NBER WORKING PAPER SERIES

AGENCY PROBLEMS AND THE FATE OF CAPITALISM Randall Morck Bernard Yeung Working Paper 16490 http://www.nber.org/papers/w16490

NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 October 2010

Partial financial support from the SSHRC is gratefully acknowledged. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. 2010 by Randall Morck and Bernard Yeung. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including notice, is given to the source.

Agency Problems and the Fate of Capitalism Randall Morck and Bernard Yeung NBER Working Paper No. 16490 October 2010 JEL No. B53,G28,G34,N20,P1,P12 ABSTRACT Economics has firms maximizing value and people maximizing utility, but firms are run by people. Agency theory concerns the mitigation of this internal contradiction in capitalism. Firms need charters, regulations and laws to restrain those entrusted with their governance, just as economies need constitutions and independent judiciaries to restrain those entrusted with government. Agency problems distort capital allocation if corporate insiders are inefficiently selected or incentivized, and this hampers economic growth absent a legal system with appropriate constraints. However, political economy problems and agency problems in corporations may reinforce each other, compromising the quality of both corporate governance and government.

Randall Morck Faculty of Business University of Alberta Edmonton, CANADA T6G 2R6 and NBER randall.morck@ualberta.ca Bernard Yeung National University of Singapore Mochtar Riady Building 15 Kent Ridge Drive BIZ 1, Level 6, #6-19 Singapore 119245 bizdean@nus.edu.sg

1.

Introduction

Neoclassical economics presents capitalism as asystem where multitudes of firms compete to offer customers the best prices. To many, especially outside America and Britain, capitalism is a system whereahandfulofoldmoniesfamiliesruntheeconomyoftenbadly.Theeconomistsmarvelatthe otherscredulityforconspiracytheories,whiletheothersmarvelateconomistsnaivetyaboutthereal world.Closeinspectionofcorporategovernanceindifferentcountriessuggeststhateachsidewelltake the other seriously. Capitalism has genuinely different forms in different countries, and these reflect fundamentaldifferencesinthedistributionsofcorporateandpoliticalcontrol. Neoclassical economics readily allows that who controls a countrys government matters, but

traditionally takes firms as profit maximizing black boxes and capital as a returngenerating substance that Samuelson dubbed shmoo. Yet who controls firms, and their capital, matters (Berle and Means 1932).Howmicroeconomicscanincorporatethisinsightisthecoreissueofagencytheory(Jensenand Meckling1976). Running a business requires scarce talent, and competition among potential leaders ideally assignscorporatecontroltothemostable.AdamSmith(1762)positsthatbusinesssuccessrequiresan empathic ability to predict potential customers desires. Hayek (1941, c. 25, p. 335) stresses the importance of exceptional foresight; Knight (1921 c. 9 3.9.7) stresses the rarity of rational decision makingability;andSchumpeter(1912)seesuniquelycreativeinnovatorsbuildingnewcorporationsthat destroyoldones,andtherebyearningthewrathofallwhopreferredthestatusquo. Somewhat more cynically, and more in line with the recent corporate governance literature, Adam Smith (1776, bk. 5, c. 1, pt. 3, art. 1) holds that corporate directors seldom pretend to understand anything of the business of the company. Keynes (1936, c. 12, 5) concurs with Smith, Hayek,Knight,andSchumpeterthatthesocialpurposeofskilledinvestmentistodefeatthedarkforces oftimeandignorancewhichenvelopourfuture,hedespairsthatthisisbeyondtheabilityofcorporate executives,whosedecisionstheattributestobehavioralanimalspirits(c.12,7).Mueller(1992)thus advocates a broadly behavioral approach to modeling managerial decisionmaking. Brandeis (1914) blaststheethicsofcorporatetycoonsrunningfirmsbuiltwithotherpeoplesmoney,andBerleand Means(1932)describeafundamentalmisalignmentoftheirincentives. Corporate governance, broadly defined, continues this discussion. Capital is not schmoo, for who controls businesses matters, as do the institutions that determine this, the interest groups that affecttheseinstitutions,andthustheinterfacebetweenfinancialeconomicsandpoliticaleconomy.

While economic theory addresses all these issues, incentive misalignment attracts the most attention perhaps because it highlights an internal contradiction within that theory. Neoclassical economics posits that individuals maximize utility and that firms maximize economic profits or, more precisely, the expected present values (NPVs) of their capital investments which, in turn, precisely equaltheexpectedpresentvaluesofeconomicprofits.Thispresentsproblemsbecause,asGabrowski andMueller(1972)rightlynote,firmsarerunbypeople.Whichthenisparamount:aCEOsutilityor herfirmsNPV? Jensen and Meckling (1976), expanding earlier theories (Ross 1973) and reflecting previous empiricalworkrejectingpurevaluemaximization(Baumol1959;Grabowski&Mueller1972andothers), provide the now standard resolution to this inconsistency. They assume utility maximization more fundamental,andtheirfirmsthereforedonotmaximizeNPVs.Theimplicitsacrificedvaluetheyduban agency cost. Specifically, they model outside investors the firms owners or principals, as in Corporations Law buying shares in firms run by utility maximizing insiders, whom Corporations Law declarestobetheiragents.Elaboratingwhatisnowstandardterminology,theychristenthisdivergence ofinterestsaprincipalagentproblem,nowoftenabbreviatedtoagencyproblem.Corporategovernance isthestudyofagencyproblemsandthemonitoringandcontrolmechanismsthatlimitagencycosts. NeoclassicaleconomicspositsthatpricecompetitioncullsfirmsthatdonotmaximizeNPVs,and thus holds that agency problems ought to be brief and economically negligible (Demsetz & Villalonga 2001). However, the empirical literature increasingly confirms nonvaluemaximizing decisions to be commonplaceincorporateboardrooms,andfartooeconomicallyimportanttobeabstractedaway(e.g. Shleifer&Vishny1997;Gompersetal.2003;Bebchuk&Fried2004;Bebchuketal.2009). Iffirmsdonotmaximizevalue,managerialutilitymaximizationmightcausefirmstoeffectively maximize something else. Baumol (1959) posits sales maximization; and Baumol (1967) argues that growthmaximizationbestfitsthefactsatleastintheUnitedStates.Recentworkinbehavioralfinance suggests alternative objective functions for individuals (Shleifer 2000), and Mueller (1992) argues that suchconsiderationsbeincorporatedintomodelsofmanagerialbehavior.Earlyworkalongtheselines includesStein(1989)andScharfsteinandStein(1990),andBakeretal.(2004)reviewthearea.Morck (2008)arguesthataloyaltyreflexdemonstratedinMilgrams(1974)experimentsmightcompromiser directorsjudgment,anddrawsfromvariantsofthoseexperimentsandthebroadersocialpsychology literature to evaluate governance reforms. Nonetheless, most work in the area presumes utility maximization by managers. This is perhaps justifiable, in that the critical issue is that neoclassical economicsassignspeople,includingmanagers,andfirmsdifferentobjectivefunctions.
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Thus,GrabowskiandMueller(1972),Jensen(1986),andothersarguethattopexecutivesattain higher utility from running larger firms, and thus invest in negative PV projects merely to grow their firms.Jensencallsthissortofcapitalmisallocationafreecashflowagencyproblem,definingfreecash flowasthefirmscashflow(revenuesminusoperatingcosts)lessthesetupcostsofallitspositiveNPV investments.Avaluemaximizingfirmshouldpayitsfreecashflowouttoitsshareholders,ratherthan investitinnegativeNPVprojects,butJensenpresentsevidencethatfreecashflowagencyproblemsare a first order determinant of overall agency costs. If this thesis is right, and the data suggest it is, microeconomictheorymissedsomethingveryfundamentalbeforetheadventofagencytheory. Fortunately,thisgapcanbespannedwithdeepereconomics(JensenandMeckling1976).Moral outrageaboutcorporatemisgovernance,incontrast,maybelargelymisdirected.Agencycostsareoften described as shareholder wealth expropriation. This is incorrect in an efficient market, where shareholdersbuylowbecausetheyrationallyforeseeextensiveagencyproblems,costlymonitoringand controlmechanismstolimitagencyproblems,oramixtureofthetwo.Firmsfoundersthusabsorball agencycostsbysellingtheirsharesatdepressedinitialpublicoffering(IPO)prices;andthesharestrade at fair value thereafter. Only outside shareholders who underestimate agency problems overpay and losemoneyonaverage,andthisisexpropriationunlesscaveatemptorapplies. Therealsocialcostsofagencyproblemsliedeeperininnerworkingsoftheeconomy.Inefficient resourceallocationbyfirmscostsmoney,asdothemonitoringandcontrolmechanismsthatmightlimit thoseproblems.Somelevelofagencycostsisthusunavoidable.Butbothfirmsandeconomiescanseek waystoreduceunavoidableagencycosts. Allelseequal,ifcorporateinsidersmorecrediblyprecommittomaximizeNPVs,investorspay more for shares. Higher share prices make outside capital readily available to firms that need it, permitting growth in firms with genuine business opportunities (Mueller 2006a). But less trusting outside investors and low share prices make outside capital scarce, growth is restricted to firms with abundantearningsfromexistingoperations(LaPorta&etal.1997)andtheseneednotbethefirms withthemostfarsighted,rational,orinnovativeleadership.Governmentscancurtailagencycostswith institutions that better facilitate or require such commitments by corporate insiders. All else equal, success at this cuts costs of capital to entrants and incumbents alike; promoting competition, innovation, and efficient resource allocation. Corporate governance is therefore most fundamentally abouthowhonestandablecorporateinsiderscanmostefficientlyandcrediblycommittolimitagency costs,andabouthowgovernmentscanlowertheircostsofdoingso(ShleiferandVishny1997;Bebchuk andWeisbach2010).
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Finally,aHandbookofCapitalismsurveyofcorporategovernancemustpayduehonortoMarx. TheinternalcontradictionattheheartofcorporategovernanceisnotunrelatedtoMarxsmorefamous contentionthatcompetitiondrivessurplusvaluetozero,andthatthisdoomscapitalism.Schumpeter (1942,p.31)interpretssurplusvalueasthepresentvalueofabnormalreturnstocapital,essentiallythe NPVsoffinancetextbooks;andarguescorrectlythatcompetitionindeeddrivesthesetozero.Thisstill disturbs the equanimity of an occasional MBA student, who learns in microeconomics how economic profits fall to zero under perfect competition, and then learns in Corporate Finance of the need for positive NPV projects that is, investments with positive economic profits. A wellplaced between termorsummerbreakobscuresthisdiscrepancyfromallbutthemostinsightfulstudents;butitstrue resolution, due to Schumpeter (1912), is that investment in innovation can have positive economic profitsforatime(Cable&Mueller2008);andthatsuccessfulinnovatorsareexceptionallyforesighted andcoldlyrationalrarities.Corporategovernanceisthusmostfundamentallyabouthowtoentrustthe governanceofbusinessestopeoplewhoarebothableandwillingtofindthepositiveNPVprojectsthat Schumpeter evokes to save capitalism from Marxist doom. Good corporate governance is therefore fundame3ntally about piloting firms through disequilibrium situations, where economic profits can be verylarge,andpositiveornegative. Ultimately,afreemarketeconomycreatessocialwelfarebyorganizingtheefficientdivisionof labor(Smith1776).Increasedefficiencyincorporategovernancethusplacescorporationsmorereliably underthecontroloftopexecutiveswithspecializedskills,talents,orinformationnecessaryforleading their firm, organizing is core activities, developing its future capabilities, and mobilizing capital to financing its growth opportunism. But designing institutions that better align CEOs personal utility maximization with value maximization also promises improved microeconomic efficiency. The normative goal of economic analysis in this context is trustworthy and wellqualified top corporate managers running firms that raise capital from rationally trusting investors. The positive goal of economic analysis in this area is enlightenment as to how top corporate insiders, firms, and investors actuallybehave,andtheeconomicconsequencesofthis.

