1. WHO CONTROLS THE JOINT-STOCK FIRM?
The firm, according to the paradigm that we are exploring in this book, is a nexus of contracts. These contracts establish an allocation of property rights among the individuals who comprise the firm. They may include rights to monitor, to administer resources, to receive income flows, to hire and fire, and so forth. In Chapter 6, we investigated how transactional hazards affect labour contracts and hierarchical arrangements within the firm, while in Chapter 7 attention was focused on contracts between buyers and suppliers of intermediate inputs and on the determinants of organisational scope. In Chapters 8 and 9, we address the problem of the relationship between the capitalist; that is, the supplier of finance; and the firm. This relationship has been traditionally intimately associated with questions of corporate governance. Where are the rights of control over the corporation ultimately held? What are the forces which determine the location of these rights? As will be seen, the association of finance with control is a close one, but the reasons are not as straightforward as is sometimes supposed, and the claims of other resources to rights of control will be considered at various points.
Fundamental to any discussion of business governance are distinctions between control rights, decision rights, and residual rights. Clearly, decision rights are often dispersed widely throughout an organisation. Workers and managers may be authorised to make a wide range of decisions about the best use of a company’s resources. Residual (that is, profit) rights in the joint-stock company, as described in Chapter 4, are held by shareholders who may have no individual decision rights over the use of the assets of the
company. Control rights are ultimately about the power to appoint the top managers of an enterprise. Again, there may be many individuals in an organisation who are empowered to negotiate on behalf of the firm and to contract with third parties. In this sense they may be thought to exercise control of the firm. However, this function is exercised on behalf of shareholders who may terminate the arrangement if they feel it is not being discharged in a satisfactory manner. The control rights of managers are thus delegated rights and can be alienated without their agreement. Ultimate control is exercised by holders of rights to appoint and dismiss directors and to approve their contractual terms; rights which cannot be alienated by the decision of some other contracting party.2
It would be quite mistaken to conclude from the above paragraph that there is anything ‘absolute’ about control rights. In the first place, the definition of control rights suggested above does not imply anything about their value and effectiveness. Property rights are never perfectly defined and costlessly enforceable. A notional control right that was too costly to exercise would be worthless, while a decision right that could not be removed from the existing holder would be a valuable asset even if it could not openly be traded. In other words, the fact that rights of control can be located and assigned to particular people in no way implies that those people are actually in control. ‘De facto’ control may lie with decisionmakers even if ‘de jure’ rights of control rest elsewhere. As we shall see, the costs of enforcing and policing property rights lie behind many of the debates about corporate governance.
A second complexity is that control rights can be reassigned other than by simple exchange to different parties in certain circumstances. Debt holders, for example, do not have control rights under normal trading circumstances, but if the company defaults on its debt, control passes out of the hands of shareholders and bondholders acquire the right to intercede to protect their interests. In the literature, these rights of control are sometimes rather confusingly called residual control rights. The word residual, in this context, does not refer to the financial surplus of the firm but to the circumstances in which control rights can be exercised.3
2. FOUR VIEWS OF CORPORATE CONTROL
2.1.Control and the Shareholder – the Traditional View
Essentially the traditional approach asserted that rights of ‘control’ in a joint-stock enterprise will be associated with risk taking and the provision of finance in the form of common stock. Shareholders are the claimants of all rents and are expected to exercise their rights to control the firm’s resources so as to maximise this rental flow. One of the clearest statements of the traditional view of Corporate Governance can be found in Robertson and Dennison (1960). The proposition is stated in the form ‘where the risk lies, there lies the control also – a proposition so important that it has sometimes been described as Capitalism’s golden rule’ (p. 75). By ‘risk’, however, Robertson and Dennison meant more than simple variability of return. The concept also embodied the notion of team dependency. Resources whose value depends on the success or otherwise of the team as a whole are team dependent. The importance of this idea is reflected in their analogy with control of a ship at sea. ‘Those who can with honour leave the sinking ship are ultimately in a stronger position than the captain who must go down upon the bridge, and have less claim therefore to the manipulation of the wheel’(p. 78).
Underlying this traditional position was the assumption that all other members of the team – workers, managers, bondholders or the suppliers of any other inputs – could find ready alternative outlets for their services at the going ‘market’ rate. It was explicitly recognised that workers might be adversely affected by changes in the demand for their particular occupational skills and that this market rate might vary over time. However, this market dependency, while it implied that a portion of the worker’s remuneration was a quasi-rent on the sunk human capital invested in acquiring occupational skills, did not make the worker dependent on the firm in which he or she worked. Nor, in the absence of monopsony power, could control of the firm in which they worked influence the overall market demand for their services. Market dependency, in other words, was not relevant in determining the assignment of rights of control within the firm. Team dependent shareholders were, by implication, those who were expected to exercise control, since failure could mean the extinction of the entire value of their ‘equity’.
