THE FINANCE APPROACH TO CORPORATE GOVERNANCE
In the pure 'finance view' of corporate governance corporations exist only to serve their shareholder's desires and therefore they have only one goal: to maximize their owner's wealth. Among the many obstacles to achieving this goal -- besides the unavoidable risks of economic trends, poorly selected strategies, cut-throat competition, and general managerial incompetence -- is that in a Berle-Means world where ownership is divorced from control, the managers hired by the owners might systematically make choices that aren't in the owner's best interests. While obviously important to the modern corporation, this observation is at least as old as economics. As Adam Smith wrote, "The directors of such companies [joint stock companies] however, being the managers rather of other people's money 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 [corporation or joint stock company] frequently watch over their own."
In the finance view, the central problem in corporate governance is to construct rules and incentives (that is, implicit or explicit 'contracts') to effectively align the behavior of managers (agents) with the desires of principals (owners). As Blair puts it,
The finance view of what is wrong with the governance system holds that shareholders do not have enough control or influence over management and that companies therefore too often get away with lackluster performance, while executives enjoy lavish perks.
The ability of managers to 'feather their own nests' either by paying themselves excessive salaries or by failing to apply maximum effort to their tasks is only possible when owners and managers are different individuals.
Managers may have important incentives to act contrary to the interests of owners in ways that are more complicated than simple greed or sloth. For example, owners can diversify their personal risk by buying stock in several firms in several different industries. Managers, whose income depends heavily on the performance of a specific firm in a specific industry, cannot so easily diversify their risk. Consequently, managers may naturally be more conservative and less risk taking in their actions than owners might like. They might also have an incentive to use diversification of the firm as a whole as a way to reduce the risk of managing a single company in a single industry.
From the finance view solving these and other agency problems requires adopting appropriate incentive systems. To take a common example, one way to give managers an incentive to maximize the value of a company's stock is to pay part of their salary in stock options so that good stock market performance translates directly into higher compensation. Other compensation schemes can be devised to tie pay to performance such as bonuses that depend on meeting predetermined financial targets. Since the board of directors of the company sets executive compensation, owners have to worry that management will co-opt them.
Co-optation is most likely to happen when a majority of the board comes from current management, former management or from the management of suppliers or customers. Such directors are said to be 'insiders' since their interests are likely to be closely aligned with management. The power of insiders is magnified when the Chief Executive Officer and the Chairman of the Board are the same individual. Since the possibility of abuse is most likely under these circumstances, proponents of the finance view frequently suggest taking measures to severely limit the number of inside directors, to appoint truly 'outside' directors and to split the CEO and the Chair. These measures are intended to enhance the board's independence and to encourage policies that are in the best interests of the owners.
While executive compensation is an obvious area in which agents might act contrary to the interests of principles, it is not the only area. A more serious deviations may come about when management embarks on an acquisition drive that is not in the long run interests of shareholders. For example,
In the 1960's Westinghouse began an aggressive diversification strategy to expand from its traditional electrical and broadcasting businesses to activities as diverse as watchmaking and low income housing. By the early 1980's it had become the classic conglomerate complete with its own financial services division, Westinghouse Credit Corporation (WCC). It's 135 divisions had little in common, aside from the nominal strategy of focusing on 'local monopolies' and avoiding mass markets.
When the company fell on hard times in the early 1990s, this excessive diversification almost bankrupt Westinghouse. Obviously, excessive diversification can be more costly to owners than a few inflated salaries. Agency theorists often suggest that the best defense against this kind of abuse is an active, independent board that carefully monitors management.
While the simple statement of the finance model presented above is generally accepted by most observers, some additional perspectives are worth noting.
In particular, the emphasis on the costs inherent in trying to get agents to act in the ways principles desire ignores the benefits from establishing the principle-agent relationship in the first place. As Blair notes, for most of the century the American economy produced the "highest levels of incomes and wealth the world had ever seen." Consequently, "The possibility that separating equity holding from control would lead to poor business performance seemed largely academic."
Blair agues that the separation of ownership from control produces efficiencies in at least three areas that could, to some extent, minimize the costs of the separation of ownership from control.