2.

AGENCYPROBLEMSANDTHEWEALTHOFNATIONS

The social purpose of the financial system is to entrust peoples savings to firms governed by trustworthypeople.Schumpetersfamouscircularflowfailsifsaversdonottrustfinancialinstitutions orfinancialmarkets,andinsteadburycoinsintheirgardens.Butifsaverscaninvestinbankaccounts, bonds, and stocks knowing their money will be entrusted to genuine entrepreneurs who can capture
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genuine economic profits, the economy can mobilize its capital to finance huge firm capturing vast economies of scale, daring technological innovators, and perceptive entrepreneurs who perceive previouslyunexploitedprofitopportunities(Mueller2006a).

2.1

BIGBUSINESS,TRUST,ANDRICHES

Rosenberg and Birdzel (1986) argue that the joint stock company and other similar business organizationalformsthatletanonymousinvestorsassemblehugepoolsofcapital,andtheinstitutional arrangements necessary to them, are fundamental to how the West grew rich and surpassed previouslymoreadvancedcivilizationssuchastheArabWorld,China,andIndia.TheWestdeveloped institutionsthatletentrepreneursassemblevastpoolsofcapitalfromdiverseinvestors,whiletherest didnot. Forlargepubliclytradedcompaniestobeviable,saversmusttrustcorporateinsiderstogovern

efficiently.Insiderscanmakecommitmentstodosoatthefirmlevelbygrantingshareholdersvoting rights, nominating trustworthy directors, mandating independent board committees, voluntarily disclosingimportantinformation,adoptingmanagerialincentive payschemes,andthelike.However, Rosenberg and Birdzel stress how countrylevel institutional developments are more important to the credibilityofsuchcommitments.Promisestohonorshareholdersappearincrediblewithoutpredictable laws and regulations governing financial markets, efficient and dispassionate courts, honest civil servants,mandatorydisclosurerules,responsiblegovernment,andthelike. WiththediscoveryofsearoutestoaroundAfricatoAsiaandoftheNewWorld,thespice,fur,

tobacco,andslavetradespromisedhighreturnsbutrequiredvastcapitaloutlaysbeyondthecapabilities of even the wealthiest merchants and aristocrats. The solution to this quandary, the joint stock company,was17thcenturyDutchinvention.1 Before the invention of the joint stock company, maritime trade was organized one ship at a

time.Attheendofeachvoyage,theshipandcargoweresoldandtheproceedsdividedbetweenthe captain and crew, the provisioners, and the financiers with each partys dividend (in the arithmetic sense) prespecified in the contract. Financiers diversified the risk of loss at sea by buying shares in multiplevoyages,ratherthanbackingasingleship.Overtime,thesearrangementsexpandedtoinclude severalshipsorallvoyagesforafixednumberofyears.

SubsequentparagraphsdrawfromFrentrop(2002). 5

The modern worlds first joint stock company, the Dutch East India Company or Vereenigde OostIndischeCompagnie(VOC)wasformedin1602.2Itwas,accordingtotheprominentinvestorIsaac le Maire (15581624), governed in a way entirely absurd and impertinent to the displeasure and complaint of both the people in the street and the investors.3 This displeasure arose because, to le Mairesfury,theVOCdirectorsrefusedtodissolvetheventure,andinsteadusedeachvoyagesprofits to finance the next, paying dividends from the residual only. Moreover, they appeared intent on continuingthisabsurdpracticeindefinitely!LeMairewantedhismoneyoutoftheVOCbecausehe felt its directors were running the company too laxly. They were building fine houses along Amsterdamsbestcanals,butlettingothersgrabpromisingbusinessopportunitiesinAsia. On January 24 1609, in what (to our knowledge) is the first recorded corporate governance

dispute, le Maire formally charged that the directors sought to retain anothers money for longer or use it ways other than the latter wishes and petitioned for the liquidation of the VOC in accordance withstandardbusinesspractice.Thepetitionwasdenied,andinvestorswhowantedoutwereforcedto findanotherexitstrategy.TheonlyoptionlefttothemwassellingthesharesoftheVOCtheyownedto other investors, for some merchants who had not participated in the initial voyage were indeed interestedinearningdividendsfromasecondroundofvoyages. BecauseleMairelost,anewbusinessmodelarosethepubliclytraded,indefinitelylonglived,

joint stock corporation with publicly traded shares. This innovation financed the successive waves of industrialrevolutionthatcreatedthemodernworld.ButleMairewasalsoquitelikelycorrectinarguing that the directors of the VOC were growing fat and indolent, living off the shareholders hardearned money. Todays top managers have moved on, graduating from fine canal houses to Lear Jets, and shareholders object just as vociferously. And todays top corporate managers, just as confidently, assureshareholdersitsallactuallyintheirbestinterests. Ultimately, Dutch shareholders accepted the new model, and British organizers copied it,

especiallyaftertheGloriousRevolutionof1688broughtDutchcourtiersandideastoLondon.Vastpools ofcapitalsoonfundedhugejointstockcompanies,liketheBritishEastIndiaCompanyandtheHudsons BayCompanywhich,attheirapogees,ownedsizablefractionsofIndiaandCanada,respectively.Others organizedsettlercolonies,slavingexpeditions,andslaveplantations.ThemodelsoonspreadtoFrance andacrossEurope.

Lit.UnitedEastIndianCompany.TheVOChadantecedentsinFlanders,andprobablyelsewhere;andbusinesses similartojointstockcompanieslikelyexistedinRomantimes(Malmendier2005). 3 (Frentrop2002,c.2)superblydocumentstheearlycorporategovernancedisputesoftheVOC,andisoursource forthefollowinghistoricalcasestudies. 6
2

Questionable business models, especially slaving and slave plantations, and later the opium

trade in China, attracted opprobrium to joint stock companies. But so did a popular perception of rampant mismanagement. Writing more than half a century after Smith (1776, bk. 5, c1, pt. 3, art. 1) despairsthatThedirectorsofsuchcompanies...beingthemanagersratherofotherpeople'smoney than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master's honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore,mustalwaysprevail,moreorless,inthemanagementoftheaffairsofsuchacompany. Courts,legislatures,andregulatorseversincehave soughttoachievethevastpoolsofcapital

joint stock companies permit without the negligence and profusion Smith denounces. As noted above,RosenbergandBirdzell(1986)arguethatwesterncountriesfirstdevelopedinstitutions,legaland informal,thatbroughtthisgoalcloserthaneverbefore,andthatthisishowtheWestgrewrichand escapedtheMalthusiantrapthatonceboundeverypartoftheworldequally. Subsequent research in corporate governance elaborates on this theme. Over the four

centuries since the VOC first defied its shareholders, much has changed to better protect public shareholdersinjointstockcompaniesandsimilarstructureslistedtrusts,listedlimitedpartnerships, widelyheldcooperatives,andthelikefromerrantorineptinsiders.Insomecountries,moreefficient hierarchies that better let honest and competent insiders credibly commit to good governance encouraged broader, deeper, and more efficient capital markets in a virtuous circle or expanding prosperity; while in other countries, this feedback loop either fails to form or quickly collapses after occasionally materializing (La Porta et al. 1997; Rajan & Zingales 2003), preserving de facto feudal institutions(Haber2000;Acemogluetal.2001a,b)

Differences in national institutions therefore merit the interest of corporate governance

researcherseitherasfactorsdirectlyresponsibleforthesedifferencesorasinstrumentsbehindother factors that are responsible. However, before exploring these issues, we pause to consider how governancequalitycanbemeasuredandmodelled.

2.2

WHOGOVERNSFIRMSMATTERS

The literature on agency problems uses a range of models and notation that remains inconsistent. However,commonthemesareevident.CorporateinsiderscreatewealthworthVfromcapitalK,and the wealth created, V = V K, is the NPV of the profits of their ventures. Agency problems arise
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becausetheinsidersmustprovidetheinvestorsthepeoplewhoprovidedthecapitalwithareturnr thatishigherthegreatertherisktheinvestorsperceiveintheventure.Businessventureshaveintrinsic risk,butagencyproblemsaddtothisriskifinsidersmightkeeppartofr,orrunthefirmtoenhancetheir utility and leave insufficient funds to pay the return the investors expect. Perceiving these elevated risks,rationalinvestorswithholdcapitalunlessthepromisedreturnisveryhighormeasuresareinplace to make the actual payment of the return credible. Agency problems thus increase firms costs of outside capital, and sufficiently serious agency problems preclude access to outside capital altogether (LaPortaetal.1997). The scope for agency problems depends on the benefits b corporate insiders pay themselves.

Entrepreneurscontributingforesight,rationality,creativity,orotherscaretalentsthefirmneedsmerit compensation bE. Since this compensates them for their skill in creating value, it is theoretically paid entirelyoutofVandleavessufficientearningstopayinvestorsr.However,utilitymaximizinginsiders determine their own compensation, within the limits the countrys regulations and the firms contractualobligationspermit. Thebenefitsinsidersgleanthuscontainotherterms.Theseprivatebenefitsofcontrolcomein

twoflavors.Someprivatebenefitssocialstatusandthesheerutilityofpower,forexampleneednot compromise the firms ability to allocate resources optimally, though they can if their consumption induces unqualified insiders to retain control. Other private benefits selfdealing, excess compensation, pet projects, pursuit of the good life at corporate expense, and the like can allocate resources suboptimally from the perspectives of as well as society. The former we call intangible privatebenefitsofcontrol,denotedbI,andthelatterwecalltangibleprivatebenefitsofcontrolbT. Agencyproblemsarisebecause,ingeneral,bEandbTareindistinguishableuntilafterthefact,andbI maybelargelyunobservable.Monitoringandcontrolmechanisms,whosecostwedenotem,cancurtail bT, but generally curtail bE and bI too. Thus, outside investors return is reduced by insiders tangible privatebenefitsbT;andmaybefurtherreducedifincumbentinsidersenjoymentofintangibleprivate benefitsbIinducesthemtoholdontocorporatepowerwhenmorequalifiedpeoplemighttakecharge. Theeconomicimportanceofsuchentrenchmentisevidentinthepositivestockpricereactionthatoccur uponannouncementsofthesuddendeathsofmanytopcorporateinsiders(Johnsonetal1985;Erbani etal1987;FaccioandParsley2009). The efficacy with which insiders have added to a firms value can be assessed by estimating Tobinsaverageqratio,q=V/K(Tobin&Brainard1976).Ifcorporateinsidershave,onaverage,added toafirmsvalue,q>1.Iftheyhave,onaverage,destroyedvalue,q<1.Sinceeventsbeyondinsiders
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controlcanalsocreateordestroyvalue,qisusuallyadjustedwithindustrybenchmarksandforother factorslikefirmsizeorage.However,wecanproceedwithoutlossofgeneralitybydeclaringthatq=1 +NPV/K,whereKisthefirmstotalstockofcapitalandNPVisthetotalaggregatednetpresentvalueof allthefirmsoperations. Figure1showsmeanfirmlevelestimatesofq,bycountry,fromthemid1990sfromLaPortaet al. (2002), who go on to show higher average q ratios in countries whose governments offer outside investors stronger legal rights against corporate insiders. Buttressing this finding, Gompers et al. (Gompersetal.2003)showthatUSfirmswithstrongercommitmentstoshareholderdemocracyintheir corporatechartersexhibithigheraverageqratios;andBebchukandCohen(2005a),Faleye(2007),and others show markedly depressed average q ratios in firms with staggered boards, that is, whose corporatechartersgrantdirectorsthreeyeartermswithathirdfacingreelectioneachyear. Figure1MeanTobinsAverageQRatiosaroundtheWorld The means of the Tobins average q ratios of the twenty largest listed firms in each country are proposed as gauges of the overall quality of corporate governance in each country. Values above 100% indicate a preponderance of value creating investments by the countrys corporations in the eyesoftheirpublicinvestors. Dataareforthemid1990s, andtheestimatesareconstructedby La Portaetal.(2002).
Argentina Australia Austria Belgium Canada Denmark Finland France Germany Greece Hong Kong Ireland Israel Italy Japan Korea Mexico Netherlands New Zealand Norway Portugal Singapore Spain Sweden Switzerland United Kingdom United States 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5

