Rethinking Corporate Governance

The Law and Economics of Control Powers

Alessio Pacces

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781135099411
• Edition: 1
• Topic: Law
• Subtopic: Corporate Law
• Index: Law

The standard approach to the legal foundations of corporate governance is based on the view that corporate law promotes separation of ownership and control by protecting non-controlling shareholders from expropriation. This book takes a broader perspective by showing that investor protection is a necessary, but not sufficient, legal condition for the efficient separation of ownership and control. Supporting the control powers of managers or controlling shareholders is as important as protecting investors from the abuse of these powers.

Rethinking Corporate Governance reappraises the existing framework for the economic analysis of corporate law based on three categories of private benefits of control. Some of these benefits are not necessarily bad for corporate governance. The areas of law mainly affecting private benefits of control – including the distribution of corporate powers, self-dealing, and takeover regulation – are analyzed in five jurisdictions, namely the US, the UK, Italy, Sweden, and the Netherlands. Not only does this approach to corporate law explain separation of ownership and control better than just investor protection; it also suggests that the law can improve the efficiency of corporate governance by allowing non-controlling shareholders to be less powerful.

1 Corporate Governance

Theory and Evidence¹

1.1 The Principal–Agent Approach to Corporate Governance

1.1.1 Separation of Ownership and Control

Economic theory of corporate governance approaches separation of ownership and control as a problem of separation of firm management from firm finance. While this is undoubtedly the core problem of corporate governance, most commentators take quite a narrow view of the matter, by stressing the latter term (finance) and overlooking the former (management). Managers and financiers of course need each other. A manager (or an entrepreneur) “needs the financiers’ funds, since he either does not have enough capital of his own to invest or else wants to cash out his holdings” (Shleifer and Vishny 1997: 740). However, the focus of the corporate governance debate is rather on how managers are hired by financiers, and on what terms. As a result, no different from other long-term contractual relations, corporate governance is typically regarded as an agency problem: financiers act as the principals, hiring one or more agents to generate returns on their funds (Jensen and Meckling 1976).

In this perspective, the manager’s position might look not much different from that of a high-rank employee. However, what distinguishes managers from the rest of the company’s employees is their position on top of the firm hierarchy. Corporate managers are vested with enormous discretionary powers, for they bear ultimate responsibility of how the firm is managed. This discretion is the very essence of firm control. The conventional approach to corporate governance deals more with how this discretion is constrained than with how it is exercised. According to the mainstream economic theory of corporate governance, the special feature of management compared to the other constituencies of the corporate enterprise is their direct accountability to one kind of financier. Managers are essentially regarded as agents of the shareholders.²

Why should shareholders, and only shareholders, be the manager’s principals? Shareholders are the firm’s owners and, therefore, the residual claimants on the firm’s assets. However, lacking both coordination and the necessary expertise, they do not know how to manage them in such a way as to maximize their value as an open-ended stream of profits. Managers are in charge of managing those assets, although they are not residual claimants unless to a limited extent. Either they lack the funds to own the firm’s assets altogether or they simply do not want to commit a too large portion of their wealth to the company’s affairs. Consequently, managers are induced to enjoy the assets under management rather than maximizing their value. Although there is quite an extensive debate about whether other providers of input (the so-called stakeholders) are also interested in the firm’s residual (see Tirole 2006), the majority of economists and many legal scholars continue to believe that only shareholders should be. This is also the approach being followed here. The economic rationale for this position will be illustrated at the end of this chapter.

In the meantime, let us assume with the mainstream theory that the fundamental principal–agent relationship in corporate governance is established between managers and shareholders and, more in general, between those who decide about the firm’s management without (entirely) owning its assets and those who (partly) own the firm’s assets but do not participate in their management. This last definition is sufficiently general to also account for a manager whose ownership stake is so large as to qualify as controlling shareholder. As opposed to the latter, non-controlling shareholders are financiers holding a very special (and difficult) position. They provide funds to the firm, but what they receive in exchange is nothing but the promise to share in a future and uncertain stream of profit. The realization of this profit, however, is not entrusted to shareholders, or at least not to all of them. It is entrusted to somebody who may, or may not, be a shareholder himself. I shall henceforth refer to this individual as to the firm (or the corporate) controller.³

The nature of a shareholder claim on the firm’s assets has also a special feature compared to a typical ownership claim. Normally, property rights over an asset confer the entitlement to both the asset management (control rights) and its profit stream (cash flow rights). The ownership of a corporate enterprise works quite differently. On the one hand, shareholders are entitled to all the firm revenues that have not been assigned to any other provider of inputs. Having the status of owners of the enterprise, shareholders are residual claimants, so they are the ones with the strongest interest in the maximization of the firm’s profits and the firm value (Fama and Jensen 1983b). On the other hand, they are not necessarily in control of the assets they own. Differently from the typical owner, shareholders who are not also the corporate controllers (non-controlling shareholders) do not have residual rights of control: that is, the rights to discretionally manage the firm’s assets in circumstances not disciplined by any contract entered into by the firm. For the reasons and in the ways that I am just about to discuss, residual rights of control are held by the firm controller(s).

