Handbook of the Economics of Finance

Corporate Finance

George M. Constantinides, M. Harris, Rene M. Stulz

• Publisher: North Holland
• Year: 2003
• Print ISBN: 9780444513625
• eBook ISBN: 9780080495071
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

Volume 1A covers corporate finance: how businesses allocate capital - the capital budgeting decision - and how they obtain capital - the financing decision. Though managers play no independent role in the work of Miller and Modigliani, major contributions in finance since then have shown that managers maximize their own objectives. To understand the firm's decisions, it is therefore necessary to understand the forces that lead managers to maximize the wealth of shareholders.

Chapter 1

Corporate Governance and Control

Marco Becht^* ECARES, Université Libre de Bruxelles and European Corporate Governance Institute (ECGI)
^* We are grateful to Bernardo Bortolotti, Mathias Dewatripont, Richard Frederick, Stu Gillan, Peter Gourevitch, Milton Harris, Gerard Hertig, Takeo Hoshi, Steve Kaplan, Roberta Romano, Christian Rydqvist and Scott Verges for helpful input and comments.

Patrick Bolton^* Bendheim Center for Finance at Princeton University, NBER, CEPR and ECGI

Ailsa Röell^* Bendheim Center for Finance at Princeton University, CEPR and ECGI

Abstract

Corporate governance is concerned with the resolution of collective action problems among dispersed investors and the reconciliation of conflicts of interest between various corporate claimholders. In this survey we review the theoretical and empirical research on the main mechanisms of corporate control, discuss the main legal and regulatory institutions in different countries, and examine the comparative corporate governance literature. A fundamental dilemma of corporate governance emerges from this overview: regulation of large shareholder intervention may provide better protection to small shareholders; but such regulations may increase managerial discretion and scope for abuse.

Keywords

corporate governance

ownership

takeovers

block holders

boards

JEL classification

G32

G34

1 Introduction

At the most basic level a corporate governance problem arises whenever an outside investor wishes to exercise control differently from the manager in charge of the firm. Dispersed ownership magnifies the problem by giving rise to conflicts of interest between the various corporate claimholders and by creating a collective action problem among investors.¹

Most research on corporate governance has been concerned with the resolution of this collective action problem. Five alternative mechanisms may mitigate it: i) partial concentration of ownership and control in the hands of one or a few large investors; ii) hostile takeovers and proxy voting contests, which concentrate ownership and/or voting power temporarily when needed; iii) delegation and concentration of control in the board of directors; iv) alignment of managerial interests with investors through executive compensation contracts; and v) clearly defined fiduciary duties for CEOs together with class-action suits that either block corporate decisions that go against investors’ interests, or seek compensation for past actions that have harmed their interests.

In this survey we review the theoretical and empirical research on these five main mechanisms and discuss the main legal and regulatory institutions of corporate governance in different countries. We discuss how different classes of investors and other constituencies can or ought to participate in corporate governance. We also review the comparative corporate governance literature.²

The favored mechanism for resolving collective action problems among shareholders in most countries appears to be partial ownership and control concentration in the hands of large shareholders.³ Two important costs of this form of governance have been emphasized: i) the potential collusion of large shareholders with management against smaller investors; and ii) the reduced liquidity of secondary markets. In an attempt to boost stock market liquidity and limit the potential abuse of minority shareholders some countries’ corporate law drastically curbs the power of large shareholders.⁴ These countries rely on the board of directors as the main mechanism for co-ordinating shareholder actions. But boards are widely perceived to be ineffective.⁵ Thus, while minority shareholders get better protection in these countries, managers may also have greater discretion.

In a nutshell, the fundamental issue concerning governance by shareholders today seems to be how to regulate large or active shareholders so as to obtain the right balance between managerial discretion and small shareholder protection. Before exploring in greater detail the different facets of this issue and the five basic mechanisms described above, it is instructive to begin with a brief overview of historical origins and early writings on the subject.

2 Historical origins: a brief sketch

The term “corporate governance” derives from an analogy between the government of cities, nations or states and the governance of corporations.⁶ The early corporate finance textbooks saw “representative government” [Mead (1928, p. 31)] as an important advantage of the corporation over partnerships but there has been and still is little agreement on how representative corporate governance really is, or whom it should represent.

2.1 How representative is corporate government?

The institutional arrangements surrounding corporate elections and the role and fiduciary duties of the board have been the central themes in the corporate governance literature from its inception. The dilemma of how to balance limits on managerial discretion and small investor protection is ever present. Should one limit the power of corporate plutocrats (large shareholders or voting trusts) or should one tolerate concentrated voting power as a way of limiting managerial discretion?

The concern of early writers of corporate charters was the establishment of “corporate suffrage”, where each member (shareholder) had one vote [Dunlavy (1998)]. The aim was to establish “democracy” by eliminating special privileges of some members and by limiting the number of votes each shareholder could cast, irrespective of the number of shares held.⁷ However, just as “corporate democracy” was being established it was already being transformed into “plutocracy” by moving towards “one-share–one-vote” and thus allowing for concentrated ownership and control [Dunlavy (1998)].⁸

In the USA this was followed by two distinct systems of “corporate feudalism”: first, to the voting trusts⁹ and holding companies¹⁰ [Cushing (1915), Mead (1903), Liefmann (1909, 1920] originating in the “Gilded Age” [Twain and Warner (1873)]¹¹ and later to the managerial corporation.¹² The “captains of industry” in the trusts and hierarchical groups controlled the majority of votes in vast corporate empires with relatively small(er) amounts of capital, allowing them to exert product market power and leaving ample room for self-dealing.¹³ In contrast, the later managerial corporations were controlled mainly by professional managers and most of their shareholders were too small and numerous to have a say. In these firms control was effectively separated from ownership.¹⁴

Today corporate feudalism of the managerial variety in the USA and the “captain of industry” kind elsewhere is challenged by calls for more “shareholder democracy”, a global movement that finds its roots with the “corporate Jacksonians” of the 1960s in the USA.¹⁵

As an alternative to shareholder activism some commentators in the 1960s p...

Table of contents

• Cover image
• Title page
• Table of Contents
• Copyright page
• Introduction to the series
• Preface
• Chapter 1: Corporate Governance and Control
• Chapter 2: Agency, Information and Corporate Investment
• Chapter 3: Corporate Investment Policy
• Chapter 4: Financing of Corporations
• Chapter 5: Investment Banking and Securities Issuance
• Chapter 6: Financial Innovation
• Chapter 7: Payout Policy
• Chapter 8: Financial Intermediation
• Chapter 9: Market Microstructure
• Subject index
• Contents of Volume