The Modern Firm, Corporate Governance and Investment

NEW PERSPECTIVES ON THE MODERN CORPORATION Series Editor: Jonathan Michie, Director, Department for Continuing Education and President, Kellogg College, University of Oxford, UK The modern corporation has a far-reaching inuence on our lives in an increasingly globalized economy. This series will provide an invaluable forum for the publication of high-quality works of scholarship covering the areas of:

corporate governance and corporate responsibility, including environmental sustainability human resource management and other management practices, and the relationship of these to organizational outcomes and corporate performance industrial economics, organizational behaviour, innovation and competitiveness outsourcing, offshoring, joint ventures and strategic alliances different ownership forms, including social enterprise and employee ownership intellectual property and the learning economy, including knowledge transfer and information exchange.

Titles in the series include: Corporate Governance, Organization and the Firm Co-operation and Outsourcing in the Global Economy Edited by Mario Morroni The Modern Firm, Corporate Governance and Investment Edited by Per-Olof Bjuggren and Dennis C. Mueller

The Modern Firm, Corporate Governance and Investment

Edited by

Per-Olof Bjuggren
Jnkping International Business School, Sweden

Dennis C. Mueller
University of Vienna, Austria

NEW PERSPECTIVES ON THE MODERN CORPORATION

Edward Elgar
Cheltenham, UK Northampton, MA, USA

 Per-Olof Bjuggren and Dennis C. Mueller 2009 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA

A catalogue record for this book is available from the British Library Library of Congress Control Number: 2009922767

ISBN 978 1 84844 225 2 Printed and bound by MPG Books Group, UK

Contents
List of contributors Preface 1 Introduction: the modern firm, corporate governance and investment Per-Olof Bjuggren and Dennis C. Mueller KEY ISSUES 11 43 vii viii

PART I 2 3

Opening the black box of firm and market organization: antitrust Oliver E. Williamson The corporation: an economic enigma Dennis C. Mueller THE THEORY OF THE FIRM FROM AN ORGANIZATIONAL PERSPECTIVE

PART II

5 6

A contractual perspective of the firm with an application to the maritime industry Per-Olof Bjuggren and Johanna Palmberg The use of managerial authority in the knowledge economy Kirsten Foss Competence and learning in the experimentally organized economy Gunnar Eliasson and sa Eliasson INVESTMENTS AND THE LEGAL ENVIRONMENT

63 82

104

PART III

Corporate governance and investments in Scandinavia ownership concentration and dual-class equity structure Johan E. Eklund The cost of legal uncertainty: the impact of insecure property rights on cost of capital Per-Olof Bjuggren and Johan E. Eklund
v

139

167

vi

Contents

The stock market, the market for corporate control and the theory of the firm: legal and economic perspectives and implications for public policy Simon Deakin and Ajit Singh THE BOARD, MANAGEMENT RELATIONS AND OWNERSHIP STRUCTURE

185

PART IV

10 11

12

13 14 15

Institutional ownership and dividends Daniel Wiberg Contracting around ownership: shareholder agreements in France Camille Madelon and Steen Thomsen Board governance of family firms and business groups with a unique regional dataset Llus Bru and Rafel Cresp Better firm performance with employees on the board? R. ystein Strm The determinants of German corporate governance ratings Wolfgang Drobetz, Klaus Gugler and Simone Hirschvogl Top management, education and networking Mogens Dilling-Hansen, Erik Strjer Madsen and Valdemar Smith

225

253

292 323 361 382

Index

401

Contributors
Per-Olof Bjuggren, Jnkping International Business School, Sweden Llus Bru, Universitat de les Iles Balears, Spain Rafel Cresp, Universitat de les Iles Balears, Spain Simon Deakin, The Faculty of Law, Cambridge University, UK Mogens Dilling-Hansen, School of Economics and Management, University of Aarhus, Denmark Wolfgang Drobetz, Department of Corporate Finance, University of Basel, Switzerland Johan E. Eklund, Jnkping International Business School, Sweden sa Eliasson, IBMP CNRS Strasbourg and Vitigen GmbH, Siebeldingen, Germany Gunnar Eliasson, KTH, Stockholm Kirsten Foss, Copenhagen Business School, Denmark Klaus Gugler, Department of Economics, University of Vienna, Austria Simone Hirschvogl, Department of Economics, University of Vienna, Austria Camille Madelon, HEC School of Management, Paris, France Erik Strjer Madsen, Department of Economic, Aarhus School of Business, Denmark Dennis C. Mueller, University of Vienna, Austria Johanna Palmberg, Jnkping International Business School, Sweden Ajit Singh, Queens College, Cambridge University, UK Valdemar Smith, Centre for Industrial Economics, University of Copenhagen, Denmark R. ystein Strm, stfold University College, Norway Steen Thomsen, Copenhagen Business School, Denmark Daniel Wiberg, Jnkping International Business School, Sweden Oliver E. Williamson, University of California, Berkeley, USA

vii

Preface
This book is a collection of papers from two workshops held in Jnkping, Sweden, in 2006 and 2007. The theme of the workshop in 2006 was Corporate Governance and Investment in a wide sense. Topics of papers could be: to describe and analyse the ownership and corporate governance structure of a given country; to make a comparative analysis of governance structures in different countries; to study corporate governance and performance in different types of firms (for example, family and non-family owned firms); to explain the levels of investment of companies; and to draw policy implications about how capital markets might be altered to improve the allocation of capital and the overall performance of companies. The workshop arranged in Jnkping was one in a series of annual meetings of a European Corporate Governance Network. The networks first meeting was at Cambridge University (UK) in 1998 by initiative of Professor Dennis C. Mueller and Professor Alan Hughes. Since then several meetings have been organized. The 2006 workshop in Jnkping was the seventh. The second workshop, held in Jnkping in September 2007, was the first of its kind inspired by the emerging literature on the economics of the firm. The background to the workshop was the revolutionary development of the theory of the firm that has taken place during the last 35 years. In spite of all the progress in the field, traces of the new developments in microeconomic and industrial organization textbooks are scant. The comments made by Ronald Coase in 1971 at an NBER meeting about a non-existent treatment of organization of economic activities within and between firms in industrial organization textbooks are still valid. But in other ways the situation today is quite different from 35 years ago. At the same NBER meeting Coase also commented upon his celebrated article from 1937 (The Nature of the Firm) with the words much cited and little used. This comment turned out to be a truthful description of the situation in 1971, but not true for the rest of the 1970s. In the same year as the NBER meeting (1971) Oliver E. Williamson published a seminal article in the American Economic Review, which was the start of a large number of books and articles that, like Coase, centred on the importance of transaction costs in analyses of economic organizations. A new field of transaction cost economics emerged. Some other articles from which new fields of research have emanated
viii

Preface

ix

were also published in the 1970s. The team production and the property rights perspective introduced by Alchian and Demsetz (1972) and the corporate governance perspective in Jensen and Meckling (1976) have been especially influential. From the 1980s the evolutionary theory of the firm presented by Nelson and Winter (1982) and the new property rights approach by Grossman and Hart (1986) have reshaped research in a similar fashion. These and other branches of the growing tree of the theory of the firm were the sources of inspiration for the workshop on The Economics of the Modern Firm. The output from the two workshops is merged in this book under the title The Modern Firm, Corporate Governance and Investment. To merge contributions from the two workshops makes sense given the close connection between the topics and papers presented at the workshops. For example, several papers at the second workshop were on corporate governance. In all, 14 papers from the two workshops have been selected, nine from the second workshop and five from the first. The keynote addresses of Oliver E. Williamson and Dennis C. Mueller at the second workshop are the first two chapters after the introduction. The participants at the workshops and the referees of the different articles in this book have helped to improve the contents. We thank them for their questions and comments. The workshops and the preparation of this book were financed by Sparbankstiftelsen Alfa, Torsten and Ragnar Sderbergs foundation and CESIS (Center of Excellence for Science and Innovation Studies). We are grateful for their support that allowed us to engage in this research. We are also indebted to Ibteesam Hossain and Maria Eriksson for excellent research assistance with this book.

1.

Introduction: the modern firm, corporate governance and investment

Per-Olof Bjuggren and Dennis C. Mueller

The book is organized into four parts. Part I contains overviews of the theory of the firm. Part II is devoted to firms and organization of economic activities. Part III deals with how the institutional framework of an economy affects investments made by firms. Part IV looks at the impact of ownership structure and board composition on firm performance.

I.

OVERVIEWS

Part I contains two overviews of the theory of the firm from different perspectives. Opening the black box of firm and market organization: antitrust by Oliver E. Williamson presents an overview of the characteristics of the transaction cost approach to the study of economic organization. The antitrust implications of this new view of economic organization are also considered. Thus, this chapter reviews both the positive and normative aspects of Williamsons theory of the firm, and offers a contractual view of economic organization. The black box of the firm is opened in the sense that the governance attributes that distinguish the firm from the market are outlined. The market of the pure vanilla type (spot contract character) found in most textbooks is complemented by the contractual deviations that can be characterized as hybrids of market and firm. The new explanations of antitrust phenomena provided by transaction cost analysis are discussed. Instead of solely focusing on market power aspects of vertical market relations, pricing practices and horizontal and conglomerate mergers, a transaction cost analysis provides a broader picture by also including cost-reducing explanations. Williamson shows how these alternative explanations gradually have been recognized by US antitrust authorities. The corporation: an economic enigma by Dennis C. Mueller looks
1

The modern firm, corporate governance and investment

at how the view on the corporate form of business has changed amongst economists since Adam Smith. The chapter addresses the key issue in corporate governance about efficiency implications of ownership and control in corporations. An overview is provided on how economists views of the corporation and its performance had changed over time. The early economists such as Adam Smith, John Stuart Mill and Alfred Marshall offered descriptions of corporate behaviour based on their observations of how companies function. Berle and Means book The Modern Corporation and Private Property from 1932 is also based on observations that are supported by an impressive amount of descriptive data. The neoclassical view emerging during the 1930s and 1940s represents a different way of doing research on the firm and corporate form. For pedagogical and simplifying reasons the firm is looked upon as a profit maximizing entity. The managerial challenge of this neoclassical view and the ongoing debate between these two schools of thoughts are then discussed. One way to resolve the conflict between these two views is to look at the return on investments. Such studies have been done recently and show that investment efficiency has actually improved since the 1990s in some countries like the United States. Possible explanations are disciplining takeovers, increased product competition due to globalization and the growth of institutional shareholding.

II.

ORGANIZATION OF ECONOMIC ACTIVITIES

In Part II, chapters studying the firm from an economic organization perspective are found. The first chapter, by Per-Olof Bjuggren and Johanna Palmberg, (entitled A contractual perspective on the firm with application to the maritime industry) introduces a contractual model of the firm and applies it to explain how the maritime sector is organized. The capacity of the firm as a legal person to enter into contracts with suppliers of goods and services, customers and creditors is highlighted. It is argued that mutual dependency is what determines the character of contractual relations. The employment contract and ownership of assets in adjacent vertical stages enables the firm to supplant price as coordination mechanism in the production of goods and services. The maritime industry offers a rich flora of contractual relations due to differing degrees of mutual dependence between shipper and carrier. Both the firm and the freight contract are analysed from a contractual perspective. A contractual explanation is also offered for the phenomenon of third-party management. A second chapter, by Kirsten Foss, (entitled Authority in the knowledge economy) takes a closer look at authority relations between employer and

Introduction

employees. In transaction cost economics, it is claimed that the possibility to use authority as a mode of coordination is what primarily characterizes firms. Authority is a key concept in the theory of the firm, and Foss throws light upon it. She claims that the emerging knowledge economy makes it necessary to take a closer look at the different dimensions of the authority concept in order to understand ongoing changes in economic organization. From a review of authority in the economic literature, the conditions under which it is efficient to use authority for coordination, contract enforcement, and dispute resolution are identified. Finally, how these conditions have to be adapted to an emerging knowledge economy is discussed. The third chapter, by Gunnar and sa Eliasson, (entitled Competence and learning in the experimentally organized economy) offers a new evolutionary perspective on how firms emerge and disappear. The authors picture an economy with boundedly rational and myopic actors who try to take advantage of perceived business opportunities. Success is to a large extent dependent on the interaction of actors in so called competence blocs. In a successful competence bloc, customers, innovators, entrepreneurs, financiers, exit markets and industrialists interact efficiently in the sense of minimizing the cost of keeping losers on for too long and losing the winners. The customer has a key function in a bloc by being the ultimate arbiter of value. In the experimentally organized economy that Gunnar and sa Eliasson envision, economic organization and the firm are a result of how the competence bloc is structured. Efficient ways to organize the relations between the actors in a bloc will be rewarded by increasing returns, which make the organization viable.

III.

IMPORTANCE OF THE INSTITUTIONAL ENVIRONMENT

Part III consists of chapters dealing with investment and legal environment. Johan Eklunds contribution (entitled Corporate governance and investment in Scandinavia ownership concentration and dual-class equity structure) looks at how ownership structure affects investment performance in the different Scandinavian countries. As a measure of investment performance, the marginal q developed by Dennis Mueller and Elisabeth Reardon is used. From legal and political perspectives the Scandinavian countries are rather similar. But there are still distinctive differences in separation of ownership and control through the use of dual-class shares. Sweden has the highest fraction of listed firms that use dual-class shares, while Norway has the lowest fraction. The implications of these differences on investment performance are investigated. It turns out that in Norway

The modern firm, corporate governance and investment

the marginal q estimate indicates overall efficient investment performance among the listed firms, while the estimate for Swedish and Danish firms indicates over-investment marginal returns on investment are lower than costs of capital. A non-linear effect of ownership concentration in Scandinavian firms is also found, implying a positive but marginally decreasing effect of ownership concentration on investment returns. In a second chapter (The cost of legal uncertainty: the impact of insecure property rights on cost of capital) Per-Olof Bjuggren and Johan Eklund study how institutional risk influences the required return on international investments. Institutional risk due to weak property rights and investor right protection represents a non-diversifiable risk to international investors, as these rights are fairly stable over time. Hence investors are likely to demand a risk premium in those countries where these rights are weak. The required return on investment in such countries will accordingly be higher. The capital asset pricing model (CAPM) is used to test for the importance of taking institutional risk into consideration, and to find out the risk premium associated with institutional risk. It turns out that the explanatory power of the CAPM is considerably increased if such a risk is taken into account. Furthermore, the risk premium due to institutional risk is found to be significantly higher for developing than for developed countries. A third chapter, by Simon Deakin and Ajit Singh, (The stock market, the market for corporate control and the theory of the firm: legal and economic perspectives and implications for public policy) takes up the question of how important an active market for corporate control is for economic efficiency. The authors have severe doubts about whether hostile takeovers have positive effects on efficiency and growth in developed countries. Their discussion of the pros and cons of a market for corporate control starts with the observation that shareholders do not own a company in the sense of being entitled to a particular segment or portion of the companys assets, at least while it is a going concern. Furthermore, directors fiduciary interests of loyalty and care are owed to the company. Even though in practice it is foremost the interests of the shareholders that are catered to, other stakeholders interests are to a differing degree also recognized. This is especially the case in civil law systems. It is argued that it cannot be taken for granted that company law and articles of association that serve as obstacles to takeovers are at the expense of economic efficiency. Two strands of thought in the economic literature are referred to in Deakin and Singhs economic analysis; On one hand, there is the principal agent view of the market for corporate control that is used in financial economics. On the other hand, there is a more antitrust oriented analysis used

Introduction

in industrial organization. The views of these schools differ. While financial economists have focused on takeovers and mergers as a mechanism to discipline managers, industrial economists also stress their negative effects on the overall economy. Balancing different views of efficiency implications, Deakin and Singh come to the conclusion that hostile takeovers are likely to harm the prospects for growth in developing and transition economies.

IV.

OWNERSHIP STRUCTURE, BOARD COMPOSITION AND FIRM PERFORMANCE

Part IV contains chapters that examine how the composition of the board, management relations and ownership structure affect firm performance. A first chapter by Daniel Wiberg (Institutional ownership and dividends) studies the relationship between institutional ownership and dividends. Wiberg wants to see both whether there is a positive relation between institutional ownership and dividends, and whether there are more rational reasons than short-termism for explaining such a relation. Swedish data are used to test the hypotheses. The Swedish institutional framework is interesting as there is widespread use of dual-class shares and the tax rules make dividends more attractive to institutional than to other ownership categories. Through the use of dual-class shares, ownership can be separated from control, leading to pronounced agency problems. One way to overcome these agency problems is to insist on dividends. If such a relationship exists it implies that dividends are higher in firms with greater separation between ownership and control due to dual-class shares. Wiberg finds this to be the case, and that institutional ownership has a positive impact on dividend growth. Camille Madelon and Steen Thomsen (Contracting around ownership: shareholder agreements in France) use data from large, French listed firms to examine the effects and determinants of shareholder agreements. These agreements represent a way to contract around the official ownership structure. While the relationship between observable formal ownership and behaviour/performance has been extensively studied, there has been no study of the relationship between real ownership structure (considering contracts between shareholders as well) and behaviour/performance. Madelon and Thomsenss study is one of the first steps towards filling this void. It is an explorative study that analyses agreements from a transaction cost approach view. The costs and benefits of acquiring control through contracting amongst shareholders are compared with the alternative of outright ownership. Several theoretical propositions are derived that consider ownership and industry characteristics and network ties as

The modern firm, corporate governance and investment

explanations as to why contractual agreements are chosen. Propositions about the impact of shareholders agreements on economic performance are also derived. Board governance of family firms and business groups with a unique regional dataset, by Llus Bru and Rafel Crespi, is both a methodological paper about how to empirically study family business and a description of what family businesses look like in the Balearic region of Spain. They have managed to trace family ownership and management by use of the Spanish two-surnames system. This system has two features. Married women usually do not change their name and newborns have both the fathers and the mothers surname. This surname system has made it possible to trace both ownership and involvement in boards and management by family members. Besides family companies, it has been possible to trace business groups under the control of associated families. The importance of family firms and groups in the Balearic economy and the characteristics of the diversification patterns of family business groups are described. Reidar ystein Strm (Better firm performance with employees on the board?) uses data from Norwegian listed firms to analyse how co-determination affects performance. He distinguishes between direct and indirect effects of employee directors. In the theoretical literature both positive and negative effects of employee directors on performance are envisioned. Employee directors might contribute to positive performance by bringing more information about how the firm functions and enhancing the incentives to invest in firm-specific human capital. On the other side, owners and employees interests might not be aligned, producing a negative effect on performance. Most empirical studies find a negative impact on performance. Strm takes the analysis one step further by taking account of the reactions of the shareholders to anticipated negative effects of employee directors. By adjusting the composition of the board and the financial leverage of the firm, these negative effects can be counteracted. This indirect effect is taken into consideration in a simultaneous equations framework. A three-stage least squares methodology with fixed effect is used to estimate both the direct and indirect effects. Even though indirect endogenous effects are taken into account, the results of the empirical analysis show a negative impact of employees on the board. Wolfgang Drobetz, Klaus Gugler and Simone Hirschvogl (The determinants of German corporate governance ratings) analyse corporate governance rating in Germany. As in many other European countries, Germany has since 2002 had a Corporate Governance Code of a comply or explain kind. Instead of assessing the impact of code fulfilment on performance of firms, Drobetz, Gugler and Hirschvogl choose to analyse the determinants of corporate governance rating. One advantage with this approach is that

Introduction

an endogeneity problem due to self-selection is avoided. The analysis is to a large extent based on the assumption that there is a positive relation between firm performance and a high corporate governance rating. The determinants of performance studied are ownership concentration, the size of the supervisory board, choice of strict accounting rules, and the use of an option-based remuneration plan. Ownership concentration is hypothesized to be non-linearly related to ratings. The rationale is that it is only at high levels of ownership concentration that the entrenchment effect of ownership is balanced by the rewards associated with better performance. For the other determinants, a negative effect is found for board size, stricter accounting rules are positively related to performance, and stock-option schemes have a positive relation to rating. All the hypotheses are corroborated in the empirical analysis based on survey data from 91 German firms. Mogens Dilling-Hansen, Erik Strjer Madsen and Valdemar Smith (Top management, education and networking) use Danish data to study how management can benefit from networking. Networking takes place through board participation by top management. They look at network ties between firms linked by ownership and between independent firms. The former ties are labelled internal ties while the latter are called external ties. Networking through external ties can increase the top managements knowledge of the competitive and technological environment of the firm. It can also facilitate collusion. Networking can then be expected to improve performance. Networking of an internal character can improve the control of subsidiaries. The extent to which networking will have a positive influence on performance can be expected to be dependent on education. An empirical analysis of a large sample of Danish firms finds a significant positive effect of internal network activities on firm performance, and that education implies a positive attitude towards networking. No other significant relationships can be traced.

PART I

Key issues

2.

Opening the black box of firm and market organization: antitrust*

Oliver E. Williamson
The task of linking concepts with observations demands a great deal of detailed knowledge of the realities of economic life. Tjalling Koopmans

Opening the black box of firm and market organization and examining the mechanisms inside is a defining characteristic of the transaction cost approach to the study of economic organization (Arrow, 1987, 1999; Dixit, 1996; Kreps, 1990). But questions remain. Do the details matter for a wide range of phenomena or only a few? Which, among the endless number of details that could be recorded, have conceptual and operational significance? What, if any, are the public policy ramifications? My responses to these queries are that the details matter for a wide range of phenomena, that many relevant details are uncovered by examining economic organization through the focused lens of contract/governance,1 and that public policy toward business has been a beneficiary. Antitrust applications are developed here. Regulatory applications are examined elsewhere (Williamson, 2007a). I begin with a statement of the crisis in antitrust as of 1970. A synopsis of the microanalytic setup is then sketched in Section 2. The paradigm problem for transaction cost economics is the intermediate product market transaction, as described in Section 3. Antitrust applications are developed in Sections 48. Concluding remarks follow and there is an Appendix on the antecedents on which transaction cost economics builds.

1.

THE CRISIS IN ANTITRUST

Victor Fuchs opens his foreword to the National Bureau of Economic Research 50th anniversary volume, Policy Issues and Research Opportunities in Industrial Organization, with the query Whither industrial organization?, to which he opines that all is not well with this once flourishing field
11

12

Key issues

(1972, p. xv). Of the various answers that could be advanced to explain this decline, the ones to which I attach the greatest weight are the all-purpose reliance by industrial organization economists (and others) on a black box theory of the firm and a plain vanilla theory of markets. Because the firm was described as a production function that transformed inputs into outputs according to the laws of technology, non-technological or nonprice theoretic explanations for reshaping the boundary of the firm were thought to be deeply problematic. Contractual deviations from simple market exchange were likewise regarded as suspect. Since economists were dismissive of the possibility that the internal organization of transactions had important economizing consequences,2 vertical integration and other organizational practices that lacked a physical or technical aspect were presumed to have the purpose of increasing the market power of the firms involved rather than reduction in cost (Bain, 1968, p. 381). Vertical market restrictions (and other deviations from simple market exchange) were also regarded as deeply problematic. As the then head of the Antitrust Division of the US Department of Justice put it, I approach customer and territorial restrictions not hospitably in the common law tradition, but inhospitably in the tradition of antitrust.3 Indeed, some protectionist antitrust enforcement officials regarded prospective efficiency gains from a merger to be anticompetitive because less efficient rivals would be disadvantaged.4 Such upside-down reasoning encouraged respondents to merger litigation to disclaim that any efficiency benefits would accrue.5 Ronald Coase summarized the prevailing state of disarray as follows: If an economist finds something a business practice of one sort or other that he does not understand, he looks for a monopoly explanation. As in this field we are very ignorant, the number of ununderstandable practices tends to be rather large, and the reliance on monopoly explanation, frequent (1972, p. 67). An altogether different lens through which to examine complex contracting and economic organization would be needed to break the grip of such convoluted thinking. As described in Section 2, the lens of contract/ governance describes firms and markets as governance structures, the different mechanisms of which matter in efficiency respects. An economics of organization takes shape in the process as monopoly is reduced to an important but special case.

Opening the black box of firm and market organization

13

2.
2.1

THE MICROANALYTICS: A SYNOPSIS

General

As Herbert Simon observes (1984, p. 40):

In the physical sciences, when errors of measurement and other noise are found to be of the same order of magnitude as the phenomena under study the response is not to try to squeeze more information out of the data by statistical means; it is instead to find techniques for observing the phenomena at a higher level of resolution. The corresponding strategy for economics is obvious: to secure new kinds of data at the micro level.

Inasmuch, however, as the social sciences are hypercomplex (Wilson, 1998, p. 183; Simon, 1957, p. 89), the details proliferate. Where precisely do the relevant microanalytics reside? That will vary with the phenomena to be investigated and the lens through which the phenomena are viewed. 2.2 The Rudiments6

Rather than operate out of the neoclassical lens of choice (with emphasis on prices and output, supply and demand, in relation to which organization is held to be unimportant), transaction cost economics works out of the lens of contract/governance. The building blocks are transactions and governance structures and the efficient alignment thereof, whereupon organization is not only important but is susceptible to analysis.7 In addition to simple market exchange (contract as legal rules), provision is made for hybrid contracting (contract as framework, for which continuity of the exchange relationship is important) and hierarchy, each of which is described as an alternative mode of governance. Note that the decision to use one mode of governance rather than another depends on the transactions for which governance support is required. Hitherto neglected transaction costs take their place in the analytical firmament. If both transactions and governance structures differ, then the relevant microanalytics for describing both of these will need to be worked out. Herbert Simons advice, to little discernible effect, that Nothing is more fundamental in setting our research agenda and informing our research methods than our view of the nature of the human beings whose behavior we are studying (1985, p. 303) is pertinent in this connection. Cognitive competence is especially relevant, but so too is the manner in which selfinterest is described. If, for example, human actors possess the cognitive ability to implement comprehensive contingent claims contracting, then we are in the

14

Key issues

world of ArrowDebreu and, in such a contractual world, organization is unimportant. If instead the list of six assumptions that are made by Drew Fudenberg, Bengt Holmstrom and Paul Milgrom (1990) apply, then we are in a world where a sequence of short-term contracts can implement an optimal long-term contract.8 More generally, the point is this: different assumptions about cognition lead into different theories of contract and organization (and the same holds for descriptions of self-interest (Williamson, 1985, pp. 647)). Transaction cost economics describes both cognition and self-interest in a two-part way. Specifically, cognition combines bounded rationality with feasible foresight while self-interest joins benign behavior with opportunism. Thus all complex contracts are unavoidably incomplete (by reason of bounded rationality) yet human actors are assumed to have the capacity to look ahead, recognize hazards, work out the mechanisms, and, albeit imperfectly, factor the ramifications back into the ex ante contractual design (which is a manifestation of feasible foresight). Also, most human actors will do what they agree to and some will do more most of the time (benign behavior), but outliers for which the stakes are great will elicit defection and/or posturing (which are manifestations of opportunism) with the purpose of inducing renegotiation. Whether contractual incompleteness (bounded rationality) and defection hazards (opportunism) pose serious governance issues depends on the attributes of transactions. Transactions for which continuity of the exchange relationship is important and for which coordinated adaptations are needed to restore efficiency are those for which the efficacy of simple market exchange breaks down. Behavioral attributes in combination with transactional attributes thus underpin the need for added governance supports (or not) where governance is defined as the means by which to infuse order, thereby to mitigate conflict and realize mutual gain. The three attributes of transactions that are especially important for preserving continuity by implementing coordinated adaptations are asset specificity (which is a measure of bilateral dependency, to which maladaptation hazards accrue), uncertainty (the disturbances, small and great, to which transactions are subject), and the frequency with which transactions recur, which has a bearing on both reputation effects (in the market) and private ordering mechanisms (within firms). Governance structures are described as discrete structural syndromes of attributes that differ in their adaptive capacities, of which two types are distinguished: autonomous adaptation to changes in relative prices as described by Friedrich Hayek (1945) and coordinated adaptations of a conscious, deliberate, purposeful kind as described by Chester Barnard (1938). Incentive intensity, decision and administrative control instruments, and

Opening the black box of firm and market organization

15

contract law regimes are the defining attributes with respect to which governance structures are described. As discussed in Section 3, the three main modes of governance for organizing intermediate product market transactions are market, hybrid, and hierarchy. Interestingly, but not surprisingly, spot markets and hierarchies are polar opposites in that spot markets are characterized by high-powered incentives, negligible administrative control, and a legal rules contract law regime, thereby to support autonomous adaptation, whereas hierarchies use low-powered incentives and hands-on administrative control, and settle internal disputes administratively under a forbearance law regime9 in support of coordinated adaptation. Hybrid contracting is located between market and hierarchy in all three attributes and in both adaptation respects and thus can be thought of as a compromise mode. The discriminating alignment hypothesis provides the predictive link between transactions and governance structures to wit, transactions, which differ in their attributes, are aligned with governance structures, which differ in their costs and competences, so as to effect a transaction cost economizing match.

3.

TRANSACTIONS IN THE INTERMEDIATE PRODUCT MARKET: THE PARADIGM TRANSACTION

The intermediate product market transaction (or in more mundane terms, the make-or-buy or outsourcing decision) is the obvious paradigmatic transaction for transaction cost economics for two reasons. First, this is the transaction to which Coase referred in pointing up a lapse in economic theory in 1937: The purpose of this paper is to bridge what appears to be a gap in economic theory between the assumption (made for some purposes) that resources are allocated by means of the price mechanism and the assumption (made for other purposes) that this allocation is dependent on . . . [hierarchical mechanisms]. We have to explain the basis on which, in practice, this choice between alternatives is effected (Coase, 1937, p. 389). Secondly, intermediate product market transactions are simpler than are labor market, capital market, and final product market transactions because they are less beset with asymmetries of information, budget, legal talent, risk aversion, and the like. The simple contractual schema, as described herein, focuses on the intermediate product market transaction but applies (with variation) to the study of transactions more generally. Thus assume that a firm can make or buy a component and assume

16

Key issues
A (unassisted market) h=0 B (unrelieved hazard) s=0 C (credible commitment) h>0 market safeguard s>0 administrative

D (integration)

Figure 2.1

Simple contractual schema

further that the component can be supplied by either a general purpose technology or a special purpose technology. Letting k be a measure of asset specificity, the transactions in Figure 2.1 that use the general purpose technology are ones for which k 5 0. In this case, no specific assets are involved and the parties are essentially faceless. Transactions that use the special purpose technology are those for which k . 0. Such transactions give rise to bilateral dependencies, in that the assets cannot be redeployed to alternative uses and users without loss of productive value. The parties therefore have incentives to promote continuity, thereby to safeguard specific investments. Let s denote the magnitude of any such safeguards, which include penalties, information disclosure and verification procedures, specialized dispute resolution (such as arbitration) and, ultimately, integration of the two stages under unified ownership. An s 5 0 condition is one for which no safeguards are provided; a decision to provide safeguards is reflected by an s . 0 result. Node A in Figure 2.1 corresponds to the ideal transaction in law and economics: there being an absence of dependency, governance is accomplished through competition and, in the event of disputes, by court awarded damages. Node B poses unrelieved contractual hazards, in that specialized investments are exposed (k . 0) for which no safeguards (s 5 0) have been provided. Such hazards will be recognized by farsighted players, who will price out the implied risks.10 Confronted with the added costs of these hazards, buyers have the incentive to mitigate the hazards (in

Opening the black box of firm and market organization

17

cost-effective degree), which is to say that node B is an inefficient mode of governance for ongoing (as against episodic) supply purposes. Added contractual supports (s . 0) are provided at Nodes C and D. Node C governance corresponds to what Karl Llewellyn referred to as contract as framework, as distinguished from contract as legal rules, where the former better preserves continuity of the transaction through a framework highly adjustable, a framework which almost never accurately describes real working relations, but which affords a rough indication around which such relations vary, an occasional guide in cases of doubt, and a norm of ultimate appeal when the relations cease in fact to work (1931, pp. 7367). This is the aforementioned hybrid transaction where credible contracting mechanisms are introduced in support of cooperative adaptation. Such hybrids are not, however, indefinitely elastic. As disturbances become highly consequential, . . . an incentive to defect [arises]. The general proposition here is that when the lawful gains to be had by insistence upon literal enforcement exceed the discounted value of continuing the exchange relationship, defection from the [cooperative] spirit of the contract can be anticipated (Williamson, 1991a, p. 273). Benjamin Klein subsequently describes the self-enforcing range similarly: if and as changes in market conditions move outside the self-enforcing range, . . . the one-time gain from breach [will] exceed the private sanction (1996, p. 449). But this is not the end of the governance story. As the expected maladaptation costs of hybrid contracting progressively mount, best efforts to craft cost-effective credible commitments notwithstanding, transaction cost economics predicts that transactions will be removed from the hybrid and organized under unified ownership (vertical integration). Inasmuch as added bureaucratic costs accrue upon taking a transaction out of the market and organizing it internally, hierarchy is usefully thought of as the organization form of last resort: try markets, try hybrids, and have recourse to the firm (Node D) only when all else fails. Node D governance (hierarchy) involves (1) unified ownership of successive stages, (2) coordinated adaptation at the interfaces by the application of routines (to manage disturbances in degree) and by the use of hierarchy (to manage disturbances in kind), (3) internal dispute resolution for settling disputes that cannot be resolved by the parties by appealing these to a common boss, and (4) the aforementioned bureaucratic cost burdens. Transaction cost economics thus predicts that generic (k 5 0) transactions will be assigned to Node A (the market mode, where continuity is of no importance and disputes are settled in court), more complex transactions (k . 0) to Node C (the hybrid mode, where continuity matters and adaptations are accomplished under the more elastic concept of contract as framework), that very complex transactions (k . . 0) will be taken

18

Key issues

out of the market and organized within hierarchy at Node D, and that few transactions (mistakes or adventitious transactions) will be located at inefficient Node B. What is furthermore noteworthy is that empirical tests of the predictions of the theory have ensued and have been broadly corroborative. Indeed, despite what almost 30 years ago may have appeared to be insurmountable obstacles to acquiring the relevant data [which are often primary data of a microanalytic kind], today transaction cost economics stands on a remarkably broad empirical foundation (Geyskens, Steenkamp and Kumar, 2006, p. 531). This applies, moreover, not merely to the tests of the paradigm problem of vertical integration but to a vast variety of other phenomena that are interpreted as variations on a theme (Macher and Richman, 2006). There is no gainsaying that transaction cost economics has been much more influential because of the empirical work that it has engendered (Whinston, 2001).

4.

APPLICATIONS TO ANTITRUST: GENERAL

The over-reaching excesses of monopoly reasoning during the 1960s contained the seeds of their own destruction. Confronted with escalating implausibility, Supreme Court Justice Potter Stewart, in a dissenting opinion, observed that the sole consistency that I can find is that in [merger] litigation under Section 7, the Government always wins. 11 Alarmist excesses of monopoly reasoning eventually elicited a series of challenges to include both allocative efficiency and transaction cost reasoning,12 where the latter made express provision for economies of organization, the myopic quality of entry barrier reasoning was confronted with remediableness considerations, nonstandard and unfamiliar contracting practices that had been declared to be anticompetitive under the inhospitality tradition were re-examined and found, often, to serve credible contracting purposes, and selective appeal to zero transaction costs was supplanted by an insistence that positive transaction costs be recognized wheresoever they may reside.13 Antitrust scholars from the Chicago School (Stigler, 1968; Demsetz, 1974; Posner, 1976; Bork, 1978) receive and deserve much of the credit, but transaction cost economics was also a contributing factor. Thus whereas the Chicago School focused on explaining why vertical integration and nonstandard vertical contracts did not create or enhance market power . . . transaction cost economics focused on why these vertical arrangements emerged as cost-reducing responses to certain transactional characteristics (Joskow, 1991, p. 56; emphasis added). Without such an affirmative rationale,

Opening the black box of firm and market organization

19

it is hard to believe that the Chicago critique of antitrust policies regarding vertical arrangements would have had as much influence, especially among professional economists and antitrust scholars, . . . for [whom] the theoretical and empirical work in transaction cost economics . . . demonstrated that previously suspect vertical arrangements often could be explained as contractual and organizational responses motivated by a desire to reduce the cost of transacting. (Joskow, 1991, p. 57)

As between critiques of wrong-headed reasoning and explanations for the practices in question for which the mechanisms have been expressly worked out, the latter is the more demanding. Interestingly, Timothy Muris, during his term as chair of the Federal Trade Commission, held that much of the New Institutional Economics literature has significant potential to improve antitrust analysis and policy. In particular, . . . [the transaction cost branch has] focused on demystifying the black box firm and on clarifying important determinants of vertical relationships (2003, p. 15). Opening the black box and acquiring an understanding of the mechanisms inside has had an impact, moreover, on practice:
The most impressive recent competition policy work I have seen reflects the NIEs teachings about the appropriate approach to antitrust analysis. Much of the FTCs best work follows the tenets of the NIE and reflects careful, factbased analyses that properly account for institutions and all relevant theories, not just market structures and [monopoly] power theories. (Muris, 2003, p. 11; emphasis in original)14

A comprehensive examination of the applications of transaction cost economics to antitrust is beyond the scope of this chapter. My purpose is merely to illustrate the ways in which examining the microanalytics of complex contract and economic organization through the lens of contract/ governance has served to alter and deepen our understanding of many antitrust related phenomena. I successively examine applications to vertical market relations, price theoretic issues, credible contracting, and the modern corporation.

5.

VERTICAL MARKET RELATIONS

Lateral integration into components, backward into raw materials, and forward into distribution are successively examined. The analysis throughout tracks the logic of the simple contractual schema in that the move from market to hybrid to hierarchy is predicted as asset specificity and outlier disturbances increase. Asset specificity refinements as among

20

Key issues

physical, human, site, dedicated, and brand name capital are also consequential. With respect, for example, to mobile physical assets (such as specialized dies), it may be possible for the specialized investments to be made by the buyer, who relieves bilateral dependency by assigning the specialized dies to the winning bidder for the duration of the supply contract and repossessing and reassigning these to a successor if the original bidder does not win the renewal contract.15 The need for unified ownership is also relieved by the use of credible commitments to support hybrid contracting as with exchange agreements, or for organizing distribution through a large number of geographically dispersed outlets by franchising rather than by forward integration (although there is also merit in dual distribution). As, however, asset specificity and disturbances increase, unified ownership is predicted. 5.1 Lateral Integration

Economies are commonly ascribed to the integration of successive stages in the technological core, an example of which is the unified ownership of iron- and steel-making stages by reason of thermal economies (Bain, 1968, p. 381). By contrast, lateral integration into components that lack such a physical or technical aspect is (under technological reasoning) believed to be deeply problematic. As discussed above, monopoly purpose and effect were commonly ascribed to these. Transaction cost economics disputes such reasoning. All that is implied by thermal economies (or, more generally, by the physical or technical aspects to which Bain refers) is that the two stages be located adjacent to each other. The governance issue is whether the exchange of product across these co-located stages should be mediated by market or by hierarchy. Unless contractual problems are projected, there is no reason why each stage could not be independently owned and the two stages joined by an interfirm contract. If, therefore, co-located stages are integrated, that is because transaction cost economies are thereby realized: unified ownership relieves the contractual hazards that would otherwise arise between independent, site-specific trading entities. But there is more: transaction cost economics also selectively offers an economizing interpretation for transactions that lack the physical or technical aspects to which Bain refers. As discussed in Section 3 above, the outsourcing of separable components of a non-site-specific kind is the paradigm problem on which transaction cost economics is based and to which empirical tests were first applied (Monteverde and Teece, 1982; Masten, 1984).16 The upshot is that the same comparative contractual logic applies to the organization of asset-specific transactions of all kinds,

Opening the black box of firm and market organization

21

site-specific or not. The contrast with earlier antitrust predilections is stark.17 5.2 Raw Materials Procurement

Except perhaps for very atypical cases, an efficiency case for vertical integration backward into raw materials is believed to be rare if not nonexistent. Surely the lesson of the Ford Motor Companys fully integrated behemoth at River Rouge, supplied by an empire that included ore lands, coal mines, 700,000 acres of timberland, sawmills, blast furnaces, a glass works and coal boats, and a railroad (Livesay, 1979, p. 175) is that this was vertical integration run amok. Exactly right: maybe comprehensive vertical integration has the appearance of being an engineers dream, but it is not an economic ideal. As John Stuckeys examination of backward integration from the refining into the raw materials stage in the Australian aluminum industry reveals, the transactional details matter. Bauxite ore, it turns out, is not a uniform mineral but, instead, is a heterogeneous commodity, . . . [where] the ore in any deposit has unique chemical and physical properties (Stuckey, 1983, p. 290). That is consequential: the cost difference of processing a mixedhydrate bauxite, which is efficiently processed with a high-temperature technology, in a low-temperature refinery instead, comes to almost 100 percent (Stuckey, 1983, pp. 534). Other details also matter. Bauxite storage covers are needed for some ores and not for others (p. 49); residue processing costs vary greatly (p. 53); and air pollution equipment is tailored to the attributes of the bauxite (p. 60). Moreover, although smelting is less idiosyncratic, there is, nevertheless, an art part of smelting, which is upset if the aluminum supply is varied (p. 63). Not every refinery, however, is dependent on a specific bauxite deposit. Thus, whereas most of the above described economies are realized by specializing the characteristics of a local refinery to a local bauxite deposit (as in Australia), the same cannot be said for remotely located refineries, as in Japan, where a general purpose refinery that can process bauxite ores procured on the world market has countervailing advantages. Interestingly, regulatory concerns sometimes get in the way of backward integration an example of which is the bilateral dependency that sometimes arises between fuel source and operating stages in electricity generation by coal-burning generators (Joskow, 1987). Lest utilities integrate backward into coal production to shift profits from a regulated to an unregulated activity, the regulatory process has discouraged this (Joskow, 1987, p. 284, n. 17). As with bauxite, The type of coal that a generating unit is designed to

22

Key issues

burn affects its construction and its design thermal efficiency (Joskow, 1987, p. 284). In some regions, as in the Eastern United States, coal of relatively uniform quality is available from a large number of small nearby mines; in other regions, as in the West, deposits are large and coal quality variation among mines and the distances for shipment are great (1987, p. 284). Mine mouth generating plants of specific design are often observed for the latter. More generally, comparative contractual reasoning predicts that longer-term and more nuanced contracts will be observed for the West than in the East, which is borne out by the data: as relationship-specific investments become more important, the parties . . . find it advantageous to rely on longer-term contracts that specify the terms and conditions of repeated transactions ex ante, rather than relying on repeated bargaining (Joskow, 1987, p. 296). 5.3 Forward into Distribution

A huge franchising literature in economics and marketing examines the decision of whether producers should own some or much of their distribution system or contract with others to manage the distribution of goods and services instead. In the event of the latter, vertical market restrictions often apply, a common purpose being to protect the network against brand name devaluation (Klein and Leffler, 1981). Many economizing issues are posed by forward integration into marketing and the uses of vertical market restrictions, of which asset specificity (especially in the form of brand name capital) is only one. Transaction cost reasoning nevertheless plays a central role in the marketing decision (Coughlan et al., 2005) as to which contractual mode to choose and, if the market, whether contractual restrictions should be imposed. Contrary to the inhospitality tradition in antitrust,18 vertical market restrictions will yield social benefits if the requisite transaction cost pre-conditions are satisfied.

6.
6.1

PRICE THEORETIC ISSUES

Price Discrimination

The price theoretic argument in favor of price discrimination (especially perfect price discrimination) is that discrimination permits parties whose valuation is below a uniform monopoly price but above marginal costs to buy the good or service in question, as a result of which allocative efficiency benefits accrue. A problem with the argument is that perfect

Opening the black box of firm and market organization

23

price discrimination assumes that the transaction costs of discovering true customer valuations and of policing against arbitrage are zero, which are heroic assumptions. Upon taking the costs of discovering price valuations and enforcing arbitrage restrictions into account, it can be shown that costly price discrimination can lead to both private benefits (monopoly profits increase) and social losses (Williamson, 1975, pp. 1113).19 6.2 Robinson-Patman

Transaction cost economics also has a bearing on the Robinson-Patman Act, which has been interpreted as an effort to deprive a large buyer of [discounts] except to the extent that a lower price could be justified by reason of a sellers diminished costs due to quantity manufacture, delivery, or sale, or by reason of the sellers good faith effort to meet a competitors equally low price. 20 The concern, plainly, is that large buyers will use their muscle to extract better deals from suppliers, as a result of which smaller buyers will be disadvantaged. To this, however, should be added the possibility that different buyers are prepared to offer different contractual supports for the same good or service. With reference to Figure 2.1, suppose that a supplier uses specialized assets to produce the same good or service for two buyers. Assume that one of the buyers refuses to offer contractual safeguards while the other does offer safeguards. These two correspond to Node B and Node C contracting, respectively. Plainly, the supplier will sell on better terms to the Node C buyer than to the Node B buyer. The upshot is that quantity and meeting competition considerations do not exhaust the legitimate reasons for offering lower prices to some buyers than to others. Application of the lens of contract/governance, as against all-purpose reliance on textbook micro theory, serves to uncover these additional purposes. 6.3 Predatory Pricing

Transaction cost economics disputes the merits of the marginal cost pricing test for predatory pricing, as advanced by Philip Areeda and Donald Turner (1975), in two respects. First, although marginal cost pricing can be thought of as a hypothetical ideal (second best considerations aside), such an ideal is a deceptive standard if the measurement of marginal costs invites accounting manipulation and deceit in the courtroom. Additionally, Areeda and Turner apply the same marginal cost pricing test to price reductions of both continuing and temporary kinds which is to say that they make no provision for strategic price reductions: now its there, now

24

Key issues

it isnt, depending on whether a new entrant has appeared or been vanquished. That is unwarranted, since the welfare benefits of temporary price cuts are at best small and could easily be net negative. Here as elsewhere, however, objections to a proposed criterion do not, alone, carry the day. There is an obligation to advance a superior feasible alternative. The output test proposed in Williamson (1977) has three advantages over the marginal cost pricing test: (1) repositioning, (2) measurement, and (3) contingent versus continuing responses. Repositioning makes allowance for the possibility that parties to which predatory pricing rules apply will adapt (reposition) in relationship to them. Areeda and Turner ignore this incentive, yet it is noteworthy that their test has inferior repositioning properties in comparison with the output test. Output, moreover, is much easier to measure than is marginal cost. And the output test expressly favors continuing over contingent supply now its here, now it isnt, depending on whether an entrant has appeared or perished by the established firm. The upshot is that transaction cost considerations are very relevant for uncovering the efficiency ramifications of two price theoretic tests for predation. 6.4 Over-searching

The market for gem-quality uncut diamonds employs two nonstandard contracting practices that are puzzling at best and are easily interpreted as efforts by de Beers to exercise muscle in its dealings with the buyers of uncut diamonds. The two trading restrictions in question are the all-or-none and in-or-out trading rules. Inasmuch as de Beers had market power in the supply of uncut diamonds, these trading rules were believed to have the muscular purpose of extracting profit from diamond cutters. Although the web of cooperative practices among diamond cutters in New York (Richman, 2006) might be interpreted as collusive, the de Beers trading rules applied to a global market. Consider therefore the possibility raised by Roy Kenney and Benjamin Klein (1983) that these rules have efficiency purposes. Whereas uncut diamonds are classified into more than two thousand categories, significant quality variation in the stones evidently remains. How can such a market be organized so as to reduce the oversearching costs that would be incurred if buyers were to evaluate every stone, or at least every grouping of stones, offered by de Beers? The combination of all-or-none with in-or-out trading rules arguably serves to reduce over-searching.21 The all-or-none trading rule requires that a buyer accept the entire grouping of diamonds assembled by de Beers (a sight) or none at all. Buyers are thereby denied the opportunity to pick and choose among

Opening the black box of firm and market organization

25

individual diamonds, yet nonetheless have the incentive to inspect each sight very carefully. Refusal to accept a sight would signal that the sight was over-priced but no more. Suppose now that an in-or-out trading rule is added. The decision to refuse a sight now has much more serious ramifications. To be sure, a refusal could indicate that a particular sight is egregiously over-priced. More likely, however, it reflects a succession of bad experiences. It is a public declaration that de Beers is not to be trusted. In effect, a disaffected buyer announces that the expected net profit of dealing with de Beers under these constrained trading rules is negative. Such an announcement has a chilling effect on the market. Buyers who were earlier prepared to make casual sight inspections are now advised that there are added trading hazards. Everyone is put on notice that a confidence has been violated and is warned to inspect more carefully. On this interpretation, the in-or-out trading rule is a way of encouraging buyers to regard the procurement of diamonds not as independent trading events but as a related series of trades. If, overall, things can be expected to average out, then it is not essential that the payment made for value received corresponds exactly on each sight. In the face of systematic under-realizations of value, however, buyers will be induced to quit. If, as a consequence, the system is moved from a high to a low trust trading culture, then the costs of marketing diamonds increase. That is an adverse outcome to the system which de Beers has strong incentives to avoid. Accordingly, in a regime where both all-or-none and in-or-out trading rules apply, de Beers will take greater care to present sights such that the legitimate expectations of buyers will be achieved. The combined rules thus infuse greater integrity of trade.

7.

CREDIBLE COMMITMENTS

Although credible contracting is the core purpose served by hybrid modes of governance, such a purpose was slow to register in antitrust enforcement mainly because of the monopoly predisposition with which nonstandard and unfamiliar contracting practices were viewed. But whereas traditional market power theories [were so predisposed], . . . TCE can [frequently] . . . illuminate the meaning of facts particularly in the context of complex contractual relations that cannot otherwise be explained, or worse, are explained incorrectly (Muris, 2003, p. 18). Credible commitment reasoning (of a Node C versus Node B kind) has been applied to a wide range of contractual practices including franchise restrictions, exchange agreements, take-or-pay agreements, and a host of other nonstandard contracting practices (Masten, 1996). Exchange agreements are an especially

26

Key issues

interesting illustration of opening the black box and interpreting the purposes served by the mechanisms inside.22 Petroleum exchanges have puzzled economists for a very long time and have been routinely challenged in antitrust cases and investigations of the petroleum industry. The 1973 case brought by the United States Federal Trade Commission against the largest petroleum firms maintained that exchanges were instrumental in maintaining a web of interdependencies among major firms, thereby helping to effect an oligopolistic outcome in an industry that was relatively unconcentrated on normal market structure criteria.23 A later study, The State of Competition in the Canadian Petroleum Industry, likewise held that exchanges were objectionable.24 The Canadian Study, moreover, produced documents contracts, internal company memoranda, letters, and the like as well as deposition testimony to support its views that exchanges are devices for extending and perfecting monopoly among the leading petroleum firms.25 Such evidence on the details and purposes of contracting is usually confidential and hence unavailable. But detailed knowledge is clearly germane and often essential to a correct assessment of the transaction cost features of a contract. Engineers, managers, and lawyers in the major petroleum companies all had a benign interpretation of exchanges. If X has a surplus of product in region A and a deficit in region B while Y has a surplus of product in region B and a deficit in region A, and if both wish to market their product in both areas, then the exchange of product will save on cross-hauling. That, however, omits another possibility: why not create a central market into which each firm can report its surpluses and deficits and procure in an anonymous rather than bilateral way? Petroleum industry engineers, managers, and lawyers found this query unsettling, yet the critical issue that needs to be faced is why bilateral exchange rather than simple market exchange? The Canadian Study lists four objections to exchanges, the first two of which I will pass over here (but see Williamson (1985, p. 148)). The other two are more intriguing: competition is impaired by conditioning supply on the payment of an entry fee (pp. 534) and by exchange agreements that impose limits on growth and supplementary supply (pp. 512). The antitrust concerns posed by the entry fee are supported by the following documentation and interpretation (pp. 523; emphasis added):
Evidence of an understanding that a fee relating to investment was required for acceptance into the industry can be found in the following quotation from Gulf: We do believe that the oil industry generally, although grudgingly, will allow a participant who has paid his ante, to play the game; the ante in this game being the capital for refining, distributing and selling products. (Document #71248, undated, Gulf)

Opening the black box of firm and market organization

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The significance of the quotation lies equally in the notion that an entry fee was required and in the notion that the industry set the rules of the game. The meaning of the entry fee as well as the rules of the game as understood by the industry can be found in the actual dealings between companies where the explicit mention of an entry fee arises. These cases demonstrate the rules that were being applied the rules to which Gulf was referring. Companies which had not paid an entry fee, that is, companies which had not made a sufficient investment in refining capacity or in marketing distribution facilities would either not be supplied or would be penalized in the terms of the supply agreement.

Once a comparative contractual perspective is adopted, a different interpretation of these practices presents itself. So as to keep the comparison simple, suppose that there are two would-be buyers and that each places an order for a significant and identical amount of product for delivery over the same time interval with the same supplier. The buyers differ, however, in that one of the buyers is prepared to create a safeguard to deter premature termination while the other is not. It is elementary that the seller will charge a higher (Node B) price to the latter. But wherein do exchange agreements relate to such trades? Given that the amount of product to be supplied is significant, and assuming that the supply interval is long and that the surplus/deficit geographic relations described above apply, then buyers and sellers so situated will find that an exchange agreement between them not only saves on cross-hauling costs but, additionally, provides a reciprocal credible commitment in that termination by one party is deterred by the expectation that it will be answered in kind. Especially if both parties to the exchange agreement experience correlated disturbances, in which event both will want to adapt similarly, exchange agreements have good adaptation and security properties. Assuming that each party to such a supply agreement constructs and maintains a larger plant than it otherwise would, the specific investments made by these firms take the form of dedicated assets large incremental additions to plant, the output from which is earmarked for a specific buyer as secured by an exchange agreement. Little wonder that petroleum firms will contract on better terms with other petroleum firms that have paid the ante to play the game than they will with buyers whose purchases are unsecured. Consider therefore the use of growth and supplementary supply restraints, an example of which is the ImperialShell exchange agreement, under which Imperial supplied product to Shell in the Maritimes and received product from Shell in Montreal (p. 51):
The agreement between Imperial and Shell, originally signed in 1963, was renegotiated in 1967. In July 1972, Imperial did this because Shell had been growing too rapidly in the Maritimes. In 197172, Imperial had expressed its dissatisfaction with the agreement because of Shells marketing policies. Shell noted:

28

Key issues [Imperials] present attitude is that we have built a market with their facilities, we are aggressive and threatening them all the time, and they are not going to help and in fact get as tough as possible with us. (Document #23633, undated, Shell)

Specifically, Imperial renewed the agreement with Shell only after imposing a price penalty if expansion were to exceed normal growth rates and furthermore stipulated that Shell would not generally be allowed to obtain product from third party sources to service the Maritimes (p. 52; emphasis added). The Canadian Study notes that Gulf Oil also took the position that rivals receiving product under exchange agreements should be restrained to normal growth: Processing agreements (and exchange agreements) should be entered into only after considering the overall economics of the Corporation and should be geared to providing competitors with volumes required for the normal growth only. 26 It furthermore sought and secured assurances that product supplied by Gulf would be used only by the recipient and would not be diverted to other regions or made available to other parties (p. 59). Limits on normal growth and prohibitions on third parties could well have anticompetitive purpose and were so regarded by the Canadian Study. Examined, however, through the lens of contract/governance, it is also possible that these same restrictions had the purpose and effect of preserving symmetrical incentives between the parties to exchange agreements, thereby allowing them to reach Node C credible commitments. Without use restrictions, bilateral dependence could become unbalanced. Also, symmetry could be placed under strain if one party was to grow in excess of normal in which event it might be prepared to construct its own plant and scuttle the exchange agreement. Marketing restraints that help to forestall such outcomes encourage parties to participate in exchanges that might otherwise be unacceptable. To be sure, credibility benefits that are valued by the parties may not be equally valued by society. Such restraints may in some cases have both market power and secure transaction purposes. My purpose is merely to emphasize that, whereas the Canadian Study viewed these entirely in a one-sided (monopoly) way, the perspective of credible contracting adds another. To repeat, transaction cost economics can sometimes illuminate the meaning of facts [and words] particularly in the context of complex contractual relations that otherwise cannot be explained, or worse, are explained incorrectly (Muris, 2003, p. 14).27

Opening the black box of firm and market organization

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8.

THE MODERN CORPORATION

The lens of contract/governance applies to the modern corporation in numerous ways: limits to firm size, scaling up, divisionalization, horizontal merger, conglomerate mergers, corporate governance, Japanese outsourcing practices, disequilibrium forms of organization, and the list goes on. My discussion here is restricted to limits to firm size, scaling up (to include corporate governance), and horizontal and conglomerate mergers.28 8.1 Limits to Firm Size

The puzzle of firm size was posed by Frank Knight in 1921 when he observed that the diminishing returns to management is a subject often referred to in economic literature, but in regard to which there is a dearth of scientific discussion (Knight, 1965, p. 286, n. 1). He elaborated in 1933 as follows (1965, p. xxxi; emphasis added):
The relation between efficiency and size of firm is one of the most serious problems of theory, being, in contrast with the relation for a plant, largely a matter of personality and historical accident rather than of intelligible general principles. But the question is peculiarly vital, because the possibility of monopoly gain offers a powerful incentive to continuous and unlimited expansion of the firm, which force must be offset by some equally powerful one making for decreased efficiency.

Tracy Lewiss later remarks that large established firms will always realize greater value from inputs than small potential entrants are apposite (1983, p. 1092; emphasis added):
The reason is that the leader can at least use the input exactly as the entrant would have used it, and earn the same profits as the entrant. But typically, the leader can improve on this by coordinating production from his new and existing inputs. Hence the new input will be valued more by the dominant firm.

If the dominant firm can use the input in exactly the same way as the entrant, then the larger firm can do everything the smaller firm could. If it can improve on the input usage, it can do more. Applied to vertical integration, the parallel argument is that the acquisition of an independent component supplier is always preferred to outsourcing because the combined firm will never do worse (by reason of replication) and will sometimes do more if the acquiring stage always but only intervenes when expected net gains can be projected (by reason of selective intervention). The puzzle of firm size thus reduces to this: what are the obstacles to the implementation of replication and selective intervention? As I discuss

30

Key issues

elsewhere (Williamson, 1985, Chapter 6), promises to replicate and selectively intervene are not costlessly enforceable. An acquired supplier can neither trust the acquirer to do the accounting (on which the suppliers net receipts are calculated) in an unbiased way nor trust the acquirer to intervene always but only for good cause; and the acquirer cannot trust the supply stage to operate the plant and equipment (now owned by the acquirer) with unchanged due care and to adapt appropriately to autonomous disturbances. The upshot is that neither replication nor selective intervention can be implemented without cost, as a result of which the governance mechanisms of markets and hierarchies differ in kind (Williamson, 1991a). The recurrent point to which I call special attention, however, is this: the bureaucratic burdens of integration are discerned only upon opening the black box and examining the microanalytics. 8.2 Scaling Up

Solow observes that The very complexity of real life . . . [is what] makes simple models so necessary (2001, p. 111). The object of a simple model is to capture the essence, thereby to explain hitherto puzzling practices and make predictions that are subjected to empirical testing. But simple models can also be tested with respect to scaling up. Does repeated application of the basic mechanism out of which the simple model works yield a result that recognizably describes the phenomenon in question? The test of scaling up is often ignored (possibly out of awareness that scaling up cannot be done) or is sometimes scanted (possibly in the belief that scaling up can be accomplished easily). The influential paper by Michael Jensen and William Meckling, Theory of the Firm: Managerial Behavior, Agency Costs, and Capital Structure (1976), is an exception. The authors work out of a simplified setup where an entrepreneur (100 percent owner-manager) sells off a fraction of the equity of the firm, as a result of which his incentive intensity is reduced and efficacious monitoring arises as a response. What the authors are really interested in, however, is not entrepreneurial firms but the modern corporation whose managers own little or no equity (1976, p. 356). Although the latter project was beyond the scope of their paper, they expressed belief that our approach can be applied to this case . . . [These issues] remain to be worked out in detail and will be included in a future paper (1976, p. 356).29 Alas, Jensen and Meckling never produced the follow-up paper, but many others have since examined the efficacy of the board of directors as monitor in the large corporation where the ownership is diffuse. The jury is still out, but I ascertain that serious obstacles stand in the way of acquiring the relevant information to support vigilant monitoring and, furthermore,

Opening the black box of firm and market organization

31

contend that the advisability of assigning the role of vigilant monitor to the board of directors is extremely problematic (Williamson, 2007b). In that event, corporate governance does not scale up from the entrepreneurial firm to the diffusely owned modern corporation. Scaling-up issues relevant to the modern corporation are also posed by the theory of the firm as team production (Alchian and Demsetz, 1972) and the theory of the firm as governance structure. The theory of team production works through technological nonseparability, which Alchian and Demsetz illustrate with the example of manual freight loading: Two men jointly lift heavy cargo into trucks. Solely by observing the total weight loaded per day, it is impossible to determine each persons marginal productivity (1972, p. 779). Accordingly, rather than each person being paid his (unmeasurable) marginal product, such activities are organized cooperatively, with a team whose members are paid as a team and are monitored by a boss lest they engage in shirking. This is instructive, but does technological nonseparability scale up to explain the modern corporation? One possibility is that the large corporation is a vast, indecomposable whole, in which event everything is connected with everything else and the model of technological nonseparability goes through. Another possibility is that, as Simon describes in The Architecture of Complexity (1962), large hierarchical systems evolve from nearly decomposable subsystems within which subsystems interactions are extensive and between which they are attenuated.30 Simons examination of social, biological, physical, and symbolic systems as well as the logic of complexity supports the proposition that decomposability is one of the central structural schemes that the architect of complexity uses (1962, p. 468). Inasmuch as such decomposability relieves the condition of technological nonseparability on which Alchian and Demsetz rely, scaling up from small groups to which nonseparability applies (such as manual freight loading and, possibly, groups as large as the symphony orchestra) does not extend to the decision to join a series of technologically separable stages, thereby to form the modern corporation. So how does that transaction cost economics setup fare in scaling-up respects? Does successive application of the make-or-buy decision, as it is applied to individual transactions, scale up to describe something that approximates a multi-stage firm? Note in this connection that transaction cost economics assumes that the transactions of interest are those that take place between technologically separable stages. This is the boundary of the firm issue as described elsewhere (Williamson, 1985, pp. 968). Upon taking the technological core as given (possibly as derived from site specific investments, of which thermal economies are an example (see Section 5.1 above)), attention is focused on a series of separable make-or-buy decisions

32

Key issues

backward, forward, and lateral to ascertain which should be outsourced and which should be incorporated within the ownership boundary of the firm. So described, the firm is the inclusive set of transactions for which the decision is to make rather than buy which does appear to implement scaling up, or at least is a promising start (Williamson, 1985, pp. 968).31 8.3 Horizontal Mergers

My initial inclination was to regard oligopoly to be outside the scope of transaction cost reasoning, mainly because I had become accustomed to thinking about oligopoly in terms of the prevailing structureconduct performance paradigm, where concentration ratios and barriers to entry were the coin of the realm. Upon viewing oligopoly as a cartel problem, however, its contractual nature is immediately evident. Consider in this connection the claim that monopoly and oligopoly are nearly indistinguishable in competitive respects.32 Such a claim fails to make allowance for (1) the advantages of hierarchy (within a monopoly) as compared with interfirm contracting (among oligopolists) for dispute settlement and coordinating purposes and (2) the differential incentives and the related propensity to cheat that distinguish internal from interfirm organization. Examining the cartel as a five-stage contracting process contract specification, joint gain agreement, implementation under uncertainty, monitoring contract execution, and penalizing contract violations is instructive. As discussed elsewhere (Williamson, 1975, pp. 23844), oligopolies differ in their complexity in all five of these contractual respects. Simple oligopolies where numbers are few and products are homogeneous, shares are easy to agree upon, disturbances are small, price and output are public knowledge, and penalties for violations are assuredly meted out will surely recognize their interdependence and behave accordingly. As, however, deviations from these simple conditions arise, cartel contracts become progressively more complex and undergo slippage and fracture during contract execution. Interestingly, even in the 1870s and 1880s, when express collusion was not unlawful, repeated efforts by the railroads to curb competitive pricing first by informal alliances, then by managed federations were undone by cheating.33 When the railroads found to their sorrow that they could not rely on the intelligence and good faith of railroad executives to manage the cartels (Chandler, 1977, p. 141), they gave up on interfirm agreements and turned to merger. Contractual reasoning is thus instructive in making oligopolymonopoly comparisons. Because, however, the predictions of the contractual approach to oligopoly are very similar to many other oligopoly theories, empirical research on oligopoly has been little affected.

Opening the black box of firm and market organization

33

8.4

Conglomerates

The conglomerate form of organization was a matter of grave concern in the 1960s, especially among those with populist predilections, of which H.M. Blake (1973) was one. According to Blake, the anticompetitive hazards of conglomerate mergers, in potential competition and other respects, were so widespread that [these] might appropriately be described as having an effect upon the economic system as a whole in every line of commerce in every section of the country (1973, p. 567). So regarded, the conglomerate was a menace. Can a contractual approach to conglomerate diversification help to inform the issues? The basic proposition is this: whereas vertical integration is viewed as taking transactions out of the intermediate product market and organizing them internally, the conglomerate can be interpreted as taking transactions out of the capital market and organizing them internally. So described, the conglomerate experiences a breadth for depth tradeoff in managing capital market transactions. The argument relies on part in the distinction between centralized (unitary or U-form) and decentralized (multidivisional or M-form) corporations, as developed by Alfred Chandler (1962) and interpreted in efficiency terms in Williamson (1970). Specifically, the conglomerate can be understood as a logical outgrowth of the divisionalized strategy for organizing complex economic affairs. Thus, once the merits of the M-form structure for managing separable, albeit related, lines of business (such as different automobile brands or different chemical divisions) were recognized and digested, its extension to manage less closely related activities was natural, although that is not to say that the management of diversification is without problems of its own. The basic M-form logic, whereby strategic resource allocation and oversight are assigned to the general office and operating decisions are the responsibility of the operating divisions, nevertheless carries over. To the degree to which conglomerates employ the M-form logic (as against the go-go conglomerates of the 1960s) and possess deep knowledge (as compared with the capital market) within a large but delimited set of diversified investment opportunities, then the indicia for an efficient resource allocation interpretation of the conglomerate take shape.34 Plainly, however, not all conglomerates qualify to be so described.

9.

CONCLUSIONS

Opening the black box of firm and market organization is accomplished by taking transaction cost economizing to be the main case, in relation to

34

Key issues

which adaptations (of autonomous and coordinated kinds) are especially important, and examining economic organization through the lens of contract. The transaction is made the basic unit of analysis and governance is the means by which to infuse order. In conformity with Simons advice that our research agenda and research methods are shaped by our description of human actors, the cognitive and self-interestedness attributes of human actors that bear on contracting are expressly identified, after which the ramifications of human actors as these relate to the key attributes of both transactions and governance structures are worked out. Aligning transactions, which differ in their attributes, with governance structures, which differ in their cost and competence, so as to effect a transaction cost economizing outcome is where the predictive content resides. The key features of the foregoing are these: (1) The lens of contract/governance is an instructive way by which to open the black box of firm and market organization and examine the mechanisms inside. This project subscribes to Jon Elsters dictum that explanations in the social sciences should be organized around (partial) mechanisms rather than (general) theories (1994, p. 75; emphasis omitted). Especially relevant to public policy analysis is that nonstandard contractual practices and organizational structures that were believed to be anticompetitive when examined through the lens of price theory are often revealed to serve efficiency purposes as well or instead. Subsequent uses of the lens of contract/governance to examine complex contract and economic organization reveal that many superficially disconnected and diverse phenomena . . . [are] manifestations of a more fundamental and relatively simple structure (Friedman, 1953, p. 33).35

(2)

(3)

(4)

Such applications notwithstanding, many conceptual, empirical, and public policy challenges await.

NOTES
* This is the first of two papers dealing with opening up the black box. This paper deals with applications to antitrust. The other paper describes applications to regulation (Williamson, 2007a). The introduction and Section 2 of this chapter overlap with Section 1 of Williamson (2007a). The importance of a focused lens is crucial. The distinction here is between promising but sprawling concepts that invite ex post rationalizations for any outcome whatsoever (which is a chronic problem with vaguely defined concepts of which power is one (March, 1966)). A focused lens both delimits the set of factors that can be invoked to explain

1.

Opening the black box of firm and market organization

35

2.

3. 4.

5. 6. 7. 8.

9. 10.

11. 12. 13. 14.

complex phenomena and reveals the mechanisms through which these factors work. The promising but vague concept of transaction costs which Coase introduced in his 1937 article, The Nature of the Firm, remained in a state of disuse 35 years later (Coase, 1972, p. 63) precisely because the key ideas had not been operationalized (Coase, 1992, p. 718). As Harold Demsetz observes, it is a mistake to confuse the firm of [neoclassical] economic theory with its real-world namesake. The chief mission of neoclassical economics is to understand how the price system coordinates the use of resources, not the inner workings of real firms (1983, p. 377). The quotation is attributed to Donald Turner by Stanley Robinson (1968), p. 29. The Federal Trade Commissions opinion in Foremost Dairies states that the necessary proof of violation of Section 7 consists of types of evidence showing that the acquiring firm possesses significant market power in some markets or that its overall organization gives it a decisive advantage in efficiency over its smaller rivals (In re Foremost Dairies, Inc., 60 FTC, 944, 1084 (1962), emphasis added). See Williamson (1985, pp. 3667) for an elaboration upon the convoluted status of antitrust enforcement during the 1960s. This terse summary is elaborated elsewhere (Williamson, 1985, 1991a, 2002, 2005). The intellectual antecedents are set out in the Appendix. R.C.O. Matthews describes the New Institutional Economics (with emphasis on transaction cost economics) in precisely these terms in his Presidential Address to the Royal Economic Society (1986, p. 903). Because I judge several of the listed six assumptions to be implausible (Williamson, 1991b, pp.1726), I take the lesson of Fudenberg et al. (1990) (which is an intellectual tour de force) to be that a sequentially optimal contract is infeasible. Especially problematic are their assumptions of three-way costless knowledge of public outcomes (by principal, agent, and arbiter) and common knowledge of both technology and preferences over action-payment streams. If and as the attainment of logical consistency (in theory) yields infeasibility (in practice), applied economists will understandably be chary of the operational significance of the theory. For a discussion of contract law regimes as these relate to governance, see Williamson (1991a). Note that the price that a supplier will bid to supply under Node C conditions will be less than the price that will be bid at Node B. That is because the added security features at Node C serve to reduce the contractual hazard, as compared with Node B, so the contractual hazard premium will be lowered. One implication is that suppliers do not need to petition buyers to provide safeguards. Because buyers will receive goods and services on better terms (lower price) when added security is provided, buyers have the incentive to offer credible commitments. United States v. Vons Grocery Co., 384 U.S. 270, 301 (1966) (Stewart, J., dissenting). As, for example, in Economies as an antitrust defense: the welfare tradeoffs (Williamson, 1968). This is an insistent theme in Coase (1960, 1964, 1972). Stephen Stockums summary of Muriss position is as follows (2002, p. 60): Muris describes his economic approach as neither Chicago School nor PostChicago, but rather New Institutional Economics, which combines theory with a study of real world institutions, . . . [is] heavily empirical, . . . [and provides relief from economic ideology in favor of] more practical discussions of how economic analysts can contribute to rational enforcement of the antitrust laws.

15. 16. 17.

This relieves problems of valuing such dies if they are owned by the supplier, although user-cost abuses of dies become a concern if the buyer owns them. For discussions, see Williamson (1979, 1987). Thus whereas industrial organization specialists and the Antitrust Merger Guidelines once advised that an antitrust issue is posed should a firm with a 20 percent market share acquire a 5 or 10 percent share in any industry from which it buys or to which it

36

Key issues
sells (Stigler, 1955, p. 183), transaction cost economics counsels that the attributes of the transaction tell us a lot more about the purposes of integration, especially for such small market shares. To be sure, vertical integration sometimes serves strategic purposes. As Alfred Marshall observed, if, in a small country, spinning and weaving were joined, the monopoly so established will be much harder to shake than would either half of it separately (1920, p. 495). Bain warned that vertical integration can be used as a means by which to disadvantage, weaken, eliminate, or exclude non-integrated competitors (1968, pp. 36062). And Stigler advised that integration becomes a possible weapon for the exclusion of new rivals by increasing the capital requirements for entry into the combined integrated production processes (1955, p. 224). I do not disagree. Because, however, strategic entry deterrence is so easy to invoke, those who would make such claims should describe the details of the underlying mechanisms and explain when we should expect alleged adverse effects to rise to the level of public policy significance. For a discussion of both the Jurisdictional Statement and the Brief for the United States in United States v. Arnold, Schwinn & Co., 388 U.S. 365 (1967), see Williamson (1979; 1985, pp. 1839). Applied welfare economics apparatus is used to display these two effects. The tradeoffs had gone unnoticed, however, until positive transaction costs were expressly introduced into the calculus. FTC v. Morton Salt Co., 334 U.S. 37 (1948); emphasis added. The remainder of this subsection is based on Williamson (1996, pp. 778). The remainder of this subsection is based on Williamson (1985, pp. 197201). FTC v. Exxon et al. Docket No. 8934 (1973). Robert J. Bertrand, Q.C., Director of Investigation and Research, Combines Investigation Act, coordinated the eight-volume study, The State of Competition in the Canadian Petroleum Industry (Quebec, 1981). All references in this chapter are to Vol. V, The Refining Sector. That study will hereinafter be referred to as the Canadian Study. Page numbers here and below that do not name the source all refer to Vol. V of the Canadian Study (see note 24, above). The Canadian Study (p. 59) identifies the source as Document #73814, January 1972. Muris (2003, pp. 1523) discusses a variety of other applications of transaction cost economics to complex contracting. Also see Joskow (2002). For discussions of divisionalization, see Williamson (1970, 1985, Chapter 11); for Japanese economic organization, Williamson (1985, pp. 120123); for corporate governance, Williamson (1988, 2007b); for disequilibrium contracting, Williamson (1991a). Other examples where scaling-up tensions are posed include Thomas Schellings treatment of the evolution of segregation in the self-forming neighborhood (Schelling, 1978, pp. 14755), the expansive uses sometimes made of the so-called paradox of voting (Williamson and Sargent, 1967), and the move from project financing to composite financing in the modern corporation (Williamson, 1988). The loose . . . coupling of subsystems . . . [means that] each subsystem [is] independent of the exact timing of the operation of the others. If subsystem B depends upon subsystem A only for a certain substance, then B can be made independent of fluctuations on As production by maintaining a buffer inventory (Simon, 1977, p. 255). In consideration of the difficulties and importance of scaling up, it is judicious to hold theories of the modern corporation for which scaling up has not been demonstrated in public policy abeyance. John Kenneth Galbraith took the position that the firm, in tacit collaboration with other firms in the industry, has wholly sufficient power to set and maintain prices (1967, p. 200). Note that while the courts tolerated collusion, they refused to enforce price setting agreements. There is an additional contractual wrinkle, in that conglomerates once posed an acquisition threat to underperforming firms, including firms that had allowed their debtequity

18. 19. 20. 21. 22. 23. 24.

25. 26. 27. 28. 29.

30.

31. 32. 33. 34.

Opening the black box of firm and market organization

37

35.

ratio to fall below the optimal level (Williamson, 1988). Leveraged buyout specialists such as Kohlberg-Kravis-Roberts are precisely attuned to such opportunities and have since taken over many of these takeover functions. In the spirit of pluralism, we will benefit from any theory that deepens our understanding of complex phenomena and satisfies the precepts of pragmatic methodology (Williamson, 2007c).

REFERENCES
Alchian, A. and H. Demsetz (1972), Production, Information Costs, and Economic Organization, American Economic Review, 62 (December), 77795. Areeda, P. and D.F. Turner (1975), Predatory Pricing and Related Practices Under Section 2 of the Sherman Act, Harvard Law Review, 88 (February), 697733. Arrow, K. (1987), Reflections on the Essays, in George Feiwel (ed.), Arrow and the Foundations of the Theory of Economic Policy, New York: NYU Press, pp. 72734. Arrow, K. (1999). Forward, in Glenn Carroll and David Teece (eds), Firms, Markets, and Hierarchies, New York: Oxford University Press, pp. viiviii. Bain, J. (1968), Industrial Organization, 2nd edn, New York: John Wiley and Sons. Barnard, C. (1938), The Functions of the Executive, Cambridge, MA: Harvard University Press (15th printing, 1962). Blake, H.M. (1973), Conglomerate Mergers and the Antitrust Laws, Columbia Law Review, 73 (March), 55592. Bork, R.H. (1978), The Antitrust Paradox: A Policy at War With Itself, New York: Basic Books. Chandler, A.D. (1962), Strategy and Structure, Cambridge, MA: MIT Press. Chandler, A.D. (1977), The Visible Hand: The Managerial Revolution in American Business, Cambridge, MA: Harvard University Press. Coase, R. (1937), The Nature of the Firm, Economica, N.S., 4, 386405. Coase, R. (1960), The Problem of Social Cost, Journal of Law and Economics, 3 (October), 144. Coase, R. (1964), The Regulated Industries: Discussion, American Economic Review, 54 (May), 1947. Coase, R. (1972). Industrial Organization: A Proposal for Research, in V.R. Fuchs (ed.), Policy Issues and Research Opportunities in Industrial Organization, New York: National Bureau of Economic Research, pp. 5973. Coase, R. (1992), The Institutional Structure of Production, American Economic Review, 82 (September), 71319. Coughlan, A., E. Anderson, L. Stern, and A.El-Ansary (2005), Marketing Channels, 7th edn, Upper Saddle River, NJ: Pearson/Prentice Hall. Demsetz, H. (1974), Two Systems of Belief About Monopoly, in V. Fuchs (ed.), Policy Issues and Research Opportunities in Industrial Organization, New York: National Bureau of Economic Research. Demsetz, H. (1983), The Structure of Ownership and the Theory of the Firm, Journal of Law and Economics, 26 (June): 37590. Dixit, A. (1996), The Making of Economic Policy: A Transaction Cost Politics Perspective, Cambridge, MA: MIT Press. Elster, J. (1994), Arguing and Bargaining in Two Constituent Assemblies,

38

Key issues

unpublished manuscript, remarks given at the University of California, Berkeley. Friedman, M. (1953), Essays in Positive Economics, Chicago: University of Chicago Press. Fuchs, V. (ed.) (1972), Policy Issues and Research Opportunities in Industrial Organization, New York: Columbia University Press. Fudenberg, D., B. Holmstrom and P. Milgrom (1990), Short-Term Contracts and Long-Term Agency Relationships, Journal of Economic Theory, 51 (June), 131. Galbraith, J.K. (1967), The New Industrial State, Boston: Houghton-Mifflin Company. Geyskens, I., J.B.E.M. Steenkamp and N. Kumar (2006). Make, Buy, or Ally: A Meta-analysis of Transaction Cost Theory, Academy of Management Journal, 49 (3), 51943. Hayek, F. (1945), The Use of Knowledge in Society, American Economic Review, 35 (September), 51930. Jensen, M. and W. Meckling. (1976), Theory of the Firm: Managerial Behavior, Agency Costs, and Capital Structure, Journal of Financial Economics, 3 (October), 30560. Joskow, P. (1987), Contract Duration and Relationship-Specific Investments, American Economic Review, 77 (1), 16885. Joskow, P. (1991), The Role of Transaction Cost Economics in Antitrust and Public Utility Regulatory Policies, Journal of Law, Economics, and Organization, 7 (March), 5383. Joskow, P. (2002), Transaction Cost Economics, Antitrust Rules and Remedies, Journal of Law, Economics and Organization, 18 (1), 95116. Kenney, R. and B. Klein (1983), The Economics of Block Booking, Journal of Law and Economics, 26 (October), 497540. Klein, B. (1996), Why Hold-Ups Occur: The Self Enforcing Range of Contractual Relationships, Economic Inquiry, 34 (3), 44463. Klein, B. and K. Leffler (1981), The Role of Market Forces in Assuring Contractual Performance, Journal of Political Economy, 89 (August), 61541. Knight, F. (1965), Risk, Uncertainty, and Profit, New York: Harper & Row, Publishers, Inc. Kreps, D. (1990), A Course in Microeconomic Theory, Princeton, NJ: Princeton University Press. Lewis, T. (1983), Preemption, Divestiture, and Forward Contracting in a Market Dominated by a Single Firm, American Economic Review, 73 (December), 10921101. Livesay, H.C. (1979), American Made: Men Who Shaped the American Economy, Boston: Little, Brown. Llewellyn, K.N. (1931), What Price Contract? An Essay in Perspective, Yale Law Journal, 40, 70451. Macher, J.T. and B. Richman (2006), Transaction Cost Economics: A Review and Assessment of the Empirical Literature, unpublished manuscript. March, J.G. (1966), The Power of Power, in David Easton (ed.), Varieties of Political Theory, Englewood Cliffs, NJ: Prentice-Hall, pp. 3970. Marshall, A. (1920), Principles of Economics, 8th edn, New York: Macmillan and Co., Ltd. Masten, S. (1984). The Organization of Production: Evidence from the Aerospace Industry, Journal of Law and Economics, 27 (October), 40318.

Opening the black box of firm and market organization

39

Masten, S. (1996), Case Studies in Contracting and Organization, New York: Oxford University Press. Matthews, R.C.O. (1986), The Economics of Institutions and the Sources of Economic Growth, Economic Journal, 96 (December), 90318. Monteverde, K. and D. Teece (1982), Supplier Switching Costs and Vertical Integration in the Automobile Industry, Bell Journal of Economics, 13 (Spring), 20613. Muris, T. (2003), Improving the Economic Foundations of Competition Policy, George Mason Law Review, 12 (1), 130. Posner, R. (1976), Antitrust Law, Chicago: University of Chicago Press. Richman, B. (2006), How Communities Create Economic Advantage: Jewish Diamond Merchants in New York, Law and Social Inquiry, 31 (2), 383420. Robinson, S. (1968), Comment, New York State Bar Association, Antitrust Symposium. Schelling, T. (1978), Micromotives and Macrobehavior, New York: Norton. Simon, H. (1957), Models of Man, New York: John Wiley & Sons. Simon, H. (1962), The Architecture of Complexity, Proceedings of the American Philosophical Society, 106 (December), 46782. Simon, H. (1977), Models of Discovery, Boston: D. Reidel Publishing Co. Simon, H. (1984), On the Behavioral and Rational Foundations of Economic Dynamics, Journal of Economic Behavior and Organization, 5 (March), 3556. Simon, H. (1985), Human Nature in Politics: The Dialogue of Psychology with Political Science, American Political Science Review, 79 (2), 293304. Solow, R. (2001), A Native Informant Speaks, Journal of Economic Methodology, 8 (March), 11112. Stigler, G. (1955), Mergers and Preventive Antitrust Policy, University of Pennsylvania Law Review, 104, 17685. Stigler, G. (1968), The Organization of Industry, Homewood, IL: Richard D. Irwin. Stockum, S. (2002), An Economists Margin Notes: The Antitrust Writings of Timothy Muris, Antitrust (Spring), 60. Stuckey, J. (1983), Vertical Integration and Joint Ventures in the Aluminum Industry, Cambridge, MA: Harvard University Press. Whinston, M. (2001), Assessing Property Rights and Transaction-Cost Theories of the Firm, American Economic Review, 91 (2), 18499. Williamson, O.E. (1968), Economies as an Antitrust Defense: The Welfare Tradeoffs, American Economic Review, 58 (March), 1835. Williamson, O.E. (1970), Corporate Control and Business Behavior, Englewood Cliffs, NJ: Prentice-Hall. Williamson, O.E. (1975), Markets and Hierarchies: Analysis and Antitrust Implications, New York: Free Press. Williamson, O.E. (1977), Predatory Pricing: A Strategic and Welfare Analysis, Yale Law Journal, 87 (December), 284340. Williamson, O.E. (1979), Assessing Vertical Market Restrictions, University of Pennsylvania Law Review, 127 (April), 95393. Williamson, O.E. (1985), The Economic Institutions of Capitalism, New York: Free Press. Williamson, O.E. (1987), Vertical Integration, in J. Eatwell et al. (eds), The New Palgrave Dictionary of Economics, Vol. IV, London: Macmillan, pp. 807 12.

40

Key issues

Williamson, O.E. (1988), Corporate Finance and Corporate Governance, Journal of Finance, 43 (July), 56791. Williamson, O.E. (1991a), Comparative Economic Organization: The Analysis of Discrete Structural Alternatives, Administrative Science Quarterly, 36 (June), 26996. Williamson, O.E. (1991b), Economic Institutions: Spontaneous and Intentional Governance, Journal of Law, Economics, and Organization, 7 (Special Issue): 15987. Williamson, O.E. (1996), The Mechanisms of Governance, New York: Oxford University Press. Williamson, O.E. (2002), The Theory of the Firm as Governance Structure: From Choice to Contract, Journal of Economic Perspectives, 16 (Summer), 17195. Williamson, O.E. (2005), The Economics of Governance, American Economic Review, 95 (2), 118. Williamson, O.E. (2007a), Opening the Black Box of Firm and Market Organization: Regulation, working paper, University of California, Berkeley. Williamson, O.E. (2007b), Corporate Boards of Directors: In Principle and In Practice, Journal of Law, Economics, and Organization, 24 (October), 24772. Williamson, O.E. (2007c), Pragmatic Methodology, working paper, University of California, Berkeley. Williamson, O.E. and T. Sargent (1967), Social Choice: A Probabilistic Approach, The Economic Journal, 77 (308), 797813. Wilson, E.O. (1998), Consilience, New York: Alfred Knopf.

Opening the black box of firm and market organization

41

APPENDIX 2.1

INTELLECTUAL ANTECEDENTS TO THE LENS OF CONTRACT/ GOVERNANCE

The comparative contractual approach to economic organization is inspired by a series of key ideas, many of which first surfaced in the 1930s (or thereabouts). Of special importance are these: (1) The organization of economic activity as among firms, markets, and other modes of governance should be derived rather than taken as given (Coase, 1937). Such a derivation should make explicit allowance for positive transaction costs (Coase, 1937, 1960). Unstated assumptions about the nature of the human beings whose behavior we are studying should be revealed (Simon, 1957, 1985). The unit of analysis should be named, of which the transaction is a candidate (Commons, 1932), and dimensionalized. Moving beyond the economics of simple market exchange, ongoing contractual relations should also be brought under scrutiny with emphasis on the triple of conflict, mutuality, and order (Commons, 1932). Provision also needs to be made for the contract law differences between modes. Simple market exchange (to which the concept of contract as legal rules applies) gives way to long-term contracting (to which the more elastic concept of contract as framework (Llewellyn, 1931) applies) and to hierarchy (whereby internal organization becomes its own court of ultimate appeal). The central problem of economic organization to which transaction cost consequences accrue is that of adaptation, of which two kinds are distinguished: autonomous adaptations (Hayek, 1945) and coordinated adaptations (Barnard, 1938). Going beyond the neoclassical lens of choice, complex economic organization is also usefully examined through the lens of contract/ governance, where the latter implements the proposition that mutuality of advantage from voluntary exchange . . . is the most fundamental of all understandings in economics (Buchanan, 2001, p. 29).

(2) (3) (4) (5)

(6)

(7)

(8)

References
Barnard, C. (1938), The Functions of the Executive, Cambridge, MA: Harvard University Press. Buchanan, J. (2001), Game Theory, Mathematics and Economics, Journal of Economic Methodology, 8 (March), 2732.

42

Key issues

Coase, R. (1937), The Nature of the Firm, Economica, N.S., 4, 386405. Coase, R. (1960), The Problem of Social Cost, Journal of Law and Economics, 3, (October), 144. Commons, J. (1932), The Problem of Correlating Law, Economics, and Ethics, Wisconsin Law Review, 8, 326. Hayek, F. (1945), The Use of Knowledge in Society, American Economic Review, 35 (September), 51930. Llewellyn, K.N. (1931), What Price Contract? An Essay in Perspective, Yale Law Journal, 40, 70451. Simon, H. (1957), Models of Man, New York: John Wiley & Sons. Simon, H. (1985), Human Nature in Politics: The Dialogue of Psychology with Political Science, American Political Science Review, 79 (2), 293304.

3.

The corporation: an economic enigma

Dennis C. Mueller

The Anglo-Saxon version of corporate organization widely dispersed ownership, and professional managers with small ownership stakes has been somewhat of an enigma throughout its 200 or so year history. Some economists have thought it to be an inefficient organizational structure; others have proclaimed its superiority over all other ways to organize business activity. The performance of US corporations during the 1970s and 1980s seemed to confirm the judgments of the corporate forms critics. One market after another was lost to companies from Japan or Europe. Articles and books appeared proclaiming the German model or the Japanese model superior to the Anglo-Saxon model.1 One student of American capitalism even predicted the eclipse of the public corporation (Jensen, 1989). The impressive performance of the United States economy during the 1990s, alongside the stumbling performances of the Japanese and the German and some other European economies, has led some to now claim that it is the Anglo-Saxon model which is superior and toward which all others must converge.2 In this chapter I review some of the arguments and evidence regarding the efficiency of the corporate form. I shall argue that one reason for the different views of economists about corporations is that they tend to see what they want to see. Although most of the evidence cited seems to support the position of the critics of the corporate form, I shall close the chapter with the suggestion that developments over the last decade or two have altered the environments in which corporations operate in such a way as to justify the efficiency claims of their defenders. I begin, appropriately enough, with Adam Smith.

1.

THE EARLY ECONOMISTS

Corporations, or joint stock companies as they were commonly called at the end of the 18th century, were relatively rare when Adam Smith wrote
43

44

Key issues

The Wealth of Nations. But Smith had seen enough of them to offer the following observations:
The directors of such companies . . . being the managers rather of other peoples money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their masters honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company . . . It is upon this account that joint stock companies for foreign trade have . . . very seldom succeeded without an exclusive privilege; and frequently have not succeeded with one. Without an exclusive privilege they have commonly mismanaged the trade. With an exclusive privilege they have both mismanaged and confined it. (1776, p. 700)

John Stuart Mill regarded this conclusion as one of those overstatements of a true principle, often met with in Adam Smith (1885, p. 140). Nevertheless, he also thought the principle to be true. After discussing the advantages of joint stock companies, Mill took up the other side of the question.
[I]ndividual management has also very great advantage over joint stock. The chief of these is the much keener interest of the managers in the success of the undertaking. The administration of a joint stock association is, in the main, administration by hired servants. Even . . . the board of directors, who are supposed to superintend the management . . . have no pecuniary interest in the good working of the concern beyond the shares they individually hold, which are always a very small part of the capital of the association, and in general but a small part of the fortunes of the directors themselves; and the part they take in the management usually divides their time with many other occupations, of as great or greater importance to their own interest; the business being the principal concern of no one except those who are hired to carry it on. But experience shows, and proverbs, the expression of popular experience, attest, how inferior is the quality of hired servants, compared with the ministration of those personally interested in the work, and how indispensable, when hired service must be employed, is the masters eye to watch over it. (Mill, 1885, pp. 1389)

Smith and Mill were, of course, giants in the development of economics. That each had a brilliant mind goes without saying. But their genius stemmed not only from their capacity to reason. Each was also a keen observer of people and institutions. Each could draw generalizations from what he saw that others would recognize to be true upon hearing. Another good example of this is Smiths statement that People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some

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contrivance to raise prices (1776, p. 128). As with his statements about corporations, what is particularly interesting about this famous passage is that it is not a proposition about what businessmen under certain assumptions will do. It is a statement about what they do do. Smiths classic treatise is not a series of hypotheses about how individuals and markets will behave, but rather a treasure chest of observations of how they do behave. Alfred Marshall was first and foremost a keen observer of the world of business. He, too, had some doubts about the efficiency of joint stock companies. In a section entitled Temptations of joint stock companies to excessive enlargement of scope in Industry and Trade (1923), Marshall notes that unfortunately many [outside directors] are unable to give the large time and energy needed for obtaining a thorough mastery of the affairs of the companies for which they are responsible (p. 321). The slack thereby created can lead to excessive enlargement of scope, because company managers cannot always approach a proposal for enlarging an existing department, or starting a new one, without some bias (p. 322). Nevertheless, he was much less concerned about the potential inefficiencies of the corporate form than Smith and Mill, for he judged there to be a countervailing development that protected the powerless position of the shareholders.
It is a strong proof of the marvellous growth in recent times of a spirit of honesty and uprightness in commercial matters, that the leading officers of great public companies yield as little as they do to the vast temptations to fraud which lie in their way . . . There is every reason to hope that the progress of trade morality will continue . . . (Marshall, 1920, p. 253)

The founders of neoclassical economics on the western side of the Atlantic were also sanguine in their views about the newly emerging corporations and trusts formed through merger. Anticipating the reasoning underlying transaction costs economics and the new learning in industrial organization by 80 years, they deduced that Darwinian competition could be relied upon to select only the most efficient combinations of assets.3 The next landmark in our intellectual history is The Modern Corporation and Private Property. As with many of the arguments contained in The Wealth of Nations, much that Berle and Means (1932) wrote about the corporation was known at the time they wrote. But they combined their thesis with an exhaustive history of the evolution of the corporate legal form, and amassed data demonstrating the extent of the separation of ownership from control, and the rise in aggregate concentration that had occurred in the first third of the 20th century. If the dangers of dispersed

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shareownership forewarned by Smith and Mill were real, Berle and Meanss book suggested that the United States had much to fear. The bulk of The Modern Corporation and Private Property must have been written in the late 1920s, and thus the book cannot be construed as an account of the collapse of 1929. But the timing of the books publication could not have been better. The arguments put forward by Berle and Means about the potential for managerial abuse of discretion created by the separation of ownership and control resonated with the thunder of falling stock prices and profits. The handful of examples of abuse of managerial power in the book were duplicated and dwarfed by the accounts appearing daily in the business press.4 The modern corporation appeared to have fulfilled the worst fears of Smith and Mill, and dashed the hopes of Marshall. The Victorian noblesse oblige that Marshall saw protecting shareholders as late as 1920 had by 1930 vanished, at least in the United States.

2.

THE MARGINALIST CONTROVERSIES

With the publication of The Modern Corporation, the Great Crash and its aftermath of revelations of misuse of position by managers, the issue of corporate efficiency could not be ignored, or so it would seem. But most economists did ignore it.5 For by the 1930s the neoclassical revolution, in which Alfred Marshall had played such an important part, had triumphed. When a new issue arose, the economist would no longer turn to his firsthand knowledge of the relevant facts and institutions for addressing this issue, or lacking first-hand knowledge proceed to gather it. The economists first reaction would now be to turn to one of the models he had used to analyze similar problems in the past. The neoclassical models had proved themselves to be insightful analytic tools for laying bare the basic elements of certain economic problems. To achieve their pedagogic potential they needed to be kept simple, however, and so it was often the case that individuals were assumed to choose a single instrument (for example, price) to achieve a single goal (profit). Thus, although the managerial corporation was by the 1930s the dominant economic institution of Western capitalism, the firm (entrepreneur) remained the main business actor in the economics literature, and it (he) maximized profit. The 1930s were difficult for mainstream economics to digest. Much seemed to be happening that the newly developed neoclassical models could not explain. Keyness response is the most famous reaction, of course. But attacks on the micro front were also afoot. A number of economists were troubled by the failure of prices to fall to eliminate significant amounts of excess supply. Gardiner Means (1935) attempted to account for this with

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the thesis that large corporations in oligopolistic markets enjoyed considerable freedom to administer prices independently of market forces. Hall and Hitch were struck by interview evidence that revealed a gross inconsistency between the way in which business men decide what price to charge for their products and what output to produce and the behavior assumed in neoclassical models (1939, p. 12). They concluded that the evidence casts doubt on the general applicability of the conventional analysis of price and output policy in terms of marginal cost and marginal revenue, and suggests a mode of entrepreneurial behavior which current economic doctrine tends to ignore (p. 12). They offered as an alternative to marginal analysis a full cost or mark-up model of pricing. Richard Lester was left with grave doubts as to the validity of conventional marginal theory and the assumptions on which it rests from answers given by 58 entrepreneurs from the South to a questionnaire circulated in the mid-1940s (1946, p. 81). Kaplan et al. (1958) conducted interviews of chief executives in the late 1940s and mid-1950s and uncovered a variety of objectives and rules of thumb for setting prices that did not resemble marginal cost equals marginal revenue. Thus, evidence gathered over two decades and two countries on how managers actually do set prices directly contradicted the assumptions upon which most economic modeling of pricing was at that time, and is today, based. Not surprisingly these challenges to the mainstream view were vigorously repelled (Machlup, 1946, 1947; Kahn, 1959).6 What is interesting is that the defenders of the neoclassical model offered neither contradictory interview and questionnaire evidence to support their positions nor empirical evidence that would allow one to reject one hypothesis and not the other. Rather the argument was made that it was not important that individuals consciously maximize as posited in economic models, but that they act as if they did. Examples from the interview/questionnaire evidence or from everyday life were then used to suggest that the data, indeed, would sustain, if systematically garnered, the neoclassical model. Although the direct rejoinders to the attacks on marginalist pricing models did not present data to support their positions, others did. Among these, the most famous perhaps is George Stiglers (1947) demolition of the HallHitchSweezy kinked-demand schedule explanation of price rigidity in the 1930s. Stigler argued quite correctly that a kink should only exist for oligopolies, and thus that the relationship between price changes and concentration or number of sellers should be U-shaped. Only oligopolies should change price less frequently than profit maximization would imply. Stigler presented data on numbers of price changes in markets with different numbers of firms that dramatically rejected the U-shape prediction. The number of price changes in a market increased directly with the

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number of sellers. In the two markets with one seller, aluminum and nickel, there were respectively two and zero price changes between June of 1929 and May of 1937.7 It is difficult to believe that, in a decade as unusual as the 1930s, the demand for a basic industrial product like nickel did not shift sufficiently to induce at least one change in the profit-maximizing price for this monopolist, especially since the coefficient of variation of output for this industry was the sixth largest of the 21 industries Stigler examined. The Stigler results, while destroying the kinked-demand schedule hypothesis, raised the puzzling question of why price rigidity increases with concentration, and Stigler admitted that the neoclassical theory does not provide a satisfactory explanation for this extraordinary rigidity of monopoly prices (1947, p. 428). The lesson drawn by the profession from Stiglers paper was, however, only that the data had rejected the challenges to neoclassical theory offered by Hall and Hitch (1939) and Sweezy (1939). That the data were equally inconsistent with what neoclassical theory predicted was ignored. In the mid-1940s one would not have had to cast about far to find a hypothesis that fit these results, however. Gardiner Meanss administered price hypothesis argued that large corporations held prices constant for long periods in markets dominated by a relatively small number of concerns (National Resources Committee, 1939, p. 143, as quoted in Scherer, 1980, p. 350). That George Stigler would not immediately seize upon the administered price hypothesis to explain his results is not surprising. Indeed, a generation later he and James Kindahl (1970) were to publish a major empirical study that claimed to refute the administered price thesis. In fact, the price rigidities that were observed could be reconciled with traditional theory if the latter was appropriately modified by additional assumptions regarding long-term contracts and transaction costs (Stigler and Kindahl, 1973, p. 719). Both Means (1972) and Leonard Weiss (1977) followed with empirical studies that they claimed were consistent with the administered price thesis. Many additional studies examined the flexibility of prices. I shall not dwell on this literature,8 but merely assert that the work of that period did not produce a resounding victory for the marginalist model in any standard form. But the profession proceeded ahead as if it did.

