Comparative Corporate Governance Economic Views

Comparative Corporate Governance
Economic Views of the Company and its Governance
Professor John Paterson
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Economic views of the firm
An outsider to the field of economics would probably take
it for granted that economists have a highly developed theory of
the firm. After all, firms are engines of growth of modern
capitalistic economies, and so economists must surely have
fairly sophisticated views of how they behave. In fact, little
could be further from the truth.
Oliver Hart
*
The basic questionWhy do firms exist?Appear to contradict
resource allocation by price mechanism—the
marketTechnological requirements—scale and efficiency
demands organisation……but much could be achieved by sub-
contracting
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Why the basic question matters

For corporate governance, the answer has implications for:
Who is integral to the firmNature of relationship with other
actorsRole in governance
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CoaseMarket and organisation are alternative methods of
coordinating productionThe firm is chosen when there is a cost
of using the price mechanismLong-term contract to obey
directions (employment) or provide goods (supply) replaces
need to discover price for every transaction
*
Coase (2)A firm consists of a system of relationships which
come into existence when the direction of resources is
dependent on the entrepreneurDivision between market and
organisation is determined by calculation of efficiencyFact of
direction distinguishes contract of service from contract for
services
*
Alchian and DemsetzDispute Coase’s idea that the basic
characteristic of the firm is directionPower is exercised in the
same way in the firm as in the marketFocus is instead on the
team use of inputs and the central role of one party in the
contractual arrangements of all other inputs
*

Alchian and Demsetz (2)
Questions then become:What is team production?Why does
it lead to emergence of a firm?
Answer lies in the metering problemEnsuring rewards
related to productivity
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Alchian and Demsetz (3)Classical economics assumes
productivity creates reward automaticallyFor A & D it is the
system of reward that produces the level of productivityTeam
production makes metering difficultLeads to the appointment of
a specialist monitor
*
To ensure monitor does not shirk, they are given a bundle
of rights:to be a residual claimant to observe input behaviour to
be the central party common to all contracts with inputs to alter
the membership of the team to sell these rights
*
What happens if ownership is diversified?Monitoring
transferred to managersShareholders retain right to revise
membership of management group, to take major decisions
affecting company, and to sell shares if unhappy with other
decisions
*

Alchian and Demsetz (6)Accounts for market for corporate
controlFirm is a highly specialised surrogate market (a nexus of
contracts)Shareholders confirmed as residual claimants
*
Jensen & Meckling
Focus is upon the agency costs: arising because the
manager will not always act in the interests of the owner, and
the sum of:Principal’s monitoring expenditureAgent’s bonding
expenditureResidual loss (cost of non-maximising decisions by
agent)
*
Jensen & Meckling (2)Taking seriously the notion of the firm as
a nexus of contracts, J & M note that such costs affect all of the
contractual relations and not just those between owner and
managerFirm is a legal fiction which serves as a nexus for these
contractual relations
*
Jensen & Meckling (3)No point in trying to establish what is in
and outside the firmThere is only a set of contracts between
firm and owners of various inputs and buyers of
outputsQuestions of function or social responsibility become
irrelevantBut does this also question the focus on shareholders
as residual claimants?
*

Williamson
Why do those who provide capital both own and control
the firm?Non-specific assets can be financed by debt
(redeployable without cost)Specialised assets must be financed
by equity (redeployable only with cost)
*
Williamson (2)Shareholders provide capital without guarantee
of return, but with a claim on profits after other costs
coveredOther stakeholders can protect their positions with
contracts, but shareholders cannotShareholders thus require
control rights
*
Williamson (3)Board is one such control
mechanismShareholders clearly have a right to representation
on the board, but other stakeholders do notThey may, however,
have informational rights
*
HartSwitches the focus away from transaction costs (and thus
authority—traceable back to Coase) and on to property rights
(and thus the physical and non-human assets of the firm)
*

Hart (2)Transaction Cost Economics cannot explain the
advantage of a manager over an independent contractorProperty
rights can, because the owner of an asset has residual rights
allowing him to withdraw it from employees if their work is
unsatisfactoryHence the firm has advantages over the market
*
Hart (3)H’s approach thus explains why ownership of physical
assets leads to control over human assetsHe concedes, however,
that work remains to be done to accommodate the separation of
ownership and control, and the consequent delegation of
authority to managers
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Corporate Governance
Seminar 4 – Sarbanes-Oxley Act 2002
Why Sarbanes-Oxley?Response to Enron, WorldCom and other
corporate scandals
Seminar 4 - Sarbanes-Oxley Act
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What does it do?New rules on:Corporate

