Chapter 10 Corporate Governance 10.1 The market for corporate control The agency problem that arises from the separation of ownership and control (Berle and Means, 1932)has been a major focus of the literature on corporate finance and the theory of the firm over the last twenty years. Various insti- tutional arrangements exist to deal with this agency problem and one that has attracted a lot of attention is the market for corporate control. Manne (1965) suggested that, if a publicly traded company is badly managed and the usual methods of corporate governance(board of directors, proxy bat tles, etc )are not effective in disciplining the management, a hostile takeover llows an outsider to acquire a controlling interest in the firm, change the management, and realize an increase in shareholder value Grossman and Hart(1980) provided a formal analysis of how the mar- ket for corporate control functions and pointed out the existence of a free- rider problem that may prevent takeovers from maximizing shareholder value Here is a brief sketch of the model. The manager of a firm chooses an action a E A and the resulting value of the firm is denoted by V(a). Suppose the firm is under the control of an incumbent manager who for some reason(e.g incompetence or private benefits) is not maximizing shareholder value. The optimal action is a* but the manager chooses a. If a raider acquires control of the firm and changes the action from a to a*, social surplus increases V(a-V(a)and this gain in surplus can be shared between the raider the shareholders A hold-out' problem arises because the existing shareholders anticipate
Chapter 10 Corporate Governance 10.1 The market for corporate control The agency problem that arises from the separation of ownership and control (Berle and Means, 1932) has been a major focus of the literature on corporate finance and the theory of the firm over the last twenty years. Various institutional arrangements exist to deal with this agency problem and one that has attracted a lot of attention is the market for corporate control. Manne (1965) suggested that, if a publicly traded company is badly managed and the usual methods of corporate governance (board of directors, proxy battles, etc.) are not effective in disciplining the management, a hostile takeover allows an outsider to acquire a controlling interest in the firm, change the management, and realize an increase in shareholder value. Grossman and Hart (1980) provided a formal analysis of how the market for corporate control functions and pointed out the existence of a freerider problem that may prevent takeovers from maximizing shareholder value. Here is a brief sketch of the model. The manager of a firm chooses an action a ∈ A and the resulting value of the firm is denoted by V (a). Suppose the firm is under the control of an incumbent manager who for some reason (e.g., incompetence or private benefits) is not maximizing shareholder value. The optimal action is a∗ but the manager chooses a¯. If a raider acquires control of the firm and changes the action from a¯ to a∗, social surplus increases by V (a∗) − V (¯a) and this gain in surplus can be shared between the raider and the shareholders. A ‘hold-out’ problem arises because the existing shareholders anticipate 1
CHAPTER 10. CORPORATE GOVERNANCE an increase in value if the raider successfully takes control of the firm. The shareholders will be unwilling to tender their shares unless they are paid the full anticipated value. If takeovers are costly, the raider will undertake a takeover only if he anticipates a positive profit. But if the raider has to pay the full price he gets no profit from the takeover To make this argument precise, consider the following game form The raider offers a price p for the shares of the firm and pays a fixed cost C>0(the cost of organizing the tender offer) . Each shareholder has a single share. which he can tender or retain If the raider acquires a fraction 0 y of the shares, he gets control, chooses the optimal action a, and the value of the firm is V(). If he acquires a fraction g y, the incumbent manager remains in control, the firms policy is unchanged, and the value of the firm is v(a) At the second stage, the shareholder receives the price p if he tenders his share. if he holds onto his share and the offer fails. his share is worth V(a). If he holds onto his share and the offer succeeds, his share is worth V(a). Thus, he will tender his share if p>v(a)(resp p>V(a*) and hold onto it if p y of the shares, his profit is (p-V(a))9-C<0