3.

THE MANAGERIALIST CHALLENGE

The attacks on economic orthodoxy just discussed all questioned the implications of profits maximization with regards to pricing decisions. In the 1950s and 1960s studies appeared that directly questioned the profits maximization assumption and neoclassical predictions regarding decisions

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other than price. William Baumol (1959, 1966) hypothesized that managers maximized sales; Oliver Williamson (1963) added staff and emoluments to the managers objective function; Robin Marris (1963, 1964), the growth of the firm. Cyert and March (1963) posited four objectives in addition to profits pursued by the firm. Most fundamentally, Herbert Simon (1957, 1959) argued that managers did not maximize any objective function at all; they satisficed. What needs to be stressed about these examples is that they all stemmed from observations about how managers and corporations actually behave. Simons satisficing hypothesis originated from his work in psychology and his study of organizational behavior. His colleagues, Cyert and March, built on Simons behavioralist approach and set out to describe the decision-making processes in actual, large corporations rather than to model an ideal, representative firm. To do so they constructed programming models of actual corporate decision structures. Williamson, a student of Simon, was also seeking a more realistic description of the managerial preference function than existed at that time. Baumols hypothesis arose from observations about the importance of sales to managers as an index of the health of their firm, and as a source of status (1966, pp. 448). Marris launches his study with a lengthy review of the literature on organizational behavior, which dwells on motivation, compensation formulae and the like.9 Thus each was seeking to model in a more accurate way the behavior of managers as they had actually observed it, or as they had come to understand it from reading a literature that came from outside of economics. These challenges to economic orthodoxy were dismissed with arguments similar to those used to repel the attacks against marginalist price theory (Baldwin, 1964; Peterson, 1965; Machlup, 1967). In 1970 William Baumol and colleagues published estimates of rates of return on reinvested cash flows during the 1950s and 1960s ranging from 2 to 6 percent. These returns were significantly below both the returns shareholders were earning over this period and the returns Baumol et al. estimated on new debt and equity issues. They corroborated the hypothesis that managers not subject to the discipline of external capital markets would, relative to what was optimal for their shareholders, overinvest their internal cash flows. As with every study that seemingly contradicts the conventional wisdom in economics, the Baumol et al. results were immediately challenged, and several additional studies followed.10 In one of these Henry Grabowski and I brought in a life-cycle hypothesis (1975). Mature firms in industries with mature technologies earned significantly lower returns than young firms in industries with newer technologies. Our results also cast light on another paradoxical finding in the literature the seemingly irrational preference of shareholders for dividends over retained earnings.

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For our sample, it was only the shareholders of mature companies earning relatively low returns on investment who preferred dividends to retentions. The preference for dividends tended to disappear for firms earning high returns on investment. Shareholders were not so irrational after all. In the late 1960s Dale Jorgenson and Calvin Siebert (1968) developed and tested a neoclassical theory of investment. The key determinant of investment for the shareholder-wealth-maximizing firm was the Modigliani and Miller cost of capital. Cash flow had no place in a neoclassical investment equation.11 Of course Jorgenson was right. But cash flow did belong in the investment equation for the managerial firm, since it was this source of capital over which managers could exercise the most discretion. Although the neoclassical cost of capital invariably outperformed cash flow in Jorgensons articles, other studies (Elliot, 1973; Grabowski and Mueller, 1972) continued to find that cash flow was superior to measures of the neoclassical cost of capital. Thus, a pattern of empirical results was visible in the 1970s that was fully consistent with a managerial discretion/size-growth maximization hypothesis about the corporation. The greater a corporations cash flow, the more it spent on capital equipment and R&D; reinvested cash flows earned relatively low rates of return; mature corporations earned lower returns than young companies or those with new technologies; the market priced the shares of mature firms in a way that implied a preference for greater dividends and less reinvested cash flows. At the same time evidence was accumulating to suggest that the conglomerate merger wave of the 1960s had reduced corporate efficiency. The wealth of the shareholders of acquiring firms steadily declined relative to other shareholders as the market learned more and more about the conglomerate mergers.12 But this pattern of evidence either went unnoticed or, if it was discerned, failed to dislodge the view that managers maximized profits or shareholder wealth. The managerial theories joined the mark-up pricing models that had preceded them as valiant but futile attempts to replace the simplistic view of managerial decision making that characterized the neoclassical model of the firm. It should be noted that this outcome is not peculiar to the field of industrial organization. Robert Frank (1985) focuses on the inadequacy of neoclassical theory in explaining wage patterns within firms, but notes also, citing Mayer (1972), that the evidence for [a] relationship [between income and savings] is so strong and so consistent that it would appear difficult for proponents of the permanent income and life-cycle [saving] theories to continue to insist that savings rates are unrelated to income. Yet these claims persist in all major undergraduate and graduate texts in macroeconomics (Frank, 1985, p. 160). Thus, despite a broad consensus among economists that hypotheses should be formulated in such a way

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that they can be rejected by the data, no empirical evidence is ever deemed strong enough to reject a hypothesis that assumes that agents maximize one of the standard behavioral objectives, that is, in the case of the firm, profits or shareholder wealth, or at least so it seemed up into the 1970s.

4.

CONSTRAINTS ON MANAGERIAL DISCRETION

In trying to explain why managers maximize profits or shareholder wealth, economists have offered essentially five different arguments. Four rely on the existence of a particular market. 4.1 Product Market Competition

The most obvious way to curb managerial discretion and force managers to maximize profits is to ensure that product markets are perfectly competitive. If managers have to maximize profits simply so that their company survives, they will maximize profits. 4.2 An Efficient Capital Market

It should be obvious to potential shareholders that the incentives managers have to maximize shareholder wealth are attenuated if the managers own only a fraction of a companys shares. If the capital market is efficient, it will recognize when an owner-manager first announces a sale of shares that the owner-manager will engage in more on-the-job consumption following the sale purchase more staff and emoluments, pursue growth to a greater degree, and so on. The assumption of capital market efficiency implies that the share price drops immediately upon the sales announcement to reflect the managers additional on-the-job consumption. All of the agency costs from a separation of ownership and control are thus borne by the original owner-manager and s/he therefore has an incentive to minimize these costs.13 4.3 The Market for Managers

Eugene Fama (1980) has claimed that agency problems are eliminated through the workings of the market for managers. Managers will wish to develop a reputation for maximizing profits (not engaging in on-the-job consumption) to improve their chances for promotion within the firm that they currently work for, and to generate attractive job offers from other companies.

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4.4

The Market for Corporate Control

Robin Marris (1963, 1964) hypothesized that the constraint upon growthmaximizing managers which prevented them from ignoring shareholders interests entirely was the threat of takeover by outsiders if the share price fell too low, and subsequent loss of job. Henry Manne (1965) coined the term market-for-corporate-control and claimed that it tended to solve the agency problems created by the separation of ownership and control. 4.5 PrincipalAgent Contracts

The fifth constraint on managerial discretion emphasized in the literature comes through the incentives built into the managers compensation contract. The principal, that is, the shareholder, is assumed to be concerned only with his wealth or the utility of his wealth. The agent gets utility from his wealth and disutility from the effort expended on behalf of the principal. One or both may be risk averse. The principal cannot fully monitor the agent and thus must try to induce the agent to maximize the principals wealth or utility by incorporating the proper incentives into the employment contract. The optimal contract typically does not maximize shareholder wealth, because it needs to insure the agent from some of the risks of the company.

5.

HOW STRONG ARE THE CONSTRAINTS?

In this section, I briefly question each of the hypothesized constraints on managerial discretion put forward in the previous section. 5.1 Product Market Competition

Few industrial organization economists believe that all or even most markets are perfectly competitive. Neither Microsofts nor Coca-Colas managers need lie awake at night worrying about whether their firm can survive the intense competition it faces. 5.2 An Efficient Capital Market

The initial share offerings of most companies occur when they are young and small. The main concern of potential buyers of these shares at that time is not over managers on-the-job consumption, but whether the young firm will survive. If it does, and if it grows big, a day will come when its

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managers can engage in on-the-job consumption at their shareholders expense. But by this time the company will most likely have ceased issuing shares. It presses the assumption of rational expectations on the part of the capital market very hard to assume that a possible share price drop upon the initial sale of a companys shares in anticipation of managerial on-thejob consumption in the distant future can curb this activity. 5.3 The Market for Managers

The market for managers seems more likely to be an effective disciplinary force for middle managers than for senior managers, at least for large companies. Once a manager has become CEO or president of a BP or a General Electric their next job is likely to be hitting golf balls. Should they choose to engage in a little on-the-job consumption or empire-building they are unlikely to worry about the effects on their future employment activities. Potential agency problems with respect to the top managers of large corporations are unlikely to disappear because of the market for managers. 5.4 The Market for Corporate Control

If a corporation has a potential market value of $100 billion and a current market value of $80 billion, then a potential gain exists from taking over the company and replacing the current managers to realize the companys potential value. If the managers of the undervalued firm are unwilling to sell out through a friendly merger, a tender offer must be made. This would require raising $40 billion at the current share price, and even more considering that a premium will have to be paid to acquire at least 50 percent of the shares. Few potential bidders have that amount of money, and it may be difficult to raise from banks if the assets of the potential target cannot be quickly turned into cash once control is gained. 5.5 PrincipalAgent Contracts

The basic problem with the principalagent incentive contract story is that we do not observe managerial compensation contracts with the characteristics that this story implies. If the shareholders were to design an incentive contract to mitigate the principalagent problem, they would tie managerial compensation to some combination of reported profits and share price, as perhaps with stock bonuses. The measure of profits or share price in the contract would be some estimate of the increase in profits or share price caused by the managers. Compensation contracts typically reward managers, however, with stock options and bonuses that

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go up with general market swings. A wise shareholder would also retain the authority to fire the manager for poor performance, for example, by giving managers only nonvoting shares. However, if nonvoting shares are issued, they typically go to the shareholders. Increasingly popular among managers in recent years have been multiple-vote, super shares. Perhaps, the clearest evidence of the failure of managerial compensation contracts to provide proper incentives to managers has been the practice following the drop in stock prices at the end of the late 1990s bull market of revaluing mangerial stock options downward. Why the discrepancy between theory and fact? It arises because the fundamental premise of the principalagent model, in the case of the shareholder and manager, is false. Shareholders do not write the contracts that define managerial compensation, and do not hire and fire managers. To a considerable degree managers select themselves and design their own contracts (Vancil, 1987; Bebchuk and Fried, 2004).

6.

DEVELOPMENTS OVER THE LAST TWENTY YEARS

In 1993 Elizabeth Reardon and I published a study in which we estimated marginal qs (ratios of returns on investment to costs of capital) for 699 companies over the period end of 1969 to end of 1988. A firm which maximizes its shareholders wealth should have a marginal q equal to or slightly greater than 1. Our estimates were less than 1 for eight out of ten companies. The median estimated marginal q was 0.71. Cumulated over the 19-year period, the 699 companies have collectively destroyed roughly $1 trillion by investing in projects with returns less than their costs of capital. General Motors alone, with a marginal q of 0.48 destroyed around $150 billion. These figures vividly reveal the significant agency problems in US corporations that existed during the 1970s and part of the 1980s with respect to investment policies. Shareholders in the 699 large companies in our sample would have been $1 trillion richer if the managers of these companies had invested in the way that economics textbooks say they do. Others observed the poor performance of US corporations and commented upon it at the time. As late as 1983, in a survey of the merger literature with Richard Ruback, Michael Jensen requested more knowledge of this enormously productive social invention: the corporation (Jensen and Ruback, 1983, p. 47). By 1989, Jensen had acquired the requested knowledge and predicted that the inefficiencies of the corporation with ownership and control separated were so significant that it was destined

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to disappear. A more rapid conversion had not taken place since Paul journeyed to Damascus. Even as Jensen was predicting the corporations demise, however, developments were taking place that would enhance its efficiency. Many economists refer to a merger wave of the 1980s in the United States. Compared with merger activity in the 1990s, that of the 1980s was barely a ripple. It is legitimate, however, to speak of a wave of hostile takeovers in the mid to late 1980s. Tender offers, of which hostile takeovers are an important part, rose to 25 percent of all mergers during this period, a figure never before or since seen (Gugler et al., 2007). Moreover, many of the hostile takeovers were headline-grabbing takeovers of major US companies. The business and popular press was filled with stories about them, and they even became the subject for a popular movie, Wall Street. For the first time in US history, the takeover constraint that Marris and Manne had postulated existed began to have some real teeth. Managers reacted. Unprofitable and unrelated divisions were sold off. Managers began buying back their companies shares rather than undertaking bad investments or mergers. Terms like back to core competences, downsizing and shareholder value began to fall from managers lips. Managers concerns about shareholder wealth changed radically following the hostile merger activity of the 1980s. The constraint on managers from product market competition can also be said to have increased in recent years due to globalization. Forty years ago a US corporation needed to worry only about the response of other US companies to an innovation or price change. Today, Schumpeters gale of creative destruction storms over the innovator from around the world. A third development that has increased constraints on managers is the growth of institutional shareholdings. In 1950, only one in ten shares was held by a pension fund, mutual fund, or some other institutional shareholder. By the mid-1990s the figure was one in two (Friedman, 1996). The managers of these institutional portfolios are full-time stockholders who appear to be increasingly willing to intervene to block a merger or other management decision that the portfolio managers believe will lower share price. These developments have had a noticeable impact on the investment performance of US companies. Estimates of marginal q for the United States over the period 19852000 yield a mean of 1.02, a dramatic improvement over the 197088 period (Gugler et al., 2004). Thus, at a point in time when many economists are finally beginning to acknowledge the existence of agency problems and to take them seriously, institutional changes may be making them less important.

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Key issues

7.

AN END TO MANAGERIAL DISCRETION?

Despite the institutional developments discussed in the previous section, and the much better investment performance of US companies, it may still be too early to declare all managerial discretion issues to be totally resolved. The study that reported the 1.02 estimate for the 19852000 period in the United States reported much lower figures for Continental European and Latin American countries. Thus, even if agency problems seem to have become less important in the United States and some other Anglo-Saxon countries, they appear to be alive and well in many other countries. The first phrase that comes to mind when trying to describe the merger wave of the late 1990s is not back to core competences or downsizing. The merger wave looked to be fueled by soaring stock prices much like all other waves. And, as in other merger waves, the shareholders of the acquiring companies appear to have suffered substantial losses (Gugler et al., 2007; Moeller et al., 2005). This wave also illustrated that institutional shareholders are not as powerful a check on managers as some think. They appear to have been just as swept up by the euphoria of the bull market, and just as willing to believe the various theories about why this or that merger will generate synergies theories which, as with other merger waves, have not received a lot of empirical support. Finally, it must be noted that managerial salaries continue to climb to unprecedented heights despite all the attention that they have received.

NOTES
1. 2. 3. 4. 5. See Gilson and Roe (1993), and Charkham (1994). See Hansmann and Kraakman (2000). See in particular the quote of John Bates Clark in Letwin (1965, p. 74) and Stigler (1950, p. 76). On these see Galbraith (1972). When not ignoring it, the economist would often ridicule it. As late as 1982, at a conference held ostensibly to celebrate the fiftieth anniversary of the publication of The Modern Corporation and Private Property, the tenor and tone of the papers reveals that many came not to praise the book but to bury it (see special issue of Journal of Law and Economics, June 1983). Douglass Norths (1983) comment is a nice exception. Friedmans (1953) and Beckers (1962) famous essays could also be cited here. Stiglers initial findings have been substantiated in several other studies; for example, Simon (1969); Primeaux and Bomball (1974); and Primeaux and Smith (1976). For a survey, see Scherer (1980, pp. 35062), and a more recent re-examination (Carlton, 1986). I also know from personal conversations with him that his thinking on these matters has been importantly influenced by personal experiences with a firm in his family. This literature is reviewed in Mueller (2003a, pp. 1458). The pioneering study of the role of cash flow in an investment equation is of course

6. 7. 8. 9. 10. 11.

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12. 13.

that of Kuh and Meyer (1957). Although they interpret the strong performance of cash flow in their investment equations as consistent with the profits maximization hypothesis, cash flow enters their list of possible explanatory variables not as a result of the application of the marginal analysis, but because by far the most outstanding aspect of . . . direct inquiries [about the determinants of investment] is their virtual unanimity in finding that internal liquidity considerations and a strong preference for internal financing are prime factors in determining the volume of investment (p. 17). The third of the three reasons they give for the strong preference for internal funds is the hierarchical structure and motivations of corporate management which make outside financing asymmetrically risky for the established or in-group (pp. 1718). See the extensive references in my surveys (Mueller, 1977, 2003b, pp. 16370). See Jensen and Meckling (1976).

REFERENCES
Baldwin, W.L. (1964), The Motives of Managers, Environmental Restraints, and the Theory of Managerial Enterprise, Quarterly Journal of Economics, 78 (May), 23658. Baumol, W.J. (1959), Business Behavior, Value and Growth, New York: Macmillan; 2nd edn, 1966. Baumol, W.J., P. Heim, B.G. Malkiel and R.E. Quandt (1970), Earnings Retention, New Capital and the Growth of the Firm, Review of Economics and Statistics, 52, (Nov.), 34555. Bebchuk, L. and J. Fried (2004), Pay Without Performance, Cambridge, MA: Harvard University Press. Becker, G.S. (1962), Irrational Behavior and Economic Theory, Journal of Political Economy, 70, (Feb.), 113. Berle, A.A. and G.C. Means (1932), The Modern Corporation and Private Property, New York: Commerce Clearing House; rev. edn, New York: Harcourt, Brace, Jovanovich, 1968. Carlton, D.W. (1986), The Rigidity of Prices, American Economic Review, 76, (Sept.), 63758. Charkham, J.P. (1994), Keeping Good Company, Oxford: Oxford University Press. Cyert, R.M. and J.G. March (1963), A Behavioral Theory of the Firm, Englewood Cliffs, NJ: Prentice-Hall. Elliot, J.W. (1973), Theories of Corporate Investment Behavior: Revisited, American Economic Review, 63 (March), 195207. Fama, E.F. (1980), Agency Problems and the Theory of the Firm, Journal of Political Economy, 88 (April), 288307. Frank, R.H. (1985), Choosing the Right Pond, Oxford: Oxford University Press. Friedman, B.M. (1996), Economic Implications of Changing Share Ownership Journal of Portfolio Management, 2 (3), 5970. Friedman, M. (1953), The Methodology of Positive Economics, in Essays in Positive Economics, Chicago, IL: University of Chicago Press, 343. Galbraith, J.K. (1961), The Great Crash, 1929, Boston, MA: Houghton Mifflin, 3rd edn, 1972. Gilson, R.J. and M.J. Roe (1993), Understanding the Japanese Keiretsu: Overlaps Between Corporate Governance and Industrial Organization, The Yale Law Journal, 102 (4), 871906.

58

Key issues

Grabowski, H.G. and D.C. Mueller (1972), Managerial and Stockholder Welfare Models of Firm Expenditures, Review of Economics and Statistics, 54, Feb, 924. Grabowski, H.G. and D.C. Mueller (1975), Life-Cycle Effects on Corporate Returns on Retentions, Review of Economics and Statistics, 57, Nov, 400409. Gugler, K., D.C. Mueller and B.B. Yurtoglu (2004), Corporate Governance and the Returns on Investment, Journal of Law and Economics, 47 (Oct.), 598633. Gugler, K., D.C. Mueller and B.B. Yurtoglu (2007), The Determinants of Merger Waves, mimeo, University of Vienna. Hall, R.L. and C.J. Hitch (1939), Price Theory of Business Behaviour, Oxford Economic Papers, os-2 (1), 1245. Hansmann H. and R. Kraakman (2000), The Essential Role of Organizational Law, Yale Law Journal, 110 (3), Dec, 387440. Jensen, M.C. (1989), The Eclipse of the Public Corporation, Harvard Business Review, (Sept./Oct.), 6174. Jensen, M.C. and W.H. Meckling (1976), Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure, Journal of Financial Economics, 3 (4), 30560. Jensen, M.C. and R.S. Ruback (1983), The Market for Corporate Control, Journal of Financial Economics, 11 (April), 550. Jorgenson, D.W. and C.D. Siebert (1968), A Comparison of Alternative Theories of Corporate Investment Behavior, American Economic Review, 58 (4), 681712. Journal of Law and Economics (1983), Special Issue, June. Kahn, A.E. (1959), Pricing Objectives in Large Corporations: Comment, American Economic Review, 49 (4), 67080. Kaplan, A.D.H., J.D. Dirlam and R.F. Lanzillotti (1958), Pricing in Big Business. A Case Study Approach, Washington, DC: Brookings Institution, 1289. Kuh, E. and J.R. Meyer (1957), The Investment Decision, Cambridge, MA: Harvard University Press. Lester, R.A. (1946), Shortcomings of Marginal Analysis for WageEmployment Problems, American Economic Review, 36 (1), 6382. Letwin, W. (1965), Law and Economic Policy in America, New York: Random House. Machlup, F. (1946), Marginal Analysis and Empirical Research, American Economic Review, 36 (Sept.), 51954. Machlup, F. (1947), Rejoinder to an Antimarginalist, American Economic Review, 37 (1), 14854. Machlup, F. (1967), Theories of the Firm: Marginalist, Behavioral, Managerial, American Economic Review, 57 (March), 133. Manne, H.G. (1965), Mergers and the Market for Corporate Control, Journal of Political Economy, 73 (April), 11020. Marris, R. (1963), A Model of the Managerial Enterprise, Quarterly Journal of Economics, 77 (May), 185209. Marris, R. (1964), The Economic Theory of Managerial Capitalism, Glencoe: Free Press. Marshall, A. (1920), Principles of Economics, 8th edn, London: Macmillan. Marshall, A. (1923), Industry and Trade, 4th edn, London: Macmillan. Mayer, T. (1972), Permanent Income, Wealth and Consumption, Berkeley, CA: University of California Press. Means, G.C. (1935), Industrial Prices and Their Relative Inflexibility, Washington, DC: U.S. Senate Document 13, 74th Congress, 1st Session.

The corporation

59

Means, G.C. (1972), The Administered Price Thesis Reconfirmed, American Economic Review, 62 (June), 292306. Mill, J.S. (1885), Principles of Political Economy, 9th edn, London: Longmans, Green and Co.; first published 1848. Moeller, S.B., F.P. Schlingemann and R.M. Stulz (2005), Wealth Destruction on a Massive Scale? A Study of Acquiring-Firm Returns in the Recent Merger Wave, Journal of Finance, 60 (2), 75782. Mueller, D.C. (1977), The Effects of Conglomerate Mergers: A Survey of the Empirical Evidence, Journal of Banking and Finance, 1, December, 31547. Mueller, D.C. (2003a), The Corporation Investment, Mergers, and Growth, London: Routledge, 2003. Mueller, D.C. (2003b), The Finance Literature on Mergers: A Critical Survey, in M. Waterson (ed.), Competition, Monopoly and Corporate Governance, Essays in Honour of Keith Cowling, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, pp. 161205. Mueller, D.C. and E. Reardon (1993), Rates of Return on Corporate Investment, Southern Economic Journal, 60 (Oct.), 43053. National Resources Committee (1939), The Structure of the American Economy, Part I, Washington, DC: National Resources Committee. North, D.C. (1983), Comment on Stigler and Friedland: The Literature of Economics: The Case of Berle and Means, Journal of Law and Economics, 26 (2), 26971. Peterson, S. (1965), Corporate Control and Capitalism, Quarterly Journal of Economics, 79 (Feb.), 124. Primeaux, W.J. Jr. and M.R. Bomball (1974), A Reexamination of the Kinky Oligopoly Demand Curve, Journal of Political Economy, 82 (4), 85162. Primeaux, W.J. Jr. and M.C. Smith (1976), Pricing Patterns and the Kinky Demand Curve, Journal of Law and Economics, 19 (1), 18999. Scherer, F.M. (1980), Industrial Market Structure and Economic Performance, 2nd edn, Chicago, IL: Rand McNally. Simon, H.A. (1957), The Compensation of Executives, Sociometry, 20 (March), 325. Simon, H.A. (1959), Theories of Decision Making in Economics and Behavioral Science, American Economic Review, 49 (June), 25383. Simon, J.L. (1969), A Further Test of the Kinky Oligopoly Demand Curve, American Economic Review, 59 (5), 9715. Smith, A. (1776), The Wealth of Nations, reprinted New York: Random House, 1937. Stigler, G.J. (1947), The Kinky Oligopoly Demand Curve and Rigid Prices, Journal of Political Economy, 55 (5), 43249; reprinted in G.J. Stigler and K.E. Boulding (eds), 1952, Readings in Price Theory, Chicago, IL: Irwin, 410 39. Stigler, G.J. (1950), Monopoly and Oligopoly by Merger, American Economic Review, 40 (2) (May), 2334; reprinted in R.B. Heflebower and G.W. Stocking (eds), 1958, Readings in Industrial Organization and Public Policy, Homewood, IL: Irwin, 6980. Stigler, G.J. and J.K. Kindahl (1970), The Behavior of Industrial Prices, New York: Columbia University Press. Stigler, G.J. and J.K. Kindahl (1973), Industrial Prices, as Administered by Dr. Means, American Economic Review, 63 (4), 71721.

60

Key issues

Sweezy, P.M. (1939), Demand Under Conditions of Oligopoly, Journal of Political Economy, 47 (4), 56873. Vancil, R.F. (1987), Passing the Baton, Boston, MA: Harvard Business School. Weiss, L.W. (1977), Stigler, Kindahl, and Means on Administered Prices, American Economic Review, 67 (Sept.), 61019. Williamson, O.E. (1963), Management Discretion and Business Behavior, American Economic Review, 53 (Dec.), 103257.

PART II

The theory of the firm from an organizational perspective

4. A contractual perspective of the firm with an application to the maritime industry

Per-Olof Bjuggren and Johanna Palmberg*
1. INTRODUCTION

In 1776 Adam Smith developed a theory for markets as the coordinating device in an economy. However, economic activities are not only coordinated through the price mechanism of the market but are also guided by firms within which the production of goods and services takes place. In contrast to markets the firm is not so well developed in economic theory. This is reflected, for example, in basic economic textbooks that usually assume the firm as something exogenously given that need not be explained or analyzed. After acknowledging the existence of firms, textbooks quickly turn to the market and analyze its importance for a well-functioning economy.1 However, since the early 1970s there has been rapidly expanding research on the theory of the firm, largely inspired by an article dating back to 1937 about the nature of the firm written by the Nobel laureate, Ronald H. Coase. However, it took more than thirty years for researchers to draw inspiration from the ideas put forward by Coase. In the 1970s (primarily) Oliver E. Williamson continued along the line of research that Coase had outlined. Since then theories of the firm have been a new expanding area of research in economics. In this chapter, a contractual perspective on the firm is used, with the concept of institution being an important cornerstone, and a synthesis of different contractual perspectives on the firm as the coordinating institution within the maritime industry. This chapter recognizes the fact that the firm itself can enter into contracts with other firms and physical persons. In a competitive environment there is a strong tendency for the most cost-efficient composition of contracts within a given institutional environment to survive (see, for example, Fama and Jensen, 1983). We will apply such a contractual view. In addition to the production costs (remuneration to suppliers of different kinds
63

64

The theory of the firm from an organizational perspective

of inputs such as labor and capital services) these costs include information costs and the costs for negotiating and monitoring contracts. In line with transaction cost economics, we consider all transactions to be costly. These transaction costs can then be used to explain market structures as well as firms and other institutions (see, for example, Chapter 2 in this volume). The focus in this chapter is on the relationship between contracts and transaction characteristics. The maritime industry offers an interesting area of research for economists. Different theories developed within the fields of financial economics, institutional economics, corporate governance and industrial organization can be applied with good analytical results. A quick glance through the volumes of Maritime Policy and Management illustrates this. Furthermore, the maritime industry is interesting for contract theory since all different types of contracts ranging from spot contracts to vertical integration are used in the industry. Also, the organization of the shipping company is affected by third-party management which in its extreme form separates ownership from control. In the early 1990s an article by Stephen Pirrong demonstrated how transaction cost analysis could be applied in the analysis of contracting practices in maritime transport (Pirrong, 1993). We extend Pirrongs analysis by applying transaction cost analysis both to the freight contract and to the firm. The idea behind this chapter originates from a larger research project on the Swedish shipping industry (see Johansson et al., 2006).2 Therefore the Swedish maritime industry is used for illustration. The maritime industry is a truly global industry; the Swedish ship-owners and their counterparts all act on international markets. Hence, characteristics valid for Sweden also apply to larger shipping nations. Section 2 of the chapter starts with a presentation of our contractual view of the firm, with maritime illustrations, and Section 3 offers a brief presentation of maritime transport and the different types of firms that operate in the market. A closer look at different contractual compositions that characterize maritime transport firms with transaction cost and institutional explanations is presented in Section 4, and Section 5 concludes the chapter.

2.

A CONTRACTUAL PERSPECTIVE ON THE FIRM

In neoclassical economics the firm is often treated as a black box, but viewing the firm as a nexus of contracts (Jensen and Meckling, 1976; Sthl, 1976) results in a much richer analysis of market processes and the allocation of resources in an economy. In this section the firm is discussed from a contractual perspective. First, an overview of the relation between specialization and productivity and the need for coordination

A contractual perspective of the firm

Increased productivity by division of labour (specialization) Mutual dependence Coordination required Institutional solutions

65

Figure 4.1

Specialization and institutions

and institutions (Section 2.1) is presented. Section 2.2 discusses the firm as a contractual entity in depth. Section 2.3 concludes with an analysis of the relation between contracts, markets and firms. 2.1 Specialization and Institutions

In an analysis of the organization of an industry, specialization is a crucial concept since it fosters increased productivity. This is an important message of the first chapter of Adam Smiths Wealth of Nations (1776). With the help of the famous pin factory example, Smith demonstrates in detail how productivity is increased by specialization. However, specialization implies increased mutual dependence and hence production must be organized in a fashion that solves this mutual dependency. In Figure 4.1 this is expressed as demands on proper institutional solutions created by the coordination problem caused by mutual dependence due to specialization. (Institutions are thereby defined as rules for individual interactions/cooperation.) Firms and markets are alternative institutional solutions to the coordination problem. We will start by looking at the firm as an institutional arrangement to solve the coordination problem caused by factor specialization. 2.2 The Firm as a Nexus of Contracts

An important feature of a firm is that it is a legal entity and can, just like a physical person, enter into binding agreements (contracts) with other physical and legal persons (see Sthl, 1976). From this perspective the firm can be seen as a nexus of contracts that coordinates financial investors, suppliers of intermediate goods, services and labor, and customers in the production of goods and services. Figure 4.2 shows the firm from such a contractual perspective. The production factors human capital (H) and physical capital (K) can serve as a starting point in a description of this contractual view of the firm. These are the independent variables commonly used in production functions such as CobbDouglas and CES. The firm can choose either to own or to rent its physical capital. Ownership implies property rights

66

The theory of the firm from an organizational perspective Shareholders

Suppliers of raw material and goods Suppliers of human capital services

The firm as a production unit and a nexus of contracts

Creditors Users/ customers

Suppliers of physical capital services = Guaranteed contracts = Residual contract

Figure 4.2

The firm as a nexus of contracts

with an exclusive right to use physical capital and the return from its use. Furthermore, private property right is associated with an exclusive right to transfer the property right through an agreement (contract) to another person. A rental agreement implies a much more limited scope for decisions about the use of the physical asset. In the maritime sector the most important physical capital is the vessel. Both ownership and rental agreements and combinations of these two alternatives are common amongst ship-owners. For labor there is a choice between an employment contract and hiring of a consultant. An employment contract is much more open than a contract with a consultant with regard to use of labor. The employment contract makes it possible to use a hierarchical type of decision making regarding the use of human capital, and thereby provides an opportunity to replace the price mechanism of the market with administrative decisions about resources allocation (see, for example, Coase, 1937; Masten, 1988). One could say that the invisible hand of the market is replaced by the visible hand of an organization. In the shipping industry a wide range of contracts with labor can be found. A phenomenon of special interest that will be discussed in more detail below is the so-called third-party ship management, where the owners of physical capital, the vessel, hire parts of or all labor and management services from another company. (See Section 4.1 for further discussion.) A firms financial contractual relations have governance implications.

A contractual perspective of the firm

67

The shareholders are considered the owners of the firm. Their contractual relation with the firm is characterized by a claim on the residual that remains when all other contractual obligations of the firm have been met. (They are residual claimants.) The return on their investment is therefore directly related to how well the firm is managed. This dependency makes it important to have a mechanism through which shareholders can control how the corporation acts as a legal person. In most cases it is the board of directors and the CEO who, on behalf of the firm, enter into binding contracts with, for example, suppliers, employees and customers. It is thus logical (understandable) that the shareholders directly or indirectly choose who will have these positions.3 On the financial side of the firm there are also lenders (investors) with fixed claims contracts (banks and bondholders). In contrast to the shareholders they have specified claims on the firm in terms of mortgage plans, maturity and interest claims. If the firm cannot meet these fixed claims it can be forced into liquidation/bankruptcy. The remuneration that lenders and also suppliers can get is then dependent on the value of assets to entities other than the bankrupted (liquidating) corporation. Fungible assets with a well-functioning second-hand market are valuable to others and can therefore serve as collaterals for loans. Consequently firms that have such assets can to a larger extent than other firms use loans as a source of finance (see Williamson, 1988). In the maritime sector the vessel is in most cases a fungible asset. There are well-functioning second-hand markets for vessels. The number of alternative carriers and customers for carrier services is for some types of vessels large enough to make the second-hand market competitive (Stopford, 1997). Finally, we turn our attention to the firms contractual relation with suppliers and customers (contracts to be found on the input and output sides of the firm in Figure 4.2). Value added chains, vertical integration and supplier-specific/customer-specific specialization are important concepts here.4 A value added chain shows the different stages in the processing of a raw material to final consumer product; for example, from axe to loaf, from stone to house, from iron ore to car. In a value added chain there are several technologically separate stages. Between all these stages it is possible to envisage transport by ship that brings the output of one stage to a succeeding stage. Just as a number of different contractual relations can be found by the supplier and user in a value added chain, an equally rich flora of contracts is found for the shipping of raw materials, intermediate goods and consumer goods. If the automotive industry is taken as an example, shipping can enter into the value added chain in different stages of the processing of raw material

68

The theory of the firm from an organizational perspective

such as iron ore and steel in the manufacturing of a car for sale to a final customer. Raw material such as iron ore might have to be transported by a dry bulk carrier to a steel mill. Different automotive parts made of steel might have to be transported over the sea in containers to the car manufacturer. The ready-made cars in turn have (if exported) to be shipped in specially designed vessels to other countries. 2.3 Contracts, Markets and Firms

What is especially important from a contractual perspective is whether there are assets whose productive value is dependent on uninterrupted transactions between a specific supplier and customer.5 As indicated in Figure 4.1 it is usually specialization of assets that is the source of the mutual dependence. Here, it is important to note the problems of sunk costs and quasirents associated with investment in transaction-specific assets. A bilateral dependence evolves immediately after the investment has been made and there is no alternative equally attractive transaction partner within a specific price span. Klein et al. (1978) call this span the appropriable quasirent as it amounts to the part of the value of a specialized investment that can be taken away without a change of employment of the factor.6 A rational supplier or customer is not prepared to make an investment in an asset of a transaction-specific character without at least some guarantee in the form of a long-term contract with a price that makes the investment profitable. But, as pointed out by Williamson (1985), it is sometimes difficult to construct such a long-term contract sufficiently watertight in terms of no loopholes and at the same time sufficiently flexible to allow for changed circumstances. This is especially the case if uncertainty and complexity characterize the business in which the supplier and the customer are engaged. Both of the requirements water tightness and flexibility have to be met if the long-term contract is to serve as a perfect institutional solution to the problem of mutual dependence. But the rationality of human beings sets, as noted by Williamson (1975, 1985 and 1996), a limit to what can be achieved in terms of water tightness and flexibility (the assumption of bounded rationality). In a complex world, contracts are therefore bound to be more or less incomplete with loopholes that invite opportunistic behavior.7 In transactions between firms with different owners there are conflicting profit incentives in contract negotiations. While the supplier has a profit incentive to obtain as high a price as possible, the customers profit incentive is to get as low a price as possible. The conflicting profit incentives make transactions costly if an appropriable quasi-rent due to asset specificity exists. Hence, a long-term contract could be preferred to a spot contract and, if the transactional problems are severe, vertical integration

A contractual perspective of the firm

69

(joint ownership) could be the most cost-efficient solution. At the same time the strong (high-powered) incentives of independent firms to minimize cost have to be factored in when the decision to vertically integrate is contemplated. The cost minimization incentive is likely to be less powered for a salaried manager than for an owner-manager (see Williamson, 1985, and Chapter 2 in this volume). With vertical integration, transaction costs may be avoided, as the incentives are different in a firm and in the market. An employee-manager of a division X, which supplies inputs to a division Y within the same firm, will not be rewarded if she/he engages in costly negotiations that increase the profit of division X at the expense of division Y and at the expense of the overall profit of the firm. Instead the manager runs the risk of being fired. Within the firm it is behavior of co-operation and not costly rival behavior that will be rewarded. The structure of vertical integration can take different paths, as can be seen in the structure of shipping services in relation to cars and car manufacturers. For instance in cases such as that of container traffic there might be a need of vertical integration forward with terminals in ports and train carriers in order to secure smooth transport of parts to the car manufacturer. If, for example, parts of a car produced in Asia are transported on a larger container vessel for assembly on the American East Coast there might be the problem that the vessel cannot pass through the Panama Canal. Consequently, the vessel has to go through a Californian port and land transport might have to be used over the continent from west to east. In order to speed up the handling in the port, special equipment might be needed and it may thus be more efficient to use special railway wagons. These are so-called dedicated assets that have to be available when the vessel arrives.8 Vertical integration with terminals and wagons is therefore an attractive solution (see Midore et al., 2005). In other cases, such as oil tankers, there has instead been a trend of vertical disintegration (see Veenstra and De la Fosse, 2006). To summarize, a contractual relation depends on the nature of the asset invested in. If assets are designed in one way or another to complement each other, it is unlikely that the coordination of the use of assets in successive stages of a supply chain will be left to an atomistic market. Some safeguard is needed in order to make transactions efficient in such cases. Vertical integration is one solution where the assets are controlled under the same ownership. In other cases it will be sufficient to have some hybrid contractual solutions aligning the interests of supplier and customer.9 Without any safeguard the conflicting profit incentives of supplier and customer are a source of costly transactional problems. Mutual dependence means that the interest of the supplier to increase revenue through

70

The theory of the firm from an organizational perspective

a higher price and the reverse interest of the customer to decrease cost through a lower price will lead to clashes. If there are no alternative transaction partners to turn to, conflicts will have to be solved within a continuing transactional relation. Otherwise costly investments will lose value. The vertical integration of container carriers can be explained in this way. Terminals and wagons are dedicated assets that are necessary for keeping down the costs of the vessels at ports (see Midore et al., 2005).

3.

CHARACTERISTICS OF MARITIME TRANSPORT MARKET AND FIRMS

The maritime sector offers a wide spectrum of institutional arrangements, which makes it an interesting field for contractual research. Economists with a background in financial economics, institutional economics and corporate governance will find contracts and organizational solutions a prospective area for empirical research. This section gives an overview of the rich contractual and organizational pattern that can be found in the maritime sector.10 Moreover, it attempts to give a transaction economics explanation for the wide array of institutional arrangements in that sector. 3.1 The Freight Market

The maritime sector can roughly be divided into four types of markets (see Figure 4.3). First there is tramp shipping. The tramp market is trafficked primarily by tankers and bulk carriers. In this market, spot contracts and forward contracts are the most commonly used contracts. Long-time charters are also used but they are less common. The bulk market is diversified with respect to various types of cargo, such as coal, ore, grain, and forest products. Some of these products demand specially constructed (designed) vessels; this implies that the ship-owner becomes more specialized and more vulnerable to long-term changes in the market structure. Magirou et al. (1992) give an excellent review of the freight market. A second market is liner shipping. The goods shipped in this market are higher up in the value added chain and are often transported in containers and various types of ro-ro vessels. In this market the shipperclient relationship is more long-term than in tramp shipping. Moreover, vertical integration forward in the logistic chain is found in the form of ownership of terminals in ports and special train wagons. Some of the goods have to be delivered just in time, which increases the mutual dependence of the assets in these later stages of the logistic chain. Another contractual difference between the tramp and liner markets is that the freight contract in

A contractual perspective of the firm

Ship-owners

71

Tramp market Perfect competition

Liner shipping Markets are often cartelized

Ferry traffic

Special cargo shipping Long-term contracts

Tank

Bulk General cargo Standard cargo (Container-, ro-ro vessels)

Spot contracts or time charters (forward contracts)

Source:

Johansson et al. (2006) based on Magirou et al. (1992).

Figure 4.3

Structure of the freight market

the tramp market is focused on the vessel whereas in the liner market the contract is focused on the transport. There are differences also in terms of the market structure between the tramp and the liner market. The tramp market is characterized by (almost) perfect competition. Sea transport is supplied by ship-owners and bought by charterers. In contrast to the tramp market the liner market is to a large extent cartelized. Groups of shippers come together in so-called liner conferences in order to negotiate prices and to supply sea transport to different trades. The ship-owners therefore have to compete on factors other than price such as service and times of transport. Due to containerization the liner conferences have declined in importance to the pricing strategy. A third shipping market is the ferry/cruise market. A strong parallel can be drawn between this market and the aircraft industry. A certain route is used. Terminals and other dedicated assets have to be invested in. However, the assets (the vessels) are not transaction specific to a specific route. They can rather easily be transferred to another ferry route. Finally there is special cargo shipping, to which car carriers and forest sea transport belong. Special shipping is characterized by long-term customer adaptation; usually the COA (contract of affreightment) is applied. Swedish ship-owners mainly operate within the tramp market or special cargo shipping. These vessels are designed for goods that are processed so far that they are downstream near the end of the value added chain. The receiver of the good is a retailer selling a good to the final consumer. Here, we find long-term contracts and vertical integration.11

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The theory of the firm from an organizational perspective

3.2

The Freight Contract

The shipping industry is characterized by at least four types of market structures, ranging from almost perfect competition on the tramp market to cartelization on the liner market. The different types of markets also use different types of freight contracts. This section focuses on the bulk market. (The other types of markets are to a larger extent characterized by long-term freight contracts.) In principle there are three types of freight contracts used in the bulk market: (i) the voyager charter, (ii) the time charter and (iii) the contract of affreightment (COA). The time span and the intensity in the contract between the shipper and the carrier depend partly on the type of freight contract and partly on the extent to which the carrier uses the same shipper (Pirrong, 1993). The voyager charter implies that the shipper transports a single cargo or a series of shipments during a given time period. This freight contract has the shortest time span. The charter is directed at the vessel, which means that the ship-owner transports one cargo from one port to another. The contract is traded on the spot market and ceases, in normal cases, directly after the cargo has been discharged at the port. The time charter, on the other hand, is used by a carrier who wants to carry out the transport process on their own. The time charter implies that the carrier exercises command over the vessel for a specified time period. The charterer is responsible not only for the commercial operation of the vessel but also for the variable costs of the vessel such as port charges, canal dues, costs for loading and discharging, stowing, and so on. The ship-owner is, on the other hand, responsible for the maintenance and the nautical operation of the vessel and for the fixed costs of the vessel, interest on equity, depreciations, and so on (Gorton et al., 1989; Johansson et al., 2006). The third type of freight contract is the COA. This is a long-term contract spanning between 34 years and 15 years. The COA implies that it is only the vessel that is leased. The charterer is responsible for the crew, insurance, maintenance, inspections, and all variable costs. The contract is often detailed and specifies the type of cargo, minimum and maximum volumes carried over specific time periods, destination and origin ports, and so on (Pirrong, 1993). 3.3 The Shipping Company

The organization of the shipping company is decided by factors such as type of shipping activities, type of market on which the company operates, and the size of the company. The structure of a company operating on the spot market differs from the structure of a liner shipping company. A

A contractual perspective of the firm

73

Liner department Operational department Freight booking Freight office and accounting Reloading Marketing/sales The shipping company Administrative department Financial and accounting Personnel department Law IT Ship management External and internal information

Tramp department Affreightment Calculation Operational department

Technological department Construction Operating Inspection Maintenance Commissariat service

Source:

Based on Nya Sjfartens Bok, 2006 (2005).

Figure 4.4

Business structure of a large shipping firm

shipping company operating on the tramp market has, in general, only two departments: administrative and technical. Shipping companies that timecharter their vessels for shorter time periods also have an affreightment department. The liner shipping company has the largest administrative department, with many employees and agents across the globe. Smaller shipping companies usually have a small administrative department and it is common that the onboard crew takes many of the decisions regarding the firm (Nya Sjfartens Bok, 2006). Figure 4.4 shows how a shipping company can be organized. It is only the larger shipping companies that have all the different departments displayed in the figure. In general, the shipping company operates on either the liner market or the spot market. Smaller shipping companies purchase administrative and technical services instead of providing them internally in the company, as shown in the figure. The liner department is responsible for all the regular traffic that the shipping company controls. The business is carried out both from the head office and from subsidiaries. In addition, the liner shipping company purchases services from shipping agencies (brokers) in ports where it is not located. The tramp department is responsible for all the vessels that are leased on the open spot market. That is, the department is responsible both for the chartering and for the commercial operation of the vessels. It is also responsible for the purchasing and the selling of vessels. The administrative department is, in the ideal case, dynamic and well able to follow the fast development that characterizes the shipping industry. In general, one can say that the larger the shipping company the more of the administrative services are handled

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The theory of the firm from an organizational perspective

internally in the company; smaller shipping companies purchase various administrative services to a larger extent (Nya Sjfartens Bok, 2006).

4.

THE ECONOMIC ORGANIZATION OF MARITIME TRANSPORT AND MARITIME FIRMS FROM A CONTRACTUAL PERSPECTIVE

A general finding is thus that the contractual relation seems to depend on the goods place in the value added chain. Raw material is transported according to spot contracts. In these markets perfect competition can be recognized. When we go further up the value chain and come closer to the final consumer good, the contractual relations exhibit more of a long-term character and asset specificity explanations can be found. The distinction between firm and market also varies in an interesting way. Third-party management is a phenomenon that illustrates the fact that labor (the crew) is not tied to the asset (the vessel) to the same extent as in other industries. Instead, it is possible to have an arms-length relation between labor and capital to an extent not found in other industries. 4.1 Third-party Ship Management

Third-party management is a denomination for a complete separation of ownership and control in maritime transport. That is, a professional management company manages ships owned by another company. In our contractual model (see Figure 4.2) it is at its extreme the same as breaking up the firm into two halves. Ownership and financing of physical capital are put in one company that contracts with another company for the supply of human capital services and other inputs necessary for the production of maritime transport services. There is no employment relation connecting capital ownership and labor. The ship-owner cannot influence the use of the ship through fiat. A contract between two separate firms decides how the use of capital and labor shall be coordinated. Contract (market) has replaced the firm as a coordination mechanism. In the extreme case, a ship-management company takes over all the activities outlined in Section 3.3 (Figure 4.4). Mitroussi (2003) describes it thus:
once a ship owner assigns activities, like crewing, technical and freight management, insurance, accounting, chartering, provisions, bunkering operations and sale and purchase of a vessel, in essence he or she gives up, together with the full management, control of his assets to third parties with no ownership rights in them. (p. 81)

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However, in practice ship managers seldom go to this extreme. In another study Mitroussi (2004) shows that in the majority of cases the firms assign crewing, technical management, service, accounting and operations to independent managers. The extreme division of ownership and control indicates that the asset specificity in the relationship between capital and labor is not large. The crew of a tanker, a bulk carrier or a container ship can serve equally efficiently on vessels owned by different firms. In line with Williamson (1996, Chapter 3), the high-powered incentives in an arms-length (market) relation can be used and the price for transport services is in most cases given. With a given price, cost minimization becomes important. A ship-management company has higher-powered incentives to minimize cost than an employee. Furthermore, as also noted by Williamson (1996, Chapter 3, p. 66), markets can sometimes aggregate demands to advantage, and thereby realize economies of scale and scope. The possibilities to reap economies of scale and scope are mentioned by Panayides and Cullinance (2002) as the main rationale for use of thirdparty management. The ship-management companies are usually subsidiaries of larger shipowners. The knowledge and the experience from operating vessels thereby remain within the company. Important customers of the ship-management firms are large multinational oil and manufacturing companies that have built up their own fleet. The rationale behind owning a fleet is lower costs of transport as well as the possibility to control the supply of sea transport. Furthermore, the cost of letting a ship-management company operate the vessel is often lower than the cost of developing a department within the existing company. It is also common that the ship-owner purchases management services in order to learn how to operate a vessel (Nya Sjfartens Bok, 2006; Branch, 1988). 4.2 A Wide Array of Contracts in Maritime Transport

The prevalence of the diversity of contracts in maritime transport cannot fully be explained by the types of asset specificity enumerated in Williamson (1985), for example, site, physical asset and human asset specificity. Vessels, in general, are not built to serve a specific shipper (customer), with the exception of vessels used in special shipping. Most of the vessels used in bulk shipping are, as pointed out by Pirrong (1993), not customer-specific in the same sense as site specificity and asset specificity. Furthermore, the use of third-party management indicates that human asset specificity is not as important as in other industries. Instead time and space considerations give rise to what Masten et al. (1991) call temporal specificities and Pirrong (1993) claims that this type of specificity is common in bulk

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shipping. Temporal specificities are, according to Pirrong, the explanation as to why some contracts are more commonly used at some freight markets than at others. Appropriable quasi-rents exist because delays in shipment cause great harm on the shipper and the carriers next best cargo shipping opportunity is sufficiently distant (Pirrong, 1993, p. 942). This temporal specificity can be costly to handle in spot market transactions. Some type of safeguard represented by a long-term contract or other type of binding between shipper and carrier has to be imposed. In markets where forward and time contracts are common a second type of specificity can arise due to the time span of the contract, namely contractual specificities. These arise in the vacuum after the expiration of the contract when all other vessels and cargos are engaged in other freight contracts. During this time period, when all other shippers and carriers are tied up in other contracts, the previously contractually related carrier and shipper are in a bilateral monopoly situation. The transaction costs of entering into a new agreement then increase considerably and there are incentives for strategic behavior. The cost of contractual specificities can, however, be mitigated by an increasing number of contracts that expire repetitively. Both the shipper and the carrier then have a number of potential new partners. Costs associated with forward contracting, such as cost of lower flexibility and the cost of opportunistic behavior, increase with the time span of the contract, whereas contractual specificities lead to longer freight contracts and vertical integration (Pirrong, 1993). In freight markets where specialized vessels are common, for example, for car transports and wooden products, the probability of long-term gaps between expiration dates of different short- and medium-term contracts is high. From a transaction costs perspective the shipper can then gain by buying its own vessel, that is, be independent of ship-owners. Long-term contracts are yet another way of reducing the transaction cost. Temporal and contractual specificities do determine the design of the freight contract. Spot contracts are used at markets where temporal specificities lack importance, whereas long-term freight contracts and vertical integration exist on markets associated with significant temporal specificities caused by i) market thinness, ii) the unavailability of supplies of the shipped commodity from non-firm specific resources, or iii) efficiencies arising from the use of specialized tonnage (Pirrong, 1993, p. 951). In Table 4.1 the different types of bulk markets are analyzed from a contractual perspective. Spot contracts should be used when there is no temporal specificity apparent, that is, when there is a no in each of the three boxes following each commodity respectively. Accordingly spot contracts are used for freights for commodities such as grain, oil (post-1973), fertilizers and

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Table 4.1
Commodity

Contracting practices in bulk shipping

Firm-specific Specialized supplies vessels No No Yes No Yes No No No No Yes/No Thin market No No No No No Typical contract Spot Spot MTC or VI Spot LTCOA for large ships, MTC for others LTCOA for large ships, MTC for others Spot Spot LTCOA or VI LTCOA or VI LTCOA or VI LTCOA or VI LTCOA or VI LTCOA or VI LTCOA or VI LTCOA or VI

Grain Oil post-1973 Oil pre-1973 Thermal coal pre1980 Thermal coal post-1980 Coking coal

Yes

Yes/No

Fertilizer Scrap Iron ore Great Lakes ore Wood chips Lumber Cement Bauxite Liquified natural gas Autos

No No Yes Yes Yes Yes Yes Yes Yes Yes

No No Yes Yes Yes Yes Yes Yes Yes Yes

No No Yes Yes Yes Yes Yes Yes Yes Yes

Note: LTCOA 5 long-term contracting, VI 5 vertical integration, Spot 5 spot chartering, and MTC 5 medium term chartering. Source: Adopted from Pirrong (1993, p. 974).

scrap, transported with general vessels, in thick markets and without firmspecific supply. Various kinds of time charters are used when the market is characterized by firm-specific supplies, specialized vessels or thin market. In these markets both time specificities and contractual specificities are significant. Freight market characteristics can change over time; for example, the characteristics of the market for oil shipping changed considerably during the late 1970s, from forward contracts and time charter (MTC or VI) into spot contracts.12 This change displays the major role that temporal specificities play in contracting practices. Also, the change in contracting practices took place when firm specificity became less important. Before 1973 most of the contracting with crude oil producers consisted of forward

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and time charters. At this time the crude oil producers in the Middle East, West Africa, and Indonesia supplied the major oil refiners British Petroleum, Exxon, Gulf, Mobil, Royal Dutch Shell, Socal and Texaco with crude oil on equity contracts or preference agreements. These market conditions resulted in temporal specificities. At the same time there was an excess supply of tankers which mitigated contractual specificities. During the 1970s political as well as economical changes took place in countries belonging to the Organization of Petroleum Exporting Countries (OPEC). These changes resulted in a drastic reduction in the use of forward contracts and time charters. The process, towards spot contracts, was supported by the development of spot oil markets in the Netherlands, the US and the UK. To summarize, the above reasoning demonstrates that firm specificities can create temporal specificities which in turn give rise to the use of forward contracts, time charters and vertical integration. The increased use of spot contracts increased the flexibility, which lowered the transaction costs of spot contracting.

5.

CONCLUDING REMARKS AND DISCUSSION

This chapter presents a contractual perspective of the firm that highlights the function of the firm as a common contracting partner to suppliers, customers, labor, capital and financiers. The nature of contracts concluded is in our model dependent on the degree of mutual dependency. A high degree of mutual dependency requires safeguards that can be provided in the form of long-term contracts, an employment relation or joint ownership of assets in different stages of a value added chain. The maritime industry is analyzed from a contractual perspective with special focus on the link between the carrier and the shipper. We present a synthesis of different contractual perspectives on the firm as a coordinating institution. The maritime industry is interesting due to the wide variation of contracts used, ranging from spot contracts, forward contracts and time charters to vertical integration. It is also interesting that in comparing different freight markets there is a large variation going from one extreme to another. The tramp market is characterized by (almost) perfect competition whereas the liner market is characterized by cartels. In general there are three types of freight contracts, the spot contract, the time-voyager and the contract of affreightment (COA). The choice of contract depends not only on the position of the commodities in the value added chain but also on the existence of temporal specificities. The spot contract is used on tramp markets mainly for raw material such as oil and

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grain where no temporal specificities prevail. Commodities higher up in the value added chain are most often transported with forward contracts or time charters. In addition, these markets are characterized by temporal specificities due to political and economic changes in the contract practices over time, such as in the shipping of oil. This example highlights the fact that firm specificities can create temporal specificities which induce the use of forward contracts and time charters in an industry that due to its characteristics normally should apply spot contracts. The existence of third-party ship management in the maritime industry is also an interesting phenomenon. It sheds light on complete separation of ownership and control. In this case the relation between physical and human capital is regulated by a contract. This in turn indicates that there is a relatively low degree of asset specificity regarding capital and labor in the maritime sector. When third-party management is applied, the allocation of resources is replaced by a contract. There is also a strong relation between commodity specialization and firm structure. For example, firms operating mainly on the spot market are usually smaller whereas firms on the liner and ferry markets usually are relatively large. The existence of temporal specificities therefore affects both the firm structure and the design of the freight contract.

NOTES
* 1. 2. 3. 4. Corresponding author. However, it is a plain vanilla theory of markets. No attention is paid to differing contractual aspects of markets (see Williamson, Chapter 2 in this volume). The report has benefited from excellent comments and branch-specific knowledge supplied by P.A. Sjberger, Swedish Shipowners Association. In many cases CEO, chairman and largest shareholder can be one and the same person. Value added chains can be used to show the different stages in shipping. For example the Swedish shipping companies Brostrm AB and Wallenius AB use comprehensive freight contracts that include several steps in the supply chain. Instead of buying these services from other logistic firms the ship-owners develop them internally in the company (Johansson et al., 2006). Williamson (1985, 1996 and Chapter 2 in this volume) uses the term asset specificity in his description of such a dependency. Klein et al. (1978) make a distinction between use and user when defining an appropriable quasi-rent. While the concept quasi-rent according to them refers to how much the value of an asset in current use exceeds the value of an asset in its best alternative use, appropriable quasi-rent denotes the difference in value in relation to what the next highest valuing user is prepared to pay for the service of the asset. According to Williamson (1975, 1985, 1996) bounded rationality refers to the limited capacity of the human mind to conceive and evaluate all alternatives pertinent to a decision. Opportunistic behavior in turn means to give false or self-disbelieved promises about the future or self-interest seeking with guile; to include calculated efforts to mislead, deceive, obfuscate, and otherwise confuse.

5. 6.

7.

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8. 9. 10. 11. 12.

The theory of the firm from an organizational perspective

According to Williamson (1996, p. 105) dedicated assets are discrete investments in general purpose plant that are made at the behest of a particular customer. By hybrid one means Long-term contractual relations that preserve autonomy but provide added transaction-specific safeguards, compared with the market (Williamson, 1996, p. 378). Section 3 is based on Johansson et al. (2006). See for example the Swedish companies Wallenius Wilhelmsen Line and SCA. The following discussion is based on Pirrong (1993).

REFERENCES
Branch, A.E. (1988), Economics of Shipping Practice and Management, 2nd edn, Chapman & Hall, London. Coase, R.H. (1937), The Nature of the Firm, Economica N.S. 4:386405, reprinted in O.E. Williamson and S. Winter (eds) (1991), The Nature of the Firm: Origins, Evolution, and Development, New York: Oxford University Press, pp. 1833. Fama, E.F. and Jensen, M.C. (1983), Separation of Ownership and Control, Journal of Law and Economics, 26:30126. Gorton, L, Ihre, R. and Sandevrn, A. (1989), Befraktning, edition 31, Liber Hermods, Lsprodukter AB, Halmstad. Jensen, M. and Meckling, W. (1976), Theory of the Firm: Managerial Behavior, Agency Costs, and Capital Structure, Journal of Financial Economics, 3:30560. Johansson, B., Karlsson C., and Palmberg, J. (2006), Den svenska sjfartsnringens ekonomiska och geografiska ntverk och kluster, Institutet fr Nringslivsanalys, http://www.ihh.hj.se/doc/3707. Klein, B., Crawford, R.A. and Alchian, A.A. (1978), Vertical Integration, Appropriable Rents, and the Competitive Contracting Process, Journal of Law and Economics, 21:297326. Magirou, E., Psaraftis, H.N. and Christodoulakis, M.N. (1992), Quantitative Methods in Shipping: A Survey of Current Use and Future Trends, Centre for Economic Research, Athens University of Economics and Business, Report no. E115. Masten, S. (1988), A Legal Basis for the Firm, Journal of Law, Economics, and Organization, 4:18198. Masten, S., Meehan Jr., J. and Snyder, E. (1991), The Cost of Organization, Journal of Law, Economics, and Organization, 7:122. Midore, R., Musso E. and Parola, F. (2005), Maritime Liner Shipping and the Stevedoring Industry: Market Structure and Competition Strategies, Maritime Policy and Management, 32:89106. Mitroussi, K. (2003), Third Party Ship Management: The Case of Separation of Ownership and Management in the Shipping Context, Maritime Policy and Management, 30:7790. Mitroussi, K. (2004), The Ship Owners Stance on Third Party Ship Management: An Empirical Study, Maritime Policy and Management, 31:3145. Nya Sjfartens Bok, 2006 (2005), Svensk sjfartstidningsfrlag, Nr 23, 16 December. Panayides, P.M. and Cullinane, K.P.B. (2002), The Vertical Disintegration of Ship Management: Choice Criteria for Third Party Selection and Evaluation, Maritime Policy and Management, 29:4564.

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Pirrong, S.C. (1993), Contracting Practices in Bulk Shipping Markets: A Transaction Cost Explanation, Journal of Law and Economics, 36(2):93776. Smith, A. (1776), The Wealth of Nations, reprinted with a foreword by A. Skinner (1976), Harmondsworth: Penguin Books. Stopford, M. (1997), Maritime Economics, 2nd edn, Routledge Taylor and Francis Group, London. Sthl, I. (1976), gande och makt i fretagen ett debattinlgg, Ekonomisk Debatt, nr 1. Veenstra, A.W. and De la Fosse, S. (2006), Contributions to Maritime Economics Zenon S. Zannetos, the Theory of Oil Tankship Rates, Maritime Policy and Management, 33:6173. Williamson, O.E. (1975), Markets and Hierarchies: Analysis and Antitrust Implications, New York: Free Press. Williamson, O.E. (1985), The Economic Institutions of Capitalism, New York: Free Press. Williamson, O.E. (1988), Corporate Finance and Corporate Governance, Journal of Finance, 43:56791. Williamson, O.E. (1996), The Mechanisms of Governance, New York: Oxford University Press.

5.

The use of managerial authority in the knowledge economy

Kirsten Foss
INTRODUCTION

1.

This chapter contributes to the ongoing debate in diverse literatures, including management, sociology and economics, on the issue of the use of authority. The debate has re-surfaced with the focus on the emerging knowledge economy. In that debate a number of management academics and sociologists have argued that authority relations will strongly diminish in importance or at least change significantly in character.1 More specifically, these writers have argued that the exercise of authority is, if not outright impossible, at least not efficient and will be substituted by different means of organizing the production of knowledge intensive goods and services. More discretion will be granted to knowledge workers and this will result in an eruption of the hierarchical structures of organizations. Such predictions are a serious concern for those theories, notably transaction cost theories (Coase, 1937; Williamson, 1985) and property rights theory (Hart and Moore, 1990; Hart, 1995, 1996), that place emphasis on authority relations as the mode of coordination that primarily characterizes firms. Thus, explanations of the existence and boundaries of firms that rely on authority are challenged. Part of the reason behind the prediction of the decline of the importance of authority relations is the assertion that firms will experience a tension between the exercise of authority by superiors based on their position in the hierarchy and the exercise of authority by knowledge workers based on their great expertise in certain areas. As superiors come to lack information about the tasks that are carried out by knowledge workers, and as knowledge workers gain bargaining power because of their control of crucial information, the economic importance of the authority of the position in a hierarchy will diminish. However, this claim is based on a much too narrow conception of what it means to exercise the authority of the position. Orders are merely one way of exercising authority; superiors may, for example, also define goals, set restrictions for employees regarding the use of firm resources, or implement
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various restrictions (N. Foss, 2001). If all such uses of authority decline in importance as means of coordinating activities in firms, we should be able to find an economic rationale for this. However, in order to do so we must first understand the economic rationale for the use of authority as a means of coordinating economic activities in order to discover whether the conditions for the use of such authority have changed. In this chapter I provide efficiency explanations for the use of different forms of authority in firms and argue that we may expect the use of different types of authority of the office in conjunction with experts who may possess authority based on their expertise. The questions to be addressed in this chapter are the following:

Can the use of authority co-exist with the delegation of discretion within a contract? If so, what factors can change the use of authority relative to the use of market contracts as a means of organizing productive activities? Is it likely that a move from the capital intensive to the knowledge intensive economy will change the relative use of authority?

2.

WHAT IS AUTHORITY?

The concept of authority is closely linked to the sociological literature on bureaucracy (for example, Weber, 1946, 1947) and organization and behavioral theories, usually drawing on sociology and psychology, present a number of interpretations of authority (Simon, 1951; Blau, 1956; Thompson, 1956; Grandori, 2001). It would be a hopeless task to present a full review and critical evaluation of the multitude of definitions and ideas regarding the concept of authority. For the purpose of this chapter the concept of authority as defined by Barnard (1938) and Simon (1951, 1991) serves as a starting point for the development of the terminology adopted here. Both Simon and Barnard employ the concept of willingness to obey (Simon, 1951, p. 126). Simon (1951) defines authority as obtaining when a boss is permitted by a worker to select actions, A0 , A, where A is the set of the workers possible behaviors. More or less authority is then defined as making the set A0 larger or smaller. Simon develops a model (specifically, a multi-stage game in the context of an incomplete contract with ex post governance), where, in the first period, the prospective worker decides whether to accept employment or not. In this period, none of the parties know which actions will be optimal, given circumstances. In the next period, the relevant circumstances as well as the costs and benefits associated with the various possible tasks are revealed to the boss. The boss then directs the worker to

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a task, which for the latter to accept it must lie within his or her zone of acceptance. An important feature of authority thus is that the authority of a superior is constrained by the subordinates acceptance of it. A subordinate may be said to accept authority, Simon (1951, p. 22) explains, . . . whenever he permits his behavior to be guided by a decision reached by another, irrespective of his own judgment as to the merits of that decision. Simons use of the notion of authority is akin to that of Coase (1937), who defines an authority relation as one whereby the factor, for a certain remuneration (which may be fixed or fluctuating), agrees to obey the directions of an entrepreneur within certain limits. The essence of the contract is that it should only state the limits to the powers of the entrepreneur. Within these limits, he can therefore direct the other factors of production (idem, p. 242). Coase (1937), Bernard (1938), and Simon (1951) all linked the notion of authority to entering into an employment contract. Others, however, have argued that an employment relation is not a necessary condition for the use of authority (Alchian and Demsetz, 1972; Cheung, 1983).

3.

AUTHORITY IN FIRMS AND MARKETS

Many contributions to the understanding of authority share the sometimes implicit assumption that if complete contingent markets existed, price coordination would suffice. This was indeed Coases point of departure in The Nature of the Firm where he posed the question, Why do firms exist? The reason for the existence of firms is that there are costs of using the price mechanism and that [t]he most obvious cost of organizing production through the price mechanism is that of discovering what the relevant prices are (Coase, 1937, p. 21). When there are high transaction costs firms pose an alternative to markets as a means of achieving coordination, because the firm allows for the use of authority as a means of allocating resources comparable to bargaining and contracting in markets. In parts of the economic literature, authority has been linked to the employment contract (Coase, 1937; Simon, 1951; Williamson, 1985) and firm coordination is seen as different from market coordination due to the use of employment contracts. According to Coase an employment contract is preferred: owing to the difficulty of forecasting, the longer the period of the contract is for the supply of the commodity or service, the less possible, and indeed, the less desirable it is for the person purchasing to specify what the other contracting party is expected to do (Coase, 1937, p. 21). Thus, the employment contract is a long-term contract for an unspecified labor

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service. Managed direction of resources substitute for price direction of resources when parties to transactions realize that contingencies of different sorts may in an unpredictable manner disrupt the choice of action or the timing and sequencing of interdependent activities (see Wernerfelt, 1997).2 However, there are also costs of using authority (that is, managed direction) which define the efficient limits for the use of authority. In an economy characterized by uncertainty with respect to the actions that need to be taken, the main costs of using authority stem from the increasing opportunity costs due to the failure of entrepreneurs to make the best use of the factor of production (Coase, 1937, p. 23). According to Coase (1937),
the costs of losses through mistakes will increase with an increase in the spatial distribution of transactions organized, in the dissimilarity of the transactions, and in the probability of changes in the relevant prices. As more transactions are organized by an entrepreneur, it would appear that the transactions would tend to be either different in kind or in different places. (p. 25)3

Managers, in other words, have limited capacity to discover the relevant prices and this increases mistakes as more dissimilar transactions are organized in a firm. Simon (1951) also links firms and authority to the use of the employment contract. Like Coase, he perceives of the employment contract as a contract for unspecified labor services. Uncertainty also constitutes the essence in the explanation provided by Simon (1951) of the use of employment contracts and authority as a means of coordination. The employment contract grants the right to the employer to postpone the decision about what services to demand from the employee until he obtains the relevant information on which to base the decision. However, limits to the use of authority are not due to managerial mistakes, as in Coase, but to the differences in costs of fulfilling the participation constraints of an employee and an independent contractor. Therefore the use of authority is efficient only when contractual adaptation is critical to one party while the other party is nearly indifferent as to the actions he carries out. The CoaseSimon view compares adaptations to uncertainty by means of authority and by means of re-contracting among independent agents. Authority differs from bargaining power in that authority is voluntarily granted by one party to another on the basis of efficiency considerations. This clear-cut distinction between bargaining power and authority is not present in later developments of the concept of authority within property rights theory as defined by, for example, Hart (1991, 1995). This theory is based on the assumption that the main problem of coordination is that of

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providing the right incentives for investing in situations where there are high costs of describing the relevant investments to be made and the output to be delivered. This kind of transaction cost makes it impossible for the contracting parties to use a third party (courts) as a means of enforcing original promises, thus creating a situation where the parties expect recontracting over the created surplus. Firms represent an efficient choice of enforcement of contracts because of the bargaining power they posses in the re-contracting situation. For example, Hart defines the firm as the physical assets over which a legitimate owner has formal residual user rights. Having residual user rights over assets provides the firm with a bargaining power that is different from that which characterizes transactions that take place between individual owners of assets. The limits to the use of authority depend on the parties incentives to invest in non-contractible assets when ownership of assets is centralized as in firms and when it is dispersed as in markets. The property rights theory shares its strong focus on incentive alignment as the central coordination issue with agency theory. Both assume that the best uses of resources are already known and that the problem of coordination arises due to asymmetric information on some relevant aspects relating to the contractual execution. In principalagency literature asymmetric information introduces the need for different contractual designs, of which some may include authority. In the work of Alchian and Demsetz (1972) teamwork creates one of the situations in which the use of authority serves the purpose of improving the efficient use of labor inputs for given ends. With teamwork it is costly to separate the contribution of each participant, creating incentives for moral hazard. The solution to such a team problem is to set up an organization (but not necessary a firm) which will economize on metering costs so as to better allocate rewards in accord with the effort delivered. A monitor specialized in metering effort is granted by the members of the team the authority (or right) to alter membership of the team in order to improve incentives for work effort.4 Thus, specialization advantages in monitoring and more advanced incentive schemes than those that can be devised for re-contracting between independent individuals (with definite time horizons) help overcome incentive problems. Authority in this conception is based on a granted right (as in Coase and Simon) but it is not necessarily related to the use of employment contracts, nor is it granted because of the need to adapt to unforeseen changes. These ideas are similar to those of Cheung (1983), who emphasizes that there is a wide spectrum of contracts, ranging from pure spot market contracts to order contracts, from piece rate contracts to employment contracts. All contracts, with the sole exception of pure spot market contracts, include some instructions or restrictions or are accompanied by orders.

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As Coase (1937) did, Cheung (1983) stresses the cost of discovering the relevant prices as the reason for this wide spectrum of contracts. However, the reasons he provides as to why prices are substituted by other means of coordination differ somewhat from those of Coase (1937), since he stresses the cost of measuring the relevant attributes of goods and services as the main reason for lack of complete contingent contracts. According to Cheung, such measurement costs are likely to be high [i]f the activities performed by an input owner change frequently [and] if these activities vary greatly (Cheung, 1970, p. 7). Moreover, it may simply be too costly to separate the contribution of each party to the production of a consumer good. In other words, measurement costs may cause team problems. In contractual relations characterized by high measurement costs, it tends to be more economical to forgo any direct measurement of these activities and substitute another measurement to serve as a proxy (ibid.). For example, instead of contracting for the use of a secretary to type a certain letter at a certain place at a certain time, one may contract for the unspecified labor service of the secretary for a given period of time and a given pay per time period. However, when a price for each job to be done by the secretary cannot be specified, the contract needs to be supplemented by directions/ instructions (or orders). The relation between remuneration of the input and the valued attributes of the output may be more or less imprecise and therefore require more or less instructions.5 We should, according to Cheung, expect an extensive use of orders where measurement costs makes it efficient to use flat wages rather than payments that more fully reflect the contribution of the subordinate to the quality of the final consumer good. The principalagency literature on firms (Cheung, 1970; Alchian and Demsetz, 1972) emphasizes that orders and restrictions are not unique to the employment relation and the exercise of authority not confined to firms. Nor does it view differences in bargaining power as discriminating firms (or employment contracts) from markets. This point of view is most clearly expressed in Alchian and Demsetz (1972), who claim that [i]t is common to see the firm characterized by the power to settle issues by fiat, by authority, or by disciplinary actions superior to that available in the conventional market. This is a delusion (p. 72). An employer has, in their opinion, no different means at his disposal for punishing disobedience than individual contractors have. According to this view every single instance of the exercise of authority is based either on implicit agreements or on the bargaining power of the parties in the relation. The conclusion one may derive from Cheung (1970) and Alchian and Demsetz (1972) is that authority exists in the same form and to the same degree in markets and in firms. This view is contrasted by those who emphasize the differences in the legal conditions that support the private exercise of authority (as

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enforcement of contracts) within firms compared with the use of market contracts (Williamson, 1985; Masten, 1991; Vandenberghe and Siegers, 2000). First, employment law requires that orders or instructions are carried out, restrictions implemented by an employer are respected and disputes about their merits and legitimacy are settled after the completion of the order. Williamson (1985), for example, describes firms as their own ultimate court of appeal. Second, the rights of the employer to monitor and sanction actions differ in employment and market contracts (Masten 1991). The extended right to monitor employees complements the functioning of authority as a means of solving disputes. For example, an employer may have better access to knowledge of relation-specific non-contractible investments than courts. Thus, although restrictions, directions and orders can be found in market contracts, they differ from employment contracts in the legal frame that supports the contracts. Market contracts do not provide one of the parties with the formal (and legally supported) right to make decisions without the consent of the other party. Adaptations can be made if there is no conflict of interest between the parties or a verifiable mechanism (such as elevator clauses) of contractual adjustment is agreed on in the contract.6 That is, measurement costs explain why contracts contain more stipulations than just the price and the item. However, only uncertainty or partly unpredictable volatility makes it necessary to use managerial discretion to make ex post adaptation of these instructions and stipulations. 3.1 Formal and Real Authority

The notion of authority as supported by firm governance structure does not imply that firms (or more precisely managers) are always able to exercise the authority they are legally entitled to exercise. That is, employees may exercise discretion and avoid the restrictions, instructions and orders issued by managers. This introduces a distinction between formal and real authority (Aghion and Tirole, 1997, p. 1). Whenever there is a legally recognized employment relation we find formal authority in the sense of an attribute that is attached to the role of an employer (for example, Weber uses the notion of bureaucratic authority or authority of the office). The employment relation supports the use of authority of the position (formal authority) but formal authority does not necessarily convey real authority which is an effective control over decisions, on its holder (Aghion and Tirole, 1997, p. 1).7 That is, employees may exercise discretion within the authority relationship. Discretion can broadly be defined as the ability of an agent to control or consume resources over which he/she does not have formal ownership. Discretion includes instances where an agent behaves morally hazardously

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or exerts influence indirectly or where peers in a group voluntarily agree to have their points of view represented by a group member or to have conflicts resolved by one member of the group.8 The exercise of discretion by employees does not fully preclude their recognition of the formal authority granted to an employer through employment law. For example, an employee may recognize the legitimacy of the formal authority relation with a superior and be willing to accept the limits within which the superior can direct the actions of the subordinate, while not fulfilling the agreement when given specific directions in areas where he is not subject to effective control. Also, the employee may recognize the legitimacy of the formal authority relation and the specific ways in which the authority is exercised, while spending resources on altering the guidance to which he is subject to by influencing superiors to change the way in which the authority is carried out. Employees ability to exercise discretion depends on the employers costs of monitoring and on their bargaining power. For example, a knowledge workers technical competences and expertise may be an important constraint on the ability of the employer to exercise his formal authority this is the assertion that seems to underlie the prediction that knowledge workers are less likely to be subject to the authority of office and more likely to possess discretion or authority themselves due to their specific qualifications. Authority and discretion may be delegated to one employee or a group of employees. Delegated (or formal) discretion can be defined as instances where an agent is delegated the rights by a superior to allocate resources (including his own labor services) to those ends he desires without the formal approval of an owner or employer.9 Delegated authority is to be distinguished from delegated discretion by the fact that the discretion does not include formal rights to direct the actions of other members of the firm. Both delegated authority and delegated discretion are limited by the formal rights of a superior to overrule the decisions made by a subordinate (Baker et al., 1999) as well as by the real discretion exercised by lower-level employees. Delegation of discretion and authority is a means of overcoming the inefficiencies that stem from centralized decision making (Jensen and Meckling, 1992). In the CoaseSimonCheung view it is implicitly assumed that the superior receives the relevant information and has the relevant knowledge to make use of the information by ordering the subordinate to carry out a specified action. With such a narrow conception of authority there is no room for the use of dispersed knowledge or information that rests with employees within the employment relation. Thus, the use of centralized decision making by an authority becomes inefficient in a knowledge economy where employees or subordinates (at least at certain

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points in time) have the relevant information or the relevant knowledge that makes them superior in using the information. However, Simon (1991, p. 31) himself pointed out four decades after his paper on authority, [a]uthority in organizations is not used exclusively, or even mainly, to command specific actions. Instead, he explains, it is a command that takes the form of a result to be produced, a principle to be applied, or goal constraints, so that [o]nly the end goal has been supplied by the command, and not the method of reaching it.10 The concept of authority introduced by Simon (1991) sets focus on the many ways in which contractual relations can be altered ex post contracting. Moreover, the definition allows for the delegation of discretion to subordinates with respect to their choice of actions. Authority on the part of the superior may then be interpreted as the right to unilaterally change the degree of delegation ex post contract agreement and to veto decisions made by the subordinate (see also Aghion and Tirole, 1997; Baker et al., 1999). It does not alter the economic rationale for formal authority if it is broadened from the narrow focus on orders to encompass situations where the superior ex post contracting vetoes decisions or implements restrictions that prevent the subordinate from picking the actions most preferred by him. In accordance with Coase and Simon, formal authority still serves the overall purpose of achieving coordination of productive activities in a setting where it is economically efficient for the parties to adapt the contractual relation to unpredictable changes in contractual circumstances. Adaptation must be costly to obtain through re-negotiations or by means of contingent plans (Coase, 1937). Given the above, I put forward the following definition of authority. Authority is a formal right granted to a superior to use managerial judgment to unilaterally decide on changes or maintenance of aspects of the term of contract ex post contracting irrespective of the contracting partys judgment as to the merits of that decision. In employment relations the formal right to exercise authority is supported by labor law.

4.
4.1

CAUSES OF CHANGE IN THE RELATIVE USE OF AUTHORITY

The Use of Authority from an Incentive Perspective

The tension between real and formal authority is center stage in some of the writings on the diminishing importance of authority compared with, for example, market contracts (or hybrids such as collaborative arrangements supported by, for example, norms (Grandori, 2001)). Two different types of

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arguments support this idea. First, a move toward the knowledge economy may be expected to increase the relative importance of investments in knowledge assets compared with investments in capital. With this change, employers costs of monitoring and bargaining with knowledge workers over the actions to be chosen may increase. In turn, this leads to increased costs from moral hazard (Jensen and Meckling, 1992) and from bargaining in all transactions dealing with knowledge workers. Also, investments in knowledge assets and allocation of bargaining power change endogenously (Hart, 1995). That is, in order to create efficient incentives for knowledge workers to invest in knowledge assets we should expect a reallocation of the real authority that follows from ownership of co-specialized physical assets from managers to knowledge workers. If we hold everything but the discretion and costs of bargaining with employees constant we should expect the benefit function from the use of formal authority to move downward, causing a relative decrease in the use of formal authority. However, there are also factors that can offset this move. For example, increased investments in knowledge assets may create more assets specificity, which in turn raises costs of market contracting and introduces a need for private courts that can handle the specific types of conflicts that arise in incomplete contract situations (Williamson, 1985). Thus increasing knowledge workers discretion (or authority) does not necessarily imply more market transactions. However, the formal authority of the employer may to a lesser extent be accompanied by real authority. A second type of argument focuses on how information is differently dispersed in the knowledge economy compared to the capital intensive one. Grandori (2001), for example, has forcefully stated that changes in the distribution of information may cause authority [as a centralized decisionmaking system] to fail in all its forms (p. 257). Along with the differently dispersed knowledge, the choice set of actions available to knowledge workers may become much greater than that available to workers in the capital intensive economy. In such a situation it may be too costly for a central manager to be informed about the entire choice sets of an employee. Knowledge workers then become better able to select actions that create joint value than the employer. However, the employer may interpret the employees choices as morally hazardous when they do not benefit the employer and he may not allow these choices although they maximize the joint satisfaction function. If as Simon (1951) argues the employee cannot make the employer commit to choose actions that maximize their joint satisfaction function, the use of authority becomes inefficient. For a given level of uncertainty (variance) employees will demand a higher compensation (compared with the compensation they get from market transactions) in order to meet their participation constraints.11 The increased costs of

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meeting employee participation constraints raise the costs of using authority relative to market contracting. Thus, the diminished use of authority in a knowledge economy should be attributed to an increased conflict of interests leaving little scope for the use of authority that satisfies the participation constraints of both the employer and the employee. A limited scope within which the participation constraints of both employee and employer are fulfilled may also arise if changes in work content produce a wider gap between the preferences of the knowledge workers and those of their employers (with no changes in the size of the choice set). For example, it may well be the case that knowledge workers to a greater extent prefer to work on projects that add to their general (non-relation-specific) stock of human capital, whereas an employer to an increasing extent wants employees to work on projects that mainly build relation-specific experience. Two mechanisms can ease the problem. One is to introduce differentiated pay for activities in accordance with the merits to the employer and the costs to the employee. It has in fact been argued that in the knowledge economy we see an increasing use of high-powered incentives within firms. Of course this re-introduces the issue raised by Coase (1937), Cheung (1983) and others of the costs of discovering the relevant prices. Another mechanism is for the firm to delegate some discretion to knowledge workers and build a reputation for allowing the employee to select actions that maximize the joint satisfaction function (Aghion and Tirole, 1997).12 The reputation has to be robust to evolving changes in the pay-off to the employer and employee of emerging actions (see, for example, Kreps, 1990). The recognition of firms as legal entities and the legal protection of corporate identity are factors that ease the use of reputation mechanisms as a means of private enforcement of implicit promises within firms as compared with across spot markets. Thus, increased distribution of knowledge and the accompanying need for delegation need not result in a relative diminished use of formal authority. However, as delegation of discretion introduces costs in the form of moral hazard, there will have to be limits to the delegation that takes place within firms. The optimal delegation of discretion is, according to Jensen and Meckling (1992), one that balances the costs of bad decisions owing to poor information and those owing to inconsistent objectives (p. 264). In order to constrain moral hazard, restrictions are often used in employment relations where assets have many different uses and where only a subset of these uses optimize the joint satisfaction function. This conclusion is in line with the work of Holmstrom and Milgrom (1994), Barzel (1989) and Holmstrom (1999), who argue that employers use restrictions in order to avoid costs of morally hazardous behavior when incentive payments are too costly to implement. Thus, the employer may replace direct monitoring

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of work effort by supervision of a set of constraints that the employer has imposed on the employee with respect to the use of the labor services and capital assets (Barzel, 1989). However, since contracting takes place in a dynamic setting in which new opportunities for value creation and for moral hazard arise, the constraints and restrictions may need to be changed over time. The employment contract ensures that the employer has the formal rights to make these changes unilaterally, thereby saving contracting costs. Thus, an increased need for delegation need not imply a diminished role for authority. To sum up: writers on the knowledge economy have emphasized the importance of increasing misalignment of preferences between employer and employee or the relative increase in employees ability to discover valuecreating actions which in turn should diminish the relative importance of the use of authority. However, there is no reason to assume that there is a diminished need for the role of formal authority as supported by a firm governance structure. It may still be efficient to use authority supported by firm governance to solve conflicts of interest in situations of incomplete contracting (as argued by Williamson, 1985) and to support the building of a credible reputation for delegating discretion. Moreover, delegation of discretion within an employment contract allows for different types of monitoring compared with market contracts, making it easier to counter moral hazard within the firm governance structure. Finally, the firm governance structure allows for a flexible adaptation of constraints to delegation as employers have the right to make these decisions unilaterally. The above discussion has centered on how incentive issues influence the relative use of authority in the knowledge economy holding the nature of the coordination problem constant. However, it is also possible that the nature of the coordination problem changes with a move from a physical capital to a knowledge intensive economy. In the following, I make use of an example of a coordination problem that arises between a marketing and a product development function in order to illustrate how changes in the nature of the coordination problem influence the relative costs and benefits of the use of authority under different conditions of dispersion of information and knowledge between an employer and two employees. For the moment I leave aside the discussion of the incentive issues, thus taking common goals as the standard assumption throughout the example. 4.2 The Use of Authority from a Production Coordination Perspective

The coordination problem consists in carrying out a product development project. Two employees (in marketing and product development respectively) and a manager are engaged in the project. The choice set for

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the marketing employee contains two different product concepts and the choice set for the product developer contains two different technical solutions. The coordination problem is that of selecting the concept and the technological solution that under the prevailing contingencies generate the greatest revenue to the firm (which in this example is the choice that maximizes joint value). The contingencies facing the firm consist of the values (which enter as parameters in the revenue function) for the state of customer preferences and for the state of technological knowledge. Both customer preferences and technological knowledge can change over time. The way in which the coordination problem can be solved depends on the nature of interdependencies and on the distribution of information and knowledge between the employer and the two employees. Information refers to information about a realized state and the solutions available, while knowledge refers to the ability to specify the revenue function and solve for the optimal solution. Either the superior or the two employees in the firm may posses information regarding the choice sets and the kind of states that have emerged. Moreover, either the superior or the subordinate or both may have the knowledge needed to select the optimal combination of product concept and technical solution, given the information available on customer preferences and technological knowledge. When the informational interdependencies between the choice of product concept and technical solution are complex, coordination requires that the decision maker has information about the contingencies and the solutions facing both design and product development. The coordination problem is characterized by decisiveness when decisions on product concept and technical solution can be made sequentially by different decision makers. For example, customer preferences may be decisive for the choice of product concept and for the choice of technique. This implies that the marketing employee (who selects product concepts) can make a decision without information about the state of technological knowledge or technical solutions. Moreover, he only needs to communicate his choice of concept to the employee in product development, who selects the technical solution on the basis of his investigation of the state of technological knowledge. Finally, the coordination problem can be characterized by complete independence, in which case the marketing employee only needs information about the state of consumer preferences and product concepts and the product development employee only needs information on the state of technological knowledge and technical solutions. Centralized authority in a setting of complex interdependencies The employer is the only one who can make the relevant decision if he is the one who possesses all relevant information of states and solutions

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available and the knowledge needed to use that information. Some ex ante communication of the information possessed by the employer will be necessary though, as employees will be unwilling to accept an employment contract unless it specifies the nature and limits of the choices that the employer can make (Simon, 1951). However, compared with the use of market contracting, which requires a more detailed specification of actions and instructions, the use of order in employment contracts may save some communication costs (Demsetz, 1995). If contingencies or the choice set of actions change, the benefits from the use of formal authority supported by firm governance structure to make adaptations increase, as more transaction costs are saved compared with carrying out the adaptation by means of spot market transactions (Coase, 1937).13 The arguments presented above indicate at least three important variables that may influence the relative use of centralized decision making (assuming there are no conflicts of interest). First, the costs of completing contracts over markets in the knowledge economy could have been reduced. For example, the introduction of IT technology in the knowledge economy and the embodiment of information needed for coordination, as well as the development of interface and measurement standards, are factors that reduce costs of re-contracting. However, these factors may influence firm internal costs of using centralized decision making to the same extent. Second, uncertainty may have been reduced. In the example above, this would be the case if the states of consumer preferences or technological knowledge did not change or if no new product concepts and solutions could be identified. However, a reduction in the level of uncertainty is contrary to what most writers on the knowledge economy assume. Finally, the costs to the central manager of obtaining relevant information and of using this may have increased. The latter falls in line with the arguments presented in much of the literature on the use of authority in the knowledge economy, where many writers argue that an increased dispersion of knowledge makes it increasingly difficult for the holder of formal (and centralized) authority to reach efficient decisions (see, for example, Minkler, 1993; Cowen and Parker, 1997; Hodgson, 1998; Radner, 2000). For example, an increase in specialization in production and knowledge in the knowledge economy results in more diverse types of transaction (in terms of choice sets, contingencies and sources of interdependencies) and this increases the costs to managers of discovering the right prices, resulting in a reduction of the efficient size of firms and an increase in the relative use of market transactions. Part of the confusion about the status of authority in a knowledge economy seems to arise because the use of authority is confused with highly centralized decision making. Indeed, the costs that arise due to the limited

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mental capacity of managers can be reduced if some discretion and authority is delegated to lower-level employees. Delegation has been mentioned in the organization literature as a means of improving decision making under uncertainty (Miller, 1992), economizing on principals opportunity costs (Salani, 1997) and avoiding decision delays under circumstances of volatility and uncertainty (Thompson, 1956; Burns and Stalker, 1961; Mintzberg, 1983). The underlying idea is that delegation of discretion provides an efficient use of distributed knowledge in firms (Jensen and Meckling, 1992) that is costly to communicate to a central decision maker (Casson, 1994).14 Uncertainty, unpredictable volatility and some level of distributed knowledge and information create the conditions under which there is an economic rationale for the coexistence of authority and delegation of discretion within hierarchies. This conclusion is based on the assumption that the coordination problem is at least partly decomposable (Simon, 1962). One such situation arises if the coordination problem is characterized by decisiveness. Delegation in a setting of decisiveness, dispersed information and centrally or dispersed knowledge When the coordination problem is characterized by decisiveness it is possible to achieve the optimal solution with delegation of discretion to employees. The employer can delegate decisions to the employee who has the relevant information about states and solutions and the knowledge needed to make the choice. When marketing information is decisive for the coordination problem the marketing employee can make the decision and communicate it to the employer, having them select the optimal technique, or they can communicate their decision directly to the product development employee who has obtained information about the state of technology. The choice between centralized decision making and decentralized corporation (through markets or within the hierarchy) depends on the trade-off between benefits from specialization in decision making and costs of communicating to the employer the states and solutions that have been observed by marketing and product development. In cases where the design problem is not characterized by natural decisiveness, it may sometimes be efficient to have the employer impose decisiveness on problems by dispensing with the communication of the decision premises. As an example, the employer can choose to take customer preferences or technological knowledge as given and make that the normal state. Decisions will only be made in a consultative manner when the employer or the employee in a marketing department discovers an unusual state. In all other situations they will be made in a sequential manner. An even stricter way of imposing decisiveness is to restrict

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employees from all examination of states. In the latter case decisions are taken in a routine manner and the only role for a central authority is to monitor the adherence to and feasibility of this restriction. Restrictions on the delegation of discretion may be needed as long as there is some level of interdependence. Costs from delegation of discretion arise when knowledge workers do not possess all relevant knowledge. Employees exercise of discretion can produce spillover effects (that is, externalities) due to unintended consequences of the actions taken. These harmful spillover effects include coordination failures, such as scheduling problems, duplicative efforts (for example, of information gathering, R&D), cannibalization of product markets and other instances of decentralized actions being inconsistent with the firms overall aims, and so on. The use of authority to restrict harmful consequences is efficient if the employer is better able to form a judgment regarding what types of actions are appropriate. The employer defines constraints that only allow the knowledge workers to choose among actions he deems appropriate (Armstrong, 1994). In this way the employer prevents the knowledge worker choosing actions that he knows or believes to be infeasible. If the employer does not know where to set the restrictions ex ante to contracting, he may instead overrule or veto decisions made by the employee (as in, for example, Aghion and Tirole, 1997). That is, even with perfect alignment of incentives between employer and knowledge there is a role for employers as monitors and enforcers of restrictions. The use of restrictions and veto brings attention to the function of authority as a means of constraining the method[s] of reaching an end goal, in Simons (1991) terminology. Under conditions of uncertainty where the choice set of the knowledge worker and interdependencies in decision change over time, constraints will have to be adjusted. Thus, the role of authority in a setting of distributed knowledge and uncertainty may well be that of unilaterally altering constraints on decisions made by lower-level knowledge workers and adjusting criteria for accepting or rejecting decisions made by such knowledge workers.15 The way in which delegation of discretion can ease the constraints on the use of authority in settings characterized by disperse information and knowledge move the focus from the discussion of authority versus market contracts to a discussion of centralized versus decentralized decisions within the employment relation. From the above it is clear that the role of the employer as one who solves coordination problems decreases as one moves from coordination problems characterized by interdependency to those characterized by (imposition of) decisiveness. Changes in production techniques can cause a shift in the nature of interdependencies. Moreover, it may have become more attractive to impose decisiveness on coordination problems with the move to the knowledge economy. This is the case

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if the costs of investigating states increase drastically compared with the benefit of reaching the optimal solution. However, a move away from the use of centralized authority toward more decentralized decisions may also be a consequence of a relative change in the importance of knowledge workers information about actions in the choice set and contingencies compared with employers knowledge of interdependencies. That is, some interdependencies are ignored or suppressed at the expense of achieving the optimal fit between subsets of the solution. The movement in the knowledge economy toward the design of modular products is an example of the latter. Firms imposed decisiveness on problem solving, dispensing with some interdependencies in the product design, and the interfaces that are specified ex post detailed product development constitute the natural state of the environment which is to be taken for granted in the choice of the specific design solutions.

5.

CONCLUSION: IS THE USE OF AUTHORITY DIMINISHING IN THE KNOWLEDGE ECONOMY?

The notion of authority is an important one in economics. In particular, it underlies important contemporary theories of economic organization (Williamson, 1985; Hart, 1995). Given this, it is surprising that so few fundamental discussions of the notion are to be found in the literature. This is problematic, because the notion of authority has recently been subject to much discussion in neighboring fields, such as sociology and business administration. Economists have had difficulties entering this discussion because of their relatively crude conception of authority, in which authority is seen as synonymous with either bargaining power or the use of ordered direction by a highly informed employer (Simon, 1951). However, the theory of economic organization is in no way necessarily limited to those notions of authority. Thus, the theory suggests other possible, yet complementary, understandings of authority, such as the unilateral right to set and change constraints on the activities of subordinates, overrule decisions made by subordinates, and implement and change reward systems. Seen in the light of this latter understanding of authority, it is not so apparent that authority will strongly decline in importance in the emerging knowledge economy, as asserted by a number of writers. Although knowledge workers may have more bargaining power and be more knowledgeable about the activities they carry out than traditional industrial workers, they too will be subject to authority, as long as productive activities are characterized by uncertainty and measurement costs which make complete contracting

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prohibitively costly. It may be conjectured that under these circumstances delegation will be more widespread. However, because of differing preferences, asymmetric information and externalities in decision making, such delegation is likely to be circumscribed. The literature on authority points to several factors that can diminish the relative use of authority in the knowledge economy:

changes in the distribution or importance of information and knowledge held by employees and employers respectively less need for adaptation more interface standards, more modular products, and so on increased complexity and diversity in transactions increased conflict in preferences over actions between employer and employee more bargaining power to employees less asset specificity greater importance of knowledge workers investments in knowledge compared with employers.

In order to fully answer the question of whether or not authority is diminishing in importance, one must empirically investigate how changing from the capital intensive to the knowledge intensive economy affects all of these variables.

NOTES
1. Some representative sources are Boisot (1998), Foss (2001), Ghoshal et al. (1995), Grandori (2001), Harrison and Leitch (2000), Hodgson (1998), Liebeskind et al. (1995), Matusik and Hill (1998), Minkler (1993), Vandenberghe and Siegers (2000), and Zucker (1991). For example, the employer can be ignorant about the best use of different labor services as in the case of innovative activities (N. Foss, 2001). Also, in cases of rather complex production or product innovations, it may be desirable to conduct a number of controlled experiments before one decides on what labor service is required for a certain task (K. Foss, 2001) Richardson (1972) has a very similar argument for the boundaries of firms Agency theory, a body of literature to which Alchian and Demsetz (1972) belongs, ascribes all contracting costs to the costs of observing variables. Monitoring denotes measur[ing] output performance, apportioning rewards, observing the input behavior of inputs as means of detecting or estimating their marginal productivity and giving assignments or instruction in what to do and how to do it (Alchian and Demsetz, 1972, p. 782). However, the reason for the last kind of activity is left unexplained. Barzel (1989) argues that orders are used in conjunction with flat wages, not because employees lack information, but because they have no incentives to devise ways of exercising use rights over assets that would produce utility. In market contracts one party may allow the other party to make some specific type of

2.

3. 4.

5. 6.

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decision ex post contracting. For example, a painter who enters a market contract with a customer may allow the customer to decide on the color and type of paint ex post contracting. This can be interpreted as an instance where the painter is indifferent between colors and types of paint to be used and therefore implicitly negotiates and accepts the order. Thompson (1956) distinguishes between authority and power as the basic means of obtaining obedience. He defines power as the ability to determine the behavior of others, regardless of the bases of that ability, and authority as that type of power which goes with a position and is legitimated by the official norms (p. 290). For example, an employee or a group of employees may formally be delegated rights to decide, among themselves, on the use of resources that influence their decisions about how to carry out certain activities. I reserve the notion of delegation of authority to those instances where a superior has formal rights to influence the decisions made by subordinates, whereas I consider it an instance of delegation of discretion when a group of employees are to decide among themselves on the use of resources. The authorization to give well-defined orders under well-defined circumstances does not fall under the definition of discretion. In fairness to Simon, it should be noted that the more expansive notion of authority in the 1991 paper can be found already in Simon (1947). Thus, Simons views of authority did not change between 1951 and 1991. What arguably happened was that Simon in the 1951 paper developed a formal model of authority and that tractability of the formal analysis required that a relatively simple concept of authority be employed. In a reinterpretation of Simon (1951), one may consider restrictions on the subordinate as a means of reducing the set of actions that the employee has the discretion to choose at a given wage. The authority relation should then be preferred when it is efficient to allow the superior to postpone the decision about the preferred type of work activity and/or the preferred set of restrictions on the work activity. For example, Aghion and Tirole (1997) have investigated the use of authority in a setting in which the agent has asymmetric information about his expected private benefits from various projects. The principal may veto projects to protect him from the agents adverse selection of projects that reveals high private benefit to the agent and little or no benefit to the principal. However, in such situations the superior must be able to credibly commit to choose projects that do not generate negative expected benefits to the agent (see also Baker et al., 1999). The employment contract could be interpreted as providing a stock of labor services that within limits could be allocated to different uses by the direction of a manager in response to unforeseen contingencies (Coase, 1937; 1991). However, managers only need to bear the cost of carrying such a stock if they cannot appropriate the benefits of their knowledge as new contingencies emerge. Three factors may explain why they cannot sell their knowledge in markets. First, there is the well-known problem of information as a public good that, if revealed before the transaction, cannot be protected from capture (Arrow, 1962); second, negotiations may take longer time than direction by orders and, because of this, the opportunity for profitable action may be gone; and third, managers knowledge may be specific to particular transactions. Employers also grant discretion to employees for a number of other reasons, including improving motivation through empowerment (Conger and Canungo, 1988), fostering learning by providing more room for local explorative efforts, and improving collective decision-making by letting more employees have an influence on decisions (Miller, 1992). However these reasons arise also if there is no uncertainty. The rather considerable literature on delegation in organizations (for example, Galbraith, 1974; Fama and Jensen, 1983; Jensen and Meckling, 1992) does not explain why delegation should be associated with the exercise of authority. Part of the reason may lie in the static nature of the analysis: all costs and benefits associated with delegation are given (hence, optimum delegation is known immediately to decision-makers), and there is no role for authority, except perhaps monitoring the use of delegated decision rights.