In subsection 2.4 we will see how the traditional view has been adjusted to take into account the existence of transaction-dependent resources. As it stands, the traditional view is inconsistent with much of the analysis of Chapters 6 and 7, where the significance, in modern conditions, of encouraging the accumulation of firm-specific human capital was emphasised. Further, the importance of alertness and the generation of entrepreneurial rents throughout an organisation is something which the traditional approach ignores. Entrepreneurship is simply associated with the provision of equity capital and control of the firm. Other factors receive rewards in straightforward neoclassical fashion according to their marginal productivity. The connection between the entrepreneur and the governance of the firm is discussed in subsection 2.3. Before coming to these questions, however, we discuss in subsection 2.2 the managerial critique of the traditional view of corporate control.
2.2. The Managerial Interest and the Berle-Means Critique
By the early 1930s, certain characteristics of the corporate economy were becoming difficult to reconcile with the traditional approach to corporate governance. In 1932, A.A. Berle and G.C. Means published their book The Modern Corporation and Private Property in which the role of the shareholder as a source of corporate control was called into question. Their thesis was based around two propositions. The first was that firms in the United States were becoming very large and that aggregate concentration was increasing. By 1930, according to Berle and Means, the two hundred largest corporations in the United States (other than banking corporations) controlled 49.2 per cent of corporate wealth, 38 per cent of business wealth and 22 per cent of national wealth (p. 33). A trend of increasing concentration had transformed the US economy in the early years of the twentieth century and seemed to show no sign of abating.4
The second proposition was that these large corporations were inevitably associated with highly dispersed shareholdings and that this made it unlikely that shareholders would exert significant control over managers. Berle and Means defined a stock interest as ‘important’ if it exceeded twenty per cent of the voting shares. Corporations with no single ‘important’ stock interest were classed as ‘management controlled’. ‘Control’ was defined (p. 66) as ‘the actual power to select the board of directors (or its majority)’. Later, in section 4, more modern thinking on what constitutes an ‘important’ stockholding will be discussed. By the Berle-Means criterion, however, 58 per cent of the assets of the two hundred largest nonfinancial corporations were classified as management-controlled in 1929. By 1963, Larner (1966) calculated that this percentage had risen to 85 per cent. ‘It would appear that Berle and Means in 1929 were observing a ‘managerial revolution’ in process. Now, thirty years later, that revolution seems close to complete, at least within the range of the two hundred largest nonfinancial corporations’ (pp. 786-7).
The continued importance of ‘private’ limited companies in the UK until the years following the First World War (see again Chapter 4) suggests that the trend towards dispersion was slower than in the USA. The inter-war years, however, saw a substantial move towards ‘public’ companies and the diversification of shareholdings. Between 1911 and 1960 ‘the minority of wealthy families no longer held their wealth in single companies in which they were also directors, choosing instead to spread their wealth over a wider range of assets’ (Hannah, 1983a, p.57).
By the middle of the twentieth century, therefore, the dispersed joint- stock corporation appeared to dominate many sectors of industry and commerce. For many observers, the consequences were expected to be far- reaching. Berle and Means (p. 116) summarised their findings using allusions to a process of imperial expansion: ‘The concentration of economic power separate from ownership has, in fact, created economic empires, and has delivered these empires into the hands of a new form of absolutism, relegating “owners” to the position of those who supply the means whereby the new princes may exercise their power.’ The managers of joint-stock corporations were thus invested by Berle and Means with princely authority over vast dominions – authority which, the word ‘absolutism’ suggests, is untrammelled by constitutional or other restraints. Galbraith (1967) has been one of the most effective modern exponents of this thesis, and has termed the managerial elite which is said to govern much of industry ‘the technostructure’. Masters of new technologies and methods, members of the technostructure have replaced the old landed gentry and the more recent Victorian capitalists as the ruling class.
To a student of economic organisation, the Berle-Means critique is not without its difficulties. To pursue the Robertson and Dennison metaphor, the shareholders seem to have abandoned the bridge to highly paid officials who have access to excellent and conveniently located life-rafts in order to carouse away a dangerous voyage below decks. One might be forgiven for doubting the survival value of this particular institutional set-up. It is certainly difficult to see how capitalism’s ‘golden rule’ can have any validity if the Berle and Means conception of events is correct. Two responses are possible. The first is that Berle and Means have misinterpreted their evidence and that, if not on the bridge, the shareholders are still able to exert their ultimate control over the management of the ship. In sections 3 to 6 we will investigate the mechanisms through which this control may be exercised. The second and more radical response is to accept the demise of shareholder control but to question the existence of shareholder dependency. If shareholders are no longer on the bridge, could it be that they have jumped ship entirely and are warm and safe in a dockyard hostelry? It is this idea which underlies subsection 2.3.
