Corporate Governance, Principal‐Principal Agency Conflicts, and Firm Value in European Listed Companies

• Date: 01 March 2012
• Author: Ann Gaeremynck,Annelies Renders
• DOI: http://doi.org/10.1111/j.1467-8683.2011.00900.x
• Published date: 01 March 2012

Corporate Governance, Principal-Principal

Agency Conf‌licts, and Firm Value

in European Listed Companies

Annelies Renders* and Ann Gaeremynck

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: Using the conceptual framework of Aguilera, Filatotchev, Gospel, and Jackson, this study

examines the impact of principal-principal agency problems on the quality and effectiveness of corporate governance

structures in listed companies from 14 European countries between 1999 and 2003. Specif‌ically, we develop an index on the

severity of the agency conf‌lict and investigate whether this index explains the quality of governance structures. We also

examine whether, given certain environmental complementarities, this index inf‌luences the effectiveness of good gover-

nance structures.

Research Findings/Insights: Using a simultaneous equations model, we f‌ind that the conf‌lict index affects the quality and

effectiveness of corporate governance.When agency conf‌licts are severe, the costs of installing good governance are high for

the majority shareholders and the quality is low. Once installed, however, good governance structures complemented with

a high-quality disclosure environment leads to higher f‌irm value, especially in companies with a severe agency conf‌lict.

Theoretical/Academic Implications: Our study adds to the governanceliterature by focusing on the costs of installing good

governance. Further, it contributes to principal-principal agency studies by examining a number of developed countries and

by developing a measure for the severity of the principal-principalconf‌lict. Finally, our study adds to institutional theory by

showing how companies’ corporate governance choices are affected by the severity of agency conf‌licts and the way

corporate governance is regulated.

Practitioner/Policy Implications: Our analyses suggest that regulatory approaches to corporate governance issues should

move away from a “one-size-f‌its-all” policy toward one that takes into account the organizational and environmental

context. By demonstrating that the severity of principal-principal agency conf‌licts results in signif‌icant differences in the

existence and effectiveness of corporate governance, our empirical evidence can guide regulators in developing new

regulations or laws intended to reduce private benef‌its of control or improve the disclosure environment.

Keywords: Corporate Governance, Firm Value, Principal-Principal Agency Problems, Majority Shareholders

INTRODUCTION

Most corporate governance research views corporate

governance as a solution to agency conf‌licts between

management and shareholders. However, this view does

not take into account other types of agency conf‌licts thatmay

arise or differences in the contexts in which companies

operate (Aguilera, Filatotchev, Gospel, & Jackson, 2008). In

this study we apply the “open-system” approach of Aguilera

et al. (2008) to investigate how agency problems between

majority and minority shareholders as well as voluntary

corporate governance affect the quality and effectiveness of

corporate governance in European listed companies.

Although the concentrated ownership structures of Euro-

pean companies maymitigate the traditional principal-agent

problem, they may lead to conf‌licts between majority and

minority shareholders (Faccio & Lang, 2002; Federowicz &

Aguilera, 2003; Gospel & Pendleton, 2005; Thomsen, Peder-

sen, & Kvist, 2006). These so-called principal-principal

agency conf‌licts (Dharwadkar, George, & Brandes, 2000;

Young, Peng, Ahlstrom, & Bruton, 2003) arise when the

*Address for correspondence:Annelies Renders, Department of Accounting and Infor-

mation Management, Maastricht University School of Business and Economics, P.O.

Box 616, 6200 MD Maastricht, The Netherlands. Tel: +31 43 3883669; Fax: +31 43

3884876; E-mail: a.renders@maastrichtuniversity.nl

125

Corporate Governance: An International Review, 2012, 20(2): 125–143

© 2011 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2011.00900.x

majority shareholders abuse their ownership control to reap

private benef‌its of control. Principal-principal conf‌licts have

traditionallybeen studied in the context of developing coun-

tries. However, given the concentrated ownership struc-

tures of European companies, such conf‌licts may also arise

in developed countries.

The introduction of good corporate governance should

reduce the private benef‌its of control enjoyed by majority

shareholders by limiting the incidence of tunneling, asset-

stripping, related-party transactions, and other ways of

diverting company assets or cash f‌lows from minority share-

holders (Love, 2010). However, because in most European

countries corporate governance is based on the “comply-or-

explain” principle and hence is largely voluntary (Aguilera

& Cuervo-Cazurra, 2009), majority shareholders are able to

decide on the quality of the governance practices that are

implemented. In doing so, they are likely to take into

account the costs of installing good corporate governance,

namely, their loss of private benef‌its. We argue that the more

severe the principal-principal conf‌lict, the larger the cost of

installing good governance and the more reluctant majority

shareholders will be to introduce it.

