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Michaels. Weisbach
andNBER
Ohio StateUniversity
to
We would like to thankLea Sternforher diligenthelp in preparingthisarticle.Send correspondence
LucíanBebchuk,HarvardLaw School,Cambridge, MA 02138. E-mail:bebchuk@law.harvard.edu.
1. Shareholders
Berle and Means (1932) identified whatappearedto be a fundamental con-
tradictionin thecorporateformof organization: Whiledispersedsharehold-
ers collectivelyhave incentives to monitor themanagement of thefirmsfor
whichtheyown stock,individually, thefree-rider
problem ruinsuchin-
can
centives,leading to a lack of shareholder involvementin firms.Giventhatthe
distributionof stockownership is importantbecauseof thesefree-riding con-
siderations,Shleiferand Vishny(1986) pointed outthatlargepercentage block
shareholdings aremoreprevalent in theUnitedStatesthanpreviously thought
(no one doubtedtheirexistenceoutsidetheUnitedStates).Morck,Shleifer,
andVishny(1988) andmanyfollow-up studieshavedocumented a robustem-
piricalrelationbetween these and
largeshareholdings corporate performance,
holdingin a widevariety ofsamplesspanning a number ofcountries andtime
periods.
940
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2. Boards ofDirectors
An alternativeto directmonitoring byshareholders is governance through the
boardof directors, who are electedby shareholders. Yet, as has been recog-
nizedat leastsinceSmith(1776) and Berleand Means (1932), directors'in-
terestsmaynotfullyoverlapwiththoseof shareholders. The complexthree-
wayrelationship amongshareholders, boards,and topmanagement has been
thesubjectof a substantial literature(see Hermalinand Weisbach2003 and
Adams,Hermalin, andWeisbachforthcoming forsurveys).
How do we makeboardsworkbetter? One recipethathasbeenincreasingly
suggestedby public and privatedecision makersis to have independent
boards(see Gordon2007 on the rise of independent directors).Indeed,a
commonpolicyresponseto observed"governance crises"has been to adopt
reformsdesignedto strengthen the independenceof boards.For example,
following theEnronandWorldComscandalsin 2002,theexchangesincreased
independence requirements, and the Sarbanes-OxleyAct of 2002 required
theindependence of auditcommittees. The financialcrisishas similarlyled
to theconsideration of legislationaimed at bolstering the independence of
compensation committees.
Whyimposeregulatory limitson thecomposition of theboard?Hermalin
andWeisbach(1998) presenta modelin whichdirectors imposedon thefirm
by regulations are likelyto be less effectivethanthosepickedthrough the
endogenousselectionprocessthatwouldoccurin theabsenceof regulation.
At thesametime,regulators are typicallyconcernedthat,without regulation,
opportunism byinsidersmightlead to insufficient independence ofdirectors.
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3. ExecutiveCompensation
In theordinary courseof events,publicfirmsare managedby executives, not
directorsorshareholders. Executives'decisionsareinfluencedbythedirectors'
oversight, as well as by shareholders'
monitoring. Executives'decisionsare
also affected,however, by theincentives providedto themby theirexecutive
compensation arrangements. Thesecompensation arrangements havebecome
thesubjectofa largeliterature(see Murphy1999andCore,GuayandLarcker
2003 forsurveys).
Thereare at least two views of executivecompensation in theliterature.
One view("theoptimalcontracting view")sees executivepayarrangements as
theproduct ofarm'slengthcontracting betweenboards and executives,which
leads to contractsthatprovideefficientincentives forreducingagencyprob-
lemsas muchas possible(e.g., Holmstrom 1979). An alternativeview ("the
managerial powerview") questionswhether pay arrangements theprod-
are
uctof arm'slengthcontracting and sees such payarrangements as partof the
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946
The estimatesof Kaplan and Rauh (2009) lead themto conclude thatnonfi-
nancial public company CEOs and top executivesdo not representmore than
6.5% of any of the top adjusted gross income (AGI) brackets(the top 0.1%,
0.01%, 0.001%, and 0.0001%). Individuals in the Wall Streetcategorycom-
priseat least as higha percentageof thetop AGI bracketsas nonfinancialexec-
utivesof public companies. Kaplan and Rauh argue thatthisevidence suggests
thatthegrowthof executivepay is notreflectiveof suboptimalcontracting,but
ratheris mostconsistentwiththeoriesof superstars,skill-biasedtechnological
change, greaterscale, and the interactionof these effects.
