Institutional Shareholders and Corporate Governance.

AuthorOrts, Eric W.

Institutional Shareholders and Corporate Governance. By G.P. Stapledon. Oxford: Clarendon Press. 1996. Pp. vi, 376. $98.

Both the law and business schools at the University of Michigan offer a basic course in Enterprise Organization. This tradition owes to the influence of Professor Alfred Conard, one of the leading scholars of his generation, who taught during most of his career at the University of Michigan Law School.(1) The tradition persists in part because Enterprise Organization suggests an appropriately broad view of its topic, unlike more common course titles such as Corporations or Business Associations. We live in a world populated not only by people but also the organized legal entities we create. Business firms and nonprofit organizations have legal frameworks, and economic forces affect them in various ways. An important topic for social research -- including not only law and economics, but also other disciplines -- is to uncover the springs of motivation, power, and belief that underlie the organizations that figure so largely in our everyday existence.

The Ownership of Enterprise and Institutional Shareholders and Corporate Governance confirm Professor Conard's broad view of the subject of Enterprise Organization, though they travel in two different directions. One direction focuses on what may be called the "microanalysis of institutions," which breaks down complex forms of organization in terms of their elements -- namely, individuals and their motivations.(2) The other direction focuses on the big picture, a "macroanalysis of society" and its major developmental changes. These two directions correspond roughly with the functional differentiation between micro- and macroeconomics. In my estimation, the same division of labor makes sense in studying the law of enterprise organization and characterizes its likely future.

  1. THE MICROANALYSIS OF ENTERPRISE

    In The Ownership of Enterprise, Professor Henry Hansmann(3) collects the themes of a number of major contributions in his extraordinarily productive career. He combines law and economics in a refreshing and undogmatic fashion to explore the elemental forces that drive enterprise to be structured in various ways. Hansmann's choice of topics is eclectic, but this range derives from the impressive scope of his research. He is perhaps best known for his scholarship on employee ownership,(4) a fact that explains his continuing interest in the worker-owned manufacturing enterprises of the Mondragon system in Spain (pp. 98-103), as well as experiments in worker ownership at United Airlines and Weirton Steel in the United States (pp. 107, 117-18). His discussion of the ownership of golf courses (pp. 184-85) gives a case study in the analysis of "status organizations," which includes his own Yale Law School.(5) In short, The Ownership of Enterprise is worth reading if only for the purpose of appreciating the depth and breadth of Hansmann's scholarship to date.(6)

    But the book also offers much more. It brings together a career's worth of thinking into a general thesis about how the world of enterprise organization works. Hansmann's main argument is that broad generalizations cannot be made about the most efficient or desirable structure of ownership in free enterprise societies. The "investor ownership" model of capitalism that puts shareholders and creditors at the center is "contingent" on the economics of enterprise, legal and political structures, changing technologies, and cultural differences (pp. 1-4, 287-88, 294-97).

    Hansmann develops this thesis through an empirical analysis of various kinds of enterprise that do not fit the model of investor-owned firms. He then provides an economic explanation for the ownership structure of enterprise in terms of two criteria: the costs of contracting and the costs of ownership.(7) Unlike other economic theorists who assume that a capitalist model of investor ownership always makes better sense than other modes of organization, Hansmann recognizes a plurality of forms of enterprise. At the same time, he offers a "comparative study of organizational types" that explains why investor ownership is common in most, if not all, forms of business enterprise (p. 3).

    1. The Costs of Contracting

      Hansmann is a contractarian economist to the extent that he adopts a view of the firm as "a nexus of contracts" or, more precisely, as "the common signatory of a group of contracts" (p. 18). The costs of contracting therefore figure largely in his explanation for the structure of enterprise. There are at least six sources of these costs.

