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E-MailZohar Goshen is the Jerome L. Greene Professor of Transactional Law at Columbia Law School and Doron Levit is Assistant Professor of Finance at The Wharton School of the University of Pennsylvania. This post is based on their recent paper.
The central theme in the theory of corporate governance is that allocating more control rights to shareholders will allow them to hold disloyal managers accountable and reduce agency costs. The common empirical prediction that follows is that a weak governance structure will be associated with weak firm value and performance due to high agency costs. However, a review of empirical studies of the last forty years reveals that every aspect of corporate governance that was studied yielded conflicting empirical findings as to its effect on firm value and performance. For instance: the level of cash flow rights held by management; dual-class firms; anti-takeover defenses, such as poison pills, staggered boards, and protective state legislations; hedge-fund activism; and the strength of corporate governance as measured by several indices.
Interestingly, despite the inconclusive empirical evidence, institutional investors with common ownership are consistently pushing toward strong governance structure for publicly traded firms, via, for instance, destaggering boards, limiting the use of poison pills, excluding dual-class firms from the indices, demanding mandatory sunsets for dual-class firms, and supporting hedge funds’ governance initiatives.
What explain the conflicting empirical findings in the studies of corporate governance? And why, given the inconclusive empirical findings, institutional investors with common ownership are consistently pushing toward strong governance structures in public firms?
To answer these questions, in our paper we develop a model in which, a priori, corporate governance can either increase or decrease firm value. Our main result shows that in a competitive equilibrium corporate governance is irrelevant to firm value. Importantly, different from the “no transaction costs” model of Modigliani and Miller (1958), the irrelevance result in our model does not arise because there is “no conflict” between shareholders and managers. It is trivial that without a conflict the allocation of control rights is irrelevant, as the manager will always resign to make room for a better manger. Indeed, for long it was assumed that with conflict (i.e., “agency costs”) governance structure is relevant. Instead, following the spirit of Miller (1977), who shows that capital structure remains irrelevant even with taxes, we show that governance structure is irrelevant even with agency costs. Our model allows us to identify the conditions under which corporate governance is relevant, thereby informing the design of future empirical studies and explaining institutional investors’ strong-governance-strategy and the consequences of common ownership.
Our model features multiple firms which run by managers, who can either preserve firm value by maintaining the status quo and paying out to shareholders, or change firm value by investing. Investment is non-contractible and requires resources (e.g., human capital, raw materials, intellectual property), which firms buy for their business activities in a competitive market. By investing, loyal managers create firm value, and disloyal managers consume private benefits and destroy firm value. Shareholders, who are not fully informed, deduce from decisions made by managers whether a manager is disloyal and should be fired. Since managers have career concerns, the fear of being fired can discipline disloyal managers but also distort decisions made by those who are loyal. The allocation of control rights allowing a shareholder to fire a manager can either be easy (“strong governance”), such as in dispersed-ownership firms without staggered boards and poison pills, or impossible (“weak governance”), such as in dual-class firms with public shareholders owning non-voting shares. These control rights are allocated at the outset in each firm by its own shareholders, to maximize the expected value of the firm.
In equilibrium, strong governance and the threat of being fired by shareholders, deters all types of managers from undertaking investment and buying resources; weak governance does the opposite. Intuitively, strong governance structures tighten managerial freedom and weak governance loosen it. Therefore, the total demand for resources is affected by the division of the universe of firms between strong and weak governance. In particular, a larger number of firms with weak governance implies more investment and a higher demand for resources, which results in a higher price of resources and a lower value of each firm with weak governance. In other words, the independent governance choices of individual firms affect the clearing of the resources markets, which in turn, feeds back into the profitability of each individual firm.
Our main result shows that the universe of firms will reach an equilibrium in which some firms have weak governance and other strong governance, but all firms will have the same value. A single firm cannot change its value by switching governance from weak to strong or the other way around; shareholders are indifferent between these choices in equilibrium. Moreover, the competitive equilibrium is socially efficient in the sense that the allocation of resources cannot be improved, and in particular, a regulatory intervention is counterproductive. Importantly, we show which broken assumptions will lead to governance relevance.
To understand the intuition behind the irrelevance of governance structure, note that the competitive resources market can clear in equilibrium only if the price is fair in the sense that investment is a zero net present value (NPV) from shareholders’ perspective. For example, if investment is expected to be a negative NPV, shareholders will switch their firms from weak to strong governance as a means to deter managers from investment, thereby increasing their firm value. As a result, the demand for resources and their price will decrease. A lower price of resources implies a higher NPV on investment, and firms will continue switching from weak to strong governance until the NPV is zero. A symmetric argument explains why the investment cannot be a positive NPV either. Since investment must be a zero NPV in a competitive equilibrium, shareholders are indifferent between strong and weak governance, which is the reflection of the governance irrelevance.
Our result has important implications. First, the model informs the design of empirical studies, showing that the hypothesis tying weak-governance to weak-performance is insufficient. And it shows the additional factors affecting the equilibrium: availability and competitiveness in the relevant resource’s market; firms’ market-power in the resources’ markets; shareholders’ competence and market power in the ownership of firms; and the strength of managers’ conflict and career concerns. Thus, the design of an empirical study should account for corporate governance being both firm-specific and market-specific, and specify the market conditions under which it expects strong-governance to outperform weak-governance.
Second, since shareholders with market power in the ownership of multiple firms violate the irrelevance conditions, the model provides insights regarding the consequences of common ownership, and in particular, it explains the increasing demand by institutional investors for strong corporate governance in public firms. Powerful common owners can enhance the value of their portfolios by increasing the mass of firms with strong governance above the competitive allocation. Since strong governance deters investment by managers, such policy lowers the demand for resources and reduces their price below the competitive level, thereby creating superior returns to the remaining weak governance firms. Importantly, our model suggests that common ownership might be harmful to the economy because of a monopsony power rather than a monopoly power. Indeed, many predictions of the model are consistent with observed empirical patterns. For example, the model shows that due to common ownership, the increased returns in the capital markets come at the expense of lowering the returns in the labor market and the input market, as well as reducing the overall level of investment in the economy.
The complete paper is available here.