Although Kaplan and Rauh (2009) suggest that the growthof pay levels
could be consistentwith the optimal contractingview, they do not attempt
to test directlywhethercompensation is indeed the productof arm's length
contracting.A full defense of this view would have to address the empirical
evidence thatcompensationlevels are higher(as well as less sensitiveto per-
formance)when governanceis weaker (see Bebchuk and Fried 2004, Chapter
6 fora survey).Among otherthings,thereis evidence thatCEO pay is higher
whenoutsidedirectorsserveon multipleboards,when theboard has interlock-
ing directors,when more of the outside directorshave been appointed under
this CEO, when thereare no large outside blockholders,when a smaller per-
centage of sharesis held by institutionalinvestors,and when antitakeoverpro-
tectionsare more significant(e.g., Borokhovich,Brunarski,and Parrino1997;
Hallock 1997; Core, Holthausen,and Larcker 1999; Cyert,Kang, and Kumar
2002; Hartzell and Starks2003).2
Whereas Kaplan and Rauh (2009) defend the optimal contractingview
against claims thatpay levels have been excessive, some otherrecent work
seeks to defend this view against claims that compensation structureshave
been inefficiently designed. In particular,Edmans, Gabaix, and Landier (2009)
presenta model in which optimalpay lines up closely withempiricalobserva-
tions on actual executive compensation.And while many public officialsex-
pressed concernsthatstandardpay arrangementsprovideexcessive incentives
to focus on the short-term (an argumentstressedin Bebchuk and Fried 2004,
Chapter14), Fahlenbrachand Stulz (2009) argue thatthereis no empiricalev-
idence that such incentiveshave played a role in the run-upto the financial
crisis.
Althoughinterestin executive pay has been high for quite some time,the
Financial Crisis of 2008-2009 has further intensifiedthisinterest.Public atten-
tionto thecompensationlevels of top officialsappears to be at an all-timehigh.
Regulators around the world are examining measures to improve the struc-
ture of compensationand not to make thingsworse throughill-thought-out
provisions.And authoritiesin the United States and elsewhere are consider-
ing measuresto improvethe corporategovernanceprocesses thatproduce pay
2 Thereis also evidencethatweaker is associatedwithlowersensitivityof pay to perfor-
corporate
governance
mance(Bertrand 2001) andopportunistic
andMullainathan compensation practicessuchas thosemanifestedby
optionbackdating (Bebchuk,Cohen,andFerrell2009; Bizjak,Whitby, andLemmon2009).
947
The examination
arrangements. of pay arrangementsand thepay-setting
pro-
cessesbypublicandprivatedecisionmakers, we hope,willbe informed
from
theongoingandfutureresearchoffinancialeconomists.
4. ControllingShareholders
The natureofgovernance problemsdiffers greatly betweenpubliccompanies
withand without a controlling shareholder (La Porta,Lopez-de-Silanes, and
Shleifer1999; Bebchukand Hamdani2009). Withcontrolling shareholders,
themarket forcorporate controlthatplayssuchan important rolein theanal-
ysisof companieswithout a controllercannotprovidea sourceof discipline.
Witha controlling shareholder, thefundamental governance problemis notop-
portunism by executivesand directorsat the of
expense publicshareholders at
large but rather opportunism by thecontrolling shareholder at the expense of
theminority shareholders.
