The Effect of Corporate Governance on Innovation Strategy - Research Paper Example

The Effect of Corporate Governance on Innovation Strategy ABSTRACT Despite the best efforts of academics and regulators alike, issues in corporate governance continue to manifest themselves in the worst ways possible. From the destructive fraud at WorldCom to recent frauds involving hedge funds, from the UK, United States to the Satyam episodes in India, failures of corporate governance have continued to lead to periodic episodes of fraud on a staggering scale. This paper attempts to understand the mechanisms underlying the relationship between corporate governance and innovative strategies through extensive research of available literature on the topic and determines the existing knowledge gap as well as suggests the methodology to put theory into practice and find evidence based on the results to bridge the gap. CORPORATE GOVERNANCE: INNOVATIVE STRATEGIES Introduction This research paper will be prepared on the principles of the definitions and explanations of corporate governance and the association between innovation and corporate governance. It is common to almost all of the various definitions of corporate governance that it refers to the controlling and managing of corporation’s practices (HIH Royal Commission 2003, Standard Australia 2004, Solomon 2007 and ANAO 1999)1. Although this concept of control was initially meant for the protection of the investment of the shareholders in companies, however, the independence of the corporation invention process might be affected by this notion. Corporate governance is simply a term used for the way that companies (corporation) are run and operated (governed). As stated by Colley et al. (2004) there have been a number of definitions for corporate governance, though, it implies as a misunderstanding of companies and the procedures practiced for the assurance of business proceedings preventing the benefit of involved groups such as the investors. It characteristically centers to alleviate the agency predicaments which may occur whilst possession and administration of the business is divided. Such problems can be diminished by means of numerous measures like the internal controls, oversight of administration or boardroom, regulatory oversight, compensation and incentive arrangements and external audits (Segrestin & Hatchuel, 2008). According to Vinten (2004) corporate governance relies upon administrative functioning and the concern of communal accountability, the socio-cultural and ecological aspect of corporation practice, and authorized and moral exercises concerning the investors, consumers and shareholders of corporations. Comprehending the inference of corporate governance seems to increase in significance amid transnational workforce, policy makers, industrialists, stakeholders and associate businesses. On a worldwide level, drive in the direction of incorporated commercial procedures and a free economy is being made available through globalization. Local organizations require competition with multinational firms in such situations. Corporate governance points towards the strategies and course of actions practiced by the corporations for achieving positive purposes, business goals and visions regarding investors, workers, patrons, dealers and various regulatory interventions and the society in general. The function of corporate governance is to make best use of investors' prosperity besides endeavoring to attain proper profits for them. By itself, corporate governance bears propositions for the corporate communal accountability of corporations (Collin, 2007). Theoretical Perspectives According to North (1990), institutions are structured out of the humanly restraints that occur as a result of the human interactions. Organizations present the regulations of the game, developed by civilizations to form order and institutions are the players that are restricted by these rules. Moreover, as expressed by Meyer and Nguyen (2005) and Wan (2005) that the impacts of the perspective contiguous organizations are underlined by the institutional perceptions, that forms their conduct. Meyer (2004) clarified that most of the corporate governance theories are observed and developed from the industrial and organizational economies and structures. Nonetheless, in terms of organizational development and progress, in various models there are significant variations. That there is a need to judge the scope to which presumptions developed from stratagem in developed economies are suitable to various organizational environments, for trade tactic study to make an enduring contribution. Since the development of international trade, corporate governance has been considered as an essential element of any firm’s conduct so that the corporate and economic expansion could be gauged to a desirable level of precision. The measures taken by investors to assure themselves of returns against their investments in certain corporations, forms the notion of corporate governance (Wright et al., 2005). Agency Theory Agency theory is considered as being the most important theory that corporate governance concepts are built on (Kooskora, 2006). It actually refers to the issues of the