The Modern Firm, Corporate Governance and Investment (2009) PDF

The Modern Firm, Corporate Governance
and Investment
NEW PERSPECTIVES ON THE MODERN CORPORATION
Series Editor: Jonathan Michie, Director, Department for Continuing

Education and President, Kellogg College, University of Oxford, UK
The modern corporation has a far-reaching influence on our lives

in an increasingly globalized economy. This series will provide an
invaluable forum for the publication of high-quality works of
scholarship covering the areas of:
● corporate governance and corporate responsibility, including

environmental sustainability
● human resource management and other management practices, and
the relationship of these to organizational outcomes and corporate
performance
● industrial economics, organizational behaviour, innovation and
competitiveness
● outsourcing, offshoring, joint ventures and strategic alliances
● different ownership forms, including social enterprise and employee
ownership
● intellectual property and the learning economy, including knowledge
transfer and information exchange.
Titles in the series include:
Corporate Governance, Organization and the Firm

Co-operation and Outsourcing in the Global Economy
Edited by Mario Morroni
The Modern Firm, Corporate Governance and Investment

Edited by Per-Olof Bjuggren and Dennis C. Mueller
The Modern Firm,
Corporate
Governance and
Investment
Edited by
Per-Olof Bjuggren
Jönköping International Business School, Sweden
Dennis C. Mueller
University of Vienna, Austria
NEW PERSPECTIVES ON THE MODERN CORPORATION
Edward Elgar
Cheltenham, UK • Northampton, MA, USA
© Per-Olof Bjuggren and Dennis C. Mueller 2009
All rights reserved. No part of this publication may be reproduced, stored in

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mechanical or photocopying, recording, or otherwise without the prior
permission of the publisher.
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A catalogue record for this book

is available from the British Library
Library of Congress Control Number: 2009922767
ISBN 978 1 84844 225 2
Printed and bound by MPG Books Group, UK

Contents
List of contributors vii
Preface viii
1 Introduction: the modern firm, corporate governance and

investment 1
Per-Olof Bjuggren and Dennis C. Mueller
PART I KEY ISSUES
2 Opening the black box of firm and market organization: antitrust 11

Oliver E. Williamson
3 The corporation: an economic enigma 43
Dennis C. Mueller
PART II THE THEORY OF THE FIRM FROM AN

ORGANIZATIONAL PERSPECTIVE
4 A contractual perspective of the firm with an application to

the maritime industry 63
Per-Olof Bjuggren and Johanna Palmberg
5 The use of managerial authority in the knowledge economy 82
Kirsten Foss
6 Competence and learning in the experimentally organized
economy 104
Gunnar Eliasson and Åsa Eliasson
PART III INVESTMENTS AND THE LEGAL

ENVIRONMENT
7 Corporate governance and investments in Scandinavia –

ownership concentration and dual-class equity structure 139
Johan E. Eklund
8 The cost of legal uncertainty: the impact of insecure property
rights on cost of capital 167
Per-Olof Bjuggren and Johan E. Eklund
v
vi Contents
9 The stock market, the market for corporate control and the
theory of the firm: legal and economic perspectives and
implications for public policy 185
Simon Deakin and Ajit Singh
PART IV THE BOARD, MANAGEMENT RELATIONS

