Ownership and control

Corporate governance deals with mechanisms by which stakeholders of a corporation exercise control over corporate insiders and management such that their interests are protected. The stakeholders of a corporation include equityholders, creditors and other claimants who supply capital, as well as other stakeholders such as employees, consumers, suppliers, and the government. The professional managers, the entrepreneur, and other corporate insiders (we will refer to them collectively as ``managers''), control the key decisions of the corporation.

Given the separation of ownership and control (or stakeholding and management) that is endemic to a market economy, how the stakeholders control management is the subject of corporate governance.

Thus, the primary reason for corporate governance is the separation of ownership and control, and the agency problems it engenders. In Section 2, we describe the various types of agency problems caused by the separation of ownership and control.

Since di? erent types of capital contributors and other stakeholders have di? erent types of pay-o? structures from the ®rm, the con? icts of interest that develop and the agency problems they cause are di? erent.

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In this survey, we will depart from convention and not simply view corporate governance mechanisms as a means to ameliorate managerial agency problems arising from con? ict of interest between managers and equityholders. We will examine the role of corporate governance mechanisms in dealing with other classes of agency problems. The topic of corporate governance has attained enormous practical importance for at least three reasons.

First, the e? ciency of the existing governance mechanisms in advanced market economies has been the subject of debate.

For example, Jensen (1989, 1993) has argued that the internal mechanisms of corporate governance in the US corporations have not performed their job. He has advocated a move from the current corporate form to a much more highly levered organization, similar to a leveraged buyout (LBO). On the other hand, legal scholars, including Easterbrook and Fischel (1991) and Romano (1993), view the US mechanisms and the legal system in a favorable light.

Second, there is an ongoing debate on the relative e? cacy of the corporate governance systems in the US and UK (typi®ed by dispersed shareholdings and a prominent role for the secondary market trading of shares) and the corporate governance systems in Japan and Germany (typi®ed by more concentrated shareholdings and a prominent role for banks). With the new and emerging market economies seeking to implement the ``right'' corporate governance, this debate has attracted serious attention from ®nance and legal scholars.

Third, there is an apparent departure of the current practice of corporate governance from the legal provisions which accord the board control over management. The basic principle of corporate governance is that the shareholders elect the board of directors who in turn select top management. The K. John, L. W. Senbet / Journal of Banking & Finance 22 (1998) 371±403 373 common practice, however, is for the board to be elected by the shareholders from the slate approved by the top management.

The monitoring role of the board of directors is an important component of corporate governance and we will pay particular attention to it. The board of directors is presumed to carry out the monitoring function on behalf of shareholders, because the shareholders themselves would ®nd it di? cult to exercise control due to wide dispersion of ownership of common stock. This problem in monitoring is endemic to most large corporations with di? use ownership, because an individual (atomistic) shareholder lacks su? cient stake in the ®rm to justify spending resources to closely monitor managers.

This leads to a free rider problem, as shareholders, individually, attempt to ``free ride'' on others to monitor managers. Thus, the board e? ectiveness in its monitoring function is determined by its independence, size, and composition. The bulk of the literature is empirical, which takes as given the current structure of board governance and studies its impact on ®rm performance. More recently, there is limited attention to endogenizing board composition and independence, with the ultimate goal of rationalizing the current governance practice as an optimal solution (e. g. , Hermalin and Weisbach, 1997; Warther, 1993).

This new strand of few papers is primarily theoretical and exploits the gaming strategies between management and the board of directors in an informationally ine? cient economy. In addition, there are theoretical and empirical attempts to examine the interaction between internal governance mechanisms and external mechanisms (e. g. , Hirshleifer and Thakor, 1994). It is our purpose to synthesize the literature focusing on the board composition and independence, along with its interaction with both product and ®nancial markets.

2 We will also provide some new perspectives, particularly on the linkage between corporate governance and debt markets. Thus, our approach takes the ®rm as a nexus of contracts and examines the role of primary stakeholders ± shareholders, creditors, management, and even the government ± in the governance scheme. (This perspective is detailed in Section 2). The manner in which debt interfaces corporate governance is derived from two sources: ®rst, the extent of alignment of board (board independence) with shareholders will have an impact on debt agency, and hence on endogenization of board structure in e? cient debt contracting.

Second, in other systems, such 2 For an interesting survey that pays special attention to the role of concentrated ownership, see Shleifer and Vishny (1997). Our survey, apart from its focus on board e? ectiveness and its interface with external mechanisms of control and managerial incentive contracts, has considerable US orientation, although we will provide some discussion of comparative governance systems. Concentrated ownership (via large shareholder and large creditor) is prevalent in Germany and Japan. In our research agenda, we will have a new perspective on the role of debt in corporate governance. 374 K. John, L. W.

