. The dominance of family owned firms in Asia indicates that this not ab issue.
  2. There is a need for task interdependence. The responsibility to fulfill duties which are not undertaken by other stakeholders. Since most firms are family owned there is a lot of task interdependence observed.
  3. The responsibility to address issues of injustice and show transparency. In ownership concentrated firms it is important to note that there is no lack of transparency as errors need to be pointed out in family firms. The actions undertaken though an internal matter is often resolved with swiftness.

(Reed 2002, p. 184-185)

Nottage (2001, p. 263) indicates that there is an inherent inability in a number of Asian firms to write concise and clear contracts for all the stakeholder relationships. In comparison with Western firms the companies in Asia do not expressly provide solutions for all possible contingencies. He attributes this lack to the absence of clear boundaries of stakeholders. However he indicates that this overlap of stakeholder duties results in an increase in transparency in the disclosure of information to all stakeholders in owner concentrated companies.

This dissertation therefore applies the stakeholder theory of corporate governance to the different firms from Singapore and Asia. This indicates that while that there is increase in task interdependence in corporations, transparency in disclosure of information to stakeholders and presence of public autonomy, therefore making the application of stakeholder theory of corporate governance in Asia.

The review of the theoretical framework indicates that there is an ever present need for corporate governance within the firm. The theoretical framework gives importance to the different aspects of the insiders of the firm interacting with the outsides. In Asian countries the domination of ownership concentrated firms indicates that sustainment of long term survival is made possible by the application of the stakeholder theory.

2.3. Mechanisms of corporate governance: Relation to family owned businesses:

2.3.1. Classification of corporate governance mechanism:

The section of definition of corporate governance indicated that it can be viewed as a set of control mechanisms which play a vital role in the governance of relationship between the firm and its stakeholders. However there can be different measures by which this mechanism can be classified.

Luo (2007) classifies corporate governance mechanisms in three different categories.

  1. Market based: This deals with the concentration of ownership. discipline of the market, constituents of board, size of board and the remuneration of management.
  2. Culture based: This deals with corporate governance issues with regard to cultural influences and integrity of corporation.
  3. Discipline based: This deals with issues like internal and external audit, code of conduct, executive penalty and the presence of an ethics programme.

However a more globally accepted view of corporate governance mechanisms has been provided by Gillian (2006) and Cremers and Nair (2005) including internal and external mechanisms.

Internal mechanisms broadly include those measures which study the relationship between the management and the board of directors. External mechanisms are those factors and laws which govern the operations of the firm from the perspective of capital provision and capital management (Gillian 2006).

Cremers and Nair (2005) have provided empirical evidence that there is a need for internal and external mechanisms to interact and work together to establish a successful corporate governance in any company. These mechanisms are found to be complementary rather than substitutionary when long term profits of any firm is considered.

2.3.2. Internal control mechanisms:

It has been observed by () and () that in a family controlled firm the mechanisms which drive the governance are internal in nature. Therefore this section deals only with the internal mechanisms of corporate governance.

Some internal mechanisms of corporate governance which have been agreed upon by researchers like Cremers and Nair (2005), Gillian (2006), Gillian and Starks (2003) are discussed below. Board of directors:

The Board of directors has been defined as the best measure of control internally in any organization. The board has the right to hire, fire as well as compensate the chief executive officer as well as provide counsel to higher management of the company (Jensen, 1993, p.862). Three factors of the board have been documented to have an effect of governance in the company.

Board size:

The size of the board has an effect on the interaction between the board members thereby affecting the dynamics of the group and efficiency of performance ( Booth et al., 2002). Jansen (1993) indicated that boards with eight people or more does not function effectively. His view is further supported by Lipton and Lorsch (1992) who have indicated that the larger the size of the board the more susceptible it is to the inverse control of the CEO. Yermack (1996) also has given evidence that the smaller the size of the board the better is the valuation of the firm.

Board composition:

The composition of the board helps in the analysis of the dependence or independence of the board from that of the chairman. Fama and Jensen (1983) have indicated that the greater the number of non executive directors the better the monitoring and control exists in the firm. Shivdasani and Smith (1997) have given indication that the presence of even a single outside director will result in lower costs to the company.

Chairman of the board and Duality of the CEO:

Fama and Jensen (1983) indicate that the best way to provide internal control in a company would be to separate the decision control function and the decision management functions. Jensen (1993) indicates that the absence of an independent chairman on the board it would be next to impossible to respond to failures of the organization of the top management team. (Jensen, 1993, p.867). There is a need to separate the role of the chairman and the CEO. Hart (1995, p.682) is of the opinion that directors have an incentive to favour the CEO in order to “stay in management’s good graces, so that they can be re-elected and continue to collect their fees”.

Independent directors and board oversight present a further way to protect the interests of small investors in family companies. Family ownership and voting control typically result in family domination of the board. For widely held companies, major international corporate governance codes clearly recommend that the board of directors consist of a majority of directors independent of management and the company, with their main role being to monitor management’s performance. This issue is subject to wider debate in regard to family-owned firms with concentrated ownership structures, however. For family-owned companies that have public listings, a baseline level of board independence would arguably be at least in proportion to the existing free float of the company (Kets de Vries, 1996). Investors should take note if this is not the case, and should generally look favorably at situations where family companies have substantial—ideally majority—independent board representation, even if this goes beyond the norms of established codes of practice (Kets de Vries, 1996).

At the same time, investors should be aware that the presence of independent directors is not a panacea, as their ultimate effectiveness may be limited, particularly when they are in the minority. Nevertheless, independent board oversight remains an important objective, and research into family companies suggests that the most valuable businesses are those in which independent directors balance family board representation (Lansberg, 1999). Ownership structure and concentration:

Jensen and Meckling (1976) hypothesize that as managers increase their stock ownership of the firm, their interests become more and more aligned with those of the outsiders, i.e., the minority shareholders. On the other hand, the shareholding in both equity ownership and voting rights by the outsiders provides a strong mechanism of corporate governance as it shapes managerial behaviour (Agrawal and Mandelker, 1987) and determines the capital structure of the firm (Harris and Raviv, 1991).

Concentration of ownership can range from a substantial minority ownership (e.g., 10% or 20%) by one or several investors, to an outright control with 50%+ ownership by the same investor(s). In a one-share-one-vote system, control rights can be concentrated in a few investors when the investors collectively own a large cash flow stake. Under such a scenario, it is easier for the investors to take concerted action (e.g., if some preferential voting rights are vested in some preferential share-holders) than when the control rights are split among many of them. Shleifer and Vishny (1997) argue that the concentration of ownership through large share holdings is a “nearly universal method of control that helps investors to get their money back” (Shleifer and Vishny, 1997, p.774).

It is therefore important to seek evidence, if any, for countries where the legal protection system is strong and yet there is a high concentration of family/insider ownership and a high possibility of expropriation of minority shareholders’ wealth (LaChappalle and Barnes, 1998). In this scenario, there can be an extreme case such that the outsiders, having a minority voting right, are exposed. to the potential expropriation of their wealth by the majority shareholder. Under such circumstances, the minority shareholders can form an alliance and seek protection under the legal and regulatory regime to safeguard their interests against the majority shareholder (LaChappalle and Barnes, 1998).

The extent of ownership concentration, including controlling family ownership, in specific countries is often linked to the development of domestic capital markets and to the perceived investor protections offered by the respective legal and regulatory environments (Rosa, 2009). Governance structures for closely held family companies are frequently referred to as “insider” systems, given the predominance of governance and control coming from

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