AND OWNERSHIP STRUCTURE
10 Institutional ownership and dividends 225

Daniel Wiberg
11 Contracting around ownership: shareholder agreements in
France 253
Camille Madelon and Steen Thomsen
12 Board governance of family firms and business groups with a
unique regional dataset 292
Lluís Bru and Rafel Crespí
13 Better firm performance with employees on the board? 323
R. Øystein Strøm
14 The determinants of German corporate governance ratings 361
Wolfgang Drobetz, Klaus Gugler and Simone Hirschvogl
15 Top management, education and networking 382
Mogens Dilling-Hansen, Erik Strøjer Madsen and
Valdemar Smith
Index 401
Contributors
Per-Olof Bjuggren, Jönköping International Business School, Sweden
Lluís Bru, Universitat de les Iles Balears, Spain
Rafel Crespí, Universitat de les Iles Balears, Spain
Simon Deakin, The Faculty of Law, Cambridge University, UK
Mogens Dilling-Hansen, School of Economics and Management, University
of Aarhus, Denmark
Wolfgang Drobetz, Department of Corporate Finance, University of Basel,
Switzerland
Johan E. Eklund, Jönköping International Business School, Sweden
Åsa Eliasson, IBMP CNRS Strasbourg and Vitigen GmbH, Siebeldingen,
Germany
Gunnar Eliasson, KTH, Stockholm
Kirsten Foss, Copenhagen Business School, Denmark
Klaus Gugler, Department of Economics, University of Vienna, Austria
Simone Hirschvogl, Department of Economics, University of Vienna, Austria
Camille Madelon, HEC School of Management, Paris, France
Erik Strøjer Madsen, Department of Economic, Aarhus School of Business,
Denmark
Dennis C. Mueller, University of Vienna, Austria
Johanna Palmberg, Jönköping International Business School, Sweden
Ajit Singh, Queen’s College, Cambridge University, UK
Valdemar Smith, Centre for Industrial Economics, University of Copenhagen,
Denmark
R. Øystein Strøm, Østfold University College, Norway
Steen Thomsen, Copenhagen Business School, Denmark
Daniel Wiberg, Jönköping International Business School, Sweden
Oliver E. Williamson, University of California, Berkeley, USA
vii
Preface
This book is a collection of papers from two workshops held in Jönköping,
Sweden, in 2006 and 2007. The theme of the workshop in 2006 was
‘Corporate Governance and Investment’ in a wide sense. Topics of papers
could be: to describe and analyse the ownership and corporate governance
structure of a given country; to make a comparative analysis of govern-
ance structures in different countries; to study corporate governance and
performance in different types of firms (for example, family and non-family
owned firms); to explain the levels of investment of companies; and to draw
policy implications about how capital markets might be altered to improve
the allocation of capital and the overall performance of companies. The
workshop arranged in Jönköping was one in a series of annual meetings of
a European Corporate Governance Network. The network’s first meeting
was at Cambridge University (UK) in 1998 by initiative of Professor
Dennis C. Mueller and Professor Alan Hughes. Since then several meetings
have been organized. The 2006 workshop in Jönköping was the seventh.
The second workshop, held in Jönköping in September 2007, was the
first of its kind inspired by the emerging literature on the economics of the
firm. The background to the workshop was the revolutionary development
of the theory of the firm that has taken place during the last 35 years. In
spite of all the progress in the field, traces of the new developments in micr-
oeconomic and industrial organization textbooks are scant. The comments
made by Ronald Coase in 1971 at an NBER meeting about a non-existent
treatment of organization of economic activities within and between firms
in industrial organization textbooks are still valid.
But in other ways the situation today is quite different from 35 years ago.
At the same NBER meeting Coase also commented upon his celebrated
article from 1937 (‘The Nature of the Firm’) with the words ‘much cited
and little used’. This comment turned out to be a truthful description of the
situation in 1971, but not true for the rest of the 1970s. In the same year as
the NBER meeting (1971) Oliver E. Williamson published a seminal article
in the American Economic Review, which was the start of a large number of
books and articles that, like Coase, centred on the importance of transac-
tion costs in analyses of economic organizations. A new field of transaction
cost economics emerged.
Some other articles from which new fields of research have emanated
viii
Preface ix
were also published in the 1970s. The team production and the property
rights perspective introduced by Alchian and Demsetz (1972) and the
corporate governance perspective in Jensen and Meckling (1976) have
been especially influential. From the 1980s the evolutionary theory of the
firm presented by Nelson and Winter (1982) and the new property rights
approach by Grossman and Hart (1986) have reshaped research in a
similar fashion.
These and other branches of the growing tree of the theory of the firm
were the sources of inspiration for the workshop on ‘The Economics of the
Modern Firm’.
The output from the two workshops is merged in this book under the
title The Modern Firm, Corporate Governance and Investment. To merge
contributions from the two workshops makes sense given the close con-
nection between the topics and papers presented at the workshops. For
example, several papers at the second workshop were on corporate govern-
ance. In all, 14 papers from the two workshops have been selected, nine