Senbet / Journal of Banking & Finance 22 (1998) 371±403 as Japan and Germany, debtholders have a direct role through board membership and perform functions separate from large shareholders, since their payo? structure is di? erent. Therefore, the dichotomy of large shareholder versus large creditor is an interesting aspect of governance scheme that has not been fully studied. For instance, what is the role of corporate governance in the e? cient resolution of ®nancial distress or private workouts and market mechanisms? Our subsidiary goal of the synthesis is, in fact, to provide avenues for future research along these lines.

The rest of the paper is organized as follows. In Section 2, we describe the various classes of agency problems that arise from the separation of ownership and control. This is in view of the fact that we take an agency perspective in approaching issues in corporate governance. In Section 3 the empirical literature on the board of directors, its characteristics, its size, and its composition on ®rm performance is surveyed. In Section 4 the theoretical literature endogenizing the structure of the board is discussed. The interaction between the internal mechanisms and the external mechanisms of corporate control is surveyed in Section 5.

New directions for further research are explored in Section 6. Concluding remarks are in Section 7. 2. Agency problems and corporate governance We view corporate governance in the context of control mechanisms designed for e? cient operation of a corporation on behalf of its stakeholders. The control mechanisms themselves are necessitated by separation of ownership and control that is endemic to a market economy. Thus, corporate governance is a means by which various stakeholders exert control over a corporation by exercising certain rights as established in the existing legal and regulatory frameworks as well as corporate bylaws.

To appreciate the role of corporate governance, let us begin by thinking about an idealized market system which supports the familiar framework of the Fisherian Separation Principle. Consider an economy with two classes of agents ± consumers and producers. On the consumption side, consumer±investors make their decisions to maximize their utility through an appropriate allocation of their consumption over time and across commodities. On the production or real sector side, ®rms make investment decisions so as to tailor to individual consumption preferences.

If this economy is devoid of capital markets with lending and borrowing opportunities, managers (separate from owners) have to infer the details of diverse consumption preferences of individual investors, and hence it is impossible to achieve unanimously agreed upon decision criteria regarding investment and production. In the presence of well-functioning capital markets, on the other hand, managers can be delegated to make investment and production decisions so as to maximize the wealth of K. John, L. W. Senbet / Journal of Banking & Finance 22 (1998) 371±403 375 ®rm owners (or ®rm-value). Capital market prices become su? cient signals for production decisions, and consumption and production decisions are completely separable.

The Fisherian Separation Principle is a basis for a market economy in which there is separation of ownership and control. It can also be shown that, under these idealized conditions, wealth (value) maximization is equivalent to social welfare maximization. Thus, the key to a well-functioning economy is the existence of well-functioning markets which play a vital role in allocating resources e? ciently, whereby resources are channeled to most productive uses. Unfortunately, the real economy is not as idealized as the Fisherian form.

It is characterized by imperfect information, agency con? icts, and a host of market imperfections, such as transactions costs, taxes, and regulatory and institutional impediments to the arbitrage process in capital markets. We take an agency perspective in discussing the issues and principles underlying corporate governance and board e? ectiveness. Indeed, the ®rm can be viewed as a nexus or network of contracts (Jensen and Meckling, 1976), implicit and explicit, among various parties or stakeholders, such as shareholders (equityholders), bondholders, employees, and the society at large. This is now a widely held view in ®nance (see Fig.

1). The pay-o? structure of the claims of di? erent classes of stakeholders is different. The degree of alignment of interests with those of the agents in the ®rm who control the major decisions in the ®rm are also di? erent. This gives rise to potential con? icts among the stakeholders, and these incentive con? icts have now come to be known as ``agency (principal-agent) problems''. Left alone, each class of stakeholders pursues its own interest which may be at the expense of other stakeholders. We can classify agency problems on the basis of con? icts among particular parties to the ®rm, such as con?

icts between stockholders (principals) and management (agent) (managerial agency or managerialism), between stockholders (agents) and bondholders (debt agency), between the private sector (agent) and the public sector (social agency), and even between the agents of the public sector (e. g. , regulators) and the rest of the society or taxpayers (political agency). (See Barnea et al. (1985) for more detailed classi®cation and discussion of private agency problems, and John and Senbet (1996) for social agency problems. ) Agency problems detract from e? cient operation of an enterprise.

Departures from e? cient investment strategies are detrimental to economic growth and development. Thus, the economic and ®nancial environment, that fosters e? cient corporate governance and e? cient contracting among parties with diverse interests, promotes e? cient allocation of resources, and hence ultimately economic development. Our focus is on private agency perspective of corporate governance. It may be useful to outline two classes of agency problems before we go into a full? edged discussion of corporate governance. First, managerialism refers to self-serving behavior by managers. Ownership of the modern corporation,