Corporate Governance and Separation of Ownership and Control by cnu54265


									         Corporate Governance and Separation of Ownership and Control

(Corporate Governance is one of the topics in the module Corporate Finance)

What is the primary goal of the corporation? The traditional answer is that managers in a
corporation snake decisions for the stockholders of the corporation. However, it is impossible
to give a definitive answer to this important question because the corporation is an artificial
being, not a natural person.
It is necessary to precisely identify who controls the corporation. We shall consider the set-
of-contracts viewpoint. This viewpoint suggests the corporate firm will attempt to maximize
the shareholders’ wealth in the firm by taking actions that increase the current value per
share of existing stock.

Agency Costs and the Set-of-Contracts Perspective

The set-of-contracts theory of the firm states that the firm can he viewed as a set of
contracts: One of the contract claims is a residual claim (equity) on the firm’s assets and
cash flows. The equity contract can be defined as a principal-agent relationship. The
members of the management team are the agents, and the equity investors (shareholders)
are the principals. It is assumed that the managers and the shareholders, left alone, will
each attempt to act in their own self-interest.
The shareholders, however, can discourage the managers from diverging from the
shareholders’ interests by devising appropriate incentives for managers and then monitoring
their behavior. Doing so, unfortunately, is complicated and costly. The costs of resolving the
conflicts of interest between managers and shareholders are special types of costs called
agency costs. These costs are defined as the sum of (1) the monitoring costs of the
shareholders and (2) the incentive fees paid to the managers. It can be expected that
contracts will he devised that will provide the managers with appropriate incentives to
maximize the shareholders’ wealth. Thus, the set of contracts theory suggests that the
corporate firm will usually act in the best interests of shareholders. However, agency
problems can never he perfectly solved, and managers may not always act in the best
interests of shareholders. As a consequence shareholders may experience residual losses.
Residual losses are the lost wealth of the shareholders due to divergent behavior of the

File name: Reading on Corporate Governance RWJ ch1_4
Managerial Goals

Managerial goals may be different from those of shareholders. What will managers maximize
if they are left to pursue their own goals rather than shareholders’ goals?
Some financial economists propose the notion of expense preference. They argue that
managers obtain value from certain kinds of expenses. In particular, company cars, office
furniture, office location, and funds for discretionary investment have value to managers
beyond that which comes from their productivity.
Economists conducted a series of interviews with the chief executives of several large
companies. From these interview they concluded that managers are influenced by two basic
underlying motivations:
1. Survival. Organizational survival means that management will always try to command
    sufficient resources to avoid the firm’s going out of business.
2. Independence and self-sufficiency. This is the freedom to make decisions without
    encountering external parties or depending on outside financial markets. The above-
    mentioned interviews suggested that managers do not like to issue new shares of stock.
    Instead, they like to be able to rely on internally generated cash flow.

These motivations lead to what is thought to be the basic financial objective of managers:
the maximization of corporate wealth. Corporate wealth is defined as that wealth over which
management has effective control; it is closely associated with corporate growth and
corporate size. Corporate wealth is not necessarily shareholder wealth. Corporate wealth
tends to lead to increased growth by providing funds for growth and limiting the extent to
which new equity is raised. Increased growth and size are not necessarily the same thing as
increased shareholder wealth.

Separation of Ownership and Control

Some people argue that shareholders do not completely control the corporation. They argue
that shareholder ownership is too diffuse (spread out) and fragmented for effective control of
management. A striking feature of the modern large corporation is the diffusion of ownership
among thousands of investors.
One of the most important advantages of the corporate form of business organization is that
it allows ownership of shares to he transferred. The resulting diffuse ownership, however,
brings with it the separation of ownership and control of the large corporation. The possible
separation of ownership and control raises an important question: Who controls the firm?

File name: Reading on Corporate Governance RWJ ch1_4
Do Shareholders Control Managerial Behavior?

The claim that managers can ignore the interests of shareholders is deduced from the fact
that ownership in large corporations is widely dispersed. As a consequence, it is often
claimed that individual shareholders cannot control management. There is some merit in this
argument, but it is too simplistic.
The extent to which shareholders can control managers depends on (1) the costs of
monitoring management, (2) the costs of implementing the control devices, and (3) the
benefits of control.
When a conflict of interest exists between management and shareholders, who wins? Does
management or do the shareholders control the firm? There is no doubt and that ownership
in large corporations is diffuse when compared to the closely held corporation. However,
several control devices used by shareholders tie management to the self-interest of
       1. Shareholders determine the membership of the board of directors by voting. Thus,
shareholders control the directors, who in turn select the management team.
       2. Contracts with management and arrangements for compensation, such as stock
  option plans, can he made so that management has an incentive to pursue the goal of the
  shareholders. Another device is called performance shares. These are shares of the
  company (often the treasury stock) given to managers on the basis of performance as
  measured by earnings per share and similar criteria.
       3. If the price of a firm’s stock drops too low because of poor management, the firm
may be acquired by a group of outside shareholders, by another firm, or by an individual.
This is called a takeover. In a takeover, the top management of the acquired firm may find
itself out of a job. This puts pressure on the management to make decisions in the
stockholders’ interests. Fear of a takeover gives managers an incentive to take actions that
will maximize stock prices.
       4. Competition in the managerial labor market may force managers to perform in the
best interest of stockholders. Otherwise they will be replaced. Firms willing to pay the most
will lure good managers. These are likely to be firms that compensate managers based on
the value they create.
The available evidence and theory are consistent with the ideas of shareholder control and
shareholder value maximization However, there can be no doubt that at times corporations
pursue managerial goals at the expense of shareholders. There is also evidence that the
diverse claims of customers, vendors, and employees must frequently be considered in the
goals of the corporation.
                                                                Portable School Brief Series

File name: Reading on Corporate Governance RWJ ch1_4

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