Thelimitationsonshareholderslegalanddemocraticrightsalsoclearlycausedepressedaverage q ratios, rather than the converse. When US states pass legislation constricting shareholders legal rights,theaveragesharepriceofallfirmsincorporatedinthosestatesdropssignificantly(Ryngaert& Netter1990;Jahera&Pugh1991),asdothepricesoffirmsthatmodifytheircorporatecharterstolimit shareholder democracy (DeAngelo & Rice 1983; Jarrell & Poulsen 1987, 1988; Bhagat & Jefferis 1991; Datta&IskandarDatta1996;Bebchuketal.2002);thoughsee alsoComment&Schwert(1995),who highlight how less democracy can create more value under the right management, and McWilliams & Sen (1997) and others, who highlight tradeoffs between different dimensions of shareholder democracy. An alternative approach Tobins marginal q (Tobin 1969), designated here q, assesses the efficiency of corporate investment on the margin. This must be distinguished from Tobins average q (Tobin & Brainard 1976), discussed above. Tobins marginal q = dV/dK, the marginal value the firms managementcreatesfromamarginalunitofcapital.4The(taxadjusted)optimalvalueofqisone,forif q>1thefirmoughttoexpandandifq<1ithasoverexpanded.Higheraverageq=V/K,incontrast, always signifies net value creation. Empirical work reveals directly estimated marginal q ratios to be closer to one (or its taxadjusted optimum) in firms about which investors have more information (Durnevetal.2004)andincountrieswithCommonLawlegalsystemsthataccordpublicshareholders strongerrightsagainstinsiders(Mueller,2005,Gugleretal.2004a;Gugleretal.2007).Empiricalstudies usingalternativemeasuresofinvestmentefficiencyfindsimilarcrosscountryresults(Rajan&Zingales 1998;Wurgler2000). Yet another approach compares the price of a firms stock price after it announces a large investment relative to the price before to back out investors estimate of the marginal q ratio of that investment(Morcketal.1990).Increasesinfirmsresearchanddevelopment(R&D)spendingsharply elevateshareprices(Chanetal.1990;Chanetal.2001),asdoforeignacquisitionsbyR&DintensiveU.S. firms (Morck & Yeung 1992), consistent with innovation as a source of genuine economic profits
Marginalqratiosarealsocalledprofitabilityindexesincapitalbudgetingtextbooks,andaverageqratioscanbe conceivedofasprofitabilityindexesforentirefirms,ratherthanmarginalprojects.Muchconfusionarisesinthe literaturebecauseoftheconfoundingofTobinsmarginalandaverageqratios(Durnevetal.2004;Gugleretal. 2004b,a),forHayashi(1982)showsextremelystronglinearityassumptionsareneededforqtoequalqand Durnevetal.(2004)findthemempiricallyuncorrelatedinUSdata.Thevalidityofbothmeasuresdependsonthe efficiencyoffinancialmarketsthatis,oninvestorsaccuratelyassessingthevalueimplicationsofallthefirms investmentopportunitiesanditstopmanagersdecisions.Ifirrationalinvestorsbiasassetprices,Vmustbe reinterpretedasanunobservablefundamentalvaluethatwouldprevailunderfullrationalityandfullinformation. Also,amarginalqofoneindicatesonlyefficiencyofcapitalallocationonthemargin;anddoesnotindicatethe completeexploitationofallvaluemaximizinginframarginalinvestmentopportunities. 10
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(Schumpeter 1912; Grabowski & Mueller 1978). In contrast, corporate takeovers, among the largest capital investments firms undertake, more markedly depress the share prices of acquiring firms with more evident agency problems (Morck et al. 1990) or in countries whose legal systems offer public shareholdersweakerlegalrecourseagainstinsiders(Mueller&Yurtoglu2007).Thechangeinvalueof thetargetandbiddercombinedsuggestnetvaluecreationinmanycases,butthemerefactthatnum valuedestroying takeovers happen suggests that corporate insiders gain personal utility from ruling over larger business empires, regardless of their profitability (Morck et al. 1990; Mueller & Sirower 2003). Determiningtheoptimalprotectionofshareholdersrightsiscomplicatedbyseveralinterrelated considerations.First,shareholdersentrustcorporategovernancetotopinsidersbecausethoseinsiders possessexceptionalforesight,rationality,orcreativity.Thismeansshareholdersrecognizethatinsiders arebetterqualifiedtogovernthefirm,andthatexcessiveshareholderpowermightinterferewiththis. Indeed, limits on shareholder democracy correlate with both unusually good and unusually poor corporateperformance(Adamsetal.2005;Adams&Ferreira2007),suggestingthatdemocracylimits bothextremes. Governmentscanimpose conditionsoncorporate charters,forcefirmstospend money making themselves transparent, and assign shareholders stronger rights in court. All such measures can limit corporate insiders freedom to extract private benefits of control, but always at a cost. Just as more democraticcharterscanlimittrulycreativeCEOsfreedomofaction,transparencyrequirementsentail auditing and compliance costs and legal rights enable opportunistic and even extortionary lawsuits (Jensen&Meckling1976).

2.3

SHAREHOLDERVALUEASANIMPERFECTGOVERNANCEMETER

The agency literature tends to identify superior corporate governance with higher share prices. Normative chapters in economics and finance textbooks charge firms with maximizing net present values,theexpecteddiscountedvaluesoffutureprofits.Thismakessense,foroutsideinvestorsalmost alwaysinvestsolelytogrowtheirsavings.Obviously,asoleproprietorshipmaximizingitsownersutility andfinancedsolelywithhersavingsentailsnoagencyconflict,forownerandmangerareone;though the textbooks describe this situation poorly. But capitalism prospers off specialized firms exploiting economiesofscale,andthistypicallyrequiresmobilizingverylargepoolsofoutsideinvestorscapital. Thisjustifiesshareholdervalueasacorporategovernancemetric;however,conditionsunderwhichthe metriccangoaskewmeritnote.
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First, shareholders are not the only people with investments in a firm. However, the prices of firms other securities bonds, debentures, bank loans, etc. fluctuate relatively little compared to stockprices.Afirmsobligationstoitsotherinvestorsalmostalwayshavelegalpriorityoverthosetoits shareholders.Firmswithcashflowshortfallsmustcutorskipdividendsfirst.Onlyiftheshortfallisvery large does a firm lay off employees or miss an interest payment, for the former triggers often costly laborlawsandthelattertriggersbankruptcy.Thus,anycashflowshortfallsinitiallyhurtdividends,and hence shareholder wealth, before affecting any other securities. Likewise, any unexpected positive revisionsinafirmsfuturecashflowestimatesnormallyaugmentexpectedfuturepayoutsavailableto commonshareholders,andthusraisetheshareprice.Bondholdersdonotgethigherinterestpayments wheneverthefirmhasanunusuallygoodyear.Consequently,mostofthevariationinafirmsmarket value,andthereforeinitsaverageqratio,isduetovariationinshareholdervalue. This is the fundamental reason why corporate governance must focus on shareholder value. Shareholders are not more important than the firms other claimants; but their squawking amid plummeting share prices turns out to be a highly sensitive corporate misgovernance alarm system. If shareholders anger can prevent or reverse misbegotten corporate policies, creditors and workers are protected.5 Nonetheless, many countries charge top insiders with balancing shareholders interests against those of all stakeholders creditors, employees, retired employees, consumers, suppliers, the environment, the state, the community, and so on seemingly to the detriment of overall wealth creation(KlausGugler&Yurtoglu2003)andquiteprobablytooverallemploymentlevelsaswell(Jensen &Meckling1979;Faleyeetal.2006). Second, stock prices can misrepresent the quality of corporate management. If the firm is

perfectlytransparent,publicinvestorscanestimatethecashflowseachofitsprojectswillgenerateinall future periods. But the public relies on public information, so shareholders might think brilliant entrepreneurs mad and depose them, or laud truly mad corporate insiders as brilliant. The former misperceptionretardsgrowth,andthelatterdestroysexistingwealth. Thisseeminglyobviouspointnonethelesscausesmuchconfusion.TheDutchcourtthatupheld

the VOCs right to life encapsulated this confusion in a mantra for disgruntled shareholders: if you
Ofcourse,thisearlywarningsystemcanfail,andacorporatedecisioncanbesoawfulastoadverselyaffect creditors,workers,orotherstakeholdersbeforeshareholderscansoundanalarm.Thelawsofmostcountries recognizethat,insuchcases,topinsidersdutyisexpandedtoencompassallaffectedstakeholders.Moreover,if shareholdervalueisalreadynearzero,shareholdersmayfavorhighriskgamblesthatmightsavethefirmbutare likelytoleavecreditorsorotherstakeholdersworseoffinaloomingbankruptcy.Insuchcases,thelegalsystems ofmostcountriesshiftinsidersdutiestowardscreditorsnowthelikelyresidualclaimant. 12
5

dontlike thewaythefirmisrun,sellyourshares.Ifthefirmwasbadlyrunwhentheshareholders boughttheirshares,andisnoworserunnow,thisisreasonableadvice.Butsellingoutisnosolutionto unexpected misgovernance. In an efficient market, the shares of an unexpectedly mismanaged firm dropinstantly,andfetchtoolittletoolatetoassuagedisgruntledshareholders. However, outside investors sometimes do misgauge the true value of a firms ongoing

investments.Firmsarenotperfectlytransparent;theirinnerworkingscanbeoccludedbyunavoidable informationgatheringandprocessingcosts,orbydeliberateobfuscationsdesignedtoconcealdubious managementdecisions.Taxesandothertransactionscostsfurthercomplicatethepicture.Thevalidity oftheefficientmarketshypothesisthespeedandaccuracywithwhichall relevantnewinformation accurately revises stock prices to reflect fundamental values is therefore critical to the validity of shareholder value being a defensible metric of corporate governance. Tobin (1984) thus stresses the functionalformoftheefficientmarketshypothesisasholdingiffinancialmarketsareefficientenough toguidecapitaltoitshighestvalueuseswithatolerablylowerrorrate.Theextenttowhichfinancial market inefficiency biases corporate governance is one of the most understudied topics in current financeresearch(thoughseeWurgler2000;Durnevetal.2004). Third, bubbles and financial panics are especially troublesome deviations from market

efficiency,andrecentworkinbehavioralfinancesuggeststhatinvestorsperceptionscanbedistortedin morenormalmarketconditionsaswell.Allthestocksinanindustry,oreveninacountry,canriseorfall because of altered terms of trade, consumer tastes, or government policies. Thus, the high Tobins average q ratios of US firms in Figure 1 might reflect more sensible regulations, a low dollar, or an expanding stock market bubble in the mid 1990s. Some evidence suggests that firms share prices relative to each other retain a relationship to their relative underlying fundamentals even as prices overall rise and fall with bubbles and panics (Samuelson 1998; Jung & Shiller 2005). These possible problemsmotivatemeasuringthequalityofgovernancebyfirmsaverageqratiosrelativetoindustryor countrybenchmarks(Morcketal.1988). Fourth, companies can go from seemingly robust financial health to probable bankruptcy

quickly, depressing both their equity and debt valuations, and even putting employment and factor market contracts at risk. Once bankruptcy is in the cards, the values of debt and other contractual obligationsfluctuatetoo,changesinshareholdervaluationarenolongerthewholepicture.Ifonlydebt is affected, switching the focus from shareholder value to the firms total market value is viable. If supplierandemploymentcontractsareputatrisk,thesevaluationdecreasesmustbeweighedintoo.

