CHAPTER 2

A SCHEMATIC CONTRACTUAL GOVERNANCE STRUCTURE

Figure 2-1 contains a schematic model of the American corporation. The owners of the corporation, who are placed at the top of the diagram, supply equity (risk) capital to the company. The contractual nature of equity capital is that it confers property rights to the owners. These rights give the owners control over the acquisition and disposal of the company’s assets and claims on whatever assets remain after all other contractual claims on the firm, such as wages, salaries, debt service charges, and taxes, have been paid.

FIGURE 2-1 A CONTRACTING SCHEMATIC OF THE MODERN CORPORATION

With respect to the company’s day-to-day operations, what is left is called net income after taxes from an accounting perspective. Within the accounting model, only two things can be done with net income: It can be returned to the shareholders as cash dividends (or repurchases of common stock, which, as we will see in Chapter 7, is the same thing) or kept in the company, where it remains under the control of the managers. When the net income is kept in the company, it can be used to buy additional assets or to pay off debt obligations.

The owners of the corporation can make their own decisions about acquiring or disposing of assets, running the day-to-day affairs of the company, and what is to be done with any residuals (net income) by themselves, or they can appoint agents to make these decisions for them. These agents, in turn, can appoint other agents. In the Anglo-American governance system, the agents directly selected by the shareholders to represent them are the corporation’s board of directors (the board). The owners write contracts (explicit or implicit) with the board, which theoretically acts in the shareholders’ best interests. The board then hires a chief executive officer (CEO), who, in turn, hires other managers, and so on down the line to nonmanagement employees. The managers act as agents for the shareholders when they write contracts with the company’s suppliers and customers and with other managers and employees. The CEO and other managers also write contracts with those who supply debt financing—financial institutions, bondholders, lessors, and so on. Potential conflicts of interest abound, even within the ownership group itself.

The Owners

Let’s start with the owners. The owners are not a homogeneous group; they include: fragmented public shareholders, large private block holders, private and public institutional investors, employees and managers of the firm, and other firms. Figure 2-2 contains information about the owners of publicly traded U.S. corporations from 1990 through 2000.

In 2000, about 38 percent of common stock was owned directly by private households. Except in unusual cases, private individuals do not own large blocks of stock in any one company; more likely, they hold a few hundred shares in many companies—say, a hundred shares in Ford and a hundred shares in Dell. Thus, an individual’s percentage ownership in any one company is trivial, meaning that the individual acting alone has no chance whatsoever of influencing management. If you own stock in Dell and you don’t like the way Dell’s management is running the company, you basically have two choices: sell the stock or wait and hope that something happens that will change the situation.

FIGURE 2-2 PERCENTAGE OWNERSHIP STRUCTURE OF COMMON STOCK OF PUBLICLY TRADED U.S. CORPORATIONS

One possible change agent would be institutional investors. A little over 40 percent of shares in the United States are owned by private and public pension funds and by mutual funds. These are large institutional investors who, through their large holdings, can influence management and effectively threaten management with removal if the best interests of the fund’s beneficiaries or owners are ignored.

One of the largest institutional investors in the United States is TIAA-CREF, which owns more than $100 million in each of the largest companies in the country. TIAA-CREF is quite explicit about what it expects from managers: It expects that they will maximize investment returns for TIAA-CREF’s participants. Furthermore, TIAA-CREF has developed a corporate assessment program to monitor and evaluate governance practices and policies. Among the policies TIAA-CREF requires are shareholder approval for any actions that alter the fundamental relationship between shareholders and the board, such as anti-takeover measures and the composition of the board of directors itself. Furthermore, TIAA-CREF requires companies to use a ‘‘pay for performance’’ system for executive compensation so as to align the interests of managers with those of TIAA-CREF beneficiaries. When necessary, TIAA-CREF also presses for improved management and operational changes in order to ensure that the investments it makes produce the highest possible returns.¹

Since 1990, institutional investors have increased their ownership substantially—from 31 percent to 42 percent. Most of the increase represents a shift from direct household ownership of shares to indirect household ownership through mutual funds (household ownership fell by 12.4 percent; mutual fund ownership rose by 12.2 percent). One consequence of this shift from direct to indirect ownership may be that individual public investors actually experienced an increase in their collective ability to influence management through the institutional investors.

The remaining shares of U.S. corporations are held primarily by insurance companies and foreigners. Actually, foreign ownership increased during the 1990s, going from 6.9 percent to 10.0 percent.