First, by atomizing equity claims into small, affordable units it is possible to mobilize large amounts of capital from many small investors thus ending the need to rely on a relatively limited number of wealthy individuals.
Second, separating management from ownership greatly expands the pool of potential managers and, presumably, increased the average ability of those who rise to top levels of large corporations.
Third, because equity interests can be small, investors can diversify risk by holding small stakes in many different companies. The result is liquid capital markets in which investors require lower risk premiums for any particular investment.
Factors one and three imply a more efficient capital market in which large amounts of capital can be raised at the lowest possible risk premium. The second improves the efficiency of the market for managers by mobilizing the best talent available for the task regardless of personal wealth. Thus professional competence is emphasized over family connections in choosing executives. Taken together these are formidable benefits, and for the middle decades of the twentieth century casual observation based on the performance of American industry indicates they considerably outweighed any costs associated with the separation of ownership from control.
The view that the efficiency inherent in professional management would outweigh agency costs began to erode in the 1960's when management 'by the numbers' was carried to its logical conclusion in the conglomerate merger movement.
The merger boom of the 1960s and the subsequent decline of stock prices in the 1970s led many academics and finance theorists to change their thinking about the nature of the problem most likely to arise from separating equity ownership from control. Their fears shifted from a concern that non-owner managers would be lazy or negligent or would defraud the owners to a concern that managers would use their positions to build empires -- building ever larger companies even at the expense of profitability.
Finance theorists saw the development of the takeover movement, the market for corporate control, as a logical outgrowth of the tendency of management to engage in inefficient practices. The logic was straight forward. If current management undertook value reducing actions this would quickly be reflected in a reduction in the price of the company's stock. An astute investor who was willing to correct these mistakes could then buy the company, paying a premium over the current price if necessary, then install new management to correct the mistakes, and come out ahead in the end. Consequently, "the phrase 'finance model' refers to the theoretical underpinnings for the cluster of arguments that have been used to defend takeovers and that are now used to advocate enhanced rights for shareholders in corporate governance."
In summarizing the lessons of the finance model, Blair says:
True believers in this finance model interpret the events of the last twenty or so years roughly as follows: corporate performance (as measured by stock prices) declined in the 1970s because executives had been making unrelated acquisitions and otherwise building empires rather than paying close attention to the bottom line. The financial markets, through hostile takeovers, the threat of hostile takeovers, leveraged buyouts, and other leveraged-driven restructuring, were correcting that problem as quickly as they could during the 1980's.
However, toward the end of the 1980s management -- which had consistently criticized takeovers as disruptive and promoting of a short term, crisis mentality that detracted from long run wealth maximization -- finally mounted an effective counter attack against hostile takeovers. First, a large number of state legislatures passed laws that made takeovers more difficult, laws that were subsequently upheld by state and federal courts. Second, the Manhattan US Attorney brought indictments in 1989 against Michael Milken and Drexel, Burnham Lambert for various securities law violations. Milken and Drexel had been a major force in the 'junk' bond market that had provided crucial financing for many takeover offers. With the collapse of the market for corporate control (in part related to the collapse of the savings and loan industry, and the consequent drying up of liquidity) the end of the hostile takeover era arrived. Thus, in the 1990s some proponents of the finance model focused on reforms that give more power to owners. Others urge developing relationships between large institutional investors and companies that can then be used to minimize the principle-agent problem.
In any case, with the end of the market for corporate control proponents of the finance model urged institutions to find ways to influence companies through approaches that didn't rely on the takeover market. Unfortunately institutions immediately came up against a common collective action problem: the free rider problem. This problem arises when one agent (a particular financial institution) bears all of the cost of bringing about reform at a particular company, but can only receive benefits that are proportional to its stock holdings.
Even with the reconcentration of ownership noted in Part I, individual institutions typically own far less than 5% and usually much less than 1% of the outstanding shares of each company. Faced with the prospect of bearing 100% of the cost of a proxy fight only to receive less than 1% of the benefit, many institutions adopted a policy of 'rational apathy.' Under this policy, they gladly took a free ride on other institution's activism -- reaping a share of the benefit proportional to their holdings in the company but avoiding any of the cost. Some authors, for example Black and Grundfest, have argued that activism may be rational for institutions even in the presence of free rider problems, most notably because the absolute size of the benefit flowing from some actions may be large relative to the cost, even if the actor cannot capture a large share of the total benefits. We will return to these issues at several points, most notably in Part IV where we discuss monitoring and corporate governance.