governanceDisclosureAuditConflicts of interest
*
*
Who does it affect?Issuers (companies)DirectorsOfficers (e.g.
CEO, CFO)EmployeesAttorneysAuditorsInvestment banks and
analysts
*
*
What else?New federal crimesIncreased penalties for some
existing crimesStudies to be conducted by SEC with a view to
possible future legislation/regulation onCredit rating
agenciesSEC enforcementInvestment banksConsolidation of
accounting firms
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Implications for issuers (1)Enhanced requirements on

disclosureMaterial changes to financial condition or operations
to be reported on a rapid and current basisInternal control report
to be included in annual reportFinancial information must be
reconciled to GAAPFinancial information must reflect any
material adjustment
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Implications for issuers (2)Corporate GovernanceAudit
committeeAll members must be independentEnhanced
powersDelisting for failure to complyEthicsImproper influence
on audits prohibitedCode of ethics for CFO to be adopted
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Implications for issuers (3)Enhanced SEC review and
enforcement, for example:Periodic reports to be reviewed at
least every 3 yearsPower to freeze extraordinary payments by an
issuer under investigation
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Implications for Directors and Officers (1)Certification of
periodic reports by CEO/CFOInvolving criminal penaltiesFull
compliance with relevant lawFair presentation of financial
condition and operationPenalties: $1million or 10 years or both
for certification knowing that it does not comply$5million or 20

years or both for willful certification knowing that it does not
comply
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Implications for Directors and Officers (2)Certification of
periodic reports by CEO/CFOInvolving civil penaltiesThat
officer has reviewed reportNo untruth or omission re material
fact based on officer’s knowledgeStringent requirements re
internal controlDisclosure of problems to auditor and audit
committeeAny changes potentially affecting internal control
after date of evaluation
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Implications for Directors and Officers (3)Repayment of
bonuses, etc.In event of accounting restatement being required
(whether personally involved in misconduct or not)Bonuses,
other incentives or equity-based compensation from previous 12
monthsWhether involved in misconduct or not
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Implications for Directors and Officers (4)Personal loans to
directors and executive officers prohibitedReporting of share
transactions speeded up (within 2 business days—previously
within 10 days of end of month)NB these reports must be filed

electronically and appear on issuer website to assist
transparency
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Implications for EmployeesProtection for whistleblowersi.e. for
those dismissed for disclosing breach of various federal laws,
especially relating to fraudAny person who knowingly dismisses
whistleblower as retaliation is subject to criminal penalties (fine
or up to 10 years prison or both)
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Implications for AttorneysMust report evidence of breach of
securities law or fiduciary duty or similar violation to issuer’s
Chief Legal Counsel or CEOIf they fail to respond
appropriately, must report to Audit Committee or other
independent committee or to the Board itself
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Implications for Auditors (1)Public Company Accounting
Oversight BoardReplaces existing self-regulatory
approachFunctionsRegister public accounting firmsEstablish
standards for preparing audit reportsInspect public accounting
firmsInvestigation and discipline of firmsEnforce
complianceSubject to SEC oversight and controlRules must be

approved by SEC
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Implications for Auditors (2)Registration with the
PCAOBMandatoryIncludes consent to cooperate with the Board
in any investigationSignificant additional disclosure
requirements
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Implications for Auditors (3)PCAOB to develop standards
on:AuditingQuality controlEthicsIndependencePCAOB has
broad discretion, but Act sets some minimum requirements, for
exampleRetention of documents for at least 7 yearsSecond
partner must review auditReport on scope of testing, evaluation
of internal control, description of weaknesses or non-
compliance
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Implications for Auditors (4)Inspection of firms by
PCAOBAnnually if audit >100 issuersLess frequently if <100
issuersResults public (with exceptions)Investigation at
PCAOB’s discretionMay pass results to regulatorsMay impose
sanctions itself that it deems appropriate

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Implications for Auditors (5)Foreign firmsSEC previously held
that foreign firms auditing US listed issuers subject to its
jurisdictionSarbanes-Oxley confirms this stanceSuch firms must
register with Board and submit to its oversight
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Implications for Auditors (6)Independence: services prohibited
if contemporaneous with audit, includingBook-keepingFinancial
information systems designActuarial servicesManagement or
human resources servicesInvestment servicesLegal and other
expert services (if not related to audit)Others permitted if pre-
approved by audit committee and disclosed
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Implications for Auditors (7)Rotation of audit partner (lead and
review)After 5 consecutive yearsAuditor reports direct to audit
committeeIncluding alternative treatments under GAAP and
their consequences and auditor’s preferenceNo audit during
cooling-off periodThat is, where CEO, CFO or CAO worked for
auditor on issuer’s audit during previous 12 monthsCriminal
penalties for knowing and willful failure to retain working
papers for 5 years