2.3. Entrepreneurship and a Neo-Austrian Critique
In Chapter 3, the idea that the modern joint-stock corporation could be viewed as a means of supplying capital to pure entrepreneurs was introduced. Kirzner mentions this interpretation as a possibility, but the theorist who develops it most fully is Wu (1989). Wu argues that the corporation represents the final stage of a long historical process during which land, labour and capital markets have become ever more developed and specialised. Whereas an entrepreneur would have once supplied his or her own labour and capital, the refinement of these markets now permits the exercise of ‘pure entrepreneurship’. Capitalists are gradually becoming mere lenders of funds and risk bearers, leaving the control of the production process in the hands of the pure entrepreneurs. Firms are coalitions of entrepreneurs who control resources, claim the pure profits (entrepreneurial rents) generated by their activities, and bargain over how these rents should be distributed between them.
Wu attempts to circumvent the moral hazard problems that beset the relationship between financier and firm by appealing to the power of reputation. As information-flows improve in the capital market, any attempt to cheat the shareholders by failing to pay a satisfactory return will damage the future viability of the firm. ‘In order to avoid jeopardising the firm’s ability to raise funds in the capital market, the entrepreneurs must protect the value of shares as jealously as the capitalist would and must offer a satisfactory rate of return’ (p. 227). The existing power of the shareholder collectively to influence decisions and change the team will become unnecessary because there is no shareholder dependency. As the capital market becomes increasingly efficient, argues Wu, ‘Shareholders’ veto power over the entrepreneurs’ decisions will become superfluous’ (p. 253). The Berle-Means ‘division of ownership from control’ becomes through Wu’s radical reconceptualisation merely the division of capitalist from entrepreneur.5
Corporate governance for Wu is therefore entirely concerned with bargaining over entrepreneurial rents generated by the coalition of entrepreneurs that comprises the firm. It is the entrepreneurs who are the team-dependent resources while the highly developed capital market permits providers of finance to reduce their dependency on any particular team to negligible proportions. By spreading their stockholdings widely, the capitalists avoid team-specific risks and are left bearing the unavoidable risks associated with the ‘market portfolio’. The returns to shareholders no longer include entrepreneurial rents but merely quasi-rents on capital because the physical resources financed by the shareholders will continue to supply their services in the short run irrespective of the return that is paid. Although the receipt of quasi-rents implies a type of dependency, the competition for shareholders’ finance and the pursuit of good reputations by entrepreneurs will ensure that the potential for opportunism is not abused and shareholders can expect to receive the ‘market rate’ for their services. The team dependency of the classical capitalist is thus transformed into a form of market dependency. Like the occupation-specific labour discussed in subsection 2.1, the return from which was a quasi-rent dependent on general market conditions, so the capitalist can be seen as in a similar situation. A bearer of risk, the shareholder can nevertheless derive no advantage from the control of any particular team.
There is an important aspect of Wu’s approach which must be explicitly recognised here, although more detailed discussion will not take place until Chapter 12. The theory has an inevitable evolutionary basis. In Chapter 3, the problem of supplying entrepreneurs with the resources necessary to back their judgements was noted. The hazards associated with the capitalist-entrepreneur relationship were seen to be so severe that throughout history the two functions have been closely integrated. Separating them out requires the generation of trust and the development of reputational capital. This is not a question of contractual design or legal innovation. It is a question of the passage of time. Only over time can firms develop reputations for integrity and reliability which can then be used to achieve ends which would otherwise have been impossible. Only over time can cultural norms develop which reduce the fear of opportunism. As Casson (1991) emphasises (see again Chapter 1), business culture is an important determinant of economic performance and a suitable culture cannot be created quickly. The approach to corporate governance explored by Wu is not therefore a straightforward rational choice approach. It is a system that is compatible with the rational behaviour of individuals, but it is the end result of a long process of historical evolution.
Capitalism’s ‘golden rule’ is not overturned by this conception of the joint-stock corporation. In some ways it seems to apply with even greater purity. With the bearing of risk now quite separate from the receipt of entrepreneurial rents the rule can simply be reformulated as ‘where the team dependency lies, there lies the control also’. Team-dependent people are the entrepreneurs – claimants to the pure profits which remain after payment of wages, interest, dividends and rents to non-dependent suppliers of factors of production.