Critiques of the Simple Finance Model
There are several important alternatives to the simple finance model presented above. In a provocative article, Eugene Fama notes that ownership of capital should not be confused with ownership of the firm. Each factor in a firm is owned by somebody. The firm is just a set of contracts covering the way inputs are joined to create outputs and the way receipts from outputs are shared among inputs. From this 'nexus of contracts' perspective, ownership of the firm is an irrelevant concept. Fama goes on to say that changing the traditional view that the firm is "owned by its security holders ... is a first step toward understanding that control over a firm's decisions is not necessarily the province of security holders." His argument is the one noted above, that since investors hold securities in many firms in order to diversify risk, they have "no special interest in personally overseeing the detailed activities of any [one] firm."
Managers, on the other hand, are both vitally interested in the success of a particular firm and well placed to monitor what goes on in it. While mangers may have an incentive to expropriate the security holders wealth, Fama suggests that managers will be disciplined by both internal and external markets since in the "nexus of contracts view of the firm, each manager is concerned with the performance of managers above and below him since his marginal product is likely to be a positive function of theirs ... [and] ... all managers realize that the managerial labor market uses the performance of the firm to determine each manager's outside opportunity wage. [Furthermore,] there is competition among the top managers themselves (all want to be the boss of the bosses)" In Fama's view, "The board of directors ... is to provide a relatively low-cost mechanism for replacing or reordering top managers; lower cost, for example than the mechanism provided by an outside take over, although ...[it] ...is another force which helps sensitize the internal managerial labor market."
From a very different perspective Blair presents an extended argument that labor has a stake in the firm that is similar to the stake equity owners have. In particular, she argues that highly-skilled labor has made important firm-specific investments in human capital that is analogous to the capital equity owners have invested. The 'capital' labor has contributed to the firm deserves -- for reasons of efficiency as well as equity -- to be represented on the board of directors. For Blair, the simple finance view that identifies the firm with equity owners and views the problem of corporate performance as one of maximizing shareholder wealth is too narrow. She stresses "that the goals of directors and management should be maximizing total wealth creation by the firm. The key to achieving this is to enhance the voice of and provide ownership-like incentives to those participants in the firm who contribute or control critical, specialized inputs (firm specific human capital) and to align the interests of these critical stakeholders with the interests of outside, passive shareholders."
Williamson develops the conceptual underpinning for Blair's view within an institutional and transaction costs economics perspective. He argues that the economics of 'idiosyncrasy' have important governance implications in a variety of areas, including labor's role in the creation and re-creation of firm specific human capital, which is taken to include both skills and relationships. Idiosyncratic exchange in human capital involves examples such as specialized training and learning-by-doing to the extent that they are non-transferable and that, "...the benefits of the set-up costs can be realized only so long as the relationship between the buyer and the seller of the intermediate product is maintained." The governance implication is that, "...special governance structures supplant standard market-cum-classical contract exchange when transaction-specific values are great. Idiosyncratic...labor...[is a] specific example..."
Williamson discusses a number of governance forms for different transaction circumstances. One type, "transaction-specific governance: relational contracting" is of direct relevance for both Blair's argument about firm specific human capital and potentially about other corporate governance issues as well. He argues that under condition of nonstandarized transactions, "...primary reliance on market governance [is] hazardous, while [transaction specific recurrence] permits the cost of the specialized governance structure to be recovered." That is, there are few scale economies in 'highly idiosyncratic transactions'.
The relation between the increasing importance of human capital as value added and corporate governance is also stressed by the authors of Lifting All Boats. They write:
As suppliers of human capital become as important to wealth creation as suppliers of physical capital...employees acquire both the means and incentives for controlling agency costs similar to those held by stockholders. [This knowledge potentially reduces agency costs if supervision is minimized, while simultaneously those employees]...may rely on skills or relationships that are specific to that firm for their value in the labor market....Thus, these employees bear an increasingly large share of the residual risks in companies....However, such costs probably cannot be minimized without making employees owners of the firm...