The typical problem of agency relationships is the conflict of interest of the agent when it comes to performing some task on the principal’s behalf. Scope for exploiting the conflict of interest is provided by asymmetric information. The agent may pretend to be more skilled than he actually is, in order to be hired – or not to be replaced. Alternatively, he may cheat on the principal by underperforming his obligations, or not performing them at all, to the extent that he has some chances of not being caught. These two problems are respectively known as adverse selection and moral hazard. Delegation of management responsibilities is the source of both problems in corporate governance. The managers might easily abuse their superior knowledge at the principals’ expenses, by staying in charge – or attempting to take over – when more capable managers are available, or by enjoying both pecuniary and non-pecuniary benefits of their position while failing to maximize shareholders’ profits. These benefits are known as Private Benefits of Control (PBC).

Based on those conflicts of interest, two major conclusions are drawn. First, the ultimate goal of corporate governance should be to cope with agency problems in such a way as to guarantee maximization of shareholder value, because the latter corresponds with the sum of residual claims on the firm’s assets – that is, the firm value. Secondly, the implementation of the above goal requires a discipline of managerial discretion, aimed at preventing managerial adverse selection and moral hazard. At its very core, the agency approach to corporate governance is based on the defense of shareholders’ interest from managerial misbehavior.

1.1.2 Agency Problems Under Incomplete Contracting

1.1.2.1 Two Models of Corporate Control

Agency costs are not sufficient to make corporate governance problematic (Hart 1995). In order for ‘governance’ to be a meaningful problem, there must be a contracting failure (Zingales 1998). Ideally, principals could write optimal contracts disciplining their agents’ behaviors. In this situation, there would be no need to take decisions that were not foreseen (and thus accounted for) in the initial contract. In reality, corporate governance is all about such decisions. The reason behind it is that contracts are incomplete. Given that the contracts between managers and the owner of a company are imperfect, one may wonder whether an optimal corporate governance model exists instead. Although this view has enjoyed some popularity (e.g. Hansmann and Kraakman 2001), the idea that one single model of separation of ownership and control is the best does not seem to be borne out by the evidence.

Large firms in the developed world are characterized by two major patterns of corporate control. One is managerial control of a company where no shareholder has enough voting power to influence corporate decision-making systematically. This is the so-called ‘public company’, a model of corporate governance prevailing in Anglo-Saxon countries and infrequent in the rest of the world. Managers govern a public company without significant share ownership, since they enjoy considerable advantages in controlling how votes are cast by dispersed outside shareholders. The second and much more widespread model of corporate governance is shareholder control. It is based on a controlling shareholder (or more of them, acting as a coalition) exerting direct voting power through share ownership. The vast majority of corporate enterprises around the world are governed by a controlling shareholder (La Porta et al 1999). Even in the US and the UK, the public company model just applies to some of the largest firms, but not to all of them.

An issue often overlooked in the corporate governance literature, especially by US commentators, is that managerial control of a public company is just one model of corporate governance; also shareholder control should be accounted for. A related problem is that ‘controlling’ shareholders are not clearly distinguished from shareholders that are just ‘large,’ but do not really exert any control over the firm decision-making and, therefore, are still ‘noncontrolling’ shareholders. The classification between corporate controllers and non-controlling shareholders that I have introduced is intended to cope with these problems. On the one hand, the notion of corporate controller points at the exercise of real authority in the firm decision-making (Aghion and Tirole 1997). As a result, it includes shareholders that are actually ‘in control’ while excluding shareholders that are just ‘large.’ On the other hand, the same notion is neutral to the two basic models of separation of ownership and control. ‘Corporate controller’ is in fact a suitable definition for either managers or a controlling shareholder having the last word over firm decision-making. Understanding corporate governance requires consideration for both models of corporate control, and not just for one of them.

