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Corporate Governance ( Zingales for Dummies)

By Stela Bagasheva

Introduction
Governance = authority, control Traditional microeconomical practices do not explain the need for governance, as they focus on commodities. However, a problem arises when talking about many daily transactions When purchasing machinery from another party, the difference between what the two parties generate together and what they can obtain in the marketplace represent a quasi-rent, which needs to be divided. In dividing this surplus, governance plays a role. Governance system: the complex set of constraints that shape the ex-post bargaining over the quasirents generated in the course of a relationship. A main role in this system is played by the initial contract. The contract will most likely be incomplete, as it will not specify every possible unforeseen event. This creates a n interesting distinction between decisions made when the two parties entered the relationship and investments were sunk (ex-ante), and when the quasi-rent are divided (expost). Thus there is room for bargaining. Outcome of bargaining will be affected by several factors, other than the initial contract: 1. Which party has ownership of the machine while it is in the production process? 2. The availability of alternatives: How costly is it for the buyer to delay receiving the machine? - How costly is it for the manufacturer to delay the receipt of the final payment - How much more costly is it to have the job finished by another manufacturer 3. The institutional environment: - How effective is law enforcement? - What are the professional norms? - How quickly and reliably does information about the manufacturer s performance travel across potential clients? All of these conditions constitute a governance system. Necessary conditions for a governance system (otherwise there will be no scope for bargaining): 1. Relationship must generate quasi-rents. 2. Quasi-rents are not perfectly allocated ex-ante.

Corporate Governance
Governance can apply to anything: from a whole organization to a single transaction. Corporate governance refers to the governance of a corporation. Formal definition: Corporate governance is the complex set of constraints that shape the ex-post bargaining over the quasi-rents generated by the firm. This definition highlights the link between how quasi-rents are generated and how they are distributed. It also raises the question of what a firm is. Properties of a firm: It is jointly owned ( thus raises question of allocation of ownership) Complex structure Cannot be instantaneously replicated Suggestion that customers, suppliers and workers are part of the firm (REMEMBER! Corporation is the legal manifestation of a firm, thus it is wrong to say that those stakeholders are part of the corporation!)

Incomplete Contracts and Governance


Governance is possible when some reliant on future observable variables are costly (or impossible to write ex-ante). That is to say, when a contract is initially made, it rarely (almost never) can specify each and every possible outcome. So governance is needed to resolve such situations. When a contract is incomplete, it is necessary to allocate the right to make ex-post decisions in unspecified critical situations. This incompleteness, however, can be strategically exploited in bargaining over the surplus.

Why Does Corporate Governance Matter?


Aside from distribution of surplus among the parties involved, corporate governance also affects economic efficiency (the total surplus). Three main channels through which this happens: 1. Ex-ante incentive effects The process through which rents are distributed ex-post affects the ex-ante incentives to undertake some actions. This can create or destroy value, as rational agents will not use the optimal resources in value enhancing, when they think the governance structure will not