2 CHAPTER 10. CORPORATE GOVERNANCE an increase in value if the raider successfully takes control of the firm. The shareholders will be unwilling to tender their shares unless they are paid the full anticipated value. If takeovers are costly, the raider will undertake a takeover only if he anticipates a positive profit. But if the raider has to pay the full price he gets no profit from the takeover. To make this argument precise, consider the following game form: • The raider offers a price p for the shares of the firm and pays a fixed cost C > 0 (the cost of organizing the tender offer). • Each shareholder has a single share, which he can tender or retain. • If the raider acquires a fraction 0 V (¯a) (resp. p>V (a∗)) and hold onto it if p<V (¯a) (resp. p<V (a∗)). • At the first stage, the raider must offer a price that equals the shareholders’ reservation price to succeed. Thus, the offer can succeed only if p ≥ V (a∗). If the raider acquires a fraction g ≥ γ of the shares, his profit is (p − V (a∗ ))g − C < 0
10.1. THE MARKET FOR CORPORATE CONTROL So it appears that a takeover cannot succeed grossman and hart suggest that dilution of the existing shareholders property rights may provide the raider with sufficient profit to undertake the raid. Suppose that the dilution ratio is o, that is, the raider can capture a fraction of the minority shareholders' property rights by self-dealing, etc Then the price offered must satisfy p2(1-oV(a*) and a successful tender offer is possible if oV(a)≥C. Bagnoli and Lipman(1987) point out that the Grossman Hart model with a continuum of shareholders is special Abstract: We noted at the outset that most of the literature on takeovers assumes atomistic stockholders. As we pointed out however, there are many large firms for which this assumption is obviously inappropriate. This led us to consider the finite stock- holder game. We showed that there are substantial differences between the finite game and the atomistic stockholder models In particular, because some stockholders must be pivotal and hence cannot free ride, successful takeovers are possible without exclusion. Since the equilibrium outcome in the finite stockholder game is quite different from the atomistic stockholder outcome the natural question to ask is under what conditions the atom- istic stockholder outcome obtains for firms which are sufficiently widely held. We showed that the atomistic stockholder outcome does not obtain in the infinite stockholder game. We also showed that the difference between the finite and atomistic stockholder outcomes may not vanish in the limit. We argued that atom- istic stockholder models may provide a reasonable appl to the outcome for takeovers with any-and-all bids if the firm is not sufficiently valuable relative to the dispersion of stock owner ship. Otherwise, the finite stockholder model is likely to provide a more accurate prediction, so that exclusion is not necessary for successful takeovers. Since, all else equal, stockholders generally benefit more from takeovers without exclusion, our analysis sug gests that stockholders would prefer to invest in firms which are valuable relative to the dispersion of stock ownership. This, in turn, suggests that a given firms stock will not be"too"widely
10.1. THE MARKET FOR CORPORATE CONTROL 3 So it appears that a takeover cannot succeed. Grossman and Hart suggest that dilution of the existing shareholders’ property rights may provide the raider with sufficient profit to undertake the raid. Suppose that the dilution ratio is φ, that is, the raider can capture a fraction φ of the minority shareholders’ property rights by self-dealing, etc. Then the price offered must satisfy p ≥ (1 − φ)V (a∗) and a successful tender offer is possible if φV (a∗ ) ≥ C. Bagnoli and Lipman (1987) point out that the Grossman Hart model with a continuum of shareholders is special. Abstract: We noted at the outset that most of the literature on takeovers assumes atomistic stockholders. As we pointed out, however, there are many large firms for which this assumption is obviously inappropriate. This led us to consider the finite stockholder game. We showed that there are substantial differences between the finite game and the atomistic stockholder models. In particular, because some stockholders must be pivotal and hence cannot free ride, successful takeovers are possible without exclusion. Since the equilibrium outcome in the finite stockholder game is quite different from the atomistic stockholder outcome, the natural question to ask is under what conditions the atomistic stockholder outcome obtains for firms which are sufficiently widely held. We showed that the atomistic stockholder outcome does not obtain in the infinite stockholder game. We also showed that the difference between the finite and atomistic stockholder outcomes may not vanish in the limit. We argued that atomistic stockholder models may provide a reasonable approximation to the outcome for takeovers with any-and-all bids if the firm is not sufficiently valuable relative to the dispersion of stock ownership. Otherwise, the finite stockholder model is likely to provide a more accurate prediction, so that exclusion is not necessary for successful takeovers. Since, all else equal, stockholders generally benefit more from takeovers without exclusion, our analysis suggests that stockholders would prefer to invest in firms which are valuable relative to the dispersion of stock ownership. This, in turn, suggests that a given firm’s stock will not be “too” widely