7.

8.

9. 10.

11.

12.

13.

14.

15.

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Galbraith, J.R. (1974), Organization Design: An Information Processing View, Interfaces, 4: 2836. Ghoshal, Sumantra, Peter Moran and Luis Almeida-Costa (1995), The Essence of the Mega Corporation: Shared Context, not Structural Hierarchy, Journal of Institutional and Theoretical Economics, 151: 74859. Grandori, Anna (2001), Organizations and Economic Behaviour, London: Routledge. Harrison, Richard T. and Claire M. Leitch (2000), Learning and Organization in the Knowledge-Based Information Economy: Initial Findings from a Participatory Action Research Case Study, British Journal of Management, 11: 10319. Hart, Oliver (1991), Incomplete Contracts and the Theory of the Firm, in O.E. Williamson and S.G. Winter (eds), The Nature of the Firm: Origins, Evolution and Development, Oxford: Oxford University Press. Hart, Oliver (1995), Firms, Contracts, and Financial Structure, Oxford: Oxford University Press. Hart, Oliver (1996), An Economists View of Authority, Rationality and Society, 8: 37186. Hart, Oliver and John Moore (1990), Property Rights and the Nature of the Firm, Journal of Political Economy, 98: 111958. Hodgson, Geoff (1998), Economics and Utopia, London: Routledge. Holmstrom, Bengt (1999), The Firm as a Subeconomy, Journal of Law, Economics, and Organization, 15: 74102. Holmstrom, Bengt and Paul Milgrom (1994), The Firm as an Incentive System, American Economic Review, 84: 97291. Jensen, Michael C. and William H. Meckling (1992), Specific and General Knowledge and Organizational Structure, in Lars Werin and Hans Wijkander (eds), Contract Economics, Oxford: Blackwell. Kreps, David (1990), Corporate Culture and Economic Theory, in James E. Alt and Kenneth A. Shepsle (eds), Perspectives on Positive Political Economy, Cambridge: Cambridge University Press. Liebeskind, Julia Porter, Amalya Lumerman Oliver, Lynne G. Zucker and Marilynn B. Brewer (1995), Social Networks, Learning, and Flexibility: Sourcing Scientific Knowledge in New Biotechnology Firms, Cambridge: NBER Working Paper No. W5320. Masten, Scott (1991), A Legal Basis for the Firm, in Oliver E. Williamson and Sidney G. Winter (eds), The Nature of the Firm: Origins, Evolution, and Development, Oxford: Oxford University Press. Matusik, Sharon F. and Charles W.L. Hill (1998), The Utilization of Contingent Work, Knowledge Creation, and Competitive Advantage, Academy of Management Review, 23: 68097. Miller, Gary (1992), Managerial Dilemmas, Cambridge: Cambridge University Press. Minkler, Alanson P. (1993), Knowledge and Internal Organization, Journal of Economic Behavior and Organization, 21: 1730. Mintzberg, Henry (1983), Structures in Five, Englewood Cliffs: Prentice-Hall. Simon, Herbert A. (1947), Administrative Behavior, New York: The Free Press. Simon, Herbert A. (1951), A Formal Theory of the Employment Relationship, in H.A. Simon (1982) (ed.), Models of Bounded Rationality, Cambridge: MIT Press.

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Simon, Herbert A. (1961), The Architecture of Complexity, Proceedings of the American Philosophical Society, 156: 46782. Simon, Herbert A. (1991), Organizations and Markets, Journal of Economic Perspectives, 5: 2544. Thompson, James D. (1956), Authority and Power in Identical Organizations American Journal of Sociology, 62: 290301. Vandenberghe, Ann-Sophie and Jacques Siegers (2000), Employees versus Independent Contractors for the Exchange of Labor Services: Authority as Distinguishing Characteristic?, Paper for 17th Annual Conference on the European Association of Law and Economics, Gent, 1416 September. Weber, Max (1946), Essays in Sociology, translated and edited by H.H. Gerth and C.W. Mills, New York: Oxford University Press. Weber, Max (1947), The Theory of Economic and Social Organization, translated by A.M. Henderson and Talcott Parsons; edited by Talcott Parson, New York: Oxford University Press. Williamson, Oliver E. (1985), The Economic Institutions of Capitalism, New York: The Free Press. Zucker, Lynne (1991), Markets for Bureaucratic Authority and Control: Information Quality in Professions and Services, Research in the Sociology of Organizations, 8: 15790.

6.

Competence and learning in the experimentally organized economy1

Gunnar Eliasson and sa Eliasson
INFORMATIONAL ASSUMPTIONS FOR A THEORY OF INDUSTRIAL DEVELOPMENT

1.

The single most important empirical assumption in economic theory concerns the totality of all possible states the economy can be in. This universal state space of the model of the economy, or what we call the business opportunities space (Eliasson, 1990a) sets the limits both of what actors can do, and of how informed about their environment they can be. We introduce the knowledge based economy (Eliasson 1987b, 1990a, b; OECD, 1996), which establishes as a necessary assumption an economic opportunities space of immense complexity that is theoretically impossible to comprehend more than fractionally from any one place. Each actor understands only a miniscule fraction of the total opportunities space. Together, however, the understanding of all actors in the markets is much larger, but still only encompasses a fraction of the whole, and the tacitness of their knowledge or competence effectively restricts expansion of that understanding through collective coordination. Attempts to speed up exploration of the opportunities space through rivalrous competition in markets encounter rapidly escalating information and communications (transactions) costs in the short run. Such exploration, however, offers opportunities for learning and increases the number of creative encounters such that the opportunities space expands, and probably faster than it is being explored. Hence, we may all be growing increasingly ignorant of what is theoretically possible to know about. This information paradox, or what we will call the Srimner effect,2 is a fundamental, sustained and distinguishing property of the experimentally organized economy (EOE) and the rational basis for the existence of a competence bloc (Eliasson and Eliasson, 1996).

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1.1

The Grossly Ignorant Actor

Under these circumstances boundedly rational (Simon, 1955) and myopic, bordering on grossly ignorant actors will constantly participate in a positive sum economic game, trying to orient themselves in the immense opportunities set, their success rates depending on their competence to discover and capture the new opportunities, constantly making more or less serious mistakes in the process (Day et al., 1974). Hence, each decision can be seen as a more or less well designed economic experiment to be tested in the market in confrontation with all other actors. Both successful and mistaken experiments involve elements of learning and the creation of new combinations on which competitors can set up new economic experiments. Economic mistakes (to be defined below) then define the ultimate transactions cost (Eliasson and Eliasson, 2005). Economic mistakes escalate if actors intensify their exploration of the state space to capture larger profits, and the reason is the problem, recognized already by Wicksell (1923) and repeated by Arrow (1959), that it is difficult, and perhaps impossible, to model the simultaneous determination of structures (quantities or organizations) and prices. In the highly non-linear micro (firm) based macro model that we will refer to below as an approximation of the theory of the EOE, both quantities and prices become increasingly destabilized as actors are pushed on by market competition, and prices become increasingly unreliable signals to guide quantity adjustments towards a both unreachable and perhaps indeterminate equilibrium. The economy will constantly be in a Heisenbergian flux (see also Eliasson, 1991a, and Eliasson et al., 2005). Since experimentation aimed at exploring and learning about state space also expands the opportunities space through learning and the creation of new opportunities (innovation), we have to reckon with the possibility that the total economic opportunities space is not only immense but also indeterminate at any point in time. Demsetz (1969) recognized this possibility when criticizing the neoclassical doctrine as being subject to a Nirvana fallacy in the sense that the best of all worlds that the neoclassical economists can calculate within their model make them miss the possibility of even better worlds beyond their prior assumptions.3 One property of the EOE to be explained below also is that there always exist better allocations than the current one, meaning that the economy will always be operating (far) below its production frontiers.4 Referring to Demsetz, Kirzner (1997) observed that economies will always fall short of their potential, a potential, Kirzner argued, that could be approached with the help of discoverers/entrepreneurs.

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1.2

The Srimner Effect

The informational assumptions are a distinguishing feature of both the neoclassical model and the theory of the EOE. They are embodied in the state space assumed for the model. The assumptions of the neoclassical model are normally tailored such that (1) a unique optimum exists, (2) it can be identified and (3) it can be reached at zero or negligible transactions costs. Convexity assumptions of some sort, of course, have to be imposed to prevent the model economy from exploding or ceasing to exist altogether. The assumption of strict convexity and continuous derivatives ensures that a unique cost minimum, profit maximizing optimum exists.5 Finding it is always possible if the information and communications (transactions) costs needed are (assumed to be) zero or negligible. If transactions costs are large they will have to influence both the position and the existence of the optimum as conventionally defined. And in reality the transactions costs are very large (Eliasson et al., 1985, p. 53; Eliasson, 1990a, b; Bergholm and Jagren, 1985; Pousette and Lindberg, 1986; Wallis and North, 1986). The informational assumptions of the EOE are embodied in its state space or in what we call its business opportunities space. Initially it is assumed to be large and populated with grossly ignorant actors positioned somewhere inside it. The problem, however, is that it has to stay that way for ever for the theory of the EOE not to converge upon the neoclassical or WAD (WalrasArrowDebreu) model. Large transactions costs in the form of business mistakes that escalate the closer you get to a stationary process keep the operating domain of the EOE away from the optimum.6 This is, however, not sufficient for the economy to grow. For endogenous growth to occur this situation has to be for ever maintained and the actors kept grossly ignorant about circumstances that are critical for their business. This can be solved mathematically (Eliasson, 1990b, pp. 46 ff) by assuming the opportunities space to be initially sufficiently large, and that it grows from being explored through innovative discovery and learning. This establishes the positive sum game of the EOE that we call the Srimner effect, and the possibility (the paradox) that in a dynamic EOE actors may grow increasingly ignorant about what is important to them because the business opportunities space grows faster than it can be explored and learned about. In this experimentally organized economy (Eliasson, 1991a, 1996) economic growth will be shown to be moved by innovative project creation and competitive selection, or the Schumpeterian creative destruction process of Table 6.1.7 The capacity of the economic system to identify winners and carry them on to industrial scale production and distribution determines economic growth. Hence, the dynamic efficiency of selection becomes

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Table 6.1

The four investment and divestment mechanisms of Schumpeterian creative destruction and economic growth

Innovative entry enforces (through competition) Reorganization Rationalization or Exit (shut down)
Source: Fretagens, institutionernas och marknadernas roll i Sverige, Appendix 6 in A. Lindbeck (ed.), Nya villkor fr ekonomi och politik (SOU, 1993, p. 16) and G. Eliasson (1996, p. 45).

Table 6.2

Competence specification of the experimentally organized firm

Orientation 1. Sense of direction (business intuition) 2. Risk willing Selection/Flexibility 3. Efficient identification of mistakes 4. Effective correction of mistakes Operation/Efficiency 5. Efficient coordination 6. Efficient learning feedback to (1)
Source: Eliasson, G. (1996, p. 56).

critical for economic growth. The organization of efficient selection and the definition of efficiency in an EOE with no exogenous equilibrium are dealt with in competence bloc theory, of which the theory of the firm can be seen as a special case. Competence bloc theory is presented in this chapter as an integral part of the EOE. Access to the business opportunies space is regulated by institutions that determine the incentives for actors to look for business opportunities there and to compete. In fact, the competence of a firm or an actor is best characterized as in Table 6.2. 1.3 Competence Specification of the Firm in the EOE the Tacit Dimension Table 6.2 represents a typical situation of a firm in reality and in the EOE (Eliasson, 1996, p. 56, 1998a, p. 87). First, no actor, including government,

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can survey the entire economic opportunities space from one point. The assumptions of the economic opportunities space make it impossible for each actor to be more than fractionally aware of its interior structures and contents and notably about what now and then may become critical for survival. Hence, business mistakes will be made by all actors all the time. Such business mistakes, however, also involve learning about the opportunities space and should be regarded as a normal cost for economic development, a transactions cost (Eliasson and Eliasson, 2005). One common form of learning is being confronted with a superior competitor and understanding that for better business solutions than ones own are possible. Second, some actors may hit upon the absolutely best solution by chance, but they will never know, and nobody else will either. Hence, third, the economy will always be operating far below its production possibilities frontier, a violation of a standard assumption of neoclassical theory. In fact, such frontiers may even be indeterminate. Fourth, as a business actor you must always believe in your proposed business experiment. If not, you cannot act decisively and forcefully in dynamically competitive markets. Fifth, however, whatever you have invented, you know one thing with almost certainty: there will be many potential solutions that are much better. Therefore, sixth, you have to recognize that among your many competitors you cannot be alone with such a good idea as yours. The business firm has to act decisively and prematurely on the basis of the competent judgment of its top competent team (intuition, Eliasson, 1990a) before somebody else has acted successfully. Each new solution, therefore, has the character of a business experiment, and the competence of a business firm is well categorized in Table 6.2. The firm in the EOE needs a good business intuition (orientation), it needs to be able to identify and correct mistakes (flexibility) and it needs to be operationally efficient. This is a tall order and all three categories of competencies can neither be embodied in one individual nor be assumed to be more than fractionally communicable between participating actors. They are tacit in the sense of limited communicability (Eliasson, 1990a). This problem of multidimensionality and tacitness of competence characteristics is solved in practice through organization, coordination being achieved to the extent possible by the top competent team of the organization and/or through competition in markets (Eliasson, 1976, 1990a). As demonstrated by Coase (1937), the mix between hierarchy and market is determined by the relative transactions costs of coordination within and between hierarchies, tacitness being one factor pushing for market solutions, dynamic efficiency another (see below). The competence and behavioral characteristics of the firm follow directly from the assumptions made about the business opportunities space and the

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EOE. It is no coincidence, however, that development of this basic idea has grown upon us during many interactions with business firms (beginning with Eliasson (1976) and currently during a study in progress on the economics of health care (. Eliasson, 2007; Eliasson and Eliasson, 2007)) and frequent participation in internal firm educational programs with the purpose of relating the internal life of firms to their external economic environment. In such reality settings you are in a hopeless situation trying to explain how the mainstream neoclassical model can be of any use. 1.4 Macro Dynamics through Experimental Selection Going from Micro to Macro

When something radically new is introduced, it almost always occurs through the launching of a new product, the establishment of a new division or through the entry of a new firm. A new product may be a complement to existing products or a substitute, in the latter case subjecting existing producers to competition and forcing them to reorganize and/ or rationalize, or die (exit). When a competitor introduces a radically new product, a firm often cannot cope with the new situation through reorganization, because it is staffed with the wrong human capital. It then has to contract or shut down, and possibly recruit new personnel to establish a new firm. The entry process, hence, is critical for long-term economic growth, pushing performance of the entire industry upwards through the four creation and selection mechanisms (investments and disinvestments of Table 6.1). But entry will not result in growth unless accompanied by a viable exit process.8 If superior entrants and successfully reorganizing firms (the winners) are supported by the market and allowed to force inferior firms to exit, growth will follow. Hence, the major information cost, again, is business mistakes in the form of lost winners and the losses of inferior firms that are allowed to continue for too long.9 Under normal circumstances, therefore, an economy will be reasonably fully employed and the thrust of firm turnover will be to reallocate resources. Hence, the question of the employment contribution of new firm formation and self-employment is normally irrelevant, and if asked (as in Blanchflower, 2004) it has to be related to a well-defined unemployment situation.10 The optimum or the benchmark for efficiency measurements will be obtained by minimizing the cost of committing the two types of errors in Table 6.3a. Under the opportunities space assumption of the EOE there will always exist better allocations than the current one.11 This optimum, hence, does not exist under the assumptions of the EOE and a unique efficiency reference cannot be determined. With lost winners defining the

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Table 6.3a

The dominant selection problem

Error Type I: Losers kept too long Error Type II: Winners rejected
Source: G. Eliasson and . Eliasson (1996).

potential of the economic system not reached, optimum performance cannot be determined even theoretically, since the benchmark for determining efficiency cannot be identified. One aspect of efficiency, however, is to make sure that the customer, or demand, is a determining force in setting directions. The optimal organization of the economy, hence, is determined by a delicate balancing of decentralized incentives, information processing and competition in markets (Eliasson and Taymaz, 2000). For a successful economic outcome actors and resource providers have to be competently guided and disciplined by signals from the ultimate end users, the customers. The competence bloc performs those functions of guidance and resource provision.

2.

COMPETENCE BLOC THEORY

Critical competencies are tacit in the sense of being limitedly communicable12 (Eliasson, 1990a). While the nature of tacit knowledge cannot be represented analytically, it can be functionally defined. A competence bloc lists the minimum number of actors with such competence that are needed to successfully create, identify, select and commercialize new business ideas and to carry them on to industrial scale production and distribution, that is, to initiate and develop a new industry (Eliasson and Eliasson, 1996). This also confirms that the competence bloc has a pronounced end product or market definition, as distinct from a technical definition, making the customer the ultimate arbiter of economic value. 2.1 The Nature of Business Competence and the Efficiency of Project Selection

Competence bloc theory is structured around three nodes of actors; the customers, the technology suppliers and the commercializers. In between them there are three markets: the markets for products, innovations and factors of production (see Figure 6.1). The commercialization process in turn is intermediated through authority within hierarchies and through three types of asset markets the venture capital market, the private

Competence and learning in the experimentally organized economy

1. Competent customers

111

2. Innovators (technology supply)

Markets for innovation

Commercializing agents 3. Entrepreneurs 4. Venture capitalists 5. Exit market agents 6. Industrialists Strategic Tactial Operational Choose Coordinate Manufacture and subcontract

Source:

Eliasson (2005a, p. 255).

Figure 6.1

Decision structure of the competence bloc

equity market and the market for strategic acquisitions and through the regular stock markets. Trading in intangible knowledge assets, however, poses particular property rights problems that we come back to in Section 3 below. The different functions of the actors in the competence bloc can be identified as relay stations in the innovation, creation and commercialization processes and are needed as a minimum. Sometimes they are all internalized within one hierarchy or in a planned economy. This was almost the case for IBM during its heyday in the 1970s (Eliasson, 1996, pp. 175ff). IBM was then to a large extent its own customer in intermediate products. Normally, however, most functions are carried out by specialized actors in the market; call them firms. The determination of the mix between market and hierarchy within the competence bloc not only becomes a Coasian (1937) type dynamic theory of the firm but also determines the dynamic efficiency of the entire economy (Eliasson and Eliasson, 2005). The efficiency of project selection in terms of identifying and supporting (commercializing) winners and forcing the exit of losers, as intermediated through the competence bloc (first crudely sketched in Eliasson and Eliasson, 1996), determines the efficiency of resource allocation and growth through the Schumpeterian creative destruction process of Table 6.1. Efficient selection in the EOE is defined as the minimizing of the economic incidence of two types of errors (Table 6.3a), that is, keeping losers on for too long and losing the winners. This minimization can, however, only be performed analytically if the business opportunities

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space of the model can be made fully transparent from at least one central point, all information and communications costs kept very small, and all winners identified. The presence of critical tacit and incommunicable knowledge in the decision process makes this theoretically impossible in the EOE. The optimal coordination of production has to be organized as an endogenously determined combination of hierarchies (firms) and markets. The limits of hierarchies are determined where the costs on the margin in the form of lost winners exceed the gains in coordination costs achieved through expanding the hierarchy. The mechanism behind this determination is simple. Centralizing knowledge at one point and ordering outcomes top-down through authority is limited (1) to the part of knowledge that can be coded as information and interpreted centrally at a determinable transactions cost and (2) by the reach of and power to impose authority (compare Simon, 1945; Williamson, 1975; Foss, Chapter 5 in this volume). If that centralization is extended to the parts of the total knowledge (probably the most important parts) that are tacit and not communicable to the intelligence center (the corporate headquarters) of the firm, an error bias in the central analysis will be introduced because some of it will be misinterpreted along the way, owing to a lack of receiver competence (Eliasson, 1976). This can be shown to reduce the total knowledge that enters each decision. Distributing tacit knowledge (or human or team embodied competencies) over the market, on the other hand, can be shown to maximize the exposure of each project to a competent evaluation, and minimize a transactions cost measure that includes an economic value of the loss of winners (Eliasson and Eliasson, 2005).13 Competence bloc theory, hence, is an organizational solution to the efficient allocation of tacit, human embodied competencies on business problems. If economic competence consists significantly of tacit knowledge, the same characteristics must also apply to consumer choices. If consumer choices are experience based tacit knowledge, exhibiting preferences for novelty, convergence on an exogenous optimum can in no way be guaranteed (Day, 1986b). The (also experience based) competence of all actors of the competence bloc to visualize the unpredictable change in consumer preferences, however, should to some extent keep the economic system from becoming erratic, as proposed by Georgescu-Roegen (1950) and modeled by Benhabib and Day (1981). The competence of the customers to appreciate quality and the competence of firms to produce new qualities go hand in hand. The perhaps most important quality demanded in an advanced market, furthermore, is product or quality variation.14 Only the customers can individually decide which variant they prefer. One critical function of the competence bloc,

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hence, is to make sure that customers preferences and competencies filter down to the actors in the competence bloc that create and select innovations. Customer receiver competence (Eliasson, 1990a) is decisive for the existence of a market. With no customer receiver competence for sophisticated products there will be no market for the same products. 2.2 The Actors in the Competence Bloc

First, the products created and chosen in the experimental process never get better than what customers (item 1 in Table 6.3b) are capable of appreciating and willing to pay for. The long-term direction of technical change, therefore, is always set by the customers. Sophisticated customers define a competitive advantage of a sophisticated industry.15 Without competent customers there are no sophisticated markets. This is so even though the innovator, entrepreneur or industrialist may take the initiative to launch a new sophisticated product. But quite often the customer takes the initiative. Technological development, therefore, requires a sophisticated customer base, capable of appreciating new products (Eliasson and Eliasson, 1996). The more advanced and radically new the product technologies, the more important customer quality becomes. In one sense, the customer analysis of competence bloc theory opens up the Keynesian macro demand schedule. But as you peek inside that black box you will find that the customer dynamic of the competence bloc has little to do with Keynesian demand. The actors of the competence bloc contribute (commercial) competence in the technological choice process. They accept or reject products offered to them in the market, thereby signaling what they want. But customers may also be directly involved in some phases of the development of the product. This is normally the case when it comes to very advanced and complicated products such as military and commercial Table 6.3b
1.

Actors in the competence bloc

Competent and active customers

Technology supply 2. Innovators who integrate technologies in new ways Commercializion of technology 3. Entrepreneurs who identify profitable innovations 4. Competent venture capitalists who recognize and finance the entrepreneurs 5. Exit markets that facilitate ownership change 6. Industrialists who take successful innovations to industrial scale production
Source: G. Eliasson and . Eliasson (1996).

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airplanes (Eliasson, 1995, 2001b). This fact also serves as a rationale for competent purchasing and acquisitions, including public purchasing in areas where goods and services are supplied by public authorities. Second, technology supply is internationally available, but the capacity to receive it and make a business of it requires local competence. Part of this receiver competence (Eliasson, 1987b, 1990a, 1996, pp. 8, 14) is the ability to create new winning combinations of old and new technologies (innovation). A rich and varied supply of subcontractor (technology) services is part and parcel of the innovation process and the competence bloc. The innovation gate into the competence bloc (item 2 in Table 6.3b), hence, is served by many technologies, or technological systems to use the terminology of Carlsson (1995), that are integrated innovatively. Third, technology supply is not synonymous with industrial progress or growth. In between comes the competence to commercialize new technologies, a far more resource demanding activity than innovation. So between innovation supply and commercialization, representing the demand for innovations, we find the market for innovations in which winners and losers are sorted out (see Figure 6.1). The problem with new growth theory and evolutionary theory is that they do not distinguish between the innovator, the entrepreneur and the competent venture capitalist, and hence do not model that sorting process. Commercialization competence is experience based and, hence, more narrowly defined than the creative innovation supply process (Eliasson and Eliasson, 2005).16 As a consequence there will always (ex definitione) be a loss of winners along the way. By explicitly modeling the commercialization process we break the linearity between innovation supply and economic growth commonly entered as a prior assumption in the different versions of new growth theory and in evolutionary theory. We find that increasing supplies of technology do not lead to faster growth and that growth can be radically increased on a sustainable basis under improved commercialization at given technology supplies.17 First among the commercializing agents come the entrepreneurs. The task of the entrepreneur is to identify commercial winners among the suppliers of technically defined innovations and to get his/her choice of technology on a commercial footing.18 The understanding may be of a long-run nature, or more temporary in the sense that entrepreneurs may have to reconfigure their thoughts soon, or make a business mistake (see Table 6.2). The main thing is that the entrepreneur acts on the perceived economic opportunity (entre prendre in French). A brief sidestep here. New growth theory is a sub-branch of neoclassical theory and neoclassical theorists tend to order their assumptions such that entrepreneurship has no economic role beyond innovation or technology supply. Innovation supply, furthermore, is commonly represented

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as drawings from a lottery, the participation in which is free of charge. This process, furthermore, is staged within a rational expectations setting or as a stationary process such that the differences between ex ante plans and ex post outcomes cancel out in expectation over time as white noise. A stochastic exogenous equilibrium can be defined. On this the Swedish economic tradition, heralded by the Stockholm School economists, takes a contrary position, more in line with Austrian economics and us (see Eliasson, 1992, p. 256).19 The enormous and varied expanses of the business opportunities space of the EOE, which keeps opening up new vistas as a consequence of its exploration by the entrepreneurs, make the assumptions of the mainstream neoclassical model empirically unreasonable. The mathematical reason is that the underlying structures of the assumed stationary process change constantly, radically redefining the distributions.20 This means that the standard assumptions of statistical learning do not hold.21 Learning under item 6 in Table 6.2 becomes unreliable. The entrepreneur, however, rarely has resources of his own to move the business project forward. He, therefore, (fourth) needs funding from an industrially competent venture capitalist, that is, a provider of risk capital, capable of understanding innovators of radically new technology and able to identify business needs and provide context. The money is the least important thing. What matters (Eliasson and Eliasson, 1996; Eliasson, 1997b, 2005c) is the competence to understand and identify winners and, hence, provide reasonably priced equity funding.22 There is an asymmetry problem here that relates to the risk willingness item in Table 6.2. The entrepreneur believes s/he has understood the business situation (business intuition, item 1).23 S/he therefore considers the risks low and is willing to take them on. The outsider, for instance the venture capitalist, does not have the same insight, and therefore considers the same situation more, usually much more, uncertain. Implicit in this statement is that the industrially incompetent venture capitalist does not understand the project and, therefore, charges an unreasonable (to the entrepreneur) price for his/her services. The supply of industrially competent venture capitalists is extremely scarce (Eliasson, 1997b, 2005c). They constitute the critical link in the overall selection process and, if lacking in performance, this is liable to result in the loss of winners. The issue of competent venture capital has long been politically sensitive in some European countries since it signals the need for privately rich and industrially competent people to move new industry formation. Such signals run counter to political ambitions to even out income and wealth distributions. The low rate of new entry in continental European countries, including Sweden (Braunerhjelm, 1993), can have two explanations; low

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entrepreneurial competence or lack of competent venture capital. The argument in Sweden for a long time focused on the lack of entrepreneurial spirit. It was often heard from banking circles that there was plenty of money but very few good projects to invest in. The most credible explanation, however, (Eliasson and Eliasson, 1996; Eliasson, 2005c) has been lack of industrially competent bankers and venture capitalists. Without a rich variety of such financial competence, you will not see many entrepreneurs. Hence, the venture capitalist and his escape (exit) market (fifth) are the most important incentive supporting actors. With no understanding venture capitalists the price of new capital will be prohibitively high, or funding will not be forthcoming, and winners will be lost. With badly functioning exit markets the incentives for venture capitalists will be small and, hence, also for the entrepreneurs and the innovators. With the rapid securitization of the global financial system the markets for ownership or corporate control have gained in importance (Rybsczynski, 1993). New actors have emerged trading in risks and the exit markets have gained in sophistication and importance as private equity investors with the capacity to mobilize very large financial resources have entered the scene. In growing markets for strategic acquisitions small high technology firms and large industrial firms (item 6) are trading in knowledge assets. Sixth, and finally, therefore, when the selection process has run its course and a winner has been identified, a new type of industrial competence is needed to take the innovation on to industrial scale production and distribution. We cannot tell in advance what the formal role of the industrialist is (CEO, chairman of the board, an active owner, or other). He or she figures in the competence bloc on account of his or her capacity to contribute functional competence. The capacity to identify, select and move winners to industrial scale production is the most important growth promoting property of the competence bloc. It defines a competitive advantage of an economy. This innovative dynamic is what endogenizes growth in the theory of the EOE. Vertical completeness of the competence bloc, hence, is a necessary requirement for the viable incentive structures that guarantee increasing returns to a continued search for winners, that is, for new industry formation. The extreme diversity of the opportunities space of the EOE means that the competence needed to identify winners cannot be specified in advance. Hence, an efficient project identification and selection in the competence bloc requires that a large number of each type of actor in the competence bloc be present, so that if one actor does not understand there will be others who might. Such horizontal diversity in competence is a necessary condition for maximum exposure of each project to a competent

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evaluation. Vertical completeness and horizontal diversity make the competence bloc complete. Seeing to it that the competence blocs are complete must, therefore, be the prime task of industrial policy (Eliasson, 2000). None of the pillars (the actors) of the competence bloc can be missing, or the whole incentive structure will fail to develop. In the EOE a premium is placed on flexibility. Actors all the time have to take premature decisions on scant and unreliable information. As a consequence they constantly commit more or less serious business mistakes and have to be prepared to change their minds constantly. Flexibility in the EOE is achieved in three ways. First, and most important, is to have the right business idea (item 1 in Table 6.2). Second, and decisive when you are on the wrong track, is early identification and correction of mistakes (items 3 and 4). Third, when the first two criteria fail, the competence bloc enforces flexibility through exit by withdrawing support. But this occurs only after the project has been exposed to a varied and maximum competent evaluation, thus minimizing the risk of losing a winner. The more widely distributed over the market the competence bloc, the more flexible the allocation process. When vertical completeness and sufficient horizontal variety have been achieved, critical mass has been reached. Then: (1) (2) Increasing returns to continued search for resources prevail. The loss of winners is minimized. Competition among all actors in the competence bloc for the gains that otherwise will be lost as lost winners ensures that less competent actors exit.

The competence bloc will now function as an investment attractor such that new entry takes place in such a way that the competence bloc benefits from the new entrants, but (because of competition) only new entrants that contribute to the competence bloc enter and/or survive. The competence bloc then functions as an industrial spillover generator and will begin to develop endogenously through its internal momentum (critical mass). We have a positive sum game. These spillovers will diffuse along many paths and both further reinforce the internal development forces of the bloc and contribute serendipitously to other related and unrelated industries. Endogenous growth will occur (Eliasson, 1997a). 2.3 The Theory of the Firm Revisited

Compared with the internal project evaluation in a large firm, project evaluation over the competence bloc draws much larger direct transactions

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costs, since the evaluation is done in a distributed fashion involving many independent actors in the market. Narrowing down the evaluation to an internal procedure within a hierarchy, therefore, may lower direct transactions costs, but the more narrow evaluation also raises the risk of losing winners and therefore both raises total transactions costs and lowers the efficiency of project selection. Hence, a relevant analysis of the optimal organization of production has to include the loss of winners as a transactions cost (Eliasson and Eliasson, 2005).24 A large firm, such as IBM in the 1980s, internalized most of its competence bloc. For a long time IBM was unable to get out of its mainframe mentality due to lack of internal experience from the new industrial markets of distributed computing and came close to disaster during the last years of the 1980s, during its attempts to transform itself away from mainframe technology. Business history is full of near losses based on narrow-minded internal business judgment in large hierarchies, the only ones that can be identified (Eliasson, 1996). The contrary solution with all functions distributed over the market, however, has other problems, even though Fama (1980) argued that there was no need for an entrepreneur in economic theory, since the services of the entrepreneur could always be rented in the market. Most of economic literature and debate, furthermore, neglects the commercialization competence altogether and we have a neo-Schumpeterian literature that comes very close to neoclassical literature in presenting the firm or an industry as a direct linear R&D, technology supply and growth machine. And socialist thinking on the matter has been even more negligent in understanding any merit in the competitive functions of markets. Competence bloc theory has no role to play under the assumptions of the static general equilibrium (neoclassical) model in which all knowledge has the qualities of codable and communicable information that can be centralized to one place for a complete overview. Competence bloc theory, however, has a decisive role to play in project selection within and between hierarchies when tacit, non-codable knowledge embodied in individuals and hierarchies has to be mobilized within hierarchies and through markets. Once this has been said, we know that the nature and distribution of knowledge determine the optimal combination of hierarchies and markets through which the total knowledge base can be mobilized for particular business problems. We have a dynamic version of Coases (1937) theory of the firm in which the hierarchical structure of markets is not only endogenized as an equilibrium property but also changes as a consequence of the constantly ongoing project selection in an experimentally organized economy. In that setting the critical task of the top competent team of a firm

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is to identify the best organizational structure for the particular business problem at hand (Eliasson, 1990a). Since that structure constantly changes, new organizational structures constantly have to be identified. This is not at all easy and management mistakes are constantly made. Hence, learning feedback (item 6 in Table 6.2) is limited. Such limited learning possibilities are typical of the theory of the EOE. It has also been a typical experience in the recent ongoing outsourcing business culture (Eliasson, 2005d). A systematic test of the limitations of business learning is presented in Eliasson (2005b) in which business planning and management methods during and between the three periods of post-World War II development are compared: (1) the pre-oil crisis steady state experience of 196975, (2) the post-oil crisis sobering-up through most of the 1990s and (3) the rapid emergence of globally distributed production from the mid 1990s, blurring the notion of the firm/hierarchy to be managed. In general, management experience did not carry over reliably between the periods, and business mistakes occurred on a grand scale during those transitions. Furthermore, distributed production and unstable hierarchies undermine the whole notion of the central authority of a corporate headquarters (Eliasson, 2005a, Chapter V). Top-down push-through of orders does not work when the hierarchy responds by changing its structure. This problem of endogenous hierarchies or organization poses the same analytical problem as that discussed already by Wicksell (1923), mentioned above, and provides a rational argument for integrating the theory of organization with that of allocation.25 Through the early 1990s Sweden featured an extreme concentration of historically grown and successful large-scale and international manufacturing companies. For decades this was considered synonymous with an equally rich endowment of business leadership competence that could be carried over from generation to generation (Eliasson, 1990b, 2005b). To some extent this was of course true, but this competence had been acquired in traditional mature industries that innovate slowly. The management of innovation in the new type of industries like biotech is radically different from that in mature industries such as engineering. Experience is that leadership competence acquired in traditional industries is of limited use in the radically new industries and sometimes outright dangerous to apply. The learning feedback (item 6 in Table 6.2) is correspondingly unreliable (Eliasson, 2005b). For some reason the large Swedish companies exhibited unusual organizational innovation capacity coming out of the oil crises of the 1970s and carrying Swedish manufacturing growth in the 1980s, but it was concluded in Andersson et al. (1993) that this was a story that no one should count on to be repeated. True enough. When Swedish industry entered the New Economy of globally distributed production during the

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second half of the 1990s the giants began to stumble, presumably because the earlier management experience was not a reliable management guide into the future (Eliasson, 2005a). Presumptuous big business leaders who enter radically new businesses with an air of authority, therefore, may even be a negative factor for development. Hence, Swedish manufacturing industry perhaps no longer features the rich and varied competence blocs needed for the efficient project selection that worked well for decades but does not seem to work at all that well as we currently attempt to enter a radically New Economy.

3.

INSTITUTIONS, TRADE IN PROPERTY RIGHTS AND SOCIAL CAPITAL/COMPETENCE

Project selection over markets always involves trade in knowledge assets between actors in a competence bloc. Competence bloc theory explains those transactions explicitly, why large resources (transactions costs) are needed and why transactions competence is critical for dynamically efficient allocations in the theory of the EOE, but not in the mainstream neoclassical model. We therefore have to relate the competence bloc theory just introduced back into the economic environment of the EOE. 3.1 Institutions, Incentives and Competition

None of the economic dynamics discussed so far can occur without a minimum of supporting institutional infrastructure needed to establish the required tradability in knowledge assets. Institutions define incentives to act on business opportunities that fuel competition. In general, if complete contracts that define the transfer of ownership associated with trade cannot be formulated, trade will be correspondingly limited and undersupply will follow (Williamson, 1985). Resource allocation in the experimentally organized economy involves trade in intellectual property rights across the competence bloc, notably throughout the markets for venture capital, the exit markets and the markets for strategic acquisitions on its commercialization side. For the full macroeconomic growth potential of innovative project creation and selection in Table 6.1 to be realized, this trade will have to occur with a minimum of risks and transactions costs. For this to be realized property rights to these intellectual assets have to be well defined. Those property rights are not needed for the same transactions to be organized within a hierarchy. For all projects to be exposed to a maximum competent evaluation over the competence bloc, efficient property rights of this kind thus have to be in place. Only then will the relative

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superiority of the broad market exposure of competence on each project be fairly compared with the narrow exposure within a hierarchy, and the key factor will be the tradability of intangible knowledge in financial asset markets (Eliasson and Wihlborg, 2003). 3.2 Social Capital/Competence

Competence bloc theory has been shown to be needed to explain the efficiency of project selection in the EOE. Under the informational assumptions of the EOE, the selection and allocation processes supporting stable economic growth at the macro level become unpredictable and socially demanding at local micro levels. This suggests that the overriding welfare and policy concern should be to design institutions that support the ability of individuals to cope with environmental unpredictability and the exposure to arbitrary change that increases with economic efficiency and growth (Day, 1986a, 1993, notably p. 77; Eliasson, 1983, 1984). This suggests that what we call social capital should be defined in terms of how it supports individuals ability to cope (Eliasson, 2001a)26 and in doing so we also recognize that the support of social capital development becomes a critical part of both industrial and social policy, to be elaborated in another context (Eliasson, 2000, 2006b).

4.

ENDOGENOUS GROWTH THROUGH COMPETITION THE DYNAMICS OF GOING FROM MICRO TO MACRO AND BACK

Endogenous growth in the theory of the EOE is explained with reference to the Schumpeterian creative destruction process of Table 6.1 and how it works in the Swedish micro-to-macro model (Eliasson, 1991a, 1996, p. 45). Competition there keeps the entrepreneurial and commercialization processes in motion and the Srimner innovation/learning effect keeps the investment opportunities space expanding to sustain growth. But competition has to be activated. It may be prohibited or regulated. Actors may enjoy monopoly conditions and earn more by colluding than competing. Incentives to compete are therefore not sufficient to activate competition. The rational foundation of endogenous growth through the Schumpeterian creative destruction process of Table 6.1, therefore, has to explain why each actor in a market of the EOE constantly has to innovate and improve its performance, or perish. The reason is that each actor lives in a constant state of fear of being overrun by new and old competition. The opportunities space or the Srimner effect combined with unrestricted

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The theory of the firm from an organizational perspective 55 50 45 40 35 30 25 20 15 10 5 0 5 10 15 20 25 0 10

Rate of returns (percent)

1990

1983

20 30 40 50 60 70 80 Cumulative capital stock (percent)

90

100

Note: The vertical columns show the position on the Salter curve of one firm, the width measuring its size in percent of total industry capital. Source: MOSES Database (1992) and updatings.

Figure 6.2a

Salter curve distribution of rates of return on total capital in Swedish manufacturing in 1983 and 1990

free entry keeps experimental exploration of the opportunities space active as a necessary means of survival. The rationale for this is that each actor is constantly challenged in the market, from above by superior (more profitable) competitors that can pay more for factors of production or lower prices, and from below by inferior firms that have to innovate and leapfrog superior competitors to prevent them from competing them out of business. The Salter curves (1960) in Figures 6.2a and 6.2b illustrate how this endogenization of growth has been specified in the Swedish micro-to-macro model (Eliasson, 1977, 1985). The Salter curves rank firms (or divisions of large firms) in Swedish manufacturing industry in 1983 and 1990 by returns to capital and labor productivity. It is part of the micro database used to initiate simulations on the Swedish micro-to-macro model. The spread of the Salter distributions illustrate the great opportunities for improvement

Competence and learning in the experimentally organized economy

Labour productivity 650 600 550 500 450 400 350 300 250 200 150 100 50 0 0 10 20 30 40 50 60 70 80 90 100 Percent 1983 1990

123

Note: The columns indicate the same firm as in the previous figure, the size now being measured in percent of total employment. The shaded areas measure unused capacity for each firm. Source: MosesDataBase (1992) and updatings.

Figure 6.2b

Salter curves of labor productivities in Swedish manufacturing in 1983 and 1990

in macro performance through reallocation of resources. This reallocation can be set in motion through competition. The firm is indicated by a column, its width measuring its size in percent of the total capital or the total employment of the firm population. This firm is challenging the less profitable or productive firms to the right, by being able to outbid them for resources. But these firms being challenged also challenge the firms to their left by attempting to leapfrog them through innovation and investment. The Salter curves in Figures 6.2a and 6.2b are snapshots at one point in time. At each point in time entrants wait behind the scene. New entrants on average exhibit lower performance than incumbents, but the spread is much wider. This is empirically well established. Hence, there will always be a few winners in the entry flow of firms that survive and grow into major players, provided the local commercialization competence is sufficient. The underperforming entrants are sooner or later competed out of business.

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The outcome for the firm indicated in Figure 6.2a in 1990 has been an improvement in profitability, but a loss in ranking. As a consequence the Salter curves ranking productivities in Figure 6.2b shift outward. Growth occurs. For this competitive process, spurred by fear, to be sustained and result in sustainable growth it is, of course, possible to introduce the standard stochastic innovation lottery that are commonly found in the new growth models. We have done that in the Swedish micro-to-macro model (Hanson, 1986, 1989; Taymaz, 1991), but a more satisfactory solution is to model the innovation process explicitly by making it possible for firms to learn to upgrade their productivity from superior competitors when exploring the opportunities space and to model creative encounters during that exploration which create new and superior combinations that in turn expand the opportunities space and open possibilities for others to discover and learn from, and so on. This Srimner creativity process has been based on the Ballot and Taymaz (1998) genetic learning mechanism in the model. The distributions that define innovation supplies will then be endogenously determined, explicitly derived and deterministic, and not entered as an assumed stochastic process as in Aghion and Howitt (1992, 1998), Pakes and Ericson (1998) and Nelson and Winters (1982) evolutionary model (on the last see in particular Winter, 1986). Competence bloc theory in combination with Ballot and Taymaz (1998) has made it possible to avoid the less satisfactory approach of modeling the source of economic development as draws of productivity gains in a given lottery (from a stationary distribution) that represents the combined outcome of innovators, entrepreneurs and venture capitalists, a lottery that does not even charge you for your participation and that is presumably organized by the state. Our approach is still a crude approximation of what we aim for, focusing on the role of industrially competent venture capital provision (Ballot et al., 2006), but it is sufficient to overcome the logical but false linearity between innovation supply (through the lottery) and economic growth27 that shortcircuits the commercialization process in new growth literature.

5.

ALLOCATION AND ECONOMIC GROWTH

The Schumpeterian creative destruction process of Table 6.1 does not guarantee macroeconomic growth. Destruction may dominate over creation for considerable time and with permanent long-term consequences. Reorganization of firms (item 2) might very well be guided by caution and mistaken perceptions and result in a general contraction of output among firms. The main thing is that institutions are organized such that

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winners are created and identified in the competence bloc and carried on to industrial scale production and distribution, while losers are pushed out. In the Swedish micro-to-macro model (Eliasson, 1991a), choice algorithms determine the decisions of individual firms in this respect. Since the competence bloc not only creates, identifies and selects winners but also supports winners by directing (financial) resources to them, this also illustrates the role of the competence bloc, not only as a creator and an identifier of winners but also as an organizer of the allocation of tacit, human embodied knowledge, and as a financial resource provider. Since all actors in the competence bloc embody a rich variety of tacit competencies, the competence bloc becomes an allocator of its own competence. The competence bloc becomes the core resource allocator in an EOE. 5.1 Technological Diffusion

The diffusion of new technology as directed by the competence bloc occurs along six distinct channels (Table 6.4): (1) when people with competence move over the labor market, (2) through the entry of new firms when people with competence leave established firms, (3) through mutual learning between subcontractors and the systems coordinator, (4) when a firm strategically acquires other firms to integrate their particular knowledge with its own competence base, (5) when competitors imitate the products of successful and leading firms (the Japanese approach), and (6) through organic growth of and learning in incumbent firms. Items 3 and 4 are particularly important for the advanced mature industrial economies. Some of them, but not all of them, have the capacity to develop and produce very advanced and technologically complex systems products such as aircraft, submarines and large trucks. Such products embody so many different technologies that change rapidly and so many Table 6.4
1. 2.

New technology is diffused

when people with competence move (labor market) through new establishment by people who leave other firms (innovation and entrepreneurship) 3. when subcontractors learn from the systems coordinating firm, and vice versa (competent purchasing) 4. through strategic acquisitions of small R&D intensive firms (strategic acquisitions) 5. when competitors learn from technological leaders (imitation) 6. through organic growth and learning in incumbent firms
Source: G. Eliasson (1995).

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specialist components that it is impossible to develop and produce them within one company. Both development and manufacturing have to be distributed over subcontractors in the market (Eliasson, 2001b). All actors have to understand how to operate as a sophisticated participant in the whole. Hence, mutual learning within such a systems product complex is an important part of the technological diffusion process of the very advanced economies.28 One observation can be made from a close study of Table 6.4: efficient diffusion of new technology requires effective market support, notably in the labor market (item 1 in Table 6.4) but also in the venture capital market and the markets for mergers and acquisitions (M&A) (Eliasson and Eliasson, 2005). Completeness of the competence bloc again becomes a critical requirement for the introduction of radically new technology. Efficient diffusion is also a necessary condition for spillovers and competence bloc development, but it is not sufficient. For new technology to be introduced in production receiver competence (Eliasson, 1987b, 1990a) is needed. Entrepreneurial and venture capital competencies are part of this, but the general and rapid introduction of new technology also requires a varied and competent labor force at all levels (workers, engineers, managers and executive people). 5.2 The Informational Assumptions Revisited

The distinguishing features of the theory of the EOE hinge on its informational assumptions. Under the assumptions of the EOE, tacit knowledge or competence in the sense of limited communicability can be shown to exist (Eliasson, 1990a). The coordination of actors guided by tacit competencies can never be perfect. It is costly, the largest cost being not resources used directly in information processing but the profits lost when business mistakes are being committed.29 It also involves the selection and coordination of tacit competencies for the same coordination, a task that unavoidably leads to an infinite regress and no determinate best or optimum outcome (read exogenous equilibrium). A competence bloc, hence, can also be defined as an organization of institutions and actors with (tacit) competence such that incentives and competition contribute to as efficient an allocation of total resources as is possible. This includes the allocation of the tacit competencies embodied in the actors. Hence, under the informational assumptions of the EOE, the best possible allocation cannot be determined. There will always be unknown better allocations. This conclusion only requires our assumption of an immense, non-transparent business opportunities space, an assumption30 that places us, and the EOE, in the early Austrian tradition of Carl

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Menger (1871), who emphasized the ignorance of actors and the frequent incidence of business mistakes (Alter, 1990). It may be considered presumptuous to modify the standard informational assumptions of mainstream economic theory such that the allpowerful mathematical tool of calculus appears to be rendered useless. But there are good reasons. First, it is easy to quote a massive empirical evidence in favor of the assumptions of the EOE. Second, attempts to penetrate the inner mechanics of new growth models, such as Pakes and Ericson (1998), that are based on a Walrasian, Arrow and Debreu (1954) type equilibrium platform tell a story that is not less complex than the story of the EOE or the mathematics of its model approximation, MOSES. A possible objection might, however, be (third) that, even though not correct, the informational assumptions of the neoclassical model work well as a reasonable approximation and generate good predictions in the spirit of Friedman (1953). Of what? It is difficult to find good examples. However, fourth, a reasonable argument for being methodologically conservative is that one might as well keep the familiar mathematical tool box until someone has come up with something better (Clower, 1986).31 Now, that has been done and it appears that the properties of the theory of the EOE that are obtained after some marginal modifications of the assumptions of the WAD model require simulation mathematics in order to be satisfactorily investigated. Removing the devotion to calculus in economics would therefore help make way for the powerful simulation tool and more relevant economic theory, a prediction voiced about fifty years ago by Koopmans (1957, p. 174).

NOTES
1. This chapter merges the theory of the experimentally organized economy (EOE) (Eliasson, 1991a) with that of competence blocs (Eliasson and Eliasson, 1996). The theory of the EOE has grown out of many years of experimenting with the Swedish micro-to-macro model (Eliasson, 1977, 1991a; Albrecht et al., 1992, Ballot and Taymaz 1998) to the extent that the model should now be seen as will be explained in the text as a quantitative approximation of the theory of the EOE. As such the text is very empirical and based as well on several hundred interviews carried out by one of us, or the two of us together, and on analyses of data assembled for the model (see Albrecht et al., 1992). To keep the theory of the EOE and its model approximation in the sustainable Austrian/Schumpeterian state that distinguishes it from the standard neoclassical model, certain assumptions relating to the nature of the state space of the model (its size, complexity and heterogeneity) have to be made. From the pig in the Viking sagas that was eaten for supper in Valhalla, only to return the next day to be eaten again, and so on. The difference from the situation in Valhalla, which we make a point of, is that the opportunities space not only stays large; it grows from being explored. We are confronted with a positive sum game. By being concerned

2.

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not only with the neoclassical problem of how to manage a given endowment of scarce resources but also with the Aristotelian problem of how resources are created, we face the positive sum game of the EOE that endogenizes growth (Eliasson, 1987a, p. 28f, 1990b, p. 46f). During the year 2007, when the 300th year birthday of the Swedish botanist Linnaeus was celebrated, it felt appropriate to mention (Frankelius, 2007) that Linnaeus, in his until now not translated (from Latin), but frequently quoted, main work Systema Naturae Sive Regna Tria Naturae Systematice Proposita Per Classes, Ordines, Genera & Species (Leyden, 1735), considered economics to be the greatest of all sciences. And his concern was to create economic value through exploration of, and discoveries in, nature. The Nirvana complex has a long history. In his Candide (1759) Voltaire poked fun at Leibnitzs vision of the best of all worlds. Leibnitz, by the way, laid the foundation of the mathematics used by neoclassical economists today. To the extent that they can be determined. Hence, starting from any place, as long as you walk uphill you will eventually reach the peak. There are hundreds of mathematical algorithms that approximate that task in economic modeling. This feature of the EOE has been investigated on a quantitative micro-based macro model of the EOE in which structures and prices are simultaneously determined in an interactive fashion, using up transactions resources in the process. In static equilibrium that can only be achieved under very restrictive assumptions, notably zero transactions costs, duality prevails and prices reflect exactly quantities, and vice versa. The further away from static equilibrium, the more unreliable prices are as signals of future optimum quantities and the more frequent and larger the mistakes. If you push the economy closer to an approximate equilibrium the entire model structure is destabilized and eventually collapses (Eliasson 1991a; Eliasson et al., 2005). The theory of the EOE is not structured as a mathematical model. The micro assumptions, therefore, can only be linked to macro through verbal reasoning. The Swedish micro(firm)-to-macro model (Eliasson, 1991a), on the other hand, is a mathematical model that can be said to approximate the EOE. Common to both, and the source of endogenous growth, is the dynamic of the Schumpeterian creative destruction process of Table 6.1. In fact, the theory of the EOE was inspired by experimenting with that model (Eliasson, 1987a). This reasoning can be nicely illustrated using a Salter (1960) curve; see Figures 6.2a and b in Section 4, and Eliasson (1991a, 1996, p. 44f). This is also the way growth occurs in the Swedish micro-to-macro model (Eliasson, 1991a), which is based on empirically determined Salter curves and firms constantly shifting position on the Salter curves as they are induced by incentives and pushed by competition. Competence bloc theory explains how this competitive process can be organized differently and more efficiently. It is particularly important to observe that innovative entry subjects incumbent firms to competition and forces them to respond. Their response in the form of reorganization and rationalization may mean either expansion or contraction, depending upon incentives embodied in the institutions of the economy and the individual competence capital of firms. Growth through competitive experimental selection through innovative entry is explicitly modeled in the micro-based macro Model Of the Swedish Economic System (MOSES) (Eliasson, 1977, 1985, 1991a) in which learning costs through business mistakes are explicit. The early, simple expectations functions have been complemented with genetic learning mechanisms in Ballot and Taymaz (1998). Which may be a relevant situation for continental Europe where such a large number of people are prematurely retired, on sick leave or outright unemployed, but much less in the US where growth to a larger extent occurs through the reallocation of employed people (G. Eliasson, 2006a, b). This is the case in the Swedish micro-to-macro model (Eliasson, 1977, 1991a) which approximates the EOE. Whatever output trajectory over the long run that you simulate, you can be fairly sure that better outcomes exist.

3. 4. 5. 6.

7.

8.

9.

10.

11.

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12. 13.

129

14. 15. 16. 17. 18.

19.

20.

21.

22. 23. 24.

25.

Most definitions of tacit knowledge are much broader than this. For our purpose, however, this narrow definition is sufficient. A broader definition will only strengthen the empirical implications of our analysis. Note that this is the exact opposite conclusion to the standard view of the Walras ArrowDebreu model, in which the Walrasian superauctioneer is assumed to be capable of achieving a complete and costless central overview of the entire economic landscape, and to identify the one superior position of the economy that is there by assumption for instance as modeled by Malinvaud (1967). This constitutes a second information paradox of economics referred to earlier, namely that we are becoming less and less informed about what is becoming more and more important, namely the quality of inputs and outputs (Eliasson, 1990b, p. 16). As pointed out already by Burenstam-Linder (1961). Burenstam-Linder, however, carried out his argument in terms of static international trade theory and called it comparative advantage. On this Granstrand and Sjlander (1990a, b) observe that a broad internal technology base makes the firm more efficient in acquiring and implementing new complementary knowledge, for instance through the acquisition of innovative technology firms. This was a property of the Swedish micro-to-macro model as early as Eliasson (1979, 1981) when the property was discovered as part of a crudely modeled commercialization process. This distinction between the innovator and the entrepreneur originated in Mises (1949). Schumpeter was not clear on this and often used the term innovator to signify what we mean by an entrepreneur. With our definition we do not need the third concept, the inventor, which Schumpeter frequently used to emphasize the technical dimensions of an innovation. Stationarity means that distributions have constant (over time) mean and variation. A stationary process will keep generating data such that the parameters of the statistically defined entrepreneur will eventually be known for sure with any precision desired. Besides being an absurd representation of the entrepreneur, it has been demonstrated that such statistical learning requires a hopelessly narrow specification of the state space, expressed as a stationary process, to allow any learning at all (Lindh, 1993). In a huge Las Vegas gaming hall la Rothschild (1974) the analogy would be each actor rushing around between the one-armed bandits using his or her personal criteria to change console. Even though each bandit is governed by a particular stationary process for ever, the activity going on in the entire gaming hall (the market) cannot be approximated by a stationary process that does not change over time. Which are identical to those of rational expectations and efficient market theory. Antonov and Trofinov (1993) demonstrate how simple statistical learning through forecasting a non-linear environment with linear economic prediction models of a standard Keynesian or neoclassical type produces worse macroeconomic outcomes than the use of completely ad hoc individual experience-based relationships. The venture capitalists also contribute managerial, financing and marketing competence through their network, but this comes after the understanding. Such services are normally available in the market and, consequently, are less critical. Knight (1921) would say that the entrepreneur converted an uncertain situation into a situation of calculable risks. See also LeRoy and Singell (1987) and Eliasson (1990a). Even though the economic value of the loss of winners is indeterminate in the theory of the EOE. This is no problem in the neoclassical model in which business mistakes and loss of winners do not exist by assumption, with the possible exception of random losses in stochastic equilibrium models which are outright irrelevant in an industrial economics analysis. An anonymous referee pointed out that this problem of seemingly endless reorganization and unpredictable market behavior has already been discussed by Ilinitch et al. (1996). It would, however, mean a new chapter to address also the problem of

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hypercompetition here. True, however, and in keeping with my argument, standard neoclassical theory has little to say on this. This is a more narrow definition of social capital than the broad, empirically difficult categories of Coleman (1988), Putnam (2000), Ritzen (2001) and Woolcock (2001). We are, in fact, much closer in definition to the abilities to cope that Wolfe and Haveman (2001) relate to educational capital. Which by accident has its origin in Schumpeter (1942). Schumpeter was a great admirer of Walras. He sometimes pedagogically began his argument by making the innovator an exogenous disturber of the Walrasian equilibrium. By postulating that once successful the routine R&D/innovation department of a firm would then for ever make that firm the dominant player in its market, Schumpeter invoked the perennial problem of economies of scale in the Walrasian model. This corner solution troubled Marshall. He invented the concept of an industrial district where the scale economies originated in the district as a whole rather than with individual firms. Romer (1986, 1990) formulated this mathematically in macro under the title of new growth theory, however without quoting Marshall. It is also obvious that as long as the distributed production system remains within the borders of a nation it offers a protective shield against foreign competitive imitation (under item 5). In fact, accounting for the implicit cost of lost profits is what distinguishes our model from the standard neoclassical model. For an interesting early discussion of this see Dahlman (1979). Note that Arrow and Debreu (1954), pioneering modern mathematical economics, carefully crafted their assumptions to avoid this result. There is no mention of Austrian economics and Hayek (1937, 1940, 1945), which, though by far the most penetrating treaties on information economics at the time, are not even quoted. In the discussion of Herbert Simons presentation at the conference on The Dynamics of Market Economies, organized by the IUI, 1983 (see Day and Eliasson, 1986, pp. 42ff).

26.

27.

28. 29. 30.

31.

BIBLIOGRAPHY
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Post- Schumpeterian Contribution, in R.H. Day and G. Eliasson (eds) (1986). Day, Richard H. (1986b), On Endogenous Preferences and Adaptive Economizing, in R.H. Day and G. Eliasson (eds) (1986). Day, Richard H. (1993), Bounded Rationality and the Coevolution of Market and State, in Day, Eliasson and Wihlborg (eds) (1993). Day, Richard H. and Gunnar Eliasson (eds) (1986), The Dynamics of Market Economies, Stockholm: IUI; Amsterdam: North-Holland. Day, Richard H., Gunnar Eliasson and Clas Wihlborg (eds) (1993), The Markets for Innovation, Ownership and Control, Stockholm: IUI; Amsterdam: NorthHolland. Day, Richard H., S. Morley and K.R. Smith (1974), Myopic Optimizing and Rules of Thumb in a Micro-Model of Industrial Growth, American Economic Review (March). Demsetz, H. (1969), Information and Efficiency: Another Viewpoint, Journal of Law and Economics, 12 (April), 122. Eliasson, sa (2007), The Markets for Bioterror and Biodisaster Protection, preliminary manuscript for the study, The Markets for Security Products and Disaster Preparedness, Stockholm: Swedish Academy of Engineering Sciences (IVA). Eliasson, Gunnar (1976), Business Economic Planning Theory, Practice and Comparison, London, New York etc.: Wiley & Sons. Eliasson, Gunnar (1977), Competition and Market Processes in a Simulation Model of the Swedish Economy, American Economic Review, 67 (1), 27781. Eliasson, Gunnar (1983), On the Optimal Rate of Structural Adjustment, in G. Eliasson, M. Sharefkin and B.-C. Ysander (eds) (1983), Policy Making in a Disorderly World Economy, Stockholm: IUI. Eliasson, Gunnar (1984), Micro Heterogeneity of Firms and Stability of Growth, Journal of Behavior and Economic Organization, 5 (34), (Sept.Dec.), 24998 (also in R.H. Day and G. Eliasson (eds), 1986). Eliasson, Gunnar (1985), The Firm and Financial Markets in the Swedish Micro-toMacro Model Theory, Model and Verification, Stockholm: IUI. Eliasson, Gunnar (1987a), Technological Competition and Trade in the Experimentally Organized Economy, Research Report No. 32, Stockholm: IUI. Eliasson, Gunnar (1987b), The Knowledge Base of an Industrial Economy, in Eliasson and Ryan, The Human Factor in Economic and Technological Change, OECD Educational Monograph Series No. 3. Eliasson, Gunnar (1990a), The Firm as a Competent Team, Journal of Economic Behavior and Organization, 13 (3), 27598. Eliasson, Gunnar (1990b), The Knowledge-Based Information Economy, in G. Eliasson et al. (1990), The Knowledge Based Information Economy, Stockholm: IUI, Chapter 1. Eliasson, Gunnar (1991a), Modeling the Experimentally Organized Economy, Journal of Economic Behavior and Organization, 16 (12), 15382. Eliasson, Gunnar (1991b), The International Firm: A Vehicle for Overcoming Barriers to Trade and a Global Intelligence Organization Diffusing the Notion of a Nation, in L.-G. Mattson and B. Stymne (eds) (1991). Eliasson, Gunnar (1991c), Financial Institutions in a European Market for Executive Competence, in C. Wihlborg, M. Fratianni and T.D. Willett (eds) (1992). Eliasson, Gunnar (1992), Business Competence, Organizational Learning, and Economic Growth: Establishing the SmithSchumpeterWicksell (SSW)

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Connection, in F.M. Scherer and M. Perlman (eds), Entrepreneurship, Technological Innovation, and Economic Growth. Studies in the Schumpeterian Tradition, Ann Arbor: The University of Michigan Press. Eliasson, Gunnar (1995), En teknologigenerator eller ett nationellt prestigeprojekt? Exemplet svensk flygindustri (A technology generator or a national prestige project? The Swedish aircraft industry), Stockholm: City University Press. Eliasson, Gunnar (1996), Firm Objectives, Controls and Organization the Use of Information and the Transfer of Knowledge within the Firm, Boston/Dordrecht/ London: Kluwer Academic Publishers. Eliasson, Gunnar (1997a), General Purpose Technologies, Industrial Competence Blocs and Economic Growth, in B. Carlsson (ed.) (1997). Eliasson, Gunnar (1997b), The Venture Capitalist as a Competent Outsider, mimeo, INDEK, KTH, IEO R: 1997-06, Stockholm. Eliasson, Gunnar (1998a), Competence Blocs and Industrial Policy in the Knowledge Based Economy, OECD Science, Technology, Industrial (STI) Revue. Eliasson, Gunnar (2000), Industrial Policy, Competence Blocs and the Role of Science in the Economic Development, Journal of Evolutionary Economics, 10, 21741. Eliasson, Gunnar (2001a), The Role of Knowledge in Economic Growth, in Helliwell, John (ed.) (2001). Eliasson, Gunnar (2001b), Advanced Purchasing, Spillovers, Innovative Pricing and Serendipitous Discovery, paper presented at the E.A.R.I.E. 2001 Conference in Dublin 30 Aug.Sept. Eliasson, Gunnar (ed.), (2005a), The Birth, the Life and the Death of Firms the Role of Entrepreneurship, Creative Destruction and Conservative Institutions in a Growing and Experimentally Organized Economy, Stockholm: The Ratio Institute. Eliasson, Gunnar (2005b), The Nature of Economic Change and Management in a New Knowledge Based Information Economy, Information Economics and Policy, 17, 42856. Eliasson, Gunnar (2005c), The Venture Capitalist as a Competent Outsider, in G. Eliasson (2005a) Chapter 4. Eliasson, Gunnar (2005d), Insourcing of Production from Foreign Subsidiaries or Subcontractors an Empirical Study of Swedish Firms, paper prepared for Invest in Sweden Agency (ISA), Stockholm; can be downloaded at www.isa.se/ kostnadellerkompetens. Eliasson, Gunnar (2006a), From Employment to Entrepreneurship, Journal of Industrial Relations, 48 (5), 63356. Eliasson, Gunnar (2006b), Policies for a New Entrepreneurial Economy, paper presented to the International J.A. Schumpeter Society 11th ISS Conference, Nice-Sophia Antipolis, 2124 June. Eliasson, Gunnar and sa Eliasson (1996), The Biotechnological Competence Bloc, Revue dEconomie Industrielle, 78 (4), 726. Eliasson, Gunnar and sa Eliasson (2005), The Theory of the Firm and the Markets for Strategic Acquisitions, in Cantner, U., Dinopoulos, E. and Lanzilotti, R.F. (eds), Entrepreneurship: The New Economy and Public Policy, Berlin, Heidelberg and New York: Springer. Eliasson, Gunnar and sa Eliasson (2007), Competence in Health Care, KTH, Stockholm, mimeo. Eliasson, Gunnar and Erol Taymaz (2000), Institutions, Entrepreneurship, Economic Flexibility and Growth Experiments on an Evolutionary Model,

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in U. Cantner, H. Hanush and S. Klepper (eds) (2000), Economic Evolution, Learning and Complexity Econometric, Experimental and Simulation Approaches, Heidelberg: PhysicaVerlag. Eliasson, Gunnar and Clas Wihlborg (2003), On the Macroeconomic Effects of Establishing Tradability in Weak Property Rights, Journal of Evolutionary Economics, 13, 60732. Eliasson, Gunnar, Fredrik Bergholm, Eva Christina Horwitz and Lars Jagrn (1985), De svenska storfretagen en studie av internationaliseringens konsekvenser fr den svenska ekonomin (The Giant Swedish Groups a Study of the Consequences of Internationalization for the Swedish Economy), Stockholm: IUI. Eliasson, Gunnar, Dan Johansson and Erol Taymaz (2005), Firm Turnover and the Rate of Growth, in Eliasson (2005a), Chapter 6. Fama, E.F. (1980), Agency Problems and the Theory of the Firm, Journal of Political Economy, 88 (2) (April), 288307. Frankelius, Per (2007), Linne i Nytt Ljus: Den frsta versttningen av Systema naturae samt ny analys av Linnes perspektiv (with a translation from Latin by Bertil Alden), Malm: Liber. Friedman, M. (1953), The Methodology of Positive Economics, in M. Friedman (ed.), Essays in Positive Economics, Chicago, IL: The University of Chicago Press. Georgescu-Roegen, Nicholas (1950), The Theory of Choice and the Constancy of Economic Laws, The Quarterly Journal of Economics, 44, 12538. Granstrand, Ove and S. Sjlander (1990a), Managing Innovation in MultiTechnology Corporations, Research Policy, 19 (1) (Feb.), 3660. Granstrand, Ove and S. Sjlander (1990b), The Acquisition of Technology and Small Firms by Large Firms, Journal of Economic Behavior and Organization, 13 (3), 36786. Hanson, K.A. (1986), On New Firm Entry and Macro Stability, in The Economics of Institutions and Markets, IUI Yearbook 19861987, Stockholm: Industriens Utredningsinstitut (IUI). Hanson, K.A. (1989), Firm Entry, in J.W. Albrecht et al., MOSES Code, Stockholm: Industriens Utredningsinstitut (IUI). Hayek, Friedrich A. von (1937), Economics and Knowledge, Economica, 4, 3354. Hayek, Friedrich A. von (1940), Socialist Calculation, Economica, 7 (26), 12549. Hayek, Friedrich A. von (1945), The Use of Knowledge in Society, American Economic Review, 35 (4) (Sept.), 51931. Helliwell, John (ed.) (2001), The Contribution of Human and Social Capital to Sustained Economic Growth and Well-being, HRDC, Canada. Ilinitch, Anne, Richard Dveni and Arie Lewin (1996), New Organizational Forms and Strategies for Managing in Hypercompetitive Environments, Organization Science, 7 (3), Special Issue 4, Part 1 of 2: Hypercompetition (MayJune), 21120. Johansson, Dan (2001), The Dynamics of Firm and Industry Growth the Swedish Computing and Communications Industry, Doctoral thesis, Department of the Organization and Management, KTH, Stockholm. Kirzner, Israel M. (1997), Entrepreneurial Discovery and the Competitive Market Process: An Austrian Approach, Journal of Economic Literature, 35 (1), 6085. Knight, F. (1921), Risk, Uncertainty and Profit, Boston: Houghton-Mifflin.

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Koopmans, Tjalling C. (1957), Three Essays on the State of Economic Science, New York: McGraw Hill Book Company Inc. LeRoy, S.F. and L.D. Singell, Jr (1987), Knight on Risk and Uncertainty, Journal of Political Economy, 95 (2) (April), 394406. Lindh, T. (1993), Lessons from Learning to have Rational Expectations, in R.H. Day, G. Eliasson, C.G. Wihlborg (eds), The Markets for Innovation, Ownership and Control, Stockholm: IUI; Amsterdam, London, New York, Tokyo: NorthHolland. Malinvaud, E. (1967), Decentralized Procedures in Planning, in E. Malinvaud and M.O.L. Bacharach (eds) (1967). Malinvaud, E. and M.O.L. Bacharach (eds) (1967), Activity Analysis in the Theory of Growth and Planning, London: Macmillan. Marshall, Alfred (1890), Principles of Economics. London: Macmillan. Marshall, Alfred (1919), Industry and Trade, London: Macmillan. Mattson, L.-G. and B. Stymne (eds) (1991), Corporate and Industry Strategies for Europe, Amsterdam: North-Holland. Menger, Carl (1871), Grundstze der Volkswirtschaftslehre, Vienna: Wilhelm Braumller. Mises, Ludwig von (1949), Human Action, Chicago: Contemporary Books. MOSES Database (1992), see Albrecht et al. (1992). Nelson, R.R. and Winter, S.G. (1982), An Evolutionary Theory of Economic Change, Cambridge, MA: Harvard University Press. Nystrm, Kristina (2006), Entry and Exit in Swedish Industrial Sectors, Jnkping: Jnkping International Business School Dissertation Series No. 032. OECD (1996), The Knowledge Based Economy, Paris. Pakes, Ariel and Richard Ericson (1998), Empirical Implications of Alternative Models of Firm Dynamics, Journal of Economic Theory, 79 (1), 145. Pousette, Tomas and Thomas Lindberg (1986), Tjnster i Produktionen och Produktionen av Tjnster, in Eliasson, Gunnar, Bo Carlsson, Enrico Deiaco, Thomas Lindberg and Tomas Pousette, Kunskap, Information och Tjnster en studie av svenska industrifretag, Stockholm: IUI Putnam, R. (2000), Bowling Alone: The Collapse and Revival of American Community, New York: Simon & Schuster. Ritzen, Jozef M. (2001), Social Cohesion, Public Policy, and Economic Growth: Implications for OECD Countries, in Helliwell (2001). Romer, P.M. (1986), Increasing Returns and Long-Run Growth, Journal of Political Economy, 94 (5) (Oct.), 100237. Romer, P.M. (1990), Endogenous Technological Change, Journal of Political Economy, 98, (5) pt. 2, S71102. Rothschild, M. (1974), A Two-Armed Bandit Theory of Market Pricing, Journal of Economic Theory, 9 (2) (Oct.), 185202. Rybsczynski, T.M. (1993), Innovative Activity and Venture Financing: Access to Markets and Opportunities in Japan, the US and Europe, in Day, Richard H., G. Eliasson and C. Wihlborg (eds) (1993), The Markets for Innovation, Ownership and Control, Stockholm: IUI, and Amsterdam: North-Holland. Salter, W.E.G. (1960), Productivity and Technical Change, Cambridge, MA: Cambridge University Press. Schumpeter, Joseph (1911) (English edition 1934), The Theory of Economic Development, Harvard Economic Studies, Vol. XLVI, Cambridge, MA: Harvard University Press.

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Schumpeter, Joseph (1942), Capitalism, Socialism and Democracy, New York: Harper & Row. Simon, Herbert A. (1945), Administrative Behavior, New York: Macmillan. Simon, Herbert A. (1955), A Behavioral Model of Rational Choice Quarterly Journal of Economics, 69, 99118. Smith, Adam (1776), An Inquiry into the Nature and Causes of the Wealthy of Nations, reprinted New York: Modern Library, 1937. Taymaz, Erol (1991), MOSES on PC: Manual, initialization, and calibration, Stockholm: IUI. Wallis, John and Douglass North (1986), Measuring the Transaction Sector in the American Economy, in Engerman, Stanley and Gallman (eds), Long Term Factors in American Economic Growth, Chicago: The University of Chicago Press. Walras, L. (1874), Elements dconomie politique pure. English translation of 1926 edition: Elements of Pure Economics, or the Theory of Social Wealth, London: Allen and Unwin, 1954. Wicksell, Knut (1923), Realkapital och kapitalrnta, Ekononmisk Tidskrift, Hfte 56, 14580. Wihlborg, C., M. Fratianni and T.D. Willett (eds) (1992), Financial Regulation and Monetary Arrangements after 1992, Amsterdam: Elsevier Science Publishers B.V. Williamson, O.E. (1975), Markets and Hierarchies: Analysis and Antitrust Implications: A Study in the Economics of Internal Organization, New York: Free Press. Williamson, Oliver E. (1985), The Economic Institutions of Capitalism, New York/ London: The Free Press. Winter, S.G. (1986), Schumpeterian Competition in Alternative Technological Regimes, in Day, Richard H. and G. Eliasson (eds), The Dynamics of Market Economies, Stockholm: IUI, and Amsterdam: North-Holland, Chapter 8. Wolfe, Barbara and Robert Haveman (2001), Accounting for the Social and NonMarket Benefits of Education, in Helliwell (2001). Woolcock, Michael (2001), The Place of Social Capital in Understanding Social and Economic Outcomes, in Helliwell (2001).

PART III

Investments and the legal environment

7.

Corporate governance and investments in Scandinavia ownership concentration and dual-class equity structure*
Johan E. Eklund
INTRODUCTION

1.

In essence, the corporate governance system in a country is the institutional framework that supports the suppliers of finance to corporations and enables firms to raise substantial amounts of capital (Shleifer and Vishny, 1997).1 By protecting suppliers of capital and safeguarding property, sound governance systems facilitate mobilization and allocation of capital to useful investments. Corporate governance systems are of outmost importance for the allocation of capital to its highest value use. It can be argued that the corporate governance system in a country determines the speed of structural change and economic development by affecting allocation and reallocation of capital. Therefore the crucial question is whether the corporate governance system induces managers of corporations to make good value enhancing investments decisions, or not. In particular, the ownership concentration and composition appear to matter for firm performance, as shown by Morck et al. (1988).2 This chapter looks at corporate governance and the rate of return on corporate investments in Scandinavia. The structure of ownership and its effects on performance are examined. Taking an outsiders view of Scandinavia, the corporate governance systems in the Scandinavian countries, Sweden, Finland, Norway and Denmark, arguably display more similarities than differences. The countries share a number of important features that unify them in comparison with other countries. It has, for example, been hypothesized that the common origin of the legal systems in Scandinavia is still reflected in the quality of corporate governance (La Porta et al., 1997). Furthermore, Scandinavian firms are typically controlled by a dominant owner and only a small minority of firms are characterized by dispersed ownership structure. Finally, the Scandinavian countries can also be said to have a common political orientation, with strong
139

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social democratic traditions (for example, Hgfeldt, 2004), which, according to Roe (2003), matters for corporate governance. Such apparent homogeneity of the Scandinavian countries in combination with the importance of well functioning corporate governance systems motivates a comparison of corporate returns and ownership structure in Scandinavia. The purposes of this chapter are therefore the following. First, the returns on investments made by the largest firms in Scandinavia are assessed. Second, the effect of ownership structure on investment decisions is examined as a factor explaining variation in performance and in returns on investments. Finally, and perhaps most importantly, the chapter analyses how deviations from the one-share-one-vote principle affect this ownership performance relationship. Outright expropriation of corporate assets and investor funds by managers is likely to be small in developed economies, such as the Scandinavian ones. Over-investment in pursuit of ends other than profit maximization and misallocation of assets is more likely to be a problem. The chapter is organized in six sections. Relevant literature on investments, corporate governance and ownership is reviewed in Section 2. In Section 3 the method is derived and the data are described. In Section 4, the return on corporate investments in Scandinavia is assessed. The fifth section examines how ownership and the extensive use of dual-class shares affect investment decisions. Section 6 provides the conclusions.

2.

CORPORATE CONTROL AND INVESTMENT

Neoclassical investment theory suggests that investments are expanded up to the point where the expected marginal rate of return equals the opportunity cost of capital. This condition would be satisfied in a friction-free world without any informational asymmetries, agency problems or transaction costs. Capital would flow automatically to the most efficient use and thereby guarantee that welfare is maximized. However, in the modern corporation, with its separation of owners and financiers from the management, there arises a set of agency problems that can cause investment decisions to deviate from what is predicted in neoclassical models (see Mueller (2003) for a review of investment theories). Berle and Means (1932) were the first to call attention to the potential agency costs.3 They argued that corporate ownership in large listed firms would become dispersed up to a point where professional managers would become unaccountable to the shareholders. Later, Jensen and Meckling (1976) provide a more theoretical underpinning to the linkages between agency costs and ownership structure. Jensen and Meckling analyse how the interests of utility maximizing owner-managers and minority shareholders

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diverge as ownership structure becomes more dispersed. Their basic argument is that the owner-manager will not bear the full cost of on-the-job consumption.4 Potential minority investors will realize this and subsequently the share price will reflect the divergence of interests between owner-managers and minority shareholders. Arguably the conflict of interests becomes more severe as the equity stake of owner-managers decreases. Jensen and Meckling (1976) argue that investors with high stakes will also have incentives to maximize firm value. This is referred to as the incentive effect. Hypothesis 1 is therefore: H1 Ownership concentration will improve investment performance.

In this view, agency costs increase as ownership is diluted and becomes dispersed. However, not all have seen the separation of ownership and control as a potential problem, where the counter-hypothesis is that control and ownership separation may improve allocation. Thorstein Veblen (1921), for example, argues that this separation would lead to the control being turned over from monopoly-seeking owners/businessmen to growth and efficiency-seeking management. Veblen claims for example that if
industry were completely organized as a systemic whole, and were then managed by competent technicians with an eye single to maximum production of goods and services; instead of, as now, being manhandled by ignorant business men with an eye single to maximum profits; the resulting output of goods and services would doubtless exceed the current output by several hundred per cent. (Veblen, 1921)

Recognizing that owner-managers are also guided by utility maximization and not pure profit maximization, Demsetz (1983) argues that it is not clear that diffusion of ownership will automatically have a detrimental effect. In fact, it has been argued that as the stake of owner-managers increases, so does their ability to misallocate resources (Stulz, 1988). This effect is referred to as the entrenchment effect (see Morck et al., 1988, and Stulz, 1988). Morck et al. (1988) find a non-monotonic relationship between ownership and Tobins q. They find that performance initially increases with ownership concentration, then declines and finally increases again, which is consistent with an entrenchment effect. McConnell and Servaes (1990) find similar results.5 Expecting a managerial entrenchment effect leads to the second hypothesis: H2 Ownership concentration will have a non-linear effect on performance. The generality of the Berle and Means (1932) observation is, however, empirically challenged. Looking at ownership structure around the world,

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most corporations have concentrated ownership and are controlled by families (Morck et al., 2005; La Porta et al., 1999). Faccio and Lang (2002) study the ownership in Europe and find that corporations are predominantly controlled by families in continental Europe. This control is achieved without corresponding capital by means of primarily three different control enhancing mechanisms (CEM): vote-differentiation of shares, pyramid ownership and cross-holdings. This means that the division between what Berle and Means (1932) call nominal ownership and the corporate control is further enhanced by separating the capital stake and the voting power, making it possible for a small group of investors, often the founding family, to maintain control of the firm. Burkart and Lee (2008) review the theoretical literature on oneshare-one-vote arguing that there are both positive and negative effects associated with dual-class shares. Adams and Ferreira (2008) review the empirical literature and find the empirical evidence inconclusive.6 Bebchuk et al. (1999), on the other hand, argue that these control mechanisms distort the incentives of the controlling owners and therefore potentially may cause a sharp increase in agency costs. When the incentives are distorted, this may potentially have a negative impact on the optimal choice of investments, scope of the firm and transferral of control. Separation of control rights and cash-flow rights not only alters the control structure of the corporation but also changes the incentives of owner-managers. An effect one can expect from the separation of cash-flow and control rights is that the positive incentive effect will be weakened whereas the entrenchment effect will be enhanced. From this, hypothesis 3 follows: H3 Control mechanisms such as dual-class equity structure will weaken the incentive and enhance the entrenchment effect. Using a market-to-book measure of Tobins q, Claessens et al. (2002) find evidence that is consistent with this hypothesis. They examine a large number of firms in East Asia and find that cash-flow rights are positively correlated with performance. However, control rights in excess of cashflow rights have a negative effect on firm value. A large number of studies also establish a link between ownership structure and concentration on the one hand and performance on the other. Countries with weaker investor protection tend to have a more concentrated ownership structure (see for example La Porta et al., 1997). In fact, the two most common ways of dealing with the agency aspects of corporate governance are, according to Shleifer and Vishny (1997), first, legal and regulatory protection of investor and minority rights, and second, large and concentrated owners.

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2.1

Corporate Governance in Scandinavia

The corporate governance systems in Scandinavia have some unique features that change the prediction of the Jensen and Meckling model. Like most firms in continental Europe, the Scandinavian firms very often have controlling owners that have maintained their control even when their capital stake has declined and the firms have grown. Most European countries allow at least one of the three principal instruments for enhancing ownership control: cross-holdings, pyramid ownership and vote-differentiation (Sderstrm et al., 2003). In particular, the extensive use of vote-differentiated shares has had a substantial impact on the way in which the ownership structure has evolved in Scandinavia. In Norway about 14 percent of listed firms use dual-class shares, in Denmark and Finland more than 30 percent, and in Sweden it is as high as 55 percent (Bhren and degaard, 2006; Sderstrm et al., 2003). Many countries in Europe do not allow for dual-class share systems, so this is one of the prominent distinguishing features of the corporate governance systems in Scandinavia. The frequent use of dual-class shares, with strong separation of voting rights and equity claims, has produced very strong and stable ownership structures in Scandinavia (Hgfeldt, 2004; Henrekson and Jakobsson, 2006). By using vote-differentiation, the founding families may retain control of firms even with a very small equity share. Most firms in Scandinavia have a single controlling owner and very few firms are characterized by dispersed ownership. Bennedsen and Nielsen (2005) report significant differences in the frequency of control mechanisms for a sample of 4096 European firms (see Table 7.1). Cronqvist and Nilsson (2003) examine a large sample of Swedish listed firms and find that controlling owners have a negative effect on Tobins average q. These controlling owners are also more likely to use control mechanisms. Maury and Pajuste (2004) examine a sample of Finnish firms and show that a more uniform distribution of votes among large block holders is positive for firm valuation. They also find that divergence between cash-flow rights and control rights have a negative effect on firm value. An additional consequence of the strong separation of ownership claims and control is that the so-called market for corporate control (Manne, 1965) virtually does not exist in Scandinavia. Successful hostile bids are therefore very rare. Supposed advantages of strong and stable owners provide the underpinning argument for the Scandinavian legislation that allows for votedifferentiation of share and pyramid ownership. In this chapter, ownership concentration is measured as the share of capital and votes controlled by the largest owner (CR1 & VR1) and the five largest owners (CR5 & VR5). About 40 percent of the firms in the aggregate Scandinavian sample

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Table 7.1

Corporate control mechanisms in European countries

Dual-class shares Pyramid structures Cross-holdings 0.27 0.06 0.07 0.25 0.17 0.22 0.18 0.26 0.24 0.33 0.15 0.27 0.13 0.16 0.20 0.21 0.01 0.00 0.00 0.00 0.00 0.00 0.00 0.01 0.03 0.02 0.00 0.00 0.00 0.00 0.01 0.01

Sweden Switzerland Finland Italy Denmark UK Ireland Austria Germany Norway France Belgium Portugal Spain European average Scandinavian average

0.62 0.52 0.44 0.43 0.29 0.25 0.25 0.23 0.19 0.11 0.03 0.00 0.00 0.00 0.24 0.37

Note: The figures represent the percentage of firms that use dual-class shares, pyramid structures and cross-holdings, respectively. Source: Bennedsen and Nielsen (2005).

separate control and cash-flow rights; see Table 7.2. The ownership data have been collected from the annual reports for each firm. Ownership concentration is very high in Scandinavian listed firms, especially compared with those in the Anglo-Saxon countries. Demsetz and Lehn (1985) examine the ownership structure in 511 large US firms. They report that, on average, the five largest owners together hold 24.8 percent and the top 20 shareholders 37.7 percent. Frequently 20 percent is assumed to be more than enough to control a firm (Morck et al., 2005). La Porta et al. (1997) have hypothesized that the legal origin of a country determines the efficiency of the countrys financial system. Scandinavia can in this respect be regarded as being relatively homogeneous. Scandinavia has a long tradition of cooperation in drafting new legislation (Carsten, 1993). Interestingly, there are still important differences with respect to deviations from the one-share-one-vote principle. Denmark, Finland and Sweden all allow dual-class shares. In Norway deviations from the proportionality principle need government approval (Faccio and Lang, 2002).

Corporate governance and investments in Scandinavia

145

Table 7.2
All firms

Ownership concentration in Scandinavia (2004)

Mean Capital share one owner, CR 1 Capital share five owners, CR 5 Voting rights one owner, VR 1 Voting rights five owners, VR 5 23.5 44.8 29.4 52.0

Std. dev. 15.5 19.6 19.7 22.6

Min 0.4 1.5 0.4 1.5

Max 82.4 95.1 89.3 96.5

No. firms Skewness 214 214 211 211 0.90 0.33 0.89 0.08

Vote-differentiated firms Mean Capital share one owner, CR 1 Capital share five owners, CR 5 Voting rights one owner, VR 1 Voting rights five owners, VR 5 23.5 47.4 35.8 64.8 Std. dev. 13.7 19.0 20.3 19.8 Min 2.9 9.4 4.6 18.6 Max 60.4 93.8 89.3 96.5 No. firms Skewness 90 90 88 87 0.70 0.43 0.73 0.33

Firms with one-share-one-vote Mean Capital share one owner, CR 1 Capital share five owners, CR 5 Voting rights one owner, VR 1 Voting rights five owners, VR 5 23.2 42.9 23.2 42.9 Std. dev. 16.7 19.9 16.7 19.9 Min 0.4 1.5 0.4 1.5 Max 82.4 95.1 82.4 95.1 No. firms Skewness 124 124 124 124 1.01 0.32 1.01 0.32

3.

METHODOLOGY

This chapter applies a method developed by Mueller and Reardon (1993) to assess the rate of return on investments. The measure produced is a marginal version of Tobins q. Tobins q is defined as the market value of a firm over the replacement cost of its assets, which translates to the average return on total assets. The marginal version of Tobins q, on the

146

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other hand, measures the return on investments, or the marginal return on capital relative to the cost of capital (Mueller, 2003). This is in effect a measure of what Tobin (1982) calls the functional form of stock market efficiency.7 Marginal q is also a more appropriate measure of performance since average q contains infra-marginal returns.8 Marginal q can be derived from the simple insight that any investments should ex ante be evaluated against the discounted present value of future cash flows that the investment generates. Obviously, only projects that have a positive net present value should be carried out. Consider an investment, It, made by a firm in period t. This investment generates cash flows, CFt1j in j periods. The present value, PVt, of this cash flow is as follows:
n

PVt 5 a CFt1j / (1 1 rt) j

j51

(1)

where rt is the discount rate. Note that the present value is the discounted expected value of future cash flows. This equation can be expressed in the following way, where it can be regarded as a quasi-permanent rate of return: PVt 5 Itit /rt (2)

For investments to be efficient from a shareholder perspective the investment being considered must generate future cash flows which, discounted to the present value, equal or exceed the investment cost. The ratio i/r is essentially a marginal version of Tobins q (Mueller, 2003) which measures the return on a marginal investment, and will therefore henceforth be referred to as qm. Equation (2) can be rearranged and expressed as follows: PVt 5 it /rt 5 qm,t (3) It For investments to be meaningful, we must have that PVt $ It. This implies that qm $ 1. If firms are investing at qm 5 1, investments are efficient. This implies that there are no further profitable investment opportunities (see Figure 7.1). Whereas if qm , 1, firms are receiving a return on their investments that is less than the cost of capital, which can only be interpreted as over-investment and a managerial failure of some sort. At the end of period t the market value of a firm may be decomposed into the market value in period t 2 1 (Mt-1), the present value of investments made in period t (PVt), the change in market value of the old capital stock (dt), and an error term for the errors the market may make in its evaluation of the firm (mt).9 Mt ; Mt21 1 PVt 2 dtMt21 1 mt (4)

Corporate governance and investments in Scandinavia

r, i

147

i q m > 1 > q m* qm* = 1 q m< 1 < qm* It

Figure 7.1

Marginal rate of return on capital, i, cost of capital, r, and marginal q

By replacing Mt-1 in equation (4) in each subsequent period, the following expression is obtained:
n i50 n21 150 n

Mt1n 5 Mt21 1 a PVt1i 2 a dt1iMt1i 1 a mt1i

i50

(5)

In a single period, the error in the markets evaluation of the firm can be substantial, assuming efficient markets: E (mt) 5 0 and E (mt, mt21) 5 0, which n implies E ( g i50mt1i) 5 0. Thus, as n grows the last term will approach zero. From equation (3) we get the following expression:
n n

a qm,t1iIt1i qm 5
i50 n

a PVt1i 5
i50 n

(6)

a It1i
i50

a It1i
i50

Using equation (5) this expression can be formulated in the following way:
n n

qm 5

(Mt1n 2 Mt21)
n

a dt1iMt1i21 1
i50 n

a mt1i 2
i50 n

(7)

a It1i
i50

a It1i
i50

a It1i
i50

This can be used to calculate a weighted average qm for each firm.10 Assuming that qm and d both are constant over time and across firms, we can use equation (4) to estimate qm and d directly. Taking equation (4) and subtracting Mt-1 from both sides we get:

148

Investments and the legal environment

Mt 2 Mt21 5 2dMt21 1 qmIt 1 mt

(8)

Dividing by Mt-1 we normalize the equation and get the following relationship that can be empirically estimated: mt Mt 2 Mt21 It 5 2d 1 qm 1 Mt21 Mt21 Mt21 (9)

Mueller and Reardons (1993) methodology can be applied to test the agency hypotheses. In contrast to the average Tobins q, this method measures the marginal return on investments, which makes it more appropriate when testing the agency hypotheses. To study the effects of ownership structure or various institutional factors on investment decisions, measures of ownership may be added as interaction terms with It /Mt21 in equation (9). If interaction terms are added, the functional form will be: Y 5 a 1 b1X 1 b2XZ, and qm is the economic interpretation of the marginal effect, Y/ X 5 b1 1 b2Z. This method has been applied by Gugler and Yurtoglu (2003) and by Bjuggren et al. (2007). The equations estimated have the following functional form: Mt 2 Mt21 It It It 5 2d 1 b1 1 b2Z1 1 . . . 1 bi11Zi 1 ei Mt21 Mt21 Mt21 Mt21 (10) where the Zs denote the explanatory variables. Thus, the marginal effect, qm, of equation (10) is: qm 5 b1 1 b2Z1 1 . . . 1 bi11Zi (11)

The total market value of a firm is defined as the total number of outstanding shares times the share price at the end of year t, plus total debt. Investments are approximated as: I 5 After tax profit Dividends 1 Depreciation 1 DEquity 1 DDebt1 R&D 1 Advertising & Marketing The market and accounting data have been collected from Compustat Global database.11 The firms included were listed at one of the four stock exchanges in Scandinavia (Copenhagen Stock Exchange in Denmark, Helsinki Stock Exchange in Finland, Oslo Stock Exchange in Norway and Stockholm Stock Exchange in Sweden) between 1998 or 1999 and 2005, in total 292 firms (2004 observations). All figures have been adjusted by

Corporate governance and investments in Scandinavia

149

harmonized consumer price indexes to 2005 constant prices. The indexes used have been compiled by Eurostat. Naturally, the standard caveats apply to the data. To use equation (7) to calculate qm, it is also necessary to determine the size of the deprecation rate d. That is, the rate at which the value of the firms assets is declining over time. According to Mueller and Reardon (1993), most estimates are around 10 percent. Naturally, the actual depreciation rate varies across firms and industries, depending on the durability of employed assets. Even within firms, we have reason to believe that the depreciation rate differs across the capital stock. Equation (9) has the advantage that no assumption regarding the size of d is necessary. In an empirical estimation of equation (9) the intercept (d) will capture the depreciation rate plus any systematic changes in market valuations of the stock of old capital. The estimated d has no bearing on the interpretation of qm.

4.

CORPORATE RETURN IN SCANDINAVIA

This study covers 292 large Scandinavian firms that are listed at one of the four stock exchanges. This accounts for about 40 percent of all listed firms. In 2004, the top 100 of these 292 firms (25 largest in each country) accounted for approximately 42 percent of the total stock market capitalization (33 percent of GDP).12 The firms approximately follow a ranksize distribution, where the second largest firm is about half the size of the largest.13 As a first step, equation (7) is used to calculate a qm for each individual firm. For Scandinavia, the estimated average marginal q, excluding the upper 95 percentile and the lower 5 percentile, is 1.19. This means that during the period 19992005 the Scandinavian firms had an average return on investments that was 19 percent above the cost of capital. However the median qm is 1.03, which implies a return that is 3 percent above cost of capital. Neither the average qm nor the median qm give any reason to believe that Scandinavian firms are under-performing. This is based on the assumption that the depreciation rate was 10 percent per annum. Equation (7) is sensitive to the choice of depreciation rate. Consequently, a more rapid deprecation will translate into a higher qm, all else equal. Investments as defined in this chapter can be negative. This will be the case if a firm is making losses that are larger in absolute terms than new equity and debt. It is not meaningful to ask what the returns on investment are if investments are negative. Nor does equation (7) make any sense when

150

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Table 7.3
Denmark Range of qm

Cumulative distribution of marginal q

1999 10 3 3 10 11 9 4 4 54 16 38

2000 9 2 3 14 19 5 4 4 60 14 46

2001 6 3 3 12 23 5 1 6 59 12 47

2002 2 4 5 9 26 8 0 6 60 11 49

2003 4 3 3 11 25 8 2 4 60 10 50

2004 5 4 6 13 23 5 1 4 61 15 46

2005 5 8 6 13 22 3 0 2 59 19 40

qm 2.00 1.50 qm < 2.00 1.00 qm < 1.50 0.50 qm < 1.00 0.00 qm < 0.50 0.50 qm < 0.00 1.00 qm < 0.50 qm < 1.00 Number of firms Number of qm 1 Number of qm < 1 Finland Range of qm qm 2.00 1.50 qm < 2.00 1.00 qm < 1.50 0.50 qm < 1.00 0.00 qm < 0.50 0.50 qm < 0.00 1.00 qm < 0.50 qm < 1.00 Number of firms Number of qm 1 Number of qm < 1 Norway Range of qm qm 2.00 1.50 qm < 2.00 1.00 qm < 1.50 0.50 qm < 1.00 0.00 qm < 0.50 0.50 qm < 0.00 1.00 qm < 0.50 qm < 1.00 Number of firms Number of qm 1 Number of qm < 1

1999 20 5 9 8 3 3 0 3 51 34 17

2000 17 1 6 11 13 3 3 4 58 24 34

2001 9 9 2 17 10 4 2 5 58 20 38

2002 11 5 9 16 8 1 3 5 58 25 33

2003 13 5 10 15 8 1 1 6 59 28 31

2004 12 4 16 11 9 1 2 4 59 32 27

2005 15 4 22 9 3 1 2 3 59 41 18

1999 23 5 7 5 0 1 1 2 44 35 9

2000 19 6 10 3 4 3 0 2 47 35 12

2001 13 3 15 7 2 1 3 3 47 31 16

2002 8 4 10 15 3 2 0 6 48 22 26

2003 12 6 13 7 4 0 0 4 46 31 15

2004 17 5 15 3 4 0 0 1 45 37 8

2005 23 7 9 2 2 0 1 1 45 39 6

Corporate governance and investments in Scandinavia

151

Table 7.3
Sweden Range of qm

(continued)

1999 36 4 12 4 23 6 0 3 88 52 36

2000 26 3 16 20 26 4 4 8 107 45 62

2001 14 7 9 25 31 9 3 10 108 30 78

2002 5 2 11 27 36 6 6 13 106 18 88

2003 12 5 12 26 32 9 3 10 109 29 80

2004 15 5 15 28 30 7 3 6 109 35 74

2005 18 12 14 28 29 3 1 2 107 44 63

qm 2.00 1.50 qm < 2.00 1.00 qm < 1.50 0.50 qm < 1.00 0.00 qm < 0.50 0.50 qm < 0.00 1.00 qm < 0.50 qm < 1.00 Number of firms Number of qm 1 Number of qm < 1
Note:

Assuming d 5 10 percent.

investments are negative or equal to zero. Accordingly, such firms have been excluded from Table 7.3. As can be seen from Table 7.3, returns on investments are approximately normally distributed around a mean of 1 in all of the four Scandinavian countries, except Norway. As the estimated qms are cumulated over 1999 to 2005 the distribution seems to become more concentrated around 1. There are a few extreme values that have a large impact on the average qm across firms. These are typically smaller firms that, for some reason, have either a very high return on invested capital or a massive loss in market value. There are several plausible explanations for these extreme values. Firms may for example introduce radical innovations that do not require any substantial investments but nevertheless substantially increase firm value. Average qm is, for this reason, also calculated excluding 5 percent in both ends of the distribution. Dropping 5 percent in both ends of the distribution, the average qm is 0.76 for Denmark, 1.27 for Finland, 1.83 for Norway and 1.11 for Sweden. The median qm is 0.57 for Denmark, 1.18 for Finland, 1.86 for Norway and 0.85 for Sweden. If the assumption that d 5 10 percent is approximately correct, this means that all four of the Scandinavian countries, with the exception of Denmark, have average returns equal to or above the cost of capital. Bjuggren and Wiberg (2008) find that qm is sensitive to stock market swings and that, depending on period selection, the qm may either be overor under-estimated. The choice of a 56 year period, which approximately

152

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coincides with the average length of a business cycle, reduces this problem. Table 7.4 reports the value of marginal q for the ten largest firms in each Scandinavian country. The first two columns report the total market values in 2005 and 1998 adjusted to 2005 constant prices. Total investments made during this period are reported in column 3. Since equation (7) is sensitive to choice of depreciation, qm has been calculated assuming 5, 10 and 15 percent depreciation of old capital (columns 4, 5 and 6). Furthermore, the implicit d can be calculated from equation (7) by assuming that qm 5 1. This implicit depreciation rate is reported in column 7. A few firms in Table 7.4 have implicit deprecation rates that are negative, which indicates that these firms all had returns in excess of their cost of capital. The dominant firm in Finland, Nokia, for example, has performed well over a long period and consequently has a qm around or slightly above 1. This can be compared with the Swedish telecom firm Ericsson, one of Nokias main competitors. Ericsson seems to have a lower qm given any depreciation rate, but remains approximately equal to 1. It is plausible to assume that the differences in returns can be attributed to differences in performance, since Nokia and Ericsson can be assumed to have approximately the same depreciation rate. The dominant firm in Denmark, Mller-Maersk, with its high marginal q, appears to be under-investing. Finally, the dominating Norwegian firm Norsk Hydro seems to have a marginal q approximately equal to 1. Assuming that the marginal rate of return (qm) and the depreciation rate (d) are the same across companies and over time, these can be estimated by equation (9). Since the data consist of a cross-sectional time series, a fixed effect model is used (industry and time fixed effects model). The stock market may fail to make a correct valuation in a single period, but assuming efficient markets, this error will approach zero as the time span increases. To take the possibility of market errors into account, time dummies were used in the estimations. Both industry and time dummies are restricted to sum to zero, so that the effects are measured as the deviation from the average depreciation rate. The results are reported in Table 7.5. In order to remove outliers, some of the observations have been removed from the data set. The absolute deviation between the dependent variable and the explanatory variable, |(Mt Mt-1)/Mt-1 It/Mt-1|,14 has been used to identify outliers. Observations that had an absolute deviation above 2 (41 observations) were removed. This captures, for example, firms that have large swings in market value without corresponding changes in investments. The excluded firms are predominantly found among relatively small high-tech firms within the biotechnology and ICT sectors. Bjuggren

Table 7.4
1 M2005a M1998a 2 3 4
a

Ten largest companies in each Scandinavian country (2005)

5 qm qm (d 5 10%)b (d 5 15%)b dc 6 7

Company

INV

qm (d 5 5%)b

153 64861.2 15108.7 13964.4 4061.7 4050.2 3914.6 3304.8 2752.5 2739.7 2589.4 68445.3 13268.3 11361.0 1415.5 789.6 2933.6 1953.9 1662.5 2298.9 409.8 14966.5 3364.9 1818.2 16770.9 658.2 16027.0 1406.0 1287.0 2135.4 662.4 0.619 0.690 0.650 0.429 2.072 0.476 1.806 1.770 0.968 3.530

Denmark A.P. MLLER MAERSK TDC NOVO NORDISK CARLSBERG H. LUNDBECK DANISCO WILLIAM DEMANT HOLDING COLOPLAST COPENHAGEN AIRPORTS DE SAMMENSLUTTENDE Finland NOKIA STORA ENSO UPM-KYMMENE METSO SANOMA-WSOY M-REAL RAUTARUUKKI WARTSILA TIETOENATOR YIT CORP 47702.9 13932.1 13124.1 6842.0 3904.8 5105.6 3165.8 2486.8 2479.6 2411.3 1.293 1.214 1.073 0.537 2.517 0.752 2.396 2.381 1.615 3.902 7211.4 15676.0 8752.7 4706.6 2607.8d 3728.0 962.1 1326.3 1441.4 292.3 27433.4 12303.0 17150.9 19592.3 5400.0 6866.8 2303.6 1998.2 811.0 1215.6 1.668 0.244 0.481 0.199 0.515 0.395 1.288 0.869 1.870 1.972 1.860 0.630 0.706 0.289 0.790 0.590 1.620 1.157 2.460 2.201 2.052 1.016 0.932 0.378 1.065 0.784 1.951 1.444 3.049 2.430 1.966 1.739 1.495 0.644 2.963 1.029 2.986 2.993 2.263 4.275

0.124 0.148 0.048 0.113 0.138 0.205 0.007 0.073 0.024 0.162 0.078 0.080 0.091 0.315 0.070 0.014 0.018 0.013 0.052 0.289

Table 7.4
1 M2005a M1998a 2 3 4
a

(continued)
5 qm qm (d 5 10%)b (d 5 15%)b dc 6 7

Company

INV

qm (d 5 5%)b

154 49367.6 24244.6 21244.0 12599.3 11652.2 11038.2 9262.2 7426.0 6787.2 5940.4 623.3 49661.1 18240.9 15067.1 5329.9 7553.9 5502.1 6128.1 9994.2 5421.3 2348.3 139.2 62411.5 32494.6 14736.6 11514.7 8847.4 12743.4 11352.3 22765.3 7191.6 7975.8 675.0 0.355 0.376 0.825 0.850 0.860 0.648 0.528 0.019 0.525 0.591 0.922

Norway NORSK HYDRO ORKLA NORSKE SKOGINDUSTRIER HAFSLUND FRED. OLSEN ENERGY SCHIBSTED DNO TOMRA SYSTEMS FARSTAD SHIPPING Sweden ERICSSON VOLVO H & M HENNES & MAURITZ ATLAS COPCO SCA SANDVIK SCANIA ELECTROLUX SECURITAS SKF SOLSTAD OFFSHORE 24942.5 9539.4 5043.3 3135.1 2152.9 1900.9 1867.4 1056.9 950.9 0.714 0.568 1.232 1.069 1.257 0.862 0.780 0.150 0.860 0.731 1.111 12014.9 5729.7 2355.1 1156.5 641.2 1121.6 46.8 1399.7 263.6 19283.6 3582.9 1477.6 1823.6 610.7 495.6 474.2 336.8 791.9 0.986 1.698 1.573 1.448 3.019 2.462 3.971 3.677 1.111 1.302 2.332 1.599 1.811 3.563 3.352 4.104 4.130 1.355 1.617 2.967 1.624 2.174 4.107 4.241 4.236 4.584 1.598 1.073 0.760 1.638 1.287 1.654 1.076 1.032 0.281 1.195 0.872 1.301

0.052 0.005 1.050 0.012 0.136 0.032 1.071 0.245 0.027 0.140 0.213 0.071 0.084 0.068 0.132 0.144 0.424 0.121 0.196 0.071

Note:

Million euros, 2005 constant prices; b qm calculated assuming that d is 5, 10 and 15 percent, respectively; c depreciation rate calculated given qm 5 1; d market value 1999.

