Family Firms and Compliance: Reconciling the Conflicting Predictions Within the Socioemotional Wealth Perspective

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(Authors: Luiz Ricardo Kabbach de Castro, Ruth V. Aguilera, and Rafel Crespí-Cladera)

Research Applied précis prepared by Navneet Bhatnagar, Thomas Schmidheiny Centre for Family Enterprise, Indian School of Business

Corporate scandals and financial meltdowns have led to corporate governance reforms all around the world. In addition to the rules and laws that firms have to legally comply with, several self-regulatory codes or ‘soft-laws’ have been enacted in many countries. These codes are formed by a legitimate collective body in the form of voluntary principles, best practices or recommendations. These codes are meant to help the firm navigate its internal governance mechanisms. These are not legally enforced but are based on the principle of ‘comply or explain,’ i.e., noncompliance warrants an explanation. As these are not legally binding, firms vary in terms of compliance to these codes. In this study, the authors examine to what extent and under what conditions does family ownership influences a firm’s compliance to these codes.

The authors’ main argument is that the family firm’s compliance to governance codes is influenced by two potentially conflicting dimensions of socioemotional wealth perspective (SEW), i.e., corporate control and reputation.

  • Higher levels of family ownership and control are associated with a higher degree of family entrenchment in the firm. Higher control also increases the family’s influence on the board of directors. Implementing governance codes may thus harm the family SEW as it would curb the family’s influence on managerial decision-making.
  • Another SEW dimension, family reputation, influences the family firm’s governance code compliance in an opposite way. Families and businesses operate in an intertwined manner, and their identities often become one. External pressures on family members to comply are hard to ignore. Hence, the family’s need to preserve its reputation positively influences governance code compliance.

Key findings of the study:

  • The two SEW dimensions were found to have a combined effect on the firm’s noncompliance with corporate governance codes. Noncompliance rises to a certain level as the family’s control over the firm increases and then reduces due to the family’s reputation preservation objective. Thus, ‘noncompliance to corporate governance codes’ and ‘family ownership’ have an inverted U-shaped relationship.
  • In case the firm has severe agency problems, the potential for taking private benefits increases for the family members and the reputation preservation objective weakens. This results in an even steeper inverted U-shaped relationship between noncompliance and family ownership.
  • Further, the study found that noncompliance with corporate governance codes reduced with the country’s institutional development.

The study was based on governance code compliance data collected from the annual reports of 267 firms from industrial and service sectors in the UK, Germany and Spain. Firm ownership structure and financial information was collected from public databases (Thomson Financial, Compustat Global and Amadeus). Practitioners are advised to read the ‘Discussion and Conclusions’ section of this paper to have a more complete understanding of the study’s findings. Readers are cautioned that the study only included large, listed firms and excluded financial services firms. Hence, further research is needed to generalize the findings to all family firms.

Nevertheless, the study has significant implications for regulators and family businesses. Firms belonging to different ownership categories exhibit different practices and structures for internal governance. Regulators need to be cognizant of this fact and frame corporate governance policies that permit firms to follow distinct bundles of practices that are most efficient and effective in respective ownership contexts.

Family businesses need to be proactive in adopting best global practices of good corporate governance. These practices will help them improve compliance (both statutory and non-statutory) and control over managerial decisions. However, very strict governance norms reduce managerial discretion. This may adversely affect the managerial ability to innovate and to be flexible and swift in responding to evolving market conditions. Hence the family firms need to strike a right balance between control over managerial decisions and allowing managerial discretion.

The understanding of family ownership effects on corporate governance compliance will help the top leadership teams and risk managers in finding ways to avoid corporate misbehavior and improve corporate governance.

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About the contributor

Navneet Bhatnagar is a research associate at the Thomas Schmidheiny Centre for Family Enterprise, Indian School of Business, in Hyderabad, India. He can be reached at [email protected].