CHAPTER 10. CORPORATE GOVERNANCE held relative to its value. This seems like an interesting topic for future research The essential idea is captured by the following game. Suppose there is a finite number of shareholders i= 1.n and shareholder i holds a fraction Bi of the firm's shares. The game is the same as above except that each shareholder i can tender a fraction t i 0i of his shares and the raid succeeds if and only if t;≥ If the tender price is p the payoff to shareholder i is ui(p, t) (62-t)V(a)+tpif∑:t≥ (02-tV(a)+tpif∑;t y, each shareholder will minimize his offer subject to constraint. Any further reduction would cause the offer to fail and his payoff would fall. For any p>v(a) it is optimal for agents to submit the maximum t i if the tender offer is expected to fail and the minimum consistent with ∑:t1≥ if it is expected to succeed. In a spe the raider will offer p≤V(a) and the shareholders will choose to offer amounts t: such that >iti2y If p< v(a)there exists a trivial continuation equilibrium in which ti=0 for all i if 0i y for each i The equilibrium constructed here depends crucially on the assumption that the fraction of the shares needed for control is known with certainty so that every shareholder is pivotal. Introducing a small amount of uncertainty could upset this equilibrium Holmstrom and Nalebuff(1992) study mixed strategy equilibria of the finite game Abstract: This paper reexamines Grossman and Hart's(1980)in- sight into how the free-rider problem excludes an external raider from capturing the increase in value it brings to a firm. The inability of the raider to capture any of the surplus depends criti- cally on the assumption of equal and indivisible shareholdings-the one-share-per-shareholder model. In contrast, we show that once shareholdings are large and potentially unequal, a raider may cap- ture a significant part of the increase in value. Specifically, the
4 CHAPTER 10. CORPORATE GOVERNANCE held relative to its value. This seems like an interesting topic for future research. The essential idea is captured by the following game. Suppose there is a finite number of shareholders i = 1, ..., n and shareholder i holds a fraction θi of the firm’s shares. The game is the same as above except that each shareholder i can tender a fraction ti ≤ θi of his shares and the raid succeeds if and only if X i ti ≥ γ. If the tender price is p the payoff to shareholder i is ui(p, t) = ½ (θi − ti)V (a∗) + tip if P i ti ≥ γ (θi − ti)V (¯a) + tip if P i ti V (¯a) it is optimal for agents to submit the maximum ti P if the tender offer is expected to fail and the minimum consistent with i ti ≥ γ if it is expected to succeed. In a SPE the raider will offer p ≤ V (¯a) and the shareholders will choose to offer amounts ti such that P i ti ≥ γ. If p<V (¯a) there exists a trivial continuation equilibrium in which ti = 0 for all i if θi < γ for each i. The equilibrium constructed here depends crucially on the assumption that the fraction of the shares needed for control is known with certainty so that every shareholder is pivotal. Introducing a small amount of uncertainty could upset this equilibrium. Holmstrom and Nalebuff (1992) study mixed strategy equilibria of the finite game. Abstract: This paper reexamines Grossman and Hart’s (1980) insight into how the free-rider problem excludes an external raider from capturing the increase in value it brings to a firm. The inability of the raider to capture any of the surplus depends critically on the assumption of equal and indivisible shareholdings—the one-share-per-shareholder model. In contrast, we show that once shareholdings are large and potentially unequal, a raider may capture a significant part of the increase in value. Specifically, the
10. 2. BENEFITS OF MANAGERIAL INDEPENDENCE free-rider problem does not prevent the takeover process when shareholdings are divisible Grossman and Hart(1988 )study the design of the firms corporate charter to optimize the role of takeovers in maximizing the value of the firm. There is a tradeoff between making the firm too difficult to take over and thus protecting incumbent management and making it too easy and allowing the existing shareholders to be exploited in a corporate control contest Abstract: This paper analyzes the optimality of the one share-one vote rule. The authors focus on takeover bids as a mechanism for locating control. They assume two types of control benefits- benefits to security holders and private benefits to the controlling party. One share-one vote maximizes the importance of benefits to security holders, relative to benefits to the