Public and Private Ownership

The listed corporation often provides the best available liquidity for external investments, resulting in cost-efficient financing. However, this corporate form often also entails standardized corporate governance solutions that can be affected by externalities. Boot, Gopalan & Thakor argue that entrepreneurs may avoid public ownership with externally fixed corporate governance regimes, choosing instead private ownership structure, where they are able to tailor the corporate governance framework to their needs together with investors.¹³³ The corporate governance structures applied to publicly listed corporations are, to some extent, externally given and based, for instance, on statutes or stock exchange rules. Corporate governance structures in public corporations can also be subject to regulatory intervention based on political agendas. Moreover, these structures may be fixed and untailored to the kind of precise trade-off desired by the entrepreneur.¹³⁴ On the other hand, a public ownership structure provides increased liquidity, generally resulting in lower costs of capital.

Boot, Gopalan & Thakor argue that the choice of ownership structure depends on the stringency of corporate governance regimes. If corporate governance is particularly lax and investor protection is low, investors may require extremely high returns. Under such circumstances, entrepreneurs tend to prefer private ownership with a small number investors where corporate governance is largely contractual. When corporate governance for publicly traded corporations is overly stringent, the entrepreneur’s autonomy will be excessively limited, and private ownership will again be preferred. Other factors affecting choices of ownership structure include the increased cost of capital for private ownership structures and the likelihood of disagreement between the entrepreneur and the investors.

For the purposes of this study, the above emphasizes that the relationships between corporate constituencies are affected by a variety of external factors and that the outcomes of bargaining are incomplete. This has important implications for corporate governance regulation. It cannot be assumed that the bases of the relationships between corporate constituencies are static; thus it remains important to address how these relationships develop.

D. THECONCENTRATION OFCORPORATECONTROL

Many of the corporate governance mechanisms used to avoid the concentration and entrenchment of control may be less effective than assumed – regardless of the structure of ownership. For example, researchers and regulators have voiced concern that shareholders are relatively powerless in the United States.¹³⁵ For some time, this concern has focused on the central role of the board of directors, and it has been argued that instead of displaying shareholder primacy, U.S. companies with dispersed ownership are in fact controlled by the board – albeit in the interest of shareholders.¹³⁶For example, boards of directors are deemed to have a considerable level of independence with regard to corporate decision making,

133SeeBoot, Gopalan & Thakor (2006),supranote 107.

134Id.

135Lucian A. Bebchuk,The Case for Increasing Shareholder Power, 118 HARV. L. REV. 833 (2005).

136SeeStephen M. Bainbridge,Director Primacy: The Means and Ends of Corporate Governance, 97 NW.U.L.REV. 547 (2002-203).

without having to refer matters to shareholders.¹³⁷Furthermore, in matters where shareholders are allowed a voice, directors have often been given a veto-right.¹³⁸ It has been assumed, however, that there are effective market-based mechanisms in place whereby the performance of directors and management is monitored.

More recently it has nevertheless been argued that the monitoring mechanisms assumed to police the board and management are not functioning as intended.¹³⁹For example, the hostile takeover is no longer thought to provide the management monitoring function it was once believed to perform. Poor performance reflected in a lower share price is assumed to result in a proposal to change management through a public takeover. In reality, however, the mechanism seldom performs this function, due to institutional entrenchment by management.¹⁴⁰ In contrast, it seems that management has means of maintaining control, while shareholders have clear disincentives to challenge incumbent management.¹⁴¹

It has been noted that the allocation of legal powers reflects dominant ownership structures, which provides a further reason why external monitoring mechanisms may be less efficient than assumed. For example, the structure of corporate law may provide an advantage to constituents representing the prevalent structure of ownership, and a relative disadvantage to other constituents in the pursuit of their interests through the regulatory framework. In other words, corporate law has evolved to favor the interests of dominant constituencies. Company law may provide monitoring mechanisms that, for example, insufficiently take into account the collective action problems associated with a diversified and dispersed shareholder base.

Moreover, the balance between the interests of the principal and the agent may not provide sufficient incentives for efficient monitoring.

