18.1The Separation of Ownership and Control

Most large corporations are effectively controlled by managers who hold a relatively

small amount of their firm’s shares. To borrow from the influential book by Berle and

Means (1932), there is a separation between ownership and control in large corpora-

tions. This separation causes problems because the interests of managers are not gen-

erally aligned with those of shareholders.

Whom Do Managers Represent?

Equity holders are interested in maximizing the value of their shares. Managers, how-

ever, generally see equity holders as just one of many potential constituents. Don-

aldson and Lorsch (1983) suggested that top executives see themselves as represen-

tatives of three separate constituencies, including both financial and nonfinancial

stakeholders:

1.Investors (for example, the company’s equity holders and debt holders).

2.Customers and suppliers.

3.Employees.

In making decisions, managers tend to trade off the interests of all three groups

rather than simply maximize shareholder value. Of course, when decisions do not affect

the well-being of a firm’s customers, suppliers, and employees, there is no conflict. In

reality, however, this is rarely ever the case.

The tendency of managers to consider the interests of all of the firm’s stakehold-

ers is somewhat natural given that executives spend most of their typical day dealing

with customers, suppliers, and employees, and building personal relationships with

these individuals. They spend much less time interacting with equity holders, although

the time spent with institutional shareholders is certainly increasing.

What Factors Influence Managerial Incentives?

Anumber of factors influence the extent to which managers act in the interests of

shareholders. For example, as the length of time a CEO stays on the job increases, the

loyalty to the individuals whom he or she must deal with on a day-to-day basis also

increases. This makes it more difficult for the executive to make tough decisions that

might improve the firm’s stock price at the expense of customers and employees.

Imagine, for example, the dilemma faced by an executive who has the opportunity

to substantially improve her firm’s value by restructuring the firm. Should she act in

the interests of the institutional shareholders who bought the stock last month and plan

to sell it after the restructuring is completed, or should she act in the interests of the

employees with whom she has worked for many years and who may be forced into

early retirement if the restructuring is implemented?

²Later chapters examine how incentive issues affect both merger and acquisition strategies (Chapter

20) and risk management strategies (Chapter 21).

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630Part VIncentives, Information, and Corporate Control

The proportion of the company’s stock owned by managers also determines the

extent to which management’s interests deviate from those of equity holders. Jensen

and Meckling (1976) provided an intuitive explanation of why a manager who owns

more shares will act more in the interests of equity holders. If the manager owns only

5 percent of the firm’s shares, each dollar of perquisites, or unnecessary expenditures

that benefit the manager personally, costs him or her only $0.05, with the other $0.95

borne by other shareholders. For example, a $1 million corporate jet will, in essence,

have a personal cost to the manager of only $50,000. Because of this, the manager is

likely to use corporate resources inefficiently, consuming in ways that would not occur

if the cost of the consumed resources were paid from the manager’s personal funds.

Result 18.1

Management interests are likely to deviate from shareholder interests in a number of ways.The extent of this deviation is likely to be related to the amount of time the managers havespent on the job and the number of shares they own.

How Management Incentive Problems Hurt Shareholder Value

The Armand Hammer and Occidental Petroleum example in the chapter’s opening

vignette provides a poignant case of how management incentive problems can affect

shareholder wealth. Although the Hammer episode is an extreme example of the extent

to which shareholder wealth can be destroyed by a self-interested manager, share prices

tend to respond favorably when entrenched executives leave their positions unexpect-

edly. Articles in Newsweekand The Wall Street Journalprovide several examples of

firms that experienced much larger price run-ups subsequent to the deaths of their

CEOs.³For similar reasons, unexpected retirements also can lead to a positive stock

price response.For example, when Fred Hartley announced on June 7, 1988, that he

was stepping down as CEO of Unocal, the company’s stock price increased 3.8 per-

cent, a one-day gain in shareholder value of about $150 million. In the subsequent year,

Unocal’s stock price nearly doubled.

One interpretation of the positive stock price reactions to CEO retirements and deaths

is that investors believe that a new CEO, with fewer ties to the firm’s other managers,

may be more willing to make the kind of tough decisions that might be required to

improve share values. In 1989, for example, the price of Campbell Soup’s stock increased

20 percent upon the death of Campbell Soup’s chairman John Dorrance, Jr. Shortly there-

after, a new and more aggressive management team restructured the firm, and, among

other things, closed down Campbell’s original soup plant in Camden, New Jersey.

Why Shareholders Cannot Control Managers

Given the large anticipated gains in share prices linked to changing the policies of man-

agers like Armand Hammer and Fred Hartley, it is surprising that stockholders were

unable to force them to act in ways that maximized the firm’s share prices or to force

them to resign earlier. In neither case did the individuals own a large amount of stock.

Armand Hammer and Fred Hartley owned less than 0.5 percent of their companies’

outstanding shares, which is typical for large U.S. corporations. Jensen and Murphy

(1990b) reported that in 1986, the median percentage of inside shareholdings for 746

³“Deathwatch Investments,” Newsweek,Apr. 24, 1989; “Death Watches Are Unseemly but Common,”

The Wall Street Journal,Aug. 6, 1996; see also an interesting study by Johnson et al. (1985),

documenting positive stock price responses to the unexpected deaths of CEOs.