Figure 2-3 gives the ownership of corporations in Japan, Germany, France, and the United Kingdom. Note that the ownership structures in Japan, Germany, and France are quite different from those in the United States and Great Britain. In Japan, Germany, and France, private individuals own a relatively small percentage of outstanding stock, especially in Germany, and other companies own a relatively larger portion—more than 50 percent in France. Thus, the dominant shareowners in these countries are other corporations, with the shares being voted by management and not by the public shareholders or by institutional investors representing public shareholders. These other corporations may have objectives that have more to do with retaining business relationships with the company in which they hold stock and selling goods to or buying them from it than with the public shareholders’ objective of share price maximization. Furthermore, the shares of companies owned by other companies are usually voted by the managers of the firm that owns the stock. These managers are more likely to be sensitive and sympathetic to the needs and employment perils facing their managerial peers and to vote with company management rather than with the public shareholders on such major issues as acquisitions, takeovers, and antitakeover proposals.

FIGURE 2-3 PERCENT OWNERSHIP OF COMMON STOCK IN SELECTED COUNTRIES, DECEMBER 1995

In Germany and Japan, banks also own sizable amounts of stock in the companies to which they make loans. While these ownership patterns may solve some governance and conflict of interest problems, they create others. For example, do the banks in Germany vote their shares in the best interests of the public shareholders or in the best interests of the banks as creditors of the company?

Ownership conflicts of interests may emerge within as well as across ownership classes. Some owners are in a better position to influence management than others, some owners have more information than others, and some owners may be more concerned about the survival of the firm than others. Holders of large blocks, especially if they have a controlling interest in the firm, can negotiate acquisitions, sales of assets, or even a sale of the company that disadvantages public shareholders with small amounts of stock unless the investors are protected by appropriate security regulations and laws. For example, in some countries, large holders of large blocks can sell their interests to an acquiring company at one price, leaving the small shareholders no alternative but to accept whatever the acquiring company offers to pay them for the now-illiquid stock they own as a minority in the target (acquired) company.

Voting Rights

Some shareholders are also more equal than others when it comes to the voting rights attached to their ownership claims—what are called different classes of common stock. Although this is not especially common in the United States, corporations may issue different classes of common stock, with one class having more voting rights than other classes. For example, Ford Motor Company has two classes of common stock: Class A, with 60 percent of the voting rights, and Class B, with 40 percent of the voting rights. Class A shares are owned by the public, and Class B shares are owned by Ford family interests. Dow Jones, the publisher of the Wall Street Journal, also has two classes of stock. Class B shares carry ten votes per share, and Class A shares, only one vote per share.

Governance systems, together with legal protection, security regulations covering the dissemination of information, and insider trading regulations, can be designed to protect the small or public investors’ equity positions. Without such protections, small investors are reluctant to buy common stock, and ownership tends to be concentrated in the hands of a few. But, what is the ‘‘democratic’’ solution to the distribution of voting rights, and, how is that related to broader governance objectives concerning how a particular governance structure inhibits or advances democratic pluralism? Should each shareholder have only one vote regardless of the number of shares owned, or should each share carry one vote so that someone who owns 100 shares has not one but a hundred votes?

The early American answer was one vote per owner regardless of the number of shares the individual owned, or at least a limit on the number of votes any one owner could cast—what is called graduated voting. This graduated voting scheme found its way into the charters of the First and Second Bank of the United States and was intended, according to Alexander Hamilton, to prevent a few principal stockholders from monopolizing the power and benefits of the bank for their own benefit. Graduated voting was also common in railroads and manufacturing firms organized in the early and middle years of the nineteenth century. For example, under legislation passed by Virginia, voting in joint stock companies was standardized: A shareholder was given one vote per share for the first 20 shares owned, then one vote for every two shares owned from 21 to 200 shares, one vote for every five shares owned from 201 to 500 shares, and one vote for every ten shares owed above 500. This arrangement lasted until the Civil War.²

The Board of Directors

Theoretically, the board of directors is elected by the owners to represent the owners’ interests. However, in addition to the problems created by differential voting rights and the composition of the owners themselves, other problems arise. These governance problems include the composition of the board and control over the process for electing the board.

