Political preconditions to separating ownership from corporate control.

• Author: Roe, Mark J.

INTRODUCTION: WHY DO ONLY SOME NATIONS HAVE PUBLIC FIRMS?

The public firm, with dispersed stockholders in deep liquid securities markets, dominates business in the United States. Despite its pervasiveness, the public firm has well-known infirmities, namely in the fragile ties that bind managers to shareholders. If shareholders strongly fear managers' disloyalty or incompetence, they invest warily; if sufficiently fearful, they do not invest at all, and other ownership structures will prevail. But the core problems of binding managers to shareholders in the United States have shrunk to acceptable levels; investors are not so afraid of managers that they refuse to invest. Indeed, these problems have been handled so well that we fail to recognize the political prerequisites to resolving them and to tying American managers to dispersed stockholders.

I argue here that the shareholders' core problems in the public firm cannot be readily resolved in a strong social democracy. Social democracies weaken the ties between managers and dispersed shareholders. When we see how they weaken those ties, we shall thereby discover the critical political prerequisite to the rise and persistence of the public firm in the United States, namely the absence of a social democracy and its concomitant powerful pressures on the business firm.

Rather than the American-style public firm, it is the family firm, or the public firm with concentrated individual, financial, or corporate ownership, that dominates business in France, Germany, Italy, and Scandinavia. How do we explain this difference and its persistence thus far? The issue is a live one among European policymakers and academics, who see Europe's inability thus far to develop rich and deep securities markets as stymieing innovation and reducing competition.(1) When I primarily focus on Europe, the United States, Canada, and Japan, as I do in this article, I am focusing on the world's richest nations. Other governments might stymie development: extreme statist regimes--like communism and fascism--are the historically most obvious. Weak legal regimes--like Russia today and some developing nations--are others. But we shall focus on a single question: why, with so much similarity in other business, social, and political dimensions, do today's rich, democratic nations differ in their ownership structure and depth of their securities markets?

Diffusely-owned public firms must make managers loyal to shareholders. Agency costs arise because managers have agendas that differ from shareholders' agendas. Diffuse shareholders want the firm to maximize profits; unconstrained managers often prefer to maximize the firm's size, to avoid severe but potentially profitable risks, and to defer hard, disruptive actions. When blockholders and private ownership persist, they may persist because they serve a function for shareholders: Blockholders and private owners have the means and the motivation to monitor managers--a motivation and an authority that dispersed shareholders in the fully public, diffusely-owned corporation often lack. Hence, blockholding may have persisted on the Continent because managerial agency costs would have been higher there and stockholders lacked good alternative means of keeping managers loyal.

Most corporate governance analyses ignore employees. But by reinserting employees into the governance inquiry, we get a richer understanding of how a society organizes its corporate institutions: Social democracies and the American-style public firm mix badly because public firm agency costs in social democracies are higher and because the mechanisms that would control the agency costs are harder to implement.

A tension exists between current employees and invested capital, and a great deal of corporate governance mitigates this tension. It does so by inducing managers to act in shareholders' interests, and, oftentimes, against the immediate interests of employees with jobs in place. When economic realities change, employees could be laid off. When technologies change, managers must alter the firm's structure and day-to-day working environment in ways that make incumbent employees and often the managers themselves unhappy. Employees' and managers' jobs must be restructured or put at risk. Employees uninspired by the excitement of change may find restructuring their work disruptive, difficult, and risky; workers and managers may resist change. Managers, for their own reasons, not only frequently delay these restructurings, but also have a long-known propensity to expand the firm's ongoing operations, even at the cost of shareholder profits; their expanding the firm down a known path usually favors themselves and current employees, but it often fails to maximize shareholder profits.

In social democracies--nations committed to private property but whose governments play a large role in the economy, emphasize distributional considerations, and favor employees over capital-owners when the two conflict(2)--public policy emphasizes managers' natural agenda and demeans shareholders' natural agenda. The pressure on the firm for low-risk expansion is high, the pressure to avoid risky organizational change is substantial, and the tools that would induce managers to work in favor of invested capital--such as high incentive compensation, hostile takeovers, transparent accounting, and acculturation to shareholder-wealth maximization norms--are weak. Life may well be better for more people, but the internal structure of public firms must necessarily be weaker for shareholders.

Hence, managerial agency costs have been higher in social democracies than elsewhere, and we have just found a deeper, richer political explanation not only for the persistence of family ownership in France, Germany, Italy, and Scandinavia, but also for the rise of the public firm in the United States. Social democracies do not strongly control public firm agency costs because they do not want unbridled shareholder-wealth maximization, and, hence, by weakening shareholder-wealth maximization institutions, they widen the gap between managers and dispersed stockholders. When the gap is wide enough, the large American-style public firm is rendered unstable.

A road map for this article: In Part I, I first set out the structural contrast in ownership around the world and show how social democracy both (a) wedges open the gap between managers and shareholders and (b) raises the costs of closing the gap. In Part II, I show a fundamental correlation: if we array the world's richest nations along a left-right political spectrum, this array correlates powerfully with one of ownership concentration. I also briefly discuss the reasons for American exceptionalism. In Part III, I discuss stronger tests and provide alternative formulations of the thesis. In Part IV, I analyze why the leading nonpolitical explanations are incomplete. Weak corporate law, the current leading explanation in the finance and legal literature,(3) disables the public firm in many transition and developing economies. But for the world's richer nations, theory and data tell us that social democratic politics is as or more important. I also discuss reservations to the political thesis, rebut several, and concede the thesis' limits. In Part V, I explicitly draw out the theory's implications for understanding the American public firm.

1. SOCIAL DEMOCRACIES' PRESSURES ON THE PUBLIC FIRM

   Some nations' large firms are diffusely held, while others are closely held. Many firms in some nations never go public, and big blockholders persist even in the few that do. In Germany, nearly every large firm has a large blockholder, usually an individual or a family or, less frequently, a bank, an insurance company, or another corporation.(4) In France, the family sector is large, growing, and highly competitive.(5) In Italy, family firms persist, and few firms are truly public.(6)

   Once one might have judged the differences as due to size: American firms were larger, and perhaps only the biggest could become truly public firms. But even among similarly sized firms, the public firms are still more widespread in the United States than in continental Europe.(7) These differences persist, despite converging living standards and business technology.

   No single factor can fully explain every difference, and I discuss the conventional explanations below in Part IV. I do not wish to displace the other explanations completely, but rather to make a large space for the unrecognized political explanation and to show why it is as or more important for the world's richer nations as any current explanation.

   1. Agency Costs and the Public Firm

      The United States has a rich literature on agency costs, one that closely analyzes the disjunction between managers' goals and shareholders' goals.(8) Shareholders, particularly diversified shareholders who are distant from the corporation, want their firms' profits maximized. Managers historically preferred to expand their firms,(9) because expansion yielded them more power, prestige, and pay. Managers, with their own human capital tied up in the firm, often wanted to avoid many profit-maximizing risks; shareholders, who can diversify better than managers, have usually preferred their firms to maximize expected value, without respect to risk. Managers have often used up capital in place rather than restructure a firm, because restructuring can be painful. And in simple terms managers may not have wanted to work as hard and as long as shareholders would prefer.

      Corporate governance is traditionally seen in the United States as a principal-agent problem. Principals cannot get agents to perform perfectly. The principals often are less well informed than their agents about the tasks to be performed and, afterwards, about how well the agents performed them. The principals usually are more time-constrained than the agents in the activity involved...