controlling party, and. hence encourages the selection of an efficient management team. However, one share-one vote does not always maximize the reward to security holders in a corporate control contest. Suffi cient conditions are given for one share-one vote to be optimal overall. The paper also includes a discussion of the empirical evidence 10.2 Benefits of managerial independence The agency approach assumes that the manager is in control of the firm that his interests are opposed to the interests of the shareholders, and that the shareholders maximize their interess by exerting control over his actions This is a useful complement to the traditional idea that managers maximize shareholders' preferences. How realistic is this view of the modern publicly traded company? In this section, we present a model of managerial indepen- dence and show that maximum control may not be optimal We assume that the interests of managers and shareholders are imper fectly aligned. Specifically, the manager has an incentive to overinvest. How- ever, the manager also has superior information about the efficient level of investment. The essential idea is that the shareholders may want to give the manager discretion in order to take advantage of his superior information even if discretion is costly because it allows overinvestment
10.2. BENEFITS OF MANAGERIAL INDEPENDENCE 5 free-rider problem does not prevent the takeover process when shareholdings are divisible. Grossman and Hart (1988) study the design of the firm’s corporate charter to optimize the role of takeovers in maximizing the value of the firm. There is a tradeoff between making the firm too difficult to take over and thus protecting incumbent management and making it too easy and allowing the existing shareholders to be exploited in a corporate control contest. Abstract: This paper analyzes the optimality of the one share-one vote rule. The authors focus on takeover bids as a mechanism for allocating control. They assume two types of control benefits– benefits to security holders and private benefits to the controlling party. One share-one vote maximizes the importance of benefits to security holders, relative to benefits to the controlling party, and, hence, encourages the selection of an efficient management team. However, one share-one vote does not always maximize the reward to security holders in a corporate control contest. Suffi- cient conditions are given for one share-one vote to be optimal overall. The paper also includes a discussion of the empirical evidence. 10.2 Benefits of managerial independence The agency approach assumes that the manager is in control of the firm, that his interests are opposed to the interests of the shareholders, and that the shareholders maximize their interess by exerting control over his actions. This is a useful complement to the traditional idea that managers maximize shareholders’ preferences. How realistic is this view of the modern publicly traded company? In this section, we present a model of managerial independence and show that maximum control may not be optimal. We assume that the interests of managers and shareholders are imperfectly aligned. Specifically, the manager has an incentive to overinvest. However, the manager also has superior information about the efficient level of investment. The essential idea is that the shareholders may want to give the manager discretion in order to take advantage of his superior information, even if discretion is costly because it allows overinvestment
CHAPTER 10. CORPORATE GOVERNANCE The value of the firm is assumed to be a function v(x,6)=(6-x/2)x of the amount invested >0 and a random variable 8, uniformly distributed on an interval, M, which can be interpreted as the profitability of invest ment The manager's preferences are represented by a utility function u(a, 0)=v(a, 0+a)=(0+a-a/2)c, where a>0 A Pigovian tax t(a)=-am achieves the first best. We assume that no such schemes are available 10.2.1 Delegation without Commitment Delegation without commitment is a special case of the "cheap talk"game ntroduced by Crawford and Sobel(1982). A strategy for the manager is a function f:0,n→[0,n and the shareholders' strategy is a function 9: 0, M-R+. The shareholders beliefs are represented by a function 1:[0,M→△0.,M, where△0,M] denotes the set of probability distribu tions on 0, M. Then u(m)is the shareholders' probability distribution over possible values of 0 when the manager announces m. The equilibrium con ditions require that each player is choosing a best response and that beliefs are consistent with Bayes rule wherever possible. (i)g(m)∈ ∫(6-x/2)xp(m); (ii)f(e)E arg max(0+a-g(m)/2)g(m) (iii)u(m)=unif f-(m), for almost all m If G is the range of the function g, then the manager is effectively choosing the level of investment from the set G and condition (ii) merely requires the choose optimally from G for each value of 0 concave the manager's objective function implies that the set f-() is convex for every a E G. Furthermore, the number of these sets must be finite, as the next lemma shows Lemma 1 Suppose that a and a belong to G and are chosen in equilibrium and Then +a<
