2.4 Theories clarifying the comply or explain principle: legitimacy theory and market failure

The comply or explain principle is theoretically a variation on the disclosure remedy (see section 2.2.5). As a remedy disclosure hopes to avoid information asymmetry and as a consequence thereof reduce opportunistic behaviour that results in agency costs. The corporate governance statement and the comply or explain principle are disclosures as such and influenced by the legitimacy theory and the theory on market failure. Those theories are reviewed below so they can be elaborated further upon when researching the application of the comply or explain principle in practice.

The legitimacy theory throws light on the reasons why companies want and have to disclose information such as by means of the comply or explain principle. Suchman and Maurer give quite sufficient definitions of the legitimacy theory:

"Legitimacy is a generalized perception or assumption that the actions ofan entity are desirable, proper or appropriate within some socially constructed system of norms, values, beliefs and definition" (Suchman 1995, p. 575).

"Legitimation is the process whereby an organization justifies to a peer group or superordinate system its rights to exist" (Maurer 1971).

In the legitimacy theory the circle of persons involved by a company is wider than in the stakeholder theory (Boot and Soeting 2004, p. 182). The circle of persons involved consists of the shareholders, other stakeholders and the rest of the community as a whole (such as the government, religion, environment and society) to which the company's right of existence has to be legitimised (Tilling 2004, p. 3). By searching for legitimacy companies increase their probability of survival which is common organisational behaviour1 (DiMaggio and Powel 1983, p. 147) (Hooghiemstra, Van Ees et al. 2008, p. 5). Two classes of the legitimacy theory exist. The institutional legitimacy (i) deals with: "how organisational structures as a whole (capitalism for example, or government) have gained acceptance from society at large (Tilling 2004, p. 3). The second class of the legitimacy theory and in this case the most relevant class is the (ii) strategic legitimacy (the organisation level). This class of legitimacy theory can be considered a process (legitimating) by which an organisation seeks approval (or avoidance of sanctions) from groups in society to ensure the organisation's continued existence (Kaplan and Ruland 1991, p. 370). A company cannot afford to ignore society; the continuity of a company is dependable on the perception in society regarding its reputation. A company constantly needs to justify its existence and activities to society (Boot and Soeting 2004, p. 182). Legitimacy helps to: "ensure the continued inflow of capital, labour and customs necessary for viability (...). It also forestalls regulatory activities by the state that might occur in the absence oflegitimacy (...) and pre-empts product boycotts or other disruptive actions by external parties (Neu, Warsame et al. 1998, p. 265).

Taking the above into account, the legitimacy theory makes disclosure by companies understandable. In particular with regard to environmental disclosures and corporate social responsibility the coherence with the legitimacy theory is often described (Neu, Warsame et al. 1998) (Tilling 2004). Other disclosures are explainable by the legitimacy theory as well. A company has to legitimate its existence to its stakeholders and society; no matter whether it concerns voluntary, mandatory, financial, mission statements or remuneration disclosures (Liu, Taylor et al. 2006, p. 10) (Gibbins, Richardson et al. 1990, p. 138) (Campbell, Shrives et al. 2001, p. 69). The annual report is considered a very appropriate instrument for disclosing all this information, because of its degree of credibility not associated with other forms of advertising (Neu, Warsame et al. 1998, p. 269).

As explained before, the legitimacy and credibility of companies, carefully established over the years by their directors and advisors, totally collapsed after the financial scandals. In the aftermath of the scandals the companies, directors and their advisors had a hard time to regain the trust of their stakeholders and society, and to secure their legitimacy once again. The doctrine differentiates three steps to be taken for repairing legitimacy: (i) offer normalising accounts, (ii) restructure and (iii) do not panic. The first step is: "to formulate a normalizing account that separates the threatening revelation from larger assessments ofthe organisations as a whole (Suchman 1995, p. 598). This offering of normalising accounts (i) can be attempted in four ways. Managers can deny the problems and proceed with their business as usual. Secondly and more successfully, they can excuse and question the organisation'smoral responsibility. Furthermore, the managers can try to justify the disruption or explain the disruption in a way that preserves a supportive worldview. The next step to repair the legitimacy is through strategic restructuring (ii), for example by creating monitors and watchdogs, by drafting government regulation and by distancing the organisation from bad influences; all to assure the public that future disruption will be avoided. The last step is not to panic (iii). Threat-rigidity responses that impair decision making and promote organisational failure must be avoided (Suchman 1995, p. 598). The above three steps can be seen in the reactions of governments and companies to the financial scandals. Scandals were denied, excused, justified and explained by managers and their auditors. Monitors, watchdogs and regulations blossomed and some believe that due to panic overregulation was created and too many overlapping watchdogs were installed.

The development of corporate governance regulation regarding mandatory and voluntary disclosures (e.g. the comply or explain principle) can to a certain extent be clarified by the legitimacy theory. In the direct aftermath of the corporate scandals companies used i.a. the comply or explain principle to regain the trust of the shareholders and to legitimise their existence. By disclosing proper corporate governance statements companies wanted to assure their stakeholders that their corporate governance structure was back in place, irregularities taken note of in time and scandals prevented. Nowadays companies still disclose based on the comply or explain principle for similar reasons. They want to signal to the market (by showing in their corporate governance statement that the company fully complies with a corporate governance code or gives proper explanations for deviations) that they 'exceed' other companies and thus hope to attract additional investors - the signalling theory (Campbell, Shrives et al. 2001, p. 71). The reasons necessary for signalling to investors are market failure and information asymmetry which are clarified in more detail below.