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Chapter 18

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CEOs in the Forbes compensation survey was 0.25 percent, with 80 percent of this

sample holding less than 1.4 percent of the shares in their firms.

As a group, outside shareholders generally cannot force managers to maximize

share prices because their ownership is too diffuse. This creates the kind of free-rider

problem described in Chapter 16. In this case, the free-rider problemarises because it

is not in the interest of any individual shareholder to take actions that discipline a non-

value-maximizing manager, even though it is in the interests of all shareholders as a

group to have this manager removed.

Shareholders who want to challenge the policies of management must stage proxy

fights, which require organizing shareholders to oust the incumbent board of directors

by electing a new board that supports an alternative policy. Proxy fights are very

expensive and outsiders who attempt to organize outside shareholders to vote against

incumbent management usually don’t win them. Carl Icahn, for example, spent more

than $5 million on his unsuccessful proxy fight to take over Texaco. While the aggre-

gate benefits to all shareholders involved in such a proxy fight may very well exceed

their costs, the individual bearing the costs usually receives only a fraction of the

benefits. The remainder of the benefiting shareholders are thus free riders. Hence, it

isn’t surprising that proxy fights rarely occur.

WhyIs Ownership So Diffuse If It Leads to Less Efficient Management?Chapters

4 and 5 noted that investors have an incentive to hold diversified portfolios. Indeed,

the Capital Asset Pricing Model suggests that all investors hold the same market port-

folio, implying that an investor’s shareholdings in any individual firm must be

extremely small. However, the preceding discussion suggests the possibility of an inher-

ent conflict between the desire to hold diversified portfolios and the ability of share-

holders to control management.

An individual investor who wishes to obtain enough shares to control management

would generally have to hold an undiversified portfolio. Although the investor would

benefit by getting management to make value-maximizing decisions, he or she would

bear significant costs by holding an undiversified portfolio. Hence, investors face a

trade-off between diversification and control. The undiversified investor, however,

shares the benefits of control (the higher stock price) with other shareholders, but must

bear alone the cost of having an undiversified portfolio, as Example 18.1 illustrates.

Example 18.1:The Trade-Off between Diversification and Improved Monitoring

John Gallalee believes that he can take control of Axel Corporation and improve its value

by $60 million over the next five years.He can do this by investing his entire wealth of $60

million to purchase 20 percent of Axel’s outstanding shares.Axel’s stock has a standard devi-

ation of about 40 percent per year, which is about twice the standard deviation of the mar-

ket portfolio.Should John go ahead with this investment?

Answer:Axel realizes the $60 million increase in value in five years if John gains con-

trol.For a $300 million company, this is equivalent to an additional 20 percent return over

five years, which is less than 4 percent per year.It’s likely that John could realize a much

higher expected return with the same level of total risk with a leveraged position in the mar-

ket portfolio.The gains from increased monitoring that arise from holding a large stake, there-

fore, are not enough to offset the costs of having an undiversified portfolio.

Result 18.2

Firms with concentrated ownership are likely to be better monitoredand thus better man-aged. However, shareholders who take large equity stakes may be inadequately diversi-fied. All shareholders benefit from better management; however, the costs of having a

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632Part VIncentives, Information, and Corporate Control

less diversified portfolio are borne only by the large shareholders. Because of the costs of

bearing firm-specific risk, ownership is likely to be less concentrated than it would be if

management efficiency were the only consideration.

Can Financial Institutions Mitigate the Free-RiderProblem?The importance of

holding a diversified portfolio explains why individual investors rarely choose to take

positions that are large enough to allow them to adequately monitor and control man-

agement. However, the diversification motive does not explain why institutions do not

arise to provide such monitoring services. For example, one can imagine an economy

in which investors pool their money and buy into large, relatively diversified mutual

funds. Given their large size, these mutual funds could in theory take individual posi-

tions that are large enough to influence management, yet still remain reasonably diver-

sified. For example a $100 billion mutual fund, such as the Fidelity Magellan Fund,

might put $1 billion into each of 100 different stocks. If a number of different funds

formed portfolios in such a way and communicated with one another, as a group they

would be able to effectively monitor management.

As noted in Chapter 1, Roe (1994) argued that regulations adopted in the 1930s, such

as the now repealed Glass-Steagall Act, prevented U.S. financial institutions from play-

ing this role until just recently. This is in contrast with the situation in Germany and Japan

where banks hold significant amounts of equity and exert control over managers.

Although mutual funds and insurance companies in the United States hold significant

amounts of stock, regulations keep them from owning more than 5 percent of the stock

of any individual firm and exerting any explicit control over corporate decisions.