relationship that exist when there is a defined relationship between the two i.e. a principle and the agent. An agency relationship is said to exist when a principle delegates decision, authority or work on his behalf to the agent. The problems of agency occurs when the actions or intention of the agent and the principle are dissimilar. The fundamental assumption of the agency theory is this that the agents act rationally and are risk adverse and self- interested individuals. There are usually two problems that may occur in an agency relationship. Firstly, it can be the insufficient monitoring by the principle of the agent that whether he has behaved in the way he was instructed or not. Secondly, it is the distribution of risk when both of them turn out to have different opinions towards risk. Jensen and Meckling (1976), defines the firm as an artificial construct which serve as a nexus of contracts between individuals, one of the most important contracts a firm engages in is the residual claim (equity) of the shareholders on the firm’s assets and cash flows. This contract is defined as the principal-agent relationship where the management team is the agent and the shareholders are the principal. The relationship between the shareholders (principles) and the top management of the company i.e. the Board of directors (agents) is an archetypal example of the agency relationship. Agency relationship emphasizes that as to how to manage the control of this relationship effectively. The agency theory illustrates that through information systems the self interests of the agents can be well monitored, therefore the formal systems applied within the firms such as the managerial reporting, budgeting systems and other sources of information i.e. for example the management surveillance and observation are the examples of the controls for management’s monitoring. In addition, the agency theory explains that all or most of the controls systems (discussed above) turn out to better define the scope or outline of the agents authority and precisely aligns them with the organizational objectives (Leong Ho, 2005). Shareholders Theory As discussed by O’Sullivan (2000) the supporters of the shareholder theory argue that, even though the shareholders rely on others for the effective running of the company, the shareholders are the ones in whose interests the corporations should be run i.e. to maximize shareholders wealth, as they are the principles. However, it is argued, that when corporations tend to maximize their shareholders wealth, it is not possible because not only the shareholder wealth itself is enhanced but also the performance of the entire economic system is also improved. They further explain that the retained earnings after interest and tax are the rewards for the shareholders for how they have behaved i.e. the reward for the waiting and the risk taking. It is commonly accepted not only in the financial economics but also in almost all of the majority economics that shareholders are appropriately unrestricted for the residual profits for corporate entity as they are the residual risk holders. It is further argued that the equity of the ordinary shareholders is the ones, who without any guarantee or without any contractual agreement for returns, alone acts economically and invest in the firms. Therefore as the residual profit takers, the shareholders have concerns of allotting their funds to different options to make the profits as much as possible, as they bear the risk that the corporation will make losses or profits (O’Sullivan, 2000). Stakeholders Theory In order to survive, corporations should be more than profit oriented (Kooskora, 2006). It takes the concerns of public and society and not just profit making. According to the contract theory, it has been argued that sufficient importance should be placed on the interests of all stakeholders (bargain power holders). However, the stakeholder theory further expands this view to a broader spectrum. They explain that it is due to the attitudes of the society members that the prosperity and survival of a corporation are continued; therefore a corporation must not ignore its social and communal responsibilities towards the society and must perform its operations in a way that if not brings benefits to the whole society, must abstain from practices that brings disadvantages to the society as a whole. It is further expressed that due to the decisive power of the society that a corporation could survive without abiding by it responsibilities to the society and even if it does, it unpopularity might lead it to its end (Wei, 2003). Corporate Strategy Lamb (1984) defined strategic management as an ongoing process that evaluates and controls the business and the industries in which the company is involved; assesses its competitors and sets goals and strategies to meet all existing and potential competitors; and then reassesses each strategy annually or quarterly [i.e. regularly] to determine how it has been implemented and whether it has succeeded or needs replacement by a new strategy to meet changed circumstances, new technology, new competitors, a new economic environment or a new social, financial, or political environment. It is the process of