13

Fifth, political rent seeking can disconnect firms NPVs, and therefore shareholder value, from

genuineeconomicprofits.Inmanycountries,oneofthehighestNPVinvestmentfirmcanundertakingis bribingpublicofficialseitherdirectlyor,morecommonly,indirectlyviafavors(Baumol1990;Murphy et al. 1991) to gain stateprotected market power, subsidies, tax breaks, or regulatory favors . The importance of such favors become visible when corrupt governments change, as when the stocks of IndonesianfirmsfavoredbyPresidentSuhartocollapseduponhisoverthrow(Fisman&Miguel2008).Is afirmwhosesharepricesoarsbecauseofthehugelyprofitablebribingofapoliticianawellgoverned firm?Isafirmillgovernedifitrefusestobribeofficials,andthereforesuffersregulatorydisfavorthat depresses its profits and share value? The answer to both is affirmative if shareholder value is the metricused.But,thisismisleadingbecausecorporategovernanceisfundamentallyaboutallocatingthe economys savings efficiently. Corruption can twist shareholder value badly out of alignment with efficientcapitalallocation. Despiteallofthesecaveats,shareholdervalueisthebestcorporategovernancegaugeavailable.

Shareholders,likecanariesinamine,areespeciallysensitivetodanger.Theirsquawkingisasometimes overlysensitivealarmsystem,andtheyoccasionallydozethroughanapproachingcrisis.Wetherefore keepoureyeonshareprices,butbearinmindtheconditionsunderwhichthisgaugecanstick.

3.

CONSTITUTIONALFINANCE

Good corporate governance is difficult because of an underlying time inconsistency problem: before corporate insiders sell shares to outsiders, they promise value maximization so the shares fetch the highestpossibleprice.Afterthesharesareissued,thesameinsidersrationallyappreciatetheutilityof policiesotherthanshareholdervaluemaximization.Goodcorporategovernancethusentailsacredible commitment against insiders maximizing their utility ex post. The problem thus resembles that of a governmentthatmusttieitsownhands(Kydland&Prescott1977),andthustheproblemofdesigning an optimal constitution (Buchanan & Tullock 1962; Mueller 1996). The best tether is often unclear becausethenonvaluemaximizingactionscorporateinsidersmighttakeareoftenhardtoanticipate evenfortheinsidersthemselves. This is most evident in the different attitudes towards good governance measures held by

insiders of younger versus older firms. Younger firms insiders, contemplating issuing new shares to public investors, logically want each share to fetch as high a price as possible, and so favor strong monitoringandcontrolmechanisms,whichareindeedmorecommonplaceinthechartersoffirmswith more bountiful growth opportunities (Durnev and Kim, 2005). But a mature or declining firms share
14

issuance days are in its distant past, and its insiders quite plausibly come to appreciate larger private benefits of control to a higher share price (Grabowski & Mueller 1975). Thus, a time inconsistency problem inevitably arises as a firm ages, despite the most earnest protestations of the young firms insiders. How countries deal with this time inconsistency matters, for this affects the pace of

Schumpeters creative destruction and thus the countrys longterm economic growth (Shleifer & Wolfenzon2002;Rajan&Zingales2004;Morcketal.2005;Mueller2006a).Thisisreadilyillustratedby the venture capital cycle documented by Gompers and Lerner (Gompers & Lerner 1999), whereby innovativeentrepreneursbuildnewfirms,entrustthemtoprofessionalmanagers,sellout,andusethe proceeds to start another innovative venture. This cycle, or something analogous to it, appears important in the United States and other highincome economies, but is altogether lacking in low incomeeconomies(Morcketal.2005).Ifprofessionalmanagerscannotbetrusted,theentrepreneur muststayincharge.Shecannotcashout,norcanherchildren,norherchildrenschildren.Rather,they musttaketheirpayintheformofprivatebenefits.Suchaneconomyisbereftofentrepreneurshipand itscapitalassetsaregovernedbyheirs,whoarerarelythebeneficiariesoftalentaswellaswealth.To avoid this fate, capitalist economies need institutions that render professional corporate managers crediblytrustworthybyconstrainingtheirscopeforprivatebenefits. The corporate finance literature often follows Jensen and Meckling (1976) in referring to corporate insiders generic nonvaluemaximizing behavior as shirking relaxing to enjoy a philosophersgoodlifeinsteadofstrivingtodefeat Keynesdarkforcestounveilthefuture.Thisis historically valid, for in his complaint to the Dutch court, le Maire accused the VOC directors of neglecting the company to enjoy quiet lives of luxury in expensive Amsterdam canal houses. It is also empirically supported, for John et al. (2008) present evidence of personally riskaverse US CEOs safeguardingtheirperksandpaybyshunningriskyprojectsthatnonethelesslikelyhadpositiveNPVs. YetotherutilitymaximizingCEOsmightspendtheirinvestorsmoneytobuildegosatisfying,but ultimately financially unstable, corporate empires (Jensen 1986), to pay themselves handsomely for running the firm poorly (Jensen & Murphy 1990), or on perks like executive jets (Yermack 2006). UtilitymaximizingCEOsmightrestricthiringtoafavoredgenderoranethnicity,ortoegopleasingyes men,eventhoughthisfillsthefirmwithsuboptimallyqualifiedemployees(Becker1957).Politicallyor socially aware CEOs might even spend their investors money lobbying for favored political agendas (Hgfeldt 2005) or funding pet charities (Atkinson & Galaskiewicz 1988) all with the best of utility maximizingintentions.
15

Thelistoftangibleandintangibleprivatebenefitsofcontrolinsidersmightextract,andthecost to share prices of these actions, is impossible to complete for it grows naturally with financial innovationslikestockoptions,technologicalinnovationslikecommuterhelicopters,newtaxloopholes, andsoon.Crediblyprecommittingtoavoideachandeveryconceivableitemonthislistisbeyondthe abilityofeventhefinestcontractlawyers.Crediblecommitmentstogoodgovernancemustthusbeofa moregeneralcharacter:theymustbeopenendedpromisestoinformandempowershareholders Genuinelycrediblecommitmentsmaythereforerequirethatpublicpolicyenforcegovernance

standards.Empiricalevidencesuggeststhatpublicpolicyistypicallymoreeffectivethanmeasurestaken byindividualfirmsinreducingagencycosts(Doidgeetal.2007).Butargumentsthatregulations,suchas theSarbanesOxleyActintheUnitedStates,imposeinefficientlylargecompliancecostsonlistedfirms cannotbedismissedsummarily(Romano2005). Obviously,themorecrediblethegoodgovernancemeasureswithwhichtheentrepreneurcan

bindtheprofessionalCEOwhosucceedsher,thehigherthereturntoentrepreneurship.Publicpolicies that enforce higher standards of corporate governance are thus defensible to encourage entrepreneurship.Sincenewfirmsoftenbringimportantproductivityenhancingtechnologiesintoplay, this has dynamic efficiency consequences (Schumpeter 1912). Even absent new technology, higher returnstothefoundersofnewfirmsencourageentryandenhancecompetition. This concern for long term dynamic efficiency, rather than ethical arguments about

expropriation,isthemoredefensibleeconomiclogicunderlyingcorporategovernancelaws,regulations, and standards. These let corporate insiders tie themselves and their successors to the mast, so that publicshareholderscanrationallyexpectagencyproblemstobemitigated,andthuscanbepersuaded topaymoreforcorporateshares.SinceSchumpeter(1912)arguesthatmucheconomicgrowtharises through innovative entrepreneurs founding new firms, unnecessarily large agency costs could reduce socialwelfarequitesubstantiallyoverthelongrun. Different countries use different mixes of alternative mechanisms to encourage shareholder valuemaximizationanddiscourageinsidersfromshirkingorotherwiseextractingprivatebenefits.And given these, different firms can constrain their insiders in different ways by relying on some available mechanisms more than others. These mechanisms range along a spectrum from open access governance, where shareholder democracy (with all its flaws) is paramount, to restricted access governance,wherebigbusinessisentrustedto(hopefullyenlightened)corporatedespots.

3.1

SHAREHOLDERDEMOCRACY
16

Themostbasicsuchmechanismisshareholderdemocracy,asspecifiedinlawandbythefirmscharter. A corporate charter is essentially a firms constitution, specifying voting rights, constituencies, voting procedures,allocationrulesforboardseats,andthelike.Thisreflectshistoricalaccident:Jointstock companiesarosebeforegovernmentswerereadyforthemand,inEnglandandelsewhereformedunder lawscribbedfromthosepertainingtomunicipalgovernments(Dunlavy2007). Thismadeacertainsense,inthatbothtownsandjointstockcompaniesarethejointproperty

of large numbers of strangers, whether landowners or shareholders. Thus, both are legal persons capableofowningcorporatepropertyandrunbyelectedboardsandchiefexecutiveofficerswithinthe constraintsofbylawsandcorporatechartersthatspecifyrulesforelectingboardsandenactingbylaws. Someearlycorporatechartersevenimitatedmunicipalelectionsingrantingonevotepershareholder, ratherthanthemodernstandardofonevotepershare(Dunlavy2007). Corporatechartersandbylaws,likethoseoftownsandcities,specifyingvotingrights,election

rules,administrativeorganization,financialaccountability,auditprocedures,andthegeneralfreedomof action entrusted to the board and management. Some corporations can thus be substantially more democraticthanothers.Gompersetal.(2003)rankthestrengthofshareholderdemocracyineachofa largesampleofUSfirmsinthe1990s,andfindthatmoredemocraticgovernancecorrelatessignificantly withhighershareholdervaluationsandsuperiorfinancialperformance. Shareholders ultimate trump card is the annual general shareholders meeting, at which all