Corporate governance and investments in Scandinavia

155

Table 7.5

Average qms in Scandinavia (19992004)

Dependent variable: (Mt 2 Mt-1)/Mt-1 Constant (5 d) It / Mt-1 Denmark* It / Mt-1 Norway* It / Mt-1 Finland* It / Mt-1 Sweden* It / Mt-1 No. obs. No. firms R2 R2-adjusted F-value 0.034** (2.25) 0.868*** (27.79) 0.205*** (5.32) 0.244*** (4.87) 0.057 (0.88) 0.097*** (2.85) 1963 292 0.48 0.46 32.45 0.039** (2.52) 0.794*** (34.06)

1963 292 0.47 0.45 32.78

Note: *** indicates significance at 1 percent, ** at 5 percent and * at 10 percent level; t-values in brackets.

and Wiberg (2008) have shown that the marginal q measure is sensitive to swings in valuation of new high-tech firms. The regressions in Table 7.4 were estimated with different intercepts, d, for the different countries; these were, however, insignificant and were therefore dropped out of the regression. In order to test for country effects, country dummy variables were interacted with It/Mt-1. These too were estimated under the restriction to sum to zero so that the country effects measure the deviation from the average Scandinavian marginal q. The Scandinavian average reported in Table 7.5 is significantly below 1. Marginal q is 0.66 for Denmark, 1.07 for Norway, 0.93 for Finland and 0.77 for Sweden. These findings seem to corroborate previous estimates of marginal q for the Scandinavian countries. In a large cross-country study, Gugler et al. (2002) found similar estimates for Scandinavia. Between 1985 and 2000, they estimated 0.65 for Denmark, 0.96 for Finland, 1.04 for Norway and 0.65 for Sweden. Bjuggren et al. (2007) have also estimated an average qm of 0.65 for Sweden. The findings reported in Table 7.4 are, in other words, consistent with previous estimates for Finland and Norway. Gugler et al. (2002) have estimated the Scandinavian average at 0.78. Their findings support the legal

156

Investments and the legal environment

origin hypothesis. Anglo-Saxon countries perform best with qm 5 1.02. Average qm for Germanic and French origin is 0.74 and 0.59, respectively. However, there is considerable variation in the returns in all four Scandinavian countries, where a large number of firms deviate from the average marginal return on investments. This can have several causes; it might for example be plausible to believe there are industry differences. This is supported by the variation of the implicit deprecation rates in Table 7.4. In the following section the relationship between ownership concentration, separation of cash-flow rights and control rights, and performance is examined.

5.

CORPORATE RETURN AND OWNERSHIP STRUCTURE

In this section, equation (10) is used to test the effects of ownership concentration and separation of control from cash-flow rights on performance. As measures of ownership concentration, the share of capital (cash-flow rights) held by the largest owner (CR1) and the five largest (CR5) are used. Control rights are measured by the share of votes (control rights) held by the largest (VR1) and five largest owners (VR5). Dummies are used to control for dual-class shares. In the sample, 49 percent of the firms use a dual-class share structure. Matching accounting and market data with the ownership data leaves 142 firms out of 292. Correlations are reported in Table 7.6. Naturally all ownership variables display high and significant correlations. Sales are negatively correlated with all ownership variables, but weaker for VR1 and VR5 than for CR1 and CR5. In other words, ownership concentration measured by cash-flow rights is inversely related to firm size. This means that controlling owners remain in large firms by resorting to dual-class equity structure. It is also interesting to note that investments are significantly correlated with control rights and vote-differentiation, but not with cash-flow rights. In order to control for unobserved, time-invariant heterogeneity across firms, a fixed effect model with firm and time effects is applied. The time fixed effect is motivated by the efficient markets hypothesis; a firm may, in any single period, be under- or over-valued but over time this error is expected to be zero. The firm fixed effect controls for differences in depreciation rates across firms and industries. To identify non-linear effects on performance, the ownership variables are also estimated in quadratic and cubic form. In Tables 7.7a and b, merely

Corporate governance and investments in Scandinavia

157

Table 7.6

Correlation matrix
Sales It/Mt-1 Mt-Mt-1/Mt-1 1 0.422* 0.069 0.068 0.118* 0.102* 0.071* CR1 CR5 VR1 VR5

Sales It/Mt-1 Mt-Mt-1/Mt-1 CR1 CR5 VR1 VR5 Votedifferentiation

Note:

1 0.012 0.043 0.088* 0.224* 0.031 0.119* 0.082*

1 0.033 0.022 0.019 0.014 0.049

1 0.847* 0.812* 0.678* 0.053

1 0.710* 1 0.835* 0.817* 1 0.033 0.310* 0.422*

* indicates significance at 5 percent.

3 out of 24 estimated ownership parameters are significant. However, a deviation from one-share-one-vote creates large negative effects. Firms with only a single class of equity do not significantly under-perform, that is, qm is not different from 1, whereas firms that rely on dual-class equity shares on average have a return on dual-class shares that is 30 percent below the opportunity cost of capital. The fact that vote-differentiation has a significant negative effect on firm performance indicates that the ownershipperformance relationship may differ between firms with one class of shares and those having separated cash-flow rights and control rights. This negative effect increases in equations A to G when the ownership variables are added. One possible interpretation is that the ownership variables are picking up a positive incentive effect. This, in turn, suggests that the ownership effects differ between the two categories of firms. In Table 7.8 ownership variables are interacted with the dummy variable for dual-class share structure (1 for vote-differentiation and zero for singleclass share structure). Different specifications of the functional form have been estimated. The results are relatively robust with respect to choice of fixed effect, random effect or simply pooled OLS model. A previous study has also found estimates of qm to be stable to model specification (Bjuggren et al., 2007). The results are robust with respect to the choice between simple pooled OLS with year dummies, fixed effect model with year and firm effects, and random effects model. The estimates are robust with respect to model specification. Since the number of firms with available ownership data is limited

Table 7.7a

Concentration of cash-flow rights and performance

Dependent variable: (Mt-Mt-1)/Mt-1 Equation B Equation C Equation D Equation E Equation F Equation G

Equation A

Constant, (5d)

It/Mt-1

Dual-class Shares

0.088*** (3.82) 0.929*** (14.95) 0.312*** (3.67)

0.087*** (3.80) 0.853*** (6.68) 0.307*** (3.60)

0.088*** (3.82) 0.948*** (4.14) 0.304*** (3.56)

0.087*** (3.79) 0.583 (1.58) 0.344*** (3.78)

CR1

0.088*** (3.84) 0.982*** (9.41) 0.327*** (3.71) 0.002 (0.63)

CR12

0.087*** (3.78) 0.711*** (4.61) 340*** (3.86) 0.026** (2.16) 0.001** (2.38)

CR13 0.002 (0.68)

158
794 142 12.39 0.42 0.790 0.614 0.941 794 142 12.32 0.42 0.894 0.711 1.051 794 142 12.03 0.42 0.890 0.710 1.044 794 142 12.40 0.42 0.796 0.630 0.937

0.087*** (3.78) 0.734*** (3.27) 0.335*** (3.55) 0.022 (0.69) 0.000 (0.27) 0.000 (0.14)

CR5

CR52

0.003 (0.33) 0.000 (0.50)

CR53 794 142 12.11 0.42 0.769 0.605 0.909

No. obs. No. firms F-value R2 Average qm Dual-class qm Single-class qm

794 142 12.69 0.42 0.785 0.617 0.929

0.031 (1.07) 0.001 (1.17) 0.000 (1.27) 794 142 11.88 0.42 0.702 0.516 0.860

Note:

*, ** and *** indicate significance at 10, 5 and 1 percent respectively; t-values in brackets.

Table 7.7b

Concentration of control/voting rights and performance

Dependent variable: (Mt-Mt-1)/Mt-1 Equation C Equation D Equation E Equation F Equation G

Equation B

Constant, (5d)

It/Mt-1

Dual-class Shares VR1

0.088*** (3.80) 0.911*** (9.56) 0.317*** (3.62) 0.001 (0.24)

0.085*** (3.72) 0.702*** (5.51) 0.390*** (4.19)

0.089*** (3.86) 0.966*** (4.29) 0.396*** (4.26)

0.090*** (3.90) 0.649* (1.82) 0.404*** (4.33)

VR12

0.085*** (3.69) 0.818*** (6.02) 0.317*** (3.61) 0.007 (0.99) 0.001 (0.96)

159
0.005** (2.03) 794 142 12.12 0.42 0.836 0.657 0.988 794 142 11.86 0.42 0.836 0.665 0.982 794 142 12.54 0.42 0.774 0.564 0.954

VR13

0.084*** (3.63) 0.709*** (3.60) 0.331*** (3.69) 0.022 (1.07) 0.001 (0.92) 0.000 (0.76)

VR5

VR52

0.007 (0.82) 0.000 (1.42)

VR53 794 142 12.32 0.42 0.728 0.514 0.910

No. obs. No. firms F-value R2 Average qm Dual-class qm Single-class qm

794 142 12.38 0.42 0.812 0.612 0.929

0.021 (0.80) 0.001 (0.92) 0.000 (1.15) 794 142 12.08 0.42 0.730 0.512 0.916

Note:

*, ** and *** indicate significance at 10, 5 and 1 percent respectively; t-values in brackets.

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Table 7.8a

Dual-class shares, ownership and performance

Dependent variable: (Mt 2 Mt-1)/Mt-1 Equation H Constant, (5d) It/Mt-1 CR1 CR12 CR1*Vote differentiation CR12*Vote differentiation No. obs. No. firms F-value R2 Average qm Dual-class qm Single-class qm 0.087*** (3.80) 0.521*** (3.61) 0.053*** (3.79) 0.001*** (3.93) 0.045*** (4.43) 0.001*** (3.79) 794 142 12.27 0.42 0.933 0.652 1.199 Constant, (5d) It/Mt-1 VR1 VR12 VR1*Vote differentiation VR12*Vote differentiation No. obs. No. firms F-value R2 Average qm Dual-class qm Single-class qm Equation I 0.084*** (3.67) 0.404*** (2.60) 0.063*** (4.34) 0.001*** (4.43) 0.053*** (5.07) 0.001*** (4.67) 794 142 12.35 0.43 0.993 0.721 1.226

Note: *, ** and *** indicate significance at 10, 5 and 1 percent, respectively; t-values in brackets.

to 143, the firm effects capture possible industry effects. Consequently, all equations have been estimated with two-digit industry SIC codes. The stock market may be under- or over-estimated in any single period, but for a longer period of time the expected error in stock market evaluations is zero, E(mt) 5 0. To control for this possibility, annual dummy variables are included and estimated under the restriction that they summarize to zero. Annual deviations in stock market evaluations are therefore measured as deviations from the average. To control for the possibility that the Scandinavian countries have systematic differences in returns, country dummies are also included. These are also estimated under the restriction that they summarize to zero, so that any deviation is measured as the deviation from the Scandinavian average. Time, industry and country effects are not reported. Hypotheses 1 and 2 (H1 and H2) cannot be rejected. For all measures of ownership concentration (CR1, CR5, VR1 and VR5) a positive nonlinear relationship is found. In firms with one-share-one-vote, increasing

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161

Table 7.8b

Dual-class shares, ownership and performance

Dependent variable: (Mt 2 Mt-1)/Mt-1 Equation H Constant, (5d) It/Mt-1 CR5 CR52 CR53 CR5*Vote differentiation CR52*Vote differentiation CR53*Vote differentiation No. obs. No. firms F-value R2 Average qm Dual-class qm Single-class qm 0.091*** (3.93) 0.336 (0.89) 0.067** (2.06) 0.002** (2.31) 0.000*** (2.45) 0.060*** (3.24) 0.002*** (2.82) 0.000*** (2.65) 794 142 11.58 0.42 0.808 0.656 0.952 Constant, (5d) It/Mt-1 VR5 VR52 VR53 VR5*Vote differentiation VR52*Vote differentiation VR53*Vote differentiation No. obs. No. firms F-value R2 Average qm Dual-class qm Single-class qm Equation I 0.092*** (3.99) 0.050 (0.12) 0.089*** (2.64) 0.002*** (2.84) 0.000*** (2.94) 0.094*** (3.89) 0.003*** (3.55) 0.000*** (3.37) 794 142 11.91 0.43 0.889 0.784 0.978

Note: *, ** and *** indicate significance at 10, 5 and 1 percent, respectively; t-values in brackets.

ownership has a positive but marginally diminishing effect on performance. For the two concentration measures of the single largest owner, CR1 and VR1, a quadratic form gives the best fit, whereas for the concentration of the five largest owners, CR5 and VR5, a cubic form provides the best fit. The average qm for single class equity firms lies between 0.95 and 1.23.15 In firms with vote-differentiated shares, the effects are similar but much weaker. By comparing the parameters in equations H and I in Tables 7.8 a and b, one can see that in vote-differentiated firms the positive effect of ownership concentration is significantly lower than in other firms. The average qms estimate for firms with dual-share class structure lies between 0.65 and 0.78 (equations H and I respectively). As in equation A, firms with dual-class shares seem to be investing at approximately 30 percent below

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their cost of capital. From equations H and I in Tables 7.8 a and b, it is clear that the separation of cash-flow and control rights reduces the positive effect of ownership and enhances the entrenchment effect. Examining listed firms in Sweden, Bjuggren et al. (2007) found similar negative effects of vote-differentiation and positive effects of ownership concentration on investment performance of firms. Controlling for ownership characteristics and dual-class equity weakens the country effects (not reported here), but remains significantly negative for Sweden and positive for Norway. However the effects of ownership and deviations from one-share-one-vote cut across national boundaries. The intercept will, as discussed in Section 2, capture both the depreciation rate and any systematic changes in market evaluations. In equations A to I, the intercept is estimated at approximately 9 percent. This is a reasonable estimate and is in line with previous estimates of depreciation rates. Furthermore, the intercept does not affect the marginal effect, and is thus not of any importance for the interpretation of the results.

6.

CONCLUSIONS

This chapter examines the linkage between corporate investments, returns and ownership structure in the Scandinavian countries. Marginal q is used as performance measure. Marginal q measures the marginal return on capital relative to its cost. This return to cost of capital ratio (r/i 5 qm) is a measure of what Tobin (1982) labelled the functional efficiency of capital markets. When studying firm performance, this method has some clear advantages over the conventional market-to-book measures of Tobins average q. Few Scandinavian firms can be characterized as having dispersed ownership as described by Berle and Means (1932). Vote-differentiation is a common tool for creating and maintaining strong and concentrated ownership structures. Scandinavian firms make more frequent use of control mechanisms than firms in comparable countries. On average the largest owner holds more than 20 percent of the capital (CR1) and close to 30 percent of the voting rights (VR1). The hypothesis that ownership concentration improves resource allocation is supported in this chapter. The effect of ownership on investment performance is, however, found to be non-linear: cubic or quadratic in form. This is consistent with the entrenchment hypothesis. Strong support of the hypothesis that control mechanisms are detrimental to firm performance is also found. Ownership concentration is found to have a non-linear effect on firm performance. This is consistent with previous studies that find both

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positive incentive effects and negative entrenchment effects of ownership concentration. For firms with one-share-one-vote ownership has a positive impact but marginally diminishing, whereas for firms controlled by dualclass shares this effect is weaker. These firms have a systematically worse performance than other firms. Dual-class shares drive a wedge between cash-flow rights and control rights. Not only does this change the control structure, but it also changes the incentive structure. Firms with only one equity class are, on average, investing efficiently, whereas firms with dualclass equity structure are over-investing. The separation of cash-flow rights and control rights reduces the positive incentive effect and enhances the negative entrenchment effect. By impairing capital reallocation, corporate control mechanisms are in the long run harmful for industry dynamics and economic renewal. Vote-differentiation creates massive entrenchment effects and destroys large values. In the long run, they are likely to harm the functional efficiency of the Scandinavian capital markets. On average, entrenched firms have returns on investments that are approximately 30 percent below their cost of capital. Differences in investment performance across firms can largely be explained by differences in ownership structure and, in particular, to what extent corporate control is upheld by dual-class equity structure. Separation of cash-flow rights from control appears to distort the incentives of the controlling owner by significantly reducing the incentive effect.

NOTES
* Acknowledgments: Financial support from the Ratio Institute and Sparbankernas forskningsstiftelse is gratefully acknowledged. This chapter was initiated during a six-month visit to George Mason University, and subsequently benefited a great deal from valuable comments and suggestions given by a large number of people. In particular, I am grateful for comments provided by Robin H. Hansson. Furthermore, I greatly appreciate valuable discussions during workshops and seminars held at Jnkping International Business School. In particular, I thank ke E. Andersson, Tom Berglund, Per-Olof Bjuggren, Brje Johansson, Agostino Manduchi, Dennis C. Mueller, Ajit Singh, Steen Thomsen and Daniel Wiberg for valuable insights and helpful comments. Naturally, any remaining errors are my own. For a review of the corporate governance literature see, for example, Shleifer and Vishny (1997), Morck et al. (2005), Mueller, (2003) and Denis and McConnell (2003). There is a large literature on ownership and firm performance/value emanating from the work of Morck et al. (1988). See e.g. McConnell and Servaes (1990). For critique see Demsetz and Lehn (1985). Agency costs are costs that arise from the principalagent problem, that is, divergence of managerial objectives from the objectives of shareholders. Jensen and Meckling (1976) also point out that the most serious problem of not

1. 2. 3. 4.

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having equity claims is probably that the incentive to seek new profitable investment opportunities and engage in innovative efforts will fall. Cho (1998) criticizes these findings and shows that market value affects ownership concentration. See also Loderer and Martin (1997). In an external study commissioned by the European Commission the proportionality between ownership and control of listed firms in the EU is examined. Among other things this study reports the results from a survey sent to institutional investors with 4.9 trillion of assets under management. A clear majority of the investors expect a discount of 10 to 30 percent of the share price of firms using CEM. See for further details ECGI (2007). Functional stock market efficiency is related to but different from the standard term market efficiency. Functional efficiency refers to the way in which capital markets are allocating resources to the most efficient usage (Tobin, 1982). Morck et al. (2005) survey a literature that shows how the functional efficiency of capital markets depends on the structure and composition of corporate control. When firms are price takers and perfectly competitive, marginal q and average q will be equal. Firms with market power will have a higher average q. For a derivation of the relationship between average q and marginal q, see Hayashi (1982). If the market makes errors in their valuation of the firm, the error component, m, may contain a revaluation factor in the following period. See Mueller and Reardon (1993) for a description of the methodology and an account of the properties of qm. Accounting data and market prices have been collected from Standard & Poors Compustat Global Database, 2006 version. The following variables have been collected from Compustat (mnemonics in brackets): after-tax profit (IB), depreciation (DP) dividends (DVT), total debt (DT), research and development (XRD), market price (MKVAL), advertising and marketing expenditures (XSGA), D equity (SSTK minus PRSTKC). These 292 firms represent all non-financial firms for which sufficient ownership information was available. In 2004, there were a total of 796 listed firms in Scandinavia (194 in Denmark, 143 in Finland, 177 in Norway and 282 in Sweden). The formula, Mi 5 M 1/i where M 1 is the largest firm and i the firm rank, approximates the size distribution of the firms in the sample. In practice this excludes variables that have missing observations or contain accounting errors. Observations that were excluded were only among the small firms in the sample. Using a robust estimation technique yields consistent results. The marginal effects have been calculated based on the average ownership concentration in the data set (CR1 5 22.24, CR5 5 44.52, VR1 5 28.58 and VR5 5 52.85).

5. 6.

7.

8. 9. 10. 11.

12.

13. 14. 15.

REFERENCES
Adams, R. and Ferreira, D. (2008), One ShareOne Vote: The Empirical Evidence, Review of Finance, 12 (1), 5191. Bebchuk, L., Kraakman, R. and Triantis, G. (1999), Stock Pyramids, CrossOwnership, and Dual-Class Equity: The Creation and Agency Costs of Separating Control from Cash Flow Rights, NBER Working Paper, No. 6951. Bennedsen M.B. and Nielsen, K.M. (2005), The Principle of Proportionality: Separating the Impact of Dual Class Shares, Pyramids and Cross-ownership on Firm Value Across Legal Regimes in Western Europe, Centre for Industrial Economics Discussion Papers, University of Copenhagen. Berle, A.A. and Means, G. (1932), The Modern Corporation and Private Property, New York: The Macmillan Company.

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Bergstrm, C. and Rydqvist, K. (1990), Ownership of Equity in Dual-class Firms, Journal of Financial Economics, 14, 25569. Bjuggren, P.-O. and Wiberg, D. (2008), Industry Specific Effects in Investment Performance and Valuation of Firms: Marginal q in a Stock Market Bubble, Empirica, 35 (3), 27991. Bjuggren, P.-O., Eklund, J.E. and Wiberg, D.K. (2007), Ownership Structure, Control and Firm Performance: the Effects of Vote Differentiated Shares, Applied Financial Economics, 17, 132334. Burkart, M. and Lee, S. (2008), One Share One Vote: The Theory, Review of Finance, 12 (1), 149. Bhren, . and degaard, A.B. (2006), Governance and Performance Revisited, in Gregouriu, G. and Ali, P. (eds), International Corporate Governance after Sarbanes-Oxley, Wiley. Carsten, G. (1993), Europische Integration und Nordische Zusammenarbeit auf dem Gebiet des Zivilrechts, Zeitschrift fr Europisches Privatrecht, 335. Cho, M.-H. (1998), Ownership Structure, Investments, and the Corporate Value: An Empirical Analysis, Journal of Financial Economics, 47 (1), 10321. Claessens, S., Djankov, S., Fan, J.P.H. and Lang, L.H.P. (2002), Disentangling the Incentive and Entrenchment Effects of Large Shareholdings, Journal of Finance, 57 (6), 274171. Cronqvist, H. and Nilsson, M. (2003), Agency Costs of Controlling Minority Shareholders, Journal of Financial and Quantitative Analysis, 38 (4), 695707. Demsetz, H. (1983), The Structure of Ownership and the Theory of the Firm, Journal of Law and Economics, 26 (2), 37590. Demsetz, H. and Lehn, K. (1985), The Structure of Corporate Ownership: Causes and Consequences, Journal of Political Economy, 93 (6), 115577. ECGI (2007), Report on the Proportionality Principle in the European Union, external study commissioned by the European Commission, European Corporate Governance Institute (ECGI). Faccio, M. and Lang, L.H.P. (2002), The Ultimate Ownership of Western European Corporations, Journal of Financial Economics, 65 (3), 36595. Gugler, K. and Yurtoglu, B.B. (2003), Average q, Marginal q, and the Relation between Ownership and Performance, Economics Letters, 78 (3), 37984. Gugler, K. Mueller, D.C. and Yurtoglu, B.B. (2002), Corporate Goverance, Capital Market Discipline and Return on Investments, mimeo, University of Vienna. Hayashi, F. (1982), Tobins Marginal q and Average q: A Neoclassical Interpretation, Econometrica, 50 (1), 21324. Henrekson, M. and Jakobsson, U. (2006), Den svenska modellen fr fretagsgande och fretagskontroll vid skiljevgen, Institutet fr nringslivsforskning, Policy Paper No. 1, Stockholm. Hgfeldt, P. (2004), The History and Politics of Corporate Ownership in Sweden, NBER Working Paper No. 10641. Jensen, J. and Meckling, W. (1976), Theory of the Firm: Managerial Behavior, Agency Costs and ownership structure, Journal of Financial Economics, 3 (4), 30560. La Porta, R., Lopez-de-Silanes, F., Shleifer, A. and Vishny, R.W. (1997), Legal Determinants of External Finance, Journal of Finance, 52 (3), 113150. La Porta, R., Lopez-de-Silanes, F. and Shleifer, A. (1999), Corporate Ownership around the World, Journal of Finance, 54 (2), 471517. Loderer, C. and Martin, K. (1997), Executive Stock Ownership and Performance: Tracking Faint Traces, Journal of Financial Economics, 45 (2), 22355.

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McConnell, J.J. and Servaes, H. (1990), Additional Evidence on Equity Ownership and Corporate Value, Journal of Financial Economics, 27 (2), 595612. Manne, H. (1965), Mergers and the Market for Corporate Control, Journal of Political Economy, 75 (2), 11020. Maury, B. and Pajuste, A. (2004), Multiple Large Shareholders and Firm Value, SSRN working paper series. Morck, R., Shleifer, A. and Vishny, R. (1988), Management Ownership and Market Valuation: An Empirical Analysis, Journal of Financial Economics, 20 (1), 293316. Morck, R., Wolfenzon, D. and Yeung, B. (2005), Corporate Governance, Economic, Entrenchment, and Growth, Journal of Economic Literature, 43 (3), 655720. Mueller, D.C. (2003), The Corporation; Investments, Mergers and Growth, London: Routledge. Mueller, D.C. and Reardon, E.A. (1993), Rates of Return on Corporate Investment, Southern Economic Journal, 60 (2), 43053. Roe, M.J. (2003), Political Determinants of Corporate Governance, Oxford: Oxford University Press. Shleifer, A. and Vishny, R.W. (1997), A Survey of Corporate Governance, Journal of Finance, 52 (2), 73783. Sderstrm, H.T. (ed.), Berglf, E., Holmstrm, B., Hgfeldt, P. and Milgrom, E.M. (2003), garmakt och omvandling Den svenska modellen utmanad, Ekonomirdets rapport 2003, SNS, Stockholm. Stulz, R.M. (1988), Managerial Control of Voting Rights, Financing Policies and the Market for Corporate Control, Journal of Financial Economics, 20, 2554. Tobin, J. (1982), On the Efficiency of the Financial Systems, Lloyds Banking Review, 153 (July), 115. Veblen, T. (1921), The Engineers and the Price System, New York: Viking.

8.

The cost of legal uncertainty: the impact of insecure property rights on cost of capital
Per-Olof Bjuggren and Johan E. Eklund*
INTRODUCTION

1.

In the required rate of return on investments a special risk premium labeled institutional risk should be included. Different countries represent institutional risks for investors. It is various risk factors tied to the institutional framework that give the rules of the game facing investors. The rules can be of a supportive nature or make long-term investments hazardous due to the lack of secure property rights. It is more or less evident that investors must use a higher discount rate in evaluations of investments in countries where property rights are weakly protected. How to account for the political risk has not received much attention in the finance literature, even though the concept political risk is sometimes mentioned. However, a formal treatment is not offered. An exception is Faure and Skogh (2003), who have shown how political risk can be incorporated in investment analysis. It is their approach that has inspired this chapter. But it is one thing to propose the necessity to add an institutional risk premium and another thing to prove the existence of such risk premiums and estimate their size. One reason why few attempts have been made so far is the difficulty of empirically quantifying and pricing institutional risk. The purpose of this chapter is to show the existence of property risk premiums and measure their magnitude. As measures of institutional risk we use two indexes; one on property right protection provided by the Heritage Foundation, and one on investor right protection provided by the Political Risk Group. With these indexes we use a type of CAPM (capital asset pricing model) to estimate the effect of property rights uncertainty on the cost of capital. The chapter starts, in Section 2, with a discussion of what is meant by institutional risk. Section 3 provides the theoretical underpinning to rational investment decisions. How to calculate capital costs and risk premiums for
167

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assets with political risk is the subject matter of Section 4. The data used in our empirical analysis are presented in Section 5. The empirical findings are analysed in Section 6. The chapter ends with conclusions in Section 7.

2.

POLITICAL RISK, PROPERTY RIGHTS, CONTRACTS AND LEGAL UNCERTAINTY

Growth, prosperity and welfare are a function of the investments made in a country. Investments add to the capital stock which is a basic production factor. However, investments are risky. A cost in the form of a capital outlay is paid today, while the benefits represented by positive net cash flows lie in the future. It is like a deferred exchange where a payment is made today in return for enhanced future consumption. When the future unfolds it might turn out that the products produced by the new capital (the investment) cannot be sold at profitable prices. This is a risk that every entrepreneur has to face. But in addition to this risk there might be an institutional risk caused by insecure property rights and a defective judicial system that makes it difficult to enforce contracts in an effective way. Secure property rights and contract enforcement were put forward long ago by David Hume and Adam Smith as two of the most important institutional factors for the prosperity of a nation. According to Kasper and Steit (1999, p. 20) David Hume and Adam Smith stressed three institutions of fundamental importance for progress and welfare: the guarantee of property rights, the free transfer of property by voluntary contractual agreement, and the keeping of promises made. In other words, secure property rights, freedom of contracts and enforcement of agreements are basic cornerstones in the quest for prosperity. Secure property rights, freedom of contracts and enforcement of agreements are basic parts of the institutional framework within which an economy is organized. It is the task of the state to develop a well functioning and adequate institutional framework through formal rules. According to North (1990, p. 47) formal rules include political (and judicial) rules, economic rules, and contracts. By economic rules North means property rights, which are defined as the bundle of rights over the use and the income to be derived from property and the ability to alienate an asset or a resource (p. 47). The link to investments is clear as investments mean the creation of new assets. Furthermore, North ascertains a hierarchical order between rules in the sense that the rules descend from polities to property rights to individual contracts (p. 52). According to, for example, North (1990) and Williamson (2000) these institutions are very stable over time. Hernando de Soto (2000) has argued powerfully that the varying degree

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169

to which countries succeed to support capital formation and accumulation is to be found in the legal structure of the property rights system of the western world. De Soto claims that:
When advanced nations pulled together all the information and rules about their known assets and established property systems that tracked their economic evolution, they gathered into one order the whole institutional process that underpins the creation of capital. If capitalism had a mind, it would be located in the legal property system. (de Soto (2000) p. 65)

Furthermore, de Soto argues that informal institutions are far less important than formal institutions in this respect. In other words it is through polity that a nation can influence the institutional framework to stimulate investments and growth. The institutional framework might be of a kind that makes investors feel secure that no one else will appropriate the fruits of their investments or the framework might be one that makes investors think that there is a risk that someone else will reap the benefits. If the property rights are insecure, long-term investments will be hampered and come at the cost of lower welfare.

3.

RISK, RETURN, PORTFOLIO THEORY AND INVESTMENT

Conventional investment theory holds that investors will evaluate alternative investments on the basis of the net present value (NPV). According to the NPV rule investments should be evaluated according to the expected cash flows (CF) minus the expected investment costs (I). Only projects with expected positive net present values should be initiated (NPV 5 PV I). When calculating the present value of cash flows generated by an investment one uses a discount factor, 1/(1 1 r), where r is the discount rate. The discount rate is also referred to as the required rate of return or as the cost of capital. For risk-free projects the required rate of return equals the riskfree interest rate, which also serves as a reference when valuing risky assets. The PV of future cash flows is calculated as follows:1
T CFt PV 5 a t t51 (1 1 r)

(1)

The discount rate will depend on the riskiness of the future cash flows. If the risk is that the actual cash flow will be lower than predicted, the discount rate will be accordingly higher than for a more certain future cash flow. As the discount rate, r, increases the present value declines, hence the aggregate number of investments also declines.

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The crucial question is therefore how to determine the size of the discount rate and the risk associated with various assets. We argue that the discount rate can be broken down to a multitude of components, among which property rights protection is one. Accordingly the discounted rate r in the formula above should be: r 5 rf 1 RPo 1 RPp (2)

where rf is the risk-free interest rate, RPp the risk premium associated with weak property rights protection, and RPo a general risk premium.2 Note that the general risk premium can presumably be broken down further into different risk factors.3 The conventional capital asset pricing model (CAPM) makes a distinction between diversifiable firm specific risk and non-diversifiable systemic risk (see Section 3). The specific risk can be diversified away. It is only the remaining non-diversifiable risk that matters for the pricing of the asset (that is, investors are only compensated for the systematic non-diversifiable risk). As a consequence, the return r that investors require depends on the systematic risk of the investment (see Section 4). On a global capital market even much of the country specific risk can be diversified away. One exception is, however, the institutional risk of insecure property rights and contracts. This is a risk associated with the institutional framework of the rules of a country. This institutional framework is made up of both informal rules like norms, customs, tradition and religion and formal rules like property and contract laws and the enforcement of these rules. It is, as pointed out above, primarily the formal rules that polity can exert an influence on. To change informal rules is a much tougher task. According to North (1990) and Williamson (2000) this institutional framework changes very slowly over time. Even changes in the formal rules (like property rights rules) and their enforcement tend to take decades to implement. As an investor you are more or less stuck with the institutional framework for a considerable time. The prospects of balancing changes in the security of property rights by having an international portfolio are small. Hence, insecure property rights represent a truly systematic risk that, according to the theory (see next section), will increase the cost of capital (the required return on investment, r). The rise in the cost of capital will, as shown in standard investment theory, decrease investment.4 According to the CAPM the expected return on a security can be calculated as: E (ri) 5 rf 1 bi (E (rm) 2 rf) (3)

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where bi measures the sensitivity of a security to market risk (systemic risk) and rm the return on a market portfolio m. The model holds that the expected rate of return should equal the risk-free interest rate plus a risk premium that varies with b. The expected rate of return, E(ri), that is obtained is simply the discount rate r used in equation (4) to calculate the present value of future cash flows. The term E(rm) rf is the market price of risk for efficient portfolios (see for example Elton and Gruber, 1995). In this model it is only one factor, the market portfolio, that matters in calculation of the risk premium. This standard CAPM can be extended into a so-called multi-beta CAPM by including other factors that influence the size of the risk premium. Merton (1973) was among the first to include a number of uncertainty factors that could influence the price of an asset. Friend et al. (1976) used the market portfolio inflation uncertainty as an additional factor that determined cost of capital. We follow their approaches and add legal uncertainty in the form of the degree of security of property rights as a risk factor.

4.

ESTIMATIONS OF RISK AND RETURN

Roll (1977) has in a seminal article levelled criticism at a general equilibrium model of the form of the CAPM. One of Rolls points is that all assets in the entire world should be included in the market portfolio m. However, in the empirical literature national stock indices like Standard and Poors 500 and the New York Stock Exchange index are used as market portfolios (see, for instance, Elton and Gruber (1995) for examples). This is clearly an incorrect measure according to Rolls critique. A step towards a more correct market portfolio measure is to use an index containing all securities in the entire world. Such an index for traded corporate shares is the Morgan Stanley world market index. That is the index that will represent the market portfolio in the present study. Estimation of beta and the risk premium can be made according to a two-pass procedure.5 In a first-pass regression, time series analysis is used to estimate bi in equation (4). rti 5 ai 1 bi 3 rmt 1 eit ^ The estimated betas (bi) are then used in a second-pass regression ^ ri 5 ai 1 RPm 3 bi 1 ei (5) (4)

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where ai is an estimate of the risk-free interest rate, ri is the average return of a security or portfolio of securities, RPm is the risk premium of the ^ market portfolio and bi is the estimated beta-coefficient. Since the institutional framework influencing investments tends to be extremely stable over time, the institutional risk stemming from flaws in the protection of property is not diversifiable and thus is systematic. However, the stability of these institutional types of risk factors offers an empirical challenge to estimation. An ideal way of estimating various risk factors influence on return is the so-called arbitrage pricing theory (APT). The APT model comes from an entirely different tradition from the CAPM.6 In contrast to the CAPM, the APT model emphasizes surprise effects; that is, sudden unexpected changes in macro variables can be used to explain return. This is not an option in the present case. The stability of institutions means that there is virtually no variation across time so one needs to focus on the cross-sectional variation. As a consequence it is not possible to use indexes of institutional risk factors in the first-pass estimation procedure. A number of tests of the CAPM using the two-pass procedure have been performed. Several of these indicate that a two-factor model (a multiCAPM) can be used.7 Consequently, there is some empirical support for use of a model where legal uncertainty as well as a market portfolio is included as a factor in the calculation of cost of capital. In that case the second-pass regression will contain a second factor representing institutional risk and look like: ^ ri 5 ai 1 RPm 3 bi 1 RPp 3 Institutional Risk 1 ei (6)

where RPp is the right risk premium due to insufficient safeguarding of property and investor rights.

5.

DATA

To calculate the impact of institutional risk on risk premium and the required return on investments stock exchange data, risk data and data of a global market portfolio are needed. Table 8.1 shows the data we have used for these variables. Monthly stock market indexes compiled by Morgan Stanley are used to calculate the rate of return on national stock markets and the world market portfolio.8 The stock market indexes cover a ten-year period, 1995 to 2005 (129 months more exactly), are expressed in US dollars, and are corrected for dividends. This ensures that the indexes are consistently defined and include all relevant returns. As a proxy for the market portfolio the world stock

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Table 8.1

Description of the variables

Measures the stock price performance including dividends. Expressed in US dollars. Source: Morgan Stanley Measures the stock price performance including dividends for 49 developed and developing countries. Source: Morgan Stanley Assessment of the protection and certainty of property rights. Annual index ranging from 1 to 5, with a higher number meaning weaker protection of property rights. Source: Heritage Foundation Index of Economic Freedom Investor profile. Assessment of a number of factors influencing the risk of investments. Monthly index ranging from 1 to 12, with a higher number meaning stronger protection of investors. The index assesses contract viability, risk of expropriation, payment delays and profit repatriation. Source: International Country Risk Guide Different forms of return are calculated. Monthly stock market return on country level. National stock market indexes corrected for dividends and in US dollars are used. Source: Morgan Stanley World market return calculated with monthly world market index. Source: Morgan Stanley

Country stock market indexes World market index Property right protection (PRPit) Investor right protection (IRPit)

Returns rit

rmt

market index from Morgan Stanley is used, which includes 49 developed and emerging country market indexes. These are the countries examined. As measures of institutional risk the Heritage Foundation index of property rights protection (PRP) and the index of investor rights protection (IRP) provided by the International Country Risk Guide (ICRG) are used. The Heritage index ranges from 1 to 5, where 1 indicates strong protection of property rights. It is an annual index which is available for the period 1995 to 2005. The property right index is an assessment of the quality of contract enforcement, legal protection of property, existence of corruption in the judicial system and the probability of expropriation. The ICRG index ranges from 1 to 12, where 1 indicates strong protection. This is a monthly index that here is used for the period 1995 to 2005. This index also measures factors that have to do with protection of property rights and enforcement of contracts. (For a further description of the two indexes used here, refer to the Heritage Foundation and the Political Risk Group.) In Table 8.2 the 49 developed and emerging countries that are included in Morgan Stanleys world market are shown. Three variables are presented. The first variable, R2-values from first-pass regression, shows the proportion of the national rate of return that can be explained by variation

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Table 8.2
Developed countries

Country data for 19952005 (129 months)

R2-values Property right Investor right protection from 1st-pass protection (IRPit) regression (PRPit) (average)* (average)* 0.53 0.22 0.40 0.68 0.47 0.40 0.69 0.65 0.20 0.38 0.48 0.39 0.37 0.68 0.30 0.48 0.32 0.37 0.59 0.60 0.45 0.69 0.87 1.00 1.00 1.00 1.00 1.00 1.00 2.00 1.00 2.36 1.00 1.00 2.00 1.36 1.00 1.00 1.18 2.00 1.00 2.27 1.64 1.27 1.00 1.00 7.52 9.16 8.68 8.52 8.21 8.74 8.44 8.50 6.89 7.63 8.87 7.99 8.49 8.94 8.47 8.23 7.89 8.79 8.96 8.12 8.95 8.85 8.96 Average rate of return

Australia Austria Belgium Canada Denmark Finland France Germany Greece Hong Kong Ireland Italy Japan Netherlands New Zealand Norway Portugal Singapore Spain Sweden Switzerland United Kingdom United States Emerging economies Argentina Brazil Chile China Colombia Czech Republic Egypt Hungary India Indonesia Israel

0.128 0.122 0.127 0.160 0.150 0.221 0.125 0.105 0.164 0.108 0.107 0.131 0.011 0.106 0.106 0.140 0.107 0.045 0.178 0.172 0.124 0.103 0.121 Average rate of return 0.165 0.200 0.083 0.017 0.179 0.205 0.274 0.287 0.108 0.101 0.135

R2-values Property right Investor right from 1st-pass protection protection regression (average) (average) 0.16 0.43 0.38 0.17 0.05 0.09 0.04 0.26 0.10 0.16 0.33 2.73 3.00 1.00 4.00 3.36 2.00 3.09 2.00 3.00 3.45 2.00 5.56 6.06 7.73 6.68 6.34 8.52 6.31 7.75 6.36 6.12 6.92

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Table 8.2
Emerging economies

(continued)
R2-values Property right Investor right from 1st-pass protection protection regression (average) (average) 0.01 0.24 0.14 0.44 0.00 0.02 0.12 0.20 0.27 0.23 0.35 0.26 0.25 0.26 0.09 2.36 1.27 2.45 2.91 3.09 3.18 3.45 2.73 2.27 3.36 2.91 2.09 1.36 2.36 3.45 6.76 7.85 7.26 7.72 6.84 4.94 6.12 6.32 7.34 5.59 7.55 7.03 9.06 6.43 5.28 Average rate of return 0.158 0.149 0.044 0.175 0.115 0.141 0.156 0.061 0.166 0.413 0.114 0.022 0.028 0.322 0.172

Jordan South Korea Malaysia Mexico Morocco Pakistan Peru Philippines Poland Russia South Africa Taiwan Thailand Turkey Venezuela

Note: * The two indexes are inverse to each other. For the PRP index a low value is good, whereas for the IRP index a high value is good.

of the rate of return in a world market portfolio. It is evident that there is a clear difference between developed and emerging countries in this respect. In most cases the stock exchanges in developed countries are more influenced by variations in the world market portfolio than those in emerging countries are. The very low R2-values for many countries could be seen as an indication that there is a need for more factors than our market portfolio to explain the rate of return on assets in different countries. The average value on the Heritage index of property rights for the examined period differs also a lot for the countries. With a few exceptions the developed countries have more secure property rights (lower values). With regard to average rate of return there are not similar systematic differences between the two types of countries. One observation is that there is more variation in the rate of return for emerging than for developed countries. The negative rate of return for the Philippines is troublesome from a theoretical perspective. According to the CAPM model this rate of return would indicate a negative risk-free interest rate, which is not possible. We will therefore exclude the Philippines when the risk premiums are calculated. Table 8.3 is a table of summary statistics that confirms the picture given.

Table 8.3
Property right protection Developed economies 1.307* 0.473 1 2.36 23 1 4 26 6.89 9.16 23 2.649* 0.749 8.426* 0.556 6.786* 0.984 4.94 9.06 26 Emerging economies Developed economies Emerging economies Investor right protection

Summary statistics for the aggregates of developed and emerging economies 19952005 (129 months)
Rate of return Developed economies 0.124 0.043 0.011 0.221 23 Emerging economies 0.149 0.101 -0.061 0.413 26

R2 from 1st-pass regression

Developed economies

Emerging economies

176

Mean Standard deviation Minimum Maximum Count

0.487* 0.170

0.194* 0.128

0.2 0.87 23

0 0.44 26

Note:

* indicates that z-test shows significantly different means at less than 5 per cent level.

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Table 8.4

Correlation matrix
R2 Property rights 1 0.827 0.205 Investor rights Average returns

R2 Property rights Investor rights Average returns

1 0.652 0.675 0.086

1 0.254

The world market portfolio is a significantly better explanatory factor of rate of return in developed than in emerging countries. Property rights protection is significantly higher in developed countries. Also, property rights protection and the rate of return show a much higher variation in emerging countries. Finally, Table 8.4 shows that the correlation between the variables is especially high between property rights and R2-values. This result does also point to an interpretation that in countries with insecure property rights the market portfolio alone does not explain as much of the rate of return as in countries with secure rights. And for obvious reasons the property right and investor right indexes are highly correlated. To test whether there is a significant link between the R2-values from the first-pass regression and the institutional framework we regress the indexes on the R2-values. We find a highly significant link in both cases and the explanatory power is relatively high. The results are reported in Table 8.5. These results suggest that in countries with weak institutional protection of property rights the systematic economic factors influencing the world market return have less explanatory power. In comparison, Roll (1988) has examined the R2s for individual stock in the US and found that there is no systematic difference in the explanatory power across industries. This seems to suggest that the CAPM provides a less adequate tool for understanding asset pricing in less developed financial markets. Therefore we believe that the R2-values can be used as proxies for financial development; countries in which the CAPM displays a lower explanatory power might be interpreted as less developed financially.

6.

MODELS AND RESULTS

In the first step monthly data were used to estimate the first-pass regression as in equation (4). In the second-pass regression the average Heritage and International Country Risk Guide indexes of property rights protection were included:

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Table 8.5

First-pass R2-values and protection of property

Property right protection Investor right protection (PRP) (IRP)

Estimation method Dependent variable: R2(first-pass) Property rights (PRPi ) Investor rights (IRPi) R2 Adj. R2 F-value No. observations

OLS Coefficient 20.147 0.42 0.41 34.1 49 t-value 25.84* 0.122 0.45 0.44 38.7 49

OLS Coefficient t-value 6.22*

Note: * indicates significance at 1 percent. The differences in sign and intercept are due to the fact that the two indexes are inverse to each other (see Table 8.1).

^ ri 5 ai 1 RPm 3 bi 1 RPPRP 3 PRPi 1 ei ^ ri 5 ai 1 RPm 3 bi 1 RPIRP 3 IRPi 1 ei

(7a) (7b)

where PRPi is the average value of the Heritage Foundation property right index and IRPi is the International Country Risk Guide index of investor right protection for a country i. We identify the Philippines as an outlier and consequently exclude it from our regression. Significant coefficients, RPPRP for the average value of the Heritage index and RPIRP for the average value of the ICRG index, indicate that the market portfolio is not the only important explanatory variable in calculations of a risk premium. The result of the estimation of the second-pass equation is shown in Table 8.6. The security of property rights is important. The coefficient for PRP is almost significant at the 5 percent level and the coefficient for IRP is significant at 5 percent. A higher degree of insecurity is consistent with a higher cost of capital. With the conventional CAPM we find that the world risk-free interest rate, (a), was on average 8 percent. However, assuming that the countries ^ with the best values on the property right index (PRP 5 1) and the investor protection index (IRP 5 9.16) have virtually no uncertainty with regard to property rights, we find lower risk-free interest rates. Using the best values of the two risk factors we estimate the risk-free rate to be 5.7 percent for the property right index and 4.8 percent for the investor right index. The

Table 8.6
Property right protection (PRP) OLS t-values 2.55* 0.19 0.15 5.18 48 1.06 1.98** Coefficients t-values OLS OLS Coefficients Investor right protection (IRP)

Risk premium factors: property rights and investor protection

Conventional CAPM

Estimation method

Dependent variable: ri 0.036 0.021 0.059 0.240 0.021 0.056 3.36* 2.41* 2.45* 0.22 0.18 6.27 48

Coefficients

t-values 0.08 0.06 2.92* 2.47* 0.12 0.10 6.08 48

179

Intercept (a) Property rights PRPi Investor rights IRPi ^ b R2 Adj. R2 F-value No. observations

Note: * and ** indicate significance at 5 percent and 10 percent respectively. The differences in sign and intercept are due to the fact that the two indexes are inverse to each other (see Table 8.1).

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influence of security of property rights is significant whichever of the two indices we use. The traditional beta stays approximately the same whatever index is used. This suggests robustness in the result that security of property rights does matter for the cost of capital. Estimated risk premiums for property right protection and investor right protection (plus the estimated risk-free interest rate) are reported in Table 8.7. We find an average 3 percent difference in interest rates, which can be explained by differences in institutional quality. A z-test shows that these differences are significant. The general beta does not differ in a significant fashion between developed and emerging countries. Hence, the developing countries have a much lower risk premium on investments due to the systematic risk that the institutional framework represents. Improvement in the institutional framework will probably be conducive to more investments and higher welfare. For the conventional CAPM Ramseys regression specification error test (RESET) indicated a problem of omitted variables (F-test 8.65), which supports the inclusion of further variables in the model. This is consistent with the fact that the R2 and R2-adjusted almost double with the inclusion of the two indexes.

7.

CONCLUSIONS

David Hume and Adam Smith stressed the importance of secure property rights for prosperity and growth. A link in the form of a formal treatment of how secure property rights lead to lower cost of capital and thereby more investment has not been established. Portfolio theory in corporate finance theory provides such a link. In portfolio theory as represented by CAPM and APT, systematic risk and surprise changes in fundamentals are determinants of cost of capital. The rationale is that an investor can get rid of unsystematic risk through portfolio diversification. A time perspective is used where unsystematic risk is avoided by combining assets that show different patterns of change over time, implying a correlation of less than 1. Insecure property rights have to do with what institutional framework a country has. The institutional framework changes slowly over time. Hence it is difficult to diversify away from the systematic risk that the institutional framework represents. The specificities of institutional frameworks of countries make it impossible to use traditional APT and CAPM methodologies to estimate the impact of insecure property rights on cost of capital. There is not much variation over time in the institutional frameworks. The variation is between countries. This makes it difficult to apply APT methodology. Instead, a multi-

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Table 8.7
Developed economies

Risk-free rate plus risk premiums

Property right premium (PRP) ^ +a 0.058 0.058 0.058 0.058 0.058 0.058 0.079 0.058 0.087 0.058 0.058 0.079 0.066 0.058 0.058 0.062 0.079 0.058 0.085 0.072 0.064 0.058 0.058 0.064* Investor right premium (IRP) ^ +a 0.084 0.050 0.060 0.063 0.070 0.059 0.065 0.064 0.097 0.082 0.056 0.074 0.064 0.055 0.064 0.069 0.076 0.058 0.054 0.072 0.054 0.056 0.054 0.065* ^ bi

Australia Austria Belgium Canada Denmark Finland France Germany Greece Hong Kong Ireland Italy Japan Netherlands New Zealand Norway Portugal Singapore Spain Sweden Switzerland United Kingdom United States Averages Emerging economies Argentina Brazil Chile China Colombia Czech Republic Egypt Hungary India Indonesia Israel Jordan

0.87 0.61 0.80 1.11 0.84 1.62 1.07 1.26 0.95 1.20 0.85 0.94 0.87 1.08 0.81 1.07 0.82 1.15 1.14 1.42 0.79 0.77 1.00 1.00

0.095 0.101 0.058 0.122 0.108 0.079 0.103 0.079 0.101 0.110 0.079 0.087

0.125 0.114 0.080 0.102 0.109 0.063 0.109 0.079 0.108 0.113 0.097 0.100

1.12 1.85 1.02 1.14 0.52 0.63 0.46 1.30 0.65 1.46 1.07 0.15

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Table 8.7
Emerging economies

(continued)

South Korea Malaysia Mexico Morocco Pakistan Peru Philippines Poland Russia South Africa Taiwan Thailand Turkey Venezuela Averages
Note:

0.064 0.089 0.099 0.103 0.105 0.110 0.095 0.085 0.108 0.099 0.081 0.066 0.087 0.110 0.093*

0.077 0.089 0.080 0.098 0.138 0.113 0.109 0.088 0.124 0.083 0.094 0.052 0.107 0.131 0.099*

1.59 0.94 1.44 0.06 0.41 0.69 1.06 1.37 2.13 1.11 1.10 1.63 2.15 1.01 1.08

* indicates that the z-test shows significantly different means at 1 percent.

factor CAPM approach has been used with a world market portfolio as one systematic factor and indices over secure property rights and contracts. The security of property rights and contractual agreements is introduced in a second-pass regression that looks at differences between countries. If a CAPM type of analysis is used an indication of higher risk premiums in countries with insecure property rights is also found. We find that a significant part of the required rate of return in developing countries can be explained by weak institutional protection of property and contracts. Our two measures of the institutional safeguarding of property rights seem to capture the same effect and indicate that institutional risk needs to be included in capital asset pricing. The conventional single-factor CAPM seems to be less useful in countries where the institutional framework is weak.

NOTES
* Acknowledgements: Financial support from Freningssparbankernas Forskningsstiftelse to Johan Eklunds dissertation work is gratefully acknowledged. A research grant from the Ratio Institute and the Marcus and Amalia Wallenberg Memorial Fund Foundation is also gratefully acknowledged. Furthermore we acknowledge valuable comments

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1. 2. 3. 4. 5. 6.

provided by ke E. Andersson, Gran Skogh and participants at the 2005 conference of the European Association of Law and Economics. The present value of future cash flows from all investments made by a firm is equal to the value of a firm set by the capital markets. A political risk premium is proposed by Faure and Skogh (2003). It can in line with the arbitrage pricing theory be argued that the discount factor RP0 can be broken down further into a multitude of components (see, for example, Ross, 1976). The problem is however to isolate the different factors that influence the rate of return. See, for example, Mueller (2003) for a pedagogical exposition of the relationship between cost of capital and investment. See, for example, Elton and Gruber (1996, Chapter 2) for a description of the procedure. The wide use of and support for the CAPM can, according to Roll and Ross (1980), be ascribed to the empirical regularity of common variation of securities, and according to the CAPM this common variation can be ascribed to a single factor, plus an error term. Even though the rationale behind the CAPM is, as noted earlier, based on the separability of systemic non-diversifiable risk and non-systemic diversifiable risk, Roll and Ross argue that There are two major differences between the APT and the original Sharpe diagonal model, a single factor generating model which we believe is the intuitive grey eminence behind the CAPM. First, and most simply, the APT allows for more than just one generating factor. Second, the APT demonstrates that since any market equilibrium must be consistent with no arbitrage profits, every equilibrium will be characterized by linear relationship between each assets expected return and its returns amplitudes, or loadings, on the common factors. (Roll and Ross, 1980, p. 1074)

7. See, for example, Sharpe and Cooper (1972), Douglas (1968) and Black et al. (1972). 8. MSCI total return indexes with gross dividends.

REFERENCES
Black, F., Jensen, M.C. and Scholes, M. (1972), The Capital Asset Pricing Model: Some Empirical Tests, in M.C. Jensen (ed.), Studies in the Theory of Capital Markets, New York: Praeger. De Soto, H. (2000), The Mystery of Capital Why Capitalism Triumphs in the West and Fails Everywhere Else, New York: Basic Books. Douglas, G. (1968), Risk in the Equity Markets: An Empirical Appraisal of Market Efficiency, Ann Arbor, MI: University Microfilms, Inc. Elton, E.J. and Gruber, M.J. (1995), Modern Portfolio Theory and Investment Analysis, 5th edn, New York: John Wiley & Sons, Inc. Faure, M. and Skogh, G. (2003), The Economic Analysis of Environmental Policy and Law an Introduction, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Friend, I., Landskroner, Y. and Losq, E. (1976), The Demand for Risky Assets and Uncertain Inflation, Journal of Finance, 31, 128797. Kasper, W. and Streit, M.E. (1999), Institutional Economics Social Order and Public Policy, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Merton, R.C. (1973), An Intertemporal Capital Asset Pricing Model, Econometrica, 41, 86787.

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Mueller, D.C. (2003), The Corporation Investments, Mergers and Growth, London: Routledge. North, D.C., (1990) Institutions, Institutional Change and Economic Performance, Cambridge and New York: Cambridge University Press. Roll, R. (1977), A Critique of the Asset Pricing Theorys Tests: Part I: On Past and Potential Testability of the Theory, Journal of Financial Economics, 4, 12976. Roll, R. (1988), R2, Journal of Finance, 43 (2), 54166. Roll, R. and Ross, S.A. (1980), An Empirical Investigation of the Arbitrage Pricing Theory, Journal of Finance, 35, 10731103. Ross, S. (1976), The Arbitrage Theory of Capital Asset Pricing, Journal of Economic Theory, 13 (3), 34160. Sharpe, W.F. and Cooper, G.M. (1972), Risk-Return Class of New York Stock Exchange Common Stocks, 19311967, Financial Analysts Journal, 28, 4652. Williamson, O.E. (2000), The New Institutional Economics: Taking Stock, Looking Ahead, Journal of Economics Literature, 38 (3), 595613.

9.

The stock market, the market for corporate control and the theory of the firm: legal and economic perspectives and implications for public policy
Simon Deakin and Ajit Singh1
INTRODUCTION

1.

In this chapter we consider the relationship between shareholder value, the market for corporate control, and economic and legal theories of the firm. We argue that, contrary to current conventional wisdom, support for an active market for corporate control is neither a core principle of company law nor an essential ingredient of financial and economic development. Indeed, the opposite could well be the case an important element of reform should be the prevention of the emergence of a market for corporate control. The absence of such a market in coordinated market systems, such as Germany and Japan during their modern economic development, was not an evolutionary deficit but an effective and positive institutional arrangement. The unravelling of that arrangement, which is currently being encouraged by regulatory changes and which some commentators see as a necessary part of adjustment to globalization, has the potential to destabilize existing production regimes, although so far it has failed to have this effect. Aspects of a regulatory regime favourable to the market for corporate control, such as a mandatory bid rule, have been adopted in many developing economies over the past decade; however, in the absence of countervailing power for employees of the kind found in most European systems, it is possible that these developments could impose significant economic and social costs associated with restructuring. The chapter is ordered as follows. Section 2 outlines the relationship between shareholder value and the core principles of company law in the common law and civil law worlds. It is argued here that company law systems, regardless of legal origin, tend to recognize the principle of
185

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managerial autonomy from shareholder control, and provide managers with discretion to run the company in such a way as to maximize returns to all stakeholders and not simply shareholders. Section 3 turns the focus to takeover regulation, which we suggest is the pivotal factor that has led to the prioritization of shareholder interests in common law systems. We explore the different approach to takeover bids in civilian regimes and discuss the implications of attempts to encourage a market for corporate control through regulatory changes in continental Europe and Japan, before looking at the adoption of similar regulatory moves in emerging and transition systems. Having reviewed the common law and civil law approaches to the market for corporate control, we turn in Section 4 turn to economic analysis. The takeover mechanism plays a pivotal role in many branches of economic theory including the theory of the firm, the theory of industrial organization and welfare economics. It is also critical to an analysis of economic and industrial policy. We, however, confine ourselves in this chapter to analysing the relationship between the market for corporate control and the theory of the firm. This subject is examined in Section 4, together with a discussion of alternative views on the efficiency of takeovers, and the need or otherwise for government regulation. Section 5 contains a discussion of the pricing process and the takeover mechanism on the stock market. It provides empirical evidence on aspects of the market for corporate control. Section 6 briefly concludes.

2.

SHAREHOLDER VALUE AND THE LEGAL CONCEPTION OF THE FIRM IN THE COMMON LAW AND CIVIL LAW

The idea that the managers of private-sector companies should act as the agents of shareholders is a focal point of the contemporary corporate governance debate. According to this view, the pursuit of shareholder value is the single corporate objective function which drives organizational and allocative efficiencies (Jensen, 2001). Its influence is increasingly felt in civilian systems that have, up to now, enjoyed a different tradition, and its adoption in transition economies and in the developing world is on the policy agenda there. This apparent convergence is occurring in large part as a result of the recent dominance of a shareholder-centred ideology of corporate law among the business, government and legal elites in key commercial jurisdictions (Hansmann and Kraakman, 2001: 439). Too close a focus on the supposed efficiency of prevailing institutions is liable to make us forget the often tortuous and uneven path by which they

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came to acquire their apparent dominance. Britains industrial revolution took place during a period when few businesses enjoyed limited liability. In the US, many states allowed personal claims to be brought against shareholders for corporate debts late into the nineteenth century and some, including California, into the twentieth. Yet corporate law scholars today assert that limited liability and the partitioning of corporate from personal assets are essential parts of the legal bedrock supporting enterprise (Hansmann and Kraakman, 2001). This view arguably ascribes survival value to institutions whose endurance may have more to do with historical contingency than efficiency (Deakin, 2003). Is the same true of todays norm of shareholder value? It is surprisingly difficult to find support within core company law for the notion of shareholder primacy. It cannot be found by referring to the rhetorical claim, associated with todays pension funds and other institutional investors, that shareholders own the company. No legal system acknowledges the claims that shareholders own the company. If we understand the company to be the fictive legal entity which is brought into being through the act of incorporation, it is not clear in what sense such a thing could be owned by anyone. But, more pertinently, nor does the ownership of a share entitle its holder to a particular segment or portion of the companys assets, at least while it is a going concern (see Parkinson, 2003). The law on directors duties is no more helpful. In the English-law based common law systems, with only a few exceptions, directors fiduciary interests of loyalty and care are owed to the company, not directly to the shareholders. In practice, the companys interests will often be synonymous with those of its members, that is, the shareholders. However, shareholders are not entitled to engage directly in the management of the enterprise; this is the responsibility of the board. According to Delaware corporate law, the business and affairs of every corporation . . . shall be managed by or under the direction of a board of directors (see Millon, 2002: 92). Many of the formative cases of English company law, dating from the nineteenth and early twentieth centuries, make the same point (see Davies, 1997: 1838). Company law does not say anything about the level of returns to which shareholders are entitled, nor about the time scale over which their expectations are to be met. This ambiguity enabled the Company Law Review Steering Committee, in the review of UK company law which was concluded in 2002, to express its support for the idea of enlightened shareholder value. This implies [a]n obligation on directors to achieve the success of the company for the benefit of the shareholders by taking proper account of all the relevant considerations for that purpose including

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a proper balanced view of the short and long term, the need to sustain effective ongoing relationships with employees, customers, suppliers and others; and the need to maintain the companys reputation and to consider the impact of its operations on the community and the environment (Company Law Review Steering Group, 2000: 12; see also Company Law Review Steering Group, 2001: 41). The Steering Group regarded its proposal as a compromise between the enlightened shareholder value position and a pluralist point of view which would have seen management as having multiple commitments to a range of stakeholder groups. The Steering Group accepted the position of agency theory that making management formally accountable to a diverse body of stakeholders might limit the effectiveness of managerial decision-making and blur lines of accountability. Nevertheless, the Steering Groups proposal was based on the proposition that companies should be run in such a way which maximizes overall competitiveness and wealth and welfare for all (Company Law Review Steering Group, 2000: 1415, emphasis added). The means chosen to achieve this end were the inclusive duty and broader accountability:
The proposed statement of directors duties requires directors to act in the collective best interests of shareholders, but recognizes that this can only be achieved by taking due account of wider interests. The transparency element provides the information needed to underpin this approach to governance. Just as importantly, we believe that [a] wider reporting requirement particularly for large companies will be an important contribution to competitiveness. Companies are increasingly reliant on qualitative and intangible, or soft assets such as the skills and knowledge of their employees and their corporate reputation. The reporting framework must recognize this and ensure that companies provide the market and other interests with the information they need to understand their companies business and assess performance. (Company Law Review Steering Group, 2000: 1415).

Section 172 of the Companies Act 2006, which is headed Duty to promote the interests of the company, now provides that:
(1) A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole . . . (3) In fulfilling the duty imposed by this section a director must (so far as reasonably practicable) have regard to (a) the likely consequences of any decision in the long term, (b) the interests of the companys employees, (c) the need to foster the companys business relationships with suppliers, customers and others,

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(d) the impact of the companys operations on the community and the environment, (e) the desirability of the company maintaining a reputation for high standards of business conduct, and (f) the need to act fairly as between the members of the company.

Such a position is by no means as contrary to US corporate law as many writings on that system might make it seem. According to Leo Strine, a leading Delaware company law judge, writing extra-judicially but expressing a view which is arguably quite compatible with the general thrust of Delaware law (as opposed to corporate governance practice) on the issue of shareholder value,
Most American workers obtain the bulk of their wealth from their labor and even most top American managers can trace their wealth (including the equity they have accumulated) to their labor as executives. Therefore, both management and labor might be thought to have more concern than trust fund babies or investment bankers do for the continued ability of American corporations to support domestic employment. Likewise both management and labor are likely to view a public corporation as something more than a nexus of contracts, as more akin to a social institution that, albeit having the ultimate goal of producing profits for stockholders, also durably serves and exemplifies other societal values. In particular, both management and labor recoil at the notion that a corporations worth can be summed up entirely by the current price equity markets place on its stock, much less that the immediate demands of the stock market should thwart the long-term pursuit of corporate growth. (Strine, 2007: 4)

The idea that the company is an organization or entity with a distinct set of interests above and beyond those of all the stakeholder groups combined is even more clearly articulated in the civil law systems. These recognize the enterprise as a legal form that corresponds to the organization. This is distinct from the concept of the company that essentially describes a set of claims to income streams and property rights. The explicit recognition of the companys organizational dimension has implications for the way in which stakeholder interests are regarded, as this quotation from the Vinot report on French corporate governance recognizes:
In Anglo-Saxon countries the emphasis is for the most part placed on the objective of maximising share values, whilst on the European continent and France in particular the emphasis is placed more on the human assets and resources of the company . . . Human resources can be defined as the overriding interest of the corporate body itself, in other words the company considered as an autonomous economic agent, pursuing its own aims as distinct from those of its shareholders, its employees, it creditors including the tax authorities, and of its suppliers and customers; rather, it corresponds to their general, common interest, which is that of ensuring the survival and prosperity of the company. (Vinot, 1995, cited in Alcouffe and Alcouffe, 1997)

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Various versions of this concept of the company interest have been expressed in continental European law and practice since the period of industrialization in the second half of the nineteenth century; it was articulated in the communitarian concept of the enterprise advanced by the German jurist Otto von Gierke in the 1890s, and in the corporatist model popularized by the industrialist and politician Walther Rathenau in the 1920s. Although German corporate law scholarship has been increasingly influenced by agency theory since the 1990s, a significant strand of it remains sceptical of the US-inspired model, and theories based on the varieties of capitalism approach, stressing the importance of firmspecific human capital in coordinated market systems, have recently been deployed to explain and defend the core civilian model (see Gelter (2007) on Germany, and Rebrioux (2007) on France).

3.
3.1

THE LEGAL REGULATION OF TAKEOVER BIDS: COMMON LAW AND CIVILIAN APPROACHES2
The Origins of Takeover Regulation

The vital factor in institutionalizing the shareholder value norm in the common law or liberal market systems has been the encouragement given to the hostile takeover bid by regulatory changes which have often been in tension with the core principles of company law. Takeover regulation is a comparatively recent phenomenon. Following the economic depression of the inter-war years, there was intense discussion of the responsibilities of companies, the role of the financial system, and the need for public regulation of the economy. The solution argued for by Adolf Berle, in particular in his debate with E. Merrick Dodd in the mid-1930s, was to reverse the separation of ownership and control (which at that point was a comparatively new development in the US: see Hannah, 2007) by returning control to the shareholders (see Dodd, 1932; Berle, 1932). But this route was thought to be impractical during a period when it was generally considered that the large enterprise was the norm, family ownership was in decline, and further dispersion of ownership could be expected. Rather, the outcome was a combination of managerial and public control of the corporation, much as Dodd had advocated, and as Berle came belatedly to accept (Berle, 1962; see Ireland, 1999). From the mid-1970s onwards, the intellectual climate in Britain and North America began to turn away from public and social control of industry, with results which are now familiar: the privatization of the large, state-owned corporations and utilities, and the so-called deregulation of

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many areas of economic life. As part of this policy turn, and as a result of the changes to industry and the economy that flowed from it, the corporate governance debate was relaunched. Corporate finance scholars argued that, in place of the state, the market should provide the principal mechanism for controlling the managers of large corporations. These authors, in common with Berle and Means, argued that dispersed share ownership the fracturing of share capital among hundreds, sometimes thousands, of individual holdings freed management from direct supervision by investors. The solution, however, lay in the activation of the very instrument which the legislation of the New Deal era in the United States, and of the post-war regulatory state in many other countries, had sought to constrain in the interests of economic stability: the capital market. The mechanism by which this was achieved was the hostile takeover bid. By offering to buy shares in a company at a premium over the existing stock market price, so-called corporate raiders or predators could obtain control of the enterprise, remove the existing managerial team, and install one of their own. If the shareholders had no greater interest in the company than the financial investment represented by their shares, they could be induced to sell in return for the premium offered by the raider, in particular if they felt that the incumbent managerial team was not looking after their interests. For the bidder, the cost of mounting the bid and buying out the shareholders could be recouped, after the event, by disposing of the companys assets to third parties. If the company had not been well run before, these assets would, by definition, be worth more in the hands of others. Thus the hostile takeover bid performed a number of tasks. It empowered shareholders, who now had a means to call management to account if it was underperforming. Conversely, the hostile takeover disciplined managerial teams, who knew that their jobs and reputations were on the line if a bid was mounted. In addition, it provided a market-led mechanism for the movement of corporate assets from declining sectors of the economy to more innovative, growing ones. That, at least, was the theory. The rise of the hostile takeover can be traced back to the late 1950s and early 1960s in the UK and the US. There had always been mergers and acquisitions of firms; what was relatively new was the idea of a bid for control directed to the shareholders, over the heads of the target board. In the inter-war period, incumbent boards would just say no to unwelcome approaches from outsiders, often without even informing shareholders that a bid was on the table (Hannah, 1974; Njoya, 2007). At this stage, accounting rules had not evolved to the point where companies were under a clearly enforceable obligation to publish objectively verifiable financial information. This changed in the post-war period as a consequence of the legal and accounting changes that were put into place in both Britain and

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America by way of response to the financial crises of the 1930s. Greater transparency made it easier for unsolicited bids to be mounted and more difficult for incumbent boards to resist them. Institutional protection for minority shareholders followed, with the adoption in Britain in 1959 of the Bank of Englands Notes on Reconstructions and Amalgamations and, in 1968, the City Code on Takeovers and Mergers; 1968 was also the year in which the US Congress adopted the Williams Act, instituting a system of regulation for hostile tender offers for US listed companies. 3.2 The US Model

The Williams Act sets time limits on tender offers and requires bidders with 5 per cent of a companys stock to disclose their holdings and to give an indication of their business plan for the company, but it does not explicitly rule out two-tier or partial bids as it does not contain a mandatory bid rule along the lines of the City Code. It regulates fraudulent activity, broadly defined, but does not place target directors under a clear-cut duty of care to provide independent financial information to shareholders in the way that the Code does. At state level, US courts have accepted that, under the business judgment rule, target directors can take steps to resist a hostile takeover where they act in good faith and with reasonable grounds for believing that a danger to corporate policy and effectiveness existed; specifically, they can take into account the inadequacy of the price offered, nature and timing of the offer, questions of illegality, the impact on constituencies other than shareholders (i.e., creditors, customers, employees, and perhaps even the community generally), the risk of non-consummation, and the quality of the securities being offered in exchange.3 The Delaware courts have nevertheless vacillated between an auction rule which would require the board to take steps to maximize shareholder returns in the event of a proposed change of control,4 and the just-say-no defence under which the target board would be obliged to charter a course for the corporation which is in its best interests without regard to a fixed investment horizon without being under any per se duty to maximize shareholder value in the short term, even in the context of a takeover.5 US corporate law has permitted the growth of a battery of anti-takeover defences of the type that are virtually never adopted in the case of publicly quoted companies in Britain. Shark repellents enable the composition of the board to be structured so as to make it difficult for an outsider to gain control. For example, company byelaws may stipulate that directors are elected for three-year terms, with only part of the board coming up for renewal each year. It is also common for byelaws to prohibit greenmail (a raider forcing the target board to buy back its shares at a premium), to

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prevent shareholders from voting by proxy, to lengthen the gaps between general meetings, and to require supermajority decisions to change these and other rules. Poison pills various devices whereby insider shareholders acquire rights which are triggered when a hostile takeover bidder makes its entry have been permitted, including the flip-in (where if the raider increases its shareholding above a certain level the target board declares a high dividend for existing shareholders, or existing shareholders are given the right to buy additional stock at half the market price) and the flip-over (shareholders get the right to buy stock of the new parent at a 50 per cent discount). In addition, most states have enacted anti-takeover statutes that enable companies to adopt internal rules aimed at fending off hostile bids. The first wave of such statutes was ruled unconstitutional in Edgar v. MITE Corp.6 on the grounds that the Williams Act preempted them. In this case, an Illinois statute that extended the bid timetable beyond that set by the Williams Act and gave state-level competition authorities the right to nullify offers was struck down. However, a second generation of share control statutes (providing the incumbent shareholders with the power to decide on whether a raider with a controlling stake should retain the voting rights of its shares) was upheld in CTS Corp. v. Dynamics Corp.7 at around the same time as the Supreme Court gave a restrictive ruling to the Williams Act, deciding that it did not bar defensive actions such as crown jewel options or sales.8 This simultaneously limited the scope of federal regulation and opened the way for further pro-defensive laws at state level. A third generation of state laws followed, which, broadly speaking, validated various poison pill defences and introduced constituency or stakeholder provisions into the definition of directors fiduciary duties. These stakeholder statutes vary in strength. Certain of them include provisions for profit disgorgement, whereby the state imposes a high tax on any short-term profits by raiders acquiring shares in connection with a bid, for example as a result of greenmail (selling their shares back to the company at a premium to the market). Modifications to directors duties include provisions to the effect that fiduciary duties are owed solely to the corporation and that no party, not even the shareholders, can enforce them directly; that directors may consider the long-term interests of the corporation; and that the directors need not regard any one constituencys interest as dominant. The stakeholder statutes, together with the adoption of poison pills by a majority of large public corporations, are credited with having helped to restrict the number and volume of takeovers at the end of the 1980s: by the mid-1990s, over two-thirds of large US public corporations had adopted poison pills, and acquisitions of public corporations, which had been running at over 400 per annum in the late 1980s, had fallen

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to half that figure (Useem, 1996: 278). However, the stakeholder statutes did little to deflect the wider impact of shareholder pressure on corporate management, which today increasingly takes the form of pressure from activist hedge funds and private-equity-led restructurings, and which has been reflected in continuing high levels of lay-offs and restructurings (Uchitelle, 2006). 3.3 The British Model

The City Code, like the Williams Act, dates from the late 1960s but, unlike the US measure, it did not until recently have statutory backing. The Panel on Mergers and Takeovers, a self-regulatory body set up by the financial and legal professions and financial sector trade associations based in the City of London, had no direct legal powers of enforcement. Its provisions were strictly observed, however, since UK-based financial and legal professionals who were found to have breached the Panels rulings could be barred from practising as a consequence. As a result of the adoption by the European Union of the Thirteenth Company Law Directive,9 the Panel has recently acquired a statutory underpinning,10 but the substance of the Code remains essentially the same as it was before, and it continues to be based on the Panels deliberations and rulings. The expectation of both the UK government and the Panel is that the implementation of the Directive will not have a major impact on the Panels mode of operation.11 The City Code reflects the strong influence of institutional shareholder interests within the UK financial sector, and their capacity for lobbying to maintain a regulatory regime, which operates in their favour (Deakin and Slinger, 1997; Deakin et al., 2003). Its most fundamental principle is the rule of equal treatment for shareholders: all holders of the securities of an offeree company of the same class must be offered equivalent treatment.12 This is most clearly manifested in the Codes mandatory bid rule which requires the bidder, once it has acquired 30 per cent or more of the voting rights of the company, to make a mandatory offer granting all shareholders the chance to sell for the highest price it has paid for shares of the relevant kind within the offer period and the preceding 12-month period.13 Partial bids, involving an offer aimed at achieving control through purchasing less than the total share capital of the company, require the Panels consent, which is only given in exceptional circumstances.14 During the bid, information given out by either the bidder or the target directors must be made equally available to all offeree company shareholders as nearly as possible at the same time and in the same manner.15 The Code also imposes on target directors a series of specific obligations that can be thought of as clarifying their duty to act bona fide in the

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interests of the company but in some respects extend this duty. The target directors must first of all obtain competent, independent financial advice on the merits of the offer,16 which they must then circulate to the shareholders with their own recommendation.17 Any document issued by the board of either the bidder or the target must be accompanied by a statement that the directors accept responsibility for the information contained in it.18 While the point is not completely clear, the likely effect of this is to create a legal duty of care owed by the directors to the individual shareholders to whom the information is issued (and not to the company as is the case with their general fiduciary duties).19 All this places the directors of the target in the position of being required to give disinterested advice to the shareholders on the merits of the offer, and makes it more difficult for them to resist a bid simply on the grounds that it would lead to the break-up of the company. In a case where the board considers that a hostile bid would be contrary to a long-term strategy of building up the companys business in a particular way, it can express this opinion, but it must be cautious in doing so, since it still has a duty to provide an objective financial assessment of the bid to the shareholders. In the case of the takeover of Manchester United FC by the US businessman Malcolm Glazer in 2005, the board took the view that Glazers offer, because it would impose a high debt burden on the company, was not in its long-term interests. However, the board was also aware that the offer could well be regarded as a fair one, since it was by no means clear that the shareholders would not be better off by accepting it. The board issued this statement:
The Board believes that the nature and return requirements of [the proposed] capital structure will put pressure on the business of Manchester United . . . The proposed offer is at a level which, if made, the Board is likely to regard as fair . . . If the current proposal were to develop into an offer . . . the Board considers that it is unlikely to be able to recommend the offer as being in the best interests of Manchester United, notwithstanding the fairness of the price.

Following this statement, a majority of the shareholders accepted Glazers bid. General Principle 9 of the Code used to state that it is the shareholders interests, taken as a whole, together with those of employees and creditors, which should be considered when the directors are giving advice to shareholders. This provision, like section 309 of the Companies Act 1985, was less significant in practice than it appeared to be on paper, since it provided no basis on which employees or creditors, who had (and have) no standing before the Takeover Panel, can challenge a boards decision. Case law on fiduciary duties from the 1980s also suggested that, during a

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contested takeover, only the interests of the shareholders could be taken into account.20 As a result it probably matters little that, following recent revisions to the Code, the relevant General Principle, which is based on the parallel provisions of the European Unions Thirteenth Company Law Directive, now simply states that the board of an offeree company must act in the interests of the company as a whole and must not deny the holders of securities the opportunity to decide on the merits of the bid.21 The Code used to require the bidder to state, in its offer document, its intentions regarding the continuation of the business of the offeree company; its intentions regarding any major changes to be introduced in the business, including any redeployment of the fixed assets of the offeree company; the long-term commercial justification for the proposed offer; and its intentions with regard to the continued employment of the employees of the offeree company and its subsidiaries. This meant little in practice; it simply required the bidder to issue a general statement of its intentions, which generally took the form of a standard-term or boilerplate provision in offer documents. However, as a result of changes made to the Code following the implementation of the Thirteenth Directive, more prescriptive provisions concerning the potential impact of takeovers on employees have been introduced. The bidder must now provide detailed information on its strategic intentions with regard to the target, possible job losses, and changes to terms and conditions of employment,22 and the target must give its views, in the defence document, on the implications of the bid for employment.23 Breach of these provisions is a criminal offence. They also have potentially significant implications for employees consultation rights under labour law.24 In addition, employee representatives of the target have the right to have their views of the effects of the bid on employment included in relevant defence documents issued by the target.25 The Code contains extensive provisions controlling the use of defences against hostile bids (or frustrating measures in the terms used by the Thirteenth Directive). Once an offer is made or even if the target board has reason to believe that it is about to be made, the target board cannot issue new shares; issue or grant options in respect of any unissued shares; create securities carrying rights of conversion into shares; sell, dispose or acquire assets of a material amount, or contract to do so; or enter into contracts otherwise than in the ordinary course of business.26 General company law is also relevant here. The proper purposes doctrine prevents the board issuing shares for the purpose of forestalling a hostile takeover, even well in advance of any bid being made.27 Other advance anti-takeover defences, such as the issue of non-voting stock or the issuing of new stock to friendly insiders, have been discouraged by a combination of the Listing Rules of the London Stock Exchange and institutional shareholder pressure. Protection

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of pre-emption rights, or the rights of existing shareholders to be granted preference when new stock is issued, is recognized by legislation28 as well as by guidelines issued by stock exchange and financial industry bodies.29 The issue of non-voting stock is permissible under general company law, but is vigorously opposed in practice by institutional shareholders.30 Thus the Takeover Code, taken in conjunction with related aspects of company law, can be seen to provide strong protection for the interests of the target shareholders; that, after all, has been its main purpose (see Johnston, 1980). An important side effect of this protection, however, is to encourage hostile takeover bids by placing limits on the defensive options available to the target management. An incumbent management is not required to be completely passive, and is permitted to put a case in its own defence, but opportunities for defence only arise in the context of an overriding responsibility to see that the shareholders interests are safeguarded. The effect is not far removed from that of an auction rule which requires the incumbent management to extract the highest possible price for the target shareholders, if necessary by making it possible for rival offers to be made. The entry of second bidders is facilitated by the bid timetable imposed by the Code and by the effective ban on two-tier and partial bids which might otherwise be used to strong-arm the target shareholders into accepting the terms of the first bid. These regulatory features might be thought to deter bids, by increasing the risk that either the target shareholders or any second bidder will free-ride on the efforts of the initial bidder. However, the possibility of free-riding by the shareholders is alleviated by the right of the bidder compulsorily to purchase the last 10 per cent of shares in the event of taking control; in the language of the European Directive, a squeeze-out rule (on its economic effects, see Yarrow, 1985). Other factors which serve to reduce the risk of an initial bid failing due to free-rider effects are the concentration of voting shares in most UK publicly quoted companies in the hands of a relatively small number of institutional shareholders (so reducing the number of shareholders who need to be persuaded to sell) and the right of an initial bidder to raise its offer price during the bid period (thereby enabling it to over-bid a second bidder). While there may, then, be a certain screening-out of partial bids which, given their oppressive nature, are arguably not efficiency-enhancing in any event (see Yarrow, 1985), the effect of the Code is to reduce the autonomy enjoyed by the management of the target company in relation to its shareholders and thereby to limit the defensive options it has available to it. This suggestion is borne out by empirical research carried out in Cambridge in the late 1990s (Deakin et al., 2003). In this study, the objective was to construct a sample of bids which contained examples of both

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hostile and agreed bids and of cross-border bids by UK companies and for UK companies mounted during the period 199396. In interviews we put this question to company directors, lawyers, merchant bankers, institutional shareholders and employee representatives:
Did directors duties to consider interests of creditors and employees as well as those of shareholders affect the preparations for, the conduct of and the aftermath of the bid?

On the central question of directors duties, the response was almost invariably that, while directors might consider employees and creditors interests, the outcome of a bid was determined by shareholder value. Shareholder value took precedence over all other considerations. The responses to the question are separated out below by group, with advisers first, followed by directors, institutional investors, and employee representatives. A typical comment from an adviser was as follows:
Directors do consider employees interests, but no one really knows what that means. At the margin the touchy-feely things matter, but the board of directors, faced with two people offering 1 and 1.10, must go for the higher. The decision, of course, is not usually put like that, but I dont know of any cases where employees interests have come first.

Employees were only mentioned out of lip service to the obligation of the offeror company to state its intentions with regard to employment:
Directors duties to consider other interests are rarely an issue unless the company is near to insolvency. These clauses together are a bit of a sop. Rule 24 of the Code requires a statement of intentions towards employees, which always gets reduced to the standard phrase: the bidder will ensure that all rights of the target employees will be met in full. Sometimes people do say more sometimes a target will screw a stronger statement out of the bidder. And where companies intend not to make redundancies, they will tend to say it.

More pithily, we were told: much is spoken about directors duties to employees, but it is rarely relevant, and the Takeover Code and Companies Acts just muddle these issues up: directors have to recommend the deal when they are really just recommending the price. Directors told us that their focus was on the financial aspects of a bid:
The one thing that [our merchant bankers] kept saying was that you have to be sure that when you say that a price is inadequate, you mean it and can back it up. Were we advised that we could take into account the interests of the

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company as a whole? No the primary advice was that there is a price at which you have to say yes.

In particular, non-executive directors were identified as advocates for the shareholder interest, even where this meant dismembering the corporate enterprise:
Were we advised of our legal obligations to our shareholders? Yes there was lots of advice. One of the non-executive directors did push us hard to consider closure and selling up as an option to get maximum shareholder value (about five years before the bid).

Institutional investors likewise thought that directors should focus on shareholder concerns. One was happy with the idea that directors owe duties to the company but was of the view that during a bid, especially, the directors understand this as being a duty to shareholders. Another considered that for directors to perform according to their fiduciary duties, they had to show that it was in the interests of shareholders to sell. The pursuit of stakeholder interests was not seen as a viable alternative to shareholder value:
It is hard to make a case that [the duty to further the interests of the company as a whole] affected the bid greatly. In principle a defending company might put employees interests before those of shareholders but they are basically serving shareholders interests first. If directors have a duty, it is to ensure that employees have marketable skills. I see directors duties to employees as being more like pension rights protection than long-term employment safeguards.

Employee representatives were less clearly opposed to bids than might have been thought. Hostile bids were sometimes seen as shaking up incumbent managerial teams with which the employees had little by way of common interest. Hence employee representatives commented unfavourably on the tendency of target directors to be excessively well rewarded, even before bids, in pay and share options, and on the negative effect that this had on the workforce. Particular criticism was reserved for the practice of linking managerial remuneration to the number of workers dismissed:
The other thing that caused trouble was the directors incentives schemes. They had a bonus system which had work completed according to certain targets divided by the number of staff that they employed to do it. So what they did was to sack a lot of staff, and employed outside contractors, to fulfil their conditions and increase their bonuses.

None of the employee representatives were convinced that a higher commitment from management to consultation would have materially

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affected the bids in which they were involved. In part this was out of a frank recognition that the decision was in the hands of shareholders and hence was purely a commercial thing. The priority was to keep lines of communication open after the bid in an attempt to avoid compulsory redundancies and smooth the way of the new owners. This was a typical comment:
We take the view now that were not going to be able to prevent [the takeover] so we try to get the best deal we can. Given the current industrial relations climate, I dont think that even a requirement to consult would make much difference.

For target directors, the nature of the advice received was of paramount importance. During bids, they saw their duty in terms of maximizing the potential value of the company as a financial asset of the shareholders. This obligation stood before any requirement to consult employees, to consider their interests, or to further the interests of the company as a whole. Even outside the bid period, the perceived duty to focus on shareholder value could lead a non-executive director to see it as their role to force management to consider closing down the enterprise. Correspondingly, institutional investors applauded directors who saw their responsibilities in these terms. The attitudes of employee representatives are best described as pragmatic. They expected little from target managers whose interests were seen to be tied up with share options and remuneration packages that would leave them better off whatever the outcome of the bid. There was no expectation of consultation with the target management, and no prospect of it making a difference to the outcome of the bid if it did take place. By contrast, the intervention of bidders could be seen in a positive light, particularly where there had already been a breakdown of trust with incumbent management. Informal links could be established with the bidder at an early stage, and a relationship constructed with a view to the future, even though it was recognized on both sides that the most immediate issue was likely to be the management of redundancies. In 1974 Leslie Hannah wrote that the takeover bid had ushered in an economic system whose logic is still being developed and is still only imperfectly understood (Hannah, 1974). We now see more clearly what kind of system it is. The takeover revolution was a catalyst for a raft of other measures and devices aimed at ensuring that managers of large corporations acted first and foremost in the interests of their shareholders. However, it is important to stress that, even in the UK context, the current focus on shareholder value is therefore the consequence not of the basic company law model but of those institutional changes which have occurred in capital

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markets and securities law with increasing rapidity, in particular since the early 1980s, namely the rise of the hostile takeover bid and the increasing use of share options and shareholder value metrics. Thus the contemporary norm or reference point of shareholder primacy is the result of a mix of institutional changes, the emergence of new forms of self-regulation and soft law, and shifts in corporate culture. 3.4 The Civil Law Model: Mainland Europe

In the civil law world, there has, until recently, been no equivalent to the rules on takeover regulation that are found in common law systems. This is not to say that there is no record, historically, of hostile takeover activity in civil law countries; as Hannah (2007) points out, takeovers by share purchase did take place in Germany in the early years of the twentieth century. However, for much of the twentieth century, they were actively suppressed, particularly in the post-World War II period when they were seen as incompatible with economic reconstruction in Germany, France and Japan. The growth of corporate cross-shareholdings and the rise of bank-led governance in these systems led to stabilization of share ownership, but also to the sterilization of the external capital market as a mechanism for controlling management. A major change appeared to be about to take place in the early 2000s as a result of the adoption of the Thirteenth Directive in the EU and changes in the Japanese system which encouraged the revival of hostile takeover activity, but a closer inspection also shows that there has been resistance to attempts to institutionalize a market for corporate control. The first significant document in the current round of initiatives was the report of the High Level Group of Experts on takeover bids, published in October 2002. This argued that what the EU needed was an integrated capital market in which the regulation of takeover bids [would be] a key element (High Level Group, 2002a: 18). The report noted that the extent to which in a given securities market takeover bids can take place and succeed is determined by a number of factors, including general or structural factors affecting financial markets, and company-specific factors such as rules of company law and articles of association affecting voting rights, protection of minority shareholders, and the legitimacy of takeover defences. It then observed that there are many differences between the Member States in terms of such general and company specific factors, with the result that the EU lacked a level playing field. The substantive content of state-level company laws was also an issue for the High Level Group. The essence of the problem was that the laws of most member states did not sufficiently conform to a model of corporate

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governance in which managers understood their principal duty to be to return value to shareholders, and in which takeovers played a crucial disciplinary role in reminding them of this obligation:
Actual and potential takeover bids are an important means to discipline the management of listed companies with dispersed ownership, who after all are the agents of shareholders. If management is performing poorly or unable to take advantage of wider opportunities the share price will generally under-perform in relation to the companys potential and a rival company and its management will be able to propose an offer based on their assertion of their greater competence. Such discipline of management and reallocation of resources is in the long term in the best interests of all stakeholders, and society at large. These views also form the basis for the Directive. (High Level Group, 2002a: 19)

The High Level Group could not have been clearer: they were proposing a measure based on the standard finance theory or principalagent view of the role of hostile takeover bids in enhancing shareholder value. The assertion that managers are after all the agents of shareholders is one based on a particular economic-theoretical position, and has no grounding in the legal conceptions of the company that the High Level Group might have looked for in the laws of the member states. Even UK company law does not go this far; it has not followed the Delaware practice of sometimes referring to duties owed by directors to the shareholders rather than to the company as a separate entity. Be that as it may, it was very largely to the UK that the EU experts looked to fill out the content of the Directive. Even more so than its many predecessors, this draft of the Thirteenth Directive drew on the model of the City Code on Takeovers and Mergers, a text notable, as we have seen, for the high level of protection it gives minority shareholders and for its restriction of poison pills and other anti-takeover defences that US law, which is otherwise takeover-friendly, by and large allows (see Deakin and Slinger, 1997). The High Level Groups second report, in November 2002, struck a similar note in stressing the role of non-executive directors in monitoring management, which is a feature of British and American practice, but is relatively underdeveloped in other member states:
Good corporate governance requires a strong and balanced board as a monitoring body for the executive management of the company. Executive managers manage the company ultimately on behalf of the shareholders. In companies with dispersed ownership, shareholders are usually unable to closely monitor management, its strategies and its performance for lack of information and resources. The role of non-executive directors in one-tier board structures and supervisory directors in two-tier board structures is to fill this gap between the uninformed shareholders as principals and the fully informed executive managers as agents by monitoring the agents more closely (High Level Group, 2002b: 59).

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Again, the standard finance or principalagent model was stressed, and a feature of the British and American systems was presented as if it had universal validity. Features of national systems that did not conform to the principalagent approach, such as the distinctive role of worker directors and community representatives in two-tier boards, were simply shoehorned into the supposedly universal model. The High Level Groups second report set out a series of objectives for reform of corporate governance (among other things) which reflected this point of view, and which were then incorporated into the Commissions Action Plan on company law, with effect from 2003.31 What happened next, and in particular the fate of the Thirteenth Directive, is instructive. Although the Directive was eventually adopted, in 2004,32 this was only after a series of compromises had been agreed, which considerably diluted the draft presented by the Commission in 2002. Contrary to the expectation that the Directive would roll out a liberal-market model of takeover regulation along similar lines to those of the UKs City Code on Mergers and Takeovers, in its final form it allows member states to retain laws which permit multiple voting rights and limit shareholder sovereignty in various ways, such as allowing anti-takeover defences to be put in place in advance of bids. Some of the derogations in the Thirteenth Directive are transitional; its general thrust is in favour of the principle of one-share-one-vote, and proportionality between investment risks and decision-making powers is clear. However, rather than impose a single model on member states, the Directive can be seen as setting out an experimentalist framework for law-making at state level. This was far from being its original objective. Nevertheless, the result of the rough-hewn compromises which informed the final text of the Directive is that the liberalization of takeover rules can be achieved in one of several different ways, which may take into account specific features of the legal and institutional environments of the different member states. Both Germany and France have taken advantage of the derogations in the Directive. In Germany, the supervisory board of a listed company has the power to authorize poison-pill-like defences. In France the board of directors can issue warrants granting new stock to existing shareholders in the face of a hostile takeover bid, subject only to majority shareholder approval at an ordinary meeting. Germany is moving in the direction of a one-share-one-vote rule but this principle is not recognized by most large listed companies in France. Cross-shareholdings in both countries are not as strong as they were. In France, over 40 per cent of shares in the top 40 listed companies (the CAC 40) are now held by overseas pension and mutual funds (mainly based in the UK and the US), a considerable shift

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from just a decade ago. However, in neither country has a market for corporate control to match the British or American model yet emerged. Another significant feature of the Thirteenth Directive is that it enabled the reformed takeover rules to make provision for information and consultation of employees. An element of employee consultation was present in earlier drafts of this Directive, and the provisions on this issue which were included in the final text are not especially far-reaching, and do not go as far as the laws of a number of member states. However, the Thirteenth Directives set a pattern, in that mandatory employee consultation provisions were then included in other company law directives, including the directive on cross-border mergers, as well as the Societas Europaea (or European company) measures (where again there has been a long debate on this issue). This illustrates the complexities involved in translating the principalagent model of corporate governance into specific legal provisions. The finance theory espoused by the High Level Group finds no room for managerial engagement with employees on issues of corporate governance, regarding it as a qualification of the principle of shareholder-based control of the firm. However, the issue of employee involvement is unavoidable when it comes to legislating at EU level. This is not just because organized labour interests have numerous possibilities for presenting their view when directives are being formulated, but also because the principle of employee consultation in the event of corporate restructurings has come to be recognized, over several decades, as an important point of reference within the EU legal order, as it is embodied in numerous labour law directives as well as in the EU Charter of Fundamental Rights. Thus the inclusion of employee voice rights in the new EU takeover regime is consistent with the wider structure of EU law in the company and labour law fields, although the extent to which these rights provide real countervailing power to that of the capital markets remains to be seen. 3.5 The Civil Law: Japan

Most large Japanese enterprises are listed companies with (by international standards) a relatively high degree of dispersed ownership. In the immediate post-war decades, cross-shareholdings were common, and indeed were actively deployed as means of limiting the influence of foreign investors. Between the mid-1960s and the mid-1970s the stable shareholding ratio across the listed company sector as a whole, including cross-shareholdings, rose from 47 per cent to 62 per cent (Miyajima and Kuruoki, 2005: 56). However, the ratio had declined again to 45 per cent by 1993 and was only 24 per cent in 2003. Cross-shareholdings of the traditional type represented only 7.6 per cent of the total in 2003 compared with 17.6 per cent in 1993

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(NLI Research, 2004). Foreign shareholdings have risen from 11.9 per cent of the market in 1996 to 26.7 per cent in 2005 (National Stock Exchanges, 2006). In 2006 around 8 per cent of the first (main) section of the Tokyo stock market, 196 companies in total, were more than 30 per cent owned by overseas investors (TSE, 2007: 4). At the same time, large Japanese companies continue to stress their role as social institutions or community firms which provide stable employment to a core of long-term employees, in return for a high level of commitment and identification with the goals of the firm. This tension between the legal form of the enterprise and its changing ownership structure, on the one hand, and its aspect as a social institution, on the other, has recently been thrown into sharp relief by a series of hostile takeover bids. The most controversial of these involved the planned takeover of Nippon Broadcasting System (NBS) by the Internet service provider Livedoor, which was launched in February 2005 (see Whittaker and Hayakawa, 2007). NBS had a cross-shareholding agreement with Fuji Television Ltd, which in turn dominated a corporate group, the Fuji-Sankei media conglomerate. Livedoors intentions were widely interpreted as being based on greenmail. When NBS attempted to issue new stock in order to dilute Livedoors holdings and frustrate its bid, the courts declared the move unlawful. In granting Livedoor an injunction, the Tokyo District Court ruled as follows:
It is inappropriate for the board of directors of a publicly listed company, during a contest for control of the company, to take such measures as the issue of new shares with the primary purpose of reducing the stake held by a particular party involved in the dispute, and hence maintain their own control. In principle the board, which is merely the executive organ of the company, should not decide who controls the company, and the issuing of new shares, etc., should only be recognized in special circumstances in which they preserve the interests of the company, or the shareholders overall.

