CORPORATE LAW AND GOVERNANCE

Chapter 12

CORPORATE LAW AND GOVERNANCE*

MARCO BECHT ECARES, Universit? Libre de Bruxells and European Corporate Governance Institute (ECGI)

PATRICK BOLTON Graduate School of Business and Department of Economics, Columbia University

AILSA R?ELL School of International and Public Affairs, Columbia University

Contents

1. Introduction

833

2. Historical origins: A brief sketch

834

2.1. How representative is corporate government?

834

2.2. Whom should corporate government represent?

836

3. Why corporate governance is currently such a prominent issue

836

3.1. The world-wide privatisation wave

837

3.2. Pension funds and active investors

837

3.3. Mergers and takeovers

840

3.4. Deregulation and capital market integration

840

3.5. The 1998 East Asia/Russia/Brazil crisis

841

3.6. Scandals and failures at major U.S. corporations

841

4. Conceptual framework

842

4.1. Agency and contracting

842

4.2. Ex-ante and ex-post efficiency

842

4.3. Shareholder value

843

4.4. Incomplete contracts and multiple constituencies

843

4.5. Why do we need regulation?

845

4.6. Dispersed ownership

846

4.7. Summary and conclusion

846

5. Models

848

* An earlier version of this chapter appeared under the title Corporate Governance and Control in the Handbook of the Economics of Finance, edited by G.M. Constantinides, M. Harris and R. Stulz, 2003 Elsevier B.V. Substantive new material is confined to Section 8.

Handbook of Law and Economics, Volume 2 Edited by A. Mitchell Polinsky and Steven Shavell ? 2007 Elsevier B.V. All rights reserved DOI: 10.1016/S1574-0730(07)02012-9

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5.1. Takeover models 5.2. Blockholder models 5.3. Delegated monitoring and large creditors 5.4. Board models 5.5. Executive compensation models 5.6. Multi-constituency models

5.6.1. Sharing control with creditors 5.6.2. Sharing control with employees

6. Comparative perspectives and debates

6.1. Comparative systems 6.2. Views expressed in corporate governance principles and codes 6.3. Other views

7. Empirical evidence and practice

7.1. Takeovers 7.1.1. Incidence of hostile takeovers 7.1.2. Correction of inefficiencies 7.1.3. Redistribution 7.1.4. Takeover defences 7.1.5. One-share-one-vote 7.1.6. Hostile stakes and block sales 7.1.7. Conclusion and unresolved issues

7.2. Large investors 7.2.1. Ownership dispersion and voting control 7.2.2. Ownership, voting control and corporate performance 7.2.3. Share blocks and stock market liquidity 7.2.4. Banks

7.3. Minority shareholder action 7.3.1. Proxy fights 7.3.2. Shareholder activism 7.3.3. Shareholder suits

7.4. Boards 7.4.1. Institutional differences 7.4.2. Board independence 7.4.3. Board composition 7.4.4. Working of boards 7.4.5. International evidence

7.5. Executive compensation and careers 7.5.1. Background and descriptive statistics 7.5.2. Pay-performance sensitivity 7.5.3. Are compensation packages well-designed? 7.5.4. Are managers paying themselves too much? 7.5.5. Implicit incentives 7.5.6. Conclusion

M. Becht et al.

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Ch. 12: Corporate Law and Governance

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7.6. Multiple constituencies

906

7.6.1. Debtholders

906

7.6.2. Employees

907

8. Recent developments

909

8.1. Regulatory responses to corporate scandals

910

8.1.1. The Sarbanes-Oxley act

910

8.1.2. Other U.S. reforms

911

8.1.3. Eliot Spitzer and conflicts of interest on Wall Street

912

8.1.4. European reforms

912

8.2. Executive compensation and earnings manipulation

913

8.3. Reforming the board of directors

915

8.4. Other major research themes

916

8.4.1. Corporate governance and serial acquisitions

916

8.4.2. Stock returns and corporate governance

917

8.4.3. Corporate governance and ownership structure

917

8.4.4. Shareholder activism and fund voting patterns

918

8.4.5. Corporate governance and the media

918

8.4.6. Corporate governance and taxes

919

9. Conclusion

919

References

920

Abstract

This chapter surveys the theoretical and empirical research on the main mechanisms of corporate law and governance, discusses the main legal and regulatory institutions in different countries, and examines the comparative governance literature. Corporate governance is concerned with the reconciliation of conflicts of interest between various corporate claimholders and the resolution of collective action problems among dispersed investors. A fundamental dilemma of corporate governance emerges from this overview: large shareholder intervention needs to be regulated to guarantee better small investor protection; but this may increase managerial discretion and scope for abuse. Alternative methods of limiting abuse have yet to be proven effective.

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Keywords Corporate governance, ownership, takeovers, block holders, boards JEL classification: G32, G34

M. Becht et al.

Ch. 12: Corporate Law and Governance

833

1. Introduction

At the most basic level a corporate governance problem arises whenever an outside investor wishes to exercise control differently from the manager in charge of the firm. Dispersed ownership magnifies the problem by giving rise to conflicts of interest between the various corporate claimholders and by creating a collective action problem among investors.1

Most research on corporate governance has been concerned with the resolution of this collective action problem. Five alternative mechanisms may mitigate it: (i) partial concentration of ownership and control in the hands of one or a few large investors, (ii) hostile takeovers and proxy voting contests, which concentrate ownership and/or voting power temporarily when needed, (iii) delegation and concentration of control in the board of directors, (iv) alignment of managerial interests with investors through executive compensation contracts, and (v) clearly defined fiduciary duties for CEOs together with class-action suits that either block corporate decisions that go against investors' interests, or seek compensation for past actions that have harmed their interests.

In this survey we review the theoretical and empirical research on these five main mechanisms and discuss the main legal and regulatory institutions of corporate governance in different countries. We discuss how different classes of investors and other constituencies can or ought to participate in corporate governance. We also review the comparative corporate governance literature.2

The favoured mechanism for resolving collective action problems among shareholders in most countries appears to be partial ownership and control concentration in the hands of large shareholders.3 Two important costs of this form of governance have been emphasised: (i) the potential collusion of large shareholders with management against smaller investors and, (ii) the reduced liquidity of secondary markets. In an attempt to boost stock market liquidity and limit the potential abuse of minority shareholders some countries' corporate law drastically curbs the power of large shareholders.4 These countries rely on the board of directors as the main mechanism for co-ordinating shareholder actions. But boards are widely perceived to be ineffective.5 Thus, while minority shareholders get better protection in these countries, managers may also have greater discretion.

1 See Zingales (1998) for a similar definition. 2 We do not cover the extensive strategy and management literature; see Pettigrew, Thomas, and Whittington

(2002) for an overview, in particular Davis and Useem (2002). 3 See ECGN (1997), La Porta, Lopez-de-Silanes, and Shleifer (1999), Claessens, Djankov, and Lang (2000)

and Barca and Becht (2001) for evidence on control concentration in different countries. 4 Black (1990) provides a detailed description of the various legal and regulatory limits on the exercise of

power by large shareholders in the U.S. Wymeersch (2003) discusses legal impediments to large shareholder

actions outside the U.S. 5 Gilson and Kraakman (1991) provide analysis and an agenda for board reform in the U.S. against the

background of a declining market for corporate control and scattered institutional investor votes.

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