      1. Simple market power includes both monopoly power of a firm with respect to its customers and monopsony power with respect to a firm's suppliers (pp. 24-25). The costs of market power provide a strong incentive for a potentially exploited group to exert influence to reduce the costs of dealing with a monopoly or monopsony through direct ownership or public regulation. For example, customers of electricity or telephone services who find themselves threatened with monopoly pricing may seek cooperative or public ownership of the utility or lobby for regulation of prices (pp. 168-70, 176-80). Farmers who face monopsony pricing by cartels of grain purchasers may bypass them through cooperative ownership of grain elevators or cooperative marketing firms (pp. 122-25).

      2. Lock-in refers to dependent relationships that may arise between various groups that contract with a firm over a long period of time (p. 25). For example, an individual who works for one firm may develop firm-specific human capital that cannot be transferred to another. Lock-in may provide an explanation for why some firms become employee-owned (p. 26), though Hansmann does not find empirical evidence to corroborate this view and concludes that other factors must play a greater role (pp. 71-72). Lock-in also explains, at least partially, the vertical integration of firms with their suppliers and distributors.(8)

      3. Long-term contracting risks refer to the well-known problem that uncertainty increases as the duration of a contract lengthens. An example is life insurance (p. 27). Before advances in actuarial science and regulatory changes made investor-owned life insurance viable, mutual ownership of life insurance companies by the policyholders made sense because the contractual terms could be changed and the proceeds distributed as the future -- and life expectancy -- grew ever more certain with time (pp. 266-74).

      4. Asymmetric information and strategic bargaining refer to a general problem involved in any complex economic enterprise: some groups have more accurate and complete information than others (pp. 27-29). Groups with better information enjoy a better bargaining position. A firm's managers, for example, often have better information than customers about the firm's products. If no other solution is found -- such as consumer protection legislation or product liability rules -- the costs of asymmetric information may lead customers to acquire ownership in the firm. For example, farmers band together in supply cooperatives to solve the problem of asymmetric information about the quality of feed and fertilizer.(9)

      5. Conflicts of interest describe the inevitable costs of meeting the demands of the diverse groups of people involved in most enterprises. These costs grow larger as an enterprise increases in size and complexity. Hansmann emphasizes the importance of resolving conflicts among whom he calls the "patrons" of the firm. Patrons "comprise all persons who transact with a firm either as purchasers of the firm's products or as sellers to the firm of supplies, labor, or other factors of production."(10) Even within one group of patrons, interests can diverge. Among employees, for example, older workers may prefer lower-risk policies than younger workers who may accept greater risk in return for higher wages (p. 31). Or older workers with retirement savings invested in pensions or employee stock ownership plans may ally themselves more closely with investors than with younger workers (p. 90). Balancing the interests of patrons is central to structuring the ownership of enterprise. Hansmann concludes that the proper structure depends on the particular circumstances of an enterprise and the relative costs for patrons who have an interest in it.

      6. Alienation, a concept from social psychology, refers to the tendency of workers in modem industrial societies to feel detached from the purpose of their Work and therefore unmotivated.(11) Hansmann recognizes market contracting to be "adversarial" and sometimes "unpleasant." Many people prefer "relationships that are more cooperative, trusting, or altruistic" (p. 32). The motivations of some people to be sheltered from the storms of constant market contracting and to avoid feeling alienated therefore explain some forms of enterprise organization. Although Hansmann avoids deeper ideological controversy about the concept of alienation, it is to his credit that he sees the phenomenon as important. Psychological preferences and social conditions, as well as calculations about economic efficiency, affect the structure of enterprise.

    2. The Costs of Ownership

      Although Hansmann emphasizes the costs of contracting, he recognizes that ownership also has costs. The costs of ownership combine with the costs of contracting to determine the structure of enterprise. These costs of ownership fall into four general types: controlling managers, collective decisionmaking, risk bearing, and organizational transition.

      1. The costs of controlling managers. Because Hansmann argues that any group of patrons can own a firm in terms of rights to residual profits -- whether the owners are shareholders, creditors, employees, or some combination -- he portrays managers as a nearly universal cost of ownership.(12) This account is a refreshing reversal of the usual economic focus on the agency costs of...

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