Differences between the allocation of corporate legal authority in the United States and in certain EU member states with concentrated ownership may provide an example in this regard.¹⁴² Cools has observed that under Delaware corporate law the allocation of legal powers favors directors and provides only limited avenues for shareholders to affect corporate matters. When founders in Delaware companies raise further equity financing, they do not need to retain high equity stakes to maintain control as long as they have ensured their representation on the board. This balance of legal authority also functions to discourage outside investors from buying larger stakes in the company, considering the limited legal power that can be obtained.¹⁴³ It has also been argued that regulation fails to facilitate the ability of shareholders to effectively coordinate decision making, giving management a relative advantage with respect to entrenching its control over corporate strategy.¹⁴⁴

By way of comparison, boards in a number of EU member states require, for example, the consent of shareholders to issue new shares (sometimes a simple majority for pre-emptive offerings and a qualified majority for directed offerings) or pay dividends. In a number of EU

137SeeCools (2004),supranote 63, at 46-47.

138Id.; for example, under Delaware law proposals for charter amendments can only be made through a proposal from the board at the shareholders’ meeting; DGCL § 242 (b)(1).

139SeeBebchuk (2005),supranote 135.

140Id.

141SeeCools,supranote 63, at 64.

142Id.

143As a significant portion of the largest US corporations are domiciled in Delaware, the laws of this jurisdiction are used to represent the prevalent position in the United States.

144SeeBebchuk (2005),supranote 135 and Lucian A. Bebchuk & Scott Hirst,Private Ordering and the Proxy Access Debate, 65 BUS. LAW. 329 (2010).

member states, shareholders have further powers that can be effectively enforced at shareholders’ meetings,¹⁴⁵ where a controlling shareholder can wield considerable influence based on his or her holdings. Where the allocation of legal powers favors shareholders, the founders must ensure they maintain sufficient voting rights in order to maintain control.¹⁴⁶In some cases, however, legal institutions have developed that further strengthen the position of controlling shareholders. Control enhancing mechanisms can be seen as a complementary institution that can be used to leverage the monitoring function of controlling shareholders. In this way, controlling shareholders can obtain economies of scale and decrease firm specific risk.¹⁴⁷In this environment, the control rights of minority shareholders may often be limited.

Even if corporate law provides legal avenues for minorities to pursue their rights, the legal system may disfavor such initiatives. For example, the lack of the legal concept of class action may result in the risks of shareholder litigation being too high for minority shareholders.

Control over the use of corporate assets is a key element in bargaining and usually prioritized by the entrepreneur (the presumed “agent”). In governance models reflecting dispersed ownership, control over the use of corporate assets is mainly in the hands of the board of directors, whereas in the context of concentrated ownership, the controlling shareholders often have de facto control over the corporation and its business.¹⁴⁸ However, it is not necessarily the case that control is used to extract private benefits of control. Instead, it is possible that control over the use of corporate assets is a key element of bargaining for an entrepreneur pursuing a business enterprise.

It seems, then, that the expectation that monitoring by principals is a key factor for corporate governance may not accurately reflect the dynamic of the relationship between entrepreneurs and investors in relation to bargaining over the terms of corporate finance and corporate governance. In the context of concentrated ownership, corporate governance mechanisms providing “voice” to the minority may be illusionary, at best. Whatever the case may be, it is also suggested that the monitoring underlying the principal-agent relationship in corporate governance is generally less effective than assumed. This suggests that in addition to agency theory other elements are needed for a better understanding of the dynamics of corporate governance.

E. CHANGING THEI^NITIALB^ARGAIN

This section has highlighted the fact that many factors affect bargaining, not least the industrial and historical development of the corporate environment, which sets the broader framework for contracting.¹⁴⁹ Institutional development is path dependent, and as complementary institutions evolve, the cost of deviating from standardized solutions increases.¹⁵⁰ It has been recognized that the corporate governance outcomes prevalent in a particular environment are not necessarily optimal, even if they are the result of bargaining on

145SeeCools (2004),supranote 63 (Belgium and France) and JESPERLAUHANSEN, NORDICCOMPANYLAW– THEREGULATION OFPUBLICCOMPANIES INDENMARK, FINLAND, NORWAY ANDSWEDEN74-75 (2003).

146Cools (2004),supranote 63, at 64.

147Ronald J. Gilson & Alan Schwartz,Constraints on Private Benefits of Control: Ex Ante Control Mechanisms versus Ex Post Transaction Review4 (ECGI Law Working Paper 194, 2012),available at

http://ssrn.com/abstract=2129502.