The Becht,Franks,Mayer,and Rossi; Ravinaand Sapienza; and Kaplan
and Rauh articlesin thisissue all focuson companieswithouta controlling
shareholder - thecommonstructure amongpubliclytradedfirms intheUnited
Statesand theUnitedKingdomand theone on whichmostresearchhas fo-
cused.Butas theworkoncomparative corporate governance has shown(Becht
and Röell 1999; La Porta,Lopez-de-Silanes, and Shleifer1999; Franksand
Mayer2001),companieswitha controlling shareholder arethedominant form
amongpublicly traded firms in most countries.Holderness (2009) shows that
controlling shareholders are more common even in the United States thanis
usually assumed.
One important typeof controlling shareholders are thoselabeled "con-
trollingminority shareholders" by Bebchuk,Kraakman,and Triantis(2000).
Theseareshareholders whoownonlya minority (and sometimes a smallmi-
nority)of the company's cash flow rightsbut controla majority of thevotesand
thushavea lockon control. An ownerofa minority ofthecashflowrights can
controla majority of thevoteswhencash flowrightsand votesare separated
duetotheuse ofdual-classstock,corporate pyramids, orcross-holdings. Such
structuresarequitecommonin manycountries and
(Claessens,Djankov, Lang
2000; Faccio andLang 2002). Bebchuk,Kraakman, andTriantis(2000) show
thatsuchstructures havethepotential tocreateverylargeagencycoststhatare
an orderofmagnitude largerthanthoseassociatedwithcontrolling sharehold-
erswhoholda majority of thecash flowrightsin theircompanies.Bertrand,
Mehta,andMullainathan (2002) present evidenceaboutthesignificant amount
oftunneling thattakesplace in suchfirms.
In theUnitedStates,controlling minority shareholder structures commonly
occurthrough theuse of dual-classshares.In suchfirms, multipleclasses of
stockswilltrade,typically withthesamedividendrightsbutdifferent voting
rights.This arrangement ensures thatcontrolis keptin thehandsof a small
groupof individuals, usuallythefounderand/orhis family, eventhoughthe
948
5. InternationalComparisons
Untilthemid-1990s, mostoftheworkon corporate governance hasbeeninthe
contextofU.S. firms. Buttheinfluential workofLa Porta,Lopez-de-Silanes,
andShleifer (1999) andLa Portaetal. (1997, 1998,2000a,b, 2002) has stimu-
lateda largebodyofworkon international comparisons (see Levine2005 and
La Porta,Lopez-de-Silanes,andShleifer2008 forsurveys).
Muchofthisworkhas focusedon differences betweencountries'legalsys-
tems(including theirsystemsofenforcement) andhas studiedhowsuchdiffer-
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6. Cross-BorderInvesting
A substantial partof theworkon international comparisonsabstractsfrom
themovement of firmsand capitalacrossborders.It takesas giventhateach
countryhas a givensetoffirms anda givenamountofcapitalinvested in these
andit focuseson howfirmsin different
firms, countries varyin howtheyare
governed.In ourincreasingly globalizedworld,however, thereis in factmuch
movement acrossborders, andthereis someresearchthatseeksto understand
thecausesandconsequencesofsuchmovement.
One important elementof cross-border movements concernsdecisionsby
firmsheadquartered andoperating in a givencountry to subjectthemselves to
thegovernance rulesof othercountries.Coffee(1999) and Stulz(1999) have
suggestedthatfirms can therefore
"bond"themselves to good governance by
incorporatinginanother countryorbylistingon a foreign exchange.Thereis a
lineofworkexamining
significant whyfirms "migrate" to foreign governance
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7. Politics
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954
8. Conclusion
ThisissueofTheReviewofFinancialStudiescontainssevenarticlesthatwere
presentedin a meetingof theNBER's corporate governance project.Each of
thearticlesmakesa significantcontribution
to an importantarea of corporate
governance. For each of theseareas,we discussits importance and current
stateof research,how thearticlein thisspecial issue makesa contribution,
and some of theworkthatremainsto be done. We hope thatthearticlesin
thespecialissue,and theadditionalworkthatwill follow,will advanceour
understanding abouttheseimportantareas.
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