award them accordingly. Basically, if after the activity takes place (distribution of quasirents), if the actor (be it manager, firm, supplier, customer, etc.) will not receive a sufficient reward, he has no reason to increase the value of the action. Which means that total surplus is not optimized. Another problem that destroys value is that rational agents are ready to engage into inefficient economic activity if this means the outcome ex-post is altered to their favour. For example, a manager would like for his firm to be part of a duopoly, as it would have a very high bargaining power to its supplier, and thus would be able to extract large part of the quasi rent. However, oligopolies do not maximize the total surplus, as we know from microeconomics. On the other hand, the governance structure might encourage the creation of value. By changing the ownership (one manifestation of governance) of a storage facility so that it is owned by a nearby manufacturer, it would be less costly for the manufacturer (thus value is increased) to store its products than to have to spent transportation costs to a further storage facility. In conclusion, a governance structure affects the incentives to power-seek (but also investments) and thus altering the marginal payoffs that these actions have in ex-post bargaining. 2. Inefficient Bargaining Another way by which a governance structure affects total surplus is by altering ex-post bargaining efficiency. So a governance structure can affect the degree of information asymmetry between the parties, the level of coordination costs, or the extent to which a party is liquidity-constrained. The divergence of interest amongst the different people who have control rights can lead to this kind of inefficient bargaining. This goes back to the selfish, although rational behaviour that each party exhibits. It is more costly to allocate the control over groups of people with varying level of skills, positions, and status. That is so, exactly because each one of these groups will have a different interest in the bargaining situation. Therefore, it rarely happens that governance is dispersed to actors with conflicting interests. 3. Risk Aversion The ex-ante distribution of surplus that affects the total surplus is also influenced by the varying levels and spread of risk. So if the parties have different risk profiles (risk-averse, risk-taker, and risk neutral) then conflicts are likely to occur. And conflicts = costs, which of course means insufficiency. If the different parties have different levels of risk aversion (or different opportunities to diversify risk), then the efficiency of a governance system is measured by how effectively it allocates risk to the most risk-loving party. For example, a partnership is about to make a risky investment and it is up to the two partners (with different levels of risk-aversion) to decide whether to make the investment. If the risk is efficiently spread, that would mean

that the risk-lover should be more financially impacted by a potential failure that the riskaverter. Different governance structures can also generate different amounts of risk. If the parties are risk-averse and cannot diversify the risk, the value of the total surplus is decreased (because concentrated risk creates inefficiency). In summary the objectives of a governance system should be: 1. To maximize the incentives for value-enhancing, while minimizing inefficient powerseeking 2. To minimize inefficient ex-ante bargaining 3. To minimize governance risk and to allocate the residual risk to the least risk-averse party.

Who Should Control the Firm?


Most controversial issue in governance: who should control the firm? Allocation of control is important because it affects the division of surplus. By controlling firm decisions, the party is less likely to rely on other parties, thus guarantees a larger part of the surplus. According to Jensen and Meckling, as the firm is a only legal fiction, the conflicting objectives of individuals are brought in an equilibrium by the initial contract, while the shareholders are protected by their ability to diversify control. This explanation of governance, however, is insufficient. We already talked about that contracts are mostly incomplete and that risk-aversion is a factor in distribution of surplus. Also, it puts shareholders in the position of limited protection by the contract. In the real world, it is exactly the shareholders that have control of a company (they are the ones that invest in the firm after all). Shareholders need more protection because: 1. They provide the most investment 2. Other parties can be better-protected by the initial contract. 3. Other parties have other sources of ex-ante bargaining power (think a CEO compared to an owner of a 100 shares in a large multinational). HOWEVER, this is also not completely satisfactory, as it just tells us shareholders need contractual protection and NOT residual rights control (governance).

RAJAN AND ZINGALES: The residual right of control (this always increases the share of surplus captured by the owner, as he has the opportunity to walk away with it) is best allocated to a group of agents who need to protect their investment against ex-post expropriation (giving away to other parties), but have little control on how much the asset is specialized (the more specialized the asset, the less value it has outside the relationship).

By this definition, we can make the assumption that shareholders are the best option when allocating the residual right of control, as their investment is money. Money is the least specialized asset, so it s the easiest to be expropriated. For example, human capital (labour) does not fit this description. So by awarding providers of funds the most of the quasi-rents, this increases their marginal incentives to invest. However, as the shareholders might have a fear that their share of the return on investment might go down, they will not use their funds for specialized purposes. So it is most efficient if providers of funds retain ownership and control of their assets, while the right to specialize the assets is given to a third party. This party should not be a mere agent, but should act in the interest of the firm. Generally, this is the board of directors.

Normative Analysis
A privately optimal governance system is not necessarily socially efficient. In a world of incomplete contracts, the legal system has an effect on the appropriation of quasirents, on the way corporate governance is structured and on the amount of finance raised. In this world, a governmental intervention that eliminate ex-post inefficiencies, while preserving the distributional consequence in the ex-ante, will increase social efficiency.

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