Chapter I CORPORATE GOVERNANCE AND CONTROL MARCO BECHT* ECARES, Universit Libre de Bruxelles and European Corporate Governance Institute (ECGI) PATRICK BOLTON* Bendheim Center for Finance at Princeton University, NBER, CEPR and ECGI AILSA ROELL* Bendheim Center for Finance at Princeton University, CEPR and ECGI Contents Abstract 3 Keywords 3 1 Introduction 4 2 Historical origins: a brief sketch 5 2.1 How representative is corporate government? 5 2.2 Whom should corporate government represent? 7 3 Why corporate governance is currently such a prominent issue 7 3.1 The world-wide privatization wave 8 3.2 Pension funds and active investors 9 3.3 Mergers and takeovers 12 3.4 Deregulation and capital market integration 12 3.5 The 1998 Russia/East Asia/Brazil crisis 12 3.6 Scandals and failures at major USA corporations 13 4 Conceptual framework 13 4.1 Agency and contracting 13 4.2 Ex-ante and ex-post efficiency 13 4.3 Shareholder value 14 4.4 Incomplete contracts and multiple constituencies 14 4.5 Why do we need regulation? 16 4.6 Dispersed ownership 17 4.7 Summary and conclusion 17 · We are grateful to Bernardo Bortolotti, Mathias Dewatripont, Richard Frederick, Stu Gillan, Peter Gourevitch, Milton Harris, Gerard Hertig, Takeo Hoshi, Steve Kaplan, Roberta Romano, Christian Rydqvist and Scott Verges for helpful input and comments. Handbook of the Economics of Finance, Edited by G M Constantinides, M Harris and R Stulz © 2003 Elsevier B V All rights reserved 2 M Becht et al. 5 Models 19 5.1 Takeover models 19 5.2 Blockholder models 24 5.3 Delegated monitoring and large creditors 29 5.4 Board models 31 5.5 Executive compensation models 33 5.6 Multi-constituency models 35 5.6 1 Sharing control with creditors 35 5.6 2 Sharing control with employees 37 6 Comparative perspectives and debates 41 6.1 Comparative systems 42 6.2 Views expressed in corporate governance principles and codes 47 6.3 Other views 49 7 Empirical evidence and practice 49 7.1 Takeovers 50 7.1 1 Incidence of hostile takeovers 50 7.1 2 Correction of inefficiencies 53 7.1 3 Redistribution 54 7.1 4 Takeover defenses 54 7.1 5 One-share-one-vote 55 7.1 6 Hostile stakes and block sales 58 7.1 7 Conclusion and unresolved issues 58 7.2 Large investors 59 7.2 1 Ownership dispersion and voting control 60 7.2 2 Ownership, voting control and corporate performance 63 7.2 3 Share blocks and stock market liquidity 64 7.2 4 Banks 65 7.3 Minority shareholder action 67 7.3 1 Proxy fights 67 7.3 2 Shareholder activism 68 7.3 3 Shareholder suits 69 7.4 Boards 71 7.4 1 Institutional differences 71 7.4 2 Board independence 72 7.4 3 Board composition 72 7.4 4 Working of boards 72 7.4 5 International evidence 73 7.5 Executive compensation and careers 73 7.5 1 Background and descriptive statistics 73 7.5 2 Pay-performance sensitivity 75 7.5 3 Are compensation packages well-designed? 76 7.5 4 Are managers paying themselves too much? 77 7.5 5 Implicit incentives 78 Ch I: Corporate Governance and Control 3 7.5 6 Conclusion 79 7.6 Multiple constituencies 80 7.6 1 Debtholders 80 7.6 2 Employees 81 8 Conclusion 82 References 86 Abstract Corporate governance is concerned with the resolution of collective action problems among dispersed investors and the reconciliation of conflicts of interest between various corporate claimholders In this survey we review the theoretical and empirical research on the main mechanisms of corporate control, discuss the main legal and regulatory institutions in different countries, and examine the comparative corporate governance literature A fundamental dilemma of corporate governance emerges from this overview: regulation of large shareholder intervention may provide better protection to small shareholders; but such regulations may increase managerial discretion and scope for abuse. Keywords corporate governance, ownership, takeovers, block holders, boards JEL classification: G 32, G 34 4 M Becht et al. 1 Introduction At the most basic level a corporate governance problem arises whenever an outside investor wishes to exercise control differently from the manager in charge of the firm Dispersed ownership magnifies the problem by giving rise to conflicts of interest between the various corporate claimholders and by creating a collective action problem among investors Most research on corporate governance has been concerned with the resolution of this collective action problem Five alternative mechanisms may mitigate it: i) partial concentration of ownership and control in the hands of one or a few large investors; ii) hostile takeovers and proxy voting contests, which concentrate ownership and/or voting power temporarily when needed; iii) delegation and concentration of control in the board of directors; iv) alignment of managerial interests with investors through executive compensation contracts; and v) clearly defined fiduciary duties for CE Os together with class-action suits that either block corporate decisions that go against investors' interests, or seek compensation for