from the second workshop and five from the first. The keynote addresses
of Oliver E. Williamson and Dennis C. Mueller at the second workshop
are the first two chapters after the introduction.
The participants at the workshops and the referees of the different
articles in this book have helped to improve the contents. We thank them
for their questions and comments. The workshops and the preparation of
this book were financed by Sparbankstiftelsen Alfa, Torsten and Ragnar
Söderberg´s foundation and CESIS (Center of Excellence for Science and
Innovation Studies). We are grateful for their support that allowed us to
engage in this research. We are also indebted to Ibteesam Hossain and
Maria Eriksson for excellent research assistance with this book.
1. Introduction: the modern firm,
corporate governance and
investment
Per-Olof Bjuggren and Dennis C. Mueller
The book is organized into four parts. Part I contains overviews of the
theory of the firm. Part II is devoted to firms and organization of eco-
nomic activities. Part III deals with how the institutional framework of an
economy affects investments made by firms. Part IV looks at the impact of
ownership structure and board composition on firm performance.
I. OVERVIEWS
Part I contains two overviews of the theory of the firm from different per-
spectives. ‘Opening the black box of firm and market organization: anti-
trust’ by Oliver E. Williamson presents an overview of the characteristics
of the transaction cost approach to the study of economic organization.
The antitrust implications of this new view of economic organization are
also considered. Thus, this chapter reviews both the positive and norma-
tive aspects of Williamson’s theory of the firm, and offers a contractual
view of economic organization. The black box of the firm is opened in
the sense that the governance attributes that distinguish the firm from the
market are outlined. The market of the ‘pure vanilla’ type (spot contract
character) found in most textbooks is complemented by the contractual
deviations that can be characterized as hybrids of market and firm. The
new explanations of antitrust phenomena provided by transaction cost
analysis are discussed. Instead of solely focusing on market power aspects
of vertical market relations, pricing practices and horizontal and conglom-
erate mergers, a transaction cost analysis provides a broader picture by
also including cost-reducing explanations. Williamson shows how these
alternative explanations gradually have been recognized by US antitrust
authorities.
‘The corporation: an economic enigma’ by Dennis C. Mueller looks
1
2 The modern firm, corporate governance and investment
at how the view on the corporate form of business has changed amongst
economists since Adam Smith. The chapter addresses the key issue in cor-
porate governance about efficiency implications of ownership and control
in corporations. An overview is provided on how economists’ views of
the corporation and its performance had changed over time. The early
economists such as Adam Smith, John Stuart Mill and Alfred Marshall
offered descriptions of corporate behaviour based on their observations of
how companies function. Berle and Mean’s book The Modern Corporation
and Private Property from 1932 is also based on observations that are sup-
ported by an impressive amount of descriptive data. The neoclassical view
emerging during the 1930s and 1940s represents a different way of doing
research on the firm and corporate form. For pedagogical and simplifying
reasons the firm is looked upon as a profit maximizing entity. The mana-
gerial challenge of this neoclassical view and the ongoing debate between
these two schools of thoughts are then discussed. One way to resolve
the conflict between these two views is to look at the return on invest-
ments. Such studies have been done recently and show that investment
efficiency has actually improved since the 1990s in some countries like the
United States. Possible explanations are disciplining takeovers, increased
product competition due to globalization and the growth of institutional
shareholding.
II. ORGANIZATION OF ECONOMIC ACTIVITIES
In Part II, chapters studying the firm from an economic organization per-
spective are found. The first chapter, by Per-Olof Bjuggren and Johanna
Palmberg, (entitled ‘A contractual perspective on the firm with application
to the maritime industry’) introduces a contractual model of the firm and
applies it to explain how the maritime sector is organized. The capacity of
the firm as a legal person to enter into contracts with suppliers of goods and
services, customers and creditors is highlighted. It is argued that mutual
dependency is what determines the character of contractual relations. The
employment contract and ownership of assets in adjacent vertical stages
enables the firm to supplant price as coordination mechanism in the pro-
duction of goods and services. The maritime industry offers a rich flora
of contractual relations due to differing degrees of mutual dependence
between shipper and carrier. Both the firm and the freight contract are
analysed from a contractual perspective. A contractual explanation is also
offered for the phenomenon of third-party management.
A second chapter, by Kirsten Foss, (entitled ‘Authority in the knowledge
economy’) takes a closer look at authority relations between employer and
Introduction 3
employees. In transaction cost economics, it is claimed that the possibility