When this judgment was appealed, eventually, to the High Court, it was upheld:
The issue of new shares, etc., by the directors who are appointed by the shareholders for the primary purpose of changing the composition of those who appoint them clearly contravenes the intent of the Commercial Code and in principle should not be allowed. The issue of new shares for the entrenchment of management control cannot be countenanced because the authority of the directors derives from trust placed in them by the owners of the company, the shareholders. The only circumstances in which a new rights issue aimed primarily at protecting management control would not be unfair is when, under special circumstances, it aims to protect the interests of shareholders overall.

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However, the High Court also ruled that defensive measures would be potentially legitimate in four situations: greenmail, asset stripping, a leveraged buy-out, and share manipulation. This was an approach based in part on the jurisprudence of the Delaware courts (Milhaupt, 2006). Unable to make a new rights issue, NBS instead lent shares, minus voting rights, to two friendly parties, and Livedoor subsequently agreed to drop its bid. It sold its shares in NBS to Fuji Television, with Fuji Television, in its turn, buying around 12 per cent of the shares in Livedoor. Around the same time, the economics ministry (METI) and the Ministry of Justice (MOJ) issued takeover guidelines that drew in part on the report of METIs Corporate Value Committee (CVC). The report of the CVC refers to the concept of corporate value in the following terms:
The price of a company is its corporate value, and corporate value is based on the companys ability to generate profits. The ability to generate profits is based not only on managers abilities, but is influenced by the quality of human resources of the employees, their commitment to the company, good relations with suppliers and creditors, trust of customers, relationships with the local community, etc. Shareholders select managers for their ability to generate high corporate value, and managers respond to their expectations by raising corporate value through creating good relations with various stakeholders. What is at issue in the case of a hostile takeover is which of the parties the bidder or the incumbent management can, through relations with stakeholders, generate higher corporate value.

The Guidelines (METI and MOJ, 2005) take a more shareholderorientated view, referring to corporate value as attributes of a corporation, such as earnings power, financial soundness, effectiveness and growth potential, etc., that contribute to shareholder interests. However, they also recommend giving scope for companies to put anti-takeover defences in place to deal with what could be regarded as opportunitistic or predatory bids. In 2006 a new law, the Financial Instruments and Exchange Law, amending basic securities legislation, came into effect. This introduced a version of the mandatory bid rule: a party purchasing 10 per cent of a companys stock over a three-month period would be required to make a public tender offer or be limited to holding no more than one-third of the companys issued share capital. In 2006 changes to company law came into effect that formally allowed companies to put in place anti-takeover defences. These include the powers to issue special class shares with limited voting rights or which can be compulsorily repurchased by the company (thereby depriving a potential bidder of its stake), to make rights issues which exclude a bidder, and to issue golden shares which confer certain rights such as the power to appoint directors or restrain voting rights. The latter type of provisions requires two-thirds majority support from existing shareholders. The response to these developments has been complex and multi-layered

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(see Whittaker and Hayakawa, 2007; Buchanan and Deakin, 2007). On the one hand, a large number of companies have put in place takeover defences. By February 2007, 197 listed companies had announced antitakeover strategies of various kinds (Nikkei, 2007). Some large companies, such as Toyota, have strengthened intra-group cross-shareholdings in an attempt to deflect Livedoor-type bids, and others, such as the three main steel producers, have announced anti-takeover defence pacts. At the same time, there has been some resistance to the growing use of anti-takeover defences. One of the main institutional investor bodies, the Pension Fund Association (PFA), has made clear its opposition to takeover defences that do not have the approval of a simple majority of shareholders. The Tokyo Stock Exchange (TSE) has also been hostile to poison pill type defences, seeing them as a barrier to stock market transparency and to accountability. In March 2006 the TSE amended its own guidelines to allow golden shares, after the main employers federation, the Keidanren, criticized the Exchanges previous opposition to this type of arrangement, but the TSE guidelines continue to stress the need for majority shareholder approval, in line with the PFA position. Further evidence of growing shareholder pressure comes in the form of dividend increases, which in a number of cases can be traced to activist shareholder pressure in the companies concerned. Having said that, the current position of Japanese law is a long way from the model of the City Code. Notwithstanding the introduction of a version of the mandatory bid rule, the Japanese position is closer to Delaware law, which permits poison pills, but with a clearer authorization for takeover defence in the face of greenmail or asset restructuring. The concept of corporate value is being distinguished from the US-inspired shareholder value in contemporary debates. Managerial practice, too, continues to prioritize the model of the community firm, with only a few exceptions. This statement, made to one of the present authors by the president of a large company in the course of empirical research on Japanese corporate governance during the autumn of 2006 (see Buchanan and Deakin, 2007), is typical of current attitudes:
Im not quite sure whether shutting out these sorts of opportunities [i.e. bid approaches] can really be called corporate defence. However this is a Japanese sort of environment the fact is that 6,000 people are working in our group and hitherto they have always had a great feeling of confidence and attachment towards the management. Accordingly, with regard to philosophy, even if for the sake of argument someone were to appear with a philosophy that was even more elevated than ours, I would be very worried and doubtful as to whether these employees who are currently contributing their confidence and attachment to us would continue to do so in the same way for them.

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3.6

Takeover Regulation in Emerging and Transition Systems

In the economies of the common law world, there is growing evidence of shareholder rent extraction. A curious effect of successive takeover waves from the 1970s onwards is that, in Britain and America, the net contribution of new equity to the financing of the corporate sector as a whole has become negative. This is the result of share buy-backs and the retirement of capital following mergers. The phenomenon has led to questioning of the sustainability of the current model from within the business school community, as in Allen Kennedys afterword to his 2000 book The End of Shareholder Value:
How many companies would spend their wealth on stock buyback programs if their objective was to create wealth? How many companies would see fit to cut R&D expenditures if their objective was to build wealth? How many companies would cavalierly shed long-term, loyal employees, their heads crammed full of information valuable to the company, if their objective was to create wealth?

In a similar vein, Marjorie Kelly (2002), writing in the pages of the Harvard Business Review, argued that:
stock-market investors have become, collectively, an extraordinarily unproductive force in business. Indeed, for the last two decades, their contribution to corporations has been literally negative . . . its wrong to shovel money out to shareholders in ever larger scoops and force other stakeholders to pay the price.

The shareholders role is no longer simply to supply finance to companies. Most trades of shares in listed companies consist of movements from one shareholder to another with no new capital being supplied to the company. Rather, as agency theory prescribes, the function of shareholders is to discipline corporate management. Thanks to the takeover revolution and the changes associated with it, the managers of listed companies must maintain shareholder approval. If they do not, they face the prospect of a takeover bid. In practice, this means that companies have to satisfy, on a continuing basis, shareholders expectations for high rates of return on equity. If they can do this, a rising share price becomes an asset in its own right, which can be deployed to fund growth through acquisitions (Millon, 2002). The position is, however, different in civil law systems and in the developing world. The net contribution of equity capital has been positive in those systems that have not followed the Anglo-American shareholder primacy norm: mainland Europe, Japan, and developing world economies such as Brazil and India (Singh et al., 2002).

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Is this going to change as a result of shifts in takeover regulation in developing and transition economies? One of the central features of the British (and now, to a degree, the EU) model is the mandatory bid rule. This is at the core of the City Code system, which aims to protect the right of minority shareholders to access, in proportion to their holdings, the surplus generated by a takeover bid. It is an important stimulus to the fragmentation and dispersion of ownership while also discouraging the construction of cross-shareholdings. Influenced by a mixture of British and EU practice, many systems have adapted a version of the mandatory bid rule in the past ten years as part of a general realignment of takeover regulation in favour of the protection of minority shareholder interests: in 1987 in Malaysia, 1994 in India, 2000 in Pakistan, 2000 in Chile, 2002 in Argentina, 2005 in Mexico (Siems, 2007). A similar trend can be observed in transition systems as a result of the adoption of the Thirteenth Company Law Directive (Commission, 2007). Two important aspects of the Directive are the board neutrality rule, which limits the scope for takeover defences both ex ante and during a bid, and the breakthrough rule under which poison pills and golden shares can be overridden during a bid. Most western European systems have taken up the opportunity provided by the Directive to derogate from both these rules, but the rate of take-up of derogations is lowest in the Central and Eastern European (CEE) countries which constitute the accession member states: the board neutrality rule has been adopted in the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Slovakia and Slovenia, and the breakthrough rule has been adopted in Estonia, Latvia and Lithuania. Of the CEE accession states, only Poland has followed the lead of Germany and other western European countries in rejecting both the breakthrough rule and the board neutrality rule. This suggests that the approach which began in the City Code is on the way to becoming a global standard. Is this in the long-run interests of developing and transition systems?

4.

THE ECONOMISTS VIEW OF THE MARKET FOR CORPORATE CONTROL

From a discussion of the alternative legal approaches to the question of takeover bids, we now turn to economic analysis. In terms of the language of the agency theory and the theory of asymmetric information, the central issue may be stated in the following terms. The modern corporations are, it is suggested, characterized by serious principalagent problems, particularly between shareholders (principals) and managers (agents); asymmetric

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information between the two; and incomplete contracting. The operation of these factors provides analytical justification for the proposition that managers have scope to pursue their own ends. One branch of the literature has pointed to the difficulties involved in limiting managerial discretion through a more rigorous analysis of corporate governance, that is, the internal governance mechanisms of the corporation, including shareholder voting and the effectiveness of the board of directors. The alternative means available to the shareholders to limit such discretion is to attempt to align managers interests with their own by devising appropriate incentive contracts. All such efforts, however, have a cost (the so-called agency cost). Within the framework of these concepts, the takeover selection argument can then be deployed in two ways. The strong form would suggest that only firms that are able to devise and implement optimal incentive contracts will be selected for survival; others will be taken over. In a weaker form, this theory would propose that, while in the real world substantial agency costs are inevitable and it is not always possible to design satisfactory incentive contracts, the takeover mechanism nevertheless helps to reduce agency costs and thus promote economic efficiency. The implication of this weaker proposition is that, other things being equal, the greater the agency costs, the more likely it is that the firm will be taken over. In this paradigm, in normative terms, the free operation of the takeover mechanism can benefit society through two distinct channels: (a) the threat of takeovers can discipline inefficient managements and reduce agency costs; (b) even if the firms are working efficiently, takeovers may lead to a reorganization of their productive resources and thereby enhance shareholder value. There is a sharp dispute between industrial organization economists and specialists in finance about the efficiency of mergers and takeovers. The former believe that takeovers do not lead to increased efficiency; at best they are neutral, but most likely they reduce efficiency. The industrial organization economists use accounting data to arrive at this conclusion (Scherer, 2006; Mueller, 2003). This leads these economists to advocate regulation of mergers since they are likely to enhance the monopoly power of the amalgamating firms without, on average, increasing their efficiency. In contrast, the finance specialists believe, on the basis of stock market data and events studies methodology, that mergers enhance economic and social efficiency. These scholars are therefore opposed to regulation of mergers. A leading exponent of this view is Professor Jensen (2005). He and his colleagues regard anti-takeover legislation, which, as mentioned before, many individual American states have instituted in reaction to the successive huge merger waves of the last three decades, as being misconceived and promoted

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by special interests. Some scholars belonging to this school would go even further. They not only oppose any new anti-merger regulatory measures but also suggest that the extant institutional obstacles to takeovers should be eliminated. There are at present a number of stock exchange provisions both in the US and the UK whose main purpose is to afford protection to minority shareholders and to ensure fair play and transparency in share transactions connected with the takeover process. For example, in the UK, a corporate raider is obliged to disclose its stake in the victim company after it has purchased 3 per cent of the victims shares. Moreover, as we have seen, the raider is required to make a full cash bid for all the shares of the company after it has purchased 30 per cent of the victims stock. The exponents of the market for corporate control believe that such regulations constitute imperfections in the free functioning of the market; they are, therefore, ipso facto inefficient, and hence should be removed. This very positive finance specialists view of the market for corporate control is vigorously contested by industrial organization economists. Their reservations are best conveyed by a critical analysis of the US business model of shareholder wealth maximization subject to the constraints of liquid stock markets (including the takeover mechanism). This model is being promoted for emerging countries by the IMF and the World Bank, and indeed is recommended as a universal standard for the whole world by these institutions and orthodox policy makers. Ironically, as we shall see below, this model has risen from the shadow of strong criticism in the early 1990s, when it was held responsible for the sluggishness of the US economy, to its current acclaim for having engineered the US lead in the information and technology revolution and for fostering faster growth in the US economy.33 The extent to which the US corporate model facilitates technological dynamism is perhaps the central issue in any assessment of its merits. However, it is now accepted that since 1995 there has been an increase in the US economys long-term rate of growth by perhaps as much as one percentage point, from 2.5 to nearly 3.5 per cent per annum. This strong performance is attributed by leading scholars such as Jorgenson (2001, 2003) to the US lead in information technology. This success, in turn, is attributed by many economists and, particularly, by the media to the pivotal role played by US stock markets and venture capital markets in financing this technological revolution.34 It is suggested that not all economies with stock markets are able to achieve these feats. Black and Gilson (1998) have argued that other advanced economies such as Germany have tried to imitate the US venture capital market but have not been successful. The American success is due in part to its having a highly efficient and effective market for corporate control. This allows a timely exit option,

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making it possible for the American-type venture market to flourish. There are also other advantages attributed to the US stock market, such as the widespread use of stock options in technology industries that bring individual managers incentives in line with corporate objectives. Larry Summers (1998, 1999), who in the past has been critical of the short-term focus of the stock market, has changed his mind. He now suggests that the increasing stock market pressure for performance has played a key role in the US economic success of the last decade. Further, the huge investment in new technology firms in the US during the technology boom of the 1990s, despite their zero or negative short-term profits, is regarded as an obvious refutation of the short-termism alleged by critics of stock markets (however, see below). Nevertheless, taking into account the above facts, a critical examination of the functioning of the stock market in the last ten years raises the following questions. Does the experience of the last decade warrant a complete reversal of the conclusions reached by Michael Porter and his colleagues in 1992? Does the so-called new US economy constitute a conclusive proof of the superiority of the countrys financial system over all others? Is there adequate analysis and empirical evidence to indicate that the Anglo-Saxon model of corporate governance outlined above is the one that all countries, including developing ones, should adopt? Singh et al. (2005) have carried out a detailed analysis of these issues and they report the following conclusions:

The experience over the last decades in the US capital markets provides little justification for revising the unfavourable 1992 verdict of Michael Porter and his colleagues, although the reasons for this are not necessarily the same now as they were then. Instead of maximizing shareholder wealth, developing country companies should pay no attention to their market valuations. Rather, they should pursue their traditional objective of increasing market share or corporate growth within the overall framework of the countrys industrial policy. The stock market based model of shareholder wealth maximization does not represent the end of history or the epitome of corporate law as some suggest.

The main reasons for these conclusions lie in the severe deficiencies of two market processes which are central to the efficient operation of stock markets: first the pricing process and second the market for corporate control. It will further be appreciated that the last decade of applause for the US stock market must at least be tempered by the fact that during this period there was not only a boom but also a very significant bust. The

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NSDAQ index of share prices of new technology companies is still well below half the value that it reached at its peak in 2000.

5.
5.1

STOCK MARKET PRICES AND THE MARKET FOR CORPORATE CONTROL

The Pricing Process on the Stock Market

It will be observed that during the last two decades the orthodox efficient markets hypothesis concerning share prices has suffered fundamental setbacks. These are specifically due to the following events: (a) the 1987 US stock market crash, (b) the meltdown in the Asian stock markets in the late 1990s and (c) the bursting of the technology stocks bubble in 2001. Following Tobin (1984) a useful distinction may be made between two kinds of efficiency of stock markets. First, there is information arbitrage efficiency (IAE), which ensures that all information concerning a firms shares immediately percolates to all stock market participants, ensuring that no participant can make a profit on such public information. Second, there is fundamental valuation efficiency (FVE), whereby share prices accurately reflect a firms fundamentals, that is, its long-term expected profitability (Tobin, 1984). The growing consensus view is that stock market prices may at best be regarded as efficient in the first sense above (IAE), but are far from being efficient in the economically more important second sense (FVE) (Singh, 1999). This point hardly needs labouring today in the light of the burst of the technology bubble in leading stock markets in 2001 and almost two decades of stock market stagnation and decline in Japan. It will be difficult to preach an EMH gospel to citizens in Thailand and Indonesia, who suffered a virtual meltdown of their stock markets during the Asian crisis of 199799 (see further Singh et al., 2005). 5.2 The Market for Corporate Control as an Evolutionary Mechanism35

There are good theoretical reasons as well as a large body of empirical evidence to suggest why the markets for corporate control in advanced countries, including the UK and the US, do not work at all well. A central point of this research is that the takeover selection process does not simply punish poor performance and reward good performance. The evidence indicates that selection in this market does not take place entirely on the basis of performance but much more so on the basis of size. A large relatively inefficient firm has a greater chance of survival than a small efficient firm (Singh, 2008).

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Further, there are good theoretical reasons as well as empirical evidence for suggesting that takeovers may lead to short-termism, and/or speculative buying and selling of shares. In addition, more broadly, they may result in economic rewards being given for financial engineering rather than for entrepreneurial effort in improving products and cutting costs. Empirical research indicates that the takeover disciplinary process is very noisy and is often arbitrary and haphazard (Ravenscraft and Scherer, 1987; Scherer, 1998, 2006; Tichy, 2001; Singh, 2000). The deficiencies of the pricing and takeover processes are compounded in the case of developing countries because of their regulatory deficits and the relative immaturity of their stock markets. Singh (1998) argues for restrictions on the development of a market for corporate control for these countries. Rather, he suggests that developing countries should find cheaper and less haphazard mechanisms to change managements than the above stock market process. 5.3 The Technology Boom, the Mispricing of Shares and the Market for Corporate Control

It is generally accepted that there was a widespread mispricing of shares during the technology boom of 19952000. There was also a huge overinvestment in technology companies. Importantly, in addition to the foregoing, there was evidence of significant resource misallocation through the working of the market for corporate control. In essence, grossly overpriced technology companies bought up underpriced old economy companies to the detriment of both and to the detriment of social welfare. Jensen (2003) drew attention in this context to the case of Nortel, a large US company that between 1997 and 2001 acquired 19 companies at a price of US$33 billion. Many of these acquisitions were paid for in Nortel shares whose value had skyrocketed during that period. When the companys price fell 95 per cent in the technology stock burst, all the acquisitions had to be written off. Jensen observed, Nortel destroyed those companies and in doing so destroyed not only the corporate value that the acquired companies on their own could have generated but also the social value those companies represented in the form of jobs, products and services. (p. 15) Although Jensen suggests various ways of reducing the mispricing of shares, in Keynesian analysis such mispricing is inherent in any asset valuation pricing process via the stock market. In this paradigm, stock market players base their investment decisions not on fundamentals but on speculative and gambling considerations. With such pricing, shareholder wealth maximization is clearly not a useful objective for corporate managers who have the firms interest in view. Kay (2003) therefore rightly suggests that corporate managers should pay no attention to the stock market at all.

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Indeed, the creation of shareholder value should not be a corporate goal. The Keynesian view of pricing process is supported by a large body of analytical and empirical studies: see, for example, Shiller (2000, 2004) and Shleifer (2000).

6.

CONCLUSION

In orthodox economic analysis, the market for corporate control is thought to be the evolutionary endpoint of stock market development. This proposition has been seriously questioned in this chapter from the perspective of both legal and economic analysis. Takeovers are a very expensive way of changing management. There are huge transaction costs associated with takeovers in countries like the US and the UK, which hinder the efficiency of the takeover mechanism (Peacock and Bannock, 1991). Given the lower income levels in developing countries, these costs are likely to be proportionally heavier in these countries. It may also be observed that highly successful countries overall, such as Japan, Germany and France, have not had an active market for corporate control and have thus avoided these costs, while still maintaining systems for disciplining managers. Significantly, the lack of a market for corperate control has not imposed any great hardship on these economies as their superior long-term economic record, say over the last 50 or 100 years, compared with that of Anglo-Saxon countries, indicates. Furthermore, there is no evidence that corporate governance necessarily improves after takeovers. This is for the simple reason that not all takeovers are disciplinary; in many of them the acquiring firm is motivated by empire-building considerations or indeed by asset-stripping. In summary, contrary to current conventional wisdom, an active market for corporate control is not an essential ingredient of either company law reform or financial and economic development. The economic and social costs associated with restructuring driven by hostile takeover bids, which are increasingly seen as prohibitive in the liberal market economies, would most likely harm the prospects for growth in developing and transitional systems. Developing countries simply cannot afford the burden of the extremely expensive, and hit and miss system of management change that takeovers represent. The following argument might be raised against the claims that we have made here: if two mechanisms were available, an internal one based on corporate governance and an external one represented by takeovers, why not use them both to improve corporate performance? One immediate difficulty with this argument is that acquiring companies may themselves be

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empire builders rather than disciplining shareholder value maximizers, as was noted above. It was also seen that, at a more macro-economic level, the takeover mechanism may subvert capitalist values by rewarding financial engineering rather than enterprise. In a survey carried out by Cosh, Hughes and Singh in the 1980s, it was found that 60 per cent of the time of the chief executives of Britains top companies was spent on roadshows to investors, rather than promoting new products or reducing costs, the essential tasks of enterprise. The authors also found that a great deal of time was spent by the chief executives and financial directors in either avoiding takeovers or trying to take over other companies themselves (Cosh et al., 1990). Perhaps our suggestion that developing country corporations should pay no attention to their market valuations is somewhat extreme. But our essential argument here is that stock market valuations are a highly inaccurate guide to the fundamental valuations of companies. This is especially so in developing countries, where theory predicts that the share price volatility is even greater than in advanced countries. With the kind of meltdown in share prices observed in East Asia during the crisis years of 199799, it was scarcely useful to ask corporations to judge their performance by changes in share prices. As mispricing of shares cannot be forecast with any accuracy, and as historical evidence suggests that such mispricing may continue over long periods of time, it does not auger well for companies to use stock market values as the main criterion for judging success or failure. Finally, it could be argued against us that all we have offered here is a critique, when what is needed is practical answers to the question of how to design institutions for the market for corporate control. A clear conclusion of our argument is that the mandatory bid rule and other similar aspects of the UK model, which are now being very widely exported around the world, will not aid the cause of economic development; we do not favour these rules. This does not mean that takeovers should be entirely unregulated far from it. Not only developing countries but also those in Continental Europe, which have long operated without a market for corporate control, should seek alternative institutional mechanisms for disciplining errant managements rather than adopting the Anglo-Saxon takeover mechanism. Instead of concentrating on shareholder value, these countries should be actively promoting new institutional mechanisms for inclusive development of the company and its diverse constituencies.

NOTES
1. This chapter was originally a paper presented at the conference on The Economics of the Modern Firm, University of Jnkping, 2122 September 2007. We are very grateful for comments received at the conference and from a referee.

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2. 3. 4. 5. 6. 7. 8. 9. 10.

217

11. 12. 13.

14. 15. 16. 17. 18. 19.

20. 21. 22. 23. 24. 25. 26. 27. 28. 29.

30.

This section updates, in part, material first set out in Deakin and Slinger (1997) and Deakin et al. (2003), and draws on Deakin (2009). Unocal v. Mesa Petroleum 493 A.2d 946, 955 (1985). Revlon Inc. v. McAndrews & Forbes Holdings Inc. 506 A.2d 173 (1986); Paramount Communications Inc. v. QVC Network Inc. 637 A.2d 34 (1994). Paramount Communications Inc. v. Time Inc. 571 A.2d 1140 (1989). On Delawares zigzags, see Roe (1993) and Blair (1995: 22022). 457 US 624 (1985). 481 US 69 (1987). Schreiber v. Burlington Northern Inc. 475 US 1 (1985). Directive 2004/25/EC of the European Parliament and the Council of 21 April 2004 on Takeover Bids, L 142 Official Journal of the European Union 30.4.2004). The Takeovers Directive (Interim Implementation) Regulations 2006 (SI 2006/1183), which came into force on 20 May 2006, provide a statutory basis for the Panels operation and empower it to issue rules on takeover bids. These Regulations have more recently been superseded by the relevant provisions of the Companies Act 2006. See DTI (2005) and Takeover Panel (2005). City Code, General Principle 1.1. Ibid., rule 9. See also Companies Act 1985, s. 430A providing a statutory right to sell where the bidder and its associates control 90 per cent in value of the relevant shares; s. 428 grants the bidder a right of compulsory purchase of the last 10 per cent of the shares. City Code, rule 36. City Code., rule 20.1. Ibid., rule 3.1. Ibid., rule 25.1(a). Ibid., rule 19.2. A claim in tort might well be made out notwithstanding the restrictive decision of the House of Lords (on auditor liability) in Caparo Industries plc v. Dickman [1990] 2 AC 6, and it is also possible that directors who provide misleading advice on the sale of shares may commit a breach of statutory duty actionable by the shareholders: Gething v. Kilner [1972] 1 All ER 1166. Heron International Ltd. v. Grade [1983] BCLC 244. General Principle 3. City Code, rule 24.1. Ibid., rule 25.1(b). See below, Section 3. City Code, rule 30.2(b). This is however subject to the target board receiving the employee representatives views in good time, which may not always be straightforward. See Takeover Panel (2006: 323) for discussion. City Code, rule 21. See Howard Smith Ltd. v. Ampol Petroleum Ltd. [1974] AC 821, discussed by Parkinson (1995: 143). Companies Act 1985, ss. 859. These Guidelines were first issued on 21 October 1987 by the International Stock Exchanges Pre-emption Group, consisting of members of the ISE and officers of the principal representatives of institutional shareholders, namely the Association of British Insurers and the National Association of Pension Funds. Under Guideline 1.2, the Investment Committees of the ABI and the NAPF agreed to advise their members, under normal circumstances, to approve resolutions for annual disapplication of preemption rights, as long as the non-pre-emptive issue did not exceed 5 per cent of the issued ordinary share capital as shown in the most recent published accounts of the company. Guidelines published by the Institutional Shareholders Committee (a body representing a number of financial industry interests and trade associations) in December 1991,

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The Responsibilities of Institutional Shareholders in the UK, stated that institutional shareholders have for many years been opposed to the creation of equity shares which do not carry full voting rights and have sought the enfranchisement of existing restricted voting or non-voting shares (para. 3). See High Level Group (2002a: 1012). On the Action Plan, and its development since 2002, see Commission (2003) and the company law website of the Internal Market Directorate: http://ec.europa.eu/internal_market/company/index_en.htm. Directive 2004/25/EC. Porter (1992) reported on the findings of a US Blue Ribbon Commission (comprising 22 leading US economists including Larry Summers) on the countrys business model and the associated system of allocating capital. The Commission made serious criticisms of Americas capital markets, indicating that they were misallocating resources and jeopardizing the American position in the world economy. It is indeed true that the US economy stagnated between 1973 and 1995, registering hardly any overall increase in productivity growth. This is not necessarily Professor Jorgensons view. He attributes the rapid uptake of information technology in the US to the sharp fall in the price of semiconductors as a result of increased competition. This in turn arose from a reduction in the product cycle from three to two years. This section is based on and updates some of Singhs previous contributions in this area including Singh (1992, 2000, 2006).

31. 32. 33.

34.

35.

BIBLIOGRAPHY
Alcouffe, A. and Alcouffe, C. (1997), Control and executive compensation in large French companies, Journal of Law and Society, 24: 85. Berle, A. (1932), For whom corporate managers are trustees: a note, Harvard Law Review, 45: 1365. Berle, A. (1962), Modern functions of the corporate system, Columbia Law Review, 62: 443. Black, B. and Gilson, R. (1998), Venture capital and the structure of capital markets: banks versus stock markets, Journal of Financial Economics, 47: 24377. Blair, M. (1995), Ownership and Control: Rethinking Corporate Governance for the Twenty-First Century, Washington, DC: Brookings Institution. Blair, M. and Stout, L. (1999), A team production theory of corporate law, Virginia Law Review, 85: 247328. Buchanan, J. and Deakin, S. (2007), Japans paradoxical response to the new global standard in corporate governance, ECGI Working Paper No. 87/2007, August. Commission (2003), Modernising Company Law and Enhancing Corporate Governance in the European Union A Plan to Move Forward, COM(2003) 584 final, Brussels: European Commission. Commission (2007), Report on the implementation of the Directive on Takeover Bids, Brussels, 21.02.2007, SEC(2007) 268. Company Law Review Steering Group (2000), Modern Company Law for a Competitive Economy: Developing the Framework, London: DTI. Company Law Review Steering Group (2001), Modern Company Law for a Competitive Economy: Final Report, Volume 1, London: DTI. Cosh, A., Hughes, A. and Singh, A. (1990), Takeovers and short-termism:

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analytical and policy issues in the UK economy, Industrial Policy Paper No. 2, London: IPPR. Davies, P. (1997), Gowers Principles of Modern Company Law, London: Sweet and Maxwell. Deakin, S. (2003), Evolution for our time: a theory of legal memetics, Current Legal Problems, 55: 142. Deakin, S. (2009), Reflexive governance and European company law, European Law Journal, 15 (2), 22445. Deakin, S. and Slinger, G. (1997), Hostile takeovers, corporate law and the theory of the firm, Journal of Law and Society, 24: 124150. Deakin, S., Hobbs, R., Nash, D. and Slinger, G. (2003), Implicit contracts and corporate governance: in the shadow of the City Code, in Campbell, D., Collins, H. and Wightman, J. (eds) Implicit Dimensions of Contracts, Oxford: Hart, 289331. Dodd, E.M. (1932), For whom are corporate managers trustees?, Harvard Law Review, 45: 114563. DTI (2005), Company Law Implementation of the European Directive on Takeover Bids, London: Department of Trade and Industry. Gelter, M. (2007), A theory on the impact of shareholder control and ownership concentration on corporate stakeholders: or, team production meets comparative corporate governance, paper presented at LSA conference, Berlin. Hannah, L. (1974), Takeover bids in Britain before 1950: an exercise in business pre-history, Business History, 16: 6577. Hannah, L. (2007), The divorce of ownership and control from 1900: recalibrating imagined global historical trends, Business History 49: 40438. Hansmann, H. and Kraakman, R. (2001), The end of history for corporate law, Georgetown Law Journal, 89: 43968. High Level Group (2002a), Report of the High Level Group of Company Law Experts on Issues Related to Takeover Bids, Brussels: European Commission. High Level Group (2002b), Report of the High Level Group of Company Law Experts on a Modern Regulatory Framework for Company Law in Europe, Brussels: European Commission. Ireland, P. (1999), Back to the future: Adolf Berle, the Law Commission and directors duties, Company Lawyer, 20: 20311. Jensen, M. (2001), Value maximization, stakeholder theory, and the corporate objective function, Journal of Applied Corporate Finance, 14: 821. Jensen, M.C. (2003), The agency costs of overvalued equity, Munich Economic Summit, 23 May, CESifo Forum, 4 (2), 1416. Jensen, M. (2005), A Theory of the Firm: Governance, Residual Claims, and Organizational Forms, Cambridge, MA: Harvard University Press. Johnston, A. (1980), The City Take-over Code, Oxford: OUP. Jorgenson, Dale W. (2001), Information technology and the U.S. economy, American Economic Review, 91 (1), 132. Jorgenson, Dale W. (2003), U.S. growth resurgence, CES Ifo Economic Studies, 49 (1), 2747. Kay, John (2003), Challenging the claims for the role of capital markets, Munich Economic Summit 23 May, CESifo Forum, 4 (2), 1720. Kelly, M. (2002), The incredibly unproductive shareholder, Harvard Business Review, January. Kennedy, A. (2000), The End of Shareholder Value: Corporations at the Crossroads, Cambridge, MA: Perseus.

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METI and MOJ (2005), (Guidelines Regarding Takeover Defence for the Purposes of Protection and Enhancement of Corporate Value and Shareholders Common Interests), Tokyo: (METI) and (Ministry of Justice). Milhaupt, C.J. (2006), The rise of hostile takeovers in Japan, Zeitschrift fr Japanisches Recht (Journal of Japanese Law), 11: 199204. Millon, D. (2002), Why is corporate management obsessed with quarterly earnings and what can be done about it?, George Washington Law Review, 70; 890920. Miyajima, H. and Kuruoki, F. (2005), The unwinding of cross-shareholding: causes, effects, and implications, in Aoki, M., Jackson, G. and Miyajima, H. (eds), Corporate Governance in Japan: Institutional Change and Organizational Diversity, RIETI Discussion Paper Series 05-E-006. Mueller, D. (2003), The finance literature on mergers: a critical survey, in M. Waterson (ed.), Competition, Monopoly and Corporate Governance, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, pp. 161205. National Stock Exchanges (2006), (Results of Shareholding Distribution Survey for 2005), Tokyo, Osaka, Nagoya, Fukuoka, Sapporo: (National Stock Exchanges). Nikkei (2007), (Introduction of anti-takeover strategies: close to 200 companies), Tokyo: (Nihon Keizai Shimbun). Njoya, N. (2007), Property in Work: The Employment Relationship in the AngloAmerican Firm, Aldershot: Ashgate. NLI Research (2004), (Cross-Shareholding Survey 2003), Tokyo: (NLI Research). Parkinson, J. (1995), Corporate Power and Responsibility: Issues in the Theory of Company Law, Oxford: OUP. Parkinson, J. (2003), Models of the company and the employment relationship, British Journal of Industrial Relations, 41: 481509. Peacock A. and Bannock, G. (1991), Corporate Take-overs and the Public Interest, Aberdeen: Aberdeen University Press for the David Hume Institute. Porter, M. (1992), Capital disadvantage: Americas failing capital investment system, Harvard Business Review, 70, (SeptemberOctober), 6582. Ravenscraft, D.J. and Scherer, F.M. (1987), Mergers, Sell-offs and Economic Efficiency. Washington DC: Brookings Institution. Rebrioux, A. (2007), Does shareholder primacy lead to a decline in managerial accountability?, Cambridge Journal of Economics, 31: 50724. Roe, M. (1993), Takeover politics, in M. Blair (ed.), The Deal Decade, Washington DC: Brookings Institution. Scherer, F.M. (1998), Corporate take-overs: the efficiency argument, Journal of Economic Perspectives, 2 (1) (Winter), 6982. Scherer, F.M. (2006), A new retrospective on mergers, Review of Industrial Organization, 28: 32741. Schleifer, A. and Summers, L. (1988), Breach of trust in hostile takeovers, in Auerbach, A. (ed.) (1988), Corporate Takeovers: Causes and Consequences, Chicago: University of Chicago Press, pp. 3356. Schleifer, A. (2000), Inefficient Markets, Oxford: Oxford University Press. Shiller, Robert J. (2000), Irrational Exuberance, Princeton: Princeton University Press.

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Shiller, Robert J. (2004), Figuring out financial markets: more psychology than economics?, interview with Robert Shiller, IMF Survey, 12 April, pp. 11112. Siems, M. (2007), Shareholder protection around the world (Leximetric II), CBR Working Paper No. 359, Centre for Business Research, University of Cambridge. Singh, A. (1992), Corporate take-overs, in J. Eatwell, M. Milgate and P. Newman (eds), The New Palgrave Dictionary of Money and Finance, London: Macmillan, pp. 48086. Singh, A. (1998), Liberalisation, the stock market and the market for corporate control: a bridge too far for the Indian economy?, in Ahluwalia, I.J. and Little, I.M.D. (eds), Indias Economic Reforms and Development: Essays for Manmohan Singh, Oxford: OUP, 16996. Singh, A. (1999), Should Africa promote stock market capitalism?, Journal of International Development, 11: 34365. Singh, A. (2000), The Anglo-Saxon market for corporate control: the financial system and international competitiveness, in Candace Howes and Ajit Singh (eds), Competitiveness Matters: Industry and economic performance in the US, Ann Arbor: University of Michigan Press, 89105. Singh, A. (2006), Stock Market and Economic Development, in Clark, David Alexander (ed.), The Elgar Companion to Development Studies, pp. 58490, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Singh, A. (2008), Stock Markets in Low and Middle Income Countries, presented at the Workshop on Debt, Finance and Emerging Issues in Financial Integration, 89 April, United Nations Headquarters, New York. Singh, Ajit, Singh, Alaka and Weisse, B. (2002), Corporate governance, competition, the new international financial architecture, and large corporations in emerging markets, Centre for Business Research Working Paper no. 250, University of Cambridge. Singh, A., Glen, J., Zammit, A., De-Hoyos, R., Singh, Alaka and Weisse, B. (2005), Shareholder value maximization, stock market and new technology: should the US corperate method be the universal standard?, Centre for Business Research Working Paper no. 315, University of Cambridge. Strine, L. (2007), Toward common sense and common ground? Reflections on the shared interests of management and labor in a more rational system of corporate governance, Discussion Paper No. 585, 05/2007, John M. Olin Center for Law, Economics and Business, Harvard University. Summers, L.H. (1998), Opportunities out of Crises: Lessons from Asia, remarks to the Overseas Development Council from the Office of Public Affairs, 19 March. Summers, L.H. (1999), quoted in Winning ways: ready bucks and a flair of risk, Financial Times, 14 December. Takeover Panel (2005), Explanatory Paper: Implementation of the European Directive on Takeover Bids, London: Takeover Panel. Takeover Panel (2006), The Implementation of the Takeovers Directive Statement by the Panel and the Code Committee following the External Consultation on Process on PCP 2005/5, London: Takeover Panel. Tichy, G. (2001), What do we know about success and failure of mergers?, Journal of Industry, Competition and Trade, 1 (4), 34794. Tobin, J. (1984), On efficiency of the financial system, Lloyds Bank Review, 115 July.

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TSE (2007), TSE-Listed Companies White Paper of Corporate Governance 2007, Tokyo: Tokyo Stock Exchange, Inc. Uchitelle, L. (2006), The Disposable American: Layoffs and their Consequences, New York: Knopf. Useem, M. (1996), Investor Capitalism, New York: Basic Books. Vinot, M. (1995), Rapport sur le conseil dadministration des socits cotes, Revue de droit des affaires internationales, 8: 93545. Whittaker, H. and Hayakawa, M. (2007), Contesting corporate value through takeover bids in Japan, Corporate Governance: An International Review, 15: 1626. Yarrow, G. (1985), Shareholder protection, compulsory acquisition and the efficiency of the takeover process, Journal of Industrial Economics, 34: 316.

PART IV

The board, management relations and ownership structure

10.

Institutional ownership and dividends

Daniel Wiberg*

1.

INTRODUCTION

During the late 1990s firms dividend payout ratios reached unprecedented low levels despite high earnings and price-to-dividend ratios. Recently however, with a continuing institutionalization of capital, dividend payout ratios have soared. At present many multinational firms pay out special dividends and buy back shares on a scale previously unseen. What role does the increasing institutionalization of capital play in this development? This chapter addresses this issue by investigating the effect of institutional ownership on dividend changes. A large body of research exists on how corporate ownership structure influences financing, investments and dividend decisions. The relationship between management ownership and dividend policy has been especially well documented (see, for example, Rozeff, 1982; Jensen et al., 1992; Eckbo and Verma, 1994; Mohd et al., 1995). The link between institutional investors ownership and dividend policy is, however, somewhat neglected (for dividends decisions see Short et al. (2002) and Gugler and Yurtoglu (2003)). This lack of research is remarkable since there has been such an increase in the importance and presence of these types of investor in recent decades. Although studies exist they are predominantly done on US or UK data (for example, Short et al., 2002) which, although central, fail to provide comprehensive insights when the institutional framework is different from what is usually referred to as the Anglo-Saxon corporate governance system. In Continental Europe and Scandinavia the general corporate governance structure is characterized by a much more concentrated ownership, often in combination with control instruments such as dual-class shares and pyramidal ownership structures. The Swedish corporate governance system is particularly interesting from this point of view, since it allows for the use of both vote-differentiated shares and corporate pyramid structures, which have jointly produced a remarkably persistent and concentrated ownership structure.
225

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The board, management relations and ownership structure

The purpose of this chapter is to investigate the impact of ownership on dividends. In particular, institutional ownership, and its relation to dividends, is considered in the context of an earnings trend model. This model allows both for partial adjustments of dividends to changes in earnings and for trends in the firms dividend behaviour. By examining Swedish listed firms the chapter also provides empirical evidence on the effects of control instruments such as dual-class shares on dividend policies. In line with the assumption that institutional investors may play a monitoring role, mitigating agency problems related to separation of ownership and control, the results show that institutional ownership has a positive effect on dividend payout policies. The relation is found to be positive but diminishing, which supports previous research concerning non-linearity and ownership structure. The chapter also provides empirical support for a negative impact of dual-class shares on dividends. The result, in line with agency cost theory, is that control instruments, such as vote-differentiated shares, induce investors to demand higher levels of dividends as compensation for the increased agency costs. Utilizing a panel data methodology which accounts for firm-specific effects and time effects, unobservable heterogeneity is controlled for. Furthermore, the chapter contributes to the literature by looking particularly at the Swedish case. In fact, Sweden is a very interesting case because it is a civil law country which, according to La Porta et al. (1999), has weaker protection of minority owners than common law countries such as the UK and the US. Opportunistic behaviour of the controlling owners is therefore more likely vis--vis minority owners (Miguel et al., 2004; Pindado and de la Torre, 2006). By European standards Sweden also has a vital capital market with a substantial part of the stock market equity controlled by both foreign and domestic institutional investors. The chapter is organized as follows. Section 2 continues with a discussion about the possible relations between institutional ownership and dividend policy. In particular, the importance of agency conflicts and signalling is discussed. The statistical models for dividend payout behaviour are provided in Section 3, together with definitions of the variables used in the regressions. Summary statistics and ownership concentration by different types of owners in the sample firms are examined in Section 4. The empirical method, estimation results and analysis are provided in Section 5. Conclusions end the chapter in Section 6.

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2.

OWNERSHIP AND CORPORATE GOVERNANCE

Given the divergence of ownership and control in listed firms, shareholders cannot perfectly control the managers actions in the strict interest of the shareholders. Hence principalagent problems arise. Managers may divert funds in their own interest at the expense of the shareholders (Williamson, 1963, 1964). This diversion of funds, usually referred to as managerial discretion, may include expropriation1 or diversion of cash flows to unprofitable projects. It might be that these alternative investments provide a positive return. In relation to the shareholders cost of capital, however, the return is too low and, therefore, in terms of shareholder value maximization, it is unprofitable (Mueller, 2003). With a separation of votes from capital, as in many firms in Sweden, agency costs might be substantial for the minority shareholders. A key feature in any corporate governance system is therefore the legal protection of minority shareholders. The effectiveness of the corporate governance system however, may also require the presence of large investors other than the controlling owner(s) or management2 (La Porta et al., 2000; Burkart et al., 1997). They can influence the managers to distribute profits to the shareholders, thus limiting the recourses available for managerial discretion. The downside to large investors of this kind is of course that they might just as well override the interest of minority shareholders (La Porta et al., 1999). Indeed, Morck et al. (1988) find that profitability is higher for firms with shareholders that have up to 5 per cent ownership; beyond that, profitability drops. This pattern indicates that larger block-holding investors might seek to generate private benefits of control that are not shared by minority shareholders. A constraint on institutional investors is that they are often limited, either by regulation or by a desire to maintain liquidity, to holding a relatively small ownership stake in the firms equity (Davis and Steil, 2001). Indeed, in Sweden mutual funds, which constitute the largest part of the institutional owners, are regulated by the mutual funds act of 2004.3 In this act it is stipulated that no single mutual fund can invest more than 5 per cent of its capital in a single equity issuer. The presence of institutional investors in the ownership structure of firms might nevertheless influence managers to be more focused on shareholder value maximization. It is also likely that this relationship between institutional ownership and dividend payout is non-linear (Miguel et al. 2004; Bjuggren and Wiberg, 2008; Bjuggren et al., 2007). That is, although the effect in general might be positive it is most likely marginally diminishing. A non-linear relation between ownership and dividend also indicates that the direction of causality goes from ownership to dividends and not the opposite.

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2.1

Institutional Ownership and Dividends

The increasing number of institutional investors and their growing dominance as owners has had a substantial influence on corporate governance (for extended discussion of agency costs and institutional owners see Davis and Steil, 2001). Compared with Anglo-Saxon countries such as the US and the UK, Continental European and Scandinavian firms pay out relatively little in dividends or via repurchase of shares (La Porta et al., 2000), despite high profitability and a very mature corporate structure. One principal reason for the low levels of dividends in Sweden is the tax system, which persistently disfavours dividends in favour of investments made with retained earnings (Hgfeldt, 2004; Henrekson and Jakobsson, 2006). A stated purpose of this tax policy is to foster so-called long-term investment. The effect, however, is that substantial funds have been made available for managers to invest with little or no scrutiny from the external capital market. So, even if high desired levels of dividends can be seen as a sign of shorttermism in the institutional owners attitudes (see, for example, Hutton 1995; Haskins 1995), it might just as well be an effect of these owners attempts to reduce the free cash flow available to management. 2.2 Taxation Arguments

Institutional owners might prefer dividends for other reasons as well. First of all, many institutional owners are tax-exempt with regard to dividends, and might thus prefer dividends to capital gains. In Sweden the majority of institutional owners are in fact tax-exempt mutual fund companies and insurance companies that manage pensions and other types of savings on behalf of the general public. Foreign ownership on the Swedish Stock Exchange is also predominantly made up of these types of institution. The Swedish corporate taxation system is a classical company tax system in which the companies are taxed separately from their shareholders. While firms pay a flat4 rate of corporation tax on their profits, individuals pay a slightly higher dividend gains tax on dividend incomes. The dividend gains tax is higher than the corporate tax rate, and individual owners might thus prefer to postpone taxes rather than pay a dividend tax immediately. Mutual fund companies and similar institutional investors are, however, tax-exempt in the sense that they do not pay tax on incomes received as dividends. The effect of this system is of course that individuals and company owners might prefer retained earnings and capital gains, whilst tax-exempt institutional owners are either neutral or positive towards dividends.

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A related issue is the need of many institutional owners for funds on an ongoing basis. That is, institutions invest in order to provide returns to fund their liabilities. Regardless of the tax bias in favour of dividends, institutions can therefore not rely entirely on capital gains to fund their activities, and hence they require dividends. For institutional owners as a group, and particularly in the case of Sweden, a positive relation to dividend payout must consequently be expected. 2.3 Agency Arguments

A second reason for why institutional owners in particular might favour dividends over reinvestments within the firm is that they might serve to curb the agency problems between controlling owners/managers and the minority shareholders, as suggested by Jensen (1986). Again, by high dividend payout ratios less funds are available for managerial discretion, and more funds will be allocated through the external capital market subject to market scrutiny. Empirically the predictions of agency theories on dividend payout (Rozeff, 1982; Easterbrook, 1984; Jensen, 1986; Eckbo and Verma, 1994) support a positive association between dividends and institutional ownership. The prediction is basically that dividends substitute for poor monitoring by the firms shareholders. Institutional owners might act as influential principals who are able to impose their preferred payout policy upon firms. The result is less cash available within the firm for managerial discretion and a somewhat mitigated agency problem. Based on the arguments above, Zeckhauser and Pound (1990) suggest that institutional owners might act as a substitute monitoring device, which would also reduce the need for external monitoring by the capital markets. However, the well-known incentives for institutional shareholders to freeride on monitoring activities suggests that institutional shareholders are in fact unlikely to provide direct monitoring themselves. 2.4 Signalling Arguments

A third reason why institutional owners might favour dividends is the potential information asymmetries that exist between owners and managements. Given these asymmetries and the equity markets preference for liquidity, dividends can act as a signal about the future prospects of the firm. A way for managements to signal their private information regarding the future earnings of the firm would be through dividends (Bhattacharya, 1979, 1980; Miller and Rock, 1985). A somewhat alternative hypothesis is put forward by Zeckhauser and Pound (1990). They argue that the presence

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of large outside shareholders, such as institutions, can act as a signal of the firms good performance. The presence of such shareholders might therefore lessen the use of dividends as a signalling device. This would then to some extent change Zeckhauser and Pounds (1990) agency theory prediction. It is however unclear in what way institutional shareholders would act as a signal of future prospects. Is it a signal of reduced agency costs due to monitoring of the institutional shareholders? According to the free-rider arguments mentioned before, probably not. The alternative is then that the institutional shareholders have some superior information regarding the future prospects of the firm. Although this explanation has some appeal, there is little evidence to support this scenario. Insider laws may, for instance, make institutional shareholders very careful in handling this type of information (if they get hold of it to start with). Also, the rapid increase of indexation, especially with respect to institutional shareholdings, implies that the presence of an institutional shareholder might not necessarily mean that the particular institution believes that the firm has better than average prospects (Short et al., 2002). While possible, the notion that dividends and institutional shareholders may act as substituting devices is not very convincing. The expected results with respect to the relationship between institutional ownership and dividends in terms of signalling would subsequently be mixed as well. These three main considerations, taxation, agency costs, and signalling, are now summarized in order to construct empirically testable hypotheses regarding the association between ownership and dividends. 2.5 Summary and Hypotheses

The association between ownership and dividends seems to depend crucially on three factors related to the corporate governance system. The first is the consideration of taxes. In a country like Sweden, with a classical company tax system, dividend payments are essentially taxed twice, both as profits within the firm and then as capital gains for the individual. Tax-exempt shareholders might for various other reasons (liabilities, and so on) prefer dividends to capital gains. Consequently one would expect a positive or at least neutral attitude to dividends relative to capital gains for this type of investor. The second factor decisively linking the corporate governance system to dividends is agency problems related to the separation of ownership from control. In corporate governance systems, such as the Swedish, where ownership is further separated from control via control instruments, such as vote-differentiated shares, the agency conflicts described by Jensen and Meckling (1976) are aggravated. From this perspective influential

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shareholders such as institutions may demand higher levels of dividends in order to force firms to go to the capital market for external funding, and hence be subject to monitoring by the external market, a notion that would hold particularly when there is a separation between ownership in terms of capital and control. The reduced levels of cash flow will thus mitigate the free cash flow problem as described by Jensen (1986) and thus lead to less inefficiency, in terms of managerial discretion. Based on the arguments of the agency theory, therefore, the hypothesized relation between institutional shareholdings and dividends is positive when capital rights are separated from control rights. Research by, amongst others, Miguel et al. (2004), Pindado and de la Torre (2006) and Crutchely et al. (1999) has shown that the relationship between dividends and institutional ownership is non-linear, and marginally diminishing. Although positive, the impact of increasing ownership leads to a convergence of the monitoring and entrenchment effects. This notion has also been widely supported by previous literature (Morck et al., 1988; McConnell and Servaes, 1990; Gedajlovic and Shapiro, 1998). One would therefore expect that any impact of institutional ownership on dividend policy is positive but diminishing. The causal relation between dividends and ownership in terms of signalling is, as mentioned, more complex, if existent. A distinct empirically testable hypothesis of this relationship is thus hard to formulate. Based on this and the arguments above about taxation concerns and the agency theory, hypotheses 1a and 1b are formulated. Hypothesis 1a dend changes. Institutional shareholdings have a positive effect on divi-

Hypothesis 1b Institutional shareholdings have a positive but marginally diminishing effect on dividend changes Hypotheses 1a and 1b are expected to hold for ownership in terms of both votes and capital. As the agency problems related to the separation of ownership from control would be aggravated by the use of control instruments such as vote-differentiated shares, institutional owners and outside investors will demand higher dividends where such control instruments are in place. A positive relationship can therefore be expected between dividend changes and vote-differentiated shares. The next hypothesis is therefore: Hypothesis 2 The use of vote-differentiated shares has a positive relation to dividend changes.

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The board, management relations and ownership structure

Again, this relationship is expected to hold for ownership in terms of votes as well as capital. As the current periods earnings are of primary importance to any eventual dividend payout, an earnings component will be incorporated in the estimated dividend model, as suggested by Fama and Babiak (1968). The interpretation of this component is straightforward: higher earnings mean more funds available for dividends and consequently a positive impact on dividend changes can be expected. To control for the previous periods earnings, an earnings trend component will also be included in the model. In addition to earnings another variable which must be controlled for is the previous periods dividends. The parameter estimate of this variable represents the speed of adjustment of dividends to new levels of earnings and is thus expected to be negative, meaning that there is some reluctance to change dividends immediately in response to changes in earnings (Short et al., 2002).

3.

METHOD AND VARIABLES

To test the relation between institutional ownership and dividends, a partial adjustment model which accounts for earnings trends is used. The model is modified by interacted shareholdings of the different ownership types. A similar approach used by Short et al. (2002) is limited to using interactive dummy variables due to the lack of ultimate ownership data. In this chapter, however, the continuous shareholdings of the different ownership categories, focusing on institutional ownership, are used. Following Short et al. (2002) the derivation of the model is based on four related models for the dividendearnings relation; the full and partial adjustment models by Lintner (1956), the Waud model (1966) and the earnings trend model by Fama and Babiak (1968).5 3.1 The Modified Earnings Trend Model

Assuming that for any year, t, the target level of dividend D* for firm i at time t is related to the long-run expected earnings, E*, of firm i at time t ti earnings, by a desired payout ratio, r: D* 5 rE* ti ti (1)

Based on the Waud model (1966) it is further assumed that the formation of expectations follows an adoptive expectation process of the form:

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E* 2 E*t21)i 5 d (Eti 2 E*t21)i) ( ( ti

(2)

Then if ownership structure, by for example institutions (Inst representing the ownership of institutional investors), alters the desired payout ratio (r) firms would have another D*, so the model becomes: ti D* 5 rEti 1 rIEti 3 Inst ti (3)

where rI is the impact on the firms dividend payout policy related to institutional ownership. This earnings generating process can then be combined with the adjustment models of dividends developed by Lintner (1956). The partial adjustment model in particular assumes that, in any given year, the firm adjusts only partially to the target dividend level, as follows: Dti 2 D(t21)i 5 a 1 c (D* 2 D(t21)i) ti (4)

where a is a constant representing the resistance to change dividends, and c is the speed of adjustment coefficient which represents managements reluctance to adjust the dividends to the new target level immediately. With the target dividend level D* for firm i at time t, as in equation (1), we can substitute in equation (4) and get the following model: Dti 2 D(t21)i 5 a 1 c (rE* 2 D(t21)i) 1 mti ti (5)

where the term uti is the usual residual term. So far the specification has yielded a partial adjustment model. But one would also like to consider that earnings can follow a firms specific trend or process (Fama and Babiak, 1968). Assume that the specific profit generating process, for firm i at time t, is of the form: Eti 5 (1 1 g) E(t21)i (6)

where g is an earnings trend factor. If the firms ownership structures also have a significant influence on the earnings of the firms it seems reasonable to assume a possible difference in the earnings trend factor. The profit generating process thus becomes: Eti 5 E(t21)i 1 gE(t21)i 1 gIE(t21)i 3 Inst (7)

It is then possible to combine the Waud models adoptive expectation process in equation (2) with the partial adjustment model of equation (4) to get:

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Dti 2 D(t21)i 5 a 1 c (r (d (Eti 2 E*(t21)i) 1 E*(t21)i) 2 D(t21)i) 1 mti (8) Assuming that there is full adjustment of dividends to the expected change (c 3 d 5 1), and partial adjustment to the reminder, equation (8) can be rearranged and reduced. The reduced and empirically testable model accounting for both trends in earnings and adjustments to target dividend levels, equation (9), is consequently: Dti 2 D(t21)i 5 a 1 rcEti 1 rg (1 2 c) E(t21)i 1 rgI (1 2 c) E(t21)i 3 Inst 2 cD(t21)i 1 uit (9)

Note that the term Inst is an example of an interaction term made up of an ownership variable (institutional ownership). In the same way other ownership variables can be tested by inserting another interaction term made up of the relevant ownership variable (for example, VotDiff, which is a dummy of vote-differentiated shares interacted with previous periods earnings). 3.2 Variables

All data on the firms book values and earnings are provided by the Compustat-Global database. The period covered is 1996 until 2005. The time period in the regressions is 19972005, due to the first difference in the dependent variable. Financial firms are removed from the sample, due to the particular nature of their investments. The ownership data are provided by Ownership and Power in Sweden,6 which is a unique database covering ownership structure, on a yearly basis, for all firms listed on any of the three major lists at the Stockholm Stock Exchange. All aspects considered, the setup requirements produced a sample of 189 Swedish quoted firms. The sample firms correspond to an aggregate share of more than 90 per cent of the total market capitalization at the Stockholm Stock Exchange, and approximately 80 percent of the total Swedish export value. The variable institutional ownership is made up of the aggregate ownership controlled by institutions, in terms of both cash flow rights (IC) and vote rights (IV). The same notation applies for foreign ownership (FC) and (FV) and so on; see Table 10.2. The group institutional investors consist of banks, pension and mutual funds, insurance companies and endowment foundations.7 The different ownership categories and how they are defined and grouped are summarized in Table 10.1. Table 10.2 provides a list of the variables used in the descriptive statistics and the regressions, together with their definitions.

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Table 10.1
Owner type Private

Ownership categories
Definition All shares controlled by individuals as well as other firms. The private owner can be either the founder of the firm or an investor who has acquired control. These owners can be institutions as well as individuals since it is hard to separate these two groups with certainty. All shares controlled by Swedish financial institutions belong to this category. In all cases the institution belongs to one of the three following types. Insurance company Insurance company-controlled shares are all firms that have an insurance company as their largest owner. Note however that mutual funds belonging to an insurance company make a separate group of controlling owners. Mutual fund As the name indicates, all shares controlled by a mutual fund; a fund can belong to a bank, an insurance company or the stateowned pension funds. Foundation This category includes foundations donated by private individuals as well as, for example, various types of profit-sharing funds and pension funds tied to individual companies.

Foreign Institutional

4.

DESCRIPTIVE STATISTICS AND OWNERSHIP CONCENTRATION

Before continuing to the estimation results, a more thorough assessment of the descriptive statistics is warranted. Descriptive statistics for the variables in the regressions are provided in Table 10.3. In addition to the variables used in the regressions, statistics of the firms sales/turnover, R&D expenses, and working capital are provided in Table 10.3. Also, descriptive statistics of the five largest owners in terms of capital share (C5) and votes (V5) are included in the table. All figures, both in the descriptive statistics and in the regressions, have been deflated to 2006 price level. It is interesting to note that in the sample firms the largest shareholder on average controls 34.84 per cent of the votes (V1); see Table 10.3. This concentrated ownership is remarkable, not only because of the concentrated ownership compared with other European and Anglo-Saxon countries, but also because of the relative size of the Swedish firms in the sample (mean sales 11 231.43 million SEK8). The sample of firms is therefore consistent with the view that the Swedish economy to a large extent is dominated by

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Table 10.2

Variables
Definition Total amount of dividends paid by firm i in period t (million SEK) Change in total amount of dividends paid by firm i between periods t-1 and t. Purchase of firm i stocks by firm i in period t (million SEK) Total payout, dividends and repurchase of shares, by firm i in period t Change in total payout, dividends and repurchase of shares, by firm i between periods t-1 and t. Earnings, calculated as net profits from ordinary trading activities after depreciation and other operating provisions (million SEK) Earnings of firm i in period t-1 Share of capital owned by the largest owner (cash-flow rights), per cent Vote rights controlled by the largest owner (control rights), per cent Share of capital owned by foreign investors, per cent Vote rights controlled by foreign investors, per cent Share of capital owned by institutional investors, per cent. Vote rights controlled by institutional investors, per cent Dummy variable for vote-differentiated shares, 1 if dualclass shares, 0 if one-share-one-vote Total sales (million SEK) Total number of persons employed by the firm i in time t Research and development expenses if reported (millions SEK) Working capital (millions SEK)

Variable name Dti Dti-D(t-1)i Prstkcti TPayti TPayti-TPay(t-1)i Et

Et-1 C1 V1 FC FV IC IV VoteDiff Sales Employed R&D-exp WCap

closely held, relatively large, often old industrial and multinational firms (Agnblad et al., 2001; Hgfeldt, 2004; Henrekson and Jakobsson, 2005). When considering cash flow rights (C1), the share controlled by the largest owner is on average 23.77 per cent, substantially lower than the vote rights (V1534.84 per cent), but still remarkably high in an international comparison. The median values for these two variables also support this notion, that the single largest owner controls the firm to a large extent by vote-differentiated shares (median C1520.50 per cent and median V1531.30 per cent). For the foreign and institutional owners cash flow rights seem to be more important than control, in line with the expectation. The ownership of vote rights for foreign and institutional owners (FV518.12 per cent

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Table 10.3

Descriptive statistics all firms

Mean Median 9.29 0 0 9.51 0 45.10 8.71 20.50 31.30 45.9 59.75 16.20 11.30 11.5 8.10 1 1204.26 0.45 0 166.15 Std. dev. 789.66 395.72 318.10 895.15 395.15 2797.37 2038.43 15.16 20.75 18.40 20.99 17.47 18.25 12.28 10.94 0.48 31 099.15 20.76 3010.69 8535.88 Min 0 5169.44 0 0 5169.44 34 529.32 40 652.38 1.00 2.50 6.40 6.40 0.00 0.00 0.00 0.00 0 0.04 0.01 0 10 884.00 Max 7862 4939.99 6518.13 8996.52 4939.98 30 724.00 37 146.87 74.50 95.10 97.60 98.80 79.60 93.50 54.90 67.6 1 298 428.10 216.99 49 553.76 110 201.90 Obs 1190 1190 1190 1190 1190 1190 1190 1190 1190 1190 1190 1190 1190 1190 1190 1190 1190 1190 1190 1190

Dt Dt-D(t-1) Prstkcti TPayti TPaytiTPay(t-1)i Et Et-E(t-1) C1 V1 C5 V5 FC FV IC IV VoteDiff Sales Employed R&D-exp WCap

261.26 31.74 28.10 289.36 31.74 714.62 78.53 23.77 34.84 47.01 58.15 20.59 18.12 14.11 11.14 0.62 11 231.43 6.93 406.07 1954.50

Note: All ownership variables, votes (V) and capital (C), are given in percentage. The vote-differentiation dummy variable (VoteDiff) takes the value 1 if the firm has votedifferentiated shares, 0 otherwise. Sales are given in millions of Swedish kronor (SEK).

and IV511.14 per cent) is substantially below the level of cash flow rights (FC520.59 per cent and IC514.11 per cent). For both ownership types the difference is around 3 per cent, which supports the assumption that the two ownership types are in fact very similar. That is, the majority of the foreign owners are in fact institutions. The incentive structure and the influence of ownership on the performance should therefore be similar for foreign and institutional owners, as expected by hypotheses 1a and 1b. Dividing the sample according to whether or not the firms have votedifferentiated shares reveals some additional insights. Table 10.4 shows the descriptive statistics of the group of firms with only one type of share (one-share-one-vote). This group represents 37 per cent of the total sample of 189 firms, or 445 observations. It also seems that this group on average represents smaller firms, compared with the group of firms that have vote-differentiated shares described in Table 10.5.

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Table 10.4

Descriptive statistics firms without vote-differentiated shares

Mean Median 0 0 0 0 0 10.69 7.77 19.4 19.4 42.3 42.3 18.2 18.2 11.3 11.3 0 650.63 0.39 0 113.95 Std. dev. Min Max 5656.38 2812.53 1158.50 5656.38 2812.53 17 972.37 18 860.71 74.50 74.50 89.20 89.20 77.00 77.00 54.90 54.90 0 87 661 39.61 2875 13 727.85 Obs 445 445 445 445 445 445 445 445 445 445 445 445 445 445 445 445 445 445 445 445

Dt Dt-D(t-1) Prstkcti TPayti TPaytiTPay(t-1)i Et Et-E(t-1) C1 V1 C5 V5 FC FV IC IV VoteDiff Sales Employed R&D-exp WCap

130.14 18.55 9.62 139.76 18.55 312.20 44.32 22.09 22.09 43.91 43.91 22.39 22.39 14.03 14.03 0 4646.75 2.48 81.49 565.97

544.10 0 186.74 1006.33 89.04 0 555.14 0 186.74 1006.33 1588.51 5823.43 1210.15 14052.01 13.78 2.50 13.78 2.50 17.63 6.40 17.63 6.40 17.94 0 17.94 0 12.01 0 12.01 0 0 0 12 093.59 0.05 5.96 0.03 287.87 0 1832.96 6236.19

Note: All ownership variables, votes (V) and capital (C), are given in percentage. The vote-differentiation dummy variable (VoteDiff) takes the value 1 if the firm has votedifferentiated shares, 0 otherwise. Sales are given in millions of Swedish kronor (SEK).

The group of firms with vote-differentiated shares consists of 745 observations which represent 63 percent of the total number of firms in the sample. Looking at the figures for sales, R&D, and working capital, and comparing Tables 10.4 and 10.5, confirms that the firms with vote-differentiated shares on average are larger than the firms without vote-differentiated shares. The correlation between the different variables is provided in Table A10.1 in Appendix 10.1. The correlations confirm the negative relationship between both foreign ownership of capital and votes (FC and FV) and institutional ownership of capital and votes (IC and IV) relative to vote-differentiation. Also, a high correlation between dividends and earnings is evident, as expected. Repurchase of shares (Prstkcti) only constitutes a fractional part of the total payout by the sample firms. Due to regulation, this way of distributing funds back to the shareholders has previously been closed for Swedish firms.

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Table 10.5

Descriptive statistics of firms with vote-differentiated shares

Mean Median 18.53 0 0 18.54 0 69.40 9.75 20.90 40.70 48.50 69.50 15.30 9.00 11.60 6.80 1 1613.46 0.97 0 204.42 Std. dev. 896.33 478.83 395.79 1036.95 478.83 Min 0 5169.44 0 0 5169.44 Max 7862 4939.98 6518.13 8996.52 4939.98 Obs 745 745 745 745 745 745 745 745 745 745 745 745 745 745 745 745 745 745 745 745

Dt Dt-D(t-1) Prstkcti TPayti TPaytiTPay(t-1)i Et Et-E(t-1) C1 V1 C5 V5 FC FV IC IV VoteDiff Sales Employed R&D-exp WCap

339.58 39.62 39.14 378.72 39.62 954.99 98.97 24.77 42.43 48.86 66.58 19.51 15.54 14.15 9.42 1 15 164.57 9.58 599.97 2783.89

3293.19 34 529.32 30 724 2401.13 40 652.38 37 146.87 15.86 1 74.10 20.51 2.90 95.10 18.61 8.90 97.50 18.09 9.60 98.80 17.10 0 79.60 17.94 0 93.50 12.45 0 54.70 9.85 0 67.60 0 1 1 37 642.09 1.02 298 428.10 25.47 0.01 216.99 3786.24 0 49 553.76 10 611.02 10 884.00 110 201.90

Note: All ownership variables, votes (V) and capital (C), are given in percentage. The vote-differentiation dummy variable (VoteDiff) takes the value 1 if the firm has votedifferentiated shares, 0 otherwise. Sales are given in millions of Swedish kronor (SEK).

The correlation matrix (Table A10.1, Appendix 10.1) nonetheless confirms a positive correlation between institutional ownership and this type of payout. As few firms in the sample have made use of this method to distribute cash to the shareholders, the focus of this chapter is on dividend changes.

5.

EMPIRICAL RESULTS AND ANALYSIS

In order to test if there is any linear relationship between institutional ownership and dividends, the policy adjustment model is estimated with interaction terms; in Table 10.6, Model 1. The estimation is made in the form of a pooled OLS, and ownership is measured as percentage of both votes and capital. The results are presented in Table 10.6., Models 1a and 1b. The results support hypothesis 1, with a positive effect of institutional ownership

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Table 10.6

Pooled-OLS estimations: Model 1 linear and Model 2 nonlinear institutional ownership (votes and capital)
Model 1a (votes) 0.1247* (26.69) 0.0612* (5.21) 0.0007* (2.56) Model 1b (capital) 0.1248* (26.60) 0.0616* (4.89) 0.0007 (1.45) Model 2a (votes) 0.1236* (26.30) 0.0777* (5.49) 0.0028* (2.71) 0.00005** (2.09) 0.0193*** (1.76) 0.2224* (10.52) 13.5043 (1.43) R250.4012 R2adj50.3982 Model 2b (capital) 0.1233* (26.16) 0.1072* (5.07) 0.0055* (2.95) 0.0001* (2.68) 0.0112 (1.05) 0.2081* (10.12) 15.5981 (1.65) R250.4004 R2adj50.3973

Dependent variable (Divt-Div(t-1)) Et E(t-1) E(t-1)*Inst E(t-1)*Inst2 E(t-1)*VoteDiff Div(t-1) constant Number of obs51190 Number of groups5189

0.0133 (1.26) 0.2122* (10.30) 13.9757 (1.48) R250.3990 R2adj50.3965

0.0110 (1.02) 0.2067* (10.02) 13.8101 (1.46) R250.3967 R2adj50.3942

Note: t-statistics are in parentheses. * denotes significance at the 1% level, ** denotes significance at 5%, and *** denotes significance at the 10% level.

on changes in dividends, for institutional ownership measured by votes. Although robust in terms of size and sign, the coefficient on institutional ownership is insignificant when ownership is measured in terms of capital. The estimated coefficient on previous periods dividends, Div(t-1), is negative and significant, which suggests that the firms adjust dividends slowly to changes in earnings, which confirms the findings in Short et al. (2002). In order to account for a potential non-linear effect of institutional ownership, another interaction term of squared institutional ownership and earnings is added (Grier and Zychowicz, 1994; Schooley and Barney, 1994; Crutchley et al., 1999); see Table 10.7, Models 2a and 2b. This allows for a marginally diminishing effect of institutional ownership on dividend changes. Pindado and de la Torre (2006) use a somewhat different approach with optimal breakpoints of the valueownership relation estimated in Miguel et al. (2004). As institutional ownership is measured as the aggregate ownership share by this type of investor, this specification seems unwarranted. Each individual institutional owner has its specific breakpoint associated with its investment profile and so on. Consequently only a diminishing effect of aggregate institutional ownership is tested.

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241

Table 10.7

Cross-sectional time-series FGLS estimations: Model 3 institutional ownership (votes and capital)
Model 3a (votes) 0.0817* (23.21) 0.0412* (6.15) 0.0007*** (1.82) 9.59e-06 (1.06) 0.0244* (4.21) 0.1878* (8.79) 7.1562* (7.75) Model 3b (capital) 0.0821* (21.47) 0.0395* (4.89) 0.0009 (1.50) 1.4e-05 (1.08) 0.0217* (3.47) 0.1906* (8.57) 8.0771* (7.60)

Dependent variable (Divt-Div(t-1)) Et E(t-1) E(t-1)*Inst E(t-1)*Inst2 E(t-1)*VoteDiff Div(t-1) constant Number of obs51190 Number of groups5189

Notes: t-statistics are in parentheses. Panels: heteroscedastic. Correlation: panel-specific AR(1). * denotes significance at the 1% level, ** denotes significance at 5%, and *** denotes significance at the 10% level.

The estimates of the non-linear specification of Model 2 again reveal a positive and significant relation between institutional ownership and changes in dividends. Correctly specified, institutional ownership, both in terms of votes (Model 2a) and capital (Model 2b), is found positive and significant. For ownership measured in votes the coefficient related to the use of votedifferentiated shares is also significant. This suggests that firms using votedifferentiated shares have higher levels of dividends, confirming hypothesis 2. The speed of adjustment coefficient, related to previous periods dividends, is again significant and negative, as expected. The same holds for this periods earnings. Consistent with the equality and stability conditions of the model, the estimated parameter for previous periods earnings is negative. As displayed by the descriptive statistics there are substantial size and scale effects in the sample of firms. For the OLS regression to produce efficient estimates under such conditions we need to control that the data are homoscedastic. The Breusch-Pagan/Cook-Weisberg test,9 however, reveals that the sample suffers from severe heteroscedasticity, and consequently we cannot rely on the results of the OLS estimation for inference. To account

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for this heteroscedasticity in the data a GLS methodology is required. Utilizing both the cross-sectional and time-series properties of the data, an FGLS regression will allow heteroscedasticity in the panels (firms) as well as panel-specific correlation (AR(1)). By including a time-specific dummy variable it is also possible to control for temporal effects, that is, the effects of macroeconomic variables that might influence the firms and their dividend behaviour, as well as their ownerships structures. Table 10.7 provides the results of the FGLS estimations, where ownership is measured in terms of both votes (Model 3a) and capital (Model 3b). As expected, institutional ownership is found to have a significantly positive effect on dividend payout, when ownership is measured in terms of votes, which support hypothesis 1. The presence of institutional owners is thus associated with positive dividend changes. For institutional ownership in terms of capital share, the results are insignificant but positive, as expected. The use of vote-differentiated shares is again found to be positively related to dividend changes, in support of hypothesis 2. This relation holds for ownership measured in terms of both votes and capital. In order to investigate the role of institutional owners in the context of the agency conflict related to the separation of ownership and control, the sample of firms is separated into two groups depending on whether or not they have vote-differentiated shares. Naturally the interaction term with the dummy for vote-differentiation is taken out of the regressions, as it would have produced collienarity. Table 10.8 presents the results from the FGLS estimations when the firms are dividend into groups depending on whether or not they have a vote-differentiated share structure, Model 3aI and 3bI (without vote-differentiated shares) and Model 3aII and 3bII (with vote-differentiated shares). The estimations are made for ownership in terms of both votes and capital. As can be seen from Table10.8, comparing Model 3aI and 3bI with Model 3aII and 3bII, institutional ownership only has a positive effect on dividend changes if the firms have vote-differentiated shares. This means that firms that separate cash flow rights from control rights suffer more from agency problems, and that institutional owners require these firms to pay higher dividends in order to reduce the cash available for management. This result is in accordance with the predictions of the agency theory arguments (Rozeff, 1982; Easterbrook, 1984; Jensen, 1986; Eckbo and Verma, 1994; Zeckhauser and Pound, 1990). No significance is found with respect to the non-linear parameter (E(t-1)*Inst2). The coefficient of earnings in period t (Et) and in period t1 (E(t1)) is also significant at the 1 percent level. Previous periods dividend payout (Div(t-1)) is again significant, both statistically and in real economic terms.

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Table 10.8

Cross-sectional time-series FGLS estimations: Model 3a firms with vote-differentiated shares, Model 3b firms without votedifferentiated shares
Model 3aI (votes) 0.0528* (9.71) 0.0237* (3.09) 0.0013 (1.48) 3.0e05 (1.52) 0.0613*** (1.80) 2.9757* (3.15) Model 3bI (capital) 0.0529* (9.71) 0.0235* (3.07) 0.0012 (1.57) 3.2e05 (1.60) 0.0598*** (1.75) 2.9029* (3.11) Model 3aII (votes) 0.0840* (19.76) 0.0206* (4.17) 0.0012** (2.35) 9.15e06 (0.74) 0.2090* (7.97) 8.7769* (7.38) Model 3bII (capital) 0.0876* (18.41) 0.0215* (2.58) 0.0015** (1.97) 2.9e05 (1.60) 0.2282*** (7.80) 9.9986* (6.49)

Dependent variable (Divt-Div(t-1)) Et E(t-1) E(t-1)*Inst E(t-1)*Inst2 Div(t-1) constant No. obs Model 4a 5 443A No. groups Model 4a 5 85 No. obs Model 4b 5 742B No. groups Model 4b 5 116

Notes: t-statistics are in parentheses. Panels: heteroscedastic. Correlation: panel-specific AR(1). A 2 obs dropped because only 1 obs in group. B 3 obs dropped because only 1 obs in group. * denotes significance at the 1% level, ** denotes significance at 5%, and *** denotes significance at the 10% level.

This indicates that the firms only partially adjust the dividends to meet changed target dividend levels. A key assumption which must hold if the FGLS method is to provide reliable estimates is that the errors are randomly distributed. Most likely, the errors are in fact correlated with the regressors, or in other words there are individual firm effects. To test whether this is true, a fixed-effects model, which allows not only time effects but also individual firm effects, is tested (Model 4 in Table 10.9). The Hausman test confirms that the suspicion of individual effects and the Hausman-H0 of non-correlated errors can be soundly rejected. As the Hausman test confirms the existence of significant firm effects correlated to the regressors, the fixed-effects estimation method is appropriate. Table 10.9 presents the results from this estimation with individual firm and time effects. As before, the estimation is made with ownership in terms of both votes (Model 4a) and capital (Model 4b).

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Table 10.9

Fixed-effects estimations: Model 4 institutional ownership (votes and capital)

Model 4a (votes) 0.1060* (7.86) 0.1100* (2.85) 0.0066* (2.77) 0.0002* (2.69) 0.0774* (3.08) 0.6094* (2.96) Yes* R2 within50.5054 between50.4884 overall50.1774 Model 4b (capital) 0.1065* (8.76) 0.1320* (2.34) 0.0079** (2.23) 0.0002* (2.76) 0.0514* (2.17) 0.5582* (2.81) Yes* R2 within50.4913 between50.4980 overall50.1965

Dependent variable (Divt-Div(t-1)) Et E(t-1) E(t-1)*Inst E(t-1)*Inst2 E(t-1)*VoteDiff Div(t-1) Fixed effects significant? Number of obs51190 Number of groups5189

Notes: Robust t-statistics are in parentheses. * denotes significance at the 1% level, ** denotes significance at 5%, and *** denotes significance at the 10% level.

The results of the fixed-effects estimation in Table 10.9 are highly significant. The coefficient of earnings in period t (Et) is significant and positive, and that of earnings in t1 (E(t-1)) is significant and negative. As expected, there is a significant earnings component related to dividends. The coefficients related to dividends in previous period (Div(t-1)) are likewise again significant and negative with respect to dividend change. Recall that this term represents the speed of adjustment of dividend changes. The results for the estimation with institutional ownership in terms of both votes and capital share are in fact remarkably stable with regard to the size of the coefficients and so on. The elasticity of dividends with regard to changes in earnings is around 30 percent, which seems highly plausible. This again confirms the robustness of the model formulation. In both estimations vote-differentiated shares have a significantly positive effect on dividend changes. Again, this is an indication that investors demand higher dividends in firms which allow vote-differentiated shares. Hence hypotheses 1a, 1b, and 2 are corroborated.

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As before, the sample of firms is separated into two groups depending on whether or not they have vote-differentiated shares. The interaction term made up of earnings and the dummy for vote-differentiation is taken out of the regressions, as it would produce collinearity. Table 10.10 provides the results for the fixed-effects estimation with institutional ownership when the sample of firms is divided in two groups depending on whether or not they have vote-differentiated shares (Model 4aI and 4bI and Model 4aII and 4bII). Looking at the results in Table 10.10, there is as expected a positive but non-linear relation between institutional ownership and dividend changes if the firms have a vote-differentiated share structure (Model 4aII and 4bII). Based on the arguments of Miguel et al. (2004) and the discussion about institutional owners incentives, hypothesis (1b) of non-linearity between institutional ownership and dividend behaviour was formulated. To control for this eventual non-linearity additional interaction terms of squared institutional ownership are added.10 The significance of these parameters confirms hypotheses 1a and 1b of a positive and diminishing effect of institutional ownership on dividend changes, for ownership in terms of both votes (Model 4aII ) and capital (Model 4bII ). For large investors in general, Mork et al. (1988) find that profitability is higher for firms with shareholders that have up to 5 per cent ownership stakes; beyond that, profitability drops (see Section 2 for further discussion). As the sample is divided between firms with vote-differentiated shares (Model 4aI and 4bI) and firms without (Model 4aII and 4bII), the estimated parameter on previous periods earnings loses its significance in the group of firms that have vote-differentiated shares (Model 4aI and 4bI). The results for all the estimations are remarkably robust in terms of the sign and size of the coefficients. The pooled OLS results strongly support the results in the FGLS estimation. However, as there are significant individual firm effects, the fixed-effects method is more appropriate, although the FGLS results point in the same direction. Furthermore the use of institutional ownership measured continuously, and not simply by dummy variables related to fixed levels of ownership percentages, provides a more thorough understanding of the non-linear relationship between ownership and dividend policies. As much of the analysis is based on reported earnings, the usual caveats related to accounting figures apply. Ownership, however, is a very stable variable over time, even though institutional ownership belongs to the category of ownership that is perhaps most volatile. This and the inclusion of time and firm effects in the estimation give a good indication of the robustness in the results. All estimations have also been made with total payout.11 These results, although limited by the small number of firms involved in share repurchases in the sample, support the estimation results for dividends.

Table 10.10

Fixed-effects estimations: Model 4a firms without vote-differentiated shares, Model 4b firms with votedifferentiated shares
Model 4aI (votes) Model 4bI (capital) Model 4aII (votes) Model 4bII (capital)

Dependent variable (Divt-Div(t-1))

Et

E(t-1)

E(t-1)*Inst

246

E(t-1)*Inst2

Div(t-1)

Fixed effects significant? No. obs Model 4a5445 No. groups Model 4a587 No. obs Model 4b5745 No. groups Model 4b5119

0.1285* (3.73) 0.0835*** (1.71) 0.0006 (0.11) 5.37e-06 (0.04) 0.4287*** (1.68) Yes* R2 within50.6961 between50.5934 overall50.0827

0.1285* (3.73) 0.0835*** (1.71) 0.0006 (0.11) 5.38e-06 (0.04) 0.4287*** (1.68) Yes* R2 within50.6961 between50.5934 overall50.0827

0.0988* (6.79) 0.0243 (1.01) 0.0069* (2.61) 0.0002** (2.45) 0.6594* (2.76) Yes** R2 within50.4990 between50.3745 overall50.1902

0.1011* (7.91) 0.0737 (1.44) 0.0079** (1.98) 0.0002** (2.35) 0.5920** (2.61) Yes** R2 within50.4815 between50.3778 overall50.2178

Notes: Robust t-statistics are in parentheses. * denotes significance at the 1% level, ** denotes significance at 5%, and *** denotes significance at the 10% level.

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6.

CONCLUSIONS

This chapter investigates the relationship between institutional ownership and dividends. To test this relationship a version of the so-called earnings trend model is utilized, with the inclusion of interaction terms made up of institutional ownership. Using a panel data methodology which accounts for firm-specific effects and time effects, unobservable heterogeneity is controlled for. Furthermore the relationship is tested by extending the investigation into a non-linear setting in which incentives, monitoring and agency-cost effects can be more accurately accounted for. The results clearly show that institutional ownership, in terms of both votes and capital, where these two are separated, has a positive effect on dividend payout policies. So even if high desired levels of dividends can be seen as a sign of short-termism (Hutton, 1995; Haskins, 1995), it might just as well be an effect of these owners attempts to reduce the free cash flow available to management, as argued by Jensen (1986). Institutional owners might thus play a monitoring role, and in doing so mitigate the problems associated with the separation of ownership and control in listed firms. The relation is found to be positive but diminishing, which supports previous research concerning the relation between dividends and ownership structure. The use of a comprehensive database covering institutional ownership continuously allowed for this additional test and also the rejection of other functional forms of the ownershipdividend relationship. Furthermore, and in line with expectations, earnings have a positive impact on dividend changes. By examining Swedish listed firms, the chapter also provides empirical evidence on the effects of control instruments such as dual-class shares on dividend policies. The result, in line with agency cost theory, is that control instruments such as vote-differentiated shares induce investors to demand higher levels of dividends as compensation for the increased agency costs. This means that firms using this type of control instrument suffer more from subsequent agency problems.

NOTES
* Acknowledgments: Financial support from Sparbankernas Forskningsstiftelse to Daniel Wibergs dissertation work is gratefully acknowledged. A research grant from the Centre of Excellence for Science and Innovation Studies (CESIS), Royal Institute of Technology, Stockholm, is also gratefully acknowledged. Beyond the obvious cases of theft, transfer pricing, and asset sales, expropriation may take the form of perquisites, high salaries, diversion of funds to pet projects, and general entrenchment even in cases in which the managers are no longer competent or qualified to run the firm.

1.

248
2. 3. 4.

The board, management relations and ownership structure

In this chapter managerial ownership is not considered. Ownership by the largest shareholder in terms of votes is thus considered in alignment with managerial ownership. Law concerning investment funds; Swedish reference, SFS 2004:46; (following European Union Directive EGT L 375, 31.12.1985, s. 3, Celex 31985L0611). In fact a myriad of different tax rates are applied dependent on the type of firm, that is, limited liability, private, partnership, and so on. For the sake of brevity this discussion is not extended beyond this note, as it is far beyond the scope of this chapter to analyse the impact of various tax rates on dividends. For extended discussion and derivation of the four models see Short et al. (2002). SIS-garservice. Note that the typical Swedish ownership spheres, large-scale conglomerates combining a number of control-enhancing mechanisms and often controlled by a foundation, are not included in this definition. The incentives of this type of owner are probably substantially different from those of what are usually referred to as institutional investors, that is, financial intermediaries. Approximately 1.2 billion, or $1.6 billion as of June 2007. Breusch-Pagan/Cook-Weisberg test for heteroscedasticity Variables: fitted values of Divt-Div(t-1) H0: constant variance Chi2(1) 5 171.96 Prob.chi2 5 0.0000 Breusch-Pagan/Cook-Weisberg test for heteroscedasticity H0: constant variance Variables: fitted values of Et E(t-1) E(t-1)*Inst (votes) E(t-1)*Inst2 (votes) E(t-1)*VoteDiff Dummy Div(t-1) Chi2(1) 5 171.96 Prob.chi2 5 0.0000 Each of these tests indicates that there is a significant degree of heteroscedasticity in this model. In order to get efficient estimators and account for this heteroscedasticity GLS estimation is thus required. A cubic specification of the model has been tested but yields no significant results. For the sake of brevity these results are available from the author upon request.

5. 6. 7.

8. 9.

10. 11.

REFERENCES
Agnblad, J., Berglf, E., Hgfelt, P. and Svancar, H. (2001), Ownership and Control in Sweden: Strong Owners, Weak Minorities and Social Control. The Control of Corporate Europe, Oxford: Oxford University Press. Bhattacharya, S. (1979), Imperfect Information, Dividend Policy, and the Bird in the Hand Fallacy, Bell Journal of Economics, 10, 25970. Bhattacharya, S. (1980), Nondissipative Signalling Structure and Dividend Policy, Quarterly Journal of Economics, 95, 124. Bjuggren, P.-O. and Wiberg, D. (2008), Industry Specific Effects in Investment Performance and Valuation of Firms Marginal q in a Stock Market Bubble, EMPERICA, 35 (3), 27991. Bjuggren, P.-O., Eklund, J. and Wiberg D. (2007), Ownership Structure, Control and Firm Performance: The Effects of Vote Differentiated Shares Applied Financial Economics, 17, 132334 Burkart, M., Gromb, D. and Panunzi, F. (1997), Large Shareholders, Monitoring and the Value of the Firm, Quarterly Journal of Economics, 113, 693728. Crutchley, C., Jensen, M., Jahera, J. and Lang, L. (1999), Agency Problems and the Simultaneity of Financial Decision Making: the Role of Institutional Ownership, International Review of Financial Analysis, 8 (2), 17797.

Institutional ownership and dividends

249

Davis, P. and Steil, B. (2001), Institutional Investors, Cambridge, MA: The MIT Press. Easterbrook, F. (1984), Two Agency-Cost Explanations of Dividends, American Economic Review, 74, 65059. Eckbo, B. and Verma, S. (1994), Managerial Shareownership, Voting Power, and Cash dividend Policy, Journal of Corporate Finance, 1, 3362. Fama, E.F. and Babiak, S. (1968), Dividend analysis: an empirical analysis, Journal of the American Statistical Association, 63, 113261. Gedajlovic, E. and Shapiro, D. (1998), Management and Ownership Effects: Evidence from Five Countries, Strategic Management Journal, 19, 53353. Grier, P. and Zychowicz, E. (1994), Institutional Investors, Corporate Discipline and the Role of Debt, Journal of Economics and Business, 46 (1), 111. Gugler, K. and Yurtoglu, B. (2003), Corporate Governance and Dividend Pay-out Policy in Germany, European Economic Review, 47, 73158. Haskins, C. (1995), A Company Should be Run Primarily in the Interest of its Shareholders, Enterprise and Governance, The Proceedings of a Conference Held at the Institute of Directors on 24 October, IoD, London. Henrekson, M. and Jakobsson, U. (2005), The Swedish Model of Corporate Ownership and Control in Transition, in Huizinga, H. and Jonung, L. (eds), Who Will Own Europe? The Internationalisation of Asset Ownership in Europe, Cambridge: Cambridge University Press. Henrekson, M. and Jakobsson, U. (2006), Den Svenska Modellen fr Fretagsgande och Fretagskontroll vid Skiljevgen, Institutet fr Nringslivsforskning, Policy Paper, No. 1. Hutton, W. (1995), The State Were In, London: Jonathan Cape. Hgfeldt, P. (2004), The History and Politics of Corporate Ownership in Sweden, NBER Working Paper Series, 10641. Jensen, M. (1986), Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers, American Economic Review, 76, 3239. Jensen, M. and Meckling, W.H. (1976), Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure, Journal of Financial Economics, 3, 30560. Jensen, M., Solbreg, D. and Zorn, T. (1992), Simultaneous Determination of Insider Ownership, Debt, and Dividend Policies, Journal of Financial and Quantitative Analysis, 27 (2), 24763. La Porta, R., Lopez-de-Silanes, F., Shleifer, A. and Vishny, R. (1999), Corporate Ownership Around the World, Journal of Finance, 52, 113150. La Porta, R., Lopez-de-Silanes, F., Shleifer, A. and Vishny, R. (2000), Agency Problems and Dividend Policies around the World, Journal of Finance, 55 (1), 133. Lintner, J. (1956), Distribution of Incomes of Corporations among Dividends, Retained Earnings and Taxes, American Economic Review, 46, 97113. McConnell, J. and Servaes, H. (1990), Additional Evidence on Equity Ownership and Corporate Value, Journal of Financial Economics, 27, 595612. Miguel, A., Pindado, J. and de la Torre, C. (2004), Ownership Structure and Firm Value: New Evidence from Spain, Strategic Management Journal, 25, 11991207. Miller, M. and K. Rock, (1985), Dividend Policy under Asymmetric Information, Journal of Finance, 40, 103151. Mohd, M., Perry, L. and Rimbey, J. (1995), An Investigation of the Dynamic

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Association Between Agency Theory and Dividend Policy, Financial Review, 30 (2), 36785. Morck, R., Shleifer, A. and Vishny, R. (1988), Management Ownership and Market Valuation: An Empirical Analysis, Journal of Financial Economics, 20, 293317. Mueller, D. (2003), The Corporation, London: Routledge. Pindado, J. and de la Torre, C. (2006), The Role of Investment, Financing and Dividend Decisions in Explaining Corporate Ownership Structure: Empirical Evidence from Spain, European Financial Management, 12 (5), 66187. Rozeff, M.S. (1982), Growth, Beta and Agency Costs as Determinates of Dividend Payout Ratios, Journal of Financial Research, 5, 24959. Schooley, D. and Barney, D. (1994), Using Dividend Policy and Managerial Ownership to Reduce Agency Costs, Journal of Financial Research, 17 (3), 36373. Short, H., Zhang, H. and Keasey, K. (2002), The Link between Dividend Policy and Institutional Ownership, Journal of Corporate Finance, 8, 10522. Waud, R. (1966), Small Sample Bias due to Misspecification in the Partial Adjustment and Adapted Expectations Models, Journal of the American Statistical Association, (Dec.), 13445. Williamson, Oliver E. (1963), Managerial Discretion and Business Behavior, The American Economic Review, 53 (5), 103257. Williamson, Oliver E. (1964), The Economics of Discretionary Behavior: Managerial Objectives in a Theory of the Firm, Englewood Cliffs, NJ: Prentice-Hall. Zeckhauser, R. and Pound, J. (1990), Are Large Shareholders Effective Monitors? an Investigation of Share Ownership and Corporate Performance, in Hubbard, R.G. (ed.), Asymmetric Information, Corporate Finance and Investment, Chicago: University of Chicago Press, pp. 14980.

APPENDIX 10.1

Table A10.1
Prstkc DTP DE TPt Et C1 V1

Correlation matrix pairwise correlation

C5

Variable

Divt

DDiv

251

Divt DDiv Prstkc TPayt DTP Et DE C1 V1 C5 V5 FC FV IC IV VoteDiff Sales Emp R&D WCap 1.000 0.490* 0.032 0.216* 0.066* 0.064* 0.067* 0.083* 0.079* 0.072* 0.044 0.103* 0.151* 0.045 0.176* 0.117* 0.060* 0.128* 1.000 0.460* 0.763* 0.197* 0.042 0.006 0.111* 0.002 0.195* 0.070* 0.216* 0.238* 0.129* 0.710* 0.503* 0.382* 0.556* 1.000 0.481* 0.518* 0.010 0.010 0.037 0.011 0.060* 0.043 0.056 0.056 0.026 0.150* 0.113* 0.022 0.149* 1.000 0.470* 0.050 0.009 0.114* 0.017 0.191* 0.095* 0.180* 0.192* 0.111* 0.541* 0.433* 0.175* 0.356* 1.000 0.018 0.017 0.063* 0.029 0.048 0.047 0.029 0.019 0.013 0.015 0.022 0.110* 0.055 1.000 0.780* 0.792* 0.636* 0.212* 0.151* 0.216* 0.242* 0.086* 0.115* 0.139* 0.119* 0.133*

1.000 0.518* 0.152* 0.936* 0.508 0.778* 0.197* 0.021 0.034 0.092* 0.029 0.192* 0.062* 0.203* 0.209* 0.128* 0.734* 0.523* 0.409* 0.579*

1.000 0.032 0.450* 1.000* 0.107* 0.112* 0.007 0.033 0.013 0.028 0.001 0.018 0.042 0.040 0.016 0.027 0.113* 0.022 0.149*

1.000 0.660* 0.823* 0.207* 0.269* 0.163* 0.328* 0.473* 0.010 0.014 0.004 0.015

1.000 0.789* 0.219* 0.145* 0.197* 0.239* 0.130* 0.157* 0.143* 0.134* 0.171*

Table A10.1
FV IC IV VoteDiff Sales Emp R&D-exp

(continued)
WCap

Variable

V5

FC

252 1.000 0.011 0.064* 0.182* 0.050 0.108* 0.031 0.003 1.000 0.899* 0.005 0.184* 0.158* 0.027 0.097 1.000 0.203* 0.208* 0.154* 0.033 0.117* 1.000 0.164* 0.166* 0.083* 0.126*

Divt DDiv Prstkc TPayt DTP Et DE C1 V1 C5 V5 FC FV IC IV VoteDiff Sales Emp R&D WCap 1.000 0.743* 0.668* 0.790* 1.000 0.395* 0.500* 1.000 0.902*

1.000 0.208* 0.268* 0.152* 0.321* 0.520* 0.039 0.034 0.075* 0.045

1.000 0.920* 0.001* 0.058* 0.080* 0.245* 0.295* 0.164* 0.204*

1.000

Note:

* Correlation coefficient significant at the 5% level.

11.

Contracting around ownership: shareholder agreements in France1

Camille Madelon and Steen Thomsen

1.