shareholderscanvoteouttheboardofdirectorsiftheydontlikethewaythecompanywasrun.Anew boardcanthenfiretheoldmanagers,hirenewones,andsetthecompanyonanewcoursemoretothe shareholdersliking.Tostayincharge,theVOCsdirectorshadtoconvinceamajorityofitsshareholders that the strategy of staying in business perpetually made sense. They succeeded in part because shareholderswhodisagreedsoldoutandotherswhoagreedboughtin. Howshareholderdemocracyworksthusdependscriticallyonthecorporationsvotingrulesat that meeting (Bebchuk & Cohen 2005a). Corporations experimented with remarkably variegated shareholdervotingrulesthroughthe19thcentury(Dunlavy2007).Oneespeciallydemocraticmodelwas onevotepershareholder, based on a direct analogy to municipal corporations (Maier 1993). Other earlyEnglishtradingcompanies,forexampletheHudsonsBayCompanys1670charter,pioneeredone votepershareinstead,andthelattermodelwonoutbythe20thcentury. Thelogicbehindrestrictinglargeshareholdersrelativepoweristhatafirmstopmanagerscan better act in all the shareholders true interests if they are not controlled too heavily by any given shareholderpreciselythemessageintheVOCexamplecitedabove.Butanaprioriequallyplausible
17

chainofreasoningholdspowerfullargeshareholdersimprovethequalityofcorporatedecisionmaking because they have the sophistication, resources, and financial incentives to monitor the firm and to intervenetocorrectwrongstrategies(Shleifer&Vishny1986).Thelatterlogicmightnotjustifysuper votingsharesforinsiders,butitcanjustifyonevotepershareunderappropriateconvexityassumptions (Grossman&Hart1988). Other companies in the 19th century had sliding scales, where shareholders with larger stakes hadfewervotespersharesoasnottomarginalizesmallershareholdersutterly,whilestillgivinglarger shareholdersmoresay(Dunlavy2007).6Relatedstructuressurvivetothepresentinmanycountriesin the form of voting caps, which restrict any shareholder from voting more than a certain fraction of a companys shares. For example, voting caps currently limit the power of large shareholders in all the majorCanadianbanks. But these relics are oddities. In 1811, New York State mandated onevotepershare (for

manufacturingcorporations),andotherstatesfollowedsuit.Onevotepersharebecamethestandard for shareholder democracy by the early 20th century. Onevotepershareholder is now barely a historicalfootnote,andfurtherreformstoletinsidersshareshavesuperiorvotingpushedsomefirms andcountriestoantidemocraticextremes,whichweexplorebelow. Even under onevoteper shareholder, consulting all the shareholders for every business

decisionwasimpracticableevenmoresoinearliercenturieswhentransportationbyhorseorclipper madequickmeetingsimpossible.Thisforceddispersedshareholderstoentrustimportantdecisionsto theboardandtopmanagement. Electing highly trustworthy directors was not always easy. For example, Charles II granted

Rupert Palatyne, his cousin and a royalist Civil War hero, a monopoly on the fur trade out of most of whatisnowCanada.PalatyneorganizedanIPOin1670,andtheHudsonsBayCompanysshareholders electedaboardofelitecourtiers.From1685to1690,theBayssharepricesoaredasitpaidlargeand increasing dividends, and then the whole board resigned. The new directors discovered the meteoric dividendswerefinancedwithassetsales,andthesharepriceplummetedaccordinglywellaftertheold directorssafelysoldalltheirsharesatthepeak.Thelawcourtshadnosympathyfortheimpoverished

AlexanderHamiltonsupportedsuchagraduatedvotingscaleinhisproposalfortheBankoftheUnitedStates, arguingthatAvoteforeachsharerendersacombinationofafewprincipalstockholders,tomonopolizethe powerandbenefitsofthebank,tooeasy.Anequalvotetoeachstockholder,howevergreatorsmallhisinterestin theinstitution,allowsnotthatdegreeofweighttolargestockholderswhichitisreasonabletheyshouldhave,and which,perhaps,theirsecurityandthatofthebankrequire 18

6

shareholders, for one of the old boards last decisions was to pay a special dividend in gold for the King. Over the subsequent decades and centuries, directors duties gelled around preventing such

abuses. At Common Law, directors fiduciary duty is to put aside their private interests, act for the shareholders, and treat all shareholders (even Kings) equally. In most Common Law countries, these dutiesarefundamentallegalprinciples. However, the Common Law courts may trust shareholder democracy excessively. First, most

smallshareholdersdonotvoteinfirmsshareholdermeetings.Thisbecauseatypicalsmallshareholder, perhapsowningonlyafewhundredorafewthousanddollarsworthofstock,mustspendconsiderable timeandmoneytobecomeinformedabouttheissues;andthesecoststypicallyexceedthedollargain governanceimprovementswouldcreateforher(GrossmanandHart1980).Second,mostshareholder votesresembleelectionstotheNorthKoreaPeoplesCongressmorethantotheNewYorkCityCouncil. Thetypicalelectionhasonecandidatestandingforeachboardposition,andshareholdersareoffered the choice of voting for the candidate or withholding their votes. The CEO traditionally selected the candidates,thoughexistingdirectorsarenowsometimesentrustedwithselectingcandidatesinstead. Contestedelectionsdooccur,butrarely.Aproxychallengeacampaigntoreplaceincumbent

directors with a socalled dissident slate of candidates is time consuming and expensive (Dodd & Warner1983;Brickley1986;Pound1988;DeAngelo&DeAngelo1989;Bhagat&Jefferis1991;VanNuys 1993;Mulherin&Poulsen1998;Romano2003;Davis&Kim2007).Dissidentsmustcampaignwiththeir own money, while insiders can use corporate funds; dissidents access to shareholders names and addresses can be constrained; and small shareholders may still not be motivated to investigate the issuesandvote.Proxycontestsarethereforerare,andoccuronlywherethecostsofmismanagement are perceived to be great (Bebchuk & Hart 2001). This means only extremely largescale shareholder valuedevastationislikelytoresultininsidersbeingturfedout.

3.2

REPRESENTATIVESHAREHOLDERDEMOCRACY

These and other limitations on direct shareholder democracy lead recent rounds of expert reports in Australia, Britain, Canada, and other Common Law countries to advocate more responsible representative democracy: more independent directors, independent lead directors or board chairs, and key committees composed of independent directors. The Sarbanes Oxley reforms in the US also mandategreaternumbersandresponsibilitiesforoutsiderdirectors.

19

The social psychology literature (Milgram 1974) shows that people tend to reflexively obey legitimateauthorityfiguresunlessdissentingpeersoralternateauthorityfiguresvoicedissent,sothese reforms are defensible as ways of limiting excessive director loyalty to CEOs and promoting critical thought (Morck 2010). Of course, endless debate over every decision is unhelpful, and an optimal amountofdissentoughttoexist(Landieretal.2009). Consistent with such a role for independent directors, Weisbach (1988) finds subpar performancemorelikelytotriggerCEOturnoverinUSfirmswhoseboardscontainmoreindependent directors. However, whether or not independent directors increase shareholder value is unclear. Althoughearlyworkfindsnocorrelation,morerecentstudiesindicateagrowingtraction(Kaplanand Weisbach 2010). This may reflect increasingly rigorous definitions of independence preventing CEOs selectingdirectorsbycombingthroughlistsoftheirfriendsforpeoplewhomeettheliteralcriteriafor independence. Defining independence for directors can be tricky. People drawn from the ranks of top

managementareclearlynotoutsiders;defyingtheCEOputstheirjobsatrisk.Peoplewithfinancialties to the firm its lawyers, accountants, marketing agencies, or suppliers are also unlikely to defy the CEO, for they risk losing business. CEOs often invite other CEOs to serve as independent directors, raisingthepossibilityoftitfortat(Axelrod1984)mutualsupportnetworksinsulatingeachotherfrom genuineshareholderdemocracy. Especially tight such networks of interlocking directorships are found in France, where the alumni of a few elite colleges fill most top government and business jobs (Kramarz & Thesmar 2006), often migrating from civil service to top business positions over their careers (Bertrand et al. 2006). Pistor(2010)detailssimilarlytightnetworksinterweavingthetopechelonsoftheCommunistPartyinto theboardsofChinesefinancialfirms.Reputationalconcernsmightkeepevenimperfectlyindependent directorsfocussedonshareholdervalueandfirmperformance(Fama1980;Fama&Jensen1983),and KaplanandReishus(1990)findseniorUSexecutiveswhosefirmscuttheirdividendsonlyhalfaslikelyas theirpeerstobeofferedadditionaloutsidedirectorships.Butloyaltytofellownetworkinsidersmight justaseasilyinduceadefensivehuddle(Hallock1997;Haunschild&Beckman1998). The effectiveness of shareholder democracy depends critically on both corporations charters

and bylaws, and on national standards. For example, American companies can adopt poison pills, rightsofferingsthatmassivelydilutethestakeofanyunfriendlyshareholderbentonacquiringenough stock to oust the board (Ryngaert 1988; Brickley et al. 1993; Brickley et al. 1994), or amend their corporate charters to establish staggered boards (Bebchuk & Cohen 2005b), which recast annual
20

shareholdervotesaselectingonlyonethirdoftheboardeveryyearforathreeyearterm.Bebchukand Cohenfindthattheseinnovations,especiallystaggeredboards,substantiallydepressshareholdervalue in US firms. In contrast, British and Canadian courts found these innovations to violate directors traditionalCommonLawdutiestotreatallshareholdersequallyandtoactforshareholders.Staggered boardsaredisallowedinbothcountries,andpoisonpillsarebannedinBritainandvulnerabletolegal challengeafterabriefstayinCanada.

3.3

MULTIPLECONSTITUENCIES

Shareholderdemocracyplaysaroleincorporategovernanceineverycountry,butsomerestrictiteven more severely than others. A major recent trend is the shifting of directors duties away from shareholders and towards more vaguely defined stakeholders. These reforms are inspired by GermanyandothercentralandnorthernEuropeancountriesthatlongexplicitlysetdirectorsafiduciary duty not only to shareholders, but also to stakeholders employees, customers, suppliers, the environment,thepeople,theState,etc.Differentcountriesoperationalizethisdifferently. AlargelistedGermanfirmtypicallyhasamanagementboard,orVorstand,chargedwithweak toweek operational decisions, and a supervisory board, or Aufsichtsrat, charged with higher level strategic decisions.Halfofthesupervisoryboardmembersinlargefirmsareelectedbyshareholders andtheotherhalfbyemployees,thoughthechair,anadditionalshareholderrepresentative,canbreak ties. In addition, German companies have works councils (Betriebsrat), elected by employees and empowered to veto human resources decisions. Supervisory board members owe a general fiduciary dutytoallstakeholders,thoughtheirconstituenciespresumablyaffecttheirpriorities. Thissystem,establishedbyAdolfHitlertoinspireboardswithadutytostakeholderssuchas

theirVolk,ReichandFhrer(Fohlin2005)stillinspiresprogressivereformerstoday.SeveralUSstates, beginning with Massachusetts and Pennsylvania, now mandate a Germanstyle fiduciary duty of directorstowardsallstakeholders,notjustshareholders(Karpoff&Malatesta1989).ArecentSupreme Courtdecision(PeoplesvWise)inCanadaalsoshiftsdirectorsduty,buttoactintheinterestsofthe corporation,ratherthanthoseoftheshareholders,creditors,employees,oranyotherstakeholders. This engenders considerable confusion, for the interests of a fictitious legal person are not readily discernable, and the court provides no further guidance. Recent reforms in Britain also move that countrysdirectorsdutytowardsabroaderresponsibilitytostakeholders,andalessexclusivedutyto shareholders.