In this study we do not use ownership concentration as a

proxy for the principal-principal conf‌lict. Instead, we con-

struct an agency conf‌lict index that takes factors beyond

ownership concentration into account in capturing the

severity of the principal-principal conf‌lict. Using this

measure we investigate whether companies with a more

severe principal-principal conf‌lict are associated with

weaker corporate governance. We also examine whether the

severity of the principal-principal conf‌lict inf‌luences the

effectiveness of good governance with regard to f‌irm value.

Because European listed companies operate in a context

characterized by high-quality informationdisclosure, major-

ity shareholders are not able to engage in window-dressing

and minority shareholders are in a better position to

monitor majority shareholders. We therefore posit that

when majority shareholders voluntarily install good gover-

nance, this should limit the consumption of private benef‌its

and in turn lead to higher f‌irm value.

For a sample of 1,064 f‌irm-year observations from 14 EU

countries over the period 1999 to 2003, we f‌ind that the

organizational context is highly relevant in explaining

the quality and effectiveness of corporate governance prac-

tices. In particular, we f‌ind that our index capturing the

severity of the principal-principal conf‌lict is negatively

associated with good corporate governance. However, once

good governance is installed, the more severe the conf‌lict,

the more effective good governance will be in improving

f‌irm value.

Our study contributes to the literature in several ways.

First, we apply the theoretical organizational framework of

governance developed by Aguilera et al. (2008) to a setting

of European listed companies in which the principal-

principal agency problem is likely to occur. To our knowl-

edge, we are the f‌irst to show empirically that the severity

of the principal-principal conf‌lict explains the quality and

effectiveness of corporate governance for a sample of

developed countries. Second, we introduce the costs of

implementing good governance. While most prior studies

focus on the benef‌its of good corporate governance (e.g.,

Durnev & Kim, 2005), the costs have received much less

attention (Aguilera et al., 2008; Filatotchev & Allcock,

2010). This study shows that majority shareholders take

into account the costs of installing good governance (Chri-

sostomos & Ozkan, 2009; La Porta, Lopez-de-Silanes,

Shleifer, & Vishny, 2002). Third, we contribute to the insti-

tutional theory by showing how institutional factors, such

as voluntary corporate governance and the disclosure envi-

ronment, affect companies’ decisions and outcomes.

Finally, we contribute to the corporate control literature.

Although a number of recent studies have focused on own-

ership concentration or type of ownership as a proxy for

agency conf‌licts (Dahya, Dimitrov, & McConnell, 2008;

Kim, Kitsabunnarat-Chatjuthamard, & Nofsinger, 2007;

Setia-Atmaja, 2009), we develop an aggregate measure that

goes beyond pure ownership structures in capturing the

severity of the principal-principal conf‌lict.

The remainder of this study is organized as follows. In

the next section, we review the existing literature and

develop the hypotheses. This is followed by a section

describing the sample and data. The research design is out-

lined in the fourth section. The f‌ifth section presents the

main results, and this is followed by a section discussing

the sensitivity analyses. A f‌inal section summarizes and

concludes.

LITERATURE REVIEW AND HYPOTHESIS

DEVELOPMENT

A “closed-system” approach of governance posits a univer-

sal set of linkages between corporate governance and per-

formance and payslittle attention to the different contexts in

which companies operate. In this study we apply the “open-

system” approach of Aguilera et al. (2008), who explicitly

reject the context-free proposition and emphasize the impor-

tance of studying governance using a holistic approach. The

open-system perspective also improves our understanding

of how environmental factorsshape the costs, contingencies,

complementarities and organizational outcome, such as

governance effectiveness (Aguilera et al., 2008). Based on

this approach, we propose two hypotheses on how the

severity of the principal-principal conf‌lict affects the cost

and effectiveness of governance practices.

Principal-Principal Conf‌lict and Good Corporate

Governance

To shed light on how the severity of the principal-principal

conf‌lict inf‌luences the quality of corporate governance, we

focus on two organizational factors, namely, ownership

structure and the way in which corporate governance is

regulated in Europe.

As most European companies are characterized by con-

centrated ownership structures, the main agency conf‌lict

does not occur between managers and shareholders, but

rather between majority and minority shareholders (Denis

& McConnell, 2003; Faccio& Lang, 2002; Federowicz & Agu-

ilera, 2003; Gospel & Pendleton, 2005; Thomsen et al., 2006).

Such ownership structures may mitigate or exacerbate

agency problems. On the one hand, the presence of large

126 CORPORATE GOVERNANCE

Volume 20 Number 2 March 2012 © 2011 Blackwell Publishing Ltd