Substitution Effects of Formal and Informal Corporate Governance Mechanisms in the Nonprofit Sector

Public and Nonprofit Division

AOM 2006

A dead end for governance?

Corporate governance has received a great deal of attention over the past two decades (Aoki, 2001)

However, virtually all popular mechanisms have produced inconclusive empirical findings, such as; the board of directors (Daily, Dalton, & Cannella, 2003) incentive alignment (Barkema and Gomez-Mejia, 1998) all agency controls (Jensen & Murphy, 1990)

AOM 2006 – Public and Nonprofit Division

Why such inconclusiveness?

Numerous mediators probably exist between mechanisms and performance (Wiseman and Gomez-Mejia, 1998)

Ongoing tension between cooperation and control of various governance mechanisms (Sundamurthy & Lewis, 2003)

Focus solely on agency theory mechanisms (Emirbayer & Goodwin, 1994).

View that “more is always better” (Hoskisson, Johnson, & Moesel, 1994)

AOM 2006 – Public and Nonprofit Division

What to attack first?

AOM 2006 – Public and Nonprofit Division

The “low hanging fruit”… Identifying the paradoxes that exist between multiple

governance mechanisms is important for gaining a deeper understanding of the culmination of contradictory findings (Demb & Neubauer, 1992).

Firm performance and curbing managerial opportunism is a function of the entire set of governance mechanisms employed by the firm at any given point in time (Walsh et al., 1990).

Informal mechanisms are typically overlooked by proponents of agency theory, and in fact, often modeled as “noise” (Oliver, 1996; Ring & Van de Ven, 1992)

How can the nonprofit sector help?

“Agency theory focus” – Incorporates multiple theoretical lenses (institutional, social networks) which have formed the basis of governance research within the nonprofit sector (Miller-Millesen, 2003)

“More is always better” - Permits the examination of substitution and complementary effects between governance mechanisms by introducing sector variance in an otherwise homogeneous for-profit sector Previous research has focused only on the substitution of

“internal” and “external” mechanisms within large publicly traded U.S. organizations (Peasnell et al., 2003)

More reliance on “informal” rather than “formal” mechanisms in the nonprofit sector (Olson, 2000)

AOM 2006 – Public and Nonprofit Division

The importance of substitution

First identified by Williamson (1985) which argues that the incremental impact of a governance mechanism on curbing managerial opportunism is dependent upon the existing set of mechanisms employed by the firm

Again highlighted by Eisenhardt (1989) in highlighting the tradeoff between “behavior-based” and “outcome-based” contracts

Despite ongoing warnings, researchers continue to view governance mechanisms as linearly additive and complementary to one another (Peasnell et al, 2003; Das et al, 1998; Zajac et al, 1994)

AOM 2006 – Public and Nonprofit Division

AOM 2006 – Public and Nonprofit Division

Formal vs. Informal Mechanisms

“Formal mechanisms” are defined as any instrument which is codified by contract or explicitly embodied within a legally enforceable or regulatory framework Such as incentive contracts (Barkema & Gomez-Mejia,

1998), disclosure regulations (Hillman & Dalziel, 2003), and the market for corporate control (Fama, 1980)

“Informal mechanisms” are defined as any influence upon opportunistic behavior that is implicit or non-binding legally Such as institutional norms (North, 1990), reputation

(Baysinger & Hoskisson, 1990), and trust (Das et al, 1998)

Hypotheses Development

H1: Informal mechanisms of governance are more effective at curbing managerial opportunism than formal mechanism of governance

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Mechanisms

Effectiveness

Formal Informal

Why? “Ratting out” has been shown to be more effective than formal sanctions for board members

(Westphal & Khanna, 2003) Informal norms often exist at routine or subconscious levels thereby precluding rational

opportunism (Brass et al, 2004) Formal mechanisms often create a “gaming atmosphere” (Ghoshal et al, 1996; Walsh et al,

1990)

AOM 2006 – Public and Nonprofit Division

Hypotheses Development

H2: Informal mechanisms of governance are more efficient at curbing managerial opportunism than formal mechanism of governance

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20

40

60

80

100

Mechanisms

Efficiency

Formal Informal

Why? Direct costs of formal mechanisms such as regulations, incentives, and takeovers are very costly (Jensen,

1993) and indirect costs of information leakage to competitors and risk averse behavior (Bettis, 1983; Hoskisson & Hitt, 1988)

While the costs of informal mechanisms can be high, they are often more dispersed amongst society or groups (Uzzi, 1997)

Cumulative cost of formal mechanisms is logarithmic (Zajac et al, 1994) while informal mechanisms are exponential (Scott, 1987)

AOM 2006 – Public and Nonprofit Division

Hypotheses Development

H3a: Informal mechanisms are adequate substitutes and positive complements to existing formal mechanisms of governance

Why? Informal mechanisms, such as trust, reduce the need for formal governance mechanisms such as

monitoring (Abrahamson et al, 1992) However, the reduction of informal mechanisms, such as trust, tend to be more dichotomous as

opposed to incremental which is more common during the building process (Uzzi, 1997; Mizruchi, 1992) The reduction of informal mechanisms diminishes the impact of other informal mechanisms in a

negative spiral manner (Granovetter, 1985)

AOM 2006 – Public and Nonprofit Division

H3b: Formal mechanisms are inadequate substitutes and negative complements to existing formal mechanisms of governance

Next Steps

Empirical evidence! Broader, multi-dimensional measures of key

constructs using SEM, especially; Performance Opportunism

Part of a larger cross-sectional comparative study of nonprofit and for-profit sector organizations using mediating “opportunism” and “resource providing” variables with multiple controls

AOM 2006 – Public and Nonprofit Division