3.4.2 Board composition according to the TCE theory

As becomes apparent from the latter subsection, the unit of analysis for the TCE theory is the transaction. From this perspective, TCE theorists prescribe the optimal composition of a board and therefore distinguish two types of production transactions carried out within a company: production with non-transaction-specific assets and with transaction-specific assets (Williamson 1985: 20-22). The difference between the two categories is that non-transaction-specific assets can be redeployed easily after the termination of a contract, whereas transaction-specific assets cannot, and therefore involve heavy costs when a contract is prematurely terminated. Figure 3-1 visualises the difference between the two situations, where k is the level of transaction-specific assets used in a production process. When k equals zero, there are no transaction-specific assets and the production process is located at node A and the compensation for the use of the production factor is p1. Production processes in which transaction-specific assets are involved are located at the lower branch in the figure (k [amp]#62; 0). In this respect, the situation in which a safeguard is provided (s [amp]#62; 0) can be distinguished from the situation without a safeguard (s = 0). Trivially, when a safeguard is refused and the production factor ends up at node B, the compensation for the production factor (p) is higher than the compensation at node C, where a safeguard is put in place (p^). As substitute for a higher price, additional benefits can be provided in order to lower the price. An example is the disclosure of information, which will reduce the information asymmetry and enables the owners of the production factor to anticipate a changing environment successfully. Another remedy is a governance mechanism, of which the board of directors is described in the remainder of this subsection. A summary of the positions of the stakeholders in the contracting scheme is given in Table 3-3 and is described below.

Figure 3-1: A simple contracting scheme. With k the level of transaction-specific assets and s the level of safeguards (Williamson 1985: 33).

Table 3-3: Summary of the locations of the different stakeholders in a company.

The TCE theory considers two types of board membership: voting and participation membership (Williamson 1985: 302). The first category naturally belongs to the voting subset of the board, while the second category is only allowed to observe strategic planning and receives information which corporate decision-making is based upon. In some cases it can be rewarding to offer workers, suppliers and (large) customers an information participation membership of the board (Williamson 1984: 1207-1215; 1985: 302). However, in most cases these three kinds of stakeholders do not need this participation membership.

Employees without company-specific assets (node A) can resign easily and do not need protection at all, according to the TCE theory. When employees have company-specific assets or knowledge, they are located at nodes B or C. At node B they can demand higher wages as compensation, and at node C they can be protected by governance structures, such as a participation membership of the board. However, transaction-specific labour is better protected by collective bargaining agreements than by board representation (Romano 1996: 280).

Suppliers without company-specific investments suffer at worst some modest transitional costs when a contract is terminated prematurely. Suppliers with transaction or company-specific assets can demand higher prices at node B or other protection, such as progress payments, at node C. Only when large volumes of business are at stake can an information participation membership of the board be offered, but normally other protection measures will suffice.

Customers at node A can switch to another supplier. When customers are located at node B they can ask lower prices and look for bargains. At node C they can get protection by buying premium brands. Electing customers to the board is problematic, because it is difficult to find a representative of a group of customers. For very large important customers an information participation membership is a way to receive protection, but this is unique. The inclusion of shareholders, debt providers and management on the board of directors according to TCE theorists is described below.

Shareholders are a very special type of stakeholder in a company. The unique relationship is based on (i) their position as voluntary constituency without periodic review rights or the right to renegotiate the terms of contract (e.g. an equity investment is for the lifetime of the company); (ii) the character of equity that is not associated with particular assets, the last position in the payout queue in case of liquidation and the role as residual claimant; and (iii) the absence of periodical (interest) payments (Williamson 1984: 1210-1211; 1985: 304-306; Romano 1996: 279). These characteristics and the diffuse character of their investment unavoidably position shareholders at node B in the scheme of Figure 3-1. The board of directors is therefore considered to be ‘a governance structure whose principal purpose is to safeguard those who face a diffuse but significant risk of expropriation because the assets in question are numerous and ill-defined, and cannot be protected in a well-focused, transaction-specific way’ (Williamson 1984: 1210). The board of directors should therefore look after the interests of shareholders and not other constituents, which brings them at node C. This supervision must be carried out by independent NEDs.

In contrast to shareholders, debt providers have more possibilities to safeguard their investments. Debt can be split in short-term and longer-term loans. In general, providers of short-term loans regard current financial health in combination with a short tenure as a sufficient safeguard. Providers of longer-term loans require pre-emptive rights against durable assets and equity participation when these durable assets cannot be easily redeployed, which places them at node C (Williamson 1985: 307). These safeguards for providers of long-term loans are more apt than a position on the board of directors, because they are a more concrete specification of the claim on the company (Romano 1996: 280).

Managers with no company-specific human assets are located at node A and do not require specialised governance. When managers develop a company-specific asset relationship with the company they are located at nodes B or C. Protection in the form of compensation schemes or a position on the board causes them to end up at node C; without either of these two forms of protection they end up at node B with higher compensation. However, management is a special sort of stakeholders, because management and the company are together often considered as one (Williamson 1984: 1216). The danger is that ‘any proposal to improve their terms of employment is automatically suspect, because managers are presumed merely to be adding another layer of down to their already well-feathered nests” (Williamson 1985: 312). The TCE theory therefore takes the view that the board, which in their opinion exists to monitor, must consist of independent directors to monitor the managers on the board, because there would not be an agency problem if executive directors were able to monitor themselves.

In sum, the TCE theory requires a majority of independent NEDs on the board in order to look after the interests of shareholders. These shareholders have – unlike other stakeholders of the company – no other protection than a board of directors that looks after their interests. Especially the risk of managers on the board must be mitigated by independent supervision.