Typically, the board is made up of both inside and outside members. Inside members hold management positions in the company, whereas outside members do not. The outside members are often referred to as independent directors, although this characterization is misleading because some outside members may have direct connections to the company as creditors, suppliers, customers, or professional consultants. These latter may be described as quasi-independent members. The governance issue is: Who do the inside and quasi-independent members represent? Both groups have a vested interest in the survival of the firm and, quite possibly, its growth at the expense of the shareholders. To put it starkly, would the management insiders vote to fire themselves? What about the outside members of the board? Would they vote to fire the managers if new managers were likely to recommend a new slate of directors? In either case, can the shareholders vote any of the directors out of office?

In theory, the answer is yes. However, the proxy (voting) machinery is controlled by the existing board and management. Thus, the control over ‘‘voter registration’’ lists as well as the dissemination of proxy ballots and the counting of ballots rests in the hands of the incumbents, who clearly have a conflict of interest in implementing the voting process.

Corporate Executives and Senior Managers

Below the board in our governance schematic lies the chief executive officer, and below this individual there are other managers, including division managers. We are now inside the organization’s bureaucracy, where conflicts of interest abound with respect to allocation of capital, consumption of perquisites, status, and turf wars. Here, the governance task is to control these conflicts and focus competing managers’ attention on shareholder concerns. These organizational governance problems extend beyond the managers of the company to its nonmanagerial employees.

Governance-related issues that loom large within the organization are managerial pay and performance and the rules for allocating capital within the firm. Should managers’ pay be tied to performance? If so, how should performance be measured? What about allocating capital within the company? How can this allocation be done so that it serves the interests of the shareholders and resolves conflicts of interest among competing management teams within the company? Increasingly, managerial pay and performance evaluation as well as capital allocation schemes are being connected to the company’s stock price performance and its cost of capital.

Whether these schemes actually work, though, remains controversial. The potential problems became very visible with the failure of Enron and other ‘‘big name’’ corporations. Because of these failures, a serious concern has arisen over whether managers ‘‘pump up’’ short-term earnings, legally or illegally (and with the acquiescence of the board and the external auditors), at the expense of the long-run performance of the company in order to collect bonuses tied to high stock prices.

Creditors

We have connected debt financing to the firm through the contracts creditors write with the managers and the board, who are presumably acting as agents for the shareholders in this process. From a legal perspective, the duties and obligations of management, and therefore of the owners, to the creditors are typically spelled out in the loan agreement. Potential conflicts of interest between creditors (bondholders) and owners (shareholders) have long been recognized and have been dealt with through positive and negative covenants as well as through the maturity and repayment terms of the debt. Should the firm default on the debt, the creditors effectively become the new owners of the company. However, it doesn’t always work out this way, and conflicts among creditors are just as likely to occur as conflicts among the shareholders.

More recently, debt financing has also come to be viewed as a way of reducing or mitigating conflicts of interest between managers and shareholders. Essentially, debt financing is seen as a way of discouraging managers from growing the firm at the expense of the shareholders and keeping cash in the company rather than distributing it to the shareholders. Interestingly, creditors are likely to approve of managers keeping cash in the company because it improves the creditor’s financial position.

Relationships with Suppliers and Customers

We have also drawn contracting lines between the managers and the company’s suppliers and customers. While it is widely recognized that suppliers and customers are corporate stakeholders, the connections between suppliers and customers, shareholder wealth maximization, and the survival of the firm are not always clear or unambiguous. We think the basic governance problem with respect to these stakeholders (especially suppliers) is how to get them to make investments or other costly commitments that benefit the company but that could be lost if the company engages in opportunistic behavior or fails. For example, an automotive company such as DaimlerChrysler or Nissan would benefit by having its parts suppliers located near its assembly facilities and would also benefit if its parts suppliers invested in product development and technology specifically directed toward Daimler’s or Nissan’s vehicles. But why would a parts supplier do that if it thought that once the investment was made, Daimler would opportunistically try to recontract so as to lower prices, since having made the investment, the supplier could recover it only by agreeing to these new price and delivery terms? Or, why would a supplier make Daimler-specific investments if it thought Daimler was financially weak and would not be able to honor its contractual obligations?

The Anglo-American governance solution to these relational issues generally emphasizes well-specified contractual terms. Other governance systems, however, such as the Japanese, have historically relied on long-standing relationships between individuals in the respective companies and unwritten expectations of reciprocal actions. Still other arrangements for dealing with this governance-related problem are to have cross ownership between the automotive company and its suppliers so that opportunistic behavior on the part of one party has negative financial consequences for that party. Still another arrangement is to share and exchange managers.

