Costs and Benefits of Concentrated Ownership and Control

Albert H. Choi is Albert C. BeVier Research Professor and Professor of Law at the University of Virginia Law School and Visiting Professor of Law at Columbia Law School. This post is based on a recent paper by Professor Choi.

Corporate ownership structure with a controlling shareholder is prevalent throughout the world. According to one study, more than two-thirds of all publicly-traded companies in East Asia have a controlling shareholder. Even in the US, not only do some of the largest public companies, such as Walmart, Ford, and Berkshire Hathaway, have controlling shareholders, concentrated ownership using dual class stock has become popular recently, as evidenced by the successful initial public offerings of companies, such as Google and Facebook. Corporate law and finance scholars have typically treated the presence of a controlling shareholder as the source of bad corporate governance and the result of bad corporate law. Controlling shareholders are known to abuse their power and extract “private benefits of control” at the expense of the minority shareholders. Examples include entering into conflicts-of-interest transactions, misusing corporate resources for personal ends, expropriating corporate opportunities, pursuing pet projects, and building a conglomerate empire. Not surprisingly, much of the existing scholarship espouses the goal of curbing the extraction of private benefits and protecting the minority shareholders. Particularly with respect to legal instruments that enhance a controller’s power, such as dual class stock, stock pyramids, and cross ownership, proposals have been made to ban them altogether or substantially limit their use.

Notwithstanding the pervasive concern, not only is the concentrated ownership structure prevalent, many companies with controlling shareholders are also quite successful. Companies, such as BMW, Ikea, Fiat, Lego, LVMH, and Samsung, not to mention younger companies like Google, Facebook, and Amazon, excel in offering products and services that are well received by consumers and generate healthy cash flows and profits for their shareholders. All of these companies have a shareholder (or a small group of shareholders) with de facto or de jure control. If the presence of a controlling shareholder leads to extraction of private benefits at the expense of the minority shareholders, how do we explain the prevalence and the resurgent popularity of such ownership structure? How do we evaluate the claim, as emphasized by the Google founders, that having a concentrated ownership structure (with uncontested control) allows a firm to focus on the “long-term” goals for the ultimate benefit for all shareholders? How do we explain the recent, rising trend of firms going public with a dual class structure when they presumably have a strong incentive to adopt the optimal corporate governance regime?

This paper attempts to solve these puzzles by more closely examining the costs and benefits of concentrated ownership. The paper, in particular, focuses on the argument that having a controlling shareholder allows the firm to take a “long-term” perspective and to maximize the “long-term” value of the firm. Google, for instance, has repeatedly defended its dual class structure (with concentrated control) with the claim that the structure allows the company to focus on the “long term interest” of the shareholders. To better evaluate this claim, the paper adopts an analytical framework that examines how a controlling shareholder, on the one hand, affects the firm’s performance (both long-term and short-term) and, on the other hand, affects the division of such return through the extraction of private benefits. For instance, a controlling shareholder can get actively involved with the firm’s research and development to produce and sell high-quality products and enhance the firm’s reputation in the product market. A controlling shareholder’s close monitoring of the top management can also affect the firm’s performance. At the same time, a controlling shareholder can influence how the fruits of improving the firm’s performance are divided among shareholders. Rather than making a pro rata distribution to all shareholders, she can divert that cash flow through various means, such as transactions with a controlled company or investments in pet projects.

When these types of actions are not readily observable by the outside investors, the controlling shareholder and the firm face two distinctive challenges: one on short-term incentive alignment and the other on long-term commitment. On the first, the controlling shareholder must retain enough “skin in the game” to have the necessary incentive to maximize the firm’s earnings. A strong incentive alignment also leads to a reduction in private benefits of control. When a substantial fraction of her return is based on private benefits that are insensitive to the firm’s earnings, by contrast, she would care less about improving the firm’s performance. On the flip side, however, when the controlling shareholder’s return comprises mostly of financial returns and little or no private benefits, it becomes easier for her to sever her relationship with the firm by liquidating her position through the market or by selling her control block to a third party. Such short-term exit options will reduce the controlling shareholder’s incentive to stay with the firm and invest for the long-term. When more of her return is based on (non-transferrable and illiquid) private benefits of control, severing her relationship with the firm implies losing all future private benefits. The larger the private benefits of control, the more likely that the controller will be locked-in with the firm for the long-term and care about the firm’s long-run reputation and performance. When these two challenges point in opposite directions, there will often be an optimal level of ownership share and the amount of private benefits of control that the controlling shareholder extracts in maximizing the long-term value of the firm.

The analysis renders several positive and normative implications. One set of implications is on legal devices—such as dual class stock, pyramidal structure, and cross ownership—that formally separate the cash-flow rights from control rights. Under certain conditions, a formal separation of cash-flow rights from control rights may be necessary in achieving the optimal tradeoff. For instance, when the optimal ownership retained by the founder is too low for the founder to exercise effective control, it may become necessary for the founder to create a dual class structure and retain control rights over the firm so as to achieve long-term commitment and to provide sufficient investment incentive. This can explain why some firms are willing to adopt a dual class structure when they go public for the first time, even though such “inefficient” governance structure has been understood to be only hurting the founders by reducing the proceeds from the stock sale. It also leads to a normative argument that, instead of an unconditional prohibition against such devices, more balanced approach could be desirable. The paper offers the possibility of applying a heightened judicial scrutiny against transactions that are undertaken by controlling shareholders with extreme separation of control from cash-flow rights. The paper also presents implications on other issues, such as sales-of-control, freeze-outs, and debt financing.

The full paper is available for download here.

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