INTRODUCTION

A wealth of studies in economics, strategy and finance have examined the relationship between corporate ownership structure and performance (Hill and Snell, 1988, 1989; Holderness and Sheehan, 1988; McConnell and Servaes, 1990; Gedajlovic and Shapiro, 1998, 2002; Thomsen and Pedersen, 2000; De Miguel et al., 2004; Anderson and Reeb, 2003; Villalonga and Amit, 2006). Other studies have examined the effect of ownership structure on strategic decisions (Amihud and Lev, 1981; Hill and Snell, 1988, 1989; Graves, 1988; Baysinger et al., 1991; Lane et al., 1998; Denis et al., 1997, 1999; Allen and Phillips, 2000; David et al., 2001; Hoskisson et al., 2002; Lee and ONeill, 2003; Desai et al., 2004; Lerner and Rajan, 2006; Mathews, 2006). Overall, this literature finds that corporate ownership structures matter to company behavior and value creation (for example, Shleifer and Vishny, 1997). Yet, there is a distinction to be made between the publicly observable formal ownership structure and what we are tempted to call the real ownership structure, namely the allocation of control, cash flow, and transfer rights, which results from implicit or explicit contracting among the various owners. Take for example Publicis, the worlds fourth largest communication group. The formal ownership structure points to two large owners in 2006: Dentsu, a Japanese based communication group, with circa 15 per cent of the equity, and Mrs Badinter, the founders daughter with 10 per cent of the equity. However, a closer look reveals a different picture. In 2002, Mrs Badinter and Dentsu signed a binding agreement in which Dentsu committed to act in unison with the founders family for decisions related to corporate strategy and board member nominations. While the formal structure indicates two blockholders with no majority power, the shareholder agreement reveals a dominant owner with a majority in terms of voting power. This case is not isolated and points to the importance of
253

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The board, management relations and ownership structure

an in-depth understanding of ownership arrangements when studying the relationship between ownership and firm outcomes. Real ownership structure may supersede the formal structure. Surprisingly, this contracting around phenomenon has received almost no attention in the literature. We have no idea (1) why the owners of publicly listed firms would resort to shareholder agreements and (2) how this might influence company behavior and value creation. One stream of literature broadly termed financial contracting has studied the deals between fund providers and those needing the funds (Hart, 2001), yet it has empirically focused on private companies and more particularly on the vertical relationships between venture capitalists and small entrepreneurial firms (Kaplan and Strmberg, 2003) in contrast to the horizontal contracts between shareholders. Another stream of literature tracks corporate strategic alliances and ownership ties between companies (Allen and Phillips, 2000; Gomes-Casseres et al., 2006), but does not include contracts between shareholders, To our knowledge, there are no studies explicitly examining the antecedents of agreements among shareholders in listed firms or their impact on value creation. In this chapter, we seek to take a first step towards bridging this gap. Given that the literature is still at an early stage, we chose to conduct an exploratory study. To this end, we performed a qualitative multi-case analysis on a selection of listed French firms with shareholder agreements. France offers a unique empirical setting to study shareholder agreements for three main reasons. First, shareholder agreements are quite common among listed firms and equally so among the very largest firms (which are part of the benchmark CAC 40 stock index). Second, the French market authority (AMF) requires that owners publicly disclose their agreements. All contracts are stored in the AMF database and their detailed content is readily accessible. Third, because of the public nature of these agreements, we may study how markets react to the announcement of agreements, thus capturing a measure of value creation. From our exploratory analysis, we propose several conditions under which shareholders are more likely to opt for agreements. They are linked respectively to the nature of ownership, the nature of the industry and the nature of the problems facing the firm. In these cases, we argue that the overall cost of signing and enforcing shareholder agreements will be offset by the benefits. In addition, we suggest that shareholder agreements are highly idiosyncratic and may create or destroy value, depending on the scope and nature of the agreement. The remainder of the chapter is organized as follows. First, we lay out the background to this study by briefly reviewing the existing arguments on shareholder agreements. Second, we describe the empirical setting and

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methods. Third, using an extended transaction cost framework we propose hypotheses on the antecedents and effects of shareholder agreements. Finally, we discuss our findings and conclude.

2.
2.1

BACKGROUND
Definition of Shareholder Agreements

Shareholder agreements can be broadly defined as written or unwritten contracts between shareholders. In this chapter, we choose to focus only on written contracts because unwritten contracts are hard to document. They involve rights or obligations beyond what is prescribed by law. Standard components include (Chemla et al., 2007): (i) Options or limitations on the right to buy or sell shares, for example, preemption rights (call options at a specified fair price), collective action clauses, such as tag-along rights (the rights to go with other investors) or drag-along rights (the obligation to do so) (ii) Control rights, for example, rights to appoint a member of the board or veto certain critical decisions or the obligation to vote with another shareholder (iii) Cash flow rights, for example, catch-up clauses which specify rights to parts of the proceeds in case the company is sold to a third party (iv) Procedures for dispute resolution in case of disagreement. Just like other private contracts, shareholder contracts are enforceable in court. One particular stream of literature, called financial contracting, has been concerned with the financial deals between financiers and those needing the funds (Hart, 2001). Yet, it has mainly addressed fundamental questions such as the nature of debt and equity or optimal capital structure. There has been very little empirical work done on the contracts themselves, and even less on the role of these contracts for strategy and management. Notable exceptions are Kaplan and Strmbergs (2003) research on shareholder contracts in venture capital firms and Chemla and colleagues (2007) on closely held firms. Kaplan and Strmberg (2003) analyze the characteristics of the real world contracts between venture capital firms and entrepreneurs with respect to board rights, liquidation rights, voting rights and cash flow rights. They find those features to be in line with the existing financial contracting theories such as principalagent and control theories (for example, Aghion and Bolton, 1992) but with

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much more internal complexity. Chemla and colleagues (2007) argue that the inclusion of strong clauses such as tag-along and drag-along clauses in the contracts protects investors from opportunism and thus ensures some efficient ex ante investments in the firm. 2.2 Related Literature

Although there has been little attention to shareholder agreements in listed corporations in previous work, there are several interesting streams of research, which may contribute to theory development: general contract theory (for example, Shavell, 2004, Chapters 1314), financial contracting theory (Hart, 2001), transaction cost theory (Williamson, 1985, 2005), research on strategic alliances and joint ventures (Kogut, 1988; Mowery et al., 1996; Doz and Hamel, 1998; Gomes-Casseres et al., 2006), theories of relational contracting (Macaulay, 1963; Ellickson 1991; Mnookin and Komhauser, 1979; Zaheer and Venkatraman, 1995; Poppo and Zenger 2002; Carson et al., 2006), takeover theories (Scharfstein, 1988; Danielson and Karpoff, 1998; Mikkelson and Partch, 1997; Adams and Ferreira, 2007; Burkart and Lee, 2007) and macrostudies of law and finance (La Porta et al., 2000; Djankov et al., 2007). We draw on these contributions in the following.

3.

EMPIRICAL SETTING AND METHODS

France offers a unique empirical setting to study shareholder agreements. First, shareholder agreements are quite common among listed firms. Second, the French market authority requires that owners publicly disclose their agreements. All contracts are stored in the market authoritys database and their detailed content is readily accessible. Third, because of the public nature of these agreements, we may study how markets react to the announcement of agreements, thus capturing a measure of value creation. In this section, we briefly describe the nature of shareholder agreements in French listed companies and explain the sources and methods used. We then provide a short description of each of the cases. 3.1 Shareholder Agreements in France

Shareholder agreements (pactes dactionnaires) are relatively common among listed firms in France. Among the 749 listed firms on Euronext Paris,2 268 firms had had at least one shareholder agreement between 1997

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and 2007. Over the same period, an average of 38 new shareholder agreements were announced each year (see Appendix 11.1). These contracts are prevalent across all sizes of listed firms including the very largest (CAC 40). A typical contract is a 16-page document that specifies the nature of the agreement between the signing shareholders. It starts by stating the names of the shareholders and their respective equity and voting shares. It goes on to describe the allocation of power between the parties, notably in terms of voting rights and allocation of board seats. It then describes the obligations and rights of the signing parties in case of events such as the nomination of new board members, corporate strategy decisions, takeovers and equity selling. The shareholder agreements used by listed firms appear to be much less detailed than the ones used by private firms and in particular by private equity funds. As an illustration, take Legrand, one of the leading worldwide manufacturers of electrical equipment. In 2002, the company was sold to two private equity funds, KKR and Wendel; in 2006, part of the equity was floated, with KKR and Wendel keeping 59 per cent of the equity. The 2006 (publicly available) agreement between KKR and Wendel is a 6-page contract. We interviewed one of the directors at Wendel, who revealed that the initial contract between the two private equity funds and subsequent partners was more than a hundred pages long with a large amount of detail. Why? We hypothesize that complex contracts among shareholders in closely held firms substitute for the standard form contracts of listing requirements and securities law which listed companies implicitly rely on. In the private setting, there is a higher level of expropriation risk for shareholders, requiring in turn a tighter control of the allocation of power and cash flow rights between shareholders. In addition, in the absence of public information requirements, shareholders of private firms often add detailed specifications of the information they will get from management (such as the detailed monthly reports). Last but not least, shareholder agreements among private equity firms usually include the compensation packages of top management and profit-sharing schemes. Shareholder agreements among publicly traded companies are most often signed for periods ranging from two to five years with tacit renewals for the shortest periods. Clauses usually specify how the parties can put a halt to the contract without suffering penalties. Shareholder contracts are officially enforceable in a commercial court (article I. 233-11 of commercial law). Yet, in case of disagreements, the contract parties rarely resort to court. They use private settlements. Why? According to the lawyers and contract parties we interviewed, private settlements are more discreet than going to court. Nothing is published.

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The board, management relations and ownership structure

The common practice is to go through what is called a referee (arbitre). Referees are not judges; they are appointed by the chamber of commerce. They act as go-betweens and tension soothers to prevent escalation between the signing parties. While private settlements keep shareholders from the spotlights, they are reported to be very costly, suggesting in turn that the benefits of privacy are highly valued by the contract parties. In fact seeking private agreements rather than enforcing contracts through the courts is quite common for many types of contract (Macaulay, 1963). The parties bargain in the shadow of the law (Mnookin and Komhauser, 1979). 3.2 Disclosure Requirements

The French market authority (Autorit des Marchs Financiers) requires that shareholders of listed companies disclose the details of the contracts they have signed with other shareholders (article I-233-11 of commercial law). There is an additional notification when shareholders choose to act in concert (article I-233-10 of commercial law).3 Those breaking the law face the risk of being deprived of their shareholder rights. The detailed contracts of French listed firms are compiled in a database and made accessible to the general public on the AMF website (www.amf-france.org) for the period 19972007. 3.3 Sources and Methods

Faced with the need to develop new theory we decided on an explorative approach which derives theoretical propositions from case studies and related research. We chose multiple cases because more cases tend to increase the degree of generalizability of the results (Yin, 1984) through the use of a replication logic. The emerging theory is tested by confronting it with new cases which force it to distinguish between the common and idiosyncratic features of the cases. We followed an abductive approach (Peirce, 1935) rather than a grounded approach (Glaser and Strauss, 1967) as we did not start with a blank slate but with some knowledge of shareholder agreements although not directly related to our setting of listed firms drawing on the theory of financial contracting, transaction theory, general contract theory and the theory of relational contracting. We focused on five different cases, all involving large listed firms. Whereas in a quantitative study the sampled firms need to be representative of the population, in a multiple-case-study design, firms are selected for theoretical reasons (Einsenhardt and Graebner, 2007). We purposely chose cases from different settings. This selection was made after reading through

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259

the 380 or so contracts available for the listed firms in the AMF database. We focus on the following five cases, which are described in greater detail in the following section:

The Pernod Ricard agreement is an unbalanced contract between a large founding family and a small minority investor. The Publicis deal features a large blockholder ready to give up control to the founding family. The Club Med agreement is a complex contract between multiple small owners with different interests (institutional investors, a hotel group and a real estate firm). The Legrand agreement involves two large private equity funds which initially took over the company privately. The Schneider Electric agreement reveals complex ownership linkages between banks, insurance companies and large non-financial corporations.

For each case, we proceeded in the following way. We first read the shareholder agreements in detail, classifying the content of the agreements into several categories (see Appendix 11.2). Second, we used a variety of secondary sources, including annual reports, analysts reports, press search and internet search to substantiate the context and content of the contracts. For data on ownership structure, we used the Dafsaliens database. Third, we carried out interviews with the firms signing parties and lawyers. At this point interviews are accepted and performed for two of the cases. For the second research question on the value impact of shareholder agreements, we examined share price reactions around announcement dates (1/2 1 month and 1/2 2 months around the publication) using Datastream financial data. 3.4 Description of the Cases

We now give a short description of each case covering key facts on the firm, the context to the shareholder agreement and the summarized content of the agreement (details are available in Appendix 11.2). Pernod Ricard Pernod Ricard is the worlds second largest operator in wine and spirits (2005 sales: 3674 million; 2005 net profit: 475 million). It owns brands like Chivas Regal, Ballentins, Malibu, Ricard and Mumm. The company originates from the 1975 merger between two traditional French companies, Pernod and Ricard (respectively held by the families Pernod

260

The board, management relations and ownership structure

and Ricard). Between 1975 and 2001 it grew through both external and organic growth. In 2001, it bought a large part of the Seagrams wine and spirits activities. In 2005 it acquired Allied Domecq in partnership with Fortune brands and became number two worldwide. In March 2006, a shareholder agreement was signed between the Ricard family (10 percent equity) and Kirin Corporation, Japans largest spirits operator (3 percent equity). In a nutshell, the agreement states that both shareholders should act in concert and that Kirin commits to vote in favor of the board recommendations on a stated number of issues. The question is, why? In the following section, we examine why Kirin would want to enter such an agreement. Publicis Publicis is the worlds fourth largest communication group (2005 sales: 4127 million; 2005 net profit: 386 million), operating in Europe (40 percent sales with a leading market share) and the US (42 percent sales). Publicis was initially founded by Marcel Bleustein-Blanchet in 1926. The company acquired Saatchi and Saatchi (UK) in 2000, and subsequently Nelson Communication (US) in 2002. In 2002 (March), Publicis merged with Bcom 3, a large US communication network including Leo Burnett, DArcy and media buying company Starcom MediaVest. Bcom 3 was created in 2000 through the merger of the Leo Group and the MacManus Group with a capital investment from Dentsu, one of Japans largest communication companies. In May 2002, Elisabeth Badinter, Marcel Bleustein-Blanchets daughter, Publicis main shareholder (28 percent of the equity in 2001; 20 percent of the equity of the new merged entity in 2002) and chairwoman, signed an agreement with Dentsu (18 percent equity). In this contract, Dentsu agrees to follow Elisabeth Badinters voice on all major strategic issues including board nomination. It also commits not to sell its shares before 2012. Club Med Club Med is one of the leading operators of holiday villages and tours (2005 sales: 1590 million; 2005 net profit: 4 million). The company was founded in 1950 by two entrepreneurs, and grew mostly organically over the subsequent years. In 2004, Accor, one of the largest worldwide hotel chains acquired a 29 percent stake in Club Med from the Agnelli family (Italian family and former dominant owner) and from institutional investor CDC. It became the dominant (so-called reference) owner. In 2006, after a CEO change, Accor partly exited Club Med and sold a portion of its shares to several investors: Icade (the real estate arm of French government-backed CDC), Air France Finance (finance arm of Air France) and

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Fipar (CDC equivalent for Morocco). In June 2006, a shareholder agreement was signed between Accor and the investors. The newly formed coalition totaled 22 percent equity. In a nutshell, the investors committed to act in concert and support the managements decisions. The agreement defines the right of the parties for board representation and in case of takeover. Legrand Legrand is one of the leading worldwide manufacturers of electrical equipment (2005 sales: 3248 million; 2005 net profit: 101 million). In 2001, Legrand was acquired by its competitor Schneider. However the deal was blocked by the anti-trust authorities and Schneider had to find a new owner. In December 2002, Legrand was acquired through LBO by equity funds KKR and Wendel (investing arm of the Wendel family). In 2006 (April), circa 20 percent of Legrands equity was floated again on the Euronext stock exchange. In March 2006, KKR and Wendel (totaling 59.1 percent equity and voting rights, with individual shares of 27.4 percent and a joint entity, Lumina Participation, owning 4.3 percent) published their new shareholder agreement in which they carefully allocate the firms board seats, cash flow rights, voting rights, equity shares and obligations. Schneider Electric Schneider Electric is one of the worlds leaders in the design and distribution of electrical equipment (2005 sales: 11679 million; 2005 net profit: 494 million). The company was founded in 1836 by the Schneider family and was initially focused on steel production. Over the years, it divested the steel business and invested in electricity-related activities. In 1999, it changed its name to Schneider Electric to signal its strong focus on electricity. Over the past decade, it has acquired a range of companies in various electricity related areas. Between 1993 and 2006, Schneider signed a number of agreements with French institutional investors (banks and insurance companies) and large French corporations. In 1993, it signed a contract with insurance companies (AXA, AGF), banks (Paribas, Socit Gnrale) and a large energy company (Elf). In 1998, the contract was renewed between AGF (3.3 percent voting rights), AXA (9.6 percent voting rights) and BNP-Paribas (5.4 per cent voting rights). In 2002, the contract was modified again (avenant), updating the respective shares of the signing parties. In 2002, AXA, AGF and BNP-Paribas broke the agreement. In 2006 (May), AXA and Schneider signed an agreement in which AXA committed to keep a certain number of shares in Schneider while Schneider reciprocally committed to maintain a minimum number of shares in Schneider.

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4.

ANTECEDENTS OF SHAREHOLDER AGREEMENTS

Why would shareholders in listed companies resort to shareholder agreements rather than use other types of governance mechanisms such as ownership concentration or financial hedging? Also, why would shareholders bother to enter into contracts rather than use the standardized provisions of company charters? We need to understand the conditions under which the benefits of contracting between shareholders outweigh their costs. The costs of shareholder agreements span both transaction costs (such as the costs of negotiating, renegotiating, concluding and enforcing the contracts) (Williamson, 1979, 2005) and the costs of lock in (shareholders agreeing to bind themselves in a contract and thus to lose some degree of flexibility). In the following sections we examine the determinants and effects of shareholder contracts in an extended transaction cost framework, which draws on advances in the theory of financial contracting, contract theory, relational contracting, law and finance, research on strategic alliances and M&A (mergers and acquisitions) as well as Williamsonian transaction cost theory. The basic argument is that ownership and shareholder contracts are alternative means of exercising control and that both may under certain circumstances be more transaction cost efficient than market solutions. 4.1 Nature of the Ownership

Prior research on governance mechanisms suggests that ownership concentration is a way to address agency issues between owners and managers (Shleifer and Vishny, 1986, 1997; Holderness and Sheehan, 1988). With increased concentration comes the power and motivation to discipline managers. Yet, in some cases, shareholders may prefer not to increase their stake in the firm. They may be capital constrained or risk averse; alternatively, they may expect a control loss and lower efficiency if they take over the firm from its present owners. Moreover, ownership concentration may not be necessary if owners can achieve their objectives by other (contractual) means like shareholder agreements that possibly allow them to act in unison and thereby exercise effective control. Our cases suggest that shareholder agreements are more prevalent for firms with intermediate levels of ownership concentration, that is, with no majority owner, yet with several large shareholders. Table 11.1 summarizes the findings. In all of the cases, there are at least two large shareholders (with more than 3 percent equity) in the ownership base. As shown by the cases, the contract is made between two or more large shareholders.

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A simple explanation is transaction costs of writing and enforcing contracts, which may be too large to be worthwhile for smaller shareholders. In addition, small shareholders would expect to gain relatively little by entering into such agreements, because they have limited bargaining power except for rare cases where they can influence the balance of power between competing blockholders. In firms with a highly fragmented ownership base, small shareholders have no interest in signing an agreement because the costs of joining forces outweigh the benefits. In firms with high levels of ownership (for example, majority ownership or dominant owner), shareholder agreements are less critical because the need to establish control is absent. However, dominant owners may be interested in entering agreements in a dynamic context when ownership changes are expected and when, for example, they plan to sell out part of their shares. In the Club Med case, Accor was initially the dominant owner with 28.9 percent of equity shares. In 2006, when it wished to partly exit its investment (down to an 11.4 percent share), it signed a contract with three institutional owners who, in addition to buying Accors pending shares, agreed to act in unison and create a virtual dominant owner. Accordingly, we propose: Proposition 1 Shareholder agreements are more likely to be found in companies with intermediate levels of ownership concentration. Another striking feature is the identity of the owners entering the agreements. Findings are reported in Table 11.1. Signing owners are mostly family owners, corporations and active financial investors such as private equity funds. In both Publicis and Pernod Ricard, the two signing parties are the founders family and a corporation. In Club Med, the coalition is led by hotel group Accor. In Legrand, the contract parties are the two private equity funds and their joint entity. As argued above, these owners may not have the incentive to increase their ownership share in the firm. Having a controlling stake can be too risky or too costly (for families such as Pernod who need external funding to sustain the strong external growth of the firm) or outside of their scope (for corporations such as Accor whose main business is hotels). The common characteristic of these shareholders is their long-term involvement in firms. Shareholder agreements are signed for an average of three to five years and create some lock-in for the signing parties. The cost of lock-in is likely to be much lower for shareholders with a long-term interest than for financial investors such as mutual funds whose managers are evaluated on the short-term performance of their funds (Graves, 1988; Hoskisson et al., 2002; Verstegen Ryan and Schneider, 2002, 2003) and who value flexibility. Thus we make the following proposition:

Table 11.1
Ownership concentration1

Shareholder agreements and the nature of ownership

Identity of main owners

Firm

Date

Validity period Contract parties

Pernod Ricard

2006 March

3.5 years (March 2006 to Dec. 2009)

Publicis

2002 May

10 years (May 2002 to July 2012)

Founders family (Ricard) 9.1% and corporation (Kirin International) 3.6% Founders family (Badinter) 19.7% and corporation (Dentsu) 18.2%

Founders family (Ricard): 9.1%2 Institutional investor (Franklin Resources): 4.0% Corporation (Kirin): 3.6% Institutional investor (CDC): 3.2% Founding family (E. Badinter3): 19.7% Corporation (Dentsu): 18.2%

264 Intermediate Between private equity funds (Wendel 5 owners with more 27.7% and KKR than 3% equity 27.7%) shares (total: 68.6%)

Club Med

2006 June

3 years (tacit renewal every year); no longer valid if investors collectively own less than 15%

Intermediate 3 owners with more than 3% equity shares (total: 19.9%) Auto-control (3.3%) Intermediate 2 owners with more than 5% equity shares (total: 37.8%) Auto-control (6.7%) Corporation (Accor) Intermediate 11.4% and selected 6 owners with more institutional investors than 3% equity (Fipar holding 10% shares (total: 60.1%) and Icade 4%)

Legrand

2006 March

Until the date of the first of these 2 events (1) KKR

Institutional investor (Richelieu Finance): 26.4% Corporation (Accor): 11.4% (from 28.9% in 2005) Institutional investor (Fipar holding): 10% Family (Agnelli family via Rolaco): 4.7% Institutional investor (Icade): 4% Insurance company (Nippon life): 4% Private equity fund (Wendel): 27.7% Private equity fund (KKR): 27.7% Private equity fund (Lumina Participation4): 4.3%

and their joint venture Lumina Participation 4.3%

Top management: 3.8%

Wendel and KKR did an LBO on Legrand in 2002 Private equity fund (Montagu): 4.8% Institutional investor (Goldman Sachs Capital Partners): 4.1%

Schneider 2002 Electric March (1)

and Wendel jointly own less than 33% of Legrands equity, or (2) one of the 2 parties individually owns less than 5% Tacit renewal of the contract every year Between banks (BNP-Paribas) and insurance companies (AXA, AGF) 3.5% Institutional investors (CDC): 3.9% Insurance company (AXA): 3.5%

265

Schneider 2006 Tacit renewal Between Schneider Electric Septem- of the contract and Axa (2) ber every year

Low 2 owners with more than 3% equity (total: 7.4%) Auto-control & employees (9.9%) Low 3 owners with more than 3% equity (total: 12.7%) Auto-control and employees (9.9%)

Institutional investors (capital group): 5% Institutional investors (CDC): 4.4% Insurance company (AXA): 3.5%

Notes: 1 Ownership concentration at the time of the contract. Criteria: Intermediate concentration: some large owners (> 3% equity), yet no majority owner; High concentration: existence of a majority owner; Low concentration: some large owners but the sum of large owners is lower than 10% 2 16.7% of voting rights. 3 Elisabeth Badinter, daughter of the founder, Marcel Bleustein-Blanchet. 4 Equally owned by Wendel and KKR.

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Proposition 2 Shareholder agreements are more likely to be found in companies in which shareholders have a long-term interest (for example, families, corporations). The heterogeneity of goals of shareholders is well established in the management literature (for example, Bushee, 1998 and 2001; Verstegen Ryan and Schneider, 2002, 2003, for institutional investors; Thomsen and Pedersen, 2000, for a large range of owner identities). Prior research suggests that owners have different objectives and strategic preferences according to their identities (Bethel and Liebeskind, 1993; Hoskisson et al., 2002: Tihanyi et al., 2003; Gaspar et al., 2005). Our data indicate that shareholder agreements are more likely to be signed between owners who have non-financial objectives. By non-financial objectives, we mean objectives that are not strictly linked to the value maximization of the shareholders equity. They span personal and strategic objectives. For example founders families such as Pernod or Badinter (the founders children) may want to keep the culture and values of the founders alive in the firm. Corporations such as Kirin and Dentsu appear to have strategic reasons to surrender their external control rights. Kirin is the largest spirits company in Japan with a long tradition of joint ventures to access markets and technology. In the 1970s, it signed a joint venture with Seagram to distribute its whisky brands in Japan. Shortly after Seagrams spirits division was sold to Pernod Ricard and Diageo in 2002, Kirin signed an agreement with the two companies to retain and acquire sales rights in Japan for the former Seagram portfolios brands. Thus Kirins equity share (3 percent) in Pernod Ricard seems to serve other purposes than financial returns, such as expanding in the non-beer business. Figuratively speaking, Pernod Ricard became part of the keiretsu. Similarly, it is hard to understand why Dentsu would assent to sign an agreement that strongly limits its controlling power over Publicis (when it has formally 18 percent of the equity) for purely financial reasons.4 Secondary data suggest that at the time of the agreement (2002) Dentsu was facing growth imperatives just after its introduction on the stock market and was struggling with a downward advertisement market in Japan. Two years before, Dentsu had made some diversification investments abroad, particularly in Bcom 3, a large US agency network. In 2002, it sold its dominant share in Bcom 3 to Publicis officially to free up some cash and signed what was described by the top management of the firms as a strategic alliance or business tie up with Publicis.5 Dentsu was probably agreeing to trade off control over Publicis for a business alliance that would possibly offset the slow growth of its Japanese activity and enhance its global offer of communication services.

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A slightly different logic applies to the Club Med agreement. Why would Accor set up a contract with several new institutional investors at the time when it exited from Club Med? Secondary data, notably press articles, suggest that Accor may have been pressured by the French government to find a substitute owner that would replace Accor (as the reference owner) and thus protect Club Med from a takeover by foreign investors. Club Med is commonly considered one of the national corporate jewels of France, one that needs to be protected against hostile bids. Another important non-financial objective which we have not seen documented in previous research is what we could call preventive ownership or preventive control, which consists in preventing third parties from acquiring control. To be sure, preventive control is not equal to protection against takeovers. It is a way for corporate owners to prevent their direct competitors from expanding their footprint. For example, in the Club Med case, it is likely that Accor did not want a foreign competitor like Hilton to establish a strong position in the leisure business by taking over Club Med. Similarly, in the Publicis case, it was probably important for Dentsu to prevent Publicis from being acquired by competitors like WPP or Grey. In this case, control over management is less important than preemption over competitors. Hence, we make the following proposition: Proposition 3 Shareholder agreements are more likely to be found in companies in which owners have non-financial objectives (for example, strategic alliance interests for corporate owners, continuity for family ownership, national protectionism for government owners, preemption in contrast to investors who prefer to avoid the loss of flexibility). Our cases also suggest that the leading shareholder of the agreement, that is, the one initiating the agreement and managing the negotiation process, has a strong historical link with the firm and seeks to maintain this link. For example, in Publicis and Pernod Ricard, the leading negotiating shareholders are the founders families. We argue that they tried to maintain their historical control over the firm. As both firms grew over the years, they needed additional financial back-up and went public, with a strong share of the firm remaining in the founders hands (in 2000, the Badinter/ Bleustein-Blanchet family still had 40 percent of the firms equity; in 2001, 28 percent). Both shareholder agreements followed just after major external acquisitions (BCom 3 for Publicis in 2002; Allied Domecq for Pernod Ricard in 2006) suggesting that the founders families used the contracts to protect themselves against a loss of power in the new entity. The Legrand contract also indicates that the incumbent shareholders (the two private funds) sought to maintain their control of Legrand after

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the firm was introduced on the stock market. Initially, in 2002, at the time of the LBO, KKR and Wendel had signed a very detailed agreement on Legrand. Once they floated part of the equity, they were required to reveal their agreement, and thus turned to a simplified version. One of our interviewees told us very strongly that [they] use shareholder agreements to maintain [their] power in the firm. These cases suggest that when incumbent owners seek to maintain their power in the firm, the costs of contracting may be offset by the benefits of control. Thus: Proposition 4 Shareholder agreements are more likely to be found in companies in which an incumbent shareholder (for example, family, private equity) seeks to maintain dominant control. 4.2 Nature of the Industry

Prior studies show that firms ownership structures vary across industries (Demsetz and Lehn, 1985; Pedersen and Thomsen, 1997; Villalonga, 2005). For example, family ownership is more prevalent in industries such as food manufacturing and media while government ownership to take extreme examples is more frequent in the weapon and aircraft industries. Similarly we would expect that shareholder agreements are not equally distributed across all types of industries. There are two main reasons for this. First, as previously shown, there are ownership conditions (related to ownership concentration and identity of owners) under which the benefits of shareholder agreements exceed the costs, and these conditions may change across industries. Second, shareholder agreements generate costs of lockin because they tie up the signing parties for several years without much flexibility. Lock-in is less costly in relatively stable and certain industries than in dynamic industries where short-term changes may be required. Our cases show that all of the firms in our sample operated in mature industries (wine and spirits, electrical equipment, advertising). Findings are reported in Table 11.2. We formally state this proposition as follows: Proposition 5 Shareholder agreements are more likely to be found in companies that operate in relatively stable businesses in which the costs of lock-in for a couple of years are small. This finding departs from previous research on interfirm ownership and strategic alliances which suggests that equity arrangements among firms are more frequent in knowledge intensive industries with high R&D intensity (Allen and Phillips, 2000) such as biotechnologies and electronics.

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Table 11.2
Firm

Shareholder agreements and the nature of industry

Industry Wine and spirits Communication and advertising Leisure and holiday village operator Electrical equipment Electrical distribution Industry development Mature Mature Mature Mature Mature

Pernod Ricard Publicis Club Med Legrand Schneider Electric

Here, the main role of interfirm shareholdings is to facilitate knowledge flows between firms (Mowery et al., 1996, Gomes-Casseres et al., 2006). In contrast, in our cases, knowledge sharing does not appear to be a dominant motive in transactions between shareholders. 4.3 Nature of the Contract Items

The benefits of shareholder contracts will be particularly high (and exceed the costs) when no other mechanism effectively addresses the issues included in the contract. One of our interviewees told us:
We do not use shareholder agreements on a standalone basis but in conjunction with other elements such as charters and commercial law. We see shareholder agreements as one of the tools of a larger toolbox which help protect our interests in the firm. Yet, these contracts are useful because we have a lot of flexibility in the content, and we may address issues that are not explicitly taken into account by charters or by commercial law.

What are these issues? Our cases point to different categories, related to equity rights, control rights and non-control and equity issues. Table 11.3 provides a summary of the issues while the details of the contracts are in Appendix 11.2. Three categories of issues are distinguished: equity rights, control rights, and other (non-equity and control) issues. Equity rights relate to the control of the equity by the signing shareholders. They encompass preemption clauses, tag-along and drag-along rights (respectively the right of joint exit and the obligation of joint exit) and rights of approval (clauses dagrment) which allow the current shareholders to avoid undesirable new shareholders entering the firm. As an illustration, the Publicis (2002) shareholder agreement states that Dentsu will not be able to transfer or sell its equity shares in Publicis until July 2012; after July 2012, Mrs Badinter has a preemptive right to buy Dentsus shares.

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Table 11.3
Firm

Shareholder agreements and the nature of the contract items

Control rights Equity rights Non-equity and controlrelated issues

Board structure Pernod Ricard Publicis Club Med Legrand Schneider

Voting rights X

Rights to sell Cash flow Strategic and acquire rights alliances/ shares business deals X X X X X X X X X

X X X

X X X

Notes: Board structure refers to the rules attached to the composition of the board of directors and its sub-committees. Shareholders agreements encompass the following board-related items: number of board seats granted to the signing shareholders, total number of members on the board, including total number of independent board members; nomination process for board members and chairman; rights to propose nominees and obligation to accept the appointments made by some of the signing parties. Voting rights refer to (1) the rights given to the contract parties relative to the strategic decisions and (2) the total voting rights granted to each of the parties. In the first case, the shareholders agreement will specify the type of strategic decisions for which the signing parties agree to vote in concert and those for which they may express an individual opinion. In the second case, it will specify the maximum number of votes given to each of the contract parties. Rights to sell and acquire shares refer to the rules attached to the sale and purchase of equity shares. Shareholders agreements specify the minimum holding period of shares, the preemptive rights given to the signing shareholders, and the process that needs to be followed in case of sell-out. They also define the rights and obligations in case of takeover attempts. Includes clauses for joint exit, rights of approval, tag-along and drag-along rights. Cash flow rights refer to the allocation of cash flows between the signing parties, in particular when the firm is sold to a third party or goes public. Strategic alliances refer to agreements between the signing parties about some joint activity, which may range from common distribution channels to joint production and knowledge transfer. Business deals refer to more ad-hoc transactions between the firm and one of the signing investors.

Control rights pertain to the allocation of board seats, the nomination process of the directors and the committees, the allocation of voting rights and the obligation to act in concert with respect to strategic decisions. Legrand provides a good illustration. The shareholder contract specifies that the board will comprise 11 members: three representatives of KKR, three representative of Wendel, two independent board members and three top managers. It also stipulates that the strategic committee will be

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chaired by a KKR representative while the compensation committee will be chaired by a Wendel representative. As for Club Med, the contract explicitly states that all signing shareholders will support the strategy of the current management. Non-equity and control issues relate to business relationships either among the shareholders or between the shareholders and the firm. For example, in the Club Med contract, Fipar, a real estate institutional investor and one of the signing parties, is granted the right to strike a deal with Club Med for its real estate assets. Our findings suggest that the equity and control rights issues included in the shareholder agreements cannot easily be addressed by standard open market transactions like hedging or financial options, partly because they are conditional on what other parties contract do, and partly because of the relatively long time horizon which they cover. Thus the following proposition: Proposition 6 Shareholder agreements are more likely to be found in companies in which shareholders need to address complex and conditional issues characterized by an intermediate level of information asymmetry (which can benefit from third-party arbitration in case of disagreement). Previous research suggests that market mechanisms do not fully address expropriation issues between shareholders (Shleifer and Vishny, 1997; Johnson et al., 2000; Djankov et al., 2008) such as tunneling and selfdealing. Two types of expropriation issues (also called principalprincipal issues) need to be distinguished: expropriation of minority shareholders by large shareholders, and expropriation among the large shareholders. La Porta et al. (1999) indicate that legal protection of minority investors is scarce in countries with French civil law origin. Although French law based investor protection has been more favorably regarded in recent research (Djankov et al., 2008), we find it interesting to examine whether French shareholder agreements are substitutes for limitations in legal investor protection, using mechanisms such as the granting of board seats and additional voting power to minority investors. But our cases do not provide evidence of this. The rights of the minority investors signing the contracts tend to be linked to the interests of the dominant owner, with no rebalancing taking place. For example, Kirin, a minority investor, clearly agrees to be on the backseat, leaving the Ricard family with the full decision and control power. However, our cases point to the relevance of shareholder agreements to mitigate expropriation among large shareholders. As an illustration, the shareholder contract between KKR and Wendel (which have equal

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stakes in Legrand) stipulates how the two owners will share the control and profits of the firm after the IPO. It forbids one of the parties to pursue an opportunistic behavior at the expense of the other. A revealing quote from our interviewee:
When we sign a shareholder agreement, we act as complete paranoiacs. We investigate all possible scenarios under which we could lose control and money because of the other partys opportunism. We make sure all the scenarios are included in the contract, with clear resolution processes. Never trust another shareholder!

Under these circumstances, shareholder agreements may represent an efficient instrument to moderate potential conflict of interests between large shareholders. Hence, we propose: Proposition 7 Shareholder agreements are more likely to be initiated by large investors seeking to protect their bargaining power than by small shareholders seeking substitute mechanisms for weak legal protection. Prior studies have shown that firms are more likely to adopt antitakeover measures when managers have high discretion and low owner control (Brickley et al., 1988). We found that shareholder agreements are commonly used by large insiders to protect themselves against the entry of undesirable shareholders. Schneider Electric and Axa for example have cross-ownership. In the event of a hostile takeover of Schneider, AXA has the right to purchase all AXA shares still owned by Schneider; and conversely for Schneider. As for the Club Med shareholder agreement, it stipulates that, in case of takeover, investors are allowed to sell their shares only if Club Meds board of directors has given its agreement on the takeover. Another good example of the use of agreement against takeover is Pernod Ricard. The shareholder agreement with Kirin reinforced the familys equity share by increasing its equity block; yet it did not seem safe enough to secure family control. The following year (2007), a new blockholder, Albert Frre, who is reported to be a 40-year-old friend of the family, entered the firm. Albert Frre had been on Pernod Ricards board of directors from 1991 to 1995. In addition, in line with the new finance law Breton, Pernod Ricard adopted a measure whereby convertible bonds can be given for free to existing shareholders (maximum 50 percent capital) in case of a hostile takeover, consequently increasing the cost of the takeover. Thus: Proposition 8 Shareholder agreements are more likely to be found in companies in which there is a takeover risk (for example, companies with large free cash flows).

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4.4

Nature of the Network Ties

A stream of research has examined the ties between directors and top managers and has revealed that the nominations of directors are not random but linked to social and professional networks (Davis et al., 2003; Conyon and Muldoo, 2006; Kirchmaier and Kollo, 2007). In France in particular, there are strong small world effects mostly related to top managements membership of the elite schools (Nguyen-Dang, 2006). In such a context, it is likely that the choice of partners for shareholder agreements follows some network rules. Our cases show that this is often so. For example, in the Club Med agreement, all signing shareholders have somewhat tight connections. Accor had close links with the government, both through its founders (notably Mr Pelisson, who also became the mayor of Fontainebleau, a posh city on the outskirts of Paris), and through Mr Espalioux, the CEO, who studied at ENA, the top administrative school in France. Accor sold part of its equity in Club Med to a consortium of investors who were related to the French government. Icade is the real estate arm of CDC, a hybrid institutional investor strongly connected with the government.6 Fipar Holding is the CDC equivalent for Morocco. Air France Finance is the finance arm of Air France, the former national French airline company, still partly owned by the French government and with a strong connection to Accor (for example, they have a common payment card and share part of their loyalty programs). While ex ante the network ties probably facilitated the signature of the contract, ex post they also increased the enforcement of the contract because of potential social sanctions in case the contract is breached. A close look at the Schneider Electric agreement also reveals many informal relationships among the signing shareholders (Axa, Schneider Electric, BNPParibas, and AGF for the 2002 agreement), in particular, board ties. Over the period 200007, the board of AXA (one of Frances top insurance companies) included Michel Pebereau (CEO of Bank BNP-Paribas, one of Frances top banks) and Henri Lachman (CEO and subsequently chairman of Schneider Electric) as members. Until 2002, Claude Bebear (CEO of AXA) was a director on the board of Schneider Electric. Directors and managers have mutual board ties which possibly give them more scope for gentlemens agreements not to interfere in the strategic decisions of socially connected parties for fear of retaliation. The Schneider Electric agreement seems to reflect a social arrangement between managers of top French corporations, banks and insurance companies. From these various cases, we propose the following: Proposition 9 Shareholder agreements are more likely to be found in companies whose leading officers and directors have social ties, such as

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belonging to the elite network (where formal contacts can be backed up by social sanctions). In the case of KirinRicard and DentsuPublicis it is relatively clear that the foreign firms did not have the same strong social ties. But recent research has indicated that alliances may be a means to achieve social ties and legitimacy (Koka and Prescott, 2002; Dacin et al., 2007). Since minor ownership shares have been used to express a commitment to future business relations among Japanese firms (in the so-called keiretsu system), the contractual relations with the French firms could be seen as an international extension of a traditional Japanese practice. In addition, a closer look at the DentsuPublicis deal reveals the existence of significant informal ties although not at the CEO level between the two companies. Secondary sources indicate that the founder of Publicis (Marcel BleusteinBlanchet) and the founder of Dentsu (Hideo Yoshida) knew each other from the 1960s. The CEO of Publicis, Maurice Levy, made a revealing comment when announcing the arrangement with Dentsu: Friendly ties were established in the sixties between Marcel Bleustein-Blanchet, our founder, and Mr Hideo Yoshida. I am glad that this partnership offers us new opportunities to build on this tradition.

5.

IMPACT OF SHAREHOLDER AGREEMENTS

Shareholder agreements bias the formal ownership structure by introducing idiosyncratic arrangements between selected shareholders. This phenomenon of contracting around ownership may constitute an impediment to the efficiency of the markets because it introduces some complexity in the allocation of control and cash flows among shareholders. Yet, the conflicting perspectives of the finance and strategic management streams of literature suggest that we still have no clear view on the effects of shareholder agreements. On the one hand, the finance literature indicates that protections against takeovers such as poison pills (included in company charters) destroy value (Gompers et al., 2003). Takeovers and particularly hostile takeovers are demonstrated to be an important source of value creation for target firm shareholders (for example, Schwert, 2000). Accordingly, we would expect a similar negative effect to apply to shareholder agreements, given that they restrict hostile takeovers and deter entry of new shareholders. On the other hand, concentrated control is believed to create value under some circumstances (Thomsen and Pedersen, 2000) and the

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Table 11.4
Firm

Impact of shareholder agreements

+/1 month +/2 months Announcement date of the Change in Change in Change in Change in shareholder company the CAC 40 company the CAC 40 agreement stock price index (%) stock price index (%) (%) (%) 27 March 2006 24 May 2002 21 June 2006 27 April 2006 +4.9 9 12.7 4.8 +1.9 7.7 +0.7 1.1 +3.9 22 16.6 N.A. (IPO occurring on 7 April 2006) 2.6 10.9 +2.4 15 1.2

Pernod Ricard Publicis Club Med Legrand

Schneider 15 March 2002 Electric (renewal) Schneider 19 May 2006 Electric

3.2 11.6

2.8 6.8

2.9 6.4

Notes: Variations of the firms stock price +/1 month or +/2 months around the announcement date of the agreement. The CAC 40 index reflects the stock price variation of the 40 largest companies in France. The source for the stock price data is Datastream.

strategic management literature suggests that equity arrangements between shareholders may be positive for the firm. They can promote strategic alliances complementary or additive between firms (Allen and Phillips, 2000), ultimately creating firm value. In addition, long-term shareholders, such as banks, corporations and government, may be in a better position to expand the firms resource base and access critical resources for the firm (for example, bank loans, lobbying of governmental bodies, R&D funding) (Pfeffer and Salancik, 1978). Accordingly, we would expect some positive reaction of the markets over shareholder agreements. Our cases suggest that the impact of shareholder agreements is highly contingent upon their content. Findings are reported in Table 11.4. Market reactions to the announcement of the Club Med and Schneider Electric (2006) deals were clearly negative, while they appear to be positive for the Pernod Ricard and Legrand agreements. As explained in the previous section, the Club Med and Schneider Electric contracts function as defense mechanisms against takeovers (see also details of contracts in Appendix 11.2). The first one points to the

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The board, management relations and ownership structure

creation of a coalition that replaces the reference owner and protects Club Med against takeovers. The later one (2006 version) is largely focused on protection against takeovers, with mutual preemption rights between Axa and Schneider in case of hostile bids. In comparison, Pernod Ricard and Publicis agreements combine both strategic and financial components. Kirin seems to have traded its investor power for some potential business agreement with Pernod Ricard, thus expanding out of its traditional (slow growth) Japanese beer business. Dentsu went for a global alliance with Publicis following the sell-out of Bcom 3. It thus gave up its role as an external shareholder for a larger financial and strategic agreement. As officially announced by Dentsu:
Dentsu Inc. has reached today a basic agreement to form a strategic global alliance with a new company created through the merger of Bcom3, a U.S. based communications group and Publicis Groupe . . . In addition, Dentsu and Publicis will discuss working together on specific projects on a global basis. (Dentsus website)

We may argue that the Publicis agreement was not positively greeted because the positive perspective of a strategic alliance was probably already included in the announcement of the deal between Publicis, Dentsu and Bcom 3. Finally, the Legrand agreement seems to follow a different logic. KKR and Wendel were the companys two main shareholders at the time of the IPO (initial public offering). The renewed commitment in the firm and the willingness to bind their fate over a somewhat longer period of time can be a reassuring signal for the markets, which may be especially important in IPOs. Private equity funds are known to be focused on value maximization and to exert strong monitoring over the firm management. Thus their agreement communicates to the financial markets that agency issues related to adverse selection will be minimal. In addition, long-term investors and particularly those with a strong financial objective in mind bring additional value through some continuity in strategies. Overall, our cases indicate that the markets are smart enough to distinguish between various types of contracts and to value those that promise a positive long-term effect on the firm. Thus, we propose the following: Proposition 10 Shareholder agreements are more likely to be negatively perceived when they are primarily defense mechanisms against takeovers. Proposition 11 Shareholder agreements are more likely to be positively perceived when they offer additional strategic benefits.

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Proposition 12 Shareholder agreements are more likely to be positively perceived when they signal an increased commitment to value creation objectives. We propose that these hypotheses are empirically testable in event studies which distinguish between alternative types of shareholder agreements based on industry and firm characteristics. For example, companies characterized by substantial free cash flow, low debt and low valuation ratios and companies in newly deregulated industries with restructuring potential are more likely to be takeover targets. In such firms we expect news of shareholder agreements to be associated with negative abnormal returns. In contrast we expect that shareholder agreements with a business case which extend the technological or sales capacity of the companies involved will tend to generate positive abnormal returns. Moreover, shareholder agreements among owners with clear value-maximizing objectives such as private equity funds are also more likely to be associated with positive abnormal returns.

6.

DISCUSSION AND CONCLUSION

This chapter explores the determinants and consequences of shareholder agreements among large listed firms in France. Shareholder agreements are contractual instruments that organize the relationships between shareholders backstage, that is, behind the formal ownership structure. Because of their confidentiality, they are often hard to study. Yet, without access to these backstage agreements, it is difficult to understand what is going on in the firm. The formal ownership structure may provide an inadequate picture of the allocation of power between shareholders and between shareholders and managers. Using a sample of shareholder agreements among listed firms in France, we look at the cost/benefit trade-off of these contracts versus other governance instruments such as increased ownership and market discipline. We define the costs of shareholder agreements as the transaction costs (negotiating, renegotiating and enforcing the contracts) and the costs of lock-in. The benefits of shareholder agreements vary according to the issues faced by the shareholders. We propose that shareholder contracts are particularly effective instruments for firms with specific ownership patterns (intermediate concentration of ownership, long time horizons and non-financial goals) and in certain (mature) industries. In addition, we conjecture that shareholder agreements are more likely to be considered when there are expropriation risks between large shareholders

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(principalprincipal issues) and takeover risks. Finally, we propose that shareholder agreements will be more effective and frequent among members of the same elite network, as the enforcement of the contract can be backed by social sanctions. With respect to the economic performance, we propose that the value of shareholder agreements is highly contingent upon the content of the contract. Agreements emphasizing protection against hostile takeovers will tend to destroy value. In contrast, agreements including both strategic and financial components and those signaling long-term commitment by valuemaximizing owners will tend to increase shareholder value. We conjecture that shareholder agreements are likely to create value when stability of ownership is required to give the firm a secure strategic direction. Despite remarkable changes in stock ownership the average holding period for common stock has fallen significantly over the past decade we have seen very little research on the importance of the stability of ownership to the continuity of strategy and financial results. We would argue that stability of ownership may under certain circumstances provide the right background for firms to progress, and that shareholder contracts can be an instrument in this regard. Moreover, we find reasons to believe that firms can occasionally benefit from having the shareholders assign ownership (control) rights to a competent owner who can then exercise authority to the benefit of the shareholders as a group. Shareholder contracts provide a flexible framework for this, because they have limited duration and need to be renewed at regular intervals. We regard this chapter as a first step towards improving our understanding of the relatively unexplored domain of shareholder agreements in listed firms. Obviously, there are limitations to this study that need to be made explicit. First, we chose to focus on a very limited number of different cases. Expanding our sample would improve the generalizability of the findings. Second, because of the availability of the agreements, we focus on the French institutional context. Research looking at cross-country comparisons of ownership structures and corporate governance practices underlines the importance of the institutional context and more particularly of company law (La Porta et al., 1999; Gedajlovick and Shapiro, 1998; Pedersen and Thomsen, 1997). Thus, we should test our propositions in other contexts, for example in both countries with similar French civil law origin and in countries with common law origin. The protection of minority investors, which is held paramount in common law countries, may limit the scope for agreements between blockholders. For example, Roe (1991) demonstrates how US law has historically blocked cooperation between minority investors because of a fear of insider trading and cornering the

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market. Countries with other legal traditions like France may be more amenable to contracts between shareholders. Nevertheless, we think this chapter contributes to the current debate on ownership from both the financial contracting literature and the governance literature perspectives. The emerging theory of financial contracting has understandably been preoccupied with fundamental issues like differences in generic types of debt and equity and what these imply for firm behavior and performance. But the fact is that the real-world financial contracts are often more complicated because they combine generic liability types with specific contractual provisions which influence the allocation of decision, control and cash flow rights. This chapter demonstrates that shareholder contracts tailor-make the relationships between shareholders. Thus we highlight the need for a systematic analysis of these contracts for fear that an important dimension of the financial structure should be missed. In addition, we provide indications of the conditions under which shareholder agreements are more likely to be efficiently used. The governance stream of literature has been relatively silent on shareholder agreements. In particular, cross-country studies have often overlooked this dimension when studying ownership structures in French civil law origin countries (for example, Gedajlovic and Shapiro, 1998; La Porta et al., 1999; Faccio and Lang, 2002). This chapter points to the importance of an in-depth understanding of less visible contextual variables such as shareholder agreements when studying governance systems as well as individual firms. As it turns out, theories emphasizing relational capitalism seem quite right; some of the relationships can be documented by studying interfirm contracts. We see several possible avenues for future research. First, one could test the propositions on a larger sample of firms within France (circa 300 detailed contracts available). Another analysis would be to measure the relative influence of the formal and real controls on firm outcomes. Thirdly, it would be interesting to test the propositions in other institutional contexts. As explained earlier, we expect shareholder agreements to be particularly frequent in countries characterized by intermediate degrees of ownership concentration such as France, Germany and Belgium, but less common in countries like the USA and the UK (firms with low ownership concentration) or Italy (firms with high ownership concentration). Finally, these findings have implications for corporate governance guidelines. On the premise that all materially relevant information (that is, with the potential to influence stock prices) should be disclosed quickly in a well-functioning stock market, shareholder agreements should be made public information, since they can influence corporate strategy and stock

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prices. In this respect, we believe that the French approach (a public register) is a good solution.

NOTES
1. This chapter originated as a paper prepared for the Workshop on The Economics of the Modern Firm, Jnkping, Sweden , 2122 September 2007. It has benefited from comments by Benito Arunada and an anonymous referee. 2. In 2005. Source: AMF. Note that some companies have been delisted while others have gone public over the period 19972007. 3. These two disclosure requirements tie in with a third requirement on ownership thresholds (declaration de franchissement de seuils et declarations dintentions article I-233-7 of commercial law) which asks shareholders to notify the market authority when their shares in a firm go above the 5, 10 and 15 percent voting or equity thresholds. 4. The contract between the Badinter family and Dentsu states that Dentsu will commit to nominate all management team members proposed by E. Badinter as well as all supervisory board members who have been chosen by E. Badinter. In addition, it will vote in favor of E. Badinters decisions in the cases of change of Publicis charters, M&A, distribution of dividends, capital offerings and share repurchase. 5. Dentsu Inc. announced today that it has reached an agreement to form a strategic global alliance with a new company created through the merger of Bcom3 Group, Inc., a U.S. based communications group and Publicis Groupe S.A., a major European communication group headquarted in France (published in Dentsus website Investors relations 7 March 2002. Emphasis added). Yukata Narita, Dentsus president, further commented: We aim to provide the very best marketing communication services covering every domain in the world market by integrating the power of the three corporations. By doing so, we believe we can win the confidence of clients and establish the very best global network (emphasis added). 6. CDC invests funds collected through the Livret A (typical non-risk placement for French households) and acts as a long-term owner in a large number of French firms. The CDC director is nominated by the French president.

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APPENDIX 11.1
Table A11.1
Year 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

SHAREHOLDER AGREEMENTS IN FRENCH LISTED FIRMS

Number of shareholder agreements

Number of (new) shareholder agreements1 16 26 34 56 37 66 45 Not available 16 58 25

Note: 1 Including changes in shareholder contracts (avenants) and changes in equity shares held by shareholders included in shareholder agreement. Excluding breach and end of contracts (rsiliation, declaration de fin de concert, fin de clauses, caducit dune convention) as mentionned in the comment section of the database. Source: amf-france.org

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APPENDIX 11.2
Table A11.2
Firm Pernod Ricard Agreement

DETAILED CONTENT OF SHAREHOLDER AGREEMENTS

Agreement on the voting patterns/voting rights Both investors agree to vote in concert In case of disagreement between parties, Kirin commits to vote in favor of all resolutions proposed by the board of directors of Pernod Ricard and to equally vote against resolutions that were not accepted by the board on issues related to: Nomination and compensation of directors Modification of the firms charters M&A Extraordinary dividends Measures against takeovers Agreement on the sale and purchase of shares Kirin commits not to sell its shares before the end of the agreement (31 Dec. 2007) After Dec. 2007, Pernod Ricard has a preemptive right to buy Kirins shares at the following price: the average between (1) the average weighted stock price over the 30-day period before Kirin announced its willingness to sell out and (2) the average weighted stock price over the 30-day period before Kirin effectively sells its shares. Publicis Agreement on the board structure Dentsu will be granted 2 seats on the supervisory board (as long as it owns at least 10% of the equity); in case the total number of directors increases, Dentsu will be granted additional seats in proportion to its voting rights. Dentsu commits to nominate or maintain all supervisory board members who have been chosen by E. Badinter Dentsu commits to nominate E. Badinter or any representative (proposed by her) as the chairman of the supervisory board Dentsy commits to nominate all management team members proposed by E. Badinter A strategic committee (named special committee will be formed. Members will be nominated by E. Badinter and Dentsu (with E. Badinter having the discretion to nominate the majority of members) Agreement on the voting patterns/voting rights Dentsu will not be able to own more than 15% of voting rights (33.5% for E. Badinter) Dentsu commits to vote in favor of E. Badinters decisions in the following cases:

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Table A11.2
Firm

(continued)

Agreement

Change of Publicis charters M&A Distribution of dividends Capital offerings Share repurchases Dentsu may freely vote (after consultation with E. Badinter) on the related topics Transfer of assets Granting of subscription rights Reserved capital offerings Transaction involving E. Badinter, Dentsu or a subsidiary of Publicis Dentsu commits to vote in favor of the certified accounts, after Dentsus comments have been taken into account by the financial auditors Agreement on the sale and purchase of shares In case of seasoned offers (that is, share issues by companies who have already listed shares), Dentsu will be granted an antidilution right. Yet it will not be able to participate in the offer through preferred subscription rights Dentsu will not be able to transfer or sell its equity shares in Publicis until July 2012 After July 2012, E. Badinter has a preemptive right to buy Dentsus shares Dentsu commits not to make any special arrangements with Publicis management without prior notice of E. Badinter. Conversely for E. Badinter Club Med Agreement on the board structure Fipar is granted the right to propose the nomination of one director (as long as it owns 4% equity) All investors commit to vote in favor of this nominee, and fire the directors that would be requested by Fipar Accor will keep one representative on the board of directors Agreement on the voting patterns/voting rights All investors confirm to support current managements strategy Agreement on the sale and purchase of shares Investors agree not to sell any of their shares without informing the other investors for a period of 2 years Investors agree not to increase their ownership level (on an individual or collective basis) until either the agreement or the date when the group of investors will own less than 20% of Club Meds equity or voting rights

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Table A11.2
Firm

(continued)

Agreement After two years, investors have the preemptive right on the purchase of shares sold by other investors The parties may unanimously decide to lift the ban on additional share purchases so as to increase their shares in Club Meds equity Agreement on takeovers: in case of takeover, investors are allowed to sell their shares only if Club Meds board of directors has given its agreement on the takeover. If one of the parties wishes to make a competitive offer, it may terminate the agreement Non-equity and control issues Icade (real estate arm of institutional investor CDC) has joined the agreement under the specific condition that it will conclude a contract with Club Med related to real estate issues Agreement on the board structure The board will include 11 members Until the initial period (2 years and 3 months after the IPO date), the parties agree that the board will be composed of: 3 representatives of each signing party 2 independent board members 3 top managers After the initial period, Wendel and KKR commit that the board will be constituted by a majority of board members nominated by both parties In addition, Wendel and KKR will be granted seats in proportion to their respective voting rights The governance structure will include A strategic committee, chaired by a KKR representative A compensation committee, chaired by a Wendel representative An audit committee, chaired by an independent board member Agreement on voting patterns/voting rights Wendel and KKR forbid to vote in favor of granting dual rights to shareholders holding Legrands shares for more than two years The chairman of the board will be granted significant discretion with respect to the daily management of the firm, except on decisions relative to Share offer and buy back Subscription of new debt or early pay back Acquisition of equity shares in other firms, acquisition of other businesses and JV for deals above 50m

Legrand

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Table A11.2
Firm

(continued)

Agreement Sell-out of businesses asset or participation above 50m Agreement or modification of Legrands 3-year strategic plan and annual budget Firing or nominating auditors Any projects that would entail the full or partial transfer of Legrands assets Any deal that would result in equity increase of equity reduction, including convertible debt or preferred shares The cancelling out of double voting rights or any decision that would modify the voting rights attached to Legrands shares Any modification of the governance rules, such as the composition of the board The introduction of Legrands shares in a stock market other than Euronext A voluntary liquidation of the firm or any decision that would generate a collective procedure against Legrand Any modification of Legrands charters that would favor one of the parties Any transaction or treaty if amounts at stake exceed 50m The parties commit that Lumina White (Lumina Participation) will vote in accordance with KKR and Wendel. In case of disagreement between the parties, Lumina White will conform to instructions given its owners in relation to their respective shares Agreement on the sale and purchase of shares Wendel and KKR both commit not to sell their equity shares before the end of the restrictive period (the minimum between (1) 18 months after the expiration of the lock-up period for syndicate loans and (2) date when the parties have jointly agreed they could sell a portion of their stocks) Some transactions will however be allowed: Cessions in favor of entities which are fully owned by either Wender or KKR (socits apparentes) Cessions that do not exceed 10m, in so far as the other party has been informed at least the day before the transaction Cessions of shares in favor of a board member of Legrand, to the extent that it does not exceed what is written in the charters After the restriction period, the sell-out of Legrands shares will be unrestrained as long as it is consistent with The right of preemptive offer The ban on block sell-out and joint sell-out (tag along) applicables to blocks Cessions that are forbidden by the investors agreement contract

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Table A11.2
Firm

(continued)

Agreement The stipulations of offering rights agreement and tag along agreement Preemptive right: each party commits to inform the other party when it wishes to sell its shares. The remaining party has the right to make a preemptive offer (at a price which equals or is superior to the one offered by the selling party) Block sell-out: when one of the parties wishes to sell out its shares in blocks, it is required to inform the other party through a letter. The recipient has 5 days to also inform the seller that it equally wishes to sell its shares. The seller commits to inform the other parties in advance of the conditions of the block sell-out Under the tag along agreement, if the informed party does not wish to sell its shares, the seller will be authorized to sell all of its shares. If the second party also wants to sell its shares, a specific rule of share allocation will be enforced. Each party will be authorized to sell only a specific portion of their shares. Each party has agreed not to sell its blocks of shares to an industrial firm above a value of 100m The above conditions do not hold for: Cessions of shares authorized along prior conditions Cessions sold within a seasoned offer led by a banking syndicate (following a guarantee contract) Swaps by one of the parties between Legrand securities and Legrand stocks or other financial instruments Cessions in the context of a takeover All cessions ruled by the tag along agreement (agreement relative to the joint cession of Legrands shares after the IPO) Agreement on takeovers by one of the parties Each party commits to get the written consent of the other party before its proceeds to a takeover offer. The informed party has three days to give its answer. Beyond this period, agreement is assumed. In case of disagreement, the takeover party is expected to incur all costs related to the offer If after the takeover offer, one of the parties becomes a majority owner and the other one a minority owner, a new investors agreement will be concluded. In any case, this new agreement will give the minority investor a veto right on all strategic decisions on Legrand as long the minority investor holds 20% of the voting rights In addition, a joint exit right will be implemented if the majority owner wants to sell its block equity

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Table A11.2
Firm

(continued)

Agreement

Schneider 2002. Agreement on the sale and purchase of shares Second modification (avenant) of the investors agreement Electric contract signed in 1993 between AXA, BNP-Paribas & AGF. Updates the respective equity shares included in the agreement, i.e. 3%, 1.4% and 0.4% of capital 2006. Agreement on the sale and purchase of shares AXA commits to keep at least 2.5m equity shares in Schneider Schneider commits to keep at least 8.8m equity shares in AXA In case of a hostile takeover of Schneider, AXA has the right to purchase all AXA shares still owned by Schneider; conversely for Schneider

12.

Board governance of family firms and business groups with a unique regional dataset
Llus Bru and Rafel Cresp

1.

INTRODUCTION

This study is a detailed description with methodological contribution to the measurement of a set of family business groups in the Balearics region in Spain that belong to either the Balearic Family Business Association (ABEF) or the nationwide association, the Spanish Family Business Institute (IEF). Before we discuss the object of our study, we will examine the main aspects that characterize the family business as an economic organization. Next, we will display their economic activity and relevance in the regions economy. Subsequently, we will take a closer look at the economic behaviour and organization of the 556 companies that belong to the 50 family business groups. In our description we will examine these companies on two levels. First, each individual company will be contemplated as a separate economic entity. Second, we will offer a specific description of each family business group. For this, we have used the data we have on the family companies and their boards of directors as the essential basic information for our study. The main methodological innovation of our study is that the Spanish two-surnames system allows us to analyse in detail the family ties among administrators at both the firm and the business group level.

2.

OUR DEFINITION OF THE FAMILY BUSINESS

What is understood by the term family business? We might define the family business as a company that fulfils two basic requirements: persistent belonging to individuals within a single family circle, and being governed by one or more of the members of that family.
292

Board governance of family firms and business groups

293

When applying this definition to specific companies, to avoid ambiguity it is important to be more precise about what we exactly mean by a family company. Three factors are taken into consideration in our attempt to define a family business.1 First, the ownership of the company by a family is essential for such company to be defined as a family business. Typically we use the term family firm when the majority of the capital, with the corresponding voting rights, is owned by individuals from a single family circle, in such a manner that we can be sure that the family do govern the fate and future of the company. Whilst the control of the company can occasionally be attained with a minority of shares, it is most common to see most of the share capital in the hands of the family. To possess the majority of the voting rights means having the power to take all sorts of strategic and operative decisions within the company. Of course, the greater the percentage of ownership, the stronger the familys influence on the fate of the company. The second defining feature of the family business is that the management of the company is controlled by the family members, who are also the primary decision makers. However, when analysing any firm, we know it is important to distinguish between the management of the company and its control. In the family company, when it is said that one or more members of the family take part in the management, this could mean that such members undertake the control and management activities simultaneously this is frequently the case in first-generation companies and small businesses or it may imply that they only undertake the control of the company, while the business is managed by professional managers who do not belong to the family. This latter case is more typical of companies in which the ownership is distributed among many members of the third and subsequent generations of a family and is also commonly seen in the case of large companies. Although the management activities of the family company are frequently conceived of as remaining in the hands of the family members, it is no less true that, if the family actively controls the company, this would be enough of a determining factor in the companys decision-making process, and thus in the path that the company will follow. The third defining characteristic of the family company is the familys continuous involvement over time, through successive generations of the same family. It makes no sense to speak of a family business if the company does not continue to be a long time under the control of the family circle.2 This aspect greatly limits the scope of enterprises that we refer to when we speak of a family company and defines certain aspects of business organization as distinguishing features of the family business.

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Thus, the transmission of the ownership, the requirements established to enable family members to become a part of the company, the leadership in the successive generations and the necessary attraction of professionals who are not family members are relevant issues in any study of the family business.

3.

DATA SOURCES AND METHODOLOGY

The quantitative information used in this study comes from the Spanish section of the Amadeus database, created by Bureau Van Djick, which basically compiles data that Spanish companies are required to record with the Companies Registry. Because this database is computerized, its contents can be processed, as we will see below. The large number of companies included in the database (virtually all of the Spanish companies) has enabled us to cover information on large, medium and small companies throughout Spain over several years. In fact, the number of Spanish companies included in the last database update was 830,000, and for the autonomous region of the Balearic Islands this figure was 26,747. There are essentially four types of information in the database that are relevant to our study: (i) the financial statements, (ii) information on the activities that the companies are engaged in, (iii) the list of administrators of the companies and the positions they hold, and finally (iv) the ownership listings, including both company shareholders and companies partially owned by other companies. The financial statements, including the balance sheets and operating statements, give us information on the size of the companies analysed and offer us an approach to the structure of their share capital. Certain proportions of business debt and earnings can also be compared among companies. The information on the business line of activity of each company is primarily based on that companys assigned NACE (economic business activity) code. This classification makes it possible to assign each company a highly specific economic activity code, up to four digits, gradually adding in three-, two- and one-digit codes, to progressively specify the economic activity, while at the same time enabling companies with similar economic activities to be grouped together. The list of company administrators is essential to our purpose, as it allows us to measure the extent to which family businesses entrust the seats on their boards of directors (and therefore the firms governance and management powers) to family members. Here we can make use of the information that the Spanish two-surnames incorporate. This surname

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system is very suitable for genealogical purposes, because it has two features that help to establish kinships. First, married women usually do not change their name; and secondly, every newborn has two surnames or family names (apellidos in Spanish): the first is the fathers first surname, and the second is the mothers first surname.3 Having the names and surnames of the administrators makes it possible to process family ties on the computer, using first two surnames (enabling us to infer whether or not two administrators are siblings) and then one surname, which allows us to trace the generational family ties among administrators of different generations (parents and children, grandparents and grandchildren, uncles/aunts and nieces/nephews, and so on) as well as among those of the same generation (cousins). By way of example, consider the very simple board of directors of Barcelo Corporacion Empresarial SA, a firm pertaining to the Barcelo family included in our sample: Board of directors of Barcelo Corporacion Empresarial SA Barcelo Vadell, Simon Pedro Barcelo Tous, Guillermo Barcelo Vadell, Francisca Gonzalez Rodrguez, Raul The names of the boards members are stated in the following order: fathers surname, mothers surname, and finally Christian name (possibly two, as in Simon Pedro). The coincidence of two surnames in exactly the same order (Barcelo first, then Vadell) allows us to infer that Simon Pedro and Francisca are siblings; whereas the fact that there is only one surname that coincides between them and Guillermo Barcelo Tous allows us to infer that they either pertain to a different generation or are cousins (the order also allows us to discard some family ties; for instance, Guillermo cannot be Franciscas son, since Barcelo would then appear in second place). Finally, the fourth member of the board is not identified as a member of the family, since there is no coincidence whatsoever of surnames. Finally, the lists of company shareholders show the proportions of share capital held by the individual shareholders of the firms, establishing who the last shareholder is. This information is not available for all of the companies included in the database. Another relevant type of information is the structure of the companies that control other subsidiary companies, with information on the percentage of their interest in their affiliates. This information is particularly useful to ascertain business groups and shed light on the relations between the companies and the ties between their administrators.

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Based on the personal information of the members of the ABEF and the Balearic families that belong to the IEF, we have used the Amadeus database to outline the different business groups in the Balearics. Our starting point was the notion that a company belongs to the family group whenever it is controlled by the family. To establish the business groups, we applied the following steps: (i) initially the family group included the companies in which the corporate partner who was a member of the above-mentioned associations figured as a company board member with significant ownership of the companies; (ii) subsequently, the group came to include companies in which its direct family members also figured as board members; (iii) this extended to the companies that were partially owned by the above companies, with the condition that such ownership consisted of at least one-fourth of the share capital; (iv) once firms were identified, we checked with representatives of the family firms associations the identification of firms within family business groups, correcting case by case any possible error which stemmed from the automated processes described in steps (i) to (iii). Finally, different controls were applied to the data to ensure that the companies analysed were indeed engaged in an actual economic activity. We eliminated from our sample any companies in the process of liquidation, those with no existing income and asset volume data for 2004 financial year, which was the last year fully published in the database, as well as the companies in which either of these two measures did not reach 60 000. Following the application of these selection criteria, the resulting number of sample companies was 556. Below we will describe the group of companies analysed. Prior to a detailed description of the family businesses, the object of our study, we offer some aggregate figures on these companies that show the significant amount of economic activity that they generate, and thus the importance of studying them. Subsequently, we explore these companies in some detail by applying two different procedures: first, we will analyse the companies individually; next, we group the companies according to the family that controls them, which gives us a group of companies for each of the 50 families of the Balearic Islands that form part of the ABEF or IEF. 3.1 The Relevance of Associated Family Companies in the Region

To address the relative importance of the member companies of the family business association in the Balearics, we can compare the figures of their economic activity with the economic activity volume generated in the autonomous region at large, namely the regional gross domestic product (GDP), or we can consider the number of workers employed by these

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Table 12.1

Aggregate values of the main magnitudes of the sample family companies

Total value in thousands of

Total assets Revenue Employees (number) Added value Equity Earnings before taxes Corporation tax

14 200 000 10 600 000 70 269 2 867 307 6 599 452 486 969 139 261

companies compared with the number of active workers in the Balearic Islands.4 In Table 12.1 we see that the 556 companies in our sample had a total asset volume of more than 14 200 million euros in 2004. If we add up the income volume generated by each of the 556 sample companies, our total is 10 060 million euros. By way of reference, for the year 2004 the value of the gross domestic product for the Balearic Islands was approximately 20 900 million euros. Obviously these figures are not comparable in the sense that the asset is a stock measure and the GDP a flow measure. To attain a figure that can be compared with the regional GDP we must refer to the added value generated by the companies in our sample. For this item, the value was 2867 million euros. As to the employee volume, the aggregate figure for 372 of the 556 companies that we have information on comes to more than 70 000 workers. Once again and to attain a point of reference, according to the statistics of the INE (Spanish Institute of Statistics), the employment volume for the year 2004 in the Balearic Islands was 455 000.5 Table 12.1 describes some aggregated data of interest on our sample of family businesses, including the value of their equity, which comes to nearly 6600 million euros; the earnings before taxes, which are approximately 486 million euros; and the total corporation tax, which comes to 139.26 million euros. Another aspect worth bearing in mind is the organization and control of the companies. All in all, the 556 companies have structured their governing bodies with a total of 2244 board members, and an average of 4.04 members, where 77.6 per cent of them are men, in 4.5 per cent of the cases another company figures as a board member in the official register, and nearly 18 per cent of board members are women. This first approach to associated family companies in the Balearic Islands gives us an idea albeit

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a rather imprecise one of their relative importance, and thus reveals their most salient magnitudes. A more in-depth study will enable us to characterize them according to what we might refer to as the typical or average company.

4.
4.1

COMPANIES UNDER THE CONTROL OF ASSOCIATED FAMILIES

The Representative Company

Characterizing the typical business based on our sample of 556 companies is by no means easy, given their vastly diverse sizes and the different sectors of activity that they belong to. Nevertheless, we see that the average company has assets of around 25.5 million euros, a revenue volume of 19.6 million euros and equity of approximately 5.19 million euros for the year 2004, as shown in Table 12.2. However these average values represent a great deal of dispersion among the 556 companies in the sample. The standard deviations are more than five times higher than the average values, which points to the bias introduced by several extreme observations, due to their very high values, for any of the financial magnitudes that we are contemplating. Hence, the median of the 556 sample companies can better characterize the typical company. We can now see that the observation of the company holding the central position in our sample is smaller than what the average of the observations could lead us to believe: it has an asset value of 2.6 million euros and a revenue volume of 1.27 million euros, it generates an added value of 543 million euros, and its equity is approximately 1 million euros. Panel B of Table 12.2 informs us about the boards of directors of these firms. The representative company has an average of four board members, one of which is a woman and the rest of which are men, with the exception of several seats assigned to legal entities (companies). The average business age of the 556 sample companies is 17.5 years. This is not excessively far from the median, which is 14 years. Panel C of Table 12.2 displays data on the average number of employees, which represents a great deal of dispersion, making the interpretation of this item quite difficult. Nevertheless, by examining the average data we can see that a third of the income from operations is allocated to staff salaries, and that the average return for shareholders is 10.4 per cent. This value goes down to 2.4 per cent when placed in relation to the return on assets. Finally, we can give information on the solvency ratio, which takes

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Table 12.2

Descriptive statistics of average values of the main magnitudes of the sample family companies (2004)
Values in thousands of

Panel A Total assets Revenue Added value Equity Earnings before taxes Corporation tax Panel B Size of board of directors Men on board of directors Women on board of directors Companies on the board of directors Panel C Employees (number) Company age (years) Staff costs/income from operations (%) Solvency ratio (%) Return on shareholders investments (%) Return on assets (%)

average 25 519 19 683 5 194 11 870 889 255

median 2 683 1 278 543 1 001 23 4

standard deviation 142 167 100 152 30 035 69 350 5 414 1 456

4.04 3.13 0.721 0.182

4 3 0 0

2.8 2.28 1.06 0.647

189 17.5 33.2 43.7 10.4 2.4

27 14.0 22.3 42.2 5.2 1.3

1 033 12.9 53.2 40.2 84.5 18.8

in the proportion of the companys assets in relation to its net worth. In this case, the average value is 43.7 per cent, which is very similar to the median for the same item. This review of the financial magnitudes and administrative bodies enables us to make an initial approach. However, the high variability on the observed magnitudes suggests that a more detailed study is in order, distinguishing the characteristics of the companies according to their size or their sector of activity, as we shall see in the sections below. 4.2 Differences According to Size

In this section we have established the parameters for company comparisons by grouping them according to their size. To do so, we have divided

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the sample into three groups, corresponding to what we shall refer to as small, medium and large enterprises, according to their asset volume. Each tertile of the 556 sample companies is made up of 185 companies.6 This procedure aims to show more homogeneity than the analysis in the above section, amid the companies of each tertile, and in turn enables us to see any differences that may emerge among the companies that belong to different size groups. The values of Panel A in Table 12.3 illustrate the significant differences between small, medium and large enterprises. Thus, the average small company has an asset volume of 484 000 euros and a revenue volume of 711 000 euros, generates an added value of 238 000 euros, and its average earnings before taxes are 7000 euros. As a group, the 185 small companies only generate 126.6 million euros, for a total asset volume of 89.5 million euros. Their overall earnings before taxes are around 1.27 million euros. At the opposite end of the spectrum, large companies together account for more than 90 per cent of the revenue volume, number of employees and asset volume for the sum total of all the companies in our sample. On average, the large companies have 33.8 million euros in equity, and the earnings before taxes of the average company within this group come to nearly 2.5 million euros. The typical medium company generates a revenue volume of 2.7 million euros, with assets of 3.14 million euros, and equity for a value of 1.46 million euros. As a group, these 186 medium companies account for approximately 500 million euros in assets and revenue, with aggregate earnings before taxes of 24.67 million euros. Beyond the descriptive figures mentioned above it is interesting to observe the behaviour of the magnitudes associated with the corporate governing bodies according to their size. In Panel B in Table 12.3 we can see that, for the same number of companies in each size group, the total number of board members is 901 for large enterprises, 543 for small enterprises, and 803 for medium companies. Indeed, it is plain to see that the average size of the board of directors goes up as the company grows larger in size. The average values are 2.94 board members for the small companies, 4.34 for the medium companies, and 4.84 for the large companies. This comes as no surprise, if we consider that larger companies may require a greater participation in their government. For example, the corporate governance report for Spanish listed companies, Corporate Governance Report of the Companies with Values Listed in Stock Exchanges for the 2004 year, published by the regulator of the Spanish Stock Exchange, the Comision Nacional del Mercado de Valores (CNMV), reveals that the number of board members also rises with the size of the companies listed on the Spanish Stock Exchange, although the average number of members

Table 12.3

Average and total values of the main magnitudes of the sample family companies for three size levels, based on assets
small total 89 587 126 629 1 450 43 613 38 792 1 273 1 185 3 140 2 726 28 836 1 460 135 53 580 901 493 350 3 772 153 870 270 012 24 647 9 746 72 678 55 101 440 14 431 33 821 2 492 694 average total average medium large total 13 500 000 10 000 000 65 047 2 669 824 6 290 648 461 049 128 330

Panel A (thousands )

average

Total assets Revenue Employees (number) Added value Equity Earnings before taxes Corporation tax

484 711 16 238 210 7 7

301 543 444 76 23 0.22 0.74 3.38 4.34 803 625 136 41

Panel B (number of persons) 4.84 3.62 1.02 0.20 901 673 189 37

2.94

2.40

0.41

Size of board of directors Men on board of directors Women on board of directors Companies on the board of directors

0.12

Note:

Data correspond to the 2004 year, with 185 companies for the small and large tertiles and 186 for the medium company tertile.

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Table 12.4

Average values of the proportions of the main magnitudes of the sample family companies for three size levels, based on assets
small medium 19.9 31.2 46.0 1.4 3.9 large 18.6 31.4 41.4 10.7 2.7

Age (years) Staff cost/income from operations (%) Solvency ratio (%) Return on shareholders investments (%) Return on assets (%)

13.9 38.2 43.6 22.1 0.6

Note: Data correspond to the 2004 year, with 185 companies for the small and large company tertiles and 186 companies for the medium company tertile.

is not directly comparable with the companies in our sample, as the average number of board members for the listed companies is 9.7. While there are differences in the number of board members according to the size of the family companies, differences can also be seen in their composition. The proportion of women on the boards of directors of the small companies is 14 per cent, becoming 16.9 per cent in the medium companies and reaching 21 per cent in the large companies. Finally, the size-based classification enables us to observe some proportions regarding the cost, profitability and structure of the family businesses. Table 12.4 shows no significant difference in the average age of the medium and large enterprises, standing at approximately 19 years for both groups. However, the average age of the small companies is markedly lower: 13.9 years. Moreover, it seems that the small companies tend to be more labour intensive, as they allocate a larger proportion of their revenue to staff salaries (38.2 per cent, in relation to the 31 per cent allocated by medium and large companies). The solvency ratio oscillates between 41 per cent and 46 per cent, with no apparent pattern related to the average size of the companies. The profitability ratios display the greatest differences in the average values according to company size. The returns for shareholders are higher for small companies than for large ones, whilst, on the other hand, the return on assets is greater for the large and medium companies. The medium companies, in this comparison, present the lowest shareholders returns of the three groups and the highest total returns on assets.7 In any case, we must proceed with caution when considering these average values, for two reasons. The first is the heterogeneity of the companies included in each

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group, as these average values are not weighted, meaning that they place the same relative importance on the smallest company within the tertile as they do on the largest. The second reason lies in the database, which conveys the information provided by the companies to the Trade Registry. A significant number of the very small companies present unaudited accounts, as the regulations in force do not require them to be audited. 4.3 Sector of Activity Diversity

Indeed, the vast disparities in the sizes of the companies allow us to observe differences in some of their behaviour variables such as profitability and the composition of their boards of directors. All the same, there are operational aspects of the companies that could potentially affect their profitability, and which are tied to their specific business activity. In this section we present different magnitudes, assessing the companies together according to their sector of activity at the NACE one-digit level. Table 12.5 illustrates the main measurement magnitudes of the companies by sector of activity, and shows the distribution of the sample companies among the eight major sectors into which the sample has been divided. Most of the economic activity, according to the aggregate values of asset and revenue volume, resides in three sectors of activity: hotel and catering, transport and communications, and real estate and business services. These three sectors embrace the majority of the companies associated with tourism, which is characteristic of the Balearic economy. Along these lines, Table 12.5 suggests that the distribution of economic activity for family firms follows a similar pattern to that of the Balearic GDP. Moreover, the distribution of the companies in the sample, which was calculated with different variables such as the number of companies in the sample, asset value and revenue level, is similar to the relative weight of each of the sectors in the Balearic economy, as shown in Table 12.5. The distribution of the number of companies in the sample is to a large degree in line with the data on the regional GDP composition, with the exception of the grouping of other activities, which takes in such diverse activities as education, healthcare and veterinary activities, social services, personal services and financial intermediation. The figures of the companies in hotel and catering and in real estate and business services are representative of the considerable weight of the tourist industry in the Balearic Islands, as it includes lodging in hotel establishments and other forms of rentals, and also what is known as the complementary supply. By asset volume, the average size of the hotel companies is significantly greater than those of agriculture, industry, construction and trade, despite the fact that its number is equal to the sum of those that form these other

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Table 12.5

Relative relevance of the economic activity sectors in the 556 sample companies
Companies in sample (%) Contribution of the sector to regional GDP (%) 3.64 Companies sample assets (%) 0.12 Companies sample revenues (%) 0.05

Agriculture, livestock, fishing and power Industry Construction Trade and repairs Hotel and catering Transport and communications Real estate and business services Other activities

1.26

6.29 6.29 9.53 21.76 12.59 35.61 6.65

5.75 10.43 9.93 25.22 8.96 18.16 17.92

1.59 1.75 2.70 43.74 8.03 40.98 1.09

2.41 1.90 7.45 22.53 41.55 23.59 0.52

Note: Comparison of relative weights of the magnitudes of asset size and revenue volume, as well as the number of sample companies, with industry distribution reported by the National Institute of Statistics (INE) in the regional accounts. The industry groupings are based on the NACE 1-digit level.

sectors. The high average revenue volume of the companies in transport and communications is due to the fact that this sector includes the Balearic Islands major travel agencies,8 which are well-established nationally and internationally and have relatively very high revenues and assets. To assess profitability, labour expenses and financial structure, Table 12.6 displays the corresponding proportions after weighting these values according to the size of the companies, which in turn was calculated according to the asset volume of each company. This prevents us from attributing to a small company the same weight that we attribute to the large sample companies in the same sector. Particularly worthy of note in the column on staff expenses over income from operations is the high intensity of labour in the primary sector and the other activities group, which is essentially made up of personal services. As to the solvency ratios, the low values for the construction companies are salient, which is now typical of this sector and of the transport and communications sector, given the high debt rates in relation to their equity. As regards the returns on assets, the values oscillate within margins that display little dispersion among the sectors. The return on stockholders equity, however, exhibits greater dispersion, although

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Table 12.6

Proportions of profit, financial structure and expenses by activity sector

Return No. of Return on companies shareholders on assets (%) investments (%) Solvency ratio (%) Staff cost / income from operations (%) 43.1

Agriculture, livestock, fishing and power Industry Construction Trade and repairs Hotel and catering Transport and communications Real estate and business services Other activities Total

25.6

4.0

51.6

35 35 53 121 70 198 37 556

2.4 26.3 16.7 7.0 39.5 8.0 5.6 10.5

3.6 5.0 8.5 3.6 4.2 2.7 3.0 3.4

38.6 23.5 46.0 45.0 18.3 60.3 54.2 48.8

24.3 15.7 8.5 33.9 10.9 38.5 71.5 32.6

Note: The proportions were weighted according to the size of each company, bearing in mind each companys total assets.

it must be viewed with caution, as some of the companies do not present audited financial statements, as we have mentioned, and the absence of certain observations could distort the average values of the sample.

5.

BUSINESS GROUPS UNDER THE CONTROL OF ASSOCIATED FAMILIES

Although we have explored the family companies in the section above, we have to consider the fact that each family can control more than one company. Naturally a family will not take a certain business decision for each company separately, but rather will consider the group of companies under its control as a whole. This calls for a description of business groups under the control of each family in the sample. The key to making this possible resides in the ability to build the group of companies to be assigned to each of the families, so as to assess the decisions of the associated corporate families in the Balearic Islands.9 The first issue that we can address by studying the family groups is

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the concentration or dispersion of sizes among the different family groups, and, within them, the differences we observe among the companies within each group. By individually studying the companies in the above section, we have seen vast differences in size, sector and even governing body composition. By attaching these companies to their respective family groups, the questions regarding heterogeneity continue to be of application among companies of a single-family group. We also explore the families corporate diversification strategy, distinguishing the degree of sector diversification, according to whether diversification revolves around a main business activity (related diversification) or whether sector diversification is more intense, meaning that it is not necessarily linked to any initial core business. Finally, we delve more deeply into the administrative and management bodies of the business groups and the degree of involvement of the controlling family. 5.1 Family Group Heterogeneity

Among the family groups studied, the typical one has an average of 11 companies, with a total asset value of 283 million euros and an average revenue nearing 213 million euros, and provides employment to a total of 1464 employees. These averages represent a great deal of dispersion, however. Another way of characterizing the usual family group would be to consider the median of the values mentioned above: 7 companies per family group, with a total revenue volume of around 29 million euros, and total assets of nearly 42 million euros. These are family group companies with an age of around 18 years and are run and controlled by the second or third generation of the family. To address the structure of the companies that form the family groups, we can present two opposite structures. On one hand, there are groups made up of several companies (on average seven), all of which are equally important as regards the volume of activity or the asset volume. On the other hand, there may be business groups that are formed by many companies but there is one of them that generates nearly all of their aggregate activity, while the other companies are virtually insignificant. What is the most common structure among the family groups in our sample? What we see is that they tend more towards the second situation than the first, although with significant differences. Indeed, Table 12.7 shows that the largest company of each of the 50 family groups of our study generates 53 per cent of the total asset volume and 44 per cent of the total revenue of the group.10 The degree to which the activity is concentrated in a reduced number of companies can also be seen in the fact that the three largest companies in each group represent three

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Table 12.7

Distribution of the importance of the largest and succeeding companies in each group in the study sample
Proportion of total activity (%) Assets 53.0 17.7 6.6 4.6 2.9 Accumulated 53.0 70.7 77.3 81.9 84.9 Revenue 44.1 19.0 13.0 3.8 2.0 Accumulated 44.1 63.1 76.1 79.9 81.9

Importance of the company in the group largest second third fourth fifth

quarters of the family group activity, both in terms of asset volume and in terms of revenues. For 36 of the 50 family groups that have formed five or more companies, the total activity of those five largest companies accounts for nearly 85 per cent of the group total, while the fifth most important company represents only 3.6 per cent of the groups activity. As regards their legal format, 270 of the 556 are limited companies, 282 are public limited companies and 4 are other types of organizations. Among the largest companies in the 50 family groups, 34 are public limited companies and 16 are limited companies. Thus, we can confirm that the business structure of the associated family companies in the Balearics is complex, though it is built upon a small number of companies. In many cases, hidden beneath the number of companies that sustain the family business structure there is a diversification strategy. Indeed diversification into activities that may or may not be similar to the core activities of the family business is important from the perspective of the diversification of risks. In the next section we apply the appropriate method to explore their diversification strategies. 5.2 Measurement of Family Group Diversification

When we speak of business diversification we refer to the entry of a company, business group or shareholder into a number of different economic activities. Alternatively, a non-diversification strategy means focusing on a single activity or line of business. Moreover, it is common in the business and the economics literature to distinguish between related and unrelated diversification. Related diversification implies involvement in several different lines of activity that share a group of corporate resources and the same organizational abilities or skills. The sharing of technology, sales forces or distribution activities might be considered an example of related diversification. When these

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technological, commercial or skill-related connections do not exist among different business units, diversification is understood as being unrelated.11 Undoubtedly, any abstract classification ranging between the extremes of non-diversification and maximum unrelated diversification enables the practice of many different levels or degrees of diversification. The actual positioning of each company or business group on this scale between the extremes can be empirically measured thanks to the existence of universally accepted sectorial classification standards. We will use below the European sectorial classification (NACE) system implemented by Eurostat, which uses four-digit codes to classify the different types of activities. There are also three-digit groupings, and two-digit divisions, which can be broken down into one-digit divisions for large-scale sectorial grouping. Moreover the database we use assigns each company a main activity code and another secondary activity code, which allows us to measure the distance between the sectorial activities, bringing us closer to the concepts of related and unrelated diversification. In the case of family groups, the relevant unit with which to study the level of diversification is the family group, not the individual company.12 A first simple way to measure the family business groups sectorial diversification consists of simply counting the number of different activity codes within a group. For the three- or four-digit NACE codes, a high number of different codes will mean a high degree of related diversification. A high number of different NACE onedigit codes, on the other hand, would be indicative of the groups unrelated diversification. Obviously, if all of the activity revolves around a single NACE code, regardless of the number of companies that make up the group, this tells us that the family group has chosen to focus its economic activity on very few activities. In other words, it has decided not to diversify. Table 12.8 illustrates how the median number of activities of the family business groups is amid three different codes, if measured within the NACE one-digit code for large sectors. When we further specify the breakdown of the codes, the averages for two- and three-digit codes are 3 and 4 respectively. The company groups with an average of 6 companies are devoted to 4 different activities if calculated with the NACE 3-digit code, or to 3, if the NACE calculation is within the one-digit sphere. For the values of the average number of activities of the 50 family business groups taken together, the number of different sectors increases with the level of precision (number of digits considered) from 2.76 for a one-digit NACE to 4.9 for a three-digit NACE. In other words, the 11.2 companies of the average are devoted to only 2.76 different NACE one-digit activities, whilst the number of different activities of these companies with greater sectorial precision is 4.9. However, these levels of diversification provide little information, as it is difficult to establish points of comparison. Nor

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Table 12.8

Family groups and sectorial diversification according to number of different NACE codes and group size
Number of different NACE codes 1 digit 2 3 3 3 2 digits 2 3 6 3 3 digits 3 4 6 4 Number of companies per group 3 6 16 6.5

Panel A: median values Family group size Small Medium Large Overall Panel B: average values Small Medium Large Overall 2.00 2.59 3.65 2.76

2.31 3.12 5.82 3.78

2.69 3.76 8.12 4.90

3.25 6.88 22.76 11.12

can such points of comparison be established with non-family-business groups, as it becomes difficult to define where these other groups begin and end. Moreover, there are no references for other studies on family business groups in other geographic regions, thus making the assessment of these levels of sectorial dispersion more difficult. All the same, Table 12.8 displays some interesting results: if we divide our sample of 50 family business groups into three sub-groups according to their size, we will see how the small groups form an average of around 3.25 companies per group, the medium family groups have 6.8 companies and the large groups show an average of 22.7. The overall median value of these large family groups is 16 companies per group. In other words, we see that the greater organizational complexity of large family groups by virtue of their numerous companies is actually based on businesses within the same activity sector. At the other extreme, for the smaller family groups each branch of activity appears to be proportionally closer to a different company, particularly for the three-digit sectorial classification. This first approach to the diversification strategies of the family business groups leads us to the conclusion that large groups tend to diversify more in absolute terms, which is probably explained by the fact that their larger size entails a large number of companies, in relation to the medium and small family business groups. We can also conclude that when entering new economic activity sectors, which may or may not be interrelated, the large family groups do so with a larger number of companies, whereas the small family groups tend more towards the structure of companies that are each associated with a different activity, if they opt for several companies.

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A descriptive study based on calculating the number of different activities that a family business group has become involved in is highly simplistic. Such approach assumes that each and every one of the activities bears the same weight within the business group, thus skewing the results towards potentially fictitious diversification rates. Hence, we next proceed to a more sophisticated analysis that takes into account the relative importance of each of the companies within the group. The literature on business diversification often makes use of the entropy measure to offer a weighted assessment of the degree of sectorial diversification, enabling the distinction between related and unrelated diversification. Our entropy measure uses a weighted average of the activities within the business group at a NACE three-digit level in relation to diversification at a one-digit level.13 This is a typical continuum measurement that assigns higher values to high diversification levels and lower values to low diversification levels. By way of example, consider two business groups with construction, hotel and food activities. Group A has 90 per cent of its activity in hotels, 5 per cent in construction and another 5 per cent in food. Group B has one-third of its activity in each of the aforementioned sectors. If we only take into account the different NACE numbers in each case, there are 3 in both groups, leading to the misleading conclusion that Group A is just as diversified as Group B. The entropy index instead gives us a value of 0.39 for Group A, whereas for Group B the index is 1.09. The entropy index is thus a more precise depiction of the concept of business diversification. As occurs with the NACE number diversification measure, the simple observation of the entropy index values offers little information on the intensity of diversification. Once again, because we have no non-family business groups as a control group, our study must be limited to the differences in behaviour according to the size of the different family business groups. Panel A of Table 12.9, which shows the entropy index diversification median values for each of the three family group sizes, does not differ considerably from Panel B, which displays the average of each of these groupings. We must point out that related diversification is more important than unrelated diversification for any family group size. In fact, in Panel B, the average of the entropy coefficient for all of the business groups together is 0.93 while the unrelated diversification is 0.56. Hence related diversification accounts for 62 per cent of the total diversification, and unrelated diversification explains the remaining 38 per cent. These values show how diversification particularly revolves around the groups core business areas, though with some dispersion in areas that are not directly related to such central business activities. This behaviour is more pronounced in the small family groups, which

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Table 12.9

Family groups and entropy coefficient for related and unrelated diversification according to the size of the business group
Diversification Related 0.71 0.79 0.90 0.81 Unrelated 0.55 0.60 0.68 0.6 Total 1.38 1.51 1.75 1.48

Panel A: median values Family group size Small Medium Large Overall Panel B: average values Small Medium Large Overall 0.84 0.90 1.03 0.93

0.44 0.59 0.64 0.56

1.28 1.50 1.67 1.49

often hinge two-thirds of their diversification on a main activity. Even though the entropy measure plots the relative importance of an economic activity sector within the family group, the diversification value is greater in large groups than in small groups, for both related and unrelated diversification. As a result, we see that the larger family groups diversify more than smaller groups, even when the measure of diversification weights the relative importance of each activity. This effect of diversification is based more on related diversification for the small groups than for the larger groups. The concept of entropy takes in the organizations natural tendency to become more complex through time. In our case, diversification comes to take on this tendency in connection with the growth and age of the organizations, and particularly for family businesses in which successive generations are admitted into the company. In the case that this assertion is true, the level of diversification will grow with the overall age of the companies that make up the family business group. In fact, as can be seen in Figure 12.1, the business groups that amass greater experience, with more consolidated and more numerous companies, adopt higher levels of diversification. For well-established family groups with several generations of experience, the evolution through time that accompanies the years of business experience leads to the decision to diversify to a greater extent than the diversification generally undertaken by younger family groups. This study of diversification gives us a reference of the behavioural business patterns of the family groups to diversify risks by investing in

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Small groups Medium groups Large groups

1000 Accumulated number of years of companies of the group

Total diversification values Adjustment

500

0 0.5 1 1.5 2 2.5 0.5 1 1.5 2 2.5 0.5 1 1.5 2 2.5

Figure 12.1

Level of sectorial diversification (entropy) and accumulated age of the companies within the family group

different sectors of activity. It is not only the reduction of financial risks that explains the tendency to diversify. Economic efficiency reasons, such as the attainment of economies of scope, capitalizing on specific skills or aptitudes within the company, or the mere need to allocate the funds generated by the business activity can explain this tendency to diversify. On the other hand, diversification also brings along potential expenses, given the need to incorporate new skills into unrelated activities, difficulties in implementing systems of control when the activities are diverse and even inefficiencies in the allocation of resources outside the discipline of the capital markets. The advantages and disadvantages of business diversification are processed by the controlling shareholders, which by definition in the case of family groups are the family members. All the same, diversification can require the incorporation of new skills or simply of new financial partners, which can lead to the possible dilution of family control. These aspects are further explored in the next section. 5.3 Business Group Directors and the Family

The control of the companies within a family group can be organized into many different possible models between two extremes: at one end of the spectrum, the governing bodies can revolve around a small number of people who amass offices as board members in each of the companies;

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and, at the other end, the administrative bodies can be entrusted to a large number of individuals that barely repeat from one company to another. If we form a hypothetical board of directors of the business group, by adding up the members of the boards of directors within the family groups, we can shed some light on these matters. The representative family group of our sample, made up of 11 companies and 4 board members per company, could be described, at the lowermost limit, as a family group entrusted to a number of people that equals the size of the largest board in the group.14 On the other hand, the maximum possible number of board members could be applied, in which case it would be made up of 44 different people. Table 12.10 illustrates the average and median values for the 50 family groups in our sample. Panel A shows how the median number of companies per family group is 6 and the number of board member posts to be covered is 23. On average, the family groups entrust these 23 board positions to 10 different individuals. Panels C and D of Table 12.10 contain the proportions of each type of relative in relation to the size of the board. The median (Panel C) for the dispersion of individuals is 43 per cent, and the average for such items is 41 per cent, as can be seen in the same column in Panel D. As we have seen in the previous section, there are significant differences in the median values for the business groups according to their size per asset volume. Thus, the small groups with 3 companies use 4 different individuals to cover the 7 positions. Abounding in this sub-sample of smaller family groups are companies with sole administrators. This circumstance makes the proportions to which they become open to different individuals higher than in larger size business groups. For the large groups, as illustrated in Panel B, the number of different individuals is higher, simply due to the larger size of their boards of directors. However, the proportion of different individuals is the lowest of the three business group sizes, with a proportion of 38 per cent, as shown in Panel D. As a result, we can conclude that the associated family groups in the Balearics rely on a common nucleus of 6 people for every 10 board positions to be covered. This proportion is smaller in the small family groups than in the larger ones, which in absolute terms place their posts in the hands of a larger number of different individuals. These measures of diversity or dispersion of individuals do not necessarily comply with the dictates of the family centre of control. Thus, for companies that have outside members or bring in experts in certain lines of business for technological reasons, the dispersion rates can vary considerably. Yet, from the perspective of family groups, the salient question is how many of the individuals that form part of the boards of directors actually share family ties. The data available in the public registries, which in this

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Table 12.10

Opening of family groups to non-family board members, for different degrees of kinship, according to the size of the business group
Dispersion of board members (number) Number of Board companies members per group 3 6 16 6 7 22 59 23 Different individuals 4 9 34 10 Different siblings 3.5 7 29 8 Different cousins 2.75 4.5 19 6

Panel A: median values Family group size Small Medium Large Overall Panel B: average values Small Medium Large Overall Panel C: median proportions Small Medium Large Overall Panel D: average proportions Small Medium Large Overall 3.25 6.88 22.76 11.12 10.69 24.18 93.59 44.44

Dispersion of board members (number) 7.13 11.12 35.29 18.06 4.81 8.65 30.29 14.78 3.88 6.59 19.53 10.12

Dispersion of board members (proportion) 0.57 0.41 0.58 0.43 0.50 0.32 0.49 0.35 0.39 0.20 0.32 0.26

Dispersion of board members (proportion) 0.67 0.46 0.38 0.41 0.45 0.36 0.32 0.33 0.36 0.27 0.21 0.23

case come from the Trade Registry (information recorded in the SABI database we use), give us the identities of the members of the different boards of directors. One way to examine family control and take advantage of the name and two-surname structure in force in Spain is to look at the number of family ties among board members. Thus, the individuals who share both first and second surnames will be listed as siblings, and those who share only one surname will be listed as cousins. The sibling kinship listings will seldom lead to an error when considering family ties,

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with the exception of situations that stem from second marriages or other special cases. Undoubtedly however, our cousin listing covers many family relations beyond those known as cousins in daily language, as it includes, in addition to actual cousins, parentchild and grandparentgrandchild relations, and uncle/auntniece/nephew relations. The concurrence of surnames on a board of directors of a family group is a reasonable indication of the degree of kinship among its members, and its consideration thus enables us to quantitatively evaluate the extent to which families keep the control of the business groups in the hands of family members or the degree to which they are open to the inclusion of non-family members on their boards of directors. Among the measures of dispersion of board members, Table 12.10 also offers the median and average values for the number of different siblings in the Balearic family groups. For a typical business group, taking the median values (Panel A), with 6 companies and 23 board members, the administrative bodies are made up of 10 different individuals. Eight of them have different pairs of surnames, suggesting that 2 of the 10 are siblings. Moreover, 6 of the 10 members show no surname concurrence with any of the other members, leading us to believe that there are 2 individuals of the remaining 8 who have a family relationship that we have generically listed as cousins. These median measures of dispersion for the family group are not proportionally very different from the values presented by the average, which can be seen in Panel D of Table 12.10. In fact, every 10 seats on the boards of directors are covered by a little more than 4 individuals (average 41 per cent proportion). More than 3 of those individuals are not siblings (average 33 per cent proportion), and nearly 2 of them have no family relationship that can be inferred from the surname (average 23 per cent proportion). Panel D of Table 12.10 also shows us the existing differences between the small family groups and the larger ones, as regards the proportion of board members that share family ties. The small family groups incorporate greater proportions of individuals without sibling or cousin family ties onto their boards of directors. These proportions of outsiders to the family are considerably lower in the large family groups, despite the fact that the latter tend to incorporate a larger number of non-family members on their boards, by virtue of the larger numbers of board seats. 5.4 Sector Diversification and Family Control

There is one last aspect that allows us to find relations between two of the points that we have discussed thus far: on one hand, diversification as a

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relevant aspect of the family group policy, and on the other, the degree to which the boards of directors are open to include board members from outside the family. Here, the relevant question is whether the family groups that opt for greater sectorial diversification do so through tighter family control over the governing bodies or whether they rather tend to be more open to the inclusion of outsiders on their boards of directors. There are numerous theory-based arguments in favour of and against family control of diversified companies. Family expansion in new business areas may require the incorporation of new members, whether financial (who contribute monetary resources) or technological (who bring in new know-how or organizational skills in order to carry out new activities). For a given size of the family that controls the business group, embarking on new business ventures can depend on the family members management skills or knowledge of the new sector. If these requirements are fulfilled, one could expect greater degrees of diversification to be accompanied by a larger number of members from outside the family, and the proportion of family members on the boards of the companies within the group would be lower than on those of the groups that do not diversify. On the other hand, the expansion into new business areas can also mean the potential loss of family control over the activities of the group of companies. The incorporation of new executive directors or managers of new business areas may require greater board supervision and control, which will be exercised by appointing family members as board members. In these situations, the mechanisms of trust are what justify a strong family presence to prevent the loss of control over the important decisions made in the groups companies. If this effect is prevalent, we might anticipate that the higher the degree of diversification, the higher the rates of family members on the boards of directors in the family business groups. Table 12.11 shows the average values and proportions of the groups openness to non-family members on the boards of directors, and divides the business groups according to their overall diversification level (measured by means of the entropy index). The results of Panel A are clear: greater diversification goes with a larger number of different individuals as well as a larger number of sibling board members. The cousin-relation trend follows a similar pattern: the greater the sectorial diversification, the larger the number of individuals with no surname concurrence. This trend is explained by the size of the business group: greater sectorial diversification also occurs with a higher number of group companies. This necessary opening of the company to incorporate new talent or new partners into the diversified activities is explained by how they complement the family administrators.