What some observers would describe as convergence of governance systems to a market-based as opposed to a bankor relationship-based governance system is disrupting implicit supplier, employee, and customer contracts in many countries. For example, Nissan Motor, a Japanese automobile manufacturer, brought in a Frenchman, Carlos Ghosn, to restructure its operations. His plan was to cut 21,000 jobs, close five factories, and scrap half the supplier base to make Nissan competitive in global markets. The plan was described as ‘‘another blow to the keiretsu system of business relationships [governance structures]. Until recently, these cosy ties … helped support a network of friendly companies bound by mutual shareholdings and personal contracts.’’³

AN ORGANIC VERSION OF THE MODERN CORPORATION

When Berle and Means wrote about the separation of management and ownership in the modern corporation, they were concerned with how to make the corporation compatible with democracy in a world in which the managerially controlled corporation had replaced the simple market economy of the nineteenth century. The allure of the premodern-corporation era was that it allowed workers to become owner-managers of small firms. This governance structure (ownership arrangement) supported the moral development of individuals and encouraged their active participation in the market and in politics because they had a vested interest in protecting their property from the opportunistic behavior of others. It also motivated owner-managers to act in a socially responsible manner toward their neighbors so as to preserve their property. Consequently, the concerns of Berle and Means and others focused on the societal role of the corporation. They were concerned with reconciling the emergence of the modern corporation with American notions of the moral development of its citizens, democracy, and economic opportunities—what can be loosely described as corporate social responsibility. They were also concerned with how economic efficiency fit into this equation and were seeking ways to reconcile economic efficiency objectives with political and social welfare objectives.

The conflicts of interest that we have identified were important to writers in the Berle and Means era in the context of how to get managers to serve the interests of the community at large and not themselves. The writers were seeking ways to advance the development of character and democracy in America—ways that included enhancing economic efficiency by preventing managers from squandering ‘‘society’s’’ economic resources. Who was to say that the only or most desirable way to get economic efficiency was to have managers ultimately serve the interests of shareholders? Shareholder wealth maximization was a means to an end rather than the end itself.

To these writers, corporations existed to serve more fundamental societal interests than making people rich. They existed to provide jobs, develop the citizens’ personality, and, if not preserve, at least not hinder the operation of democratic institutions—and, for Berle and other members of Roosevelt’s brain trust in the 1930s, to prevent the collapse of capitalism in the face of the Great Depression. For the modern corporation, fostering these societal objectives implied that there were benefits to having the company survive as a social organization—benefits that would be lost if the firm disappeared. From a social welfare perspective, then, corporate governance is ultimately tied to finding ways to ensure that managers do not waste economic resources within the overriding social responsibility functions of the firm, functions that require the firm to become a organic entity. The ways of doing this and the implications for managers are what we address in this book.

DO MANAGERS ACCEPT THE SHAREHOLDER SUPREMACY MODEL?

One place to look for clues about management’s attitudes toward shareholder wealth maximization is a company’s annual report and the CEO’s report to the shareholders. The H.J. Heinz Company’s 1999 annual report is a good example. In a Q & A-style format, Bill Johnson, the president and CEO of Heinz, describes what Heinz shareholders can expect during the 2000 fiscal year. He says: ‘‘Be assured that whatever we do will be directed first and foremost towards increasing shareholder value.’’ And he continues with, ‘‘Shareholders can also expect continued improvement in return on invested capital, in our use of working capital and in cost reduction. Gross margins should improve further.’’

Robert G. Schoenberger, the CEO of Unitil Corporation, is also straightforward about the company’s objectives. Unitil is an electricity-generating company in a newly deregulated New Hampshire electric industry. Schoenberger, in the company’s 1999 annual report, says: ‘‘While we can’t claim the ability to predict the future [of where deregulation will go], we have set out to be a leader in exploiting changes in our industry for the benefit of our shareholders.’’ He closes his letter to shareholders with, ‘‘We are also among a limited few in our industry that are finding new ways to create value for our shareholders.’’

Georgia-Pacific, in its 2000 Annual Review, described a ‘‘brandnew G-P.’’ In this review, management says that

The ultimate measure of our success is the creation of wealth for our shareholders… . Georgia-Pacific is transforming our business portfolio to improve investor returns… . While total shareholder returns for the 1990s were better than most in the industry, they still fell short of broad equity market returns… . This convinced us that something had to change.

This Georgia-Pacific objective takes us to our next topic: stock prices and stock markets.