There is, however, a further difficulty to discuss. Are the entrepreneurs the only team-dependent people, or are there other non-entrepreneurial inputs that are nevertheless dependent on the team and likely to be claimants to some control of its operations? It is this issue which comes to the fore in subsection 2.4.
2.4. Contractual Incompleteness, Dependency and Control
People who have claims to the pure profits generated by a team are clearly team dependent. There is, however, another form of dependency discussed in Chapters 6 and 7 which is relevant to the issue of corporate governance. If resources receive quasi-rents on firm-specific capital which they have financed, they may become vulnerable to ‘hold-up’. Examples include implicit bond-posting arrangements which support monitoring arrangements within the firm and investments in human capital which have a payoff to a given team but not elsewhere. The quasi-rents which accrue to such resources are derived from the value created by the team, but they are not necessarily entrepreneurial in nature and do not imply any claim on the team’s residual.6 As was seen in earlier chapters, incentive devices involving the creation of dependency can be analysed in a rigorously neoclassical setting. They rely on trust in the firm’s integrity, but (in the absence of bankruptcy) do not imply that the relevant resources are dependent on the team’s performance as a whole.
We will term recipients of quasi-rents on firm-specific capital transaction-specific resources and the accompanying dependency on the goodwill of the firm transaction dependency. It is important to realise that transaction dependency does not derive from an assumption that the firm is unreliable. On the contrary, the state of dependency exists only if the firm is perceived as sufficiently reliable. As Alchian and Woodward (1987) put it ‘a resource is “dependent” when it would lose value if separated from the team’. Any firm which stole the quasi-rents on transaction-specific resources would free those resources from further dependency since they would now lose nothing by deserting the team. A trustworthy firm is therefore required to create dependency and the quasi-rents associated with it.
Nevertheless, transaction-specific resources might still feel vulnerable to breach of trust or even managerial incompetence and this might be expected to influence the governance of the firm. ‘Firm-specific7 dependent resources will be the parties who place the highest values on the right to administer …In general, whoever has a value that has become firm specific will seek some form of control over the firm’ (Alchian and Woodward, pp. 119-20). According to this approach, therefore, the controlling interest in a firm will not be associated with particular specialised functions (discussed in subsections 2.1 to 2.3) such as shareholding, managing, or entrepreneurship, but may include any resource which is firm specific and receives rent from its participation in the team activity. Transaction-dependent labour may, for example, form unions to monitor the adherence of firms to their implicit obligations. Representation on company boards might be a means of protecting vulnerable specific assets. If takeovers are perceived as a threat to firm-specific quasi-rents, modification to company constitutions may be sought to make takeovers more difficult. These possibilities will be taken up at various points later in this chapter and in Chapter 9.
The ideas explored in this subsection are related to those of subsection 2.3. Entrepreneurs must control resources in order to back their judgement and derive the profit from them. As claimants to entrepreneurial profit they are dependent on the performance of the team and are therefore holders of the team’s equity. In a world in which reputation was powerful enough to reassure transaction-dependent resources that the value of their assets was safe from opportunism and rent seeking, governance mechanisms giving an element of control to these resources would not be necessary and pure entrepreneurs could be the sole holders of the team’s equity and the associated rights of control. In the messier world of uncertainty, bounded rationality, and contractual incompleteness in which we live, control rights will be sought by all holders of dependent assets, and corporate governance will be a compromise between the interests of many different parties. Managerentrepreneurs will fear raids on entrepreneurial rents by workers or shareholders; workers will expect their quasi-rents to be stolen by shareholders in takeover raids; shareholders will contemplate the possibility that managers will renege on their obligations to provide a suitable return on their capital. When we observe the governance structures that actually exist, therefore, we should not expect them to look like any of the ‘pure cases’ covered in this section.
3. CORPORATE GOVERNANCE AS A PRINCIPAL-AGENT PROBLEM
No relationship in business life is more subject to transactional hazards than that between the financier and the managers of a joint-stock corporation. As we saw at the end of Chapter 4, the inability of the financier to observe the behaviour of managers gives rise to the problem of moral hazard. Managers may divert resources to their own personal ends, and, as Adam Smith expressed it, look with less ‘anxious vigilance’ over the shareholders’ wealth than they would do over their own. Only if granted a monopoly or ‘exclusive privilege’, argued Smith, could the joint-stock form of enterprise hope to prevail over the ‘private adventurer’.8
Hidden action is not the only problem with which contractors are faced, however. In an uncertain and complex environment it will usually be difficult for an outside financier to evaluate managerial competence and to distinguish good decisions which turned out badly from poor decisions which stood only a small chance of success in the first place. Because managers are much better informed about the affairs of the company than are financiers, the hidden information or adverse selection problem is serious.