past actions that have harmed their interests. In this survey we review the theoretical and empirical research on these five main mechanisms and discuss the main legal and regulatory institutions of corporate governance in different countries We discuss how different classes of investors and other constituencies can or ought to participate in corporate governance We also review the comparative corporate governance literature 2 The favored mechanism for resolving collective action problems among shareholders in most countries appears to be partial ownership and control concentration in the hands of large shareholders 3 Two important costs of this form of governance have been emphasized: i) the potential collusion of large shareholders with management against smaller investors; and ii) the reduced liquidity of secondary markets. In an attempt to boost stock market liquidity and limit the potential abuse of minority shareholders some countries' corporate law drastically curbs the power of large shareholders 4 These countries rely on the board of directors as the main mechanism for co-ordinating shareholder actions But boards are widely perceived to be ineffective 5 Thus, while minority shareholders get better protection in these countries, managers may also have greater discretion. i See Zingales (1998) for a similar definition. 2 We do not cover the extensive strategy and management literature; see Pettigrew, Thomas and Whittington (2002) for an overview, in particular Davis and Useem (2002). 3 See ECGN (1997), La Porta et al (1999), Claessens et al (2000) and Barca and Becht (2001) for evidence on control concentration in different countries. 4 Black (1990) provides a detailed description of the various legal and regulatory limits on the exercise of power by large shareholders in the USA Wymeersch (2003) discusses legal impediments to large shareholder actions outside the USA. 5 Gilson and Kraakman (1991) provide analysis and an agenda for board reform in the USA against the background of a declining market for corporate control and scattered institutional investor votes. Ch 1: Corporate Governance and Control 5 In a nutshell, the fundamental issue concerning governance by shareholders today seems to be how to regulate large or active shareholders so as to obtain the right balance between managerial discretion and small shareholder protection Before exploring in greater detail the different facets of this issue and the five basic mechanisms described above, it is instructive to begin with a brief overview of historical origins and early writings on the subject. 2 Historical origins: a brief sketch The term "corporate governance" derives from an analogy between the government of cities, nations or states and the governance of corporations 6 The early corporate finance textbooks saw "representative government" lMead (1928, p 31)l as an important advantage of the corporation over partnerships but there has been and still is little agreement on how representative corporate governance really is, or whom it should represent. 2.1 How representative is corporate government? The institutional arrangements surrounding corporate elections and the role and fiduciary duties of the board have been the central themes in the corporate governance literature from its inception The dilemma of how to balance limits on managerial discretion and small investor protection is ever present Should one limit the power of corporate plutocrats (large shareholders or voting trusts) or should one tolerate concentrated voting power as a way of limiting managerial discretion? The concern of early writers of corporate charters was the establishment of "corporate suffrage", where each member (shareholder) had one vote lDunlavy (1998)l The aim was to establish "democracy" by eliminating special privileges of some members and by limiting the number of votes each shareholder could cast, irrespective of the number of shares held 7 However, just as "corporate democracy" was being established it was already being transformed into "plutocracy" by moving towards "one-share-one-vote" and thus allowing for concentrated ownership and control lDunlavy (1998)1 8 In the USA this was followed by two distinct systems of "corporate feudalism": 6 The analogy between corporate and political voting was explicit in early corporate charters and writings, dating back to the revolutionary origins of the American corporation and the first railway corporations in Germany lDunlavy (1998)l The precise term "corporate governance" itself seems to have been used first by lRichard Eells (1960, p 108)l, to denote "the structure and functioning of the corporate polity". 7 Frequently voting scales were used to achieve this aim For example, under the voting scale imposed by a Virginia law of 1836 shareholders of manufacturing corporations cast "one vote for each share up to 15, one vote for every five shares from 15 to 100, and one vote for each increment of 20 shares above 100 shares" lDunlavy (1998, p 18)l.