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Table 12.11

Opening of family groups to non-family board members, for different degrees of kinship, according to the degree of sectorial diversification
Dispersion of board members (number) Board members 10.69 24.18 93.59 43.46 Different individuals 7.13 11.12 35.29 18.06 Different siblings 4.81 8.65 30.29 14.78 Different cousins 3.88 6.59 19.53 10.12

Panel A: average values Sectoral diversification Low Medium High Overall Number of companies per group 3.25 6.88 22.76 11.12

Panel B: average proportions Sectoral diversification Low Medium High Overall

Dispersion of board members (proportion) Different individuals 0.67 0.46 0.38 0.42 Different siblings 0.45 0.36 0.32 0.34 Different cousins 0.36 0.27 0.21 0.23

Panel B of Table 12.11, nevertheless, shows that as the business groups diversify more, they become less open to non-family members. Indeed, the proportion of non-sibling board members in relation to the total number of board members for the group is 45 per cent for the family groups with more limited sectorial diversification, whereas for more diversified groups the rate is only 34 per cent. A similar result is seen when the type of family relation taken into consideration is limited to one surname. In such cases, the less diversified groups display a 36 per cent proportion of non-cousin individuals, whereas the more diversified groups only have a 21 per cent dispersion rate, suggesting that the remaining 79 per cent of the members share a surname. This study can lead to the conclusion that the more diversified business groups incorporate a larger number of new talents into their boards of directors, and that such new individuals do not necessarily share any family relations with already-existing members. Nevertheless, the control effect is also prevalent, as the proportion of non-family members brought into the group is increasingly lower in relation to the members that share some sort of family tie.

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6.

CONCLUSIONS

This chapter presents a general description of the business groups of families that belong to the ABEF and IEF associations in the Balearic Islands. The first thing to be verified, their economic relevance in the general level of economic activity of the Balearic Islands, has become evident when we evaluate their weight through aggregate measures such as total regional employment and GDP. We have presented a description of the organizational structure of the companies that belong to the associated families, which are analysed individually. Organizational aspects such as the size of the boards of directors and the most relevant economic information from their annual accounts reveal large disparities in activity sectors and company size. The relatively high presence of women in the governing bodies of the companies (by Spanish standards) is also worthy of note. The 566 sample companies are not intended to be a representative sample of the economic activity of the Balearics. However the distribution of their activities in the different sectors, and particularly those directly or indirectly associated with tourism, are not significantly different from the information of the aggregate official statistics. We also have analysed the characteristics of the business groups that have been formed around the 50 member families studied. Once again, the diversity of the sizes has allowed us to undertake a homogeneous comparison after grouping them according to their asset volume. These groups of companies are formed around one or two central companies, which generate nearly 70 per cent of their activity, despite the fact that the average number of companies per group is eleven. The largest family business groups present higher degrees of sectorial diversification, although it is the smallest groups that base a larger proportion of their diversification on activities that are not related to their main core business activity. The study of the governing bodies of the family groups reinforces the idea of family control in the sense that these groups rely on a small group of people to serve as board members in their companies, and the types of family relations among them are diverse. This phenomenon is more pronounced in the largest family groups: by having larger boards of directors, the number of different people that they rely on is also larger. However, these larger groups also show a larger proportion of board members that share family ties than the smallest family groups do. The trust effect inherent in the inclusion of officers that share family ties is predominant over the entry of non-family member officers for the companies with the highest rates of sectorial diversification, demonstrating that

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diversification strategies are possible while keeping the family structure of the business groups intact. Future studies could enhance the description of these family groups by following two basic approaches. The first would be to gradually incorporate new sources of data that would allow us to describe in greater detail the elements discussed here and explore new aspects of the organization of the family groups. For example, it would be interesting to look into the requirements for the degree of participation of women on the boards of directors of these companies. Could such participation be contingent on the founding generations continued control of the business group or on successive generations being incorporated into it? We have taken an aggregate approach to family relations, using public information. A detailed study of the specific posts held by the family members and outsiders might clarify the concept of family control, while enabling us to ascertain the true role of the women in this mechanism of control. Secondly, here we have offered a static description of these family business groups. It would be interesting to follow their evolution through time, which would allow us to examine the determining factors of the groups business organization decisions in greater detail, their diversification strategies, their organizational structure and even their profitability.

NOTES
1. See Shanker and Astrachan (1996) and Sharma (2003) for a discussion and different definitions of family firms, based on the degree of family involvement in the firm. Another literature develops a typology of family firms along the potential combinations of three axes: the ownership of the firm, the family structure and the characteristic of the company (see Gersick et al., 1997; Neubauer and Lank, 1998). Indeed, it has been argued that one main non-pecuniary benefit for family members to own and control a firm is the satisfaction of transferring the firm to the descendants (see Casson, 1999). The law has recently been modified in Spain, so that the order of surnames can be changed: first the mothers surname, and then the fathers surname. This change can be done by mutual agreement of both parents, or by the choice of the concerned individual when he/she reaches the age of majority (18 years). Until now this modification has had almost no practical impact on the structure of surnames in Spain. In any case, the reader will have to bear in mind that the data on the companies studied do not exclusively refer to the economic activity or employment generated in the Balearic Islands. Indeed, when a hotel chain of an ABEF member, for example, has establishments in Mexico, and its earnings are calculated within a Spanish company that is included in the database that we have used, such economic activity is under the control of the member families of the ABEF and is therefore taken into account in our study of the economic activity of the family businesses under control of ABEF-member families, although it is not an economic activity in the Balearic Islands. Similarly, our study calculates the activity of the Banca March, where it is a well-known fact that this institution has a large number of offices outside of the Balearics that generate employment

2. 3.

4.

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and economic activity outside of the Islands. By our definition, this is a new economic activity under the control of a Balearic family business. Let us recall again that we must proceed with caution when drawing these comparisons, as the sample includes companies under the control of the families of family business associations in the Balearic Islands, regardless of where their activity is carried out, and in some cases a significant part of such activity is undertaken outside of the Islands. Actually, the middle tertile is made up of 186 companies. The univariant study presented does not allow us to reach any conclusions or explanations for the non-monotonic behaviour of a variable, although we could make some speculations on this significant fact. These also include those of the group Globalia. Section 3 above explains the procedure we follow to assign the companies to Balearic ABEF- and IEF-member families. If, rather than measuring the importance in relation to the total activity volume, the average relative importance of the largest company is measured and expressed in the percentage of each family group, such percentage goes up to 56 per cent. There is a large literature that tries to evaluate the possible benefits of diversification for firms; see Campa and Kedia (2002), Grant et al. (1988), Hadlock et al. (2001) and Villalonga (2004). For the particular case of family firms, see Anderson and Leeb (2003). Anyway, let us mention that, for the family firm, Anderson and Reeb (2003) find that family firms diversify less than non-family firms. The use of the entropy index for measuring diversification is based on work by Jacquemin and Berry (1979). For further details, see Appendix 12.1, which displays the breakdown of the entropy index. For a group of 11 companies with 4 board members each, the minimum number of people to whom the administration would be entrusted in this case would be 4.

5.

6. 7. 8. 9. 10. 11.

12. 13. 14.

REFERENCES
Anderson, R.C. and D.M. Reeb (2003), Founding-family ownership, corporate diversification, and firm leverage, The Journal of Law and Economics, 46, 65384. Campa, J.M. and S. Kedia (2002), Explaining the diversification discount, The Journal of Finance, 57 (4), 17362. Casson, M. (1999), The economics of the family firm, Scandinavian Economic History Review, 47, 1023. Gersick, K.E., J.A. Davis, M. Hampton and I. Lansberg (1997), Generation to Generation: Life Cycles of the Family Business, Boston: Harvard Business School Press. Grant, R.M., A.P. Jammine and H. Thomas (1988), Diversity, diversification, and profitability among British manufacturing companies, Academy of Management Journal, 31, 771801. Hadlock, C., M. Ryngaert and S. Thomas (2001), Corporate structure and equity offerings: are there benefits to diversification?, Journal of Business, 74 (4) 61335. Jacquemin, A.P. and C.H. Berry (1979), Entropy measure of diversification and corporate growth, Journal of Industrial Economics, 27, 35969. Neubauer, F. and A.G. Lank (1998), The Family Business: Its Governance for Sustainability, London: Macmillan. Shanker, M.C. and J.H. Astrachan (1996), Myths and realities: family businesses

Board governance of family firms and business groups

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contribution to the US economy: a framework for assessing family business statistics, Family Business Review, 9 (2), 10723. Sharma, P. (2003), Stakeholder mapping technique: toward the development of a family firm typology, mimeo, Laurier Business & Economics. Villalonga, B. (2004), Diversification discount or premium? New evidence from the business information tracking series, Journal of Finance, 59 (2), 475502.

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APPENDIX 12.1

THE ENTROPY INDEX

This index is used as a measurement of diversity. In our case, it allows us to assess the extent to which a family group diversifies its activity in different economic sectors. If Pij is the proportion of the assets of a given business group in activity i (NACE 3-digit code) in industry j (NACE one-digit code), the entropy index for the total diversification of this business group is calculated as follows:
m n

Total diversification 5 DT 5 a a [ Pij 3 ln (1/Pij) ] for Pij 2 0

j51 i51

Jacquemin and Berry (1979) propose the following breakdown of the total diversification into related and unrelated diversification:
m n Pij Pij Related diversification 5 DR 5 a Pj a c a b 3 lna b d Pj Pj j51 i51 m Pij Non-related diversification 5 DNR 5 a Pj 3 lna b P j51 j

It must be noted that these two measurements and the measurement of total diversification are consistent in the sense that the measurement of the entropy of the total diversification is the sum of the related and unrelated diversification, DT 5 DR 1 DNR. Reference
Jacquemin, A.P. and C.H. Berry (1979), Entropy measure of diversification and corporate growth, Journal of Industrial Economics, 27, 35969.

13.

Better firm performance with employees on the board?

R. ystein Strm*

1.

INTRODUCTION

This chapter deals with the impact of co-determination1 upon firm performance. Two conflicting views on the benefits of co-determination exist. One says that co-determination increases firm performance, either because employee directors supply outside directors with information they would otherwise not have access to (Freeman and Reed, 1983; Blair, 1995), or because co-determination is a safeguard against dismissal, inducing employees to invest in firm-specific human capital (Zingales, 2000; Becht et al., 2003). The other view is that owners and employees interests are not aligned, and therefore allowing employees into the boardroom means that conflicting goals are pursued. When decision makers with different objectives share in the boards decisions, its focus may become unclear (Tirole, 2001), its decision time longer (Mueller, 2003), and its decision quality inferior.2 The prediction is that firm performance will be lower than it could otherwise be. Even though co-determination is important in many European countries,3 few firm-level studies have been made of its firm performance impact. This chapter is an attempt to bring more academic research to the still under-researched (Goergen, 2007) comparison of firm performance in shareholder determined companies and co-determined companies. Earlier studies give mixed results, showing a negative impact in German firms (Fitzroy and Kraft, 1993; Schmid and Seger, 1998; and Gorton and Schmid, 2000, 2004), Canadian (Falaye et al., 2006), and Norwegian (Bhren and Strm, 2008), but a positive impact in a later German study (Fauver and Fuerst, 2006). Compared with former literature, the simultaneous equation estimation of the relationship between firm performance and explanatory variables is the distinctive feature of this chapter. The need for simultaneous modelling arises from the fact that the presence of employee directors may induce shareholders to adjust other governance mechanisms, notably board
323

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composition and leverage, in order to neutralize the co-determination effects (Buchanan and Tullock, 1962). Employee directors may have a direct impact upon firm performance, but also an indirect effect. This also means that board composition is at least partly determined by employee directors. Thus, the chapter necessarily also relates to the board endogeneity issue (Hermalin and Weisbach, 2003). And since the data cover several periods, it is possible to test the reverse causation hypothesis that firm performance determines board composition (Hermalin and Weisbach, 1998). The simultaneous equation setup allows not only the discovery of endogeneity in governance mechanisms, but also a quantification of its importance compared with direct effects. I am unaware of former literature containing a measure of the endogeneity effects. The chapters results come from a panel data set of non-financial firms spanning the 14 years from 1989 to 2002, containing financial information, data on ownership, and board composition data. Employee representation was mandated by law in 1972 in Norway, and regulations have remained almost unchanged since (Aarbakke et al., 1999). The data on employee directors seem to be superior to those pulled from German and Canadian institutional frameworks. While the employee director in a German board may be elected from the national labour union, and the Canadian evidence is from firms where employees have considerable shareholdings, in Norway the employee director must be employed in the company. Furthermore, because the mandatory employee director rules only apply to certain firms, some firms have employee directors, others have none. Thus, the study avoids the Dow (2003, p. 87) objection that empirical investigations on the effects of employee directors suffer from a lack of control group. Thus, unlike previous studies, the Norwegian institutional framework allows comparison between similar firms with and without employee directors. This setting allows for sharper estimates of the co-determination effects. The chapter has relevance for the emerging regulation literature on boards (Hermalin, 2005). Because the sample includes both the co-determined (by regulation) and the shareholder determined kind, I can study the effects of governance regulation by comparing the two sub-samples. Compared with the related Bhren and Strm (2008) study, I introduce a number of new features. I construct a board structure index that captures many standard board characteristics in the same manner as Bertrand and Mullainathan (2001), I add financial leverage and average wage as new explanatory variables, I perform a system estimation rather than a single-equation estimation, and I make separate regressions for various sub-samples, for instance employee director firms only. These steps should yield better estimations of the employee director impact than the partial regressions in Bhren and Strm (2008), and should also subject the

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co-determination hypothesis to more severe robustness tests. Furthermore, I confirm their results when using individual board characteristics instead of the board index. In order to fully utilize the information in the panel data, I use the fixed effects model (Woolridge, 2002), employing a three-stage least squares (3SLS) methodology in system estimations. With the fixed effects method, I am able to remove firm heterogeneity, as did Palia (2001). Therefore, few (if any) control variables are needed. Using Tobins Q as the measure of firm performance, the results confirm the employee directors negative relationship to firm performance in earlier studies, but also show a positive indirect effect on the board index and leverage. This reflects endogeneity, but the economic significance of the indirect effects turn out to be much smaller than the direct. The reverse causation hypothesis also finds confirmation, since lagged firm performance is significant regarding both the board index and leverage. But again, the indirect effects of the lagged firm performance are low compared with the direct. I find clear differences in the various board characteristics impact upon firm performance in sub-samples of co-determined and shareholderdetermined firms. This means that regulations have costs, both in relation to firm performance and in the remaking of boards. The results stand up to a number of robustness tests, including alternative performance measures (stock return and accounting return on assets), and also to dividends replacing leverage. The chapter proceeds as follows. In the next section, a brief review of the literature is given. Then, in Section 3 testable implications are spelled out. Section 4 contains data sources and institutional background, while Section 5 discusses estimation methodology. Then Section 6 shows results, in Section 7 robustness checks are undertaken, and Section 8 concludes.

2.

LITERATURE REVIEW

Few empirical studies of co-determination have been undertaken. Evidence in Fitzroy and Kraft (1993), Schmid and Seger (1998), and Gorton and Schmid (2000, 2004) shows that co-determination has a negative economic effect upon firms in Germany, where employees have the right to equal representation in the Aufsichtsrat with shareholders. Recently, Fauver and Fuerst (2006) find a positive relationship to performance in a 2003 sample of German companies in information intensive industries. In the regressions with all industries, however, the relationship is not significant. The German data often contain two kinds of employee directors, some elected from among the employees in the company and others, national

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union representatives. In contrast, the Norwegian system is such that only persons employed in the company may be elected. Thus only a company and not a national union representative may sit on a Norwegian board. Presumably, company employed persons are more authentic stakeholders than their national union representatives. Using Canadian data, Falaye et al. (2006) find that firms giving employees a greater voice in corporate governance spend less on new capital, take fewer risks, grow more slowly, create fewer new jobs, deviate more from value maximization, show greater cash flow problems, and exhibit lower labour and total factor productivity. This chapter is set in a different institutional environment. The Canadian employee directors are elected in their capacity as owners of company shares. The influence of these directors on firm performance thus picks up two effects, one as a supplier of labour services, the other as owner. None of these studies use panel data or simultaneous data estimations. Using Norwegian data, Bhren and Strm (2008) show that the employee director variable has a negative impact upon Tobins Q. They also find evidence of interdependencies among board characteristics. However, they do not explore the indirect effects of co-determination, nor do they carry their analyses into sub-samples of co-determined and shareholder determined firms. In this chapter, the analysis is extended to include effects upon average wage, leverage is a new governance variable, and the board index is defined; I employ simultaneous equations modelling, and perform regressions in sharply defined sub-samples. The robustness tests are also more extensive, as I use return on assets and stock return as new dependent variables, and also vary the definition of the board index.

3.
3.1

THEORY AND HYPOTHESES

Stakeholder or Interest Group?

Board decisions include the formulation and control of strategy, larger investments and disinvestments, and the determination of the companys organization. Employee directors influence upon these decisions may have long-time impact upon firm performance. Therefore, an analysis over a long period of time is needed to detect the effects. The impact upon firm performance could be positive, non-significant, or negative. One possibility is that the firm performance and employee link is positive. Blair and Stout (1999) view stakeholders as members in a team production. Since stakeholders make firm-specific investments, it is in their interest to co-operate. The firm-specific human capital investments make

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the employees residual claimants to much the same extent as shareholders (Zingales, 2000; Becht et al., 2003). The upshot is that employees should be represented on the board, and that this co-determination will lead to improved firm performance. The conclusion rests on the argument that the stakeholders, including the shareholders, interests are aligned. How could this be manifested in the board? Employee directors could have a dual informational role in bringing inside information to the board (Blair, 1995, p. 16) but also relating board information to the employees (Freeman and Lazear, 1995). Since employees are in the middle of the day-to-day running of the company, they may bring valuable operational knowledge to the board. The information may expand on or contrast with information from the CEO. Thus, the information set available to the outside directors is enlarged. This comes close to viewing the employee director in the same role as the insider in the Raheja (2005) theory, although in this model the insider is willing to furnish the outside directors with information only if this furthers his own career interests. Secondly, the role as messengers of board information to the employees at large could be of particular value in the case of personnel reductions or plant closures, when the board may want to instil an understanding for the need for drastic measures among employees. The dual informational role of employee directors should lead to better firm performance (Fauver and Fuerst, 2006). Another possibility is that co-determination has no significance for firm performance. This may come about through co-optation (Pfeffer, 1981, pp. 16673). In the board employee directors are exposed to fiduciary duties and conformity pressures to accept the shareholder value logic. Also, since the employee director is made co-responsible for decisions with adverse outcomes for employees, the decisions carry higher legitimacy among employees. If co-optation is the case, interests are again aligned, but this time because employee directors have taken on the views of shareholders. The effect upon firm performance should be non-significant. The third possibility is that the co-determination impact upon firm performance is negative. It may be hard to accept the premise that stakeholder interests are aligned. If this were so, co-determination would be an efficient economic organizational mode, and firms would adopt this mode voluntarily (Jensen and Meckling, 1979; Hansmann, 1996). But while shareholders seek to maximize residual income, employees want to maximize pay and the protection of firm-specific human capital,4 that is, a part of the residual income. The inconsistency of these two objectives makes the board decision process longer and more difficult (Mueller, 2003). The firms objectives may become unfocused, and the CEO may develop capabilities as a compromise maker rather than a shaper of the firm under a

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clear objective (Tirole, 2001, 2002). The implied consensual decision model in co-determination means that the firm pursues stability and predictability instead of bold new moves (Siebert, 2005). If employee directors are successful, they should influence the average wage positively. The unfocused decision structure should result in weaker firm performance. I call this the interest conflict model for reference, and hypotheses stemming from the model are set forth in the next section. When objectives diverge, shareholders and employees may game against each other so as to further their own interests. Employees may furnish information strategically to further their own interests (Pistor, 1999; Hopt, 1998), and they may use moral arguments in parallel. Information strategizing could take the form of economizing on the supply of internal information to the board. For instance, employee directors may not inform of low productivity units in the organization. Another form could be information leakage from the board.5 Employee directors will hardly inform their fellow workers only on matters that owners and management find in their interests to inform about. Stakeholder theorists seem to assume only beneficial information dissemination through employee directors. Furthermore, moral arguments against, for instance, plant closures or high management pay may be put forward, too. The shareholder elected directors may have trouble withstanding such arguments, since they may experience large personal costs and small personal gains from making decisions that affect employees adversely (Baker et al., 1988). Taking the issue to the public attention could make the decision even harder for the shareholder elected directors. Thus, even though the employees are in a minority position in the board, they may influence board decisions to their advantage. Their access to board information seems to be vital in this respect. But the presence of employee directors may have indirect effects upon the use of other governance mechanisms as well. Shareholders may adjust governance mechanisms in order to neutralize the co-determination impact. This is analogous to the situation Buchanan and Tullock (1962) point out, that when an exogenous regulation is imposed upon a (political) committee, it will try to compensate for the regulatory effect by placing a heavier weight on the unregulated. These previously unexplored indirect effects make a simultaneous equations approach necessary. In the remainder of this section governance mechanisms and hypotheses about interactions are explained. 3.2 Simultaneity and Endogeneity

In a simultaneous equations system some variables are endogenous, others exogenous. In the present setup, the exogenous variables are the fraction of employee directors, the lagged firm performance, the firm size, and firm

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risk. Since employee directors are imposed from outside the firm, they must constitute an exogenous variable. These variables determine firm performance and average wage, but also the intervening governance variables, the board characteristics and leverage. Thus, the intervening governance variables and the average wage are at least partly determined by the employee directors and lagged firm performance. The simultaneous setup gives the researcher the opportunity to recognize the governance variables endogeneity, but at the same time also to measure the magnitude of the effect relative to their direct effects upon firm performance. Specifically, the co-determination hypothesis says that the mechanism of employee directors has a negative relationship to firm performance, but a positive one to average wage, the board characteristics, and leverage. The reverse causation hypothesis says that lagged firm performance is associated with governance variables and average wage, but that signs are uncertain. The remainder of this section concerns explanations of variables and their relationships. In this chapter, shareholders may adjust the board characteristics and the leverage. In order to achieve a reliable measure, and in the interest of economy, I build an index by including board characteristics that have proven to be important in board studies. The board index BI is:6 BI 5 DH 1 BN 2 BS 2 G (1)

DH is directors holdings, BN is the board network, BS is board size, and G is gender. The board index construction follows the Bertrand and Mullainathan (2001) procedure, as each index variable in equation (1) is standardized to have average zero and standard deviation 1 before summation. The sum is then standardized. This gives a continuous variable, in contrast to the Gompers et al. (2003) type of index. Their governance index is based upon a subjective allocation of categorical points for reasons that restrict shareholder rights, and then summed over all characteristics. Since all variables in equation (1) are continuous, the resulting index is continuous as well, and this is an advantage in estimations. Another advantage is that the index is likely to be more stable in sub-samples than the individual variables. The interpretation is that the higher the board index, the better is the board structure. It should be positive towards firm performance and negative towards average wage. If it is complementary to leverage, a positive sign will appear. The choice of variables in the index reflects important board characteristics that are decision variables for shareholders. Directors ownership represents the need for the board to be aligned with shareholders, the network variable the need for the board to be informed, the board size

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and gender diversity the need for the board to be decisive. The signs in are common findings in the literature. The ownership literature (Morck et al., 1988; McConnell and Servaes, 1990) confirms the positive sign on directors ownership share, and so do studies taking other board characteristics into account, for example, Bhren and Strm (2008).7 The network variable is little used in studies of boards, but Bhren and Strm (2008) find a positive sign.8 It comprises direct and indirect connections to other listed non-financial firms stemming from directors multiple board seats. A variety of studies, such as Yermack (1996) and Eisenberg et al. (1998), document that performance decreases with increasing board size. The relationship between gender and firm performance may be more controversial, as Shrader et al. (1997), Smith et al. (2006), and Bhren and Strm (2008) report a negative relationship, whereas Carter et al. (2003) find the opposite. I perform robustness tests with other definitions, described in Section 4, to test the choice of index. Next, I include leverage. A higher leverage will decrease the firms free cash flow, and will, therefore, limit the potential for agency costs (Easterbrook, 1984; Jensen, 1986). Perotti and Spier (1993) model how the lower free cash flow may be used as a bargaining tool against employees, implying better firm performance and lower average wage. Both effects should point to higher firm performance from higher leverage. However, the complexity of leverage leads to an indeterminate prediction. On the one hand, given the presence of employee directors, owners may fear higher debt may bring even higher decision costs. If, as Easterbrook (1984) supposes, higher leverage brings the lender into closer oversight of the firm, the firm may end up with three decision makers with potentially divergent interests. Furthermore, if the leverage is also used to signal investment prospects (Myers, 1977), a high leverage used to discipline employees can be taken to signal weak investment opportunities in the firm. Another aspect is that, as Tirole (2006, pp. 513) points out, higher leverage may cause costs related to illiquidity and bankruptcy. This complexity of leverage means that the sign is uncertain. It could be the case that shareholders in co-determined firms adjust the leverage in an effort to neutralize employee directors to a greater extent than they do in shareholder determined firms. In a simultaneous equations setup, Brick et al. (2005) find a negative relationship. Thus, I expect employee directors to be associated with better board composition and higher leverage. If these are successful from the shareholder point of view, a positive indirect effect may compensate for the negative direct employee director effect upon firm performance. In the stakeholder theory, the employee director should be a welcome addition to the board, and thus carry a positive sign to firm performance, while the indirect effects should not appear.

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In addition to the endogeneity induced by employee directors, the reverse causation hypothesis says governance mechanisms may be at least partly determined by past performance (Hermalin and Weisbach, 1998, 2003). The signs on the board index and the leverage may be difficult to set out. In the Hermalin and Weisbach (1998) bargaining model the CEO bargains over pay and monitoring intensity. Good past firm performance gives the CEO a better bargaining position, which he will use to reduce monitoring. This means that the association between past firm performance and governance mechanisms should be negative. However, it may well be that governance mechanisms are improved after a good performance, for instance, since the firm learns good practices. Since shareholders may adjust either board composition or leverage, or both, leverage and board composition may be either complements or substitutes (Agrawal and Knoeber, 1996). Thus, the sign is ambiguous. I study the direct and indirect effects of employee directors in a simultaneous setup. Since the lagged firm performance is included, the system is dynamic. Taken together, and with constants suppressed, this results in the system of equations

(2)

where FP is firm performance, and FPt21 indicates one period lag; W stands for the average wage, BI is the board index, DE is the leverage (debt to equity), ED is employee director, FS is firm size, FR is firm risk, and uit is the error term. The main hypotheses are summarized below the coefficients. Thus, the co-determination hypothesis is set out for the ED variable.

4.

DATA AND INSTITUTIONAL BACKGROUND

The sample comprises all non-financial firms listed on the Oslo Stock Exchange (OSE) at year-end at least once during the period 1989 to 2002.9

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Board data are collected from the handbook Kierulfs Hndbok for the first years, and from the national electronic register at Brnnysund from 1995. The register provides information on name, date of birth, and director status (chairman, vice-chairman, ordinary member, and employee director). The CEOs name and date of birth are recorded as well. The CEO or director name gives gender information. Data on board and CEO ownership, as well as outside ownership concentration, are pulled from the public securities register, while share price and accounting data come from OSEs data provider (Oslo Brs Informasjon). The ownership structure data cover every equity holding by every investor in each sample firm. By international standards, the size and quality of the data are considerable. The data for this chapter span the period from 1989 to 2002. During this period, the law regulating the governance of the companies is from 1972, with amendments in 1987 (Aksjeloven), and a new law in 1997 (Allmennaksjeloven). The regulations for representation have been unchanged since 1987. In this respect, there is no before-and-after situation, as with the Cadbury Committee (1992) report in the UK, in the sample period. As a general rule, firms with more than 200 employees must have at least two employee directors, or at least one-third of the board.10 In the size bracket 31 to 200 employees, the firm must have labour board seats if a majority of the employees vote in favour, first with one representative in the 31 to 50 bracket, then two in the 51 to 200. The employee director must be employed in the company. A number of important Norwegian industries are exempted from these rules, that is, the employees have no rights of representation in these industries. These include newspapers, news agencies, shipping, oil and gas extraction and financial firms. The characteristics of employee board representation mean that some firms have employee directors, others do not, and also that co-determined firms have different fractions of employee directors. Thus, an implication of the regulations is that comparisons of two sets of differently governed but otherwise similar firms can be made, and that further analyses can be carried out in subsamples of, say, co-determined firms with more than 200 employees. This data property answers the Dow (2003, p. 87) objection that the study of co-determined firms lacks a proper control group. I define the employee director variable as the fraction of employee directors, unlike most former studies, which only use employee directors as a dummy variable. This institutional framework offers advantages over the German and Canadian studies referred to in Section 2, since the Norwegian employee directors represent an authentic stakeholder group. The German regulations are such that one-third of the employee representatives on German boards need to be labour union officials (Siebert, 2005). Presumably, the

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union officials are supposed to look after the interests of workers in general, not only those in the firm. No such minimum is required in Norway, and the employee directors need to be employed in the firm. The Canadian co-determination comes about when workers are also shareholders in the company. This might cause a conflict of interests, when the optimal policy from the shareholder point of view is detrimental to the optimal policy for workers. In Norway, employee directors are elected in their capacity as workers in the firm, not through their shareholdings. The initiative for employee representation came from a joint committee of the Labour Party and the major employee union (LO) in the early 1960s. However, concurrent with this initiative, LO and the employer association (NAF) ran a co-operative project together with researchers to study co-determination in selected companies. This was in the consensus and cooperation spirit that arose from common war-time experience. The question was not only about co-determination, but also about new production methods. Later, the need for co-determination in order to improve productivity was the guiding principle of the official document NOU (1985:1), whose recommendations were unanimous, as opposed to the original 1971 report. The insider information argument was behind the codification of employee board representation in Norway. Thus, it seems as if the lawmakers were familiar with stakeholder theory. Brthen (1982, p. 14) interprets the law on co-determination to imply that profit maximization is no longer the single objective of the company. Employees interests now become one of several objectives the firm has to consider. Thus, a harmony of interests model is behind the regulations on co-determination in Norway. Next, I report some descriptive statistics on employee directors. Table 13.1 shows the number of employee directors in firms according to employment size. The table shows the percentage of firm-year observations of employee directors in various employment sizes. It turns out that in firms where employees may demand representation, few do so. In the 101200 employees category, 61.5 per cent do not have employee directors. Furthermore, in the highest category, where representation is compulsory if the industry is not exempted, employees have no board seats in about one-third of the companies. Among the firms that do have employee directors, the legal minimum, two representatives, is found in the majority of cases. Very few have four employee board seats. Thus, the Jensen and Meckling (1979) conjecture that co-determination requires law backing seems to be supported in our Norwegian data. Next, Table 13.2 shows the distribution of employee directors according to industry, and also the percentage of firms with no employees on the board in each year. Exempted industries such as Energy and Transport (including shipping) have no employee directors to a higher degree than average. The

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Table 13.1

The percentage of firms with zero or more employee directors by employment size
Employee directors 0 1 0.5 2.1 5.3 4.5 8.1 6.3 96 2 0.5 2.1 18.6 24.4 30.0 24.0 363 3 0.5 0.0 2.7 9.6 27.1 19.3 292 4 0.0 0.0 0.0 0.0 1.3 0.9 13 N 190 48 113 156 1006 1513

Employees

030 3150 51100 101200 200+ Total N

98.4 95.8 73.5 61.5 33.5 49.5 749

Note: The table shows the percentage of firms having employee directors, according to employment categories. N is the number of firms in the employee directors or the number of employees category. The number of employees category reflects the regulations on co-determination (Aarbakke et al., 1999). With more than 200 employees co-determination is compulsory. In the 31 to 200 bracket co-determination is realized if an employee majority demands it, with a larger proportion of representation with a larger workforce. In all categories, including the above 200 employees, firms in some industries are exempted from the rules.

low representation in Hotels, restaurants and entertainment is perhaps due to high labour turnover. The two industries Health care equipment and supplies and Software and supplies also have a lower than average representation. These are industries where the human capital element should be above average, and co-determination of extra value, according to stakeholder theory. Yet, obviously, employees do not demand board seats to a great extent. The time trend is that firms with no employee directors increase in relative importance. Thus, nothing in the overall descriptive statistics shows that co-determination is a preferred organizational mode. Firms seem to avoid it if they can, and keep it to a minimum if they cannot. Variable definitions are shown in Table 13.3, which also presents the main characteristics of variables in the analysis in the two main subsamples of co-determined and shareholder determined firms. The table shows that a large number of variables are distributed differently in the two sub-samples. The firm performance variables Tobins Q and stock return are not significantly different, while the ROA in co-determined firms is significantly higher than in shareholder determined firms. Apart from directors holdings, all other variables are significantly different at the 5.0 per cent level or better. Obviously, the two types of firms are different. The table shows that the fraction of employee directors is 0.301, or slightly below the minimum requirement for the 2001 employee size group.

Table 13.2 The percentage of firms with zero or more employee directors by industry and the percentage with zero by year
Employee directors 0 1 2 3 4 % of total N Year % no empdir N

Industry

335

Energy Materials Capital goods Commercial services Transport Autos and components Consumer articles, clothes Hotels, rest., entertainment Media Retailing Food/staples Retailing Beverages Health care equip./supplies Pharmaceuticals biotech. Real estate Software/supplies Hardware/equipment Telecom. Total

77.7 17.8 34.5 49.4 77.1 0.0 24.0 90.9 24.3 46.2 50.0 36.4 75.0 55.2 88.5 71.4 40.2 15.8 57.4

1.1 8.5 2.8 8.9 5.8 4.3 18.0 0.0 8.1 6.2 0.0 0.0 0.0 3.4 3.1 5.8 14.5 5.3 5.7

8.2 39.5 35.3 25.3 5.6 69.6 48.0 9.1 35.1 24.6 50.0 36.4 5.0 24.1 8.5 15.3 23.2 31.6 20.0

12.7 34.1 27.0 16.5 11.6 26.1 10.0 0.0 21.6 23.1 0.0 27.3 20.0 13.8 0.0 6.9 20.7 47.4 16.3

0.3 0.0 0.4 0.0 0.0 0.0 0.0 0.0 10.8 0.0 0.0 0.0 0.0 3.4 0.0 0.5 1.2 0.0 0.7

16.0 5.8 11.4 3.6 18.8 1.0 2.3 2.5 3.4 2.9 0.4 3.5 0.9 1.3 5.9 8.6 10.9 0.9 100.0

354 129 252 79 414 23 50 55 74 65 8 77 20 29 130 189 241 19 2208

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

50.5 49.5 48.4 45.3 48.4 52.4 61.3 60.9 62.8 59.0 57.3 58.4 60.9 61.8

95 99 93 95 91 103 186 192 215 217 213 209 202 199

57.4

2209

Note: The table shows the distribution of employee directors across industries. The Global Industry Classification Standard (GICS) is used. The whole or parts of the industry may be exempted, for instance the Energy (hydro power and petroleum) sector. Transport contains the important shipping segment. Media is exempted as well, but in some firms co-determination comes about through union negotiations. Empdir is short-hand for employee directors.

Table 13.3
Shareholder determined Median Std N Mean Median Std N Co-determined

Definitions of various board measures and their main statistical properties

Mean

F sign

336

Tobins Q Stock return ROA Average wage Directors holdings Network Size1 Gender1 Board index Leverage Div. payout rate Empdir Empdirfrac Firm size Systematic risk Volatility

1.461 16.109 3.272 558.442 0.065 0.180 4.834 0.024 0.192 2.387 0.197 0.000 0.000 5.427 0.828 0.918

1.105 1.700 6.220 340.878 0.000 0.198 5.000 0.000 0.233 1.165 0.000 0.000 0.000 5.462 0.724 0.646

1.156 121.515 18.840 1516.360 0.189 0.115 1.330 0.078 1.877 5.955 0.747 0.000 0.000 0.788 0.749 1.200

867 774 838 677 966 1264 1267 1267 965 857 960 1267 1267 905 888 885

1.501 17.666 6.531 355.909 0.063 0.191 5.341 0.045 0.271 1.903 0.261 2.282 0.301 6.071 0.707 0.738

1.162 2.520 8.210 316.306 0.000 0.208 5.000 0.000 0.078 1.044 0.085 2.000 0.300 6.021 0.690 0.584

1.064 78.204 13.883 222.129 0.187 0.075 1.271 0.101 1.956 3.216 0.564 0.707 0.082 0.725 0.535 0.597

773 724 771 762 825 942 942 942 825 761 822 942 942 801 794 788

0.459 0.770 0.000 0.000 0.828 0.015 0.000 0.000 0.000 0.046 0.042 0.000 0.000 0.000 0.000 0.000

337

Notes: Tobins Q is market value divided by book value of assets; Stock return is the raw stock return corrected for dividend and stock split; ROA is accounting profits on book value of assets; Average wage is the logarithm of total wages divided by the number of employees; Directors holdings is the percentage of directors ownership; Network is a summary measure of the boards direct and indirect relations to other firms through multiple directorships (see endnote 8); Size1 is the board size of shareholder elected directors; Gender1 is the fraction of women of the shareholder elected directors; Board index is a summary measure of the above board variables; Leverage is the book value of debt on book value of equity; Dividend payout rate is dividends on net income; Empdir is the number of employee directors divided by the number of directors; Empdirfrac is the fraction of employee directors in the total board; Firm size is the natural logarithm of accounting income; Systematic risk is the companys exposure to market changes (equity beta); Volatility is the firms total risk measured as its yearly standard deviation. The F sign shows the significance of the test of the null hypothesis that the two group means are equal, estimated from an analysis of variance (ANOVA). Low values indicate rejection of the null hypothesis. The F value is found by dividing the Between Groups Mean Square by the Error Mean Square (Johnson and Wichern, 1988, p. 235).

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Like the findings in Table 13.2, this is evidence that the firms attempt to minimize the employee director importance. The two firm groups differ in background variables, notably firm size. The co-determined firms are larger on average. This warrants paying particular attention to the largest firm size groups in regressions, in order to control for firm size biases.

5.

ESTIMATION AND METHOD

I estimate the relationships in equation (2) with simultaneous equations regressions on the full samples as well as sub-samples. The equations spell out behavioural relationships between variables. Since the equilibrium model of governance is not known, reduced form estimation is not possible (Greene, 2003, section 15.2). The equations are behavioural, but not structural in the sense of belonging to an equilibrium model. The fixed effects method (Woolridge, 2002) is common to all regressions. Fixed effects estimation amounts to removing the individual heterogeneity of firms contained in the fixed effect ci.11 Remember the error term in the system equation (2) is uit, which contains the fixed effect ci and a idiosyncratic effect vit, which varies over time and companies; i refers to the firm number, and t is the time period. When demeaning the variables, the fixed effect element disappears. So does the constant term. I use the three-stage least squares (3SLS) methodology in estimations. The 3SLS is an instrumental variables estimation method where the instruments are the predicted values of the dependent variable in a regression on all the explanatory variables in the system (Greene, 2003, p. 398). The predicted values are found from GLS regressions, and iterations are taken until convergence is achieved. Meaningful overall measures, such as R2 in OLS regressions, are not available. Instead, I include a Wald test (Greene, 2003, p. 107) to study whether all coefficients in a given equation are zero. The danger in simultaneous equation estimation lies in the model specification (Greene, 2003). If, for instance, a misspecification has occurred in the first equation, the mistake may contaminate all other equations as well. To investigate if this propagation of misspecification is a serious problem, I perform several robustness tests. I perform estimations in the full sample and for sub-samples. First, the model in equation (2) is estimated on the full sample with Tobins Q as firm performance, and then on sub-samples of co-determined and shareholder determined firms. The sub-sample tests will reveal whether results from the overall sample really apply to co-determined firms alone, or whether the employee director effect is merely due to difference in sampling. I further

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partition the sample to include only firms with more than 200 employees, when co-determination is compulsory. This will remove firm size effects. In robustness tests, I perform an estimation with all index variables included individually (the right hand side of equation (1) on p. 329), as well as an estimation of a wider definition of the board index,12 this time including non-significant effects in Bhren and Strm (2008) as well. Further robustness tests include replacing Tobins Q with ROA and stock return as a dependent variable, and replacing leverage with the dividend payout rate. Also, I remove the lagged firm performance in order to investigate whether parameter estimates remain stable. The last robustness test is a test of the Fauver and Fuerst (2006) information hypothesis, which I interpret to mean that in information intensive industries firm performance is improved with co-determination. This regression should show whether their positive employee director result is also the case in Norway. The explanatory variables are assumed to be simultaneous with firm performance. Since board members are predominantly elected in the late spring, the new board should also have had some time to make a noticeable impact upon firm performance, measured at year-end. This assumption is reasonable, given some market efficiency.

6.

ECONOMETRIC EVIDENCE

Do employee directors improve firm performance, and are governance mechanisms at least partly endogenously determined? This section reports simultaneous regression results of the model in equation (2). I estimate for the whole sample, and then turn to sub-samples of co-determined and shareholder determined companies, and for firms with more than 200 employees. All regressions are done with standardized values. This means that comparisons of economic importance can be read off from coefficient values. I start with estimations of the model in equation (2) for the entire sample. Table 13.4 shows the estimation results. The Wald tests show that no equation supports the null hypothesis that all coefficients are zero. Comparing the two sections of the table, signs and coefficient values are very much the same. Thus, I restrict comments to the case of systematic risk in the upper section. The co-determination hypothesis says that the employee director variable is negative to firm performance, and positive to the board index and leverage. Table 13.4 confirms this except for the leverage, where only the sign is as predicted. Furthermore, the co-determination hypothesis implies a positive impact on average wage. Here too, only the sign is confirmed.

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Table 13.4

Is co-determination associated with negative firm performance and positive governance mechanisms? Full sample (N51135) estimations using systematic and firm specific risk
Dependent variable Tobins Q 0.106** 0.035 0.122** 0.041** 0.119** 0.141** 0.004 79.516 0.000 0.105** 0.031 0.119** 0.034 0.123** 0.136** 0.045** 85.137 0.000 Average wage 0.028 0.030 0.145** 0.072 0.027 0.030 39.396 0.000 0.032 -0.029 0.131** 0.066 0.019 0.028 36.095 0.000 Board index 0.065* 0.038 0.171** 0.314** 0.060 0.010 82.612 0.000 0.062* 0.036 0.167** 0.311** 0.066 0.003 79.369 0.000 Leverage 0.094** 0.204** 0.191** 0.044 0.129** 0.035 87.617 0.000 0.082** 0.181** 0.182** 0.042 0.145** 0.116** 103.055 0.000

Independent Variable

Tobins Q lagged Average wage Board index Leverage Employee directors Firm size Systematic risk Wald c2 test p-value Tobins Q lagged Average wage Board index Leverage Employee directors Firm size Volatility Wald c2 test p-value

Notes: The table reports the simultaneous equation estimation of the system of equations in (2) with systematic risk (upper part) and firm-specific risk (lower part). The dependent variable is Tobins Q, which we measure as the market value of the firm over its book value. Variables are defined in Table 13.3. Each variable is time demeaned in the regressions. For each firm and each variable, I time demean by subtracting a given years observation from the firms overall mean. The table shows the estimates based on the standardized variables, which we construct by deducting each observation from its mean value and dividing by its standard deviation. Fixed effects estimation in 3SLS framework with standardized variables. All nonfinancial firms on Oslo Stock Exchange 1989 to 2002. The Wald test (Greene, 2003, p. 107) is here a test of the null hypothesis that the coefficients in the given equation are all zero. A low value indicates null hypothesis rejection. If R is the q 3 K matrix of q restrictions and K coefficients, g the K vector of coefficients, and r the vector of the q restrictions, the Wald c2 (q) statistic is c2 (q) 5 (r 2 Rg) r [ RSXRr ] 21 (r 2 Rg) , where SX is the estimated covariance matrix of coefficients. The test results show that a hypothesis that all coefficients are zero must be rejected in all relations at the 1% level. Significant results at the 5% (10%) level are marked with ** (*).

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This weaker result may be due to pay being determined by external market conditions. Thus, the direct and indirect effects of co-determination are partly confirmed. Consequently, employee directors carry a negative association with firm performance, and shareholders tend to take compensatory actions to alleviate the influence of employee directors. The board index is at least partly endogenously determined. Are the board index and the leverage positively related to firm performance and negatively to average wage? For the board index, this is confirmed for firm performance, but the only sign is as expected for average wage. Thus, a better composed board will improve firm performance. On the other hand, leverage is against the free cash flow hypothesis expectations in both firm performance and average wage. A higher leverage indicates a lower firm performance and higher average wage. In conclusion, the governance hypothesis is not fully confirmed. The negative association between leverage and firm performance confirms findings in empirical studies (Barclay et al., 1995; Rajan and Zingales, 1995; Brick et al., 2005). I offer two alternative explanations to the free cash flow hypothesis: the fear of higher decision costs in a situation with three decision makers, that is, shareholders, employees, and banks; and the negative signalling effect of a high leverage (Myers, 1977). Also note the complementarity between the board index and leverage (Agrawal and Knoeber, 1996). The sign is negative and significant. Thus, the two governance mechanisms are substitutes rather than complements. The Hermalin and Weisbach (1998) reverse causation hypothesis is only partly confirmed, as the board index is positive and leverage is negative. Lower leverage should bring lower monitoring intensity. The results are significant, indicating that good performance leads to a better board index and to an easier debt burden. In all, endogeneity is confirmed, as both the board index and the leverage are at least partly determined from the presence of employee directors and from past performance. Are shareholders able to neutralize the employee director by adjustments in the board index and the leverage, taking the employee director relationship to average wage into consideration as well? Since the variables are standardized to have average zero and standard deviation 1.0 in regressions, coefficients can be compared. They show that the direct effect is stronger than the indirect effect on the board index. For the negative direct employee director effect is now 0.119, while the indirect effect upon the board index is positive and 0.314. Since the board index is now 0.122 to firm performance, the positive, indirect impact of employee directors through the board index is only 0.038 (5 0.122 3 0.314), or 31.1 per cent of the direct board index effect. The shareholders are able to compensate 31.9 per cent of the negative direct effect of employee directors through adjustments to board

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characteristics. Furthermore, the employee director also impacts positively upon average wage, which is negatively related to firm performance. Even though the average wage is not significant in the overall sample, it is for codetermined firms, as I shortly report. The same applies to leverage. Likewise, the economic significance of the indirect effects from the lagged firm performance is very low, being 0.01 for both the board index and the leverage. Thus, the economic magnitude of the indirect effects from employee directors or past firm performance upon firm performance is small compared to the direct effect of the board index and the leverage. Endogeneity matters, but not very much. The volatility measure in the lower section of Table 13.4 gives two interesting relationships in the board index and the leverage equations. It turns out that only leverage has the expected positive and significant sign. The Raheja (2005) theory of board composition implies that the board index is positively related to firm risk. For volatility the opposite sign obtains. Next, the model is studied in sub-samples. If regulation plays a role, a less than optimal board composition is likely to follow. Therefore, we should observe stronger and more significant coefficients in the co-determined firms than in the shareholder determined. Table 13.5 is a report on the two sub-samples of firms. Note that the Wald test shows rejection of the null hypothesis that all variables have zero significance. Furthermore, a Chow dummy variable test rejects the hypothesis that the coefficients of the sub-samples are equal to those in the overall sample. Thus, there is a difference between co-determined and shareholder determined firms. In the co-determination sub-sample the employee director effects are even more pronounced than in the overall sample. The negative employee director impact upon firm performance is about 45 per cent higher than in the overall sample and the indirect effect on the board index increases even more. Now, the employee director variable is significant in relation to leverage and to average wage. Thus, the co-determination hypothesis is even more strongly confirmed in the sub-sample of only co-determined firms than in the overall sample. The board index and the free cash flow hypotheses come out more in line with expectations in the co-determined firms too. Now a significant result for the board index towards average wage appears. Leverage turns out to be negative and significant towards average wage, while positive in the overall sample. In shareholder determined firms, significant results are fewer and of different sign. Leverage is positively correlated with average wage, in contrast to the co-determined firms. In both sub-samples the board index and leverage are negatively related. Thus, the substitution result from the overall sample is confirmed in the

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Table 13.5

Is firm performance (Tobins Q) differently related to governance mechanisms in co-determined and in shareholder determined firms?
Dependent Variable Tobins Q Average Wage 0.011 0.175** 0.080** 0.186** 0.001 0.010 83.056 0.000 0.030 0.035 0.208** 0.077 0.060 30.281 0.000 62.160 Board Index 0.059 0.520** 0.414** 0.484** 0.210** 0.027 212.330 0.000 0.041 0.032 0.109** 0.021 0.006 9.986 0.076 p-value Leverage

Independent Variable

Co-determined firms N5639 Tobins Q lagged 0.303** Average wage 0.089 Board index 0.118** Leverage 0.103** Employee 0.173** directors Firm size 0.077 Systematic risk 0.034 112.123 Wald c2 test p-value 0.000 Shareholder determined firms N5496 Tobins Q lagged 0.072** Average wage 0.023 Board index 0.121** Leverage 0.018 Firm size 0.296** Systematic risk 0.048 57.543 Wald c2 test p-value 0.000 Chow dummy c2 (7): variable test

0.069* 0.156** 0.274** 0.140** 0.083 0.035 89.279 0.000 0.101 0.272** 0.158** 0.237** 0.028 45.030 0.000 0.000

Notes: The table reports the simultaneous equation estimation of the system of equations in (2) with co-determined firms in the upper part and shareholder determined firms in the lower part. The dependent variable is Tobins Q , which we measure as the market value of the firm over its book value. Variables are defined in Table 13.3. Each variable is time demeaned in the regressions. For each firm and each variable, I time demean by subtracting a given years observation from the firms overall mean. The table shows the estimates based on the standardized variables, which we construct by deducting each observation from its mean value and dividing by its standard deviation. Fixed effects estimation in 3SLS framework with standardized variables. All nonfinancial firms on Oslo Stock Exchange 1989 to 2002. The Wald test is explained in Table 13.4. The test results show that a hypothesis that all coefficients are zero must be rejected in all relations at the 1% level, except one where a 7.7% level is required. The Chow (Greene, 2003, Ch. 7) dummy variable test is an exclusion test for the null hypothesis that variables formed by a co-determination dummy variable interacted with each of the explanatory variables are all zero. Low value indicates hypothesis rejection. The test result shows that the hypothesis that the two sub-samples have equal coefficients must be rejected. Significant results at the 5% (10%) level are marked with ** (*).

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sub-samples. We also see that the past firm performance endogeneity hypothesis gains less support in the sub-samples than in the overall sample. In fact, only the negative leverage result in the co-determined sub-sample is significant. Another difference exists for firm size. Firm size is negative and significant in the firm performance equation in shareholder determined firms, while positive in co-determined ones. Also, in the leverage equation the signs are reversed, and significant in shareholder determined firms only. The latter confirms stylized facts about the positive relationship between firm size and leverage (Harris and Raviv, 1991). An interpretation of the difference in sub-samples is that in shareholder determined firms the board composition is closer to the optimal, and therefore exogenous characteristics such as firm size play a larger role. The large differences between samples confirm the Buchanan and Tullock (1962) theory. Are the results arrived at so far driven by a firm size effect? Table 13.6 shows regressions for all firms with more than 200 employees in the upper part, while the lower part is limited to the largest co-determined firms. The 2001 employee sample shows results very similar to those in the entire sample in Table 13.4 in the upper part, and for the co-determined firms in Table 13.5 in the lower part. Thus, the former results are not due to some firm size effect. In fact, even among firms where co-determination is compulsory, the main co-determination hypothesis is confirmed. Looking back, the co-determination and governance hypotheses are confirmed. Tests in sub-samples do not overturn these conclusions; on the contrary, they add to their strength. For instance, while the employee director effect is negative for leverage in the overall sample, it is positive in the codetermined sub-sample, as the hypothesis predicts. Thus, having representatives of one stakeholder group, the employees, in addition to shareholders on the board does not improve firm performance, as a stakeholder (Freeman and Reed, 1983; and Blair, 1995) or a new economy position (Zingales, 2000; Becht et al., 2003) implies. Instead, the results point to conflict of interests among the stakeholders. Furthermore, evidence of substitution between the board index and leverage is present in all regressions. I also find evidence of endogeneity (or reverse causation) from past firm performance, but with opposite signs to those predicted in Hermalin and Weisbach (1998). However, the indirect effects of employee directors and past firm performance upon firm performance through the board index and leverage are small compared with the direct effects from the board index and leverage. Endogeneity counts, but has low economic significance. The negative relation between employee directors and firm performance is in agreement with Fitzroy and Kraft (1993), Schmid and Seger (1998), Gorton and Schmid (2000, 2004), Falaye et al. (2006), and Bhren and

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Table 13.6

Are the employee director direct and indirect (endogenous) effects upheld in all firms with more than 200 employees and in co-determined firms with more than 200 employees?
Dependent Variable Tobins Q Average Wage 0.008 0.041* 0.041 0.049 0.103* 0.045 13.037 0.042 0.025 0.148** 0.180** 0.093** 0.031 0.027 73.992 0.000 Board index 0.139** 0.101* 0.197** 0.420** 0.093 0.025 85.068 0.000 0.091* 0.478** 0.413** 0.522** 0.248** 0.008 190.267 0.000 Leverage ratio 0.090* 0.075 0.145** 0.006 0.172** -0.101** 46.726 0.000 0.060 0.359** 0.256** 0.099** 0.028 0.041 99.414 0.000

Independent Variable

200+ employee firms, N5814 Tobins Q lagged 0.168** Average wage 0.012 Board index 0.094** Leverage 0.065** Employee directors 0.107** Firm size 0.083 Systematic risk 0.013 73.709 Wald c2 test p-value 0.000 200+ employees co-determined, N5565 Tobins Q lagged 0.358** Average wage 0.111* Board index 0.047 Leverage 0.126** Employee directors 0.148** Firm size 0.008 Systematic risk 0.017 110.682 Wald c2 test p-value 0.000

Notes: The table reports the simultaneous equation estimation of the system of equations in (2) with all firms larger than 200 employees in the upper part and all co-determined firms larger than 200 employees in the lower part. The dependent variable is Tobins Q , which we measure as the market value of the firm over its book value. Variables are defined in Table 13.3. Each variable is time demeaned in the regressions. For each firm and each variable, I time demean by subtracting a given years observation from the firms overall mean. The table shows the estimates based on the standardized variables, which we construct by deducting each observation from its mean value and dividing by its standard deviation. Fixed effects estimation in 3SLS framework with standardized variables. All nonfinancial firms on Oslo Stock Exchange 1989 to 2002. The Wald test is explained in Table 13.4. The test results show that a hypothesis that all coefficients are zero must be rejected in all relations at the 1% level, except one, where a 4.3% level is required. Significant results at the 5% (10%) level are marked with ** (*).

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Strm (2008), but at odds with Fauver and Fuerst (2006). None of these studies contain simultaneous equations models, and only the Bhren and Strm (2008) paper investigates the endogeneity of board mechanisms. I will return to the Fauver and Fuerst (2006) and Bhren and Strm (2008) articles in the following robustness section.

7.

ROBUSTNESS CHECKS

I perform robustness checks on the definitions of the board index, firm performance, and leverage. In addition, I check for the absence of serial dependence of the firm performance, that is, whether lagged firm performance is zero. Finally, I check the Fauver and Fuerst (2006) results in two sub-samples of information industries and other industries. With simultaneous equations, changes in one place are likely to propagate throughout the system. Thus, different coefficient values and significance from the original formulation are quite likely to appear. Fortunately, the results largely confirm those in Section 6. Do the co-determination results survive when the individual board mechanisms are used in place of the board index? Table 13.7 shows simultaneous regressions results when all four board characteristics making up the board index enter the regressions individually. Former results for codetermination largely apply. The employee director variable is negative to Tobins Q, and positive to average wage and leverage. For the board characteristics, only the relation to board size is significant. On the other hand, the hypotheses on governance variables are upheld for all board characteristics but the gender variable. It turns out to be non-significant in the Tobins Q relation. The other variables are as expected, and their coefficients are close to those Bhren and Strm (2008) find in partial GMM estimations. These authors also discuss endogeneity. Even though the estimations are not directly comparable, none of the significant results in Table 13.7 conflict with the endogeneity results in Bhren and Strm (2008). The second endogeneity effect from lagged firm performance is significant in the leverage but not in any of the board variables. However, the signs on the individual board variables conform to the positive sign of the board index in earlier tables. Besides these main points, Table 13.7 contains many new details, which it is beyond this chapter to explore. For instance, the substitution effect between the board index and leverage in former tables now turns out to concern network, while leverage is a complement to board size and gender. Thus, overall the results are well in line with former findings, except for the lagged firm performance relationship to governance variables. In Table (13.8) I have modified the board index to include all board

Table 13.7

The employee director direct and indirect (endogenous) effects upon firm performance when the individual board variables are used instead of the board index (N5 1135)
Average wage 0.026 0.022 0.049* 0.071 0.127** 0.046 0.030 0.043 0.131** 0.070** 0.027 0.097** 0.024 0.067** 0.122** Directors holdings Network Board size Gender Leverage 0.091** 0.199** 0.038 0.090** 0.212** 0.082**

Variable

Tobins Q

347

Tobins Q lagged Average wage Directors holdings Network Board size Gender Leverage Employee directors Firm size Systematic risk Wald c2 test p-value 0.057* 0.061** 0.052 0.124** 0.140** 0.102** 0.043 0.022 65.395 0.000 0.019 0.136** 0.026 0.023 0.074 0.082 0.104** 45.170 0.000 0.175** 0.177** 0.131** 0.043 0.044 0.093** 57.520 0.000 0.129** 0.124** 0.565** 0.258 0.034 301.551 0.000 0.045** 0.005 0.006 0.041 58.640 0.000

0.106** 0.039 0.051* 0.091** 0.062** 0.025 0.041** -0.114** 0.144** 0.001 86.300 0.000

0.108* 0.089 0.032 98.443 0.000

Notes: The table reports the simultaneous equation estimation of the system of equations in (2) when the individual variables making up the board index replace the board index. The board index consists of directors holdings, network, board size, and gender. The definition of directors holdings is the fraction of ownership for the board as a whole; network is information centrality (Wasserman and Faust, 1994), see note 9; the board size is the number of shareholder elected directors; and gender is defined as the number of shareholder elected women over board size. The dependent variable is Tobins Q , which we measure as the market value of the firm over its book value. Variables are defined in Table 13.3. Each variable is time demeaned in the regressions. For each firm and each variable, I time demean by subtracting a given years observation from the firms overall mean. The table shows the estimates based on the standardized variables, which we construct by deducting each observation from its mean value and dividing by its standard deviation. Fixed effects estimation in 3SLS framework with standardized variables. All non-financial firms on Oslo Stock Exchange 1989 to 2002. The Wald test is explained in Table 13.4. The test results show that a hypothesis that all coefficients are zero must be rejected in all relations at the 1% level. Significant results at the 5% (10%) level are marked with ** (*).

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Table 13.8

Does a wide definition of the board index change the relationship between firm performance, employee directors and governance mechanisms? (N51135)
Dependent Variable Tobins Q 0.114 ^** 0.031 0.091 ^** 0.048 ^** 0.094 ^** 0.129 ^** 0.005 65.962 0.000 Average Wage 0.027 0.102 ^** 0.143 ^** 0.077 ^* 0.048 0.030 54.197 0.000 Board Index 2 0.009 0.136 ^** 0.077 ^** 0.152 ^** 0.218 ^** 0.005 42.933 0.000 Leverage 0.109** 0.204** 0.083** 0.004 0.126* 0.037 56.620 0.000

Independent Variable

Tobins Q lagged Average wage Board index 2 Leverage Employee directors Firm size Systematic risk Wald c2 test p-value

Notes: The table reports the simultaneous equation estimation of the system of equations in (2) when all individual variables enter the board index, and not just directors holdings, network, board size, and gender. The added variables are outside owner concentration, independence, CEO director, exported and imported directors, and board age dispersion. Outside owner concentration is the sum of squared equity fractions across all the firms outside owners; independence is the board tenure of the non-employee directors minus the tenure of the CEO; CEO director equals 1 if the CEO is a member of his companys board and zero otherwise; exported CEO is the number of outside directorships held by the firms CEO; imported CEO is the proportion of CEOs from other companies on the board; board age dispersion is the standard deviation of board age. The dependent variable is Tobins Q, which we measure as the market value of the firm over its book value. Variables are defined in Table 13.3. Each variable is time demeaned in the regressions. For each firm and each variable, I time demean by subtracting a given years observation from the firms overall mean. The table shows the estimates based on the standardized variables, which we construct by deducting each observation from its mean value and dividing by its standard deviation. Fixed effects estimation in 3SLS framework with standardized variables. All nonfinancial firms on Oslo Stock Exchange 1989 to 2002. The Wald test is explained in Table 13.4. The test results show that a hypothesis that all coefficients are zero must be rejected in all relations at the 1% level. Significant results at the 5% (10%) level are marked with ** (*).

variables used in Bhren and Strm (2008) as specified in note 12 to check whether the board index is sensitive to the selection of board characteristics. The overall Wald tests are strong and the significance of the coefficients are almost similar to what earlier full sample results in Table 13.4 show. We note that the impact of the employee director variable is less in the new board index, and is now significant in its positive relationship to average wage. Thus, the co-determination hypothesis is supported with

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this new board index, although with lower coefficient values. The endogeneity effect of a lagged firm performance loses significance in the board index relation. The same happens when individual board characteristics replace the board index, and the effect also disappears in the shareholder determined sub-sample. Thus, a preliminary conclusion is that the reverse causation in the board index relation seems to be sensitive to the specification of the index and in sub-samples. The conclusion from the discussion of the two previous tables is that the results are upheld; in particular, the co-determination hypothesis is confirmed. Now I turn to variations on firm performance, using the stock return and ROA instead of Tobins Q. The stock return and ROA may be seen as two extremes in performance measurement, the one only market based, the other only accounting based. Bhagat and Jefferis (2002) argue in favour of accounting measures, noting that market measures may contain an anticipation bias, since accounting numbers may be manipulated during a given year. Since our data span 14 years, this accounting manipulation should be a minor concern. These two measures of firm performance should together provide an adequate framework for robustness tests. The results for the full sample are given in Table 13.9. Since the results in the sub-samples largely parallel those found for the full sample, the subsample results are not reported. The results in Table 13.9 largely replicate those already found for Tobins Q in Table 13.4. The co-determination and the governance hypotheses show the same confirmations. As before, leverage is negative in the firm performance equation. Again, the board index and leverage are substitutes. Endogeneity (or reverse causation) is evident in both firm performance specifications, although at different variables. For the stock return the lagged stock return is significant in firm performance and leverage, as before. One would expect this to happen with accounting numbers due to earnings management or conservative accounting practices (Watts, 2003), which would induce serial correlation. However, lagged performance is significant for only the board index for the accounting measure ROA. Overall, Table 13.9 supports earlier findings. The upshot is that alternative performance measures do not upset conclusions reached with Tobins Q. Therefore, further robustness tests may well proceed with Tobins Q as the dependent variable. Next, Table 13.10 shows results when the dividend payout rate replaces leverage, and Tobins Q is the firm performance in the upper part, while in the lower part the lagged firm performance is removed. Dividend payout rate is gauged as the annual dividend as a fraction of the earnings before interest, taxes, depreciation, and accruals (EBITDA). During the period of study, share buybacks were illegal in Norway.

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Table 13.9

The employee director direct and indirect (endogenous) effects when the stock return and the return on assets (ROA) define firm performance
Dependent Variable Tobins Q 0.242** 0.056 0.132** 0.232** 0.165** 0.112 0.138** 123.539 0.000 0.008 0.129** 0.066** 0.170** 0.125** 0.033 0.024 68.694 0.000 Average Wage 0.046** 0.055* 0.056** 0.052 0.012 0.003 15.975 0.014 0.043 0.022 0.077** 0.062 0.010 0.014 15.739 0.015 Board Index 2 0.008 0.057* 0.169** 0.302** 0.026 0.010 78.542 0.000 0.063** 0.028 0.183** 0.322** 0.051 0.025 86.037 0.000 Leverage

Independent Variable

Stock return, N51019 Stock return lagged Average wage Board index Leverage Employee directors Firm size Systematic risk Wald c2 test p-value ROA N51135 ROA lagged Average wage Board index Leverage Employee directors Firm size Systematic risk Wald c2 test p-value

0.072** 0.077** 0.223** 0.039 0.117* 0.043 61.258 0.000 0.011 0.106** 0.195** 0.060 0.103 0.048 57.564 0.000

Notes: The table reports the simultaneous equation estimation of the system of equations in (2) when the stock return replaces Tobins Q in the upper part and the return on assets replaces Tobins Q in the lower part. The dependent variable is the stock return, defined as the raw stock return adjusted for dividend and stock splits; alternatively, as the return on assets, gauged as the accounting profits on book value of assets. Variables are defined in Table 13.3. Each variable is time demeaned in the regressions. For each firm and each variable, I time demean by subtracting a given years observation from the firms overall mean. The table shows the estimates based on the standardized variables, which we construct by deducting each observation from its mean value and dividing by its standard deviation. Fixed effects estimation in 3SLS framework with standardized variables. All nonfinancial firms on Oslo Stock Exchange 1989 to 2002. The Wald test is explained in Table 13.4. The test results show that a hypothesis that all coefficients are zero must be rejected in all relations at the 1% level, except for the average wage, where at least a 1.6% level is needed. Significant results at the 5% (10%) level are marked with ** (*).

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Table 13.10

The relationships between firm performance, employee directors and governance mechanisms when dividend payout rate replaces leverage ratio and when lagged firm performance is removed
Dependent Variable Tobins Q Average Wage 0.014 0.059** 0.011 0.082* 0.004 0.028 8.236 0.221 Average Wage Board Index 2 0.088** 0.075** 0.012 0.317** 0.106* 0.020 48.154 0.000 Board Index 0.018 0.014 0.152** 0.058 0.021 0.015 45.253 0.000 0.161** 0.306** 0.066 0.017 85.976 0.000 Dividend Payout 0.035 0.025 0.021 0.092 0.022 0.066 4.785 0.572 Leverage

Independent Variable

Dividend payout rate, N51150 Tobins Q lagged 0.106** Average wage 0.046* Board index 0.125** Dividend payout rate 0.005 Employee directors 0.117** Firm size 0.178** Systematic risk 0.002 79.275 Wald c2 test p-value 0.000 Tobins Q No lag N51333 Average wage Board index Leverage Employee directors Firm size Systematic risk Wald c2 test p-value 0.062** 0.131** 0.058** 0.117** 0.151** 0.027 71.943 0.000

0.201** 0.169** 0.029 0.100** 0.031 84.992 0.000

Notes: The table reports the simultaneous equation estimation of the system of equations in (2) when the dividend payout rate replaces leverage in the upper part and the lagged firm performance is removed in the lower part. The dependent variable is Tobins Q, which we measure as the market value of the firm over its book value. Each variable is time demeaned in the regressions. For each firm and each variable, I time demean by subtracting a given years observation from the firms overall mean. The table shows the estimates based on the standardized variables, which we construct by deducting each observation from its mean value and dividing by its standard deviation. I use fixed effects estimation in 3SLS framework with standardized variables. The sample comprises all non-financial firms on Oslo Stock Exchange 1989 to 2002. The Wald test is explained in Table 13.4. The test results show that a hypothesis that all coefficients are zero must be rejected in all relations at the 1% level, except for the average wage and the dividend payout relations in the upper part, where I cannot reject the hypothesis. Significant results at the 5% (10%) level are marked with ** (*).

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The striking results are first that the dividend payout rate is nowhere significant as an independent variable, and second, as a dependent variable no variable in the system is related in a significant way. In fact the Wald test cannot reject the hypothesis that all coefficients in the dividend payout rate equation are zero. An exclusion test (not reported) for the dividend payout rate cannot confirm that the variable coefficient is different from zero. Thus, the dividend payout rate is an inferior substitute for leverage. Moreover, the results for the other variables are not affected, even though changes in one part of a simultaneous system may bring about new values in other parts. Therefore, the results in Table 13.10 increase the confidence in the original model. The lower part of Table 13.10 shows results when the lagged firm performance is left out. The reason for the removal is that lagged firm performance induces bias (Hsiao, 2003, pp. 712), since the errors are no longer independent of the regressors. The smaller the bias, the larger is the number of periods in the panel and the closer to zero is the auto-correlation coefficient on lagged firm performance. Furthermore, if the explanatory variables apart from the lagged firm performance have very persistent elements, the bias will not disappear. This persistence can be a concern in governance studies. For instance, the firms board size is likely to be fairly stable. To test for the seriousness of this bias, I include static system regressions, that is, with no lagged performance. Comparing the results from the no lagged firm performance regression with the original estimates in Table 13.4, we see that practically all signs are maintained, and also that coefficient values are quite similar. The co-determination hypothesis is confirmed. For average wage on firm performance, the variable is significant in the static specification but not in the dynamic. But overall the results from the dynamic estimations are upheld. Apparently, the low auto-correlation coefficient, the rather long time period and the small persistence in the explanatory variables warrant the use of the dynamic specification in Table 13.4. I also run a regression (not reported) with all explanatory variables lagged one period for the entire sample. This regression shows far fewer significant results, and, although the signs are the same as before, this specification is far inferior to the main regression in Table 13.4. Again, this points to a contemporaneity in governance mechanisms. Finally, I run a test for the Fauver and Fuerst (2006) information hypothesis in the sub-samples. The authors assume information significance to trade, transportation, and manufacturing industries. Using the same GICS industry classification as in Table 13.2, I allocate Capital goods, Transport, Consumer articles, Retailing, Food and staples retailing, Health care equipment and supplies, and Telecommunications to the information intensive industries, while the rest are in other industries. Co-determined firms are

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distributed in the two sub-samples almost as in the total population, with 61.1 per cent without employee directors in the Other industries category against 57.4 in the full sample. A test for the Fauver and Fuerst (2006) information hypothesis is that the employee director variable is positive in the information intensive industries. Table 13.11 shows the results. The main interest is in the employee director, that is, the co-determination hypothesis. Both sub-samples show a negative and significant coefficient on the employee director variable. The Chow test shows that the two subsamples are different, but the main Fauver and Fuerst (2006) hypothesis is not supported. Overall, the results for the robustness tests do not invalidate the results found in Table 13.4.

8.

CONCLUSION

In this chapter I pose the question whether board representation of one group of non-owner, the employees, improves firm performance. I conclude it does not. The conclusion runs counter to claims from stakeholder theorists (Freeman and Reed, 1983; Blair, 1995) and some financial economists (Zingales, 2000; Becht et al., 2003) that co-determination improves firm performance. Instead the results support most former findings in the empirical literature (Fitzroy and Kraft, 1993; Schmid and Seger, 1998; Gorton and Schmid, 2000, 2004; Falaye et al., 2006; Bhren and Strm, 2008) that employee board representation reduces firm performance. The Norwegian regulations on co-determination provide the institutional framework. Co-determination is required by law for firms with more than 200 employees, and is an option if an employee majority demands so in firms having between 30 and 200 employees. A number of industries are exempted, and in all industries employees exercise their option. Thus, testing can take place using sub-samples, for instance in co-determined and shareholder determined sub-samples. For the whole sample, nearly 60 per cent do not have employee directors. The percentage has been rising during our period from 1989 to 2002. For firms with more than 200 employees, twothirds have employee directors. The resultant data set is of a panel nature. I estimate a system of simultaneous equations where employee directors, firm size (sales), firm systematic risk, and one period lagged Tobins Q are the exogenous variables, and Tobins Q, average wage, board index, and leverage are the endogenous. The board index is constructed from important board characteristics, that is, directors holdings, the boards network, board size and the female fraction. The free cash flow hypothesis (Easterbrook, 1984; Jensen, 1986) warrants the use of leverage.

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Table 13.11

Firm performance, employee directors and governance mechanisms in sub-samples of information intensive industries and other industries
Dependent Variable Tobins Q 0.277** 0.041 0.015 0.024 0.081** 0.007 0.003 60.354 0.000 0.069* 0.050 0.153** 0.081** 0.117* 0.215** 0.062 41.646 0.000 c2 (7): Average Wage 0.210** 0.093** 0.217** 0.182** 0.167* 0.055 88.323 0.000 -0.040 0.131^ ** 0.044 0.033 0.129^ * 0.013 14.737 0.022 28.362 Board Index 0.127 0.150** 0.032 0.197** 0.060 0.062 17.790 0.007 0.036 0.113** 0.033 0.157** 0.145** 0.165** 35.541 0.000 p-value Leverage

Independent Variable

Information industries N5533 Firm performance lag Average wage Board index Leverage Employee directors Firm size Systematic risk Wald c2 test p-value Other industries N5601 Firm performance lag Average wage Board index Leverage Employee directors Firm size Systematic risk Wald c2 test p-value Chow dummy variable test

0.240** 0.440** 0.040 0.044 0.141 0.009 61.376 0.000 0.088** 0.047 0.040 0.016 0.131* 0.133** 15.583 0.016 0.000

Notes: The table reports the simultaneous equation estimation of the system of equations in (2) when the full sample is sub-divided into informationally intensive industries in the upper part and other industries in the lower. Using the same GICS industry classification as in Table 13.2, informationally intensive industries are Capital goods, Transport, Consumer articles, Retailing, Food and staples retailing, Health care equipment and supplies, and Telecommunications, while the rest are in other industries. The dependent variable is Tobins Q, which we measure as the market value of the firm over its book value. Each variable is time demeaned in the regressions. For each firm and each variable, I time demean by subtracting a given years observation from the firms overall mean. The table shows the estimates based on the standardized variables, which we construct by deducting each observation from its mean value and dividing by its standard deviation. I use fixed effects estimation in 3SLS framework with standardized variables. The sample comprises all non-financial firms on Oslo Stock Exchange 1989 to 2002. The Wald test is explained in Table 13.4. The test results show that a hypothesis that all coefficients are zero must be rejected in all relations at the 1% level, except for a 2.3% level in the average wage relation in the Other industries estimation. The Chow dummy variable test is explained in Table 13.5. The test result indicates that coefficient values are different in the two sub-samples. Significant results at the 5% (10%) level are marked with ** (*).

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The setup allows the testing of direct and indirect employee director effects upon firm performance. The indirect effects constitute a test of endogeneity (Hermalin and Weisbach, 2003). The lagged firm performance gives a test of the reverse causation hypothesis (Hermalin and Weisbach, 1998) that past firm performance determines current governance. Furthermore, it allows testing of complementarity between the two governance variables board index and leverage (Agrawal and Knoeber, 1996). Regressions are performed on the whole sample, the sub-samples of codetermined and shareholder determined firms, and then the sub-samples of firms with more than 200 employees. I use a fixed effects model implemented in a three-stage least squares (3SLS) estimation. In all regressions, the estimated coefficient for employee directors is significantly negative. Moreover, the economic importance becomes larger as regressions proceed from the overall sample to the sub-sample of codetermined firms, and then to co-determined firms with 200 employees or more. The result is at odds with Fauver and Fuerst (2006), who find a positive relationship when a dummy employee director variable is interacted with information intensive industries. In sub-samples of information intensive and other industries I confirm the negative employee director correlation to Tobins Q. Overall, the results support agency theory and reject stakeholder theory. The indirect effects are also present. Employee directors are positively associated with average wage, the board index, and, in co-determined samples, leverage. For the board index, this means that shareholders improve board composition so as to neutralize the negative employee director effect, as Buchanan and Tullock (1962) predict. However, this neutralizing effect falls far short of the negative direct employee director effect. The lagged firm performance is significantly positively related to the board index and negatively to leverage. This result runs counter to the Hermalin and Weisbach (1998) reverse causation theory that earlier firm performance determines board composition. Thus, the results show endogeneity effects, but the economic significance falls far below the importance of the direct effect. The negative direct effect of employee directors is only partially compensated for by a better board. Endogeneity matters, but not very much. Furthermore, leverage turns out to be negatively related to firm performance, contrary to the free cash flow hypothesis (Easterbrook, 1984; and Jensen, 1986). The negative association with firm performance confirms findings in empirical studies (Barclay et al., 1995; Rajan and Zingales, 1995; Brick et al., 2005). Jensen and Meckling (1979) argue that co-determination can only survive if supported by law. The long-term data set employed here supports this view. Evidently, owners have good economic reasons for not

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choosing the co-determination form of organization if they can. This also implies that there are costs to maintaining co-determination required by law. First, I document the negative impact of employee representation upon firm performance. Second, shareholders try to work around the regulations by strengthening aspects of board characteristics that are left unregulated. Thus, co-determination, supported by law, has costs. Therefore, these results are relevant for the emerging literature on board regulation (Hermalin, 2005).

NOTES
* Acknowledgements: I have benefited from comments made by yvind Bhren, Ole Gjlberg, Roswitha King, Gudbrand Lien, participants at the 7th workshop on Corporate Governance and Investment, Jnkping, 2006, and at the 2nd International Business Economics Workshop, Majorca, 1314 September 2007. Pl Rydland and Bernt Arne degaard have guided me to data. Co-determination is defined as employee board representation (Jensen and Meckling, 1979; Furubotn, 1988). Tirole (2002, p. 118) argues that these [c]onflicts of interest among the board generate endless haggling, vote-trading and log-rolling. They also focus managerial attention on the delicate search for compromises that are acceptable to everyone; managers thereby lose a clear sense of mission and become political virtuosos. In a similar vein, Hansmann (1996, p. 44) states that because the participants [that is, stakeholders] are likely to have radically diverging interests, making everybody an owner threatens to increase the costs of collective decision making enormously. According to the EIRO (1998) full employee representation is found in Austria, the Nordic countries, and Germany, while the Netherlands and France have systems closer to a consultative function for employee representatives. In a recent booklet, the long-time employee director Svein Stugu (2006) says that the main objective is to prevent plant closures. Mergers, takeovers, and outsourcing must also be prevented. Stugu (2006, p. 63) says that opposition to plant closures was organized in co-operation with representatives of the local community, but that this could only be done effectively if labour representatives had access to internal information. The variables are defined as follows. Directors holdings is defined as the fraction of equity owned by the board of directors; board network is the information centrality, constructed from network theory (Wasserman and Faust, 1994), see note 8 below; board size is the number of shareholder elected directors; gender is the proportion of shareholder elected female directors. I keep only a linear specification in the board ownership relation, despite evidence in Morck et al. (1988) and McConnell and Servaes (1990) pointing towards a concave relationship. The Bhren and Strm (2008) study finds no significance in the squared term, maybe due to the inclusion of other board characteristics. Network theory uses concepts such as nodes and lines. In our setting, a node is a firm, and a line between two firms represents a joint director in the two firms. We define geodesic gjk as the shortest path between two nodes j and k, and G as the total number of nodes. The node i is designated as ni. Using Wasserman and Faust (1994, pp. 1927), our information centrality measure is constructed in the following way. Form the G 3 G matrix A with diagonal elements aii equal to 1 plus the sum of values for all lines incident to ni and off-diagonal elements aij, such that aij 5 0 if nodes ni and nj are not adjacent, and aij 5 1 2 xij if nodes ni and nj are adjacent. xij is the value of the link from firm ni

1. 2.

3. 4. 5. 6.

7.

8.

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357

to nj, that is, 0 or 1. The inverse of A, which is C 5 A21, has elements { cij } , where we G G define T 5 g i51cii and R 5 g j51cij. The information centrality index for firm ni is: Ci (ni) 5 1 cii 1 (T 2 2R) /G

9.

10. 11. 12.

The index measures the information content in the paths that originate and end at a specific firm. The OSE had an aggregate market capitalization of 68 billion USD equivalents by yearend 2002, ranking the OSE 16 among the 22 European stock exchanges for which comparable data are available. During the sample period from 1989 to 2002, the number of firms listed increased from 129 to 203, market capitalization grew by 8 per cent per annum, and market liquidity, measured as transaction value over market value, increased from 52 per cent in 1989 to 72 per cent in 2002 (sources: www.ose.no and www.fibv.com). The main sources are Brthen (1982) and Aarbakke et al. (1999) and a government report (NOU 1985:1). In order to maintain readability, specific references have been dropped in tables and text. For every individual firm, an overall average is constructed. Then, from each company observation the overall individual average is subtracted. In addition to the variables in (2), I include outside owner concentration, independence, CEO director, exported and imported directors, and board age dispersion. Outside owner concentration is the sum of squared equity fractions across all the firms outside owners; independence is the board tenure of the non-employee directors minus the tenure of the CEO; CEO director equals 1 if the CEO is a member of his companys board and zero otherwise; exported CEO is the number of outside directorships held by the firms CEO; imported CEO is the proportion of CEOs from other companies on the board; board age dispersion is the standard deviation of board age.

REFERENCES
Aarbakke, M., J. Skre, G. Knudsen, T. Ofstad and A. Aarbakke (1999), Aksjeloven og Allmennaksjeloven (Company Law), Oslo: Tano Aschehoug. Agrawal, A. and C.R. Knoeber (1996), Firm performance and mechanisms to control agency problems between managers and shareholders, Journal of Financial and Quantitative Analysis, 31 (3), 37797. Baker, G.P., M.C. Jensen and K.J. Murphy (1988), Compensation and incentives: Practices vs. theory, Journal of Finance, 43 (3), 593616. Barclay, M.J., C.W. Smith and R.L. Watts (1995), The determinants of corporate leverage and dividend policies, Journal of Applied Corporate Finance, 7 (4), 419. Becht, M., P. Bolton and A. Rell (2003), Corporate governance and control, in G. Constantinides, M. Harris and R. Stulz (eds), Handbook of the Economics of Finance, Volume 1A, Amsterdam: North-Holland, pp. 1109. Bertrand, M. and S. Mullainathan (2001), Are CEOs rewarded for luck? The ones without principals are, Quarterly Journal of Economics, 116 (3), 90132. Bhagat, S. and R.H. Jefferis (2002), The Econometrics of Corporate Governance Studies, Cambridge, MA: The MIT Press. Blair, M.M. (1995), Ownership and Control: Rethinking Corporate Governance for the Twenty-first Century, Washington DC: The Brookings Institution. Blair, M.M. and L.A. Stout (1999), A team production theory of corporate law, Virginia Law Review, 85 (2), 247328.

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Bhren, . and R.. Strm (2008), Aligned, informed, and decisive: characteristics of value-creating boards, in R.. Strm, Three Essays on Corporate Boards, Dr. Oecon. thesis, BI Norwegian School of Management, Oslo, Norway, pp. 2160. Brthen, T. (1982), Bedriftsforsamlingen i aksjeselskaper (The Supervisory Board in Shareholder Owned Companies), Oslo: Tanum Nordli. Brick, I.E., D. Palia and C.-J. Wang (2005), Simultaneous estimation of CEO compensation, leverage, and board characteristics on firm value. Buchanan, J.M. and G. Tullock (1962), The Calculus of Consent: Logical Foundations of Constitutional Democracy, Ann Arbor: The University of Michigan Press. Cadbury Committee (1992), Report of the Committee on the Financial Aspects of Corporate Governance, London: Gee and Co. Ltd. Carter, D.A., B.J. Simkins and W.G. Simpson (2003), Corporate governance, board diversity and firm value, Financial Review, 38, 3353. Dow, G.K. (2003), Governing the Firm: Workers Control in Theory and Practice, Cambridge, UK: Cambridge University Press. Easterbrook, F.H. (1984), Two agency-cost explanations of dividends, American Economic Review, 74 (4), 65059. Eisenberg, T., S. Sundgren and M.T. Wells (1998), Larger board size and decreasing firm value in small firms, Journal of Financial Economics 48, 3554. European Industrial Relations Observatory On-line (EIRO) (1998), Board-level employee representation in Europe, September. Falaye, O., V. Mehrotra and R.Morck (2006), When labor has a voice in corporate governance, Journal of Financial and Quantitative Analysis, 41 (3), 489510. Fauver, L. and M.E. Fuerst (2006), Does good corporate governance include employee representation? Evidence from German corporate boards, Journal of Financial Economics, 82 (3), 673710. FitzRoy, F.R. and K. Kraft (1993), Economic effects of codetermination, Scandinavian Journal of Economics, 95 (3), 36575. Freeman, R.B. and E.P. Lazear (1995), An economic analysis of works councils, in J. Rogers and W. Streeck (eds), Works Councils: Consultation, Representation, and Cooperation in Industrial Relations, Chicago: The University of Chicago Press, pp. 2750. Freeman, R. E. and D. L. Reed (1983), Stockholders and stakeholders: a new perspective on corporate governance, California Management Review, 25, 88106. Furubotn, E.G. (1988), Codetermination and the modern theory of the firm: a property-rights analysis, Journal of Business, 61 (2), 16581. Goergen, M. (2007), What do we know about different systems of corporate governance?, ECGI Finance Working Paper No. 163/2007. Gompers, P., J. Ishii and A. Metrick (2003), Corporate governance and equity prices, Quarterly Journal of Economics, 118 (1), 10755. Gorton, G. and F.A. Schmid (2000), Universal banking and the performance of German firms, Journal of Political Economy, 58 (12), 2980. Gorton, G. and F.A. Schmid (2004), Capital, labor, and the firm: a study of German codetermination, Journal of the European Economic Association, 2 (5), 863905. Greene, W.H. (2003), Econometric Analysis, 5th edn, New York: Prentice Hall. Hansmann, H. (1996), The Ownership of Enterprise, Cambridge, MA: Harvard University Press. Harris, M. and A. Raviv (1991), The theory of capital structure, Journal of Finance 46 (1), 297355.

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Hermalin, B.E. (2005), Trends in corporate governance, Journal of Finance, 60 (5), 235184. Hermalin, B.E. and M.S. Weisbach (1998), Endogenously chosen boards of directors and their monitoring of the CEO, American Economic Review, 88 (1), 96118. Hermalin, B.E. and M.S. Weisbach (2003), Boards of directors as an endogenously determined institution: a survey of the economic literature, Economic Policy Review, 9 (1), 726. Hopt, K.J. (1998), The German two-tier board: experience, theories, reform, in K.J. Hopt, H. Kanda, M.J. Roe, E. Wymeersch, and S. Prigge (eds), Comparative Corporate Governance: The State of the Art and Emerging Research, Oxford: Oxford University Press, pp. 22758. Hsiao, C. (2003), Analysis of Panel Data, 2nd edn, Cambridge: Cambridge University Press. Jensen, M.C. (1986), Agency cost of free cash flow, corporate finance and takeovers, American Economic Review, 76, 32339. Jensen, M.C. and W. Meckling (1979), Rights and production functions: an application to labor-managed firms and codetermination, Journal of Business, 52 (4), 469506. Johnson, R.A. and D.W. Wichern (1988), Applied Multivariate Statistical Analysis, 2nd edn, Englewood Cliffs, NJ: Prentice-Hall. McConnell, J. and H. Servaes (1990), Additional evidence on equity ownership and corporate value, Journal of Financial Economics 27, 595612. Morck, R., A. Shleifer and R. Vishny (1988), Management ownership and market valuation: an empirical analysis, Journal of Financial Economics, 20, 293315. Mueller, D.C. (2003), Public Choice III, Cambridge, UK: Cambridge University Press. Myers, S.C. (1977), Determinants of corporate borrowing, Journal of Financial Economics, 5, 14775. NOU (1985), Videreutviklingen av bedriftsdemokratiet (Further development of codetermination), Oslo: Statens forvaltningstjeneste. Palia, D. (2001), The endogeneity of managerial compensation in firm valuation: a solution, Review of Financial Studies, 14 (3), 73564. Perotti, E. and K.E. Spier (1993), Capital structure as a bargaining tool: the role of leverage in contract renegotiation, American Economic Review, 83 (5), 113141. Pfeffer, J. (1981), Power in Organizations, Cambridge, MA: Ballinger Publishing Company. Pistor, K. (1999), Codetermination: a socio-political model with governance externalities, in M.M. Blair and M.J. Roe (eds), Employees and Corporate Governance, Washington, DC: Brookings Institution Press, pp. 16393. Raheja, C.G. (2005), Determinants of board size and composition: a theory of corporate boards, Journal of Financial and Quantitative Analysis, 40 (2), 283306. Rajan, R.G. and L. Zingales (1995), What do we know about capital structure? Some evidence from international data, Journal of Finance, 50 (5), 142160. Schmid, F.A. and F. Seger (1998), Arbeitnehmermitbestimmung, Allokation von Entscheidungsrechten und Shareholder Value (Codetermination, decision right allocation, and shareholder value), Zeitschrift fr Betriebswirtschaft, 68 (5), 45373. Shrader, C.B., V.B. Blackburn and P. Iles (1997), Women in management and

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firm financial performance: an exploratory study, Journal of Managerial Issues, 9 (3), 35572. Siebert, H. (2005), The German Economy: Beyond the Social Market, Oxford: Oxford University Press. Smith, N., V. Smith and M. Verner (2006), Do women in top management affect firm performance? A panel study of 2300 Danish firms, International Journal of Productivity and Performance Management, 55 (7), 56993. Stugu, S. (2006), Orkla: Bedriftskultur og bedriftsdemokrati 19912004 (Orkla: Company culture and democracy 19912004), Oslo: DeFacto. Tirole, J. (2001), Corporate governance, Econometrica, 69 (1), 136. Tirole, J. (2002), Financial Crises, Liquidity, and the International Monetary System, Princeton: Princeton University Press. Tirole, J. (2006), The Theory of Corporate Finance, Princeton: Princeton University Press. Wasserman, S. and K. Faust (1994), Social Network Analysis: Methods and Applications, Cambridge, UK: Cambridge University Press. Watts, R.L. (2003), Conservatism in accounting: Part I: Explanations and implications, Accounting Horizons, 17 (3), 20721. Woolridge, J.M. (2002), Econometric Analysis of Cross Section and Panel Data, Cambridge, MA: The MIT Press. Yermack, D. (1996), Higher market valuation of companies with a small board of directors, Journal of Financial Economics, 40, 185212. Zingales, L. (2000), In search of new foundations, Journal of Finance, 55 (4), 162353.

14.

The determinants of German corporate governance ratings

Wolfgang Drobetz, Klaus Gugler and Simone Hirschvogl

1.

INTRODUCTION

In recent years many countries have introduced corporate governance codes. These codes represent unmistakable improvements in minority shareholder right protection as well as transparency, and they generally entail a movement towards Anglo-Saxon institutions. Many of the rules in these codes are only recommendations, however, and there is much scepticism that best-practice recommendations and/or principles-based approaches are effective substitutes for more rule-based approaches, such as the US Sarbanes-Oxley Act. This is all the more the case since there is the widespread perception that markets do not function well in punishing deviant behaviour of managers, particularly in Continental Europe, where regulators tend to rely heavily on principles-based approaches in their attempts to reform corporate governance. There are many reasons to believe that markets are less of a constraint on managerial discretion in Continental Europe than in the US or the UK, in particular. For example, ownership and voting right concentration is tremendous, liquidity of shares is low, and there is frequently a separation between cash flow and voting rights.1 In general, therefore, the exit option is less of a threat to firms management, and the voice of institutional investors, in particular, ought to be strengthened. The existing literature on codes is scant at best, and if it exists it is on the effects of corporate governance codes on performance.2 Most recently, Drobetz et al. (2004) construct a corporate governance rating for 91 German firms and find that the rating of a firm positively affects market value and the returns to shareholders. Their empirical analysis reveals that for the median firm a one standard deviation change in the governance rating results in about a 24 per cent increase in the value of Tobins Q.

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This evidence notwithstanding, there are problems with the link between corporate governance code ratings and firm performance. First, there is the well-known endogeneity problem already mentioned above: if only good firms adopt the code (for example, because the costs are low, since they fulfil the code anyway), one must expect a positive codeperformance relationship.3 Second, a high rating on the code only indirectly affects performance: a high rating must correlate with the true spirit of good governance, which only then can affect performance.4 In fact, very little is known about the underlying mechanism that relates corporate governance practices and firm performance (for example, see Shleifer and Wolfenzon, 2002). A more cautious approach of analysing corporate governance codes is adopted in this chapter. We take one step back and do not try to assess the impact of code fulfilment on the performance of companies (which is, of course, ultimately the most interesting question). Instead, we use the corporate governance rating constructed by Drobetz et al. (2004) for publicly listed German firms and analyse the determinants of this rating. This approach has the advantage that we do not run into the same endogeneity problems with the determinants of code fulfilment that we would encounter by trying to assess the effects on firm performance. For example, one cannot sensibly argue that a high or low governance rating affects the voting rights of the largest shareholder or the size/composition of the supervisory board. It must be the case that the decision making process is determined or at least monitored by the largest shareholder and/or the board, and their decisions naturally affect compliance with the code. The decision to improve corporate governance practices and attitudes should be made in awareness of its consequences and obligations (for example, see Demsetz and Lehn, 1985). However, we only have a cross-section of data at hand, which may also limit our analysis. Our results show that there is a non-linear relationship between ownership concentration and the corporate governance rating. Moreover, firms with larger boards have lower ratings, but firms that apply US-GAAP or IAS rules or use an option-based remuneration plan have higher ratings. The remainder of this chapter is structured as follows. Section 2 develops our hypotheses, which are subject to empirical testing. Because our corporate governance rating mainly refers to the rules and recommendations of the German Corporate Governance Code, we give a brief and general comparative analysis of the governance codes in place throughout the European Union in Section 3. Section 4 describes the data, Section 5 presents our empirical results, and Section 6 concludes.

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2.

HYPOTHESES

Germany is the prototype of an insider system of finance and control, and thus our hypotheses as to the determinants of ratings must reflect its institutional background. The most striking fact of even large, listed firms in Germany is that ownership and voting right concentration is tremendous. While the median largest ultimate voting block in US or UK listed firms is well below 10 per cent, it is above 50 per cent in Germany, Italy and Austria (see Becht and Rell, 1999). Therefore, presumably the owner of this block has ultimate control over the company and can decide which stance to adopt with regard to the code of good corporate governance. Accordingly, we hypothesize that the voting power of the largest shareholder affects the code rating. We also develop the notion that the size of the board of directors, a firms accounting principles, and its method of executive remuneration impact the code ratings. 2.1 Ownership Concentration

In the literature two main effects of large shareholders have been disentangled (for example, see Claessens et al., 2002; Gugler et al., 2003a). First, with increasing cash flow rights of the largest shareholder, there is a positive incentive effect. A good code rating provided it is awarded by the capital market increases the value of the firm and, hence, the value of the ownership stake of the largest shareholder. S/he should therefore have an incentive to comply with the code. However, there is a second, negative entrenchment effect. The larger the voting rights of the largest shareholder, the more entrenched s/he is and the more s/he can influence the decision making process. A high code rating achieved by making it easier for small shareholders to cast their votes in general assemblies, increasing transparency by disclosing information on individual compensation of management and the supervisory board, or agreeing to strict incompatibility regulation, to give a few examples, is not necessarily in the largest shareholders interest. We summarize the discussion as follows: Hypothesis 1 Ownership concentration is non-linearly related to the corporate governance rating. At low to intermediate holdings of the largest shareholder the entrenchment effect outweighs the incentive effect and we expect a negative relation between ownership concentration and the corporate governance rating. At high levels of ownership concentration the incentive effect outweighs the entrenchment effect and, hence, we expect a positive relation between ownership concentration and the corporate governance rating.

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2.2

Board Size

Our second determinant of code compliance is the size of the supervisory board. The decision making process in the supervisory board is likely to be affected by its size for at least two reasons. First, coordination problems are larger on a large board than on a small board. Jensen (1993) and Lipton and Lorsch (1992) suggest that large boards can be less effective than small boards, presuming that the emphasis on politeness and courtesy in boardrooms is at the expense of truth and frankness. Specifically, when boards become too big, agency problems (such as director free-riding) increase and the board becomes more symbolic and neglects its monitoring and control duties. Moreover, large boards may reflect an inadequate perception of the true executive function, particularly in firms with public involvement. Supporting this rather ad hoc proposition, Yermack (1996) was the first to report empirical evidence for a negative relationship between board size and firm valuation (see also Eisenberg et al., 1998; Beiner et al., 2004). Second, on a large board it is likely that more conflicting groups of stakeholders, such as representatives of large shareholders, employees, and creditors, are represented than on smaller boards. Third, many companies do have a (and if so, at most one) representative of small shareholders. However, the larger the board the less weight this representative has at a ballot. All of these arguments lead us to: Hypothesis 2 Larger boards tend to be reluctant to adopt good corporate governance practices and, hence, board size is negatively related to the corporate governance rating. 2.3 Accounting Principles

There are several papers that find significant effects of accounting practices on the performance of companies as well as on the distribution of profits among stakeholders, such as dividends or interest payments on debt (see, for example, La Porta et al., 1997, 1998, 2000; Gugler et al., 2003b, 2004). In Germany there are three possibilities as to how firms are allowed to account: US-GAAP (US Generally Accepted Accounting Principles), IAS (International Accounting Standards) and HGB (Handelsgesetzbuch). US-GAAP and IAS contain much stricter rules on accounting practices than HGB, which is the national law standard for accounting, particularly with respect to transparency and details of information. Due to its conservative approach (for example, historical cost accounting), HGB accounting appears to favour debtholders and large shareholders versus minority shareholders.