For centuries, therefore, economists have observed the joint-stock enterprise and wondered at its survival potential. At the time of the Joint Stock Companies Act 1856 in the UK, it was by no means obvious that this form would come to dominate industrial and commercial life. The rest of this chapter concerns the ways in which these glaring problems of inducing managerial efficiency have affected the governance of the joint-stock enterprise. This is attempted by applying the theory of principal and agent to the relationship between financier and firm, just as in Chapters 6 and 7 it was applied to the analysis of labour contracts and the firm’s relationships with suppliers.
The most systematic exposition of the idea of the firm as a ‘legal fiction which serves as a nexus for contracting relationships’ is to be found in Jensen and Meckling (1976, p.311). Their discussion of ‘ownership structure’ in the corporation is based entirely on the concept of ‘agency costs generated by the contractual arrangements between the owners and top management of the corporation’ (p. 309). This conception is not entirely uncontroversial, however. To a lawyer, for example, the shareholder’s relationship with the firm cannot be regarded as a contractual one. Neither is it true that shareholders have contracts with managers. This has led some theorists to argue that the principal-agent paradigm is not appropriate in the context of shareholder and manager. Clark (1985, p.56), for example, objects to the use of the terms ‘principal’ and ‘agent’: ‘The core legal concept implies a relationship in which the principal retains the power to control and direct the activities of the agent.’ The shareholder’s powers in a corporation, however, are limited, and ‘the officers and directors are “fiduciaries” with respect to the corporation and its stockholders’. They have various responsibilities and duties but they are not agents.9
Accepting that managers are not, legally speaking, agents of shareholders, it is still reasonable to argue that the manager does have a contract with the firm, that the provisions of this contract and the incentive devices built into it will crucially influence the willingness of people to hold the financial instruments of the company, and that in assessing the likely effectiveness of these contracts the shareholder and bondholder will presumably have the same factors in mind as in an assessment of an agency contract. If it were objected that few shareholders would have detailed knowledge of managerial contracts in a firm, the defence must be similar to that advanced by Stiglitz in the context of the discussion of piece-rates and time-rates in Chapter 6. Over time, the competitive process selects those arrangements with survival value and these will look, in the end, like a ‘solution’ to an agency problem.
According to the nexus of contracts approach, we would expect the structure of rights within the corporation to reflect the hazards to which the contributors are subject. Shareholders will be aware that managers may shirk or may use profits to finance investments with low net present values rather than to pay higher dividends. Bondholders will know that shareholders’ may be induced to endorse more risky projects because the benefit from successful (if rather lucky) outcomes will accrue entirely to shareholders rather than the recipients of fixed interest, while limited liability provides a floor to possible shareholder losses in the event of bad luck. Managers and workers who have accumulated much firm-specific expertise and are vulnerable to opportunistic recontracting (for example, after a takeover) will look for ways to defend their interests. These observations suggest that different conditions will be conducive to different contractual arrangements and differing financial structures. Sections 4 to 9 investigate responses to the agency problem in more detail. As Fama and Jensen (1983, p. 345) express it, ‘we explain the survival of organisational forms largely in terms of the comparative advantages of characteristics of residual claims in controlling the agency problems of an activity’.
In Chapter 5, the major forces moulding relationships between principal and agent were set out. The ‘observability’ of effort; the cost of monitoring; the availability of informative signals concerning the agent’s behaviour; the efficiency of effort; the degree of risk aversion of the contractors; the uncertainty of the environment; the durability of the relationship – all these matters were expected to play a part in establishing the contractual outcomes. In the following sections, the same considerations will be discussed in the context of corporate governance. Section 4 investigates incentive contracts for managers on the assumption that their actions are unobservable. In section 5, the role of monitoring is discussed. Is it true that shareholders have no incentive to monitor managers? Are there informative signals about managerial effort available? Are there ways that influence can be exerted even with dispersed shareholdings? The use of information on the relative performance of managers facing similar environmental conditions, and the role of the managerial labour market as a provider of incentives is covered in section 6. The constraining and stimulating influence of competition in the product market is the topic of section 7.
Source: Ricketts Martin (2002), The Economics of Business Enterprise: An Introduction to Economic Organisation and the Theory of the Firm, Edward Elgar Pub; 3rd edition.