6 CHAPTER 10. CORPORATE GOVERNANCE The value of the firm is assumed to be a function v(x, θ)=(θ − x/2)x. of the amount invested x ≥ 0 and a random variable θ, uniformly distributed on an interval[0, M], which can be interpreted as the profitability of investment. The manager’s preferences are represented by a utility function u(x, θ) ≡ v(x, θ + a)=(θ + a − x/2)x, where a > 0. A Pigovian tax t(x) = −ax achieves the first best. We assume that no such schemes are available. 10.2.1 Delegation without Commitment Delegation without commitment is a special case of the “cheap talk” game introduced by Crawford and Sobel (1982). A strategy for the manager is a function f : [0, M] → [0, M] and the shareholders’ strategy is a function g : [0, M] → R+. The shareholders beliefs are represented by a function µ : [0, M] → ∆[0, M], where ∆[0, M] denotes the set of probability distributions on [0, M]. Then µ(m) is the shareholders’ probability distribution over possible values of θ when the manager announces m. The equilibrium conditions require that each player is choosing a best response and that beliefs are consistent with Bayes’ rule wherever possible. (i) g(m) ∈ arg max R M 0 (θ − x/2)xdµ(m); (ii) f(θ) ∈ arg max(θ + a − g(m)/2)g(m); (iii) µ(m) = unif f −1(m), for almost all m. If G is the range of the function g, then the manager is effectively choosing the level of investment from the set G and condition (ii) merely requires the manager to choose optimally from G for each value of θ. The concavity of the manager’s objective function implies that the set f −1(x) is convex for every x ∈ G. Furthermore, the number of these sets must be finite, as the next lemma shows. Lemma 1 Suppose that x and x0 belong to G and are chosen in equilibrium and x<x0 . Then x + a<x0
10. 2. BENEFITS OF MANAGERIAL INDEPENDENCE Without loss of generality, we can identify the manager's strategy with a finite list of intervals (0k, 0k+)k, where 01=0 and 0K+1=M, such that all manager types 0 E( 0k, 0k+1) send the same signal, which causes hareholders to choose an investment level k Theorem 2 Let [ (Ok, k)K be a sequence satisfying 01=0 and Ok 0k+1 and the following conditions ()xk=(6k+bk+1)/2, for k=1,., K, where 0K+1= M (i)(6k+1+a)=(xk+xk+1)/2,fork=1,…,K-1 Then there exists a perfect Bayesian equilibrium (, g, u) such that(0k, 0k+1)C mk) and g(mk)=ak, for k= 1,..,K. Conversely, for any perfect Bayesian equilibrium(, g, p), there erists a sequence [ (Ok, xk))k satisfying conditions(i)and (ii) and such that(0k, 0k+1)Cf-(mk)and g(mk fork=1,…,K 10.2.2 Delegation with Commitment By the revelation principle, we can restrict attention to direct revelation mechanisms. A direct revelation mechanism is a function g: 0, MI where g()is the investment specified by the shareholders when the manager reports his type to be 8. The manager will report his type truthfully if the mechanism is incentive-compatible and the optimal (incentive-compatible mechanism maximizes the shareholders'payoff E[0-g0)/2)g(0) subject t the manager is effectively choosing an element from the range of g, @ at the incentive-compatibility constraint. As in the case without commitment 9(10, M). It will be convenient to use this representation of the mechanism in our analysis. To avoid pathological cases, we assume that g is a closed set Lemma 3 If g is an optimal, incentive-compatible mechanism, the graph G is an interval Theorem 4 If*: 0, M-R+ is an optimal incentive-compatible mech- anism for the shareholders, then for some value of T1 <M, the mechanism has the form g(0)=min 0+a, 21, V0E0, M
10.2. BENEFITS OF MANAGERIAL INDEPENDENCE 7 Without loss of generality, we can identify the manager’s strategy with a finite list of intervals {(θk, θk+1)}K k=1, where θ1 = 0 and θK+1 = M, such that all manager types θ ∈ (θk, θk+1) send the same signal, which causes shareholders to choose an investment level xk. Theorem 2 Let {(θk, xk)}K k=1 be a sequence satisfying θ1 = 0 and θk < θk+1 and the following conditions: (i) xk = (θk + θk+1)/2, for k = 1, ..., K, where θK+1 = M; (ii) (θk+1 + a)=(xk + xk+1)/2, for k = 1, ..., K − 1. Then there exists a perfect Bayesian equilibrium (f, g, µ) such that (θk, θk+1) ⊂ f −1(mk) and g(mk) = xk, for k = 1, ..., K. Conversely, for any perfect Bayesian equilibrium (f, g, µ), there exists a sequence {(θk, xk)}K k=1 satisfying conditions (i) and (ii) and such that (θk, θk+1) ⊂ f −1(mk) and g(mk) = xk, for k = 1, ..., K 10.2.2 Delegation with Commitment By the revelation principle, we can restrict attention to direct revelation mechanisms. A direct revelation mechanism is a function g : [0, M] → R+, where g(θ) is the investment specified