Unless a comprehensive theory of corporate governance is first agreed upon, efforts to improve it will not amount to much.

In varying degrees, everyone cheats. Businessmen are no exception. So one of the biggest problems of modern economic organisation, which is dominated by the joint stock company, is to minimise such cheating. Corporate cheating has many dimensions but two of them have attracted the most attention. One is the cheating of customers, mainly on quality and price. The other is the cheating of shareholders by taking their money but giving them less than what they deserve by way of dividends.

By and large, competition takes care of the former. In competitive markets the customer has a choice and simply goes to the alternative supplier if he feels he is not getting value for money. But the second type of cheating has proved harder to minimise. Indeed, the effort has even been given a nice sounding name -- corporate governance.

In a recent paper*, Thomas H Noe, Michael J Rebello and Ramana Sonti say that all this is very well, but unless a comprehensive theory of corporate governance is first agreed upon, these efforts will not amount to much. The reason: good corporate governance depends on many things and focusing on just one or two of them is not of much use.

They say the "key determinants of governance are board vigilance, the market for corporate assets, executive compensation, and shareholder activism" and what matters is the relationship between them. In a sense, they are talking of what economists call a dynamic general equilibrium model where the standard assumption of economics -- other things being equal or the same -- is given the go by.

"The effect of any one factor on governance may well depend on how the other governance parameters are set." This is a very important insight because, as the authors point out, institutional factors such as, say, jurisdiction can lead to different components of the policy on governance "being fixed at different levels for different firms".

Second, say the authors, "because a number of the components of the governance mechanism are choice variables, a sample of firms selected on the basis usage of a particular governance mechanism may not be random. Further, the choice of one component of the governance mechanism depends endogenously on other choices. For this reason, predictions based on the examination of a single component of the governance mechanism may be misleading."

From this the authors go on to develop a model for corporate governance. There are two key givens for this model. One is a competitive securities market; the other is a market for asset liquidation. They go on show that "varying the liquidity and opacity of corporate assets and the costs of enforcing shareholder rights to cash flow" can result in a large number of designs.

Basically, what happens is this. If shareholders can easily sell off their holdings their rights get automatically enforced as the management is forced to behave itself rather better than if "the opacity of corporate assets is relatively high and asset liquidity is relatively low." The threat of liquidation and the resulting threat to the managers that they may have to accept lower salaries somewhere else may well be the most efficient form of governance.

The other insights in the paper are reproduced verbatim below:

• Management compensation is highest for high and low liquidity firms;
• Managerial compensation is higher under direct shareholder control as opposed to board control;
• Managerial compensation is increasing in asset opacity;
• In the absence of mandatory restrictions, firm with high and low asset liquidity will have more passive boards and less sophisticated governance mechanisms;
• Diffusion of shareholder ownership will be lowest for firms with illiquid and opaque assets;
• If the market for corporate control is impeded, large block-holding and board activism increase;
• Shareholder intervention will be positively correlated with the premium paid by activists for block acquisition;
• Absent mandatory restrictions, the better the legal regime, the larger the fraction of management affiliated directors on the board;
• Weakening the protection of minority shareholders can lead to both less board vigilance and better firm performance.
• *Activists, raiders, and directors: Opportunism and the balance of corporate power, April 2007, http://www.isb.edu/WorkingPapers/governance.pdf