The determinants of German corporate governance ratings

365

Accounting according to international standards and compliance with the code can be viewed as complements for a number of reasons. First, many of the requirements of code compliance are antedated by the decision to account according to international principles. Thus the marginal costs of code compliance are smaller for these firms than for firms using HGB. Second, firms that account with US-GAAP or IAS may want to signal their good investment opportunities, and code compliance is one way to achieve this goal. Finally, although we explicitly account for firm size (total assets) in the determinants regressions below, part of the co-variation in accounting principles and code rating may be attributable to firm size (for example, due to measurement errors of true firm size), which is a main determinant of international accounting. Accordingly, we formulate: Hypothesis 3 Firms accounting according to US-GAAP or IAS have higher corporate governance ratings than firms accounting according to HGB. 2.4 Executive Remuneration

Our final variable affecting code rating is whether or not the firm has adopted an option-based remuneration plan. Diamond and Verrechia (1982) and Holmstrm and Tirole (1993) developed models that are based on the interaction of capital markets and contingent compensation. Giving managers an equity stake in the firm is a solution to ensure that managers pursue the interests of shareholders without necessarily increasing managerial entrenchment. Provided that a high governance rating is awarded by the capital market, management of firms using option-based remuneration has an incentive to comply with the code. Therefore, we formulate: Hypothesis 4 Firms that use an option-based remuneration plan have higher corporate governance ratings than other firms.

3.
3.1

CODES OF GOOD CORPORATE GOVERNANCE

European Corporate Governance Codes

Recently, all EU member states have adopted at least one governance code document.5 It is generally acknowledged that the legal framework for corporate governance is most effective if it aims at ensuring: (i) fair and equitable treatment of all shareholders, (ii) managerial and supervisory body accountability, (iii) transparency as to corporate performance, ownership structure and governance, and (iv) corporate responsibility. While the codes originate

366

The board, management relations and ownership structure

from countries with very diverse cultures, financing traditions, ownership structures, and legal origins, they are remarkably similar in their general notion of best practice corporate governance rules. In fact, codes appear to serve as a converging force in corporate governance practices. Nevertheless, two observations are noteworthy. First, the coverage of the codes differs substantially due to differences in legal origins and frameworks. While some codes address general principles and practices of corporate governance, other nations establish these in company laws and securities regulation. Second, while some codes strongly emphasize the supervisory body holding managers accountable to a broad base of relatively dispersed shareholders (for example, in the UK), other codes focus on the protection of minority shareholders to ensure equal treatment to a dominant shareholder (for example, in Germany). The codes have three stated objectives: (i) stakeholder and/or shareholder interests, (ii) the work of supervisory and managerial bodies, and (iii) disclosure requirements. The majority of codes recognize that corporate success, shareholder profit, employee security and well-being, and the interests of other stakeholders are strongly interrelated. They generally call for shareholders to be treated equitably, disproportional voting rights to be avoided or at least fully disclosed to all shareholders, and removal of barriers to shareholder participation in general meetings, whether in person or by proxy.6 Despite structural differences between two-tier and unitary board systems, they all stress that supervisory responsibilities are distinct from management responsibilities. Many suggest practices designed to enhance the distinction between the roles of the supervisory and managerial bodies, including supervisory body independence, separation of the chairman and CEO roles, and reliance on board committees (such as the nominating committee).7 Finally, all codes contain various disclosure requirements. An issue that has received specific public attention is the greater voluntary transparency as to executive and director compensation.8 In addition, the codes also support the increasing public interest in disclosure as regards director independence (in both one-tier board and two-tier board systems), share ownership, and, in many instances, issues of broader social concerns. With regards to code enforcement, the prescriptions supplement and complement the mandatory prescriptions provided by company and securities laws and listing rules. However, they are non-imperative and lack mandatory compliance authority. The vast majority of codes merely require companies to provide greater voluntary disclosure of governance practices, including disclosure about the extent of compliance with a particular code recommendation. Listed companies are required to disclose whether they comply with the specified code and explain any deviations

The determinants of German corporate governance ratings

367

(comply or explain). Even though compliance with code provisions is wholly voluntary, reputational market forces can result in significant compliance pressures. Finally, codes are increasingly used by investors and market analysts, rating agencies, shareholder monitoring groups and commentators to benchmark supervisory and management bodies. 3.2 The German Corporate Governance Code

After a few private interest groups began establishing best practices of corporate governance in the late 1990s, in June 2000 the German federal government appointed a commission with the goal to formulate proposals for modernizing German corporate law. This report prepared the ground for the development of a national code for improving the management and control functions of publicly quoted companies. The results were elaborated into the code of conduct by a second, follow-up commission. The German Corporate Governance Code was finally published on 26 February 2002, and the Transparency and Disclosure Act (TransPuG), which took effect on 26 July 2002, obliges publicly quoted companies to apply the code recommendations. The code is an example of self-commitment by the corporate sector and requires disclosure on the comply or explain rule described in Section 3.1. The stated goal of the code is to promote the trust of international and national investors, customers, employees and the general public in the management and supervision of listed German stock corporations.9 This is in contrast to the Anglo-Saxon view of corporate governance, where there is little room for the general public. Nevertheless, the code constitutes a regime shift in the German corporate governance system by taking a surprisingly pragmatic view on the fundamental differences in stakeholder and shareholder interests, an issue that has been fiercely debated in particular in the German literature (for example, see Albach, 2003).

4.
4.1

DATA DESCRIPTION
A German Corporate Governance Rating

The corporate governance rating applied in this chapter is from Drobetz et al. (2003, 2004). They construct a broad, multifactor corporate governance rating, which is based on responses to a survey sent out to a broad sample of German publicly listed firms. To qualify for inclusion in the corporate governance rating, each practice and attitude (i) had to refer to a governance element that is not (yet) legally required and (ii) needed to be considered as

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The board, management relations and ownership structure

international market practice from an investors perspective. Most proxies included in the rating represent recommendations and suggestions of the German Corporate Governance Code. Note that while the former work according to the comply-or-explain principle, the latter are wholly voluntary. A few other governance proxies originate from the DVFA German Corporate Governance Scorecard,10 from CalPERS German Market Principles, and from the Deminor Corporate Governance Checklist. In total, the rating contains 30 governance proxies divided into five categories: (1) corporate governance commitment, (2) shareholder rights, (3) transparency, (4) management and supervisory board matters, and (5) auditing. A representative question from each category is listed below:

Are there firm-specific corporate governance guidelines set out in writing? Are there measures in place to facilitate the personal exercising of shareholder voting rights (for example, via internet) and to assist the shareholders in the use of proxies? Are the fixed and variable remuneration elements as well as share ownership (including existing option rights) of members of the management and supervisory board published separately and in individualized form in the notes to the financial statements? Are there supervisory board committees to deal with complex matters (such as audit, compensation, strategy)? Are there firm-specific rules to ensure that the auditor does not perform other services for the firm (such as consulting work)?

A questionnaire with all 30 governance proxies was sent out to all firms in the four principal market segments of the German stock exchange: DAX 30 (blue-chip stocks), MDAX (mid-cap stocks), NEMAX 50 (index of growth firms), and SDAX (small-cap stocks), comprising a total of 253 firms. Data collection was completed at the end of March 2002. Overall, the survey had a response ratio of 36 per cent, which results in a sample of 91 German firms. The construction principles of the aggregate governance rating are kept simple. Twenty-five basis points are added for each acceptance level of the respective proxy in a five-scale answering range. For each firm the aggregate rating is an unweighted sum of the basis points across all proxies, ranging from 0 (minimum) to 30 (maximum).11 Hence, the dependent variables in our empirical analysis are: OVERALL (aggregate corporate governance rating), CG_UNT (governance commitment), CG_AKT (shareholder rights), CG_TRA (transparency), CG_ENT (management and supervisory board matters), and CG_ABS (auditing).

The determinants of German corporate governance ratings

12 10 Number of firms 8 6 4 2 0 0 2 4 6 8 10 12 14 16 18 20 22 Corporate governance rating 24 26 28

369

30

Note: This figure shows the distribution of the survey-based corporate governance rating (CGR) for 91 German public firms from Drobetz et al. (2004). The survey was sent out in February 2002, and the data collection was completed by the end of March 2002. The rating represents an unweighted sum of the basis points (on a five-scale answering range) for all governance proxies in five broad categories: (1) corporate governance commitment, (2) shareholder rights, (3) transparency, (4) management and supervisory board matters, and (5) auditing. The corporate governance rating ranges from 0 (minimum) to 30 (maximum). The ratings in the figure are rounded to the nearest integer.

Figure 14.1

Distribution of the German corporate governance rating

The histogram in Figure 14.1 shows that the rating over the 91 firms in our sample is slightly skewed to the right. More than 40 per cent of the firms have a rating between 20 and 23. Nevertheless, governance proxies display a sufficiently wide distribution to mitigate a possible sample selection bias in the survey. Panel A in Table 14.1 presents summary statistics of the dependent variables. Due to data limitations for the independent variables, the sample in our empirical analysis is reduced to 80 firms. The average rating is 19.51, with firm ratings ranging from 9.75 to 27.25. The sub-indices with the highest ratings are CG_ENT (management and supervisory matters) and CG_TRA (transparency), which can be explained by the fact that these areas are strongly accompanied by laws and regulation. 4.2 Explanatory Variables

The data for ownership structure/voting rights are based on the CD-ROM Wer gehrt zu Wem? (Who owns whom?, 30 April 2002) or taken

370

The board, management relations and ownership structure

Table 14.1
Variables

Summary statistics
Mean Median Minimum Maximum 27.25 5.00 5.00 5.00 9.50 5.00 Obs. 85 85 85 85 85 85 33 21 21 8 100.00 10,000.00 25.00 25.00 50.00 21.00 1.00 1.00 1.00 20.64 8.02 80 80 85 85 80 85 85 85 85 85 85

Panel A: Aggregate rating and components OVERALL 19.51 19.75 9.75 CG_UNT 2.27 2.00 0.00 CG_AKT 3.07 3.00 0.00 CG_TRA 4.55 4.75 2.00 CG_ENT 5.98 6.25 1.25 CG_ABS 3.63 3.75 1.00 Panel B: Aggregate rating by ownership concentration VR1<25% 21.42 18.67 25%VR1.50% 17.30 50%VR1.75% VR175% 19.47 Panel C: Independent variables VR1 37.13 31.85 4.60 VR1^2 2112.94 1014.45 21.16 VR1_25 19.80 25.00 4.60 VR1_25to50 12.01 9.10 0.00 VR1_50 6.45 0.00 0.00 BOARDSIZE 10.29 8.00 3.00 GAAP 0.26 0.00 0.00 IAS 0.32 0.00 0.00 OPTION 0.60 1.00 0.00 TA 13.78 13.22 8.26 TQ 1.63 1.17 0.46

Notes: The variables relating to the corporate governance score are drawn from the study by Drobetz et al. (2004), estimates on the ownership structure are based on the CD-ROM Wer gehrt zu Wem (Who owns whom?, 30 April 2002) and from BaFin (Bundesanstalt fr Finanzdienstleistungsaufsicht) March 2002; all the rest of the calculations are based on annual reports as of end 2001. The independent variables are: OVERALL (corporate governance rating), CG_UNT (governance commitment), CG_AKT (shareholder rights), CG_TRA (transparency), CG_ENT (management and supervisory board matters), CG_ABS (auditing). The corporate governance variables are: VR1 denotes the voting rights of the largest ultimate shareholder, and VR1^2 is the squared value of VR1. VR1_25 equals the voting rights of the largest shareholder if the voting rights are below 25%; in any other case it is set to 25%. VR1_25to50 is 0 if the voting rights of the largest investor are below 25%; if the voting rights are beyond or equal to 25% and below 50%, this variable is calculated as voting rights 25%. VR1_50 is set to 0 if the voting rights are below 50%; in any other case it is computed as voting rights 50%. BOARDSIZE is the number of directors on the companys supervisory board. GAAP is a dummy variable and equals 1 if US-GAAP are used as accounting standards in the annual reports and equals 0 otherwise. IAS is a dummy variable and is set to 1 if IAS are used as accounting standards in the annual reports and equals 0 otherwise. OPTION is a dummy variable and equals 1 if the firm uses an option-based remuneration plan and 0 otherwise. TA is defined as the natural logarithm of the book value of total assets. TQ equals the ratio of market value of equity plus liabilities divided by book value of total assets.

The determinants of German corporate governance ratings

371

from BaFin (Bundesanstalt fr Finanzdienstleistungsaufsicht, March 2002). All other variables are based on annual reports as of end 2001. To appropriately capture the distribution of control rights and decision power among shareholders, we use voting concentration as a proxy for ownership concentration. Following the hypothesis formulated in Section 2, we construct several variables related to voting concentration. VR1 denotes the voting rights of the largest ultimate shareholder. To account for a possibly non-linear relationship between ownership concentration and the corporate governance rating, VR1^2 is the squared value of VR1. Alternatively, we follow Morck et al. (1988) and use the following variables to estimate piecewise linear regressions: VR1_25 5 voting rights of the largest shareholder if voting rights , 25%, 5 25% if voting right of the largest shareholder $ 25%; VR1_25to50 5 0 if the voting rights of the largest shareholder , 25%, 5 voting rights of the largest shareholder minus 25% if 25% voting rights , 50%, 5 25% if voting rights of the largest shareholder $ 50%; VR1_50 5 0 if voting rights of the largest shareholder , 50%, 5 voting rights minus 50% if voting rights $ 50%. Panel B in Table 14.1 presents a breakdown of the aggregate corporate governance rating by four breaking points of ownership concentration. The average rating is higher than 21 points if the largest shareholder holds less than 25 per cent in voting rights, but it is lower than 19 (18) points if VR1 is larger than 25 per cent (50 per cent) but smaller than 50 per cent (75 per cent). The average rating again increases above 19 points if the firm is in super-majority control (VR1.75%). This hints at possible non-linear effects of the largest shareholder on firms ratings. BOARDSIZE denotes the number of directors on the companys supervisory board. The data are taken from the firms annual reports as of year-end 2001. GAAP is a dummy variable and equals 1 if a firm uses US-GAAP as the accounting standards in its annual report, and equals 0 otherwise. Similarly, IAS is a dummy variable and is set to 1 if IAS are used as accounting standards, and equals 0 otherwise. OPTION is a dummy variable that equals 1 if the firm uses an option-based remuneration plan, and 0 otherwise. Finally, we use two additional control variables: (i) SIZE is defined as the natural logarithm of the book value of total assets, and (ii) TQ refers to the Tobins Q, approximated as the ratio of market value of equity plus liabilities divided by book value of total assets. Summary statistics of the independent variables are presented in Panel C of Table 14.1.

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The board, management relations and ownership structure

5.
5.1

EMPIRICAL RESULTS
Main Empirical Results

Table 14.2 presents our main results. In equation (1), VR1 and SIZE are the only independent variables. The corresponding coefficient on VR1 is negative and statistically significant at the 5 per cent level. Controlling for size, we observe that larger voting rights are associated with lower governance ratings, indicating that the entrenchment effect, on average, dominates the alignment effect. We will explore this relation in more detail below. As expected, the coefficient on SIZE is positive and statistically significant. The explanatory power (adjusted R2) for this simplest regression specification is almost 20 per cent. In equation (2), BOARDSIZE is included as an additional explanatory variable. Confirming our second hypothesis, the relationship between board size and the governance rating is significantly negative. The analysis again controls for firm size, taking into account that larger firms also possess larger boards. This result confirms the hypothesis by Jensen (1993) and Lipton and Lorsch (1992), suggesting that larger boards are hampered by coordination and communication problems. In addition, the decision finding process may be complicated by more conflicting groups of stakeholders on larger boards. Equation (3) contains the full set of explanatory variables, where the possibly non-linear relationship between the corporate governance rating and the voting rights by the largest shareholders is captured using the three variables related to the breakpoints described in Section 4.2. We find supporting evidence for all four hypotheses. First, there is some evidence that the relationship between the corporate governance rating and ownership concentration is non-linear. At intermediate holdings of the largest shareholder the entrenchment effect dominates the incentive effect, as indicated by the negative and significant coefficient on the VR25_50 variable. However, with ownership concentration above 50 per cent, the incentive alignment effect begins to dominate, as reflected by the positive (albeit insignificant) coefficient on the VR1_50 variable. Together, these results imply a U-shaped relationship between the corporate governance rating and ownership concentration. In addition, confirming our second hypothesis, board size is significantly negatively related to the corporate governance rating even when we include all our explanatory variables. Our empirical results further support the third hypothesis, that firms accounting according to US-GAAP or IAS have higher governance ratings than firms accounting according to HGB. This is indicated by the significant positive coefficients on both the GAAP and IAS dummy variables. Finally, we find

Table 14.2
GAAP 80 80 80 80 IAS OPTION TA Const.

Main equations
Obs. Adj. R2 0.1965 0.2793 0.4555 0.4470

Eq.

VR1

VR1^2 VR1_25 VR1_25to50 VR1_50 BOARDSIZE

(1)

(2) 0.0969 (2.09)** 0.0468 (1.55)

0.0300 (2.18)** 0.0296 (2.26)**

(3)

0.0061 (0.10)

(4)

0.0834 0.0007 (2.08)** (1.75)*

0.3429 (3.14)*** 0.2536 (2.54)** 0.2447 (2.44)** 3.2071 (3.59)*** 3.0942 (3.48)*** 1.6669 (2.31)** 1.6288 (2.24)** 1.2759 (1.81)* 1.2002 (1.69)*

0.5457 (3.72)*** 1.2584 (4.73)*** 0.9555 (3.87)*** 0.9627 (3.88)***

13.0737 (5.92)*** 6.7290 (2.31)** 7.4942 (2.76)*** 8.2896 (3.06)***

373

Notes: The estimating sample contains 85 German firms; variations are due to data limitations. Time period: 2002. The table shows the results from OLS regressions of the corporate governance rating as dependent variable on the main corporate governance mechanisms along with the control variable. Eq. (1) is a partial model with ownership concentration explaining the corporate governance score. Eq. (2) introduces another corporate governance mechanism, the firms board, into the equation. Eq. (3) includes all corporate governance mechanisms and is similar to the piece-wise linear regression estimated by Morck et al. (1988); however, other turning points are used. Eq. (4) allows for non-linearities by including a squared term. The dependent variable refers to the corporate governance rating as calculated by Drobetz et al. (2004). The corporate governance variables are: VR1 denotes the voting rights of the largest ultimate shareholder, and VR1^2 is the squared value of VR1. VR1_25 equals the voting rights of the largest shareholder if the voting rights are below 25%; in any other case it is set to 25%. VR1_25to50 is 0 if the voting rights of the largest investor are below 25%; if the voting rights are beyond or equal to 25% and below 50%, this variable is calculated as voting rights 25%. VR1_50 is set to 0 if the voting rights are below 50%; in any other case it is computed as voting rights 50%. BOARDSIZE refers to the number of directors on the companys supervisory board. GAAP is a dummy variable and equals 1 if US-GAAP are used as accounting standards in the annual reports and equals 0 otherwise. IAS is a dummy variable and is set to 1 if IAS are used as accounting standards in the annual reports and equals 0 otherwise. OPTION is a dummy variable and equals 1 if the firm uses an option-based remuneration plan and 0 otherwise. The control variable is TA, the natural logarithm of the book value of total assets. ***/**/* denotes significance at the 0.01/0.05/0.10 error level, respectively.

374

The board, management relations and ownership structure

supporting evidence for our fourth hypothesis, that firms with optionbased remuneration plans have higher governance ratings than other firms. The coefficient on OPTION is (marginally) significantly positive. Again, the regression controls for firm size, as measured by TA, confirming that larger firms exhibit a higher governance rating. The explanatory power is reasonably high, with an adjusted R-square of 45.5 per cent. In equation (4) we use VR1 and VR1^2, in addition to all other explanatory variables, to measure the non-linear relationship between the governance rating and ownership concentration. The results confirm our previous findings. The coefficients on VR1 and VR1^2 are significantly negative (at the 5 per cent level) and positive (at the 10 per cent level), respectively, again indicating a U-shaped relationship between the governance rating and ownership concentration. All other coefficient estimates are as before. 5.2 Robustness Tests

In order to determine the reliability of our results, we conduct two robustness tests for equation (4) in Table 14.2. First, we test whether industry effects drive the results and estimate a fixed-effects model. Using the Dow Jones STOXX classification scheme, the model incorporates intercepts for 18 industries. The estimation results are shown in Table 14.3. Compared with the previous results in Table 14.2, VR1 and IAS are now significant only at the 10 per cent level, and the squared term VR^2 as well as BOARDSIZE and OPTION turn insignificant. The notion that industry is a determinant of board size, compensation packages and accounting standards should come as no surprise. For example, supervisory boards of traditional industries tend to be larger, while boards of New Economy firms are smaller. Furthermore, the optimal compensation package is likely to be influenced by the presence of asymmetric information between principal and agent, by the riskiness of the firms environment and by its asset specificity (for example, see Demsetz and Lehn, 1985). All of these firm characteristics are likely to be influenced by the industry a firm operates in. As a second robustness test we include one (so far) possibly omitted variable, namely the performance of a firm. Firms with better performance and higher valuations could be more inclined to choose better corporate governance instruments, since it may be cheaper for them as they fulfil most of the recommendations anyway. We apply Tobins Q as a measure of firm valuation and use this variable as an additional explanatory variable for the governance rating. To account for endogeneity, we estimate a two-stage least-squares regression. The first-stage regression involves a regression of Tobins Q on all exogenous variables and the following instrument variables: industry dummies (18 industry dummies according

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375

Table 14.3

Robustness tests
Industry fixed effects Coeff. t-value (1.79)* (1.37) (0.72) (2.99)*** (1.84)* (1.13) (1.91)* (2.86)*** Endogeneity (2SLS) Coeff. 0.0737 0.0007 0.2776 2.5774 1.6891 1.1029 1.0926 0.3518 6.2065 77 0.4458 t-value (1.71)* (1.52) (2.58)** (2.40)** (2.24)** (1.40) (3.85)*** (0.75) (1.71)*

VR1 VR1^2 BOARDSIZE GAAP IAS OPTION TA TQ Const. Obs. Adj. R2 Hausman-test: c2(7) p-value

0.0880 0.0007 0.1000 3.5001 1.5394 1.1015 0.6701 11.0366 80 0.3685

2.55 0.9232

Notes: The estimating sample contains 85 German firms; variations are due to data limitations. Time period: 2002. The table shows robustness test for equation (4) from Table II. The first specification applies an industry fixed-effect model to equation (4). The second specification uses two-stage least squares whereby in the first stage TQ (Tobins Q, ratio of market value of equity plus liabilities divided by total book value of assets) is regressed on the following instruments: industry (refers to 18 industries from Dow Jones EURO-STOXX classification), beta value calculated from monthly stock returns over the period from 1998 to 2001, and the natural logarithm of the age of the firm. A Hausman-test accepts exogeneity. The dependent variable refers to the corporate governance score as calculated by Drobetz et al. (2004). The corporate governance variables are: VR1 denotes the voting rights of the largest ultimate shareholder, and VR1^2 is the squared value of VR1. BOARDSIZE is the number of directors on the companys supervisory board. GAAP is a dummy variable and equals 1 if US-GAAP are used as accounting standards in the annual reports and equals 0 otherwise. IAS is a dummy variable and is set to 1 if IAS are used as accounting standards in the annual reports and equals 0 otherwise. OPTION is a dummy variable and equals 1 if the firm uses an option-based remuneration plan and 0 otherwise. The control variable is TA, the natural logarithm of the book value of total assets. ***/**/* denotes significance at the 0.01/0.05/0.10 error level, respectively.

to the Dow Jones EURO-STOXX classification), a firms beta value calculated from monthly stock returns over the period from 1998 to 2001, and the natural logarithm of the age of the firm. The second-stage regression applies all governance mechanisms and the fitted value of Tobins Q as the explanatory variables. As shown in Table 14.3, Tobins Q is insignificant, a Hausman-test accepts exogeneity, and all the results for the different corporate governance mechanisms remain essentially the same, both in

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The board, management relations and ownership structure

the magnitude of the coefficients and their level of significance. Overall, these results indicate that our previous results for the baseline regressions in Table 14.2 are not afflicted by the inclusion/exclusion of Tobins Q. 5.3 Results for the Components of the Governance Rating

In this section we split the aggregate rating into its five components: (1) shareholder rights, (2) management and supervisory board matters, (3) transparency, (4) governance commitment, and (5) auditing. The results of the regressions using the respective sub-indices as dependent variables are shown in Table 14.4. Shareholder rights (equation (1) in Table 14.4) encompass criteria such as the one-share-one-vote principle, subscription rights for capital increases, and modern communication (that is, internet) used for the general meeting and/or the voting process. As can be seen from equation (1) in Table 14.4, there is no positive part in the relation between this sub-index and VR1. Regressing VR1 linearly on the shareholder rights rating, VR1 is estimated significantly (at the 5 per cent level) negative. This indicates that the largest shareholder is particularly wary of code recommendations that increase the control rights of minority shareholders. A significantly negative/positive relationship between VR1 and a subindex are obtained for the categories management and supervisory board matters (equation 2) and auditing (equation 5). Management and supervisory board matters encompass dimensions such as remuneration and performance criteria of board members; disclosure of individual board members variable and fixed pay components in the annual reports; selection process of directors; separate committees within the board; and the number of board members directorships. We therefore argue that this category (besides shareholder rights) is the most relevant with respect to corporate governance improvement. Given that board size also has a significantly negative influence, our main results are confirmed strongest for this sub-index. None of our corporate governance variables are significant in the regression for the category transparency (equation 3). Together with the fact that the average rating is extremely high (4.55 out of a maximum of 5), this reflects the general understanding in Germany as well as in other Continental European countries that transparency is vital for good corporate governance, and not even large shareholders can oppose this. A major improvement in transparency legislation was achieved when the European Unions Transparency Directive (88/627/EEC) was transposed into German law and became effective at the beginning of 1995. The component related to governance commitment (equation 4) investigates whether there are corporate governance guidelines set out in writing,

Table 14.4
GAAP 80 80 80 80 80 IAS OPTION TA Const. Obs. Adj. R2 0.313 0.313 0.043 0.065 0.276

Components of the corporate governance rating

Eq.

VR1

VR1^2

BOARDSIZE

(1)

(2)

(3)

(4)

377

(5)

0.0046 (0.38) 0.0590 (2.68)*** 0.0019 (0.26) 0.0080 (0.41) 0.0297 (2.53)**

0.00003 (0.23) 0.0006 (2.52)** 0.000001 (0.01) 0.0001 (0.69) 0.0003 (2.61)***

0.0256 (0.83) 0.1375 (2.49)** 0.0148 (0.79) 0.0494 (1.01) 0.0174 (0.59)

0.1152 0.3189 (0.42) (1.44) 1.2683 0.5007 (2.60)*** (1.25) 0.0530 0.0892 (0.32) (0.65) 0.9239 0.1061 (2.14)** (0.30) 0.8397 0.7922 (3.22)*** (3.72)***

0.4539 (2.09)** 0.4978 (1.27) 0.1962 (1.47) 0.1883 (0.55) 0.2406 (1.15)

0.2218 0.0721 (2.93)*** (0.09) 0.4001 2.0826 (2.93)*** (1.40) 0.0864 3.3753 (1.85)* (6.61)*** 0.1917 0.0021 (1.59) (0.00) 0.0628 2.7616 (0.86) (3.47)***

Notes: The estimating sample contains 85 German firms; variations are due to data limitations. Time period: 2002. The table shows the results from OLS regressions of the components of the corporate governance rating as dependent variables on the main corporate governance mechanisms along with the control variable. The dependent variables in the different equations are: Eq. (1) shareholder rights (Aktionrsrechte). Eq. (2) management and supervisory board matters (Entscheidungs- u. Kontrollgremien). Eq. (3) transparency (Transparenz). Eq. (4) governance commitment (Unternehmensausrichtung und Corporate Governance). Eq. (5) auditing (Abschlussprfung). The corporate governance variables are: VR1 denotes the voting rights of the largest ultimate shareholder, and VR1^2 is the squared value of VR1. BOARDSIZE is the number of directors on the companys supervisory board. GAAP is a dummy variable and equals 1 if US-GAAP are used as accounting standards in the annual reports and equals 0 otherwise. IAS is a dummy variable and is set to 1 if IAS are used as accounting standards in the annual reports and equals 0 otherwise. OPTION is a dummy variable and equals 1 if the firm uses an option-based remuneration plan and 0 otherwise. The control variable is TA, the natural logarithm of the book value of total assets. ***/**/* denotes significance at the 0.01/0.05/0.10 error level, respectively.

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or whether there is a corporate governance representative reporting on corporate governance issues to the supervisory board. The only significant governance variable is GAAP. This could be explained by the fact that firms employing US-GAAP are those which strive for a listing in the US, where corporate governance is organized more formally, and where it is more common to structure the corporation according to corporate governance guidelines. Finally, the sub-index referring to auditing (equation 5) is based on the following questions. Do quarterly reports contain segment reporting? Are there firm-specific rules to ensure that the auditor does not perform other services for the firm? Does the annual report contain information about the risk-management system of the corporation? Besides the significant negative/positive VR1 influence, international accounting standards (IAS and GAAP) exert a positive and significant influence on auditing. International accounting standards, which are supposed to reveal more information than national accounting standards, also raise the quality of auditing.

6.

CONCLUSION

There is mounting empirical evidence that there is a relationship between the quality of firm-level corporate governance and firm valuation. Ultimately, this is the only reason why corporate governance issues should be of interest for financial economists at all. Unfortunately, all empirical studies are inherently plagued with endogeneity problems, as causality could well run from performance to governance. This chapter tries to circumvent the problem of causality by taking one step back and investigating the determinants of good corporate governance as measured by the corporate governance rating of Drobetz et al. (2004). It is ultimately the owners who decide (or at least monitor the decision) on whether or not to adopt better governance practices. Ownership structure may thus be regarded as exogenous and even more so in Continental European countries, where significant ownership concentration is the rule rather than an exception. Similarly, the structure of the supervisory authorities can be expected to affect the governance rating of a firm. The board of directors ultimately takes the decisions with respect to all governance issues (and, hence, has to assume responsibility for all corporate governance malfunctions). While our research question is clearly a lot more modest than directly exploring the link between corporate governance and firm valuation, we still uncover several interesting interrelationships within firms. We confirm the non-linear relationship between ownership concentration and the quality of firm-level governance familiar from previous governance/

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performance studies. We interpret it as being caused by two opposing influences, incentive alignment and entrenchment, and document a significant entrenchment effect at intermediate holdings of the largest shareholder (between 25 and 50 per cent). With increasing holdings of the largest shareholders (more than 50 per cent), there are positive wealth effects and, hence, incentive effects start to dominate. Our results hold up strongest when analysing the sub-index relating to management and supervisory board matters. In addition, firms with larger board size have lower governance ratings, but firms that apply US-GAAP or IAS rules and/or use an option-based remuneration plan have higher governance ratings. It is worth putting our results into perspective. First, there is a positive and reassuring message. Corporate governance codes potentially improve the governance and decision making processes of companies. Otherwise, if provisions were not binding anyway, large shareholders or large boards had no need to oppose (some of) them (for example, transparency of executive pay). Second, however, there is a more negative and cautious conclusion that follows from our results. Large shareholders still have a tight grip on companies in Continental European countries and veto recommendations that might lead to a loss of their control and power, such as recommendations for one-share-one-vote or disclosure of individual board members pay.

NOTES
1. See Barca and Becht (2001), Becht and Rell (1999), Gugler (2001), and La Porta et al. (1998) for analyses of ownership and voting right concentration. See Becht (1999) on liquidity, and see Claessens et al. (2002) and Gugler and Yurtoglu (2003a) on the separation of voting and cash flow rights. Pagano et al. (2002) show that European markets having the highest trading costs, lowest accounting standards and poorest shareholder protection fare worst in attracting and retaining cross-border listings. There is a much more developed literature on the effects of corporate governance mechanisms on performance, though. Using firm-level data from 27 developed countries, La Porta et al. (2002) find that better shareholder protection is associated with higher valuation of corporate assets. Gompers et al. (2003) report for a broad sample of US firms that firms with stronger shareholder rights receive higher valuations and have higher profits, higher sales growth, and lower capital expenditures. Klapper and Love (2003) use firmlevel data from 14 emerging stock markets and also report that better corporate governance is highly correlated with better operating performance and higher market valuation. On the endogeneity issue and suggestions for cure, see Brsch-Supan and Kke (2002) and Gugler and Yurtoglu (2003b). For example, Cuervo (2002) argues that especially in civil law countries such as Germany the codes of good governance can be applied formally, following the letter but not the spirit of the law, since they cannot be legally enforced. Specifically, a variety of organizations have issued governance codes, including governmental entities, committees and commissions organized or appointed by governments, stock exchange related bodies as well as business, industry and academic associations. In addition to national codes, several pan-European and international governance

2.

3. 4. 5.

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codes have emerged (such as the OECD Principles of Corporate Governance). For the codes of almost 40 countries, see http://www.ecgi.org/codes/all_codes.htm. For an extensive comparative analysis we refer to http://europa.eu.int/comm/internal_market/ en/company/company/news/corp-gov-codes-rpt_en.htm. Baums and Fraune (1994) report that only 58 per cent, on average, of all voting rights are represented at the annual meeting of a German publicly listed firm. For empirical analysis see Loderer and Peyer (2002). Because two-thirds of the German firms included in the DAX blue-chip index opted out and do not report the salaries of each director separately, the public discussion has intensified only recently. There are even suggestions by major political parties to legally force disclosure of individual compensation (see Keeping stumm, Economist, 2127 August 2004). See the German Corporate Governance Code (2002), www.corporate-governance-code. de. DVFA is the German Society of Investment Analysis and Asset Management. More in-depth analysis in Drobetz et al. (2004) shows that an equal-weighting scheme is not a restrictive assumption.

6. 7. 8.

9. 10. 11.

REFERENCES
Albach, H. (2003), Corporate governance large and small corporations, agents, principals, competitors, in Fandel, G., U. Backes-Gellner, M. Schlter and J.E., Staufenbiel (eds), Managing Enterprises of the New Economy by Modern Concepts of the Theory of the Firm, Proceedingsband zur Tagung der ErichGutenberg-Arbeitsgemeinschaft. Barca, Fabrizio and Marco Becht (eds) (2001), The Control of Corporate Europe, Oxford: Oxford University Press. Baums, T., and C. Fraune (1994), Institutionelle Anleger und Publikumsgesellschaft: Eine empirische Untersuchung, working paper, University of Frankfurt. Becht, M. (1999), European corporate governance: trading off liquidity against control, European Economic Review, 43 (46), 107183. Becht, M. and A. Rell (1999), Blockholdings in Europe: an international comparison, European Economic Review 43 (46), 104956. Beiner, S., W. Drobetz, F. Schmid and H. Zimmermann (2004), Is board size an independent corporate governance mechanism?, Kyklos, 57 (3), 32758. Brsch-Supan, A. and J. Kke (2002), An applied econometricians view of empirical corporate governance studies, German Economic Review, 3 (3), 295326. Claessens, S., S. Djankov, J.P.H. Fan and L.H.P Lang (2002), Disentangling the incentive and entrenchment effects of large shareholders, Journal of Finance, 57, 274171. Cuervo, A. (2002), Corporate governance mechanisms: a plea for less code of good governance and more market control, Corporate Governance: An International Review, 10 (2), 8493. Demsetz, H. and K. Lehn (1985), The structure of corporate ownership: causes and consequences, Journal of Political Economy, 93 (6), 115577. Diamond, D. and R. Verrechia (1982), Optimal managerial contracts and equilibrium security prices, Journal of Finance, 37, 27587. Drobetz W., A. Schillhofer and H. Zimmermann (2003), Ein Corporate Governance Rating fr deutsche Publikumsgesellschaften, Zeitschrift fr Betriebswirtschaft, 74 (1), 121.

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Drobetz W., A. Schillhofer and H. Zimmermann (2004), Corporate governance and expected stock returns: evidence from Germany, European Financial Management, 10 (2), 26793. Eisenberg, T., S. Sundgren and M. Wells (1998), Larger board size and decreasing firm value in small firms, Journal of Financial Economics, 48, 3554. Gompers, P., L. Ishii and A. Metrick (2003), Corporate governance and equity prices, Quarterly Journal of Economics, 10755. Gugler, K. (2001), Corporate Governance and Economic Performance, Oxford: Oxford University Press. Gugler, K. and B.B. Yurtoglu (2003a), Corporate governance and dividend pay-out policy in Germany, European Economic Review, 47 (4), 73158. Gugler, K. and B.B. Yurtoglu (2003b), Average Q, marginal Q, and the relation between ownership and performance, Economics Letters, 78 (3), 37984. Gugler, K., D.C. Mueller and B.B. Yurtoglu (2003a), Separating the wealth and entrenchment effects of insider ownership on investment performance, Center for Business Studies, Department of Economics, University of Vienna, Working Paper Series. Gugler, K., D.C. Mueller and B.B. Yurtoglu (2003b), The impact of corporate governance on investment returns in developed and developing countries, The Economic Journal, 113, 51139. Gugler, K., Mueller, D.C. and Yurtoglu, B.B. (2004), Corporate governance, capital market discipline and the returns on investment, Journal of Law and Economics, 47 (2), 589633. Holmstrm, B. and J. Tirole (1993), Market liquidity and performance monitoring, Journal of Political Economy, 101, 678709. Jensen, M.C. (1993), The modern industrial revolution, exit, and the failure of internal control systems, The Journal of Finance, XLVIII (3), 83180. Klapper, L.F. and I. Love (2003), Corporate governance, investor protection, and performance in emerging markets, Journal of Corporate Finance, 195, 126. La Porta, R., F. Lopez-de-Silanes, A. Shleifer and R. Vishny (1997), Legal determinants of external finance, Journal of Finance, 52 (3), 113150. La Porta, R., F. Lopez-de-Silanes, A. Shleifer and R. Vishny (1998), Law and finance, Journal of Political Economy, 106 (6), 111355. La Porta, R., F. Lopez-de-Silanes, A. Shleifer and R. Vishny (2000), Agency problems and dividend policies around the world, Journal of Finance, 55, 133. La Porta, R., F. Lopez-de-Silanes, A. Shleifer and R. Vishny (2002), Investor protection and corporate valuation, Journal of Finance, 57, 114770. Lipton, M. and J. Lorsch (1992), A modest proposal for improved corporate governance, Business Lawyer, 48, 5977. Loderer, C. and U. Peyer (2002), Board overlap, seat accumulation and share prices, European Financial Management, 8, 16592. Morck, R., A. Shleifer and R. Vishny (1998), Management ownership and market valuation: an empirical analysis, Journal of Financial Economics, 20, 293315. Pagano, M., A. Roell and J. Zechner (2002), The geography of equity listing: why do companies list abroad?, Journal of Finance, 57, 265194. Shleifer, A. and Wolfenzon, D. (2002), Investor protection and equity markets, Journal of Financial Economics, 66, 327. Yermack, D. (1996), Higher market valuation of companies with a small board of directors, Journal of Financial Economics, 40, 185211.

15.

Top management, education and networking

Mogens Dilling-Hansen, Erik Strjer Madsen and Valdemar Smith*

1.

INTRODUCTION

The corporate governance literature has primarily focused on agent problems in management and, consequently, on the misallocation of resources as a result of bad decision making by managers as they do not have an incentive to behave in the best interests of all share- and debt-holders. Another important theme in the literature is misallocation of resources as a result of cash flow expropriation of major shareholders at the expense of minority shareholders; see, for example Tirole (2006). However, good decision making is not only a question of the right long-run target or incentives of the management; it also depends on their knowledge and the level of significant information about the competitive and technological environment of the firm. In that respect personal or professional networks may play an important role for the firm managers. The chapter uses a social network approach to analyse the importance in respect to firm performance of this external network between managers and board members of different firms by using a data base of the largest Danish companies. The corporate networking activity is divided into two types: networking between firms with a common owner structure and networking between independent firms. We use the Bonacich centrality approach to measure the networking activity; see Bonacich (1987). Moreover the primary goal of the paper is to analyse whether firm performance is affected by the strength of the professional networks with other firms held by top management, that is, CEOs and members of the supervisory board of the firm. Recognizing that the strength of network and firm performance are potentially endogenous, we set up a system of simultaneous equations in order to explain firm performance and network strength between firms.

382

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383

2.

NETWORKING AND FIRM PERFORMANCE

The traditional discussion of the effect of networking is linked to the relation between ownership structure and performance: a positive effect of concentrated ownership is found if alignment of incentives is dominant and a negative effect is found if the entrenchment effect dominates. Although a substantial part of all small firms is controlled by a family with a majority share in the company, a lack of formal relations between independent firms is unlikely. It is often seen that a manager of one firm is associated with another firm as a board member. Furthermore, as verified by La Porta et al. (1999), even the majority (70 per cent) of the top 20 firms in 27 developed countries are controlled by wealthy families or foundations through control pyramids and other structures. Only in the United States and the United Kingdom are widely held corporations predominant among large firms. Moreover, in many countries the ownership structure has developed into networks by cross-holding of shares between companies, but even without common ownership structures between two firms, persons employed in the top management of the firms create formal relations when they are members of an outside board. If the networking connections between top managers are clustered in relatively small but concentrated groups a small world is identified. Conyon and Muldoon (2006) find that there may be signs of small world characteristics in USA, Germany and UK, but the concentration found could also have been the effect of a random process. However, Kogut and Walker (2001) studied the ownership ties in large German corporations and found that the ownership networks constitute a small world and that this Rhineland capitalism is robust against globalization with increasing foreign direct investment. Using a sample of Danish firms, Thomsen and Sinani (2005) find the same stability over time in the corporate network. This study does not control for the existence of ownership ties as opposed to ties between independent board members or CEOs. Ownership and performance have been analysed intensively. It has been documented that firms with dispersed ownership perform worse than closely held firms due to the agency problem; see, for example, the survey by Shleifer and Vishny (1997). And in their survey of the empirical evidence for family controlled firms, Morck et al. (2005) conclude that large block-shareholdings by a family, and family involvement in management, need not destroy value, and may even add value for public shareholders. However, the finding that the average family firm is doing as well or better than other firms does not rule out cases where families mismanage their firms. Burkart et al. (2003) examined whether the founder of a firm wants to

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surrender control of the firm to professional managers. On the one hand, the family has potential benefit from owner control; on the other hand, by self-control it misses the opportunity to hire the best qualified manager of the firm. When the benefit of owner control is smaller than the foregone benefit of not having a professional management, the family may choose to hand over control of the firm. However, this may not be an easy decision for many families/founders and there is some evidence that family owned firms that appoint an insider family CEO perform significantly worse than family owned firms that appoint an outside professional CEO; see Bennedsen et al. (2005). Very few empirical studies have examined the social networking of board members and the board of directors (including the CEO) and its influence on firm decision and performance. As an exception, Booth and Deli (1996) report a negative correlation between firm performance and social networking using the simple number of outside directorships. The argument for this finding is high opportunity cost of spending time at another firm, that is, external networking may benefit the individual but the hiring firm does not get a positive spin-off from this activity.

3.

NETWORKING ACTIVITY

A social network perspective and social network analysis are an efficient way to analyse the effect of informal knowledge transfer between firms. The information flow is created by persons interacting even though they are employed in legally independent firms, and the overall expectation is that there is a positive relation between interaction and performance of the firms involved. A simple example is the process of separation of ownership and control: handing over the CEO position to an external manager is a drastic decision and a more gentle way to create a structure with professional corporate governance is probably to invite an external manager to take a seat in the boardroom. Of course, this would enhance the professional decision of the board and leave the family control over the firm unaltered. In this chapter, we examine the external ties to other firms of board members and the management team and calculate a measure of the firms integration in management networks between firms. Our measure covers both the situation where an external professional is appointed to the board of a firm and the situation where the CEO of the firm or some of its board members are appointed to the board of an external firm. The latter case may also signal that the internal CEO or board member has the professional qualification to be appointed to an external board.

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The expected positive effect on performance of this first step on the line to professional corporate governance is based on several arguments. Firstly, firms who invite other professionals into their boardroom may benefit from the professional managers advice and at the same time retain the documented benefit of owner control, which they could partly lose by handing over control to an external CEO, who may expropriate firm value and increase the monitoring cost for the family. Secondly, in firms with minority shareholders the external board members or the CEOs may reduce the majority shareholders possibility of appropriating the cash flow at the expense of the minority shareholders and cause the firms value to increase. Next, board members and managers external links to other firms may bring in valuable information and knowledge concerning the competitive environment, best practice and threats from innovation or other developments of importance for the management of the firm. Information sharing in the professional networks may increase firm value also in cases where members of the controlling family are invited to be part of the management system in another firm. Finally, information sharing could bring about an understanding between managers within the market that potentially could promote collusion in the market and bring in more value to the firm at the expense of the consumers. The value of information and knowledge sharing may depend on the educational level of CEOs and board members. Thus the absorption capacity concerning the exploitation of information is expected to depend on the formal education of the managers, meaning that education improves the quality of their decisions. This argument is in line with standard human capital theory. We therefore expect that a higher level of education of CEOs and board members will increase the performance of the firm and for managers with many external links the effect may even be stronger. Even though the arguments for a positive relation are prevalent there are also arguments for a negative relation. Booth and Deli (1996) argue that the negative effect is caused by the opportunity cost of spending time at another firm: the networking person may benefit from the networking but the parent firm experiences no spin-off from the board membership (it may even lose if the person with social relations uses confidential information from the parent firm). Finally, there may be an ambiguous effect of using networking as a control mechanism for a parent firm; in line with the classical entrenchment argument (see Morck et al., 1988), board members of a subsidiary will pursue the goals of the parent firm and without full information of the subsidiarys market situation these goals may affect subsidiary performance negatively.

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4.
4.1

IMPLEMENTATION OF THE SOCIAL NETWORK ANALYSIS

Firm Interaction

Firms interact with other firms in several ways and naturally the most important interaction is a consequence of transactions between firms in the value chain. Even though some of these transactions are automated using digital technologies, there are still a significant number of transactions involving human interaction between people in different firms but also within the firm. Focusing on the firms executive level, that is, the board of managers and the board of executives, the top management, implementation of strategies is expected to result in communication across various groups of individuals. Thus, communication between the top management and other staff within the same firm is part of the management process, but the fact that there is business-based communication and relations between separate firms necessitates that it must be explained by other factors such as exercising control, information seeking, knowledge sharing. Depending on the reasons for external networking different effects on firm performance may be expected. Table 15.1 illustrates the direction of human interaction between firms in a simple two-firm model. Basically the focus of this chapter is networking between top managers, that is, the top left corner of the table. In general, the motive behind human interaction between two firms may be purely business orientated or personal, but sometimes it is the contact between the top management in the two firms that is interesting when analysing firms long-run performance. Of course, if the two firms are formally related, there is an ownership structure that may control both firms and, in that case, the firms can be seen as a joint unit. At the other extreme, there are no joint owners at all and, in this situation, the interaction between the firms is defined as purely business related. 4.2 Measuring Power using Social Network Analysis

Measuring the interaction between top managers using a social network approach is based on data that differ from data used in traditional quantitative analysis. Network data is defined by actors (also called nodes) and by relations (also called links or ties) and in this chapter, we analyse the effect of relations (ties) created by persons in top management. In a social network context, firms are the nodes in the network; persons create the relations or ties between these nodes and the ties are symmetric if the relation goes in both directions.

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Table 15.1

Formal interaction between person employed in a firm and business partners

Firm B Top management Other staff Joint firms Business related firms Joint firms Business related firms

Firm A

Top management Joint firms Business related firms Other staff Joint firms Business related firms

Notes: Firm A and firm B are defined as joint firms if they are legally connected, e.g. by common owners. Firm A and firm B are defined as business related firms if there is no legal tie between the firms.

A firm without ties to other firms will obviously have no social power, and using a full network approach with all firms in the sample (in contrast to an ego network) these firms will perform worse. A firm with many ties will, on the other hand, perform better because information will flow more easily between relevant firms; that is, there will always be a path between firms with many ties associated. The social power of a firm is therefore directly related to the number of ties connected to the firm and the relative importance of the nearest neighbours a firm with many relations to other (important) firms will benefit from these relations (centrality in social network analysis). Other measures, mainly based on distance, connectivity, reachability and number of paths, are also focused on the assumption that the power of an actor placed in the centre of the network will be greater than the power of an actor placed on the periphery; see Bonacich (1987), Conyon and Muldoon (2006), Freeman (1979) and Wasserman and Faust (1994). Mizruchi and Bunting (1981) find that centrality based network analysis is superior to examining corporate control. The Bonacich power measure of centrality (see Bonacich, 1987) is a general measure of power based on centrality and it is used to measure the social power of a firm in this chapter. Actors with more connections are more likely to be powerful because they can directly contact other actors and, moreover, the power is dependent on the connections the actors in the neighbourhood have. The Bonacich measure for node i in a network is a function of two parameters, a and b: Bonacichi 5 ci(a, b) 5 SAij(a 1 bcj) (1)

The Bonacich measure of centrality is a standard measure of centrality using the sum of connections (links) weighted with centralities (Aij is the

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adjacency matrix describing the tie between nodes and cj is the centrality of node i). The first parameter, a, is a normalizing parameter, while b reflects the individuals status compared with that of the neighbours connected to the first node. If b is positive then the power of each node is a positive function of the status of the connected neighbours. If the power is interpreted as bargaining power then we experience increased power when neighbours are powerless and this situation is covered by a negative value of b. The value of a is selected automatically, but choosing the right value of b has been discussed; see Bonacich (1987) and Bonacich and Lloyd (2004). Still, the standard application of the Bonacich measure is based on a positive value of b whose absolute value is less than the absolute value of the reciprocal of the largest eigenvalue of the adjacency matrix, Aij; see Borgatti et al. (2002). If b50, formula (1) will no longer take any secondary effects into account and the social power of the firm will simply be the number of ties connected to the firm. Both approaches (b50 and optimal b) are applied in the empirical part of this chapter. Almost all social network analysis is based on the assumption that power is closely related to centrality and the discussion about betweenness, nearness and degree results in arguments in favour of using Bonacichs centrality measure c(a, b); see Bonacich (1987) and Freeman (1979). Firms (nodes in network analysis) are related to each other through persons in the top management and the ties are constructed using information on ownership structure and type of relation (betweenness and nearness) and strength (degree). We use the full network approach in contrast to a special network using snowballing methods to select firms; see Hanneman and Riddle (2005). Using the full network approach, attention is paid to the network structure between all large firms in Denmark and the ties between firms are established via persons in the top management. This means that ties between the large firms in the sample and smaller firms outside are neglected; however we identify the network structure regardless of the number and strength of the ties. 4.3 Measuring Ties between Firms using Information on Ownership Structure

A tie is identified if a person in the top management of one firm has an equivalent role in another firm; that is, we only define a tie if a person has a formal position in the other firm. The ownership structure is used to identify two types of ties, internal and external ties, and a firm may have both types of ties.

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An internal tie or an owner tie is identified if a firm is related by ownership to another firm. The formal link can have different appearances, but existence of a pyramid structure or information on an owner share larger than 50 per cent is the most frequent way of identifying an owner tie. This definition focuses on the actual control over a firm and, even though the controlling firm has the majority of control, it is not certain that the networking person actually owns the majority shares. Other links between firms without a formal ownership structure are defined as external ties. Persons in the top management are either management board members or board members: 1. 2. 3. 4. chief executive officer other members of the board of management chairman of the board members of the board

and a person with a tie can have any of the four roles in the other firm. If a person has several involvements with other firms, we identify a tie for each and we use a symmetric approach, because it is not possible to identify the primary activity. Using the symmetric approach we do not distinguish between the effect of a tie between firm 1 and firm 2 and the corresponding tie from firm 2 to firm 1; that is, we implement the same network effect whether one or two ties are found. Finally, we use binary weights because there is no objective method to determine the strength of the relations.

5.

DATA DESCRIPTION

The empirical analyses are based on a sample of the 1000 largest Danish firms supplying information on economic performance available. The individual relations between persons in the firms are defined by the relations between persons belonging to the top management. Thus we focus on the external relations between top managers and members of the supervisory board (board of directors). Top CEOs can be members of the supervisory boards of other firms and board members can be members of boards or CEOs of another firm and so on. Information on economic performance is based on the official annual report of the firm, which includes turnover and standard measures of profitability. The information on the relations between the persons in top management is based on a private on-line company supplying information on ownership structure and persons in the top management (CEOs and board members).1 Only relations between persons in legally independent

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firms are recorded and relations between profit-oriented firms and nonprofit organizations are not included. 5.1 Descriptive Statistics

In the sample of large firms used in the network analysis, we end up with 999 firms with valid information for the year 2004 (descriptive statistics are presented in Table 15.2). The general picture of industry structure and firm performance is that there is no significant difference between the relatively large firms (more than 500 employees) and smaller ones. The minimum efficiency scale (MES) is unchanged, but the average market share is of course a bit higher for large firms. We find a relatively stable average profit Table 15.2 Descriptive statistics for small and large firms
Small and medium sized firms (< 500 employed) Number of firms Industry structure Market share MES (log (lower quartile of turnover)) Performance Profit Labour productivity (mill DKK/empl) Governance structure Number of persons in management Number of persons on the board Links from board of management of which external links Links from the board 747 (74.8%) 0.149 8.47 Large firms ( 500 employed) 252 (25.2%) 0.233 8.55 All firms

999 (100.0%) 0.170 8.49

0.099 3.43

0.103 2.51

0.100 3.20

1.4 (0.8) 5.7 (2.5) 1.9 (3.5) 0.4 (1.2) 10.0 (12.5)

2.2 (1.3) 6.7 (3.1) 4.5 (6.1) 1.2 (2.9) 13.5 (14.4)

1.6 (1.0) 5.9 (2.7) 2.5 (4.4) 0.6 (1.8) 10.9 (13.0)

Note: An external link is defined as a link from the management board to another firm not owned partially or entirely by the first firm. Standard deviation is shown in brackets. Information about firm performance and other financial information is based on 999 firms with valid data. Results on external links between the firm and other firms are based on valid information from 854 firms.

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391

rate (ROE, defined as net result compared with net capital) even though this measure is very unstable with a standard deviation about 2 times higher than the average. Information about number of persons on the management board and the board is based on valid information from 854 firms and there is a clear difference between relatively large and small firms in respect to the number of persons on the board. We find a relatively small management board, and the overall average of 1.6 persons on the board of managers is the result of a right-skewed distribution with one person as mode value (in about 50 per cent of all firms, an owner is on the management board) and a few firms with 6 persons on the management board. As expected, larger firms tend to have a higher number of persons on the management board and on average 60 per cent of the managers are represented in another external firm (an external firm is defined as a firm with no obvious owner dependency of the first firm). The number of persons on the board is around 6 and these persons are very active in respect to representation on other boards and on average we find 11 links from the board to another external board. However, these data do not allow us to identify the relative importance of the other firm, so the networking activity is in general somewhat overrated. 5.2 Educational Background

The educational background of the CEO and the chairman of the board is based on the same source, GreensOnline. The information is reported by the persons themselves and we can therefore expect a relative overrepresentation of persons without any formal educational background as a result of no information. The results are presented in Figure 15.1 and we do find a high number of persons in top management without formal education. Only about 30 per cent of the CEOs or chairmen of the board have a higher education and about half of the chairmen of the board have a business related education. The CEOs on the other hand are more oriented toward a business related education if the person has a higher education. The relation between the relatively low educational background and a tendency towards professional CEOs is illustrated in Table 15.3. The table underlines a number of interesting results. Firstly, we find that a relatively low level of formal education among managers is prevalent and less than one-third have a masters degree. Secondly, there is a significant dependency between the educational background of the chairman of the board and the CEO. If the chairman has a masters degree then the probability of a CEO with a masters degree is about 50 per cent higher than expected. If the chairman does not have a higher education we find the opposite

392
70%

The board, management relations and ownership structure

Chief executive Chairman of the board 60% Relative distribution in per cent 50% 40% 30% 20% 10% 0% None listed Commercial background Undergraduate business education Education Higher education Higher business education

Figure 15.1

Educational background of the top management

relation with an almost 20 per cent lower probability of finding a CEO with a higher education. In other words, we find a significant overrepresentation of chairmen and CEOs with the same educational background. These findings are especially significant for the group of large firms with more than 500 employees (these results are not shown in Table 15.3).

6.

EMPIRICAL MODEL AND RESULTS

The estimation results of the estimated models are listed in Tables 15.5ac. A basic productivity model is presented in Table 15.5a and we find the general translog specification superior to the simple Cobb-Douglas model. No social networking activity is included and there is no support for a significant effect of educational level of the top management. Education and networking activity may be seen as complementary activities and, if that is the case, we can still find a positive effect from networking without any effect from education. The relation between educational level of the top management and social networking is shown in Table 15.4. The correlation between internal and external networking is relatively low (below 30 per

Top management, education and networking

393

Table 15.3

Formal education of executives in large Danish firms: relation between chairman and executive manager
Chairman of the board Low education High education

Executive manager

Low education High education

Total

504 (477) 132 (159) 636 (74%)

136 (163) 82 (55) 218 (26%)

640 (75%) 214 (25%) 854 (100%)

Notes: The table shows the highest formal education of 854 executives in the largest Danish firms. A high education is defined as a university based education (masters degree). Numbers in brackets are expected number given independence between the two characteristics. Row and column totals are presented together with percentages. c2-test of independence rejects H0; c2 (1)524.6; P(c2 (1).24.6) < 0.0001

Table 15.4

Average number of links (social networking) and education

High educational level All firms 0.31 0.31

Internal networking External networking

0.66 (1.04) 0.71 (0.88)

Notes: High educational level is defined as at least a masters degree. The averages reported are the number of links to other external and internal firms, and the numbers in brackets are the average numbers for firms with high education for both the CEO and the chairman of the board.

cent) and, on average, there is an external and an internal link in 30 per cent of the firms. The average propensity to participate in social networking activities is doubled if only top managers with a higher education are considered even though formal education has an effect on performance, social networking activity complements education. Concerning firm performance (Table 15.5a), which is measured by the productivity effect in an augmented production function, 65 per cent of all variation in firm turnover is explained by the simple model. Of course, the coefficients for labour and capital are correctly signed and highly significant and reflect approximately constant returns to scale in the production. As we have no data for the firms use of raw and other materials, we include a manufacturing dummy to correct for the fact that the retail sector especially has a high level of other intermediate inputs. As expected, the coefficient is negative and highly significant. The negative size effect

394

The board, management relations and ownership structure

Table 15.5a

Single equation (OLS) models: firm productivity

Cobb-Douglas OLS 6.120 (0.186) 0.670** (0.033) 0.265** (0.015) Translog specification OLS 8.482 (1.169) 0.864** (0.303) 0.224* (0.134) 0.071** (0.032) 0.002 (0.005) 0.063** (0.021) OLS 8.620 (1.277) 0.698** (0.333) 0.153 (0.133) 0.060* (0.034) 0.002 (0.005) 0.068** (0.021) 0.311** (0.142) 2.862 (6.909) 110.48** (37.95) 0.272** (0.049) 0.262** (0.104)

Dependent variable Estimation method Intercept Labour Capital Labour*Labour Capital*capital Labour*capital Size (dummy) Management size/ employment Size* (manag. size/ employment) Manufacturing (dummy) Market share Education of the CEO Education of the chairman

5.270 (6.963)

0.004 (0.061) 0.033 (0.059) 0.602 989 0.634 850 0.649 850

Adj. R2 Number of observations

Notes: Numbers in brackets are standard errors of the estimated parameters. * indicates that the estimated parameter differs significantly from zero at the 10% level of significance and ** at the 5% level.

could also reflect a higher degree of in-sourcing for larger firms which have enough scale in production to pursue even some of the more specialized tasks in the production. The number of persons in the management board relative to firm size does not affect performance directly but the interaction between firm size and management size has a positive and significant effect on productivity. This result

Top management, education and networking

395

supports the human capital argument: relatively small firms can be controlled efficiently by one manager but large firms take advantage of a relatively large management board with complementary skills. Market share affects firm performance positively and significantly and this is in line with Demsetzs efficiency hypothesis, whereby the most efficient firms gain market shares, and with Porters home based hypothesis, whereby multinational firms need a strong and competitive home market to be innovative and competitive. The standard productivity model is enhanced with the external social networking variables in Table 15.5b. The first column (b50) uses the simple number of ties as a proxy for social networking power while column two uses the optimal b, and it is clear that there is no significant effect on firm performance from social networking. External networking activity and firm performance using a SURE specification allowing for interdependence between firm performance and networking is reported in the last part of Table 15.5b and their effect on performance from networking is the same. In the equation for the social networking activity, the coefficients of educational level are positive and significant as expected. The general picture is an insignificant coefficient to all tested variants of the Bonacich power measure of centrality when we look at the external networking. This leads to the conclusion, in line with Booth and Deli (1996), that persons involved in networking activities may benefit from the activity, but firms representing these persons are not sharing any of this surplus. Table 15.5c presents the model with internal networking activities. The correlation between internal and external networking is relatively low and therefore there are no significant changes in the results if external networking activity is reported in the same model. The basic model reports the same results and, while the effect of external networking is insignificant and with positive and negative signs, the overall picture is that internal networking activities do increase productivity of the firms involved. Using the optimal version of the Bonacich power measure (including secondary values of a network), we find a significant positive effect on performance. However, the overall picture is not convincing and the significance disappears when the models are estimated using SURE methodology (last columns in Table 15.5c).

7.

CONCLUSION

Networking among persons in top management positions may serve as a means for sharing knowledge and, furthermore, the educational level might increase the capacity of gaining advantages from new information.

396

The board, management relations and ownership structure

Table 15.5b

External networking effects in models for firm ties and productivities

Productivity b50 8.62 (1.29) 0.698** (0.334) 0.154 (0.136) 0.060* (0.034) 0.002 (0.005) 0.068** (0.022) 0.272** (0.049) 0.262** (0.104) 0.312** (0.143) 2.87 (6.92) 110.60** (38.22) 0.001 (0.028) optimal b 8.49 (1.30) 0.718** (0.336) 0.141 (0.135) 0.060* (0.034) 0.002 (0.005) 0.066** (0.021) 0.272** (0.049) 0.264** (0.104) 0.309** (0.142) 2.89 (6.91) 110.17** (37.97) 0.001 (0.003) SURE (produc., network) Productivity 8.63 (1.29) 0.697** (0.334) 0.154 (0.136) 0.060* (0.034) 0.002 (0.005) 0.068** (0.021) 0.273** (0.049) 0.262** (0.104) 0.313** (0.143) 2.85 (6.91) 110.60** (38.22) 0.001 (0.028) Network 0.028 (0.045)

Dependent variable Model Intercept Labour Capital Labour*labour Capital*capital Labour*capital Manufacturing (dummy) Market share Size (dummy for emp. 500) Management size/ employment Size* (man. size/empl) Networking (Bonacich power) Education of the CEO Education of the chairman Minimum efficiency scale, MES Adj. R2 Number of observations

0.029 (0.057)

0.493** (0.066)

0.648 850

0.648 850

0.343** (0.066) 0.387** (0.065) 0.741** (0.057) r(produc.,netw.)50.002 850

Notes: Numbers in brackets are standard errors of the estimated parameters. * indicates that the estimated parameter differs significantly from zero at the 5% level of significance and ** at the 1% level. Models for productivity and networking activity are estimated simultaneously using a SURE (seemingly unrelated regressions) procedure.

Top management, education and networking

397

Table 15.5c

Internal networking effects in models for firm ties and productivities

Productivity b50 8.51 (1.28) 0.725** (0.334) 0.145 (0.133) 0.062* (0.033) 0.002 (0.005) 0.067** (0.021) 0.269** (0.049) 0.264** (0.104) 0.308** (0.142) 2.52 (6.91) 109.80** (37.95) 0.028 (0.025) optimal b 8.61 (1.27) 0.675** (0.333) 0.133 (0.132) 0.056* (0.034) 0.002 (0.005) 0.065** (0.021) 0.265** (0.049) 0.263** (0.104) 0.297** (0.142) 2.01 (6.90) 108.64** (37.85) 0.002** (0.001) SURE (produc., network) Productivity 8.51 (1.28) 0.724** (0.334) 0.145 (0.133) 0.062* (0.034) 0.002 (0.005) 0.067** (0.021) 0.269** (0.049) 0.264** (0.104) 0.309** (0.142) 2.51 (6.91) 109.79** (37.95) 0.030 (0.025) Network 0.140 (0.050)

Dependent variable Model Intercept Labour Capital Labour*labour Capital*capital Labour*capital Manufacturing (dummy) Market share Size (dummy for emp. 500) Management size/ employment Size* (man. size/empl) Networking (Bonacich power) Education of the CEO Education of the chairman Minimum efficiency scale, MES Adj. R2 Number of observations

0.110* (0.063)

0.452** (0.073)

0.649 850

0.651 850

0.269** (0.073) 0.344** (0.072) 0.002 (0.279) r(produc.,netw.)50.002 850

Notes: Numbers in brackets are standard errors of the estimated parameters. * indicates that the estimated parameter differs significantly from zero at the 5% level of significance and ** at the 1% level. Models for productivity and networking activity are estimated simultaneously using a SURE (seemingly unrelated regressions) procedure.

398

The board, management relations and ownership structure

In addition, networks among CEOs could facilitate and lead to collusion among the competitors in the market. Therefore, the expected influence on firm performance of this networking and education is positive. The empirical analysis is based on a sample of large Danish firms and it shows no effect of the educational level of the top management on performance. On the other hand, we find interdependency between the educational level of the CEO and the chairman of the board. Education also affects the overall attitude towards networking positively. The effect of networking between top managers on their firms performance is in general not found. However, we find a weak significant positive effect on firm performance regarding internal network activities, which means that social networking activities may be interpreted as control of subsidiaries, but we find no support for a conjecture of a positive effect on firm performance from the old boy networks.

NOTES
*
We would like to thank two anonymous referees and the participants of the 7th Workshop on Corporate Governance and Investments in Jnkping, April 2006, for helpful comments. 1. Online access: www. GreensOnline.dk

REFERENCES
Bennedsen, M., K. Nielsen, F. Prez-Gonzlez and D. Wolfenzon (2005), Inside the Family Firm: The Role of Families in Succession Decisions and Performance, WP 2005-13, Centre for Industrial Economics, University of Copenhagen. Bonacich, P. (1987), Power and Centrality: A Family of Measures, The American Journal of Sociology, 92 (5), 117082. Bonacich, P. and P. Lloyd (2004), Calculating Status with Negative Relations, Social Networks, 26, pp. 331338. Booth, J. and D. Deli (1996), Factors Affecting the Number of Outside Directorships Held by CEOs, Journal of Financial Economics, 40, 81104. Borgatti, S.P., M.G. Everett and L.C. Freeman (2002), Ucinet for Windows: Software for Social Network Analysis, Harvard, MA: Analytic Technologies. Burkart, M., F. Panunzi and A. Shleifer (2003), Family Firms, Journal of Finance, 58, 2167201. Conyon, M. and M. Muldoon (2006), The Small World of Corporate Boards, Journal of Business Finance & Accounting, 33, 132143. Freeman, L.C. (1979), Centrality in Social Networks Conceptual Classification, Social Networks, 215239. Hanneman, Robert A. and Mark Riddle (2005), Introduction to Social Network Methods, Riverside, CA: University of California, Riverside (published in digital form at http://faculty.ucr.edu/~hanneman/)

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399

Kogut, B. and G. Walker (2001), The Small World of Germany and the Durability of National Networks, American Sociological Review, 66, 3175. La Porta, R., F. Lpez-de-Silans and A. Shleifer (1999), Corporate Ownership Around the World, Journal of Finance, 54, 471517. Mizruchi, M. and D. Bunting (1981), Influence in Corporate Networks: An Examination of Four Measures, Administrative Science Quarterly, 26, 47589. Morck, R., A. Shleifer and R.W. Vishny (1988), Management Ownership and Market Valuation: An Empirical Analysis, Journal of Financial Economics, 20, 293315. Morck, R., D. Wolfenzon and B. Yeung (2005), Corporate Governance, Economic Entrenchment and Growth, Journal of Economic Literature, 43, 657722. Shleifer, A. and R.W. Vishny (1997), A Survey of Corporate Governance, Journal of Finance, 52, 73783. Tirole, J. (2006), The Theory of Corporate Finance, Princeton, NJ: Princeton University Press. Thomsen, Steen and Evis Sinani (2005), A Small World in a Small Country: Ownership and Board Ties in Denmark 19912001, Working Paper, Copenhagen Business School. Wasserman, S. and K. Faust (1994), Social Network Analysis: Methods and Applications, Cambridge, MA: Cambridge University Press.

Index
accounting principles, German corporate governance ratings 3645 Adams, R. 142 administered price hypothesis 48 agency costs 140, 141, 163, 210 and institutional ownership 229, 230 principalagent contracts 4, 52, 534, 86, 87 principalagent model 202, 204 and property rights theory 86 theory 86, 99, 188 Alchian, A. 31, 86, 87 allocation and economic growth 1247 all-or-none trading rule 24 Amadeus database 294 antitrust 45 crisis in (1970) 1112 general application to 1819 inhospitality tradition in 22 objections to exchanges 267 appropriable quasi-rent 68, 79 arbitrage pricing theory (APT) 171, 180, 183 The Architecture of Complexity (Simon) 31 Areeda, Philip 23, 24 Arrow, K.J. 105, 130 asset specicity 14, 1920 associated families, Balearic region see family businesses, Balearic region auction rule, US 192, 197 authority bureaucratic 88 denitions 834, 90 delegation of 89 formal and real 8890, 91 managerial see managerial authority automotive industry 678 backward integration 21 Bain, J. 20 Balearics region (Spain), family rms in see family businesses, Balearic region bargaining power, and authority 85 Barnard, Chester 14, 83 Baumol, William 49 bauxite ore, raw materials procurement 212 Bebchuk, L. 142 behavioral attributes 14 Bennedsen, M.B. 143 Berle, A.A. The Modern Corporation and Private Property 2, 45, 46 on ownership concentration 140, 141, 142, 162 and takeover regulation 190 Bertrand, M. 329 bilateral dependency, asset specicity 14 Bjuggren, P.-O. 148, 151, 152, 155 Black, B. 211 black box of rm, opening antitrust analysis 19 exchange agreements 26 rm size, limits to 30 and market organization 1, 11, 33 and neoclassical model 64 Blair, M.M. 326 Blake, H.M. 33 board composition 57 board neutrality rule, Thirteenth Company Law Directive 209 board size, German corporate governance ratings 364 Bhren, O. 324, 326, 330 Bonacich, P. 382, 3878 Booth, J. 385 boundary of rm issue, scaling up 31 401

402

Index econometric evidence 33946, 340, 343, 345 employee directors, eects 6 estimation and method 3389 xed eects estimations 325, 338 lagged rm performance 328, 352 leverage 330, 342, 355 literature review 3256 methodology 338, 339 reverse causation hypothesis, and co-dermination hypothesis 329 robustness checks 339, 34653, 347, 35051 simultaneity and endogeneity 3234, 32831 stakeholder or interest group 3268 theory and hypotheses 32631 three-stage least squares (3SLS) methodology 6, 325, 338 Wald test 342, 352 see also employees cognition, transaction cost economics 14 cognitive competence 13 commercialization competence 114 company interest, concept 190 Company Law Directive (13th), takeover bids 194, 196, 201, 203, 204, 209 Company Law Review Steering Committee/Group 187, 188 competence 13 bloc theory see competence bloc theory business, nature of 11013 commercialization 114 horizontal diversity 11617 receiver 113 and social capital 121 specication of rm in EOE 1079 venture capital 115 competence bloc theory 107 actors in 3, 110, 111, 11317 decision structure of bloc 111 denitions 126 hierarchies, limits 112 industrial spillover generator, bloc as 117 institutions and incentives/ competition 12021

bounded rationality (contractual incompleteness) 14, 79 Brick, I.E. 330 Burkart, M. 142, 3834 business judgment rule, US 192 business opportunities space (universal state space) 104, 107, 108 and competence bloc theory 11112 CAPM (capital asset pricing model) 4 conventional 180 institutional risk and uncertainty 17071, 175, 178, 182 multi-beta 171 cargo shipping 71 Carlsson, Bo 113 Carter, D.A. 330 cash ows cash ow rights and control rights 142, 143, 163 cash ow rights and performance 142, 158 and dual-class shares 163 and neoclassical model 50 rates of return on 49 role in investment 567 Chandler, Alfred 33 Cheung, Stephen 86, 87 Chicago School, antitrust scholars from 18 civil law shareholder value and legal conception of rm 18690 takeover bids Europe 2014 Japan 2047 Claessens, S. 142 Club Med, shareholder agreements 261, 267, 271, 273, 275, 276 Coase, Ronald H. 15, 63, 85, 87, 108 The Nature of the Firm 84 co-determination, impact upon rm performance 6, 32354 board employee directors 326, 330, 331 negative employee director eect 3278, 355 data and institutional background 3318, 3357

Index nature of business competence and eciency of project selection 11013 theory of rm 11720 vertical completeness of bloc 11516 competition endogenous growth through 1214 and institutions 12021 product market 51 Compustat Global database 148 concentration of ownership in Anglo-Saxon countries 144 and descriptive statistics 2359 Germany, corporate governance in 7, 363 intermediate levels of 263, 2645 and investment performance 1412 non-linear eects on performance 1412, 156, 1623, 226 and ownership structure 142 in Scandinavia 144, 145 see also Scandinavian countries conglomerates 33 contract of areightment (COA) 71, 72 contracts contract as framework/contract as legal rules 17 employment 66, 845, 100 rm as nexus of 64, 658, 66 freight 72 hazards, contractual 20 insecure, risk of 170 long-term 68 in maritime transport 66, 758 and markets and rms 6870 principalagent 52, 534, 86, 87 spot 767 wide spectrum of 86, 87 see also contractual perspective of rm; freedom of contracts contractual perspective of rm 2, 6470 rm as nexus of contracts 64, 658, 66 exibility 68 maritime industry 2, 748 mutual dependency 2, 6970, 78 specialization and institutions 65 water tightness 68 see also contracts

403

contractual specicities 76 control enhancing mechanisms (CEM) 142 control rights, shareholder agreements 27071 Conyon, M. 383 coordination 938 problem 856, 94, 96 corporate control economists view of market 20913 and investment, in Scandinavia 14044 market for 52, 53, 21314 stock market prices and market 21316 corporate governance Anglo-Saxon model 212, 225 Codes 3657 French model 189 in Germany 36179 governance structures 1415 and ownership 22732 principalagent model 202, 204 in Scandinavia 13940, 1434, 145 corporate return, in Scandinavia 149, 1516 cash-ow rights and performance 158 concentration of control, voting rights and performance 159 dual-class shares 160, 161 and ownership structure 1567, 16062 corporate value, concept of 206, 207 corporation Anglo-Saxon version 43 centralized/de-centralized 33 and early economists 436 managerial discretion 514, 56 managerialist challenge 4851 marginalist controversies 468 M-form structure 33 modern see modern corporation recent developments 545 Cosh, A. 216 creative destruction process, Schumpeterian 106, 121, 124 credible commitments 258 Cronqvist, H. 143

404 cross-holdings 142, 143, 203, 204 Cyert, R.M. 49

Index ownership and performance 160, 161 Sweden 3, 5, 143, 144 early economists 436 Easterbrook, F.H. 330 economic mistakes, informational assumptions 105 educational background, networking 3912 ecient capital market 2, 51, 523 Eisenberg, T. 330 Eliasson, G. 108, 109, 119 Elster, Jon 34 employees on board see co-determination, impact upon rm performance costs of bargaining with 91 discretion, exercise of 89, 100 and hostile bids 198, 199, 200 employment contracts 66, 845, 100 endogenous growth competition, through 1214 micro-to-macro model, Swedish 122 Salter curves 1223 entrenchment eect 141, 142, 163, 383, 385 entrepreneurs 114, 115, 168 EOE (experimentally organized economy) see experimentally organized economy (EOE) equity rights, shareholder agreements 269 Ericsson 152 Europe Codes of Corporate Governance 3657 takeover bids 2014 Eurostat 149 exchange agreements 258 Canadian Study 26, 28 entry fees 267 growth and supplementary supply restraints 278 objections to exchanges 267 petroleum exchanges 26 executive remuneration, German corporate governance ratings 365 experimentally organized economy (EOE) 10427

de Beers 24, 25 de la Torre, C. 240 De Soto, Hernando 1689 Debreu, G. 130 dedicated assets 69, 80 Delaware courts, US 189, 192 delegation of authority 968 of discretion 92, 97 Deli, D. 385 Demsetz, H. 35 on experimentally organized economy 105 on managerial authority, knowledge economy 86, 87 on ownership concentration 141, 144 on scaling up 31 Denmark dominant rm 152 dual-class shares 143, 144 networking in see networking: in Denmark descriptive statistics 2359, 39091 diusion, technological 1256 disclosure requirements, shareholder agreements 258 discount rate 169, 170 discretion dened 889 delegation of 89, 97 exercise by employees 89 managerial 514, 56 discriminating alignment hypothesis 15 distribution, vertical market relations 22 dividends, and institutional ownership see institutional ownership and dividends Drobetz, W. 361, 362, 378 dual-class shares 3 and cash-ow rights/control rights 163 Denmark 143, 144 eects 142 Finland 143, 144 Norway 3, 143

Index allocation and economic growth 1247 business opportunities space 104, 107, 108, 11112 competence bloc theory see competence bloc theory competence specication of rm in 1079 critical mass 117 dominant selection problem 109, 110 ecient selection in 111 endogenous growth 1214 exibility 117 informational assumptions 10410 macro dynamics, experimental selection 10910 MOSES model 127, 128 opportunities space assumption 109 property rights 120 static equilibrium 128 tacit dimension 108 Faccio, M. 142 Falaye, O. 326 Fama, Eugene 51, 118 family businesses, Balearic region 292319 business group directors and family 31215 business groups under control of associated families 30517 companies under control of associated families 298305 data sources and methodology 2948 denition of family business 2924 family group heterogeneity 3067 measurement of family group diversication 30712 relevance of associated family companies in region 2968 representative company 2989 sector diversication and family control 31517 sector of activity diversity 3035 size, dierences according to 299 300, 301, 3023 two-surnames system 6 Faure, M. 167 Fauver, L. 325, 352, 353

405

Federal Trade Commission, US 26, 35 Ferreira, D. 142 ferry/cruise market, maritime industry 71 nancial contracting 255, 279 Finland dominant rm 152, 153 dual-class shares 143, 144 rm interaction, social network analysis 386 ip-in/ip-over, anti-takeover defences 193 Ford Motor Company, raw materials procurement 21 forward contracts contractual specicities 76 tramp shipping 70 Frank, Robert 50 freedom of contracts 168, 26274 freight market 7071 Fuchs, Victor 11 Fudenberg, Drew 14, 35 Fuerst, M.E. 325, 352, 353 functional eciency of capital markets 146, 162 fundamental valuation eciency (FVE) 213 General Motors 54 Georgescu-Roegen, N. 112 Germany, corporate governance in 36179 accounting principles 3645 board size 364 Code of Corporate Governance 367 comply or explain kind 6 see also corporate governance: Codes concentration of ownership 7, 363 data description 36771 empirical results 372, 373, 374 executive remuneration 365 explanatory variables 369, 370, 371 HGB rules 364, 365 hypotheses 3635 IAS rules 362, 364, 365 ownership concentration 363 ratings 3679 components of 376, 377, 378

406 robustness tests 3746 US-GAAP rules 362, 364, 365, 378 Gierke, Otto von 190 Gilson, R. 211 Gompers, P. 329 governance structures 1415 Grabowski, H. 49 Gugler, K. 148, 1556 Hall, R. L. 47, 48 Hannah, Leslie 200, 201 Hart, Oliver 86 Hayek, Friedrich 14 Heisenbergian ux, economy in 105 Heritage Foundation 167, 173, 177 Hermalin, B.E. 331 hierarchies, governance structures 15 High Level Group of Experts, on takeover bids 201, 202, 203, 204 Hitch, C.J. 47, 48 Holmstrom, Bengt 14, 92 horizontal diversity, competence 11617 horizontal mergers 32 Hughes, A. 216 human capital (production factor) 65 Hume, David 168, 180 hybrid contracting, governance structures 15

Index economic mistakes 105 grossly ignorant actor 105 industrial development theory 10410 Srimner eect 1067 innovations, market for 114 in-or-out trading rule 24, 25 institutional ownership and dividends 5 agency arguments 229, 230 Breusch-Pagan/Cook-Weisberg test 241 concentration, and descriptive statistics 2359 earnings trend model, modied 2324 empirical results and analysis 23945, 246 FGLS estimations 241, 242, 243 xed eects estimations 244 full and partial adjustment models 232 Hausman test 243 hypotheses 23032 institutional shareholdings, positive eect on dividend changes 231 non-linear relationship 231, 241 OLS regression 241, 245 research methodology 2324 signalling arguments 22930 taxation arguments 2289 variables 234, 235 vote-dierentiated shares 2312, 242, 244, 245 Waud model 232, 233 see also ownership institutional risk and uncertainty adaptations to 85 estimations of risk and return 1712, 180 rst-pass regression 173, 177 freedom of contracts 168 insecure property rights and contracts, risk of 170 models and results 17780, 179 net present value 169 political risk 168 portfolio theory and investment 17071, 180 property rights 4, 1689

IBM 111, 118 ImperialShell exchange agreement 278 incentives business opportunities space (universal state space) 107 concentration of ownership 141 and institutions 12021 in knowledge economy 92 Srimner eect 107 use of authority from perspective of 9093 Industry and Trade (Marshall) 45 information arbitrage eciency (IAE) 213 informational assumptions allocation and economic growth 1267 competence specication of rm in EOE 1079

Index regression specication error test (RESET) 180 research data 1723, 1745, 176 risk-free rate plus risk premiums 1812 second-pass regression 177, 178 transaction attributes 14 world market portfolio 177 Institutional Shareholders Committee, guidelines 21718 institutions and incentives/competition 12021 institutional environment, importance 35 and specialization 65 intermediate product market transaction (paradigm transaction) 1518 Node A (unassisted market) 16 Node B (unrelieved hazard) 1617, 23 Node C (credible commitment) 17, 23 Node D (integration) 17, 18 simple contractual schema 16 International Country Risk Guide (ICRG) 173, 177, 178 International Stock Exchange, Preemption Group 217 investor rights protection (IRP) 173 Japan, takeover bids 2047 Jensen, Michael 3031, 545, 92, 14041, 143 joint stock companies 43 Jorgenson, Dale 50, 211 Kaplan, A.D.H. 47 Kaplan, S. 255 Kasper, W. 168 Kay, John 214 Kelly, Marjorie 208 Kennedy, Allen 208 Kenney, Roy 24 Keynes, John Maynard/Keynesian economics 46, 113 Kindahl, James 48 kinked-demand schedule hypothesis 47, 48 Kirzner, I.M. 105 Klein, Benjamin 17, 24, 68 Knight, Frank 29 knowledge economy 3 centralized decision making 95 diminishing use of authority in 3, 92, 989 information dispersal 912 informational assumptions 104 investment in assets 91 managerial authority in 8299 Kogut, B. 383 Koopmans, Tjalling 11 Kuth, E. 57

407

La Porta, R. 144, 226, 383 Lang, L.H.P. 142 lateral integration 2021 Lee, S. 142 legal conception of rm, and shareholder value, in common and civil law 18690 Legrand, shareholder agreements 261, 2678, 276 Lehn, K. 144 lens of contract/governance 12, 13, 34 Lester, Richard 47 Lewis, Tracy 29 life-cycle hypothesis 49, 50 liner market, maritime industry 71 Lintner, J. 232 Llewellyn, Karl 17 Magirou, E. 70 managerial authority and bargaining power 85 centralized 946 change in relative use of 9098 diminishing of use, in knowledge economy 3, 92, 989 from incentive perspective 9093 from production coordination perspective 938 coordination problem 856 delegating, setting 968 in rms and markets 8490 incentive perspective, use from 9093 managerial, in knowledge economy 8299 measurement costs 87

408

Index third-party ship management 66, 745, 79 tramp shipping 70, 71 vessel as fungible asset 67 mark-up pricing model 47 market corporate control 20916 see also corporate control economists view of, for corporate control 20913 for innovations 114 for managers 51, 53 pure vanilla type 1 and stock market prices 21316 market organization antitrust see antitrust credible commitments 258 intermediate product market transaction (paradigm transaction) 1518 lens of contract/governance 12, 13, 34 microanalytics 1315 and opening black box of rm 1, 11, 33 price theoretic issues 225 vertical market see vertical market relations see also corporation; modern corporation market-for-corporate control 52 Marris, Robin 49, 52 Marshall, Alfred 2, 45, 46 Masten, S. 75 Matthews, R.C.O. 35 Maury, B. 143 McConnell, J.J. 141 Means, G.C. 467, 48 The Modern Corporation and Private Property 2, 45 on ownership concentration 140, 141, 142, 162 Meckling, William 3031, 92, 14041, 143 mergers 32, 208 Merrick Dodd, E. 190 METI (Japanese economics ministry) 206 Meyer, J.R. 57 micro-to-macro model, Swedish 122, 124, 125

orders 823, 87, 99 production coordination perspective, use from 938 and property rights 82, 856 relations between employer/ employees 23 subordinates acceptance of 84 see also authority managerial discretion constraints on 512 strength of constraints 524 end to 56 managers managerialist challenge 4851 market for 51, 53 of private-sector companies 186 see also managerial authority; managerial discretion mandatory bid rule, United Kingdom 194, 209 Manne, Henry 52 March, J.G. 49 marginal q, use of 3, 4, 55 agency hypothesis 148 cumulative distribution 15051 denitions 1456 measurements 146, 162 ratios 146 in Scandinavia 3, 149, 15051, 152 see also Tobin, J./Tobins q marginalist pricing models 468 maritime industry 2 bulk shipping, contracting practices 77 carrier and shipper, link between 78 characteristics of maritime transport 7074, 778 contractual perspective 748 contracts in maritime transport 66, 72, 758 see also contractual perspective of rm economic organization 748 freight loading, and scaling-up 31 freight market 7071 shipping company 724 structure of shipping services in relation to cars/car manufacturers 69

Index Miguel, A. 245 Milgrom, Paul 14, 92 Mill, John Stuart 2, 44, 45, 46 Mitroussi, K. 74, 75 modern corporation conglomerates 33 rm size, limits to 2930 horizontal mergers 32 scaling up 3032 modied earnings trend model, institutional ownership 2324 Modigliani and Miller cost of capital 50 The Modern Corporation and Private Property (Berle and Means) 2, 45, 46 Moller-Maersk 152 monopolies, oligopolymonopoly comparisons 32 moral hazard 91, 92 Morck, R. 139, 141, 227 Morgan Stanley world market index 171, 172, 173 MOSES (Model of the Swedish Economic System) 127, 128 Mueller, D.C. 145, 148, 149 Muldoon, M. 383 Mullainathan, S. 329 Muris, Timothy 19, 35 mutual dependency, contractual perspective of rm 2, 6970, 78 NACE (economic business activity) codes 294, 309 one-digit level 303 two- and three- digit levels 308, 310 The Nature of the Firm (Coase) 84 NBS (Nippon Broadcasting System) 205 neoclassical model 2, 45 assumptions 106 black box theory 64 corporate control and investment 140 investment 50 limitations of 50 and marginalist controversies 46, 47 net present value (NPV) 169 networking activities 3845

409

Bonacich approach 382, 3878 data description 38992 in Denmark 7, 38298 descriptive statistics 39091 educational background 3912 empirical model/results 3925 and rm performance 3834 network ties French shareholder agreements 2734 internal and external 7, 389, 392 measuring, using ownership structure information 3889 nodes and lines 356 social network analysis 3869 translog specication 392 new growth theory 114 New York Stock Exchange index 171 nexus of contracts, rm as 64, 658 Nielsen, K.M. 143 Nilsson, M. 143 Nippon Broadcasting System (NBS) 205 Nirvana fallacy 105, 128 Node A (unassisted market) contracting 16 Node B (unrelieved hazard) 1617, 23, 27, 35 Node C (credible commitment) 17, 23, 35 Node D (integration) contracting 17, 18 Nokia 152 Norsk Hydro 152 Nortel 214 North, D.C. 168 Norway dominant rm 152, 153, 154 dual-class shares 3, 143 marginal q, use of 4 proportionality principle 144 oligopolies 32, 47 one-share-one vote principle 142, 144 opportunism 14 organization of economic activities 23 over-searching 245 ownership and capital 656 categories 235

410

Index repositioning 24 Robinson-Patman Act 23 trading rules 24, 25 principalagent contracts 4, 52, 534 principalagent corporate governance model 202, 204 private equity market, competence bloc theory 110 product market competition 51, 52 product variation 112 production coordination, use of authority from perspective of 938 prot disgorgement 193 prot maximization 47, 48, 141 proper purposes doctrine 196 property rights and agency 86 experimentally organized economy 120 insecure, risk of 170 institutional risk and uncertainty 1689 and managerial authority 82, 856 nexus of contracts, rm as 656 property rights protection (PRP) index 173 proportionality principle, Norway 144 Publicis, shareholder agreements 260, 266, 267, 276 pyramid ownership 142, 143 Raheja, C. G. 327 Rathenau, Walther 190 raw materials procurement, vertical market relations 212 Reardon, Elizabeth 54, 145, 148, 149 regression specication error test (RESET) 180 remuneration, German corporate governance ratings 365 repositioning, predatory pricing 24 RESET (regression specication error test) 180 Robinson-Patman Act (Anti-Price Discrimination Act) 1936 23 robustness tests co-determination, impact upon rm performance 339, 34653, 347, 35051

concentration see concentration of ownership and corporate governance 22732 institutional see institutional ownership and dividends nature of, and shareholder agreements 2628, 2645 nominal 142 pyramid 142, 143 single owners 143 structure see ownership structure ownership structure and board composition/rm performance 57 and concentration of ownership 142 and corporate return, Scandinavia 1567, 1589, 16062 measuring network ties between rms using information on 3889 Pajuste, A. 143 Panel on Mergers and Takeovers, UK 194 paradigm transaction 1518 Pernod Richard, shareholder agreements 25960, 266, 267, 272, 276 Perotti, E. 330 physical capital (production factor) 65 Pindado, J. 240 Pirrong, Stephen 64, 756 poison pills, anti-takeover defence 193 political risk 167, 168 Political Risk Group 167 Porter, Michael 212 portfolio theory and investment 17071, 180 Pound, J. 229, 230 predatory pricing 234 present value (PV) 169 price discrimination 223 price rigidity 47, 48 price theoretic issues marginal cost pricing test 24 mark-up pricing model 47 output test 24 over-searching 245 predatory pricing 234 price discrimination 223

Index German corporate governance 3746 Roe, M. 278 Roll, R. 171, 177 Ruback, Richard 54 rules, formal and informal 168, 170 Srimner eect, informational assumptions 1067 scaling up 3032 Scandinavian countries 3, 13963 cash-ow rights and performance 158 corporate control and investment 14044 corporate governance in 13940, 1434, 145 corporate return in 149, 1516 and ownership structure 1567, 1589, 16062 dual-class shares 142, 160, 161 homogeneity of 140, 144 hostile bids rare in 143 largest countries in 1534 marginal q, use of 3, 149, 15051, 152 micro-to-macro model, Swedish 122, 124, 125 over-investment 4 research methodology 1459 vote-dierentiated shares in 142, 143, 157, 162 Schneider Electric, shareholder agreements 261, 272, 273, 275 Schumpeter, J. 55, 130 creative destruction process 106, 121, 124 on innovator and entrepreneur 129 self-interest, transaction cost economics 14 Servaes, H. 141 shareholder agreements 5, 25380 antecedents of 26274 background 2556 cases Club Med 261, 267, 271, 273, 275, 276 Legrand 261, 2678, 276

411 Pernod Richard 25960, 266, 267, 272, 276 Publicis 260, 266, 267, 276 Schneider Electric 261, 272, 273, 275 control rights 27071 denition of 2556 disclosure requirements 258 duration of 257 empirical setting and methods 25661 equity rights 269 in France 2568 impact 2747 listed rms, used by 2567 minority investors, protection 271 more likely to be found, where in companies with intermediate levels of ownership concentration 263, 2645 incumbent shareholders seeking to maintain dominant control 268 large investors seeking to protect bargaining power 272 long-term interest of shareholders 2667 non-nancial objectives of owners 2678 shareholders addressing complex and conditional issues with intermediate information asymmetry 2712 social ties of leading ocers and directors 2734 stable businesses with small lock-in costs 2689 takeover risk 272 nature of contract items 26972, 270 nature of industry 2689 nature of ownership 2628, 2645 negatively perceived where 276 network ties 2734 non-equity and control issues 271 positively perceived where 2767 related literature 256 sources and methods 2589 typical contracts 257 written contracts 255

412

Index The State of Competition in the Canadian Petroleum Industry 26 static equilibrium, EOE 128 Stigler, George 47, 48 stock market corporate control, market for 21415 as evolutionary mechanism 21314 in developed countries 175 eciency types 146, 162, 213 mispricing of shares 21415 over- or under- estimation of 160 pricing process 213 in Scandinavia 1489 swings, sensitivity to 151 technology boom (19952000) 214 see also takeover bids Stout, L.A. 326 strategic acquisitions market, competence bloc theory 110 Streit, M.E. 168 Strine, Leo 189 Strm, R.O. 324, 326, 330 Strmberg, P. 255 Stuckey, John 21 Summers, Larry 212 Sweden dividends 228, 230 dominant rm 154 dual-class shares 3, 5, 143, 144 economic tradition 115 innovation capacity 119 micro-to-macro model 122, 124, 125 MOSES model 127, 128 mutual funds 227 shipping industry 64, 71 taxation system 2289 Sweezy, P.M. 47, 48 takeover bids anti-takeover defences 1923, 196, 207 British model 194201 City Code 194, 197, 202, 203 civil law model, mainland Europe 2014 Company Law Directive (13th) 194, 196, 201, 203, 204, 209

shareholder value and legal conception of rm, in common and civil law 18690 shareholders free-riding by 197, 230 issues addressed by, with intermediate information asymmetry 2712 long-term interest of 2668 as owners of rm 67 primacy, notion of 187, 208 see also shareholder agreements shark repellents, anti-takeover defence 1923 ship-management companies 75 shipping company, and marine industry 724 see also maritime industry Shleifer, A. 142 Short, H. 232 short-termism 212, 247 Shrader, C.B. 330 Siebert, Calvin 50 Simon, Herbert 13 on authority 834, 85, 90 on knowledge economy 91, 97 on managers 49 on scaling up 31 Sinani, E. 383 Singh, A. 212, 216 size of rm and associated families 299300, 301, 3023 limits to 2930 Skogh, G. 167 Smith, Adam 2, 434, 45, 46, 63 on property rights 168, 180 The Wealth of Nations 44, 65 Smith, N. 330 social capital, and competence 121 social network analysis rm interaction 386 measuring power using 3868 measuring ties between rms 3889 Solow, R. 30 specialization 65, 67 Spier, K.E. 330 spot markets/contracts 15, 70, 767 Standard and Poors 500 index 171

Index High Level Group of Experts on 201, 202, 203, 204 hostile takeovers 4, 55 and employees 198, 199, 200 rare, in Scandinavia 143 rise of 191 just say no defence 191, 192 legal regulation of 190209 origins of takeover regulation 19092 regulation in emerging and transition systems 2089 stakeholder statutes 193 tender oers 55 US model 1924 taxation, and institutional ownership 2289 teamwork 31, 86 technological core 20, 31 technological diusion 1256 temporal specicities 75, 76 tender oers 55 theory of rm 31, 11720 thermal economies 20 third-party ship management 66, 745, 79 Thomsen, S. 383 three-stage least squares (3SLS) methodology 6, 325, 338 time charter, freight contract 72 time contracts, contractual specicities 76 time series analysis 171 Tirole, J. 330 Tobin, J./Tobins q 143, 146, 162 co-determination, impact upon rm performance 325, 326, 343 denition of Tobins q 145 Germany, corporate governance in 375 marginal q distinguished 148 see also marginal q, use of measuring 142 relationship between ownership and Tobins q 141 Tokyo Stock Exchange (TSE) 207 total market value of rm, dened 148 trading rules 24, 25 tramp shipping 70, 71 transaction cost economics

413

and authority 3 cognition and self-interest 14 costly nature of transactions 64 intermediate product market transaction (paradigm transaction) 17 lateral integration 20 lens of contract/governance 13 and managerial authority 82 predatory pricing 23 Robinson-Patman Act 23 scaling up 31 shareholder agreements 5 transactions, attributes of 14 transparency, and takeover regulation 192 Turner, Donald 23, 24 United Kingdom City Code on Takeovers and Mergers 194, 197, 202, 203 Companies Act 2006 188 Company Law Review Steering Committee/Group 187, 188 deregulation policy 19091 mandatory bid rule 194, 209 networking and rm performance 383 privatization policy 190 takeover bids 194201, 203 United States corporate law 189, 192 Delaware courts 189, 192 deregulation policy 19091 economy, during 1990s 43 Federal Trade Commission 26, 35 marginal q, use of 55 networking and rm performance 383 privatization policy 190 Sarbanes-Oxley Act 361 takeover bids 1924 utility maximization 141 value added chains 678 Veblen, Thorstein 141 venture capital market 110, 115 vertical integration 36, 67, 69, 70 vertical market relations 1922 distribution 22

414 lateral integration 2021 raw materials procurement 212 vertical market restrictions 12, 22 Vishny, R. W. 142 vote-dierentiated shares and dividend changes 2312 institutional ownership and dividends 2312, 242, 244, 245 in Scandinavia 142, 143, 157, 162 voyager charter, freight contract 72

Index The Wealth of Nations (Smith) 44 Weber, Max 88 Weisbach, M. S. 331 Weiss, Leonard 48 Wibert, D. K. 151 Wicksell, Knut 105 Wieberg, D. 152, 155 Williams Act, US 192, 193 Williamson, Oliver 49, 63, 68 Yermack, D. 330 Yurtoglu, B. B. 148 Zeckhauser, R. 229, 230

Walker, G. 383 Walras, L. 130 WalrasArrowDebreu (WAD) model 106, 127, 129