Corporate Governance: Managerial Discretion and Organization Form

Enthusiasts of laissez-faire capitalism are loath to confront, and are sometimes schizophrenic on the subject of, managerial discretion. Focusing on any given time, they commonly deny the existence of managerial discretion. Comparing current practices with the past, however, those same enthusiasts point with pride to the development of new techniques that have brought managerial discretion under more effective control.

To be sure, the earlier condition may have been irremediable: The cor- rective instruments to which investors earlier had access could have been, indeed arguably were, fully deployed. But it is inconsistent to employ the very same neoclassical model—whereby the firm is characterized as a production function to which unrestricted profit maximization is continuously ascribed— at both the earlier and later dates. A conception of the firm in which opportunities for managerial discretion are expressed as a function of the control instruments is needed instead. Such a conception leads to greater respect for successive organizational innovations that have superior control properties and that attenuate managerial discretion.

Managerial discretion can take numerous forms, some very subtle. Indi- vidual managers may run slack operations; they may pursue subgoals that are at variance with corporate purposes; they can engage in self-dealing. Such distortions become more severe where there is logrolling. These and other manifestations of managerial discretion were well-known to Berle and Means, Mason, and other observers of the corporate scene. What went unnoticed, however, was the vast transformation of the corporate form between 1930 and 1960 and the consequences that had on managerial discretion. The earlier, centralized, functionally organized, unitary (or U-form) structure of the cor- poration was progressively supplanted by the multidivisional (or M-form) structure.

The direct effects of the M-form innovation on corporate performance are described in Chapter 11. For one thing, the shift from a functional to a divisional form served to rationalize decision-making. The confusion of purposes that characterized the U-form firm, where causality and responsibility were difficult to trace, was supplanted by a divisionalized structure where separability among quasi-autonomous parts was emphasized. Sharper definition of purpose and savings in informational costs resulted.

Disengaging the general office from operating affairs also improved incentives. What had been short-run, partisan involvements by the top execu- tives who had previously been heads of functional activities (e.g. manufacturing, marketing, finance) gave way to longer-run, strategic decision-making. The general office gave precedence to objectives of the enterprise over functional responsibilities. A competence to monitor the performance of the divisions, allocate resources to high-valued uses, and use internal incentives and controls in a discriminating way was perfected. The M-form organization thereby attenuated managerial discretion in what had previously been U-form firms.

The attenuation of managerial discretion does not, however, imply its elimination. Rather, the argument is comparative. Albeit in reduced degree, continuing managerial discretion can be expected to survive those direct ef-fects Interestingly, however, the M-form innovation also had indirect effects that operate on managerial discretion through competition in the capital market.

It has often been noted that tender offers increasingly replaced proxy contests as a takeover technique beginning in the late 1950s.28 What explains this? Gregg Jarrell and Michael Bradley contend that the costs of proxy contests were increased by new regulations.29 Takeovers are thus explained as the response to a regulation-induced change in the relative price of the methods for gaining control.

That is an interesting hypothesis, but it would be more compelling if proxy contests actually had been widely and successfully used to challenge incumbent managements before those rule changes. In fact, proxy contests were never numerous and were usually unsuccessful. Moreover, although the regulation of proxy contests could encourage greater reliance on a takeover, why should a switch to this (previously inferior) device be associated with a larger number of contests for corporate control-and a greater degree of success?

In principle, takeover by tender offer was always feasible. I submit that the reason why it was not employed earlier is that a corporate structure conducive to takeover was not yet in place. Specifically, reorganization of the corporation from a functionally departmentalized to a divisionalized structure had profound consequences for corporate control. Conceiving of the firm as a governance structure rather than as a production function is the key to understanding the phenomenon of takeover by tender offer.

The main advantage of an M-form firm over a U-form enterprise in takeover respects is the ability of an M-form acquirer to “digest” its acquisition.

The acquired firm is normally assigned profit center status and thereafter becomes subject to the corporation’s internal incentive, control, and resource allocation processes. The firm does not attempt to integrate comprehensively the new assets with the old. Inasmuch as M-form firms separate operating from strategic decision-making, the general office neither seeks nor requires the same familiarity with the operating parts that managers in U-form firms must have. The greater competence of the large M-form firm to manage extant assets thus applies to the management of acquired assets as well.

To be sure, managerial preferences and stockholder preferences do not become perfectly consonant as a result of M-form organization and the associ- ated activation of the capital market. The continuing tension between manage- ment and stockholder interests is evident in the numerous efforts that incumbent managements have taken to protect target firms against takeover (Cary, 1969; Easterbrook and Fischel, 1981). Changes in internal organization have nevertheless relieved legitimate concerns with managerial discretion. To char- acterize the corporation as a production function, rather than as a governance structure, misses those consequences. The vitality of the modem corporation, and its importance as an economic institution of capitalism, is thereby undervalued.

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

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