21

Withstakeholderrightsascendant,shareholderdemocracyisnecessarilyweakened.CEOsand

directors,citingtheirdutiestootherstakeholders,caninstructtheirfirmslawyerstofightshareholders seekingtooustthem.Sincealmostanycorporatepolicycanbedefendedasintheinterestsofsome stakeholder, top insiders need only pick the stakeholders whose interests align with their own on an issuebyissuebasistodefendsequencesofentirelyselfinteresteddecisions.SinceArrow(1964)shows that no simple rule aggregates the preferences of heterogeneous constituents, such cynically self interestedgovernancecannotbejudgedsociallyworsethanalternativedecisionrules.

3.4

OPENACCESSCORPORATEGOVERNANCE

Inpolitics,theelectoratesultimatepoweristothrowthebumsout(Haberetal.2008).Shareholders have a similar last line of defence: the corporate takeover. If insiders let the share price fall too far belowitsreplacementcost7pershare,theyputtheirfirmonsale.Evenifthedismayedshareholders cannotreplacetopmanagement,theycanselltheirsharestoaraiderwho,uponacquiringundisputable control,canfiretheboardandbringinnewmanagement. IntheUSinthe1980s,serialraidersamassedhugefortunesbuyingupmisgovernedfirmswhose sharepriceswereseverelydepressed(Easterbrook&Fischel1982;Jensen&Ruback1983;Jarrelletal. 1988; Morck et al. 1989). After gaining control, the raider replaced management, imposed credible commitmentstogoodgovernance,andsometimesbrokebloatedfirmsupintomoremanageablepieces (Berger&Ofek1996).Thisdone,theraiderssoldthefirmsbackintotheopenstockmarket,wherethey fetched far more than acquiring the mismanaged firm cost. This market for corporate control saw raiders specializing in fixing broken firms, much like specialists in gentrification buying broken down houses,fixingthemup,andsellingthem.Criticismsthatraiderscreatenovaluebecausetheybuildno newfactoriesorofficebuildingsmissthisfundamentalpoint. Amoreconsideredcriticismisthatsomeraidersareworsemanagersthantheonestheyoust. Jensen(1986)arguesthategodrivenCEOssometimesusetakeoverstobuildshakycorporateempires that they cannot manage, and a wealth of empirical evidence now supports this (Lang & Litzenberger 1989; Morck et al. 1990; Lang et al. 1991; Opler & Titman 1993; Christie & Nanda 1994). This is plausible,formuchevidencesuggeststopcorporateinsidersgainmoreutilityfromrunninglargerfirms (Baumol1959;Grabowski&Mueller1972).

Chapter16inthisvolume,MergersandtheMarketforCorporateControlbyDMueller,providesamorein depthdiscussionoftheissuesdiscussedinthissubsection. 22
7

Another plausible criticism is that stock market bubbles can trigger nonsensical takeovers (Shleifer & Vishny 2003; RhodesKropf & Viswanathan 2004; RhodesKropf et al. 2005). Acquirers, whoseownsharesareboostedbyabubblein,sayhightechstocks,canusetheirovervaluedsharesasa currencywithwhichtobuyotherfirms,andcanagainamasshugecorporateempires.Oncethebubble bursts,formertargetshareholdersleftholdingtheacquirersnowgreatlydeflatedstockmaywellfeel shortchanged(Moelleretal.2005;Mueller&Yurtoglu2007). These problems call for better corporate governance of acquirer firms, not prohibitions of takeovers.Indeed,badacquirersinthe1980softenbecametargetsofmoreadeptraiders(Mitchell& Lehn 1990). Mueller (2010) points out that while hostile takeovers can be an effective constraint on managerialexcess,themarketforcorporatecontrolisnotsufficientlyeffectivetoeliminateallwealth destroying mergers. In particular, many countries and U.S. states curtail their markets for corporate controlinresponsetovariousmixturesoflegitimateandillegitimateconcerns. Somecountriesresistthistrendmorethanothers.InBritain,thecourtsnullifiedasuccessionof

devicesCEOstriedtousetostopraiders,andarobustmarketforcorporatecontrolpersists,preventing insiders from becoming too neglectful of shareholder value or they risk ouster by a raider (Cheffins 2009).Takeoversalsocontinuetoreininanyexcessivelyutilitymaximizingtopmanagersoffirmsthat lackdefensivearmamentsintheUnitedStates,Canada,Australia,andelsewhere. However,hostiletakeovers,wherearaideraggressivelybuyscontrolwiththeavowedpurpose ofoustingunderperformingtopmanagement,grewrareintheU.S.afterthe 1980sbecausepotential target firms top managers erected arrays of takeover defences (Mikkelson & Partch 1997). As mentionedin3.3,themostimportantarepoisonpills,rightsofferingsthatdiluteraidersstakesbefore theybecomelarge;staggeredboards,whichlockdirectorsintothreeyeartermswithathirdstanding forelectioneachyearandthusmakearaiderwaittwoyearsbeforereplacingamajorityofdirectors; andstatetakeoverlaws,whichempowerCEOstolitigateagainsttakeoverbids(DeAngelo&Rice1983; Linn & McConnell 1983; Jarrell & Poulsen 1987; Mitchell & Netter 1989; McWilliams 1990; Bhagat & Jefferis 1991; Comment & Schwert 1995; Borokhovich et al. 1997; Bebchuk et al. 2002; Cheng et al. 2005). TakeoversstillhappenintheUS,butnowrequiretheconsentoftheincumbentmanagement, who have the power to waive poison pills, fire staggered boards, and undo other takeover defences. Underperforming managers now expect large golden parachutes, side payments for dismantling takeover defences and stepping aside (Hartzell et al. 2004). Since the potential gains from fixing up broken corporations can be very large, even very large golden parachutes can still leave the control
23

transaction viable. Only if the CEO gleans so much utility from remaining in control that no feasible goldenparachutesidepaymentcaninducehimtostepasidedoesthemarketforcorporatecontrolfail. Since these negotiations are conducted behind the scenes, we have no reliable estimate of the full shadow cost of takeover defences to the US economy in terms of takeovers of underperforming corporationsthatdidnothappen. Underperforming firms in other countries use different takeover defences. In Japan, the

keiretsu defence was long favoured (Sheard 1991; Morck & Nakamura 2005). This entails a group of CEOs,whoallfearousterbyraiders,greatlyincreasingtheirfirmstreasurysharessharesthatexist, buthavenotbeensoldtoanyinvestor.Thefirmsswaptheseshareswitheachothersothateachends upwithofamajorityofitssharesheldbyotherfirmsinthenewkeiretsugroup.Eachofthirtyfirms mightendupwitha1%or2%stakeineveryotherfirminthegroup,andeveryfirminthegroupthen endsupmorethan50%ownedbyotherfirmsinthegroup.Atnocost,thesefirmsarenowallinsulated fromraiders,forthegroupsCEOspledgenevertoselltheirsharesineachothersfirms.Thekeiretsu defence remains important in Japan, but shareholder pressure to sell interlocking shares has induced manyfirmstoadoptpoisonpillsinrecentyears.8 Dutch firms use a variety of oligarchic mechanisms that let insiders control seemingly widely

heldfirmswithnofearofshareholderrebellion(deJongetal.2001;deJong&Roell2005).Asnoted above,largeseeminglywidelyheldGermanfirmsarecontrolledbythecountrysbigbanks,whichare empoweredtovotesmallshareholdersshares(Fohlin2005). ButmostcountriesinContinentalEurope,Asia,andLatinAmericahavenoeffectivemarketfor

corporate control. This is because most listed companies have a controlling shareholder, usually a wealthybusinessfamily,whocontrolsaneffectivemajorityofthevotesintheshareholdermeeting,and thusessentiallyappointstheboard(LaPortaetal.1999;Fogel2006).AslongastheCEOandothertop managerspleasethatshareholder,theirpositionsaresecure.Inthesecountries,corporategovernance istherealmofdespots(Gugleretal.2007).

CORPORATEDESPOTS

Likethegovernmentofnations,corporategovernancecanprovideveryopenaccessorrestrictdecision makingtotinyelitesofinsiders(Northetal.2009).Entrustinggovernancetoacontrollingshareholder bringstothecorporationtheefficiencyofthedictator(Blau1957).Asinpolitics,abrilliantandhighly

Seee.g.AndrewMorse&SebastianMoffett,2008.Japan'sCompaniesGirdforAttackFearingTakeovers,They RebuildWallsTheRiseofPoisonPills.WallStreetJournal 24
8

ethicaldespotcanprovideverygoodgovernment(Johnson1910).Butseveralstrandsofempiricalwork convergetoshowthat,againasinpolitics,despotsofthisilkareexceedinglyrare.

4.1

ENLIGHTENEDCORPORATEDESPOTS

Ifafirmscontrollinglargeshareholderdemandseconomicefficiency,topmanagementhaslittlechoice but to forego maximizing their utility functions and maximize value (Shleifer and Vishny 1986). The individualsorinstitutionsthatcanaffordtoholdlargeequityblocksinlargecorporationsaretypically either enormously wealthy families or institutional investors like pension funds, insurance companies, banks,governmentorgans,andlargecharitablefoundations.Alloftheseemploysophisticatedfinancial analysts,accountants,andlawyerswhocananddotakeactiontomakesurethefirmstheiremployer controls are run as their employer wants. Because large shareholders have large multimillion dollar investments in their firms, the benefits of better management quite often outweigh their costs of becoming informed and taking action. Large shareholders thus overcome the free rider problem of GrossmanandHart(1980). Institutional investors effect on corporate governance appears to vary markedly across

countries. British pension funds and insurance companies were empowered by postwar Labour governments to finance workers retirements, and are largely run by independent professional fund managers. Black and Coffee (1994) describe how the institutional investor whose portfolio is most heavily weighted in a problem firm is expected to take the lead in forcing changes, and how other institutional investors organize to back the lead institution. Cheffins (2009) also highlights the effectiveness of institutional investors lobbying against takeover defenses. Canadian and Australian institutionalinvestorsmaybeonthepathtowardssimilarroles. Americaninstitutionalinvestorsarelessindependent,formostprivatesectorworkerspension

fundsaremanagedbytheiremployers(Bodie&Davis2000;Woidtke2002).Thus,GeneralMotors,IBM, and Northwest Airlines each run pension funds for their employees. Corporate pension funds seem reluctant to vote against the incumbent top management of firms they own perhaps hoping their pensionfundswillreciprocateshouldtheneedarise(Wahal1996;DelGuercio&Hawkins1999;Faccio & Lasfer 2000; Woidtke 2002). This leaves only government employees pension funds and a few pensionfundsorganizedbyoccupation,ratherthanbyemployer,toactasgenuineguardiansofgood governance.CalPERS,theCaliforniaPublicEmployeesRetirementSystem,andvariouspensionfundsfor teachers and university professors denounce problematic governance, and often vote against incumbentsinproxycontests(Pound1988).However,civilservantspensionfundscanbestymiedby
25

otherproblems,suchaspoliticalpressuretofavorfirmswithstronggovernmentconnections(Romano 1993c;Romano1993a;Romano1995),andcansuffergovernanceproblemsoftheirown(Lakonishoket al.1991). Butmostcontrollingshareholdersinmostcountriesaretycoonsorwealthyfamilies(LaPortaet

