Ownership and Control: Rethinking Corporate Governance for the Twenty-first Century.

Siegfried, John J.

In this provocative book Margaret Blair argues that because of limited shareholder liability, the maximization of corporate shareholder wealth does not insure the maximization of society's wealth. Because shareholders will declare bankruptcy and liquidate a firm when shareholder value turns negative even if the net present value of rents accruing to other investors outweighs the shareholders' losses, what is good for shareholders may not be good for society.

Other corporate investors with a stake in complete or partial liquidation decisions include employees, unsecured creditors, and suppliers who have made firm-specific investments. Some employees, for example, may develop valuable firm-specific skills that cannot be marketed elsewhere. In the absence of some assurance that the expected stream of positive rents earned on such investments will not be truncated against their will by corporate downsizing or bankruptcy, employees will underinvest in firm-specific skills, and wealth creation opportunities will be squandered.

Blair argues that shareholders are seldom the sole bearers of residual risk. In particular, when the total value of a company falls below the level where the value of shareholders' equity is zero, the value of creditors' claims begins to decline, and creditors become residual claimants.

The ability of corporations to maximize total wealth, argues Blair, depends on who has what ownership and control rights over corporate resources, who faces what incentives, who has what information, and how decisions get made. Corporate governance is about setting up the rules that answer these questions in corporations. Governance problems arise when decisions are made by parties who do not bear all of the consequences of the decisions they make.

Ironically, the vast separation of ownership from control in large modern corporations first identified by Adolph Berle and Gardiner Means in 1932, may promote the maximization of social welfare by insulating corporate management from the myopic pursuit of shareholder goals. Because shareholders face fixed costs of monitoring and controlling management behavior, and are tempted to free-ride on other shareholders, modern management hierarchies may be better able to balance claims for control from all the stakeholders. This, in turn, would induce more efficient investments from those stakeholders whose otherwise reduced control would have discouraged them from risking capital on investments whose returns could be truncated by the decisions of others.

Blair argues that modern corporations do not fit the naive "finance model," in which shareholders are the sole residual claimants. Rather, the growing importance of technology-intensive or service-oriented firms means that most contemporary value added is created by innovation, product customization or specialized services, all of which derive from employees whose skills are specialized to their employer. In such firms, employees may have as much interest' as shareholders in insuring that the firm's resources are employed efficiently. Consequently a governance structure which allocates control exclusively to shareholders could create considerable inefficiency.

Stakeholders who have significant specialized investments at risk have equity invested in the firm even if they own no common stock. Therefore, their rights and obligations as owners should be formalized through compensation schemes, board membership, or other mechanisms that assure them sufficient control to induce optimal investment behavior. Governance structures must be devised to give all of the participants an incentive to cooperative and act in the best interest of the entire firm.

The problem identified by Blair is not new. Numerous economists have written about the implications of co-specialized assets, and the bi-lateral monopoly bargaining problem that results from such circumstances. The problem is more severe in the case of human capital investments, since the vertical integration solution is not available there. Blair's excellent exposition, however, expands the accessibility of the argument beyond readers of technical economics journals.

The recommendations to remedy the problem are disappointing. Most are old ideas, or approaches with risky by-products. Directors should be required to hold a substantial amount of a company's stock. Employees with firm-specific skills should receive some of their compensation in stock that cannot be cashed out immediately. Stock options should be replaced by restricted stock (that cannot be sold for a period of time) to insure that management shares in downside as well as upside risk. Employees should have full control over shares held for them in ESOPs or profit-sharing plans. And rules should be changed to encourage institutional investors to take larger positions in portfolio companies, and develop a "relationship" with their investments.

This book is well written. It argues persuasively that the naive "finance model," in which corporate shareholders are the sole residual claimants, doesn't apply very well to modern corporate America. Whether the recommendations to alleviate the problem will be effective, however, is less certain.

John J. Siegfried Vanderbilt University