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Implications for Investment Banks and AnalystsRules to deal
with conflicts of interest between investment banks and
analysts, for exampleTo prevent retaliation against analyst for
negative report which could damage existing or potential
investment banking relationshipTo prevent publication of
reports while bank is involved in public offeringTo ensure
disclosure of conflicts of interest
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New Federal Crimes and PenaltiesDestruction of Records in
Federal Investigations and Criminal ProceedingsSecurities
Fraud involving a Public CompanyAny such penalties, damages,
etc. are not discharged by bankruptcyIncreased penalties for
mail and wire fraudIncreased penalties for willful violations of
the Securities Exchange Act
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But does it work?What do the critics say about Sarbanes-
Oxley?Does the rules-based approach solve the problems we
identified in the previous seminar with the UK’s principles-
based approach?
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Stakeholder Theory
Professor John Paterson
1
Directors’ duties
Recall the Dodd-Berle debate on directors duties
Whereas Berle said duties were owed only to shareholders,
Dodd concluded that they were owed to the community
2
2
The rise of stakeholder theory
Dodd’s ideas find modern expression in stakeholder theories of
the company
Whatever the company is, it is surely more than the relationship
between shareholders and directors, as the economic theories
appear to suggest
3
3
Problems for stakeholder theory
Who exactly is included and what are the arrangements for their

inclusion in governance?
There are many different theories and ideas but a lack of clarity
about how these questions can be answered
4
4
Donaldson & Preston’s approach
Divides stakeholder theories into three categories
Descriptive
Instrumental
Normative
What do they mean by each of these terms?
5
5
Descriptive theories
Descriptive
Theories which claim to based on descriptions of existing
examples of stakeholder organisation
6
6
Instrumental theories
Instrumental
Theories based on a hypothetical (if, then) proposition,
suggesting adherence to theory results in some desirable
business outcome

7
7
Normative theories
Normative
Theories based on moral or philosophical foundations,
suggesting adherence to a stakeholder approach is required
because it is “right” in some respect
8
8
The need for clarity
If we are not clear what sort of theory we are dealing with, it is
not easy to reach clear conclusions about its value for informing
corporate governance reform
9
9
Problems with descriptive theories
The naturalistic fallacy
Just because something is does not mean that it ought to be
10
10

Problems with instrumental theories
We lack empirical evidence that the stakeholder theories
actually produce the desired effects
11
11
Hidden normativity?
Do the problems with descriptive and instrumental theories
mean that they are really based on their authors’ normative
beliefs?
12
12
Problems with normative theories
If all normative theories are based on a moral or philosophical
conception of what is right or good, what happens if that
conception is not accepted by others?
13
13
A fundamental problem?
If Donaldson and Preston are right that all stakeholder theories
ultimately depend on a normative foundation, does that mean
that all are equally likely to be rejected?
14

14
A solution?
Can stakeholder theory be based on property rights?
Seems unusual, given that this was an approach adopted by at
least one economic theorist (Hart)
But D&P’s idea of property as a bundle of rights and duties
looks interesting…
15
15
A property rights approach
Property rights are not unlimited
The limitations reveal the rights of other stakeholders as well as
notions of distributive justice
16
16
Conclusions
Could an analysis of the company from this perspective identify
the stakeholders and the mechanisms for integrating their
interests in governance arrangements?
What are D&P’s views?
17
17

Economic Views of Corporate Governance
An outsider to the field of economics would probably take it for
granted that
economists have a highly developed theory of the firm. After
all, firms are
engines of growth of modern capitalistic economies, and so
economists must
surely have fairly sophisticated views of how they behave. In
fact, little could
be further from the truth.
Oliver Hart
Firms are such a pervasive element of the economy that to ask
‘why are there
firms?’ may appear an odd, even superfluous, question. And yet,
given that the
dominant economic view has been that resources are allocated
according to
the price mechanism, the existence of organisations begins to
appear as
something of mystery. A standard response has been to point to
technological
requirements, such as the efficiency of a certain scale of
production or of a
certain rate of production that could not be achieved without the
long-term
contracts, hierarchy, management, coordination, etc. associated
with the firm.
(In the previous session, for example, we spoke in very general

terms about
the efficiencies and power of concentrations of capital, without
being explicit
about how this might operate in practice.) Other economists,
however, have
pointed out that the same ends could be achieved by
independent short-term
contractors, with management services also being bought in as
required. Such
realisations give new prominence to the question of why firms
exist. For those
of us who are interested in corporate governance, the answer
provided to this
question by economists is significant because it will have an
impact on the
actors who are regarded as integral to the firm, the nature of
their relationship
with it and ultimately what role if any that they will have in its
governance.
The notes below are based on the readings set for this meeting
of the class.
Page references relate to the versions of these readings (with
the exception of
that by Williamson) collected in Louis Putterman & Randall S.
Kroszner
(1996) The Economic Nature of the Firm: A Reader (Second
Edition)
Cambridge: Cambridge University Press.
Ronald Coase, ‘The nature of the firm’
The basic observation upon which Coase’s work proceeds is that
the market
and the organisation are essentially alternative methods of
coordinating