148SeeBecht, Bolton & Roell (2002),supranote 44.

149SeeRoe (2000),supranote 14 and Roe(2003), supranote 51.

150SeeBebchuk & Roe (1999),supranote 52.

market terms. Incumbent governance structures do not necessarily exist because they are efficient; rather they can also be the resultof strategic behavior and maneuvering by parties seeking to maximize their own interests.¹⁵¹Empirical research also supports the position that the structure of ownership tends to persist over time.¹⁵²Nevertheless, as the relevant parties’

investments are specialized and mutually dependent, there will be interest in renegotiating the terms of bargaining on an on-going basis.

As contractual arrangements are necessarily incomplete, there is a need to organize mechanisms for bargaining on an ex-post basis. The participants in an enterprise are aware of the possibility of ex-post bargaining and are therefore unwilling to make initial investments unless they are satisfied that the initial agreement will be respected and that they will not be disenfranchised. Sufficient guarantees against ex-post changes will therefore be a central element of the bargain. This, in turn, emphasizes the importance of corporate governance. In the bargaining approach to corporate governance, the structure of corporate finance can be seen as the main tool for changing the terms of corporate control. As discussed, the balance between the use of equity and debt instruments in corporate finance, and how they are bundled, will determine how control is allocated on the basis of corporate performance. A case in point is including convertible instruments in the bargain, whereby the parties can set triggering events for changing control.¹⁵³

However, there may well be pressure to change the original terms of the bargain. For example, when initial investments are made in specialized assets, resulting in sunk costs, the relative bargaining position of the constituencies may change. Even if the various corporate constituents have committed to certain corporate governance rules, they may well seek to renegotiate these rules as their relative bargaining power increases. In this respect contracts can merely be seen as “frozen” bargaining power.¹⁵⁴ Investors may hesitate to make initial investments if they face a risk of ex-post changes, and may require guarantees to protect their investment. However, they will also compare these risks with other investment alternatives (including making no investment at all), which are all likely to include similar risks in an environment of incomplete contracts.

New legal regulation can also be seen as a mechanism for changing the original corporate governance framework. Corporate constituencies are also interest groups that can use political avenues to pursue corporate interests, and changes in regulation can be seen to reflect changes in the relative bargaining power of these constituencies. The relationship between entrepreneurs and investors will be renegotiated, in part, through political and regulatory intervention as the political bargaining power of these constituencies evolves. Corporate governance regulation can be expected to reflect the interests of politically dominant constituencies. However, different constituencies have different requisites for pursuing their interests in this regard.¹⁵⁵Theories on political coordination suggest that small interest groups with similar interests overcome coordination problems to sufficiently promote their interests.

Small groups of large shareholders in an environment of concentrated ownership have often

151Utset (1994-1995),supranote 12, at 609.

152SeeJeremy Grant & Thomas Kirchmaier,Who Governs? Corporate Ownership and Control Structures in Europe(SSRN Working Paper, June 7, 2004),available athttp://ssrn.com/abstract=555877.

153SeeGilson (2006),supranote 35, at 1677-1678.

154Peter Nobel,Stakeholders and the Legal Theory of the Corporation, in PERSPECTIVES INCOMPANYLAW AND FINANCIALREGULATION176 (Michael Tison, Hans De Wulf, Christoph Van der Elst & Reinhard Steennot, Eds., 2009) .

155See MANCUROLSON, THELOGIC OFCOLLECTIVEACTION(1971).

been identified as such a constituency. On the other hand, the interests of large interest groups with similar interests are generally reflected through the political system. It has been argued, for example, that labor interests are pursued through political avenues. However, large interest groups with dissimilar interests may be more vulnerable than others, as they may face disproportionate coordination costs. Minority shareholders, for example, may have insufficiently similar agendas and overly small financial interests to allow for efficient coordination. The interests of these constituencies, then, may require special attention.

Changes in bargaining power may reflect changes in the overall political economy. As industrial structures develop and the political economy evolves, the initial outcome of bargaining may become sub-optimal. In other words, the original allocation of control is no longer value maximizing from a property rights perspective. At the same time, the relative bargaining power of the corporate constituents may change, leading, a consequence, to changes in the framework for feasible corporate governance outcomes. Technological change can affect the relative importance of different types of firm-specific investments in this regard. For instance, much attention has been paid to the increase in the relative importance of human capital. Here, the outcome of a dispute between the new owners and the manager and former owner of the advertising agency Saatchi & Saatchi has often been cited as a case in point.¹⁵⁶ When the new owners rejected the salary demands of the former chairman, he and several others left the company to set up a competing enterprise – taking with them a significant portion of the company’s assets in the form of the human capital.

