COPYRIGHT NOTICE: Jean Tirole: the Theory of Corporate Finance Is Published by Princeton University Press and Copyrighted, © 2005, by Princeton University Press
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COPYRIGHT NOTICE: Jean Tirole: The Theory of Corporate Finance is published by Princeton University Press and copyrighted, © 2005, by Princeton University Press. All rights reserved. No part of this book may be reproduced in any form by any electronic or mechanical means (including photocopying, recording, or information storage and retrieval) without permission in writing from the publisher, except for reading and browsing via the World Wide Web. Users are not permitted to mount this file on any network servers. Follow links for Class Use and other Permissions. For more information send email to: [email protected] 1 Corporate Governance In 1932, Berle and Means wrote a pathbreaking book Chapter 1 is organized as follows. Section 1.1 documenting the separation of ownership and con- sets the stage by emphasizing the importance of trol in the United States. They showed that share- managerial accountability. Section 1.2 reviews var- holder dispersion creates substantial managerial ious instruments and factors that help align man- discretion, which can be abused. This was the start- agerial incentives with those of the firm: monetary ing point for the subsequent academic thinking on compensation, implicit incentives, monitoring, and corporate governance and corporate finance. Sub- product-market competition. Sections 1.3–1.6 ana- sequently, a number of corporate problems around lyze monitoring by boards of directors, large share- the world have reinforced the perception that man- holders, raiders, and banks, respectively. Section 1.7 agers are unwatched. Most observers are now seri- discusses differences in corporate governance sys- ously concerned that the best managers may not be tems. Section 1.8 and the supplementary section selected, and that managers, once selected, are not conclude the chapter by a discussion of the objec- accountable. tive of the firm, namely, whom managers should Thus, the premise behind modern corporate fi- be accountable to, and tries to shed light on the nance in general and this book in particular is that long-standing debate between the proponents of the corporate insiders need not act in the best interests stakeholder society and those of shareholder-value of the providers of the funds. This chapter’s first maximization. task is therefore to document the divergence of in- terests through both empirical regularities and anec- 1.1 Introduction: The Separation of dotes. As we will see, moral hazard comes in many Ownership and Control guises, from low effort to private benefits, from inef- ficient investments to accounting and market value The governance of corporations has attracted much manipulations, all of which will later be reflected in attention in the past decade. Increased media cover- the book’s theoretical construct. age has turned “transparency,” “managerial account- Two broad routes can be taken to alleviate in- ability,” “corporate governance failures,” “weak sider moral hazard. First, insiders’ incentives may be boards of directors,” “hostile takeovers,” “protection partly aligned with the investors’ interests through of minority shareholders,” and “investor activism” the use of performance-based incentive schemes. into household phrases. As severe agency prob- Second, insiders may be monitored by the current lems continued to impair corporate performance shareholders (or on their behalf by the board or both in companies with strong managers and dis- a large shareholder), by potential shareholders (ac- persed shareholders (as is frequent in Anglo-Saxon quirers, raiders), or by debtholders. Such monitoring countries) and those with a controlling shareholder induces interventions in management ranging from and minority shareholders (typical of the European mere interference in decision making to the threat of corporate landscape), repeated calls have been is- employment termination as part of a shareholder- or sued on both sides of the Atlantic for corporate board-initiated move or of a bankruptcy process. We governance reforms. In the 1990s, study groups document the nature of these two routes, which play (such as the Cadbury and Greenbury committees in a prominent role throughout the book. the United Kingdom and the Viénot committee in 16 1. Corporate Governance France) and institutional investors (such as CalPERS 1.1.1 Moral Hazard Comes in Many Guises in the United States) started enunciating codes of There are various ways in which management may best practice for boards of directors. More recently, not act in the firm’s (understand: its owners’) best in- various laws and reports1 came in reaction to the terest. For convenience, we divide these into four cat- many corporate scandals of the late 1990s and early egories, but the reader should keep in mind that all 2000s (e.g., Seat, Banesto, Metallgesellschaft, Suez, are fundamentally part of the same problem, gener- ABB, Swissair, Vivendi in Europe, Dynergy, Qwest, ically labeled by economists as “moral hazard.” Enron, WorldCom, Global