specifying the organization's mission, vision and objectives, developing policies and plans, often in terms of projects and programs, which are designed to achieve these objectives and then allocating resources to implement the policies, and plans, projects and programs. Corporate Strategy and the role of Board and Non Executive Directors It has been emphasized by strategy research on the importance of the board’s service and the important of strategic roles when the firm faces a highly uncertain environment (Daily and Dalton, 1994). Moreover, a number of researchers suggest that in turbulent environment board characteristics, such as size, diversity, stock ownership or financial commitment, etc., may have greater impact on the effectiveness of the service and strategic roles of non-executive directors than board composition (Dalton et al., 1999). In particular, the links that non-executive directors have with the firm’s environment can be used in obtaining the financial resources needed for growth and/or effective restructuring, or restructuring expertise (Pfeffer, 1972; Pearce and Zahra, 1992). These links are directly related to board diversity measured in terms of board structure and size, the number of outside directors, and the number of outside directorships (‘interlocks’) each individual board member holds in other organizations both within the industry and outside (Dalton et al., 1999; Pfeffer, 1972; Zahra and Pearce, 1989). In particular, Higgins and Gulati (2003) in their study of US biotechnology firms show that an IPO’s board diversity is positively associated with the firm’s ability to partner with a prestigious underwriter. Therefore, board diversity may be used by the IPO firm to compensate for a lack of experience and external links of its executive officers. When an organization encounters uncertain environmental conditions or is in its growth phase, the board of directors may provide a particularly important strategic contribution by direct involvement in formulating the firm’s mission and development of its strategy (Goodstein and Boeker, 1991; Zahra and Pearce, 1989). The board may shift emphasis from financial control and evaluation of managerial decisions to strategic control more focused on longer-term organizational outcomes. A number of empirical studies on strategic restructuring (e.g., Hitt et al., 1996; Hoskisson et al. 2002) related the choice of control to the composition of a company’s board. Hambrick and Jackson (2000) indicate that non-executive share ownership not only creates financial incentive for non-executives but also increases their identification with the company, making them more vigilant in their oversight and more generous in their time and attention. So, in order for a policy to work, there must be a level of consistency from every person in an organization, including from the management. This is what needs to occur on the tactical level of management as well as strategic. Corporate Governance and Innovative Strategy Inadequate governance mechanisms can lead managers to pursue inappropriate strategies. Managers and owners may have different risk-return preferences. If owners can monitor managers perfectly, manger can be induced to pursue strategies consistent with the interests of owners (David, 2006). Innovation is widely accepted as critical to the dynamics of wealth creation. Corporate strategy decisions involve choices of resource commitments to types of innovation, and such decisions place innovation squarely in the realm of corporate governance. Even so, there is a paucity of literature addressing the relationship of governance to innovative outcomes of the firm. Within the domains of economics and management, innovation is generally acknowledged as critical to the dynamics of wealth creation in competitive, market-based economics (Ven de Ven, 2006), and is a central theme of corporate strategy and competitive advantage. Research on innovation highlights the importance of corporate enterprises as institutions of innovation, (O’Sullivan, 2000). In the context of strategy decisions, innovation can be framed as a core concept of choices among possible resource commitments (Hoskisson et al, 2002). Strategy formulation figures prominently in corporate governance, placing innovation squarely in the governance realm, yet there is a paucity of literature that addresses the relationship of governance to innovative outcomes. Research of corporate governance has assumed a divergence of interests and risk profile between management and investors in firms with diffused shareholders. This divergence creates an agency problem manifested in the propensity of managers to pursue agendas that may be at odds with shareholders interests and preferences, including less investment in research and development (Amihud & Lev, 1981; Demsetz, 2003; Hill & Snell, 1989; Hoskisson &Turk, 1990). While some empirical evidence has substantiated the relationship of governance to innovative inputs, measured by constructs based on research and development spending (David, Hitt, & Gimeno, 2001; Hill & Snell, 1989), there is scant evidence regarding the relationship of corporate governance to the resulting productivity of those inputs, namely the innovative output of the