It has been argued that change is the central characteristic of interaction between economic, political and corporate environments.¹⁵⁷ Technological change affects the business and organizational environments of corporations, and it is vital that the organizational structures of businesses can be adapted to such changing circumstances. Corporate acquisitions and the transfer of control are important elements in this respect. The transfer of control can be seen as a process whereby access to corporate assets is transferred to a party that, due to technological or other changes, can use them more efficiently and give them a higher value.¹⁵⁸ It is therefore important that the transfer of control is appropriately facilitated. However, as discussed earlier, the entrenchment of control is a central characteristic of corporate governance. Creating incentives for changing the structure of corporate ownership may consequently be as important as trying to regulate concerns related to currently dominant structures of corporate ownership.¹⁵⁹ Moreover, many of the governance mechanisms based on monitoring by external parties are less effective than assumed. Consequently, the continued development of different approaches to corporate governance regulation remains important.

F. IMPLICATIONS FORREGULATION

On a general level, parties should enjoy freedom of contract with respect to different corporate governance solutions, and the promotion of specific structures of governance or ownership through regulation is generally unwarranted. However, it is also the case that the outcomes of bargaining are not necessarily optimal or efficient – especially in the longer term

156See Raghuram G. Rajan & Luigi Zingales,The Governance of the New Enterprisein CORPORATE GOVERNANCE, THEORETICAL& EMPIRICALPERSPECTIVES(Xavier Vives, ed., 2000).

157Ronald J. Gilson,The Political Ecology of Takeovers: Thoughts on Harmonization of the European Corporate Governance Environment, 61 FORDHAML. REV. 161, 175 (1992).

158Id.at 164.

159Id.at 174-175.

as the political economy evolves. Moreover, in many cases bargaining is carried out in “an institutional, legal, standardized framework”¹⁶⁰that shapes the outcomes of that bargaining, and resulting in structures that may or may not be optimal for the enterprise in question.

Political factors also have a considerable impact in this respect. The ex-post bargaining process is therefore very important. Moreover, it has been emphasized that as the corporate environment evolves, organizations must have the ability to adapt, in which context the transfer of control is a key element. However, due to the characteristics of corporate governance and the deficiencies in many corporate governance mechanisms, corporate control may be entrenched so that control is not necessarily transferred when it would be expedient to do so. Consequently, new regulatory concepts and mechanisms warrant continued consideration. The next section will turn to a consideration of the regulatory implications of an environment of concentrated ownership.

V. REGULATORYIMPLICATIONS FORCONCENTRATEDOWNERSHIP

A. INTRODUCTION

This study approaches corporate governance from the perspective of financial contracting in order to provide a better understanding of the assumptions upon which corporate governance regulation is based. This approach may capture the dynamic of corporate governance, especially in the context of concentrated ownership, where a controlling shareholder can be seen as an entrepreneur negotiating the terms of corporate finance with other constituencies, including other shareholders. The study argues that a corporation’s corporate finance and corporate governance structures are the outcome of bargaining, and that parties should be allowed freedom of contract in this regard. For example, it could be argued that introducing the concept of one-share-one-vote would be an inappropriate limitation of the potential outcomes of bargaining and freedom of contract.¹⁶¹However, adopting this approach does not mean that regulatory intervention is unwarranted as such. It is clear that different corporate governance structures are vulnerable to abuse, and there is no guarantee that different corporate constituencies are not primarily driven by self-interested action at the cost of others.

The study also recognizes that control is often entrenched and that regulatory intervention may be justified to prevent abuse and to facilitate transfer of control where incumbent control has become suboptimal. However, the question remains as to how these issues could be approached through regulation.

The bargaining theory of corporate governance suggests that for an entrepreneur the value of control is based on the ability to direct corporate strategy and the use of corporate assets to

The bargaining theory of corporate governance suggests that for an entrepreneur the value of control is based on the ability to direct corporate strategy and the use of corporate assets to