by the shareholders when the manager reports his type to be θ. The manager will report his type truthfully if the mechanism is incentive-compatible and the optimal (incentive-compatible) mechanism maximizes the shareholders’ payoff E[(θ−g(θ)/2)g(θ)] subject to the incentive-compatibility constraint. As in the case without commitment, the manager is effectively choosing an element from the range of g, G = g([0, M]). It will be convenient to use this representation of the mechanism in our analysis. To avoid pathological cases, we assume that G is a closed set. Lemma 3 If g is an optimal, incentive-compatible mechanism, the graph G is an interval. Theorem 4 If g∗ : [0, M] → R+ is an optimal incentive-compatible mechanism for the shareholders, then for some value of x1 ≤ M, the mechanism has the form g∗ (θ) = min{θ + a, x1}, ∀θ ∈ [0, M]
CHAPTER 10. CORPORATE GOVERNANCE The optimal mechanism involves putting an upper bound 1 on the amount of investment but apart from that the manager can choose the level of investment that he wants. Although there is some constraint on managerial discretion, it will be very small when M is large or a is small. In other words when uncertainty is large and/ or the divergence between the interests of the manager and shareholders not too great, the manager will be given almost complete discretion. One is led to speculate that if the support of 0 were un- bounded, the optimal mechanism could give managers complete discretion In any case, this exercise indicates that there may be circumstances in which shareholders are best served by the separation of ownership and control, in spite of the existence of private benefits that distort the manager's decision 10.2.3 Burkart, Gromb and Panunzi (1997) This is a variant of solving the agency problem by "selling the firm to the agent" If the confict of interest bet ween shareholders and managers leads to inefficiency, reducing the claim of the shareholders may lead to greater ef- ficiency. Too much control by shareholders is not a good thing. The manager must have some discretion to pursue his own interests and reap private ben- efits: otherwise he will not have an incentive to make an effort on behalf of the firm. The problem is that shareholders, once they start to micro-manage cannot commit themselves to reward the manager in a way that is consistent with optimal incentives. So the firm has to be constituted in a way that re- stricts shareholder power, in other words, commits them to leave some rents for the manager. Burkart, Gromb and Panunzi argue that ownership struc ture can act as such a commitment device. By having dispersed ownership of outside equity, shareholders are effectively precommitting not to interfere with the managers. Each shareholder's ownership will be sufficiently small that there will be little incentive to monitor 10.3 Competition Over the last twenty years, the literature on corporate governance or cor porate finance for that matter--has focused on the agency problems facing shareholders under separation of ownership and control. The assumption derlying this literature seems to be either that
8 CHAPTER 10. CORPORATE GOVERNANCE The optimal mechanism involves putting an upper bound x1 on the amount of investment but apart from that the manager can choose the level of investment that he wants. Although there is some constraint on managerial discretion, it will be very small when M is large or a is small. In other words, when uncertainty is large and/or the divergence between the interests of the manager and shareholders not too great, the manager will be given almost complete discretion. One is led to speculate that if the support of θ were unbounded, the optimal mechanism could give managers complete discretion. In any case, this exercise indicates that there may be circumstances in which shareholders are best served by the separation of ownership and control, in spite of the existence of private benefits that distort the manager’s decision. 10.2.3 Burkart, Gromb and Panunzi (1997) This is a variant of solving the agency problem by “selling the firm to the agent”. If the conflict of interest between shareholders and managers leads to inefficiency, reducing the claim of the shareholders may lead to greater ef- ficiency. Too much control by shareholders is not a good thing. The manager must have some discretion to pursue his own interests and reap private benefits; otherwise he will not have an incentive to make an effort on behalf of the firm. The problem is that shareholders, once they start to micro-manage, cannot commit themselves to reward the manager in a way that is consistent with optimal incentives. So the firm has to be constituted in a way that restricts shareholder power, in other words, commits them to leave some rents for the manager. Burkart, Gromb and Panunzi argue that ownership structure can act as such a commitment device. By having dispersed ownership of outside equity, shareholders are effectively precommitting not to interfere with the managers. Each shareholder’s ownership will be sufficiently small that there will be little incentive to monitor. 10.3 Competition Over the last twenty years, the literature on corporate governance–or corporate finance for that matter–has focused on the agency problems facing shareholders under separation of ownership and control. The assumption underlying this literature seems to be either that