production. If standard microeconomic theory holds that in the
market
production is coordinated by the price mechanism, the question
arises as to
why organisations emerge that essentially supersede the price
mechanism.
Indeed, it is this characteristic that Coase regards as the
‘distinguishing mark
of the firm’ (p91). The thrust of this seminal paper is then to
explain the choice
between the alternative coordinating mechanisms.
Having dismissed such basic suggestions as that firms might
emerge because
individuals prefer to be directed than to contract independently
on a
continuous basis or because people prefer to direct others,
Coase observes that
‘[t]he main reason why it is profitable to establish a firm would
seem to be
1
that there is a cost of using the price mechanism’ (p93). Thus,
in place of the
need to discover the price for every single transaction among a
number of
factors of production, each factor enters into a contract whereby
he agrees, in
return for a certain remuneration, ‘to obey the directions of an
entrepreneur
within certain limits’ (p93). Similarly, as regards the supply of
goods or
especially services, a long-term contract will reduce the costs

associated with a
series of short-term contracts. Given the desire of the purchaser
in such
circumstances to achieve a degree of certainty over the longer
term, such an
arrangement may ultimately take the form of a contract where a
high degree
of direction is afforded the purchaser vis-à-vis the supplier, at
which point
Coase suggests that a firm has emerged. While he does not
believe that such
additional factors as the existence of sales taxes on market
transactions as
compared with intra-firm transactions can explain the
emergence of firms,
they would seem to encourage the growth of firms (pp94-5). For
Coase,
therefore, a firm ‘consists of a system of relationships which
comes into
existence when the direction of resources is dependent on an
entrepreneur’
(p95).
A key advantage of this approach is that it allows one to
examine the question
of why a firm gets larger or smaller – why, in the ultimate, it is
the size it is.
Insofar as it is possible to point to the costs associated with
market exchange
giving rise to the emergence of firms, the question then arises
as to why all
transactions are not ultimately organised by the entrepreneur
rather than
being subject to the price mechanism. Coase offers three
possible reasons
(which may in reality operate in combination):

• a point is reached where the cost of organising the additional
transaction is greater than the cost of leaving it to the market;
• the increasing number of transactions to be organised means
that a
point is reached where the entrepreneur is no longer able to
deploy
resources most efficiently and where an open market transaction
is
preferable;
• the supply cost of a factor may rise due to the expansion of the
firm, the
lower initial cost having been influenced by the smaller size of
the firm
(p96).
After then dealing with some further details and indicating the
shortcomings
of certain alternative accounts of the emergence of firms, Coase
checks to see
whether his account matches reality. By looking at the nature of
the legal
relationship between employer and employee, he finds that it is
indeed the
‘fact of direction which is the essence’ of the relationship
(p104). In other
words, it is this fact that distinguishes a contract of service (or
employment)
from a contract for services (a market transaction). Satisfied
that the theory is
realistic, Coase emphasises that the ‘question always is, will it
pay to bring an
extra exchange transaction under the organizing authority?’
(p104). The

manager will accordingly continually experiment, producing an
equilibrium
between market and organisation.
2
Armen Alchian & Harold Demsetz, ‘Production, information
costs,
and economic organization’
These authors begin by contesting the basic observation made
by Coase that
the distinguishing characteristic of the firm is the fact of
direction, the ability
of the employer to direct the employee. For Alchian and
Demsetz there is no
difference between the way in which power is exercised in the
firm and in the
market – the withholding of future business or resort to the
courts for redress.
The question then again becomes one of explaining why firms
emerge, of
where the difference lies between organisation and market. For
them, it ‘is in a
team use of inputs and a centralized position of some party in
the contractual
arrangements of all other inputs’ (p194). This shifts the
question to one of
explaining what a team process is and why it leads to the
emergence of the
firm.
They describe the fundamental problem of efficient economic

organisation as
‘the metering problem’ (p194), in other words, the problem of
ensuring that
rewards are appropriately related to productivity. Whereas
classical
economics assumes that productivity automatically creates
reward, Alchian
and Demsetz propose that the causal relationship is actually
reversed. In other
words, it is the precise system of reward which produces a
given level of
productivity. The quality of the system by which productivity is
metered or
monitored is therefore crucial for efficiency.
For them, what makes metering difficult and thus what leads to
a search for
means to reduce the costs of metering is team production. Team
production
arises where the output produced by a team from several types
of resources is
more than would have been produced by the sum of the
separable inputs of
each team member and where the difference is sufficient to
cover the cost of
organising the team. It is this situation which gives rise to
metering costs. If it
were simply a matter of summing the separable inputs, each
input could be
measured and rewarded accordingly. But how does one detect an
individual’s
contribution to team production? One way is to observe
individual behaviour.
But this has costs and results in a degree of viable shirking –
i.e. the amount
which it is cheaper to ignore. Competition for places from

