The foundation of my understanding of corporate governance rests on a small but growing number of essays, articles and books.
These writings include Henry Manne’s “Mergers and the Market for Corporate Control“; Michael Dooley’s “Two Models of Corporate Governance“; Stephen Bainbridge’s Director Primacy: The Means and Ends of Corporate Governance and “The Business Judgment Rule as Abstention Doctrine“; Kenneth J. Arrow’s The Limits of Organization; Frank H. Easterbrook and Daniel R. Fischel’s The Economic Structure of Law; Zohar Goshen and Gideon Parchomovsky’s “The Essential Role of Securities Regulation“; and Alon Brav, Wei Jiang, Frank Partnoy and Randall Thomas’ “Hedge Fund Activism, Corporate Governance, and Firm Performance.”
Recently, I have added to this esteemed list Zohar Goshen and Richard Squire’s “Principal Costs: A New Theory for Corporate Law and Governance.”
Goshen and Squire put forth a new theory, the “principal-cost theory,” which posits that a firm’s optimal corporate governance arrangements result from a calculus that seeks to minimize total control costs, not just agency costs (“the economic losses resulting from managers’ natural incentive to advance their personal interests even when those interests conflict with the goal of maximizing their firm’s value”):
The theory states that each firm’s optimal governance structure minimizes total control costs, which are the sum of principal costs and agent costs. Principal costs occur when investors exercise control, and agent costs occur when managers exercise control. Both types of cost can be subdivided into competence costs, which arise from honest mistakes attributable to a lack of expertise, information, or talent, and conflict costs, which arise from the skewed incentives produced by the separation of ownership and control. When investors exercise control, they make mistakes due to a lack of expertise, information, or talent, thereby generating principal competence costs. To avoid such costs, they delegate control to managers whom they expect will run the firm more competently. But delegation separates ownership from control, leading to agent conflict costs, and also to principal conflict costs to the extent that principals retain the power to hold managers accountable. Finally, managers themselves can make honest mistakes, generating agent competence costs.
Moreover, it is important to understand that the theory is firm specific:
Principal costs and agent costs are substitutes for each other: Any reallocation of control rights between investors and managers decreases one type of cost but increases the other. The rate of substitution is firm specific, based on factors such as the firm’s business strategy, its industry, and the personal characteristics of its investors and managers. Therefore, each firm has a distinct division of control rights that minimizes total control costs. Because the cost-minimizing division varies by firm, the optimal governance structure does as well. The implication is that law’s proper role is to allow firms to select from a wide range of governance structures, rather than to mandate some structures and ban others.
The bottom line is that: “A firm that seeks to maximize total returns will weigh principal costs against agent costs when deciding how to divide control between managers and investors.”
As an approach to identify optimal governance arrangements, minimizing total control costs allows for the fundamental value of authority in large organizations to be respected and acknowledged, something missing in many academic works that only focus on agency costs. According to Michael Dooley: “Where the residual claimants are not expected to run the firm and especially when they are many in number (thus increasing disparities in information and interests), their function becomes specialized to risk-bearing, thereby creating both the opportunity and necessity for managerial specialists.”
Especially where there are a large number of shareholders, it is much more efficient, in terms of maximizing shareholder value, for the Board and executive management—the corporate actors that possess overwhelming advantages in terms of information, including nonpublic information, and whose skills in the management of the company are honed by specialization in the management of this one company—to make corporate decisions rather than shareholders.
The calculus of the principal-cost theory also allows potential for Bainbridge’s director primacy as a positive theory to be proven correct for any particular firm: “As a positive theory of corporate governance, the director primacy model strongly emphasizes the role of fiat – i.e., the centralized decisionmaking authority possessed by the board of directors.” In the context of Goshen and Squire’s calculus, Bainbridge is arguing that principal costs will greatly outweigh agency costs when total control costs are minimized.
Finally, Goshen and Squire’s theory allows for an understanding of why dual-class share structures continue to persist and why they have been successfully implemented at companies such as Alphabet (Google) and Facebook. Their theory is critical to the argument I make in my most recent paper, “A Private Ordering Defense of a Company’s Right to Use Dual Class Share Structures in IPOs.” In sum, Goshen and Squire’s theory allows for a more robust understanding of what is meant by optimal corporate governance arrangements, something that an exclusive focus on agency costs does not allow.
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