al.1999),forindependentinstitutionalinvestorsuptothejobofchallengingcorporateinsidersarerare outside a handful of English speaking countries (Turner et al. 1991). Top insiders who are also large shareholdersoughttobelesspronetoagencyproblemsthanthetopmanagersrunningthewidelyheld firmsfeaturedinsection2.2.Thisisbecauseanydropinshareholdervalueduetotheinsidersacrificing valueforutilitycostshimmoneytoobecauseheisalsoashareholder.However,topinsiderswhoare alsolargeshareholdersmightalsobemorepronetoagencyproblemsthanthemanagersofwidelyheld firmsbecausetheformercannotbeejectedbyshareholdervotesorcorporateraiders,whilethelatter can.Modestlevelsofmanagerialshareownershipseemtomitigateagencyproblems,buthigherlevels that precipitate entrenchment appear to magnify agency problems (Morck et al. 1988; McConnell & Servaes1990;Holdernessetal.1999,Mueller2005). Thefoundersofgreatfamilybusinessdynastiesarenecessarilyhighlytalentedbusinessleaders, and that talent may more than make up for any problems associated with entrenchment. Indeed, powerful tycoons may do their countries great service by coordinating socalled big push industrialization (Murphy et al. 1989), a process that requires the coordinated capitalization of interdependent firms across many sectors of the economy. RosensteinRodan (1943) argues that a moderneconomyisacomplexwebofinterdependencies,witheachfirmimplicitlyrelyingonhostsof suppliers, customers, and complementary good producers in numerous other industries, and on their suppliers, customers, and complementary goods providers, and so on. This, he argues, means rapid industrializationmustberunundercentralplanning,forotherwiseearlymoversaresubjecttoholdup problems, economy of scale mismatches, and problems due to missing industries or insufficient competitioninearlystageindustries. MorckandNakamura(2007)arguethatthelargebusinessgroupstycoonsassembleinrapidly industrializingcountriesmayreflectbigpushgrowthinprogress.Thefirmsinsuchagroupareusually arrangedinacontrolpyramid,withthetycooncontrollinganapexfirmthatcontrolsotherlistedfirms, each of which controls yet other listed firms, and so on as illustrated in Figure 2. Actual control pyramids also involve an apex firm, directly controlled by the family, controlling several listed firms, eachofwhichcontrolsseveralmorelistedfirms,andsoon;butareoftencomplicatedbycrossholdings, control blocks split between multiple parent firms, control by parent firms in more distant tiers, dual
26

class stock, and numerous other factors. Thus, Figure 3 illustrates an actual business group, that of ItalysAgnellifamily.

Figure2.AnArchetypicalPyramidalBusinessGroup
Eachboxrepresentsalistedfirm.Linesconnectcontrolledfirmstothefirmthatcontrolsthemor,at theapexofthestructure,tothecontrollingfamily.Suchstructuresletbusinessfamiliesortycoons magnifycontroloveronefirmintocontroloverbusinessgroupscontainingvastlygreaterassetsthat, insomecases,amounttosizablefractionsofnationaleconomies.
Family Firm
>50% >50%

A1
>50% >50% >50%

A2
>50%

B1
>50% >50% >50%

B2
>50% >50%

B3
>50% >50%

B4
>50%

C1
>50% >50%

C2
>50% >50%

C3
>50% >50%

C4
>50% >50%

C5
>50% >50%

C6
>50% >50%

C7
>50% >50%

C8
>50%

D1

D2
<50% in each

D3
<50% in each

D4
<50% in each

D5
<50% in each

D6
<50% in each

D7
<50% in each

D8
<50% in each

D9
<50% in each

D10
<50% in each

D11
<50% in each

D12
<50% in each

D13
<50% in each

D14
<50% in each

D15
<50% in each

D16
<50% in each

Public Shareholders

Source:Wolfenzonetal.(2005)

27

Figure3.TheAgnelliPyramidalBusinessGroup
Each box is a separate firm, with lines indicating controlling equity blocks. Figures designated O are the familys actual ownership stake and those designated C are the fraction of votes the family controls in the annualgeneralshareholdersmeeting.Thegroupisdepictedasitwasinthemid1990s.

Source:AgaininandVolpin(2005).

These structures can contain dozens, and even hundreds of distinct firms, each drawing energetically onpublicequitycapitalbutcontrolledthroughadominantvotingblock heldbythefirm aboveit(Bebchuketal.2000).Thisstructureletsthebusinessgroupmobilizevastamountsofcapital, yetpreservesforthecontrollingshareholderoftheapexfirmanundisputableruleovereveryfirminthe group. One person in command means the group member firms do not hold each other up, that venturesinnewindustriescanbeestablishedasfirmsinothersectorsneedthem,andthatfirmsforced to operate at inefficient scales can be subsidized via intercorporate income shifting, or tunneling (Johnson&etal.2000). Consistentwithabigpushcoordinationrole,pyramidalgroupsinemergingeconomiestendto be extraordinarily widely diversified, with one firm in virtually every major sector (Khanna & Yafeh 2007). Business group member firms also tend to be more profitable, on average, than independent

28

firmsinemergingmarkets(Khanna& Palepu2000b,a;Khanna&Rivkin2001;Khanna&Yafeh2005), perhapsreflectingtheircentralroleinbigpushindustrialization.Finally,someIndianbusinessgroups appear to take a leading role in setting up new firms in new industries (Khanna & Palepu 2005), and similarpatternsareevidentelsewhere(Almeida&Wolfenzon2006). However,thecontributionofpyramidalbusinessgroupstorapidindustrializationisevidentonly inMeijiJapan(Morck&Nakamura2007).Furtherevidencefromothercountriesisneededtoassessthe generalityofthistheoryvalidatingdespoticcorporategovernance.Meanwhile,otherpotentialbenefits of a controlling shareholder in emerging market economies include reputational capital (Khanna & Palepu 2000b) and an ability to sidestep weak institutions and commonplace market failures by controllingfirmsonbothsidesofanotherwiseriskytransaction(Khanna&Yafeh2005).

4.2

SIMPLEDESPOTS

Thisbenignviewofdespoticcorporategovernancemaywellbevalidinsomecountries,oreveninall countriesatacertainstageofdevelopmentwherebigpushindustrializationisneeded.Butthereis ampleempiricalevidencethatdespoticcorporategovernanceisoftenmalign,andcanseriouslyretard livingstandardsandinstitutionaldevelopment. First, intelligence need not run reliably in families and brilliant tycoons, whose sweeping governancepowerisentirelyappropriate,mayleavetheirempirestosonsandgrandsonsofdecidedly lessability.Consistentwiththis,studiesusingdatafromdevelopedeconomiesfindfamilycontrolblocks inthehandsofheirscorrelatingwithdepressedfirmperformance(Morcketal.1988;Villalonga&Amit 2006).Eventstudyevidencefromsuccessionsinfamilyfirmsconfirmsthat controlpassingtoanheir causes poor performance (Smith & AmoakoAdu 2005; PerezGonzalez 2006), as does careful instrumentalsvariablesestimation(Bennedsenetal.2007).Thisappearstobealesserprobleminmany developing economies (Khanna & Yafeh 2007) perhaps because arranged marriages let business familiesbreedfortalent(Mehrotraetal.2010),orperhapsbecausewealthyheirscanreadilysubstitute connectionsfortalentinmorecorrupteconomies(Krueger2002;Morck&Yeung2004;Fogel2006),or haveunique(intheircountries)accesstogoodeducationandmanagementtraining. Second,businesstycoonsandfamiliesoftencontrolfirmswithoutactuallyowningmanyoftheir

shares. They usually accomplish this by using dual class shares, pyramiding, or both. Regardless, this greatlyexpandsthescopeforagencyproblemsandnonvaluemaximizingcorporategovernance. Dual class shares are the rotten boroughs of corporate finance. A dual class equity structure

meansafirmhastwokindsofshares:superiorvotingshares,ownedbytheinsiders,theirfriends,and
29

theirrelatives,givetheirowners10,100,ormorevotespershare;andinferiorvotingshares,ownedby outside investors, give their owners one, or often even no votes per share. Examining U.S. dual class firms, Gompers et al. (2010) report that average q ratios fall sharply with the extent to which their insiders voting rights exceed their actual ownership stake. Other evidence, including event studies around the establishment of dual class structure and changes in the relative importance of different shareclasses,suggeststhatdualclassequitycausesdepressedshareholdervalue(DeAngelo&DeAngelo 1985;Jarrell&Poulsen1988;Smith&AmoakoAdu1995;AmoakoAdu&Smith2001;Nenova2003). DualclasssharesbarredfirmsfromgraduatingfromtheNASDAQorMAMEXtotheNYSE,soup

andcoming US firms tended to avoid them. However, dual class equity is more common in other countries such as Canada (Smith & AmoakoAdu 1995; AmoakoAdu & Smith 2001) and Sweden (Hgfeldt2005).AgeneraltrendtowardsunificationofsuchequitystructuresisevidencedbytheIsraeli policyof1989thatdualclassfirmsunifytheirequitypriortoissueadditionalshares,(Hauser,andBeni Lauterbach2004). In many countries, supervoting shares and inferiorvoting shares in the same company trade

side by side on the same stock exchange. Zingales (1994) explains an 80% premium for supervoting shares on the Milan stock exchange as reflecting the extensive private benefits Italys legal system permitscontrollingshareholderstoextract.Nenova(2006)showsthatsuperiorvotingrightscommand higher premiums in more corrupt economies, suggesting that more efficient and public shareholder friendlylegalandregulatorysystemscurtailprivatebenefitsofcontrol. Pyramiding lets a controlling shareholder leverage a modest fortune into control over firms

worthvastlymore.Forexample,afamilymightownfiftypercentplusoneshareofFirmA,withsmall shareholdersowningtheremainderofitsstock.FirmAmightthenownfiftypercentplusoneshareof Firm B, again with small shareholders owning the remainder. The family can thus appoint Firm As board,controlofwhichletsthefamilyalsoappointFirmBsboard.Butthefamilyhasonly50%ofa50% stakeinFirmB,andthusreallyonlyowns25%offirmB.Toseethis,considerwhathappensifFirmBs valuedrops$1M.ThiscausesFirmAsstockinfirmbetodropinvalueby$500K,andthiscausesthe familys wealth to drop by $250K. This precisely replicates what would happen if the family owned a 25%stakeinBdirectly. Actualpyramidscaninvolvemuchlongerchainsoffirmscontrollingfirms,andthosereinforced

with supervoting shares, golden shares, and the like can include links with far less than 50% control. Forexample,inthe1990sabranchoftheCanadianBronfmanfamilydirectlycontrolledBroncorpInc., whichcontrolledHILCorp.witha19.6percentstake.HILowned97percentofEdperResources,which
30

owned60percentofBrascanHoldings,whichowned5.1percentofBrascan,whichowned49.9percent ofBraspowerHoldings,whichowned49.3percentofGreatLakesPowerInc,whichowned100percent ofFirstTorontoInvestments,whichowned25percentofTrilonHoldings,whichowned64.5percentof Trilon Financial, which owned 41.4 percent of Gentra, which owned31.9 percent of Imperial Windsor Group(Morcketal.2000). Thisgivesrisetotwosortsofpotentiallysevereagencyproblems.First,ifthebrotherswereto

sacrifice $1M of Imperial Windsors assets to obtain a private benefit, this would reduce the value of Gentraby31.9%$1M=$399K,whichwouldreducethevalueofTrilonFinancialby41.4%$399K=$ 165K. Multiplying ownership stakes all the way back shows the personal financial cost to the family wouldbe$300,or0.03percentofthe$1Mtotalcostofprivatebenefit.Ifthefamilyhadnoconcernfor publicshareholders,aprivatebenefitworth$301wouldoutweighthe$1MlossforImperialWindsor.9 Sincethefamilyfullycontrolsthisfirmbydintofcontrollingitsparent,anditsparentsparentsallthe wayupthroughthecontrolchain,theycoulddothisiftheysochose. Second,pyramidingcantemptacontrollingshareholdertofavouronefirminthepyramidover

another.Forexample,abusinessdealbetweenImperialWindsorandHILthatcausedtheformertolose $1M, costing the family $300, and the latter to gain that amount, increasing the familys wealth by 19.6% of $1M or $196,000. Since the family controls the boards of both, it could easily instruct both boards to approve the onesided deal. Such transactions are variously called transfer pricing, income shifting,relatedpartytransactions,ortunnelling;andcaninvolvethesaleofgoods,services,insurance, orfinancialassetsatartificialpricesthatshiftwealthfromonefirmtotheother. Tunnellingisentirelylegalinmanycountries,andisconsideredaroutinebusinesspractice.In

many Western Europe, Latin America, and much of Asia the practice is either explicitly legal or essentially unregulated (Johnson & et al. 2000). Other countries regulate related party transactions (Djankovetal.2008).Forexample,Israelrequiresapprovalbyonethirdofdisinterestedshareholders before group firms can proceed with substantial related party transactions. In Canada, large related party transactions must be disclosed and can require approval by the majority of disinterested shareholdersinavote.EmpiricalstudiesrejectpervasivetunnellinginCanada(Tian2006)andWestern Europe(Faccio&Lang2002);butnotinIndia(Bertrandetal.2002),Korea(Baeetal.2002),orother EastAsianeconomies(Claessensetal.2002;Claessensetal.2006).