individuals offering
lower costs or greater rewards is an alternative – but this
assumes a high level
of information for the outsiders.
The authors thus examine the classical firm and suggest that an
individual can
be assigned the function of specialist monitor. The danger that
he in turn may
shirk can be addressed by paying him the net earnings of the
team, by making
him, in other words, the residual claimant. But the task of the
monitor is a
complex one and he thus must enjoy an entire bundle of rights:
1. to be a residual claimant
2. to observe input behaviour
3. to be the central party common to all contracts with inputs
4. to alter the membership of the team
5. to sell these rights (p201).
Alchian and Demsetz assert that the ‘coalescing of these rights
has
arisen…because it resolves the shirking-information problem of
team
production better than does the noncentralized contractual
arrangement’ (i.e.
3
the market) (p201). There is thus nothing distinctive about the
contracts
which link team members to the owner.

The authors then go on to apply their analysis to a number of
different
organisations, but we are most interested in their treatment of
the
corporation. The complication introduced by the corporation is
that
ownership may be very diversified, with a large number of
shareholders all
owning a small fraction of the firm. In such circumstances, the
cost for any
one shareholder of informing him or herself about every
decision is likely to
be higher than the loss incurred by a bad decision. Accordingly,
decision
making authority is transferred to a smaller group of managers
with the
shareholders retaining ‘the authority to revise the membership
of the
management group and over major decisions that affect the
structure of the
corporation or its dissolution’ (p207). As a result of this
arrangement, any
individual has the right to sell his or her shares rather than have
to accept
decisions with which they do not agree and which they are
unable individually
to influence. Alchian and Demsetz thus provide an account of
the market for
corporate control. The existence of other groups of would-be
external or
internal managers and a market for shares means that diversified
holdings can
‘congeal’ into temporary blocs in order to displace the existing
management.
Alchian and Demsetz see these features of corporate structure as
having

emerged as a result of the ‘problem of delegated authority to
manager-
monitors’ (p208).
Their analysis confirms owners as residual claimants (p212) and
identifies the
firm as ‘a highly specialized surrogate market’ (p214).
Eugene Fama, ‘Agency problems and the theory of the firm’
Fama recognises Alchian and Demsetz’s ‘striking insight’ in
seeing the firm as
a set of contracts between factors of production, but does not
believe that their
analysis is capable of explaining the large modern corporation
where
ownership and control are separated so radically as there
between
shareholders and directors – despite Alchian and Demsetz’s
efforts in this
direction. His thesis is that separation of ‘ownership and control
can be
explained as an efficient form of economic organization within
the ‘set of
contracts’ perspective. More radically still, he states that:
ownership of capital should not be confused with ownership of
the
firm. Each factor in a firm is owned by somebody. The firm is
just the
set of contracts covering the way inputs are joined to create
outputs and
the way receipts from outputs are shared among inputs. In this
‘nexus
of contracts’ perspective, ownership of the firm is an irrelevant
concept.

Dispelling the tenacious notion that a firm is owned by its
security
holders [i.e. shareholders] is important because it is a first step
towards
understanding that control over a firm’s decisions is not
necessarily the
province of security holders (p304).
Fama wants to develop ‘a perspective on management and risk-
bearing as
separate factors of production, each faced with a market for its
services that
provides alternative opportunities and, in the case of
management, incentive
towards performance’ (p304).
4
While shareholders, as risk-bearers, will act optimally insofar
as they spread
the risk by investing in a portfolio of shares, the manager
invests his human
capital in one firm. Accordingly, while an individual
shareholder may not have
much interest in the oversight of the running of a given firm, he
will have an
interest in an efficient capital market which accurately reflects
the risk he has
undertaken as well as any rewards (or losses) that ought to
accrue to him as a
result of his investment decision. The signals thus produced by
the capital

market with regard to the value of a firm’s shares ‘are likely to
be important
for the managerial labor market’s revaluations of the firm’s
management’
(p305).
That said, Fama’s main question remains to be answered: ‘[t]o
what extent
can the signals provided by the managerial labor market and the
capital
market…discipline managers?’ (p305-306). He demonstrates
that the former
does exert many pressures on the firm to ‘sort and compensate
managers
according to performance’ (p306), but it does not answer the
question as to
how managers are to be disciplined. This task is allocated to the
board of
directors, the question then being how this ought best to be
constructed.
Because of diversified ownership of shares, shareholder
domination of the
board does not appear to offer effective oversight. Management
themselves
have an incentive to ensure that the firm is well-run in order to
send the right
signals to the managerial labor market and thus are prima facie
candidates for
positions on the board. They may, however, but may equally
engage in
expropriation and thus there is a need for some check on their
behaviour.
Accordingly, boards also contain outside directors who
‘stimulate and oversee
the competition among the firm’s top managers’ (p307). ‘The
role of the board