10.3. COMPETITION government intervention is required to solve problems of corporate gov- ernance or that the us economy is underperforming because of the corporate gover- nance problems inherent in the separation of ownership and control of publicly traded companies compared with other systems While it is possible to build theoretical models to substantiate these claims, the empirical evidence is less clear. There is, of course, anecdotal ev- dence of agency problems. But, the equity premium puzzle and the success of publicly traded companies in the US and UK, suggest that shareholders have done quite well by comparison with bondholders An alternative approach is to focus not on the governance of individual firms but instead to focus on the effect of competition among firms. Corpo- rate governance can be regarded as a technology. Competition forces firms to adopt the most efficient technology. If a new technology arrives and is not exist at any date are to be regarded as the state of the art technolog t will be implemented y a competitor. Whatever ineffic It has been argued (see, e. g, Alchian(1950) and Stigler(1958)) that com- petition in product markets is a very powerful force for ensuring good corpo- rate governance. If the managers of a firm waste or consume large amounts of resources, the firm will be unable to compete and will go bankrupt. There seems little doubt that competition, particularly international competition, is a powerful force in disciplining management 10.3.1 Competition and managerial slack One idea studied in the corporate governance literature is that competition between different organizational forms may be helpful in limiting efficiency losses. If a family-owned business has the sole objective of maximizing share value, it may force all the corporations in that industry to do the same thing An early attempt to model product-market competition as a mechanism te discipline managers is found in Hart( 1983). On the supply side, Hart assumes that there is a large number of small firms. a fraction v are traditional profit maximizers: these are called entrepreneurial firms. The remaining fraction 1-v are operated by managers who maximize their own interest
10.3. COMPETITION 9 • government intervention is required to solve problems of corporate governance, or that • the US economy is underperforming because of the corporate governance problems inherent in the separation of ownership and control of publicly traded companies compared with other systems. While it is possible to build theoretical models to substantiate these claims, the empirical evidence is less clear. There is, of course, anecdotal evidence of agency problems. But, the equity premium puzzle and the success of publicly traded companies in the US and UK, suggest that shareholders have done quite well by comparison with bondholders. An alternative approach is to focus not on the governance of individual firms but instead to focus on the effect of competition among firms. Corporate governance can be regarded as a technology. Competition forces firms to adopt the most efficient technology. If a new technology arrives and is not adopted, it will be implemented by a competitor. Whatever inefficiencies exist at any date are to be regarded as the state of the art technology. It has been argued (see, e.g., Alchian (1950) and Stigler (1958)) that competition in product markets is a very powerful force for ensuring good corporate governance. If the managers of a firm waste or consume large amounts of resources, the firm will be unable to compete and will go bankrupt. There seems little doubt that competition, particularly international competition, is a powerful force in disciplining management. 10.3.1 Competition and managerial slack One idea studied in the corporate governance literature is that competition between different organizational forms may be helpful in limiting efficiency losses. If a family-owned business has the sole objective of maximizing share value, it may force all the corporations in that industry to do the same thing. An early attempt to model product-market competition as a mechanism to discipline managers is found in Hart (1983). On the supply side, Hart assumes that there is a large number of small firms. A fraction ν are traditional profit maximizers; these are called entrepreneurial firms. The remaining fraction 1 − ν are operated by managers who maximize their own interests;
