by R. Christopher Small for The Harvard Law School Forum, May 20nd, 2011.
In our paper, Concentrating on Governance, forthcoming in the Journal of Finance, we develop a unified account of the costs and benefits of external governance and explore the economic determinants of the resulting trade-offs for shareholder value. The importance of corporate governance is broadly recognized, but there is a great deal of disagreement on whether existing governance mechanisms ultimately benefit or hurt shareholders. Our novel perspective explains shareholder governance trade-offs, why they arise, and how they vary across firms and industries.
The classical agency view is that it is costly for shareholders to yield power to managers because managers pursue private benefits of control whenever their jobs are protected from takeovers or shareholder initiatives. A challenge to the agency view comes from the alternative bargaining view, which suggests that it is in the interest of shareholders to yield power to managers, a popular argument among M&A lawyers and practitioners.
A middle-ground view would argue that there are both agency costs and bargaining benefits of empowering managers. This third view acknowledges the multifaceted nature of governance. However, it is seldom formalized or developed as it does not make immediate unambiguous conclusions about repealing provisions that protect managers. Our paper makes progress on this trade-off view by arguing that robust conclusions obtain once we explicitly consider how a firm’s economic environment interacts with the costs and benefits of corporate governance.
Our approach is to develop a novel model of governance trade-offs that recognizes that there is significant heterogeneity across provisions and their effects in a cross-section of industries. We exploit the idea that industry concentration modulates both the costs and benefits of governance mechanisms since more competition disciplines managers and reduces the value of bargaining tools. Consistent with the theory, our empirical analysis shows that provisions that allow managers to delay takeovers have a significant bargaining effect and a positive relation with shareholder value in concentrated industries. By contrast, non-delay provisions have an unambiguously negative relation with value, and more so in concentrated industries. Our trade-off model offers a new and unique perspective on these facts, which are otherwise hard to explain by appealing exclusively to agency considerations.
Overall, by integrating seemingly opposing views of corporate governance, our analysis offers important new policy implications that emphasize the joint importance of industry and the nature of governance provisions in deciding which governance mechanisms should be implemented.
The full paper is available for download here.