Thisexampleisillustrativeonlyofthepotentialforagencyproblems.Stangelandetal.(1995)findnoevidenceof governanceproblemsinthisbusinessgroupduringthisperiod. 31
9

Shares not part of the control blocks holding the structure together are sold to outside

investors,andarediscountedappropriatelyfortheagencyproblemsexpectedineachfirm.Thisdiffers acrossfirmsinthegroup,foritdependsonthecontrollingfamilyslikelypropensitytousethefirmto generate private benefits of control, and on whether the firm is more likely to give or receive in tunneling.

4.3

EFFICIENTDESPOTISM

Top corporate insiders whom shareholders cannot fire are said to be entrenched (Stulz 1988). The tycoonsandbusinessfamilieswhocontrolpyramidalbusinessgroupscommandcontrolblocksinevery firminthepyramid,andsoareentrenched.ButsoaretheCEOsofwidelyheldUSfirmswhorigtheir corporatecharterswithstaggeredboardsorwhoreincorporatetheirfirmsintostatesthatcurtailhostile takeovers. Adegreeofentrenchmentmightnotbeinefficient.First,AlmazanandSuarez(2003)arguethat anefficientcompensationcontractfortopmanagersmightprovideadegreeofentrenchmentbecause jobsecurityisacomponentofcompensationalongwithsalary,bonus,andoptions.Indeed,jobsecurity might be a desirable way of compensating CEOs when taking risks with very longterm payoffs maximizessharevalueSecond,ifinterpersonalutilitycomparisonsarepermitted,anentrenchedinsider might gain so much utility from controlling a great corporation that it outweighs the disutility her blunders inflict upon others. Stulz (1988) models how she selects what fraction of her firm to sell to outsideshareholdersandwhatlevelofmonitoringandcontrolmechanismstoinstallsoastobalance her marginal utility of wealth against the marginal utility she gains from control. In such a situation, alteringtherulestoletshareholdersremoveherwouldnotbeaParetoimprovement,andcouldonlybe justified on distributional grounds. Finally, an exceptionally able and socially minded insider might deliver more efficient capital allocation, all else equal, if freed from constraints imposed by less insightfulpublicshareholders.

5.

CORPORATEGOVERNANCEANDCAPITALISM

The division of labor underlies capitalisms success: just as people specialize in specific trades, firms specializeincorebusinessactivities.Capitalismachieveseconomiesofscale,despitespecialization,by mobilizing vast pools of public savings to capitalize efficiently large efficiently specialized firms run by peoplewiththespecializedabilities.

32

Capitalism thus entrusts top executives with huge amounts of other peoples money and commands they be trustworthy agents that maximize the value of the pool of capital under their stewardship. That is, without regard for their own utility, they must identify and undertake ventures thatearngenuinelypositiveeconomicprofitsexploitingnewmarkets,technologies,businessmodels,or otheropportunities.Clearly,suchexpertisedeservescompensation,butitsappropriatemagnitudeand form are ill understood at present. If the top managers are inefficiently selected or incentivized, and attendtoomuchtotheirownutilityratherthantheirinvestorswealth,wehaveanagencyproblem. Firm performance aggregates to economy performance, so how top corporate executives are selected and incentivized matters for productivity, jobs, and taxfinanced public goods and services. Onesuchpublicserviceistheevenhandedenforcementofcosteffectiveregulationstoefficientlyselect andincentivizetopexecutivessofirmsarecrediblytrustworthy,andtheirstockareviableinvestments. The voters of virtually all major democracies have elected governments that mandate standardized accountinginformationandcriminalpenaltiesforreleasingfalseinformation.Thisimposescompliance costs on firms, reducing investors returns; but helps reassure investors that the firm is run in a trustworthyway.Governmentsthatgetthistradeoffrightmobilizetheirsaverswealthefficientlyand optimizetheircitizenriespotentialwellbeing. Most major democracies reward unfaithful corporate insiders with fines or jail for a range of excessivelyselfinterestedbehavior.However,therangevariesacrosscountries,asdoesthedefinition ofgoodfaith.ACEOloadingcorporateassetsintoatrucktobesoldforpersonalgainviolatesthelaw almosteverywhere.Insidertradingisillegalinanincreasingnumberofcountries,thoughenforcement varies.IntheUnitedStates,andafewothercountriestoalesserextent,investorssuetopcorporate insiders for failing to run their firms well. Good faith in the United States and United Kingdom traditionally meant making reasonable decisions aimed at maximizing longterm shareholder value (Romano 1993b), but other countries define it otherwise. In Canada, top corporate officers and directorshaveadutyonlytothelegalpersonofthecorporation,nottoitsshareholdersoranyother stakeholders(Lee2005).InGermany,theirdutyistobalancetheinterestsofshareholdersagainstthose ofallotherswithastakeinthefirmcreditors,workers,managers,communities,theenvironment,and soon(Fohlin2005). Overthepastdecades,UScorporategovernancelawsandregulationshavegrownprogressively lessinterestedinshareholdervalue(Bebchuk2007).CourtsinmanyAmericanstatesnowrequiretop managers to balance the interests of all stakeholders, let top managers protect themselves from shareholder democracy with poison pills, staggered boards, and other entrenchment devices. Some
33

studentsofcorporategovernanceseethisarisingfromayetdeeperagencyproblem(Bebchuk&Cohen 2003;BarGilletal.2006). In a democracy, the people entrust politicians and top civil servants with command over the capitalassetsofthegovernment,rulemakingauthority,andpolicepowersofenforcementtoadvance thepublicinterest.Intheframeworkofagencytheory,thesepublicsectormanagersareagentsofthe people,muchastopcorporatemanagersareagentsofshareholders.Politiciansandtopcivilservants alsohaveutilityfunctions,andareaspronetomaximizethemasanyoneelse(Krueger1974).Ifpublic officialsput personalutilityaheadofthepublicinterest,thepublicsector toohasanagency problem (Stulz2005). Justasshareholderscanselltoaraider,thevoterscanturnouterrantleadersinelectionsand forcecivilservicerationalizationsinreferendums.Butjustascorporategovernancecan,inreality,drift farfromefficientvaluemaximization;governmentcanlosesightofthepublicinterest.Indeed,thetwo sortsofagencyproblemmaywellreinforceeachother:CEOsmightuseshareholdersmoneytosupport politicians who grant them greater leeway in using shareholders money as they will; while politicians might use taxpayers money to support inefficiently governed firms that open competition would otherwisedestroy.Marketfailurebegetsgovernmentfailure,whichbegetsmoremarketfailureinan acceleratingracetothebottomtodrainawayinvestorwealthandthepublicgood(Morck,Wolfenzon andYeung2005). Aswithcorporategovernance,differentcountriesatdifferenttimesusedifferenceinstitutions to check public officials all too human selfinterest. Again, as with corporate governance, different systems have different strengths and weaknesses, and the optimal system has yet to identify itself (Mueller2006b).Thegenuinemarvelisperhapsthatcapitalismanddemocracyworkaswellastheydo, giventhissharedinternalcontradiction.Theirvitalitysuggeststhateconomistsmayunderestimatethe strength and resilience of less appreciated checks on self interest perhaps moral sentiments long constrainedmostagentsselfinterestaseffectivelyasSmith(1762)claims;thoughreligionandculture canalsoconstraineconomicandfinancialdevelopment(Stulz2005).Evenmoreremarkably,suchforces maywellcontinuetogatherforceevennow,amidthecynicalsophisticationofthe21stcentury(Mueller 2009). The development of institutions surrounding corporate governance is nonetheless clearly incomplete,formostcountriesemployregulationsthatarebothcostlyandlargelyineffective(LaPorta etal.2006).Thismaywellreflectlobbyingbycorporateinsidersinmaturefirms,whobenefitdirectly

34

from the freedom to use their investors money as they please; or by financial advisors, lawyers, accountants,andotherswhobenefitindirectlyfromregulatorycomplexityandopacity. In this sense, corporate governance is where political science was a century or two ago. Hereditary power entrusted to business family dynasties remains the default form of governance in most countries, and the limited shareholder democracy on offer often works poorly. Intelligent observers can, with straight faces, argue that despots serve some economies better than democrats. Competition between governments for capital and skilled labor to tax may well induce continually strongerandmoreefficientlyprovidedshareholderrights(Tiebout1956;Buchanan1965).Butlobbying by powerful top corporate insiders might equally well induce a race to the bottom in corporate governance(Bebchuk&Ferrell2000)amonggovernments. Hereweseegroundsforoptimism.Institutionsaroseinotherareastopromotesocialwelfare attheexpenseofpreviouslyseeminglyimmovableelites.Democracyisamoreprevalentnowthana century ago; courts in the industrial democracies are also arguably less tolerant of corruption in high places and academia is more open to new ideas. In these is discernable a wellbeaten path towards reformthatcorporategovernancemightalsofollow(Morck2008).Thus,callsforboardstodesignatea leadindependentdirectorevokepoliticalparallelsintheleaderoftheloyalopposition,whosedutyof loyaltytodemocracyrequiresacontinualcriticismofgovernmentpolicies.Callsformoreandstronger independent directors likewise seem bent on injecting more argument and dissent into boardrooms, ratherliketheconstructiveargumenttheadversarysystemevokesinCommonLawcourtroomswhich, somewhatinexplicably,appeartodeliverbetterdecisionsincasesinvolvingbusinessdisputesthando theinquisitorialproceedingsinlegalsystemsdescendedfromtheNapoleoniccode(Gennaioli&Shleifer 2007). These efforts to induce dissent in corporate boardrooms are likely to be unpopular with some CEOs, just as discussants and referees were initially controversial in academia. But opposition politicians,counterargumentsincourt,andrefereesdoseemtodeliverbetterdecisions,andsomight corporateboardroomssubjectedtomoreshareholderdemocracyandaccountability.

35

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