Connecting the Dots: Bringing External Corporate Governance into the Corporate Governance Puzzle

Abstract

Corporate governance (CG) research has largely focused on internal governance mechanisms (i.e. the board of directors, controlling owners, and managerial incentives). However, much of this work ignores the role that external CG practices play in preventing managers from engaging in activities detrimental to the welfare of shareholders, and the overall firm. In this essay, we first review and organize current research on external governance mechanisms and integrate this siloed body of work within the broader CG equation. We explicitly focus on six external governance mechanisms: the legal environment, the market for corporate control, external auditors, stakeholder activism, rating organizations, and the media. We discuss findings showing how external governance mechanisms act both as independent forces and in conjunction with internal CG mechanisms. We conclude the review by mapping an agenda for future research on CG that better integrates internal and external governance mechanisms. Our review suggests that studying different configurations of external and internal governance mechanisms will help us to better understand what factors and conditions lead to effective CG.

Acknowledgements

We would like to acknowledge the helpful suggestions that we received from the “External Corporate Governance” symposium panelists and participants at the 2014 Annual Academy of Management Meetings, research seminar participants at the Lee Kong Chian School of Business at Singapore Management University, Jill Brown, Jennifer Goodman, Michel Goyer, William Judge, Judith Walls, Cynthia Williams, and Alessandro Zattoni.

Notes

1. Even though boards typically have a majority of independent directors who are also employed outside the firm, the corporate finance and managerial governance literatures conceptualize boards of directors as an internal mechanism, in part because directors represent the highest legal authority of the firm, they are compensated by the firm, and they are prominently associated with the firm.

2. Our conceptualization of external governance mechanisms is substantially different from an analysis of different stakeholders to the firm. While some of the external governance mechanisms that we describe involve actors that could be considered stakeholders (e.g. journalists, shareholder activists, etc.), not all stakeholders play a governance role. In particular, we are interested in mechanisms that facilitate effective CG and that can lead to the imposition of sanctions for actions that would go against the general firm interest. In this sense, while many key stakeholders, such as clients, providers, or employees, undoubtedly can exert direct firm pressure; this is typically done for reasons that are focused solely on the interests of that particular stakeholder. Furthermore, only stakeholder activism and the media would likely emerge from a traditional stakeholder analysis, as the legal framework and the market for corporate control represent broader institutions, while external auditors and governance rating agencies are professional firms specialized in reducing information asymmetries between firm's insiders and outsiders.

3. ISS claims that its ratings “identify the worst corporate offenders” and that “there is no doubt that [its] ratings could have helped some investment managers avoid the gigantic losses experienced during the corporate scandal era defined by meltdowns at Enron, Global Crossing and WorldCom”.