in this framework is to provide a relatively low-cost mechanism
for replacing
or reordering top managers; lower cost, for example, than the
mechanism
provided by an outside takeover’ (p308).
In contrast, therefore, to Alchian and Demsetz, Fama rejects the
allocation of
the role of disciplining managers to the shareholders as risk-
bearers.
The viability of the large corporation with diffuse security
ownership is
better explained in terms of a model where the primary
disciplining of
managers comes through managerial labor markets, both within
and
outside the firm, with assistance from the panoply of internal
and
external monitoring devices that evolve to stimulate the ongoing
efficiency of the corporate form, and with the market for
outside
takeovers providing discipline of last resort. (p308)
Michael Jensen and William Meckling, ‘Theory of the firm:
managerial behavior, agency costs, and ownership structure’
In this ambitious paper, the authors seek to make advances
along a number of
fronts in the theory of the firm. Their precise focus is upon the
‘behavioral
implications of the property rights specified in the contracts
between the
owners and managers of the firm’ (p318) which means that they
are concerned

among other things with the question of agency costs as
between owners and
managers and with the nature of the firm as a ‘nexus of
contracts’.
5
In the owner-manager relationship, agency costs arise because,
assuming both
parties to be utility maximizers, it is likely that the manager, or
agent, will not
always act in the best interests of the owner, or principal. These
costs,
therefore, are the sum of:
1. the monitoring expenditures by the principal
2. the bonding expenditures by the agent (i.e. costs incurred by
the agent
to guarantee that he will not act so as to harm the principal)
3. the residual loss (i.e. the cost arising from the divergence
between the
decisions taken by the agent and the decisions which would
maximize
the principal’s utility).
For Jensen and Meckling, ‘an explanation of why and how the
agency costs
generated by the corporate form are born leads to a theory of
the ownership
(or capital) structure of the firm’ (p319). In contrast to the
general literature in

this area, they assume that owners and managers solve these
agency problems
and they investigate the ‘incentives faced by each of the parties
and the
elements entering in to the determination of the equilibrium
contractual form’
of the relationship between manager and owner (p320).
Particularly interesting for us in Jensen and Meckling’s paper is
their
definition of the firm. They locate themselves in the literature
stretching from
Coase to Alchian and Demsetz, but they regard the focus of the
latter as too
narrow. In particular, they insist that ‘[c]ontractual relations are
the essence
of the firm, not only with employees but with suppliers,
customers, creditors,
etc.’ (p320). Unlike Alchian and Demsetz, however, who focus
only on the
costs associated with team production, Jensen and Meckling
note that agency
costs and monitoring problems exist for all of these contracts.
They thus stress
that the firm is only a ‘legal fiction which serves as a nexus for
contracting
relationships and which is also characterized by the existence of
divisible
residual claims on the assets and cash flows of the organization
which can
generally be sold without permission of the other contracting
individuals’
(p321). Consequently, they see little point in trying to establish
what is inside
and what is outside the firm. There is only a set of contracts
between the firm

and the owners of the material, human and capital inputs and
consumers of
the firm’s outputs. This ‘nexus of contracts’ perspective also
makes questions
of the firm’s objective function or of its social responsibility
irrelevant – or at
least no more relevant than they would be to the operation of a
market, which
is essentially how Jensen and Meckling view the firm.
Without going into the more detailed analysis conducted by
Jensen and
Meckling, it is possible to see that their approach focuses
attention on the
nature of the contracts that arise for a particular organization,
their
consequences and the effects of changes ‘exogenous to the
organization’
(p321). While they particularly focus on these questions with
respect to the
relationship between shareholders and managers and thus are
frequently cited
in support of understandings of the firm and of corporate
governance
emphasising shareholder value, the market for corporate
control, etc., it is
useful to bear in mind their insistence on the pervasiveness of
the problems of
agency and monitoring across all the contractual relations that
characterise
the firm. If we extend the investigation to those other
contractual
relationships, will the model of governance change?
6

Eugene Fama & Michael Jensen, ‘Organizational forms and
investment decisions’
This paper, dealing with a more specific question, is
nevertheless within the
same stream of literature. Its significance for us is in its focus
on the
relationship between organisational form and decision-making
processes. In
the case of what the authors describe as the open corporation
(that is, a
corporation where ownership and control are separate and
whose shares may
be freely traded) most shareholders ‘have no direct role in the
decision
process’ and have interests that conflict with those of the
managers.
Accordingly, agency problems arise and so, in making
investment decisions,
shareholders will consider the ‘decision control process’ (p337).
The authors
state that ‘maximizing market value involves extending decision
control
mechanisms to the point where the incremental market value of
improved
decisions is just offset by the market value of the cost of
improved decision
control’ (p337).
Again, therefore, economic analysis justifies a focus on the
relationship
between shareholders and managers when it comes to corporate
governance.

