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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

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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



$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


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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



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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


(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


E [0.0, 0.5]

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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


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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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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.

References Aguilera, R. V. and Jackson, G. (2003) The CrossNational Diversity of Corporate Governance: dimensions and determinants, Academy of Management Review, 28, 447–467. Aoki, M. (1994) The Contingent Governance of Teams: analysis of institutional complementarity, International Economic Review, 35, 657–676. Arthur, M. M. (2003) Share Price Reactions to WorkFamily Initiatives: an institutional perspective, Academy of Management Journal, 46, 497–505. Berglof, E. and Perotti, E. (1994) The Governance Structure of the Japanese Financial Keiristsu, Journal of Financial Economics, 36, 259–284. CLSA (Credit Lyonnaise Securities Asia) (2001) Saints and Sinners: who’s got religion. Hong Kong: CLSA. Daily, C. M., Dalton, D. R. and Cannella, A. A. (2003) Corporate Governance: decades of dia-

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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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March 2007