Next to the legitimacy theory, the theory on market failure explicates the existence of disclosures and more in particular the comply or explain principle. Market failure encompasses a situation where, in any given market, the quantity or quality of a product demanded by consumers does not equate with the quantity or quality supplied by suppliers. This is a direct result of a lack of some economically ideal factors, which prevents a social optimum (Leftwich 1980, p. 194). For example, the problem of information asymmetry is the lack of an ideal economical factor. No perfect financial market exists in which every agent and principal receive all the information needed (i.e. no information asymmetry) and in which moral hazard and adverse selection do not occur. Nevertheless, one tries to minimise these problems to come as close as possible to achieving the perfect financial market, for instance by disclosing (mandatorily or voluntarily) the information relevant to prevent market failure (Schôn 2006, p. 13).

The first legislations to mandate disclosures offinancial accounting information are the US Securities Act 1933 and the US Securities Exchange Act 1934. Since these acts the requirements to disclose (financial) information by companies have been expanding (Kaplan and Ruland 1991, p. 361). The necessity for disclosure imposed by regulation to prevent market failure is stressed by Baums: "if a market failure arises because of externalities, asymmetric information, the dominant position of a market participant or the production of "public goods", an appropriate state intervention in the market process can lead to an increase in social welfare. A rule of law requiring disclosure would thus be advisable where the market for the information to be disclosed is characterised by market failures (Baums 2002, p. 3).

Although disclosures are meant to prevent information asymmetry and to reduce market failure, problems are also attached, such as monopoly control over information by management regarding the disclosure of financial information. The managers control the information and decide what and which information the investors receive. Information can be considered the most valuable ' assets' within a company and the managers can act as real monopolists regarding these assets. The annual reports to be published are the investors' most important access to information about the company. Their inability to obtain more additional information from the monopolistic managers or possibly ' coloured' information in the annual reports could result in faulty investment decisions (Kaplan and Ruland 1991, p. 363) (Leftwich 1980, p. 200). In fact, this problem of market failure coheres with the agency theory. A shareholder will only make a contribution to the equity of a company when the uncertainties of his investment can be decreased to a minimum: an investor makes an investment when the asymmetric information problem between him as principal and the management as agents is brought to a satisfactory level. Taking this problem into consideration, disclosure regulation could be of assistance, for example in contracts, articles of association, or if necessary issued by the legislator. Disclosure regulation can be considered a legal regulatory strategy, more specifically the affiliation terms. The ten legal strategies of Kraakman, Davies et al. are explained further in section 2.2.7 and play a large role in reducing agency problems. Affiliation terms imply that regulation requires agents to disclose information before contracting with principals: like investors (principals) desire information from the managers (agents) before investing in them (i.e. the company).

Whilst acknowledging the problems of disclosure (such as monopoly control over information), six generally accepted principles of disclosure help to prevent market failures as much as possible:

A downside of these six general disclosure principles is that they entail agency costs, such as information collection costs, cost for auditors and the time management spends on these disclosures. When the disclosure quality improves, the disclosure costs increase as well. An optimum should be searched for: sufficient disclosure quality taking the legitimacy theory and market failure into account with not too many costs incurred (Forker 1992, p. 114).

Disclosure in line with the six principles above should prevent costs or perhaps even create profits. This should apply as regards the comply or explain principle as well. As stated before, the comply or explain principle is a variation on the disclosure remedy. Specific market failure - the corporate scandals - resulted in more disclosure regulation, among which the comply or explain principle.

Through disclosure based on this principle companies and managers tried to reestablish their legitimacy towards their stakeholders; they tried to regain the trust of society. The appropriate use of the comply or explain principle should contribute to a good corporate governance structure, fewer agency problems and therefore lower agency costs. Next to lower agency costs, companies do hope for more investments or a higher share value by disclosing a 'better' corporate governance statement than other companies.2 In the words of Cromme, the chairman of the German corporate governance commission, in the Frankfurter Algemeine Zeitung of 19 December 2001: "Wer sich nicht an den Kodex hält, den straft der Kapitalmarkt?" (Nowak, Rott et al. 2005, p. 259).

Several empirical studies have tried to reveal whether higher rates of code compliance are indeed related to superior financial performance or lower rates to inferior financial performance (Talaulicar and Von Werder 2008, p. 255). The findings are, however, premature, diffuse, and difficult to compare due to the differences in the conducted empirical studies. More information is provided in section 5.2 below on previous studies on code compliance.

The comply or explain principle as a form of disclosure is theoretically embedded in the legitimacy theory and the theory on market failure. By legitimising its corporate governance to their stakeholders companies try to prevent market failure (agency costs) and gain trust and investments. As an instrument of corporate governance the comply or explain principle tries to make a contribution to the minimising of agency cost/problems and enhance good corporate governance.