But again, since the authors state that their analysis is
‘applicable to all
decisions’, the question is raised as to whether a more extensive
analysis
would yield a different view of corporate governance.
Harold Demsetz, ‘The Structure of Ownership and the Theory of
the Firm’
This author makes a number of interesting modifications to the
debate as it
had developed up to this point. His focus is particularly upon
the issue of
consumption on the job by managers – the issue that becomes
the agency
problem in the context of the separation of ownership and
control and of the
diversification of ownership. Demsetz is not convinced that this
problem is
greater in the latter context and suggests that even where firms
are effectively
producing goods for employee-consumers, it will be doing so
efficiently. As
regards the problem of shirking, Demsetz indicates that it can
be reduced and
all parties to the firm made better off ‘if the monitoring cost
required to
reduce shirking is less than the value of the resources consumed
in shirking’
(p350). He continues ‘[p]resumably, shirking is reduced to its
optimal level by
various pressures from within and outside the firm’ (p350). The
amount that
an individual is paid will be reduced by an amount reflecting on
the job
consumption, with the reduction being greater in firms where

the cost of
monitoring is higher. Demsetz’s point therefore is that in any
situation it is the
firm and not those who work for it that bears the cost of
monitoring – their
total compensation (including pay and on the job consumption)
will be the
same whether they work for a firm with high cost or with low
cost monitoring,
only the fractions of each component will change. In choosing a
particular
form of business organisation, therefore, the firm must check to
see whether
higher cost monitoring will also lead to reductions in other
costs such that the
higher cost monitoring is worthwhile.
From the corporate governance perspective, therefore,
Demsetz’s insights
focus attention on the cost of any particular governance
arrangement, and
7
especially upon its impact on costs beyond those it is
immediately concerned
with controlling. He does this by indicating the extent to which
any
arrangement does not have an impact upon the total
compensation of, say, the
managers whom previous authors have focused upon in terms of
the agency
problem. Once the overall cost of any governance arrangement
(in terms of its

effects beyond those it is aimed at achieving) is an issue, a
broader range of
governance arrangements should be considered in order to
discover which is
optimal for the firm as a whole.
Oliver Hart, ‘An economist’s perspective on the theory of the
firm’
Hart’s motivation is a concern with certain shortcomings he
perceives in the
transaction cost economics approach to the firm. He takes
instead a property
rights approach to the firm, which focuses attention on the
physical or
nonhuman assets of the firm. Whereas the TCE approach
emphasises the
importance of authority within the firm over the price
mechanism of the
market, Hart points out that it is not clear on the basis of the
TCE approach
alone what the advantage of the manager is over the
independent contractor
and thus of the firm over the market. He states instead that ‘[I]n
a world of
transaction costs and incomplete contracts, ex post residual
rights of control
will be important because, through their influence on asset
usage, they will
affect ex post bargaining power and the division of ex post
surplus in a
relationship’ (p356). Hart is thus able to show that the firm
offers advantages
over the market to the extent that the owner of an asset has
residual rights of
control over them and hence the right to withdraw them from

employees if
their work is unsatisfactory. The employee therefore has more
of an incentive
to work more efficiently for the owner of the assets he requires
to complement
his labour input than he does for someone who does not own the
assets he
requires to complement his labour input. Not only, therefore,
does the
property rights approach have something to say about the
location of the
boundaries of the firm vis-à-vis the market, but it also explains
why ownership
of physical assets leads to control over human assets.
It might be thought, accordingly, that Hart’s approach provides
an
explanation for the priority of shareholders in corporate
governance
arrangements and the relatively weak position of employees.
Shareholders
after all own the physical assets of the firm and possess some
residual rights of
control such as the right to replace directors. The difficulty that
Hart
acknowledges, however, is that the property rights approach
cannot easily
accommodate the fact of the separation of ownership and
control and the
consequent delegation of control to managers. He is
nevertheless hopeful that
this can eventually be done.
Oliver Williamson ‘Corporate Governance’
This author is concerned to know why it is that those who

provide capital, the
shareholders, both own and control the firm. His argument is
that
redeployable (i.e. non-specific) assets can be financed by debt,
but that
specialized and intangible assets must be financed by equity.
This is because
the former can be transferred to other uses without cost,
whereas the latter are
bound up with the specific business of the firm and cannot be
redeployed
8
without cost. Shareholders, of course, provide capital without
any guarantee
of a return but with a claim to profits after all other costs have
been covered.
Williamson makes the point that while members of other
constituencies are
able to protect their positions through contracts (or through the
exercise of
political power) all of which can be revisited periodically,
shareholders make a
once for all investment which they cannot adjust periodically
(short of
outright sale). For this reason, shareholders require control
rights over the
firm by such mechanisms as the board of directors. While
Williamson is thus
able to point to reasons why other constituencies should not be
represented
on the board insofar as they have a direct influence on decisions
through