Crossing, and Tyco in the United States). (a) Insufficient effort. By “insufficient effort,” we But what is corporate governance?2 The domi- refer not so much to the number of hours spent nant view in economics, articulated, for example, in in the office (indeed, most top executives work very Shleifer and Vishny’s (1997) and Becht et al.’s (2002) long hours), but rather to the allocation of work time surveys on the topic, is that corporate governance to various tasks. Managers may find it unpleasant or relates to the “ways in which the suppliers of finance inconvenient to cut costs by switching to a less costly to corporations assure themselves of getting a re- supplier, by reallocating the workforce, or by tak- turn on their investment.” Relatedly, it is preoccu- ing a tougher stance in wage negotiations (Bertrand 4 pied with the ways in which a corporation’s insiders and Mullainathan 1999). They may devote insuffi- can credibly commit to return funds to outside in- cient effort to the oversight of their subordinates; vestors and can thereby attract external financing. scandals in the 1990s involving large losses inflicted This definition is, of course, narrow. Many politi- by traders or derivative specialists subject to insuf- cians, managers, consultants, and academics object ficient internal control (Metallgesellschaft, Procter to the economists’ narrow view of corporate gover- & Gamble, Barings) are good cases in point. Lastly, nance as being preoccupied solely with investor re- managers may allocate too little time to the task they turns; they argue that other “stakeholders,” such as have been hired for because they overcommit them- employees, communities, suppliers, or customers, selves with competing activities (boards of directors, also have a vested interest in how the firm is run, political involvement, investments in other ventures, and that these stakeholders’ concerns should some- and more generally activities not or little related to how be internalized as well.3 Section 1.8 will return managing the firm). to the debate about the stakeholder society, but we (b) Extravagant investments. There is ample ev- should indicate right away that the content of this idence, both direct and indirect, that some man- book reflects the agenda of the narrow and ortho- agers engage in pet projects and build empires to dox view described in the above citation. The rest of the detriment of shareholders. A standard illustra- Section 1.1 is therefore written from the perspective tion, provided by Jensen (1988), is the heavy explo- of shareholder value. ration spending of oil industry managers in the late 1970s during a period of high real rates of inter- 1. In the United States, for example, the 2002 Sarbanes–Oxley Act, est, increased exploration costs, and reduction in and the U.S. Securities and Exchange Commission’s and the Financial expected future oil price increases, and in which buy- Accounting Standards Board’s reports. ing oil on Wall Street was much cheaper than obtain- 2. We focus here on corporations. Separate governance issues arise in associations (see Hansmann 1996; Glaeser and Shleifer 2001; Hart ing it by drilling holes in the ground. Oil industry and Moore 1989, 1996; Kremer 1997; Levin and Tadelis 2005) and gov- managers also invested some of their large amount ernment agencies (see Wilson 1989; Tirole 1994; Dewatripont et al. 1999a,b). of cash into noncore industries. Relatedly, econo- 3. A prominent exponent of this view in France is Albert (1991). mists have long conducted event studies to analyze To some extent, the German legislation mandating codetermination the reaction of stock prices to the announcement (in particular, the Codetermination Act of 1976, which requires that supervisory boards of firms with over 2,000 employees be made up of an equal number of representatives of employees and shareholders, 4. Using antitakeover laws passed in a number of states in the with the chairperson—a representative of the shareholders—deciding United States in the 1980s and firm-level data, Bertrand and Mul- in the case of a stalemate) reflects this desire that firms internalize the lainathan find evidence that the enactment of such a law raises wages welfare of their employees. by 1–2%. 1.1. Introduction: The Separation of Ownership and Control 17 of acquisitions and have often unveiled substantial ranging from benign to outright illegal activities. shareholder concerns with such moves (see Shleifer Managers may consume perks5 (costly private jets,6 and Vishny 1997; see also Andrade et al. (2001) for a plush offices, private boxes at sports events, coun- more recent assessment of the long-term acquisition try club memberships, celebrities on payroll, hunt- performance of the acquirer–target pair). And Blan- ing and fishing lodges, extravagant entertainment chard et al. (1994) show how firms that earn wind- expenses, expensive art); pick their successor among fall cash awards in court do not return the cash to their friends or at least like-minded individuals who investors and spend it inefficiently. will not criticize or cast a shadow on their past management; select a costly supplier on friendship (c) Entrenchment strategies.