The Hobgoblin of Separation of Ownership and Control
By Gary Galles • Thursday November 19, 2015 4:07 PM PDT •
The Great Recession heightened people’s search for scapegoats. One common target was corporate management, accused of harming shareholders and consumers, rather than advancing their interests, with more government regulation put forward as the necessary solution. We saw it when the self-styled 99% blamed the 1% for their frustrations, when Hillary Clinton blamed weak economic growth on “quarterly capitalism,” and in other manifestations.
However, this line of argument is far from new. Its pedigree traces at least as far back as the doctrine of “the separation of ownership and control,” in Adolf Berle and Gardiner Means’ 1933 The Modern Corporation and Private Property.
The “separation of ownership and control” story focused on the widely dispersed ownership of corporations. In a nutshell, it argued that because corporate shares were spread among many small holders, no one had enough at stake to keep close tabs on corporate managers. Since managers knew that was the case, they could take advantage of shareholders, rather than advancing their interests. Therefore they did.
If the only incentive mechanism in the relationship between shareholders and managers was that managers could take advantage of current shareholders and get away with it, the separation of ownership and control conclusion could be true. That accounts for why many have accepted its implication that more government intervention was needed to protect citizens from private sector misbehavior. However, that story ignores multiple incentive mechanisms that override the simplistic story.
The separation of ownership and control story treated the fact that there are typically many small owners as if all shareholders were small owners. It may be true that small owners will not monitor managers at all. But there are multiple owners with substantial stakes in a particular firm. They have sufficient incentives to monitor the management, so they pay close attention. This is especially true when large owners have seats on a company’s board of directors, where malfeasance at the expense of stockholders can best be controlled. Warren Buffet may be the most famous illustration.
Higher-level managers and board members are also substantial owners of stock in their firms. In fact, substantial ownership can be a necessary condition of managerial and board membership. That ownership sometimes takes on the obvious form of direct stock ownership. However, the same is true of stock options or stock appreciation rights which are, or are likely to be, “in the money” (i.e., profitable to exercise), because every dollar a share price rises also increases the value of each option by one dollar. When managers and board members are substantial owners, directly or “at the margin,” the incentive for managers to rip off owners is substantially reduced.
Even if every current owner had a very small stake, as long as shares can be resold without restriction, even some who may own no current shares have incentives for careful monitoring of management. Investors can accumulate stock at prices lowered to reflect managerial misbehavior, then take over the firm and profit from share prices that capitalize the predictable benefits. That incentive can be undermined by takeover defenses such as poison pills or regulatory restrictions, but to the extent it is not, it can add many zeroes to the payoff from monitoring management.
It can be true that once investors have delegated decision-making power over their resources to managers of a firm by buying its stock, it may be difficult to revoke or reassign that power, particularly if stockholders have small stakes. But even if that was true, stockholders still maintain the power to determine the terms at which they will delegate that power in the first place. If yet-to-be owners can anticipate predictable managerial misbehavior, the prices they will pay to enter the relationship will be lower to capitalize the likely harm to them. Management, not stockholders, will then bear the cost of such actions. This is true even when takeover defenses exist, as their consequences can also be anticipated, although changes in takeover defenses after power has been delegated can harm existing owners.
In a similar way, bondholders will incorporate potential misbehavior that could put future repayment at risk into the terms at which they lend. They can impose restrictions to control risk-increasing behavior (e.g., limits on future mergers and the issuance of additional debt that could finance increased “gambling”) and/or demand higher interest rates to reflect the risk involved. Management, not bondholders, will bear the cost of any predictable abusive behavior in this dimension, as well.
We must also remember that many managers’ greatest financial asset is the present value of their future income as managers. That value, in turn, is inextricably linked to current performance, which acts as an indicator of likely future performance. If a management group did take advantage of current shareholders, their future prospects of advancement, not just within their current firm, but especially in other, larger firms (the typical path to far higher compensation), would be sharply curtailed. Even if they could take advantage of shareholders, it would often be in their interest not to do so.
In fact, even if a management group intended to take advantage of current shareholders, some members of the group, particularly those whose future prospects will be most damaged, have incentives to stop it. When some capture disproportionately less of the gains, but put disproportionately greater future income at risk, they are more interested in benefitting current shareholders. They can then short-circuit attempts at such abuse, including by going over the misbehavers’ heads to the board of directors, major owners, or those who could mount successful hostile takeovers. This, too, limits management misbehavior.
Further, even one of the most common “proofs” of management misbehavior—perks of the job, such as an enjoyable working environment—may reflect shareholder gain rather than shareholder harm. Managers often spend more waking hours at work than at home. Just as they exchange money for a nicer home, they are willing to accept less in other compensation for a better work environment. Such arrangements would be made only if a manager valued the perks more than they cost. But that would benefit both managers and shareholders, whose total management compensation costs decline. When we add the advantages of tax deductibility for business expenses versus private expenditures that must be financed with after-tax income, it is even likelier to benefit stockholders.
What do all these additional incentive mechanisms imply about to the claim that the separation of ownership and control enables management to misbehave to the detriment of stockholders, requiring more government control? They argue for a very different conclusion: as long as arrangements are voluntary, corporations and their managements offer stockholders better returns for their investments, and consumers better possibilities, than their alternatives, benefitting both groups.
The separation of ownership and control conclusion could be true in the absence of other constraints. But there are large investors (including pension and other investment funds) who do watch management carefully. Many are, in fact, the managers accused of harming stockholders (and themselves). The potential for takeovers, if not throttled, also means that even some with little or no current ownership pay careful attention. Even if there is misbehavior, both stockholders and bondholders who can anticipate it are able to protect themselves from harm by capitalizing it into the prices and terms at which they enter their relationships. The effects of management misbehavior on the future income of both management teams and dissenting members of those teams mean that even if they could abuse stockholders, they would often choose not to. And even the management perks so often portrayed as unjustified shareholder abuses actually benefit them.
For managers to damage shareholders due to the separation of ownership and control, the combination of the other incentive mechanisms at work would have to be less binding than the story being told. But the many other market incentive mechanisms at work actually impose far tighter constraints. That makes the separation of ownership and control a false alarm, offering unreliable guidance.
One way to illustrate this is with an example from economics principles: non-binding price controls. Unlike the standard analysis of price ceilings below market equilibrium prices, leading to shortages and their attendant adverse effects, a price ceiling imposed above the equilibrium price will have no effect at all, because the constraints of market competition are more binding. And changes in that price ceiling will have no effect, either, as long as it remains above the market price. Similarly, unlike the standard analysis of price floors above market equilibrium prices, leading to surpluses and their attendant adverse effects, a price floor imposed below the equilibrium price will have no effect at all, because the constraints of market competition are more binding. And changes in that price floor will have no effect, either, as long as it remains below the market price.
I not-infrequently remind my students that in economics, it is not what someone can do that we assume will happen, but what they have incentives to do. The separation of ownership and control is one application. Managers can indeed take advantage of current shareholders to some degree. But their incentives to do so are dominated by many other market incentive mechanisms, which also destroys it as a rationale for more government control. What remains is something very different—an illustration of what H.L. Mencken once described as “the whole aim of practical politics,” which was “to keep the populace alarmed (and hence clamorous to be led to safety) by menacing it with an endless series of hobgoblins, all of them imaginary.”