Corporate Governance: Concluding Remarks

The composition and functions of the board of directors have been the subject of controversy at least since the exchange between Dodd and Berle in 1932.30 Recent commentary shows little signs of convergence. Thus Andrews (1982) favors the participatory model, whereby the board becomes implicated in the management of the firm, and characterizes the monitoring model as legalistic. And Dahl would radically shift the composition of the board in favor of the employees. The contractual approach takes exception with both.

Thus consider Dahl’s views on the composition of the board:

I do not see why a board of directors elected by the employees could not select managers as competent as those selected by a board of directors chosen by banks, insurance companies, or the managers themselves. The board of a self-governing firm might hire a management team on a term contract in the way that a board of directors of a mutual fund often does now—and also fire them if they are incompetent. If the “profit motive” is all that it has been touted to be, who would have more at stake in improving the earnings of a firm than employees, if the management were responsible to them rather than to stockholders? [Dahl, 1970, p. 21]

Dahl evidently assumes that mutual funds and manufacturing firms are equivalent. The possibility that workers can and will craft superior governance structures at the contractual interface between workers and firm goes unmentioned. And the expropriation risks that Dahl’s procedures would introduce are ignored.

The contractual approach views those matters differently. Thus mutual funds are distinguished by the facts that ownership can be instantly liquidated at objective market values and mutual fund performance assessments are easy. The price of shares in a manufacturing enterprise, by contrast, is supported not by a diversified portfolio of separately priced securities but by its own performance prospects. Comparative assessments of those prospects are often difficult. Also, whereas workers are often able to craft a sensitively attuned bilateral governance structure at the contractual interface between firm and workers, that is much more difficult for holders of equity. Lacking control over the board, equity holders are vulnerable to expropriation. Some economists and many noneconomists nevertheless maintain the view that “not by logic but by history, owners of capital have become the owners of the enterprise’’ (Lindblom, 1977, p. 105). The prevailing view notwithstanding, Richard Cyert and James March invite us to consider economic organization more symmetrically: “Why is it that in our quasi- genetic moments we are inclined to say that in the beginning there was a manager and he recruited workers and capital?” (1963, p. 30). Paul Samuelson’s remarks on the symmetry between capital hiring labor and labor hiring capital, made in the context of Marxian models with technical change, are even stronger: “In a perfectly competitive market it doesn’t really matter who hires whom: sollave labor hire ‘capital’ ” (1975, p. 894).

Whether there is a contractual logic to corporate governance can usefully be assessed by adopting a Cyert and March/Samuelson orientation. Thus suppose that a group of workers wish to create opportunities for employment without themselves investing equity capital in the enterprise. Suppose further that the business in question has the need for a series of inputs, of which investments in nonredeployable durable assets are included. We can imagine the workers approaching a series of input suppliers and asking each to participate. General purpose inputs contract easily and without hazard. Special purpose inputs offer a supply on or terms, depending on whether or not governance safeguards are crafted. Considering the above described problems of crafting a well-focused safeguard for equity capital (which, by definition, is used to finance diffuse but specific assets), the equity suppliers initially offer to hold debt at a price of p¯. Upon realizing that this is a very inefficient result, the workers who are organizaing the enterprise thereupon invent a new general purpose safeguard, name it the Board of Directors, and offer it to the suppliers of equity. Upon recognizing that expropriation hazards are thereby reduced, the suppliers of equity capital lower their terrffs”df participation to p. They also become the “owners” of the enterprise. Not by history but by logic does this result materialize.

By way of summary, the argument advanced in this chapter comes down to this:

First, Those who are associated with the firm in a node A relation have no need for supportive governance, whether it be of a board-connected kind or otherwise. Instead, market mediation suffices for such parties.

Second, those who are associated with the firm in a node C relation have already crafted bilateral governance that is attuned to the idiosyncratic needs of the transaction. Unless there áre significant gaps or defects in the bilateral governance, board participation is unnecessary. The main occasion for those with node C governance to be included on the board of directors is for information purposes. Labor may sometimes qualify, especially when a firm is experiencing difficulties and is asking for givebacks. Suppliers who are engaged in a large-scale firm-specific project and very large customers may also qualify.

Third, those whose contracting relation is of a node B kind are in the greatest need of remedial governance. By its very nature, the contractual relationship between the shareholders and firm is difficult to safeguard. Providing stockholders with an ability to monitor the affairs of the firm and to replace the management in a crisis will arguably facilitate obtaining equity financing on superior terms. For that reason the board of directors should be regarded principally as a governance instrument of the shareholders. Viewed in the context of all contractual relations, moreover, it is in the interests of all constituencies that voting board membership be reserved for those whose contractual relation to the firm is of a node B kind.

It is difficult to craft governance structures for managers whose relation to the firm is highly specific. Management’s presence on the board can improve the amount and quality of information and lead to superior decisions. But such a presence should not upset the board’s basic control relation with the corporation.

The manner in which boards of directors in most large corporations are constituted and operated is broadly consonant with that prescription. Yet there are significant differences. The management often plays a larger role in gov- ernance than the contractual framework dictates; boards are often pressed to go beyond a monitoring role to adopt a participative one; and corporations have been under economic and political pressure to extend voting board membership to various interest groups. In theory, the first two of those phenomena may be explained by the efficacy of ex post settling-up (Fama, 1980). An alternative explanation is that the deviations are a reflection of the continu-ing presence of managerial discretion: Incumbent managements feel more secure and have greater latitude in participative boards which they dominate.

Note with respect to this last that I have assumed throughout that, once struck, all node C bargains will thereafter be respected. That ignores the possibility that circumstances will change and that departure from the spirit, if not the letter, of the contract will sometimes follow. For example, the resolve of a regulatory commission to set rates at a level that yields a fair rate of return may weaken if regulated firms do not have recurring needs to resort to capital markets for expansion and renewal capital.117 The same applies to stockholders in a firm that has no need for equity financing. Although management may have enthusiastically supported governance structure safeguards for the stockholders at the time that initial equity financing was secured in order to benefit from more favorable terms, it may subsequently prefer relief from the monitoring pressures that such a node C bargain implies. If additional equity capital is not needed, the composition and character of the board may be altered to the disadvantage of the shareholders.118 To be sure, there are checks against such distortions. But as FitzRoy and Mueller (1984) observe, assertions that ex post settling-up processes are always and everywhere fully efficacious strain credulity.

Source: Williamson Oliver E. (1998), The Economic Institutions of Capitalism, Free Press; Illustrated edition.

Leave a Reply

Your email address will not be published. Required fields are marked *