Williamson, when referring to the standard critique of the finance model's concern with management, warns that the,
study of capitalist enterprises which makes no allowance for changes in organization form and their ramifications in the capital market will naturally overlook the possibility that the corporate control dilemma exposed by Berle and Means has since been alleviated more by internal than by external (regulatory) organizational reforms.
Here he is referring to the development of the M-form of corporate organization in which general management coordinates the activities of a number of conceptually independent businesses. Williamson recognizes this doesn't completely alleviate the principle-agent problem, but he believes the M-form corporate form has "served to attenuate aspects of the managerial discretion problem."
Alternative Views of Corporate Governance
Other views of the corporation contrast with the 'pure' finance model of corporate governance. Two, the 'stewardship' model and the 'stakeholder' model, suggest very different roles for the board of directors. The third, what might be called the 'political' model, broadens the analysis to such a degree as to constitute another view.
The stewardship model "argues that managers are good stewards of the corporation and diligently work to attain high levels of corporate profit and shareholder returns. Managers are principally motivated by achievement and responsibility needs." According to this view "organizational financial performance and shareholder wealth will be maximized by empowering managers to exercise unencumbered authority and responsibility." The logical extension is either toward an executive-dominated board or toward no board at all.
While the stewardship model shares with the finance model a goal of maximizing shareholder wealth, a broad version of the stakeholder model asks that firms be 'socially responsible' and often subordinates profit maximization to other goals. From this perspective the corporation is responsible to a wide range of individuals and groups in addition to those having a direct financial interest in the company. Stakeholders may, among others, be members of the community in which plants are located, consumers of the product, and, sometimes, the environment at large, society, and even future generations. According to this point of view the corporation -- through the board of directors -- mediates these potentially competing interests in some fashion that is typically difficult to describe. Blair states the arguments against this point of view when she says: "The idea never had much theoretical rigor to it, failed to give clear guidance to help managers and directors set priorities and decide among socially beneficial uses of corporate resources, and provided no obvious enforcement mechanism to ensure that corporations live up to their social obligations." A narrow stakeholder view argues, based on the fragmentation or 'stripping' of 'ownership' into capital's equity, idiosyncratic equity, debt and other non-equity claims and the like, that these claimants all have concrete and financial stakes as a function of their participation in the firm's activities.
The political model of corporate governance has had immense influence on corporate governance developments and debates in the last five to seven years. In this section we briefly discuss its general perspective, in Part IV we focus on how this model of governance has informed and shaped the monitoring of corporate managers and of board of director members, as well as how it has influenced government policy.
Roe and others argue that the extreme form of the principle-agent problem in the U.S., and the finance model's near exclusive reliance on the market for corporate control, were primarily the result of the political traditions of federalism/decentralization dating back to the American Revolution, and more recently of populism with its suspicion of all forms of centralized power, especially economic power. Additionally, the division of fiduciary duties and financial institutions among various financial intermediaries has meant that,
The American boardroom looks the way it does in significant part because American politics deliberately suppressed ... [banks and insurance companies] size, ability to hold and manage stock, and the ability to be active in corporate governance. The rise of private pensions can be seen as a consequence of suppressing their predecessor.
The authors of Lifting All Boats conclude similarly:
...federal policy directly and indirectly encouraged the fragmentation of shareholdings by two of the largest classes of institutional investors, pension funds and investment companies....Accordingly, concentration of ownership in institutions exists in an aggregate but not in an individual sense. This dichotomy begins to explain why the steady institutionalization of investment...has created only the potential for, rather than the reality of, significant minority holdings and closer monitoring.
Thus, given historical and legal traditions, the US system has long had a proclivity for market liquidity over institutional control. Analysts suggest that when access to capital is primarily through the market (in the US case), liquidity will be high; and, alternatively, when access is through dedicated and/or internal sources (e.g. banks in Germany), liquidity will be low and control (that is, influence by the lender) high. Control flows directly from the negotiated process of obtaining capital from a financial institution.