voting rights, he is not averse to their presence for
informational purposes.
9
1
SEMINAR 1
Week 27
Theories of the Company and of Corporate Governance
In the first seminar, we move on from the initial discussion of
definitions by considering some of the key theories
that have sought to explain and account for the nature of the
company and of corporate governance. In the first
part of the class we will discuss economic approaches and, in
the second, so-called stakeholder approaches.
Given the apparent position of the company as the pre-eminent
expression of capitalism, it is not surprising to
find that it has been the focus of considerable attention by
economists who have sought to explain its nature and,
as a consequence, how it should be governed. What is perhaps
more surprising is that there is little agreement
among economists on these issues. As the Harvard economist
Oliver Hart has expressed it:
An outsider to the field of economics would probably take it for

granted that economists have a highly developed
theory of the firm. After all, firms are engines of growth of
modern capitalistic economies, and so economists must
surely have fairly sophisticated views of how they behave. In
fact, little could be further from the truth.
In the first part of the seminar, the aim will be to gain an
impression of some of the major schools of thought
regarding the company within the economic literature and to
consider what their implications are for corporate
governance. It will also be important to bear in mind the
relationship between economic thinking and the legal
understanding of the company. As lawyers, we are ultimately
concerned with what law has to say about corporate
governance. It is important to realise, however, that the legal
model of the company in any given jurisdiction is
an implicit or explicit reflection of a set of underlying
economic, social and political decisions. Thus, in order to
understand the legal position, we need to understand the models
that have informed those decisions. We begin
by looking at economics.
Some of the papers listed below are quite complex, some are
quite long. DON’T PANIC! You are not expected to
understand complex equations or complex economic concepts.
In each case, there is a fairly straightforward
message relating to the company and its governance, which the
authors discuss in relatively straightforward
language. This is what you need to identify and focus upon.
Even if you still find the exercise difficult, again please
don’t worry. We will ensure in the class that the key points are
identified and after the class a short document
will be made available which summarises the lessons to be
drawn from these important and influential texts.

Reading
• Coase, Ronald, ‘The Nature of the Firm’, Economica,
November 1937, 386-405
• Alchian, Armen & Harold Demsetz, ‘Production, information
costs, and economic organization’, The
American Economic Review, Vol. 62, No. 5 (Dec., 1972), 777-
795
• Jensen, Michael and William Meckling, ‘Theory of the firm:
managerial behavior, agency costs, and
ownership structure’, Journal of Financial Economics, 3,
(1976), 305-360
• Williamson, Oliver, ‘The Modern Corporation: Origins,
Evolution, Attributes’, Journal of Economic
Literature, Vol. 19, No. 4 (Dec., 1981), 1537-1568
• Hart, Oliver, ‘An economist’s perspective on the theory of the
firm’, Columbia Law Review, Vol. 89, No.
7, Contractual Freedom in Corporate Law (Nov.,1989), 1757-
1774
The following questions will help us to focus our discussions:
1. For Coase, why do firms emerge? Or, in other words, why is
it suddenly the case that the market is no

longer good enough?
2. What is the essence of the firm as far as Alchian and Demsetz
are concerned?
2
3. What are the implications of Jensen and Meckling’s ideas on
agency costs and the firm as a ‘nexus of
contracts’?
4. How does Williamson suggest that asset specificity affects
the emergence of firms and by extension their
governance?
5. For Hart, how does ownership of physical assets lead to
control over human assets?
6. Which economic account of the firm do you find most
convincing and why?
Following on from the examination of the relatively narrow
view of the company and its governance allowed by
economic accounts, this seminar will consider more recent
theorising which understands the company as being
composed of a broader range of interests or stakeholders. Such
thinking is intuitively attractive, especially in the
face of concerns about corporations acting with a lack of

concern for social responsibility, environmental
protection, etc. It is necessary to consider, however, whether
such a broad understanding of the company could
usefully inform practical corporate governance arrangements. In
particular, how might a decision be made about
which interests are to be included within the company?
Assuming that such a decision could be made, what
mechanism might allow these interests to be integrated so as to
ensure its governance?
Reading
• Donaldson, Thomas and Lee E. Preston (1995) ‘A Stakeholder
Theory of the Corporation: Concepts,
Evidence, and Implications’, Academy of Management Review,
20(1), 65-91.
Consider especially the following questions when reading this
paper.
1. How do Donaldson and Preston categorize different versions
of stakeholder theory?
2. What is their critique of the different categories of the theory
that they identify?
3. What is the basis of their proposal for stakeholder theory?
Does this resolve the problems they have
identified with existing varieties of the theory?
All articles cited for this seminar are available online via the

University Library, most easily by using the Primo
search facility.

Comparative Corporate Governance Economic Views

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