firm. Innovative Strategies Prior research on corporate innovation suggests that managers may invest less in innovation if not constrained by strong governance mechanisms. Stock concentration in firms has been found to be positively related to innovation, suggesting that powerful shareholders may induce managers to invest in innovation (Hill & Snell, 1988). Also Barring study (Greve, 2003; Kogut & Zander, 2003) found a positive association between institutional ownership and innovation, suggesting that institutional owners strongly encourage managers to invest in innovation. R & D expenditure is commonly used as a proxy for investment in innovation. This measure may not be a good indicator of innovation because it is possible that firms may have the same level of R & D expenditure, yet differ in innovation ability because these resources are not managed efficiently (Bertrand & Schoar, 2003). Also, R & D expenditure could be indicative of retention of surplus funds within the firm instead of distributing them to shareholders (Vinten, 2004), suggesting that R & D expenditure could indicate a greater level of agency costs (Cremers & Nair, 2005). It has been suggested that more direct measures of outcomes of innovation, such as the number of new products developed by the firm, may be a better measure of innovation (Doidge et al., 2009; Hoskisson & Turk, 1990) A higher number of new products reflects superior innovative ability and has been found to be associated with firm value (Lemmon & Lins, 2003). They found that ownership by pressure-resistant institutions (institutions that do not have business relationships with the firm) is positively associated with the number of new products introduced, while other institutions have no effect. Thus, firms with poor internal governance systems are likely to be less innovative. They are likely to invest less in R & D and as a consequence, have fewer new product announcements. Institutional investors are likely to be dissatisfied with these firms, and accordingly, target such firms for activism. CEO Power and Attributes CEOs have the most powerful voice in a corporation. Board of Directors hires CEOs to maximize shareholder’s wealth. However, CEOs have interests that differ from share holders and can use their decision making authority within the corporation to promote their own interests over those of shareholders. Therefore, boards of directors will design a CEO’s contract and compensation with an eye on keeping the CEO’s attention on maximizing firm value (Musa, 2008). Firm’s innovation is not motivated by maximization of shareholder wealth but is associated with CEO’s compensation increase (Lehn & Zhao, 2006). Knowledge Gap in corporate governance Before we get to discuss that what is knowledge gap we need to know some other concepts that may help us define what is knowledge gap or governance gap. Knowledge gap may be present where there is no or less ‘Project governance’. Project governance may be referred to as a system or procedure that is process oriented through which the managements try to holistically control, strategically and interactively manage their projects or opportunities where they have invested their shareholders investments, in a way that is driven by entrepreneurial and ethical considerations. Renz (2007) has summarized six key aspects that are the fundamentals of project governance, and are discussed below: System management This aspect helps to obtain an understanding of the influences and environment of the firm in which the project are being carried out. This notion expresses an application that enables the management to first of all set up the project as per their rate of return by skimming through the opportunities that are available, and then allocate all of the involved stakeholders from the management to the shareholders to direct the project on a way to the attainment of its goals with limiting its scope to its environment. Mission management The individual tasks of the governance board and controlling the project with its mission i.e. objectives are the determinants of mission management. Sensitivity to what is significant of development cooperation is the key requirement of following the management mission. In addition, effective development cooperation is only possible through a recognition based and discursive approach. However there may be challenges in the development cooperation that may influence the project’s integrity i.e. threats to integrity in the form of ethical consideration. Therefore it is important that such considerations should be dealt with by incorporation of integrity management. Integrity management Integrity management proposes an approach which considers both recognition and discourse ethical issues. Explicating and understanding such an intermixed approach helps the stakeholders of the project in their need to explicate and understand the challenges that are threatening to the project’s integrity and its core structural elements by the creation of tension sectors within these elements and integrity challenges. Extended stakeholder management They main dependence of development cooperation is on the stakeholders. Management commitment and management tools are required in order to go