What Is a Market-Based Corporate Governance System?

A market-based corporate governance system relies on investors to exert influence on the management of the company. It defines the responsibilities of the different participants in the company, including shareholders, the board of directors, management, employees, suppliers, and customers.

KEY TAKEAWAYS

  • A market-based corporate governance system relies on investors to exert influence on the management of the company.
  • This system relies on capital markets to influence corporate management.
  • The most significant advantage of a market-based corporate governance system is its ability to respond dynamically to changes.
  • Issues with market-based governance systems include short-termism and the potential of index funds to undermine accountability.

Understanding Market-Based Corporate Governance Systems

A market-based corporate governance system is derived from Anglo-American law. It is one of several corporate governance systems that have developed throughout the world. Since markets are the primary source of capital, investors have the most power in determining corporate policies. Therefore, the system relies on capital markets to influence corporate management.

Corporate governance covers how public companies are managed and interact with shareholders. An overriding goal of corporate governance, according to the Organization for Economic Cooperation and Development (OECD), is to create an environment of market and business confidence in individual companies. That maximizes their ability to put capital to use for long-term productive investments.

Corporate governance addresses issues ranging from concentrated ownership and executive compensation to workplace diversity and the independence of a company's board of directors. One of the fundamental tenets of effective corporate governance is transparency in public disclosure of information pertinent to shareholders and the investing public.

Market-based corporate governance is one of several approaches to ensuring proper protections to shareholders and company adherence to existing regulations. The U.S. and India are examples of market-based corporate governance systems that do not have national governance policies that companies must follow. Instead, they rely on securities laws and regulations. The global trend in governance is toward a “comply or explain” system where companies are required to adhere to state or market exchange-developed governance codes.

Benefits of Market-Based Corporate Governance Systems

The most significant advantage of a market-based corporate governance system is its ability to respond dynamically to changes. In the short term, corporate leadership responds to changes in the market price of the company's stock. If an issue arises with a company's product, the stock price will fall, investors will be upset, and management will usually attempt to fix the issue. In a competitive market, rival firms will gain market share if the company does not successfully resolve the problem. That is in sharp contrast to political issues, most of which take years or even decades to solve.

In the long run, the dynamism of a market-based governance system makes it much easier for new business practices to be established. For example, some investors believe that firms should focus on growing dividends for investors. Berkshire Hathaway CEO Warren Buffett became one of the most successful investors of all-time in part by pursuing this sort of dividend growth approach. However, others believe that growing investor capital should be the objective. Amazon CEO Jeff Bezos became the wealthiest person in the world by focusing on growing capital while ignoring traditional goals like profits and dividends. Multiple methods and metrics are allowed to compete in a market-based governance system.

Market-based governance allows new theories to be applied more rapidly.

Whenever a single standard is externally imposed, it always puts limits on competition and innovation. If laws were to mandate ever-increasing dividends for all firms, companies like Amazon would not be possible. New technologies could be delayed for years. On the other hand, eliminating dividends would deprive conservative investors of steady streams of income. Without dividends, it would also be more challenging to evaluate the performance of well-established companies and make the right investments. The dynamism of market-based governance systems allows the best approaches to win in the long run.

Criticisms of Market-Based Corporate Governance Systems

One of the most significant issues in a market-based corporate governance system is a tendency toward short-termism, according to governance experts. Public companies are managed to meet quarterly earnings targets set by sell-side analysts on Wall Street. Companies have a repertoire of accounting maneuvers they can utilize to meet or consistently beat Wall Street forecasts, thus boosting their stock price. However, a quarterly earnings miss can cause a sharp stock price decline and send company management scrambling for a short-term solution. Governance experts suggest eliminating earnings guidance as a way to promote a long-term view of a company's goals and give firms more time to accomplish them.

Another criticism of market-based governance is that it is being undermined by index funds. While index funds save fees for investors, their approach is passive by design. Index funds are the largest shareholders of many publicly traded companies, and they almost always vote with management. The passive acceptance of management plans undermines accountability in a market-based governance system.