Pension funds, the other major institutional holders of common stock, have recently

begun to exert more influence on corporate behavior. Private pension funds, however,

are still reluctant to exert significant influence on corporate managers, which is not sur-

prising. For example, the managers of IBM would not like to see the company’s pen-

sion fund second-guessing the management of another firm. Doing so might set a prece-

dent that would give the pension funds at other corporations the idea that they should

meddle in IBM’s affairs. However, pension funds for public employees have no simi-

lar disincentive keeping them from acting as active monitors of management. Indeed,

a number of large pension funds—most notably CALPERS, the large pension fund for

California’s public employees—have recently taken on a more active role in their rela-

tionship with corporate management. As we discuss below, there has recently been

much more pressure on U.S. managers to act in the interests of their shareholders, partly

because of the growing importance of public pension funds.

Changes in Corporate Governance

Anumber of changes took place between the mid-1980s and the early 1990s that made

managers more responsive to the interests of shareholders. These include a more active

takeover market, an increased usage of executive incentive plans (e.g., stock options)

that increase the link between management compensation and corporate performance,

and more active institutional shareholders (for example, CALPERS) who have demon-

strated a growing tendency to vote against management.⁴

The active role of institutional investors was sparked, in part, by two Securities

and Exchange Commission rule changes in the early 1990s. The first change, which

⁴We discuss the use of executive stock options later in this chapter (as well as in Chapter 8) and the

takeover market in Chapter 20.

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Chapter 18

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required fuller disclosure of executive compensation packages, put managers under

greater pressure to perform up to their level of compensation. The second change made

it easier for shareholders to get information about other shareholders, which substan-

tially reduced the costs of staging a proxy fight.

For a number of reasons, we believe that corporate boards of directors are becom-

ing more effective monitors of management. First, corporate boards have been getting

smaller, and the percentage of directors who are not directly affiliated with the com-

pany has increased. In a study of corporate boards, Bacon (1989) reported that the

number of board members at large companies declined from a median of 14 in 1972

to a median of 12 in 1989, which may have had the effect of making the individual

board members take their responsibilities as monitors more seriously. Perhaps more

importantly, the percentage of manufacturing companies with a majority of outside

directorsincreased from 71 percent to 86 percent during this same time period. In addi-

tion, board members are receiving an increasingly higher percentage of their com-

pensation in the form of stock and stock options, which aligns their interests with those

of shareholders.

Arecent study by Huson, Parrino, and Starks (2001) concludes that as a result

of these changes, CEOs in more recent years are much more likely to be terminated

for poor performance. Specifically, they found that a CEO’s probability of losing his

or her job in the 1983 to 1994 period was about twice as high as the probability in

the 1971 to 1982 time period. Moreover, the CEO appointed following a termina-

tion was much more likely to be someone from outside the company in the later

time period.

In this changing environment, eight prominent CEOs lost their jobs in 1993, includ-

ing John Akers of IBM, Kay Whitmore of Eastman Kodak, John Sculley of Apple Com-

puter, Paul Lego of Westinghouse Electric, and James Robinson III of American

Express. American Express is a particularly good example of the use of clout by insti-

tutional investors.

Terminations at American Express

American Express lost about 50 percent of its value between 1989 and the end of 1992. As

a result, Harvey Golub, the chairman of American Express, replaced James Robinson, its

CEO. However, Robinson stayed on as chairman of the board and chief executive of the

Shearson Lehmann Brothers brokerage and investment banking unit of American Express.

On January 28, 1993, Golub met with about a dozen of American Express’s largest institu-

tional investors who had expressed their displeasure with Robinson’s continued role in the

company. The next day, Robinson resigned.⁵

Do Corporate Governance Problems Differ Across Countries?

Corporate governance problems differ across countries as well as over time. In some

countries, most notably the United States, the United Kingdom, and other former

British colonies, there is relatively strong legal protection for outside shareholders.

Other countries, however, provide much less legal protection for outside share-

holders. For example, Chapter 1 mentioned that Lukoil, a Russian oil company, had

amarket value of about five cents per barrel of proven oil reserves because of

uncertainty about shareholder rights in Russia. The concern is that the managers of

5

“Good-Bye to Berle & Means,” Forbes,Jan. 3, 1994.

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634Part VIncentives, Information, and Corporate Control

Lukoil will consume the value of the oil reserves, leaving almost nothing for the

shareholders.⁶

As one might expect, countries with the strongest protection for outside sharehold-

ers have the largest and the most active stock markets. Countries with weaker protection

for outside shareholders have smaller stock markets and many fewer new companies

going public. Recent evidence suggests that there are clear advantages associated with

the increased stock market activity that is associated with greater investor protection.⁷

Of course, changes that improve investor protection and create more active stock

markets are not necessarily easy to implement. In particular, there may be intense oppo-

sition from the politically connected families who control the large corporations in those

countries where the investor protection is the weakest. Such reforms are likely to reduce

the degree to which these families control their businesses, and the reforms are likely

to make it easier for potential competitors to raise cash and challenge their dominance.

However, the financial crisis that started in Asia in 1997 and spread to Eastern Europe

and Latin America in 1998 provided added pressure in the affected countries to reform

their financial systems in ways that would allow them to attract capital from interna-

tional sources. As a result, there has been a recent impetus for legal and financial mar-

ket reforms that promote the interests of outside shareholders.