10 CHAPTER 10. CORPORATE GOVERNANCE these are called managerial firms. The firms have identical cost functions C(w, L), where w is the input price, q is the output level, and L is the level of managerial effort. Managerial effort and input prices are assumed to be substitutes, in the sense that greater effort compensates for higher input C(, 9, L)=C((w, L), q) The cost index q (w, L is increasing in the input price w and decreasing in managerial effort L. Ex ante, the input prices are independently and identi- cally distributed across firms. Ex post, there is no aggregate uncertainty: the cross-sectional distribution of input prices is non-stochastic and proportional to the ex ante probability distribution The manager takes output and input prices as given and decides how much output to produce and how much managerial effort to exert in order to maximize his own preferences. An incentive problem arises because the manager can observe his input price w and his effort L, but the shareholders cannot. Thus, a manager who faces a low input price may choose to shirk instead of achieving high profits for the shareholders he exerts a low level of effort and claims that profits are low because the input price is high The manager's preferences are assumed to be additively separable inin come and effort: the von Neumann-Morgenstern utility function is H(U(D) V(L)), where I is the manager's income and L is his effort. The manager is infinitely risk averse: his utility-of-income function is very flat above I and very steep below I. The manager's reservation utility is U. In order to be acceptable to the manager, a managerial contract must guarantee the manager an income that is at least and never call on the manager to make an effort greater than L. where These restrictive assumptions are chosen to make the problem analytically tractable, but it turns out that they are crucial for the substantive results as well. as we shall see below Since the manager must be paid a fixed income and exert a fixed amount of effort to achieve his reservation utility, this is the only outcome that consistent with efficiency. If the shareholders could observe the manager's effort L, they could achieve the first best by offering the manager a contract that pays him I as long as he exerts an effort L= L. Since they cannot do this, they must settle for the second best. It is assumed that the shareholders
10 CHAPTER 10. CORPORATE GOVERNANCE these are called managerial firms. The firms have identical cost functions C(w, q, L), where w is the input price, q is the output level, and L is the level of managerial effort. Managerial effort and input prices are assumed to be substitutes, in the sense that greater effort compensates for higher input costs: C(w, q, L) = Cˆ(Φ(w, L), q). The cost index Φ(w, L) is increasing in the input price w and decreasing in managerial effort L. Ex ante, the input prices are independently and identically distributed across firms. Ex post, there is no aggregate uncertainty: the cross-sectional distribution of input prices is non-stochastic and proportional to the ex ante probability distribution. The manager takes output and input prices as given and decides how much output to produce and how much managerial effort to exert in order to maximize his own preferences. An incentive problem arises because the manager can observe his input price w and his effort L, but the shareholders cannot. Thus, a manager who faces a low input price may choose to shirk: instead of achieving high profits for the shareholders he exerts a low level of effort and claims that profits are low because the input price is high. The manager’s preferences are assumed to be additively separable in income and effort: the von Neumann-Morgenstern utility function is H(U(I)− V (L)), where I is the manager’s income and L is his effort. The manager is infinitely risk averse: his utility-of-income function is very flat above ¯I and very steep below ¯I. The manager’s reservation utility is U¯. In order to be acceptable to the manager, a managerial contract must guarantee the manager an income that is at least ¯I and never call on the manager to make an effort greater than L¯, where U(¯I) − V (L¯) = H−1 (U¯). These restrictive assumptions are chosen to make the problem analytically tractable, but it turns out that they are crucial for the substantive results as well, as we shall see below. Since the manager must be paid a fixed income and exert a fixed amount of effort to achieve his reservation utility, this is the only outcome that is consistent with efficiency. If the shareholders could observe the manager’s effort L, they could achieve the first best by offering the manager a contract that pays him ¯I as long as he exerts an effort L = L¯. Since they cannot do this, they must settle for the second best. It is assumed that the shareholders