Coffee, and Porter, suggest that the structure of capital markets is a critical factor in the salience and form of governance issues, since liquid markets sacrifice control for investors' ease of entry and exit. In highly liquid markets governance is thought to occur primarily through a dynamic market for corporate control, as in the 1980s in the US. Various terms are used to characterize the polarity of access to capital: 'control vs. liquidity', 'adaptive vs. stable', 'market based vs. institution based', 'dedicated vs. liquid'.
Given the decline of the US market for corporate control in the late 1980s, Pound argues most forcefully that a 'political model' of governance is (or is in the process of) and should replace the "transaction-based 'market for corporate control.'" Grundfest concurs: For him active proxy voting replaces market transactions in order to deal with 'barbarians inside the gates,' that is, to monitor and control corporate managers.
What is unusual about the US in the 1990s (and to a lesser degree to the UK, too) is that while markets retain high liquidity (although Friedman raises a warning about the future), the absolute and relative growth of pension funds and selected other governance activists has developed exactly due to their long-term and consequently illiquid portfolio. Since many pension funds index their investments, they trade only in order to maintain their index's composition. Coffee suggests that the US has the potential to transcend what has been the 'liquidity-control trade-off' as, "...American institutional investors have the capacity to unite liquidity and control....[more than in] any modern industrial economy...if institutional investors are 'unleashed." The US has a diversity of institutions some of which have the long-term incentive to be corporate monitors (e.g. pension funds) while others will likely remain shorter term players (e.g. some sectors of mutual funds), maintaining a degree of liquidity in the markets.
Typical of the political model of corporate governance is Joseph Grundfest's 'Subordination of American Capital.' He begins by observing that "America seems not to trust her capitalists" and cites as evidence the large web of rules and regulations that subordinate investor's interests to other constituencies, most notably corporate management. Grundfest then goes on to say:
Governments thus have an incentive to create,
exacerbate, or ameliorate agency problems to further political
agendas. Accordingly, from a politician's perspective, agency
problems are not an exogenous consequence of otherwise efficient
specialization. Instead they are endogenous variables in a
complex political and economic system -- variables that can be
manipulated for political as well as economic ends -- and there
is no a priori reasons to conclude that equilibrium in this
system minimizes the economic costs the agency problems impose.
From this point of view owners face greater problems than simply fine tuning corporate governance structures to minimize the cost of getting their agents to do what they want them to do. They are faced with a situation in which 'agency costs' are "better viewed as entitlements to be allocated [by some political process] than costs to be minimized." And that, "By making it more expensive for principals to monitor agents, governments can confer valuable benefits on favored constituencies without imposing taxes, without providing direct subsidies, and without engaging in repeated and detailed regulatory intervention."
The political model of corporate governance (whether Pound's or Grundfest's version) places severe limits on the traditional economic analysis of the governance problem, and locates the performance-governance issue squarely in a broader political context. Political does not necessarily imply a government role, merely that it is non-market. Grundfest concludes "there is no reason to believe that corporate agency problems can be resolved in an economically rational manner, or that the corporate governance process will, over time, tend toward greater economic efficiency."
While of some interest, the stewardship and stakeholder views have had minimal impact on the corporate governance debate in the United States and will, therefore, not be considered further. The political view, however, has a great deal of merit as a practical description of the constraints owners face when trying to solve the problems presented by the simple finance model of corporate governance. The fact that agency costs may, in fact, be benefits worth fighting for should be kept in mind. This and the other important issues raised by the political approach to governance are the subject of extensive discussion in Part IV.
Blair's conclusion on the finance model serves well as a conclusion to this section. In it she says:
...the free-market, finance-driven perspective on takeovers dominated the academic debate and much of the policy arena through the late 1980s. For those who continue to view the world in these terms, if anything is ailing corporate America in the mid-1990s, it is that shareholders in general are still too passive, that executives are not being held accountable to shareholders, and that the chief mechanism that had existed to make them accountable -- the threat of takeover-- has been dismantled or at least crippled. Thus, the corporate governance problem to be solved is one of restoring an active market for corporate control or, failing that, creating other institutions that can more effectively hold executives accountable to shareholders.