further than lip service to these parties. It is proposed that particular focus is to be kept on the stakeholders with expansive analysis of the stakeholders and their respective requirements that come into existence when new projects are taken. Risk management Once again, relying on the explication and understanding of the firms’ environment and threats to integrity, risk management lets management of analyze the risks that the project may be prone to in an all inclusive way. Audit management This refers to the role of the audit in the corporate governance activities of the firm. It suggests that the internal audit can play a significant role in the risk analysis of the projects as the projects are highly prone to internal frauds and one of the main functions of internal audit is to design internal controls along with monitoring that they are implemented effectively, efficiently and economically (Renz, 2007). The phrase ‘knowledge gap’ is also referred to as the governance gap expresses that presently in the common practices of the firm there are no practices of projects that are not under the surveillance of the corporate strategy of the firm or where there is little or no project governance, but it can be said that knowledge gap is present where the corporate strategy is probably not implemented or being carried out in the way it should have been. It may be the case that it is not holistically controlled or strategically managed or incorporated at the desired level of detail and therefore it may lead to the growth of diversified considerations that may affect ethical and entrepreneurial stability. Research Questions On the basis of above discussion the researcher comes out with the following research question: 1. What association is there between diversity of managers and stakeholders’ response to shareholders views; and how this affects quantity and quality of firms’ inventive? This main research question may be divided into two sub questions: a) The first sub question is: How the shareholders view the level of invention altitude by companies through corporate Strategy? b) The second sub question is: How the managers respond to shareholders views of the innovation intensity? These two questions may be developed as a proposition to be examined. Suggested Methodology to Find Answers The centrality of knowledge stocks and flows to the model arguments is influential in selecting an appropriate data to test these questions. In consideration of the foregoing, a sample of “Technology-based firms” is the basis of analysis for this study, firms that exploit business opportunities with reliance principally on technical resources (Granstrand, 1998). As such, the analysis addresses the relationship between product diversification in technology-based firms and the quantity and quality of their output. The data collected through this exercise is broadly divided into two classes - primary and secondary information. The primary information refers to the direct information collected from the samples selected or chosen for the data collection process. This is carried out using either structured or unstructured interviews, discussions, questionnaire survey etc. The outcome from such exercises would result in huge volume of qualitative and quantitative information for analyzing the research objectives. The quantitative information refers to the statistical information and the qualitative approach would relate on the broad aspects or the qualitative details about the target information. Quantitative information is collected for establishing precise answers to the observed behavior of the sample. The results of the analysis could be represented as numbers, percentages, mean value etc. The secondary information, on the other hand, is collected from the already published information by judiciously choosing the most relevant aspects from the available literature or documents. This information would help to identify the quantity and quality of inventive output. REFERENCES Amihud, Y. & Lev, B 1981, ‘Risk reduction as a managerial motive for conglomerate Mergers’, Bell Journal of Economics, vol.12, pp: 605-617. Bertrand, M. & Schoar, A., 2003, ‘Managing with Style the Effect of Managers on Firm Policies’, Quarterly Journal of Economics, Vol.118, no.4, pp:1169-1208. Colley, J. L., Doyle, J. L., & Logan, G, 2004, ‘What is Corporate Governance? McGraw-Hill Companies, pp. 2-3. Collin, S, 2007, ‘Governance strategy: A property right approach turning governance into action’, Journal of Managerial Governance, Vol.11, pp:215-23. Cremers, K. J. M., & Nair,V. B. 2005, ‘Governance mechanisms and equity prices’, Journal of Finance, Vol.60, no.6, pp:2859-2894. Daily, C. M.. & Dalton, D. R. 1994. Bankruptcy and corporate governance: The impact of board composition and structure. Academy of Management Journal, 37: 1603-1617. Dalton, D.R., Daily, C.M., Johnson, J. and Ellstrand, A. 1999, ‘Number of directors and financial performance: a meta analysis’, Academy of Management Journal, Vol. 42 No. 6, pp. 674-86. David, P. 2006, ‘Corporate governance, strategy and performance: Antecedents and consequences of activism by institutional investors’, Dissertation Abstracts International. David, P., Hitt, M. & Gimeno, J. 2001, ‘The