Both under shareholder control and under managerial control there is delegation of residual rights of control from non-controlling shareholders to a corporate controller. This is motivated by the owners’ wealth constraints, their liquidity needs and their risk aversion (the ultimate reason why their financial investments are diversified). It is not only entrepreneurs (and managers) that may not be rich enough or otherwise unwilling to own all of the firm’s assets. Investors are the same, and that is the reason why large, publicly held companies have many small non-controlling shareholders. Ownership dispersion of large companies leads to the problem of shareholders’ rational apathy. Within the incomplete contracts approach, this generates likewise a principal–agent problem. Professor Hart (1995: 127) has described it very clearly in the stylized case of a public company subject to managerial control:

[Dispersed ownership] creates two . . . problems that [are] not relevant in the case of a private company. First, those who own the company, the shareholders, are too small and too numerous to exercise control on a day-to-day basis. Given this, they delegate day-to-day (residual rights of) control to a board of directors who in turn delegate it to management. . . . Second, dispersed shareholders have little or no incentive to monitor management. The reason is that monitoring is a public good: if one shareholder’s monitoring leads to improved company performance, all shareholders benefit. Given that monitoring is costly, each shareholder will free ride in the hope that other shareholders will do the monitoring. Unfortunately, all shareholders think the same way and the net result is that no – or almost no – monitoring will take place.

Although it may be less intuitive, a similar reasoning applies to those companies where a controlling shareholder is in charge. Non-controlling shareholders are normally no less dispersed, and thus they are induced to delegate residual control rights to the controlling shareholder while abstaining from monitoring his behavior. In theory, the latter might be less of a problem compared to the case where managers are in charge with (almost) no shareholding, due to the large ownership stake that must be maintained to support the position of a controlling shareholder (Becht et al 2007). While a non-owner manager may waste too many resources in enjoying perquisites or building empires at the shareholders’ expense, a controlling shareholder will refrain from doing so to the extent he loses more as an owner than he gains as a controller. Apparently, then, the exercise of corporate control by a large shareholder requires less monitoring by the other owners. In practice, however, the difference in incentives between the two models of corporate governance is more apparent than real (Hellwig 2000).

On the one hand, the ownership stake of controlling shareholders is always limited by their wealth constraints and risk diversification needs. Based on Jensen and Meckling’s original insight (1976), standard theory holds that ownership concentration arises as a solution of a tradeoff between enhanced monitoring incentives of large owners and reduced liquidity of their investment. In that perspective, a controlling shareholder may even be preferable to a completely dispersed ownership structure, if only he could be subsidized to hold larger blocks (Bolton and Von Thadden 1998). However, the empirical evidence shows us a somewhat different picture. There are legal devices that allow separation of control rights from ownership claims. These devices – such as dual class shares, pyramidal group structures, or other instruments allowing departure from the ‘one share–one vote’ default rule governing corporate voting – help to satisfy liquidity preferences or constraints of the corporate controller. This of course dilutes the corporate controller’s incentives as a residual claimant, by allowing control to be exercised and maintained with a limited ownership stake (Bebchuk et al 2000). For instance, one comparative study on corporate control patterns presents “examples in which the cash flow rights of the controlling family in some of the pyramid member firms are comparable to the stakes of the managers of the most diffusely held of US corporations” (Morck et al 2005: 678).

On the other hand, where managers are in charge with a tiny (or even no) ownership, their incentives can be nonetheless aligned with shareholder interest by putting them on an incentive scheme contingent on the realization of shareholder value (Shleifer and Vishny 1997). This mechanism has also an important limit. “[I]f managers have a strong interest in power, empire, and perks, a very large bribe may be required to persuade managers to give up these things” (Hart 1995: 128). Beyond a certain threshold, shareholders will prefer to share a smaller pie rather than to award managers the biggest part of a larger one.

The above results are consistent with the generality of Jensen and Meckling’s analysis. Whatever the model of corporate governance (i.e., whatever the degree of separation of ownership and control), the incentives of the corporate controller can never be perfectly aligned with the interest of the non-controlling owners. Unfortunately, this framework does not completely explain the choice of ownership structure. In theory, this should just depend on minimization of agency costs across the board. In practice, however, agency costs minimization does not tell us why managerial control with dispersed outside ownership prevails in a few countries, whereas the governance of most publicly held companies around the world features controlling shareholders even with limited inside ownership. One possible solution to this puzzle is that the law makes a difference (La Porta et al 1998).

1.1.2.2 Law Matters

The idea that law plays a role in corporate governance comes from the application of the agency theory to an incomplete contracts setting (Shleifer and Vishny 1997). Under asymmetric information, shareholders (the principals) cannot perfectly monitor the manager’s (the agent’s) behavior; therefore they are willing to buy stock only at a discount. The source of the discount is the agency cost. Agency costs could be minimized by an incentive-compatible contract between shareholders and the manager. If the corporate contracts were complete, minimization of agency costs would take place without the aid of legal rules, because it is in the interest of both managers and financiers. However, given contractual incompleteness, optimal shareholder protection cannot be specified ex-ante in detailed corporate contracts. What is optimal today might not be optimal tomorrow. For this reason managers are vested with discretionary authority in corporate governance. Minimization of agency costs requires that some external constraints on the managers’ behavior be established by institutions, particularly by corporate law. Failure of corporate law to place sufficient constraints on the ability o...