Influence of activism by institutional investors on R&D’, Academy of Management Journal, vol.44, no.1. Demsetz, H. 2003, ‘The Structure of Ownership and Theory of the Firm’, Journal of Law and Economics, vol.26, pp: 387-389. Doidge, C. G., Andrew, Lins, K. V., & Rene M. S. 2009, ‘Private benefits of control, ownership, and the cross-listing decision’, Journal of Finance, vol.64, pp:425-466. Goodstain, J. & Boeker, W 1991, ‘Turbulence at the top: A new perspective on governance structure changes and strategic change’, Academy of Management Journal, vol,34, pp:306-330. Granstrand, O 1998, ‘Towards a Theory of a Technology-Based Firm’, Research Policy, vol.27, pp:465-489. Greve, H. R. 2003, ‘A Behavioral theory of R & D expenditures and innovations: evidence from shipbuilding’. Academy of Management Journal, vol.46, no 6, pp: 685-702. Hambrick, D. & Jackson, E. 2000, ‘Outside directors with stake: The linchpin in improving governance’ California Management Review, Vol.42, No.4, pp: 108–127. Higgins, M. C. & Gulati, R. 2003, ‘Getting off to a good start: The effects of upper echelon affiliations on underwriter prestige. Organization Science, Vol.14, pp: 244-263. Hill, C. W. L. & Snell, S. A. 1989, ‘Effects of ownership and control on corporate productivity’, Academy of Management Journal, vol.32, no.1, pp: 25-46. Hitt, M.A., Hoskisson, R.E., Johnson, R.A., &Mosel, D.D. 1996, ‘The market for corporate control and firm innovation’, Academy of Management Journal, vol.39, pp:1084-1119. Hoskisson, R. E. & Turk, T. A, 1990, ‘Corporate restructuring: Governance and control limits of the internal capital market’, Academy of Management Review, Vol.15, No.3, pp:459-477. Hoskisson, R. E., Hitt, M. A. Johnson, R. A. & Grossman, W. 2002,. ‘Conflicting voices: The effects of institutional ownership heterogeneity and internal governance on ccorporate innovation strategies’. Academy of Management Journal, vol.45, no.4. Jensen, M. & Mecking, W., 1976, ‘ Theory of the firm: Managerial behavior, agency costs and ownership structure’, Journal of financial economics, vol.3, pp: 305-360. Kogut, B. & Zander, U. 2003, ‘Knowledge of the firm and the evolutionary theory of the multinational corporation’, Journal of International Business Studies, vol.34, pp: 516-529. Kooskora, M. 2006, ‘Corporate governance from the perspective of stakeholder theory and in light of perceptions among Estonian Owners and managers of relations with stakeholders. EBS Review, pp: 27-49. Lamb, R. B. 1984, ‘Competitive Strategic Management’, Englewood Cliffs: Prentice-Hall. Lehn, K. & Zhao, M. 2006, ‘CEO Turnover after Acquisitions: Are Bad Bidders Fired?’ Journal of Finance, vol. 61, no.4, pp:1759-1811. Lemmon, M. L., & Lins, K. V. 2003, ‘Ownership structure, corporate governance, and firm value: Evidence from the East Asian Financial Crisis, Journal of Finance vol.58, pp:1445-1468. Leong Ho, K. 2005, ‘Reforming corporate governance in southeast asia: Economics, Politics, and Regulations, Institute of Southeast Asian Studies, pp. 354-355. Meyer, K. E., Nguyen, H.V., 2005, ‘Foreign investment strategies and sub-national institutions in emerging markets: Evidence from Vietnam, Journal of Management Studies Vol.42, no.1, pp: 63-93 Meyer, K., 2004, ‘Stakeholder influence and radical change: A coordination game perspective’, Asia Pacific Journal of Management, vol.21, pp: 235-253. Musa, M., Ismail, S. & Othman, S., 2008, ‘Corporate governance and innovative leaders’, Social Responsibility Journal, Vol.4, No.1/2, pp: 34-40. North, D. C. 1990, Institutions, Institutional Change, and Economic Preference, Norton: New York. O’Sullivan, M, 2000, ‘The Innovative enterprise and corporate governance’, Cambridge Journal of Economics, vol.24, pp: 393-416. Pearce, J. A. & Zahra, S. A., 1992, ‘Board composition form strategic contingency perspective’, Journal of Management Studies, Vol.29, pp: 411-438. Pfeffer, J. 1972, 'Merger as a response to organizational interdependence', Administrative Science Quarterly. Vol.17, pp. 382-394 Renz, P. S. 2007, ‘ Project Governance: Implementing Corporate Governance and Business Ethics in Nonprofit Organizations Contributions to Economics’, Springer, p. 219-223. Segrestin, B. & Hatchuel, A., 2008, ‘The Shortcomings of the corporate standard: Towards new enterprise frameworks?’ International Review of Applied Economics, vol.22, no.4, pp: 429–445. Ven de Ven, A. H., 2006, ‘Central Problems in the Management of Innovation’, Management Science, vol.32, no.5, pp: 366-457. Vinten, G 2004, ‘Corporate Governance: Corporate Mandate’ Emerald Group Publishing Limited, pp. 84-87. Wan, W.P 2005, ‘Country resource environments, firm capabilities, and corporate diversification strategies’, Journal of Management Studies, Vol. 42, No.1, pp: 161-182. Wei, Y 2003, ‘Comparative Corporate Governance: A Chinese Perspective’, Kluwer Law International, pp. 44-45. Wright, M., Filatotchev, I., Hoskisson, R.E. & Peng, M.W., 2005, ‘Strategy research in emerging economies: Challenging the conventional wisdom’, Journal of Management Studies, vol.42, no.1, pp:1-33. Zahra, S., and Pearce, J., 1989, ‘Boards of directors and corporate financial performance: a review and integrative model’, Journal of Management, Vol.15, No.2, pp: 291-334. Read More