to use authority as a mode of coordination is what primarily characterizes
firms. Authority is a key concept in the theory of the firm, and Foss throws
light upon it. She claims that the emerging knowledge economy makes it
necessary to take a closer look at the different dimensions of the authority
concept in order to understand ongoing changes in economic organization.
From a review of authority in the economic literature, the conditions under
which it is efficient to use authority for coordination, contract enforce-
ment, and dispute resolution are identified. Finally, how these conditions
have to be adapted to an emerging knowledge economy is discussed.
The third chapter, by Gunnar and Åsa Eliasson, (entitled ‘Competence
and learning in the experimentally organized economy’) offers a new evo-
lutionary perspective on how firms emerge and disappear. The authors
picture an economy with boundedly rational and myopic actors who try
to take advantage of perceived business opportunities. Success is to a large
extent dependent on the interaction of actors in so called competence blocs.
In a successful competence bloc, customers, innovators, entrepreneurs,
financiers, exit markets and industrialists interact efficiently in the sense
of minimizing the cost of keeping losers on for too long and losing the
winners. The customer has a key function in a bloc by being the ultimate
arbiter of value. In the experimentally organized economy that Gunnar
and Åsa Eliasson envision, economic organization and ‘the firm’ are a
result of how the competence bloc is structured. Efficient ways to organize
the relations between the actors in a bloc will be rewarded by increasing
returns, which make the organization viable.
III. IMPORTANCE OF THE INSTITUTIONAL

ENVIRONMENT
Part III consists of chapters dealing with investment and legal environ-
ment. Johan Eklund’s contribution (entitled ‘Corporate governance and
investment in Scandinavia – ownership concentration and dual-class equity
structure’) looks at how ownership structure affects investment perform-
ance in the different Scandinavian countries. As a measure of investment
performance, the marginal q developed by Dennis Mueller and Elisabeth
Reardon is used. From legal and political perspectives the Scandinavian
countries are rather similar. But there are still distinctive differences in
separation of ownership and control through the use of dual-class shares.
Sweden has the highest fraction of listed firms that use dual-class shares,
while Norway has the lowest fraction. The implications of these differences
on investment performance are investigated. It turns out that in Norway
the marginal q estimate indicates overall efficient investment performance

among the listed firms, while the estimate for Swedish and Danish firms
indicates over-investment – marginal returns on investment are lower
than costs of capital. A non-linear effect of ownership concentration
in Scandinavian firms is also found, implying a positive but marginally
decreasing effect of ownership concentration on investment returns.
In a second chapter (‘The cost of legal uncertainty: the impact of insecure
property rights on cost of capital) Per-Olof Bjuggren and Johan Eklund
study how institutional risk influences the required return on international
investments. Institutional risk due to weak property rights and investor
right protection represents a non-diversifiable risk to international inves-
tors, as these rights are fairly stable over time. Hence investors are likely
to demand a risk premium in those countries where these rights are weak.
The required return on investment in such countries will accordingly be
higher. The capital asset pricing model (CAPM) is used to test for the
importance of taking institutional risk into consideration, and to find out
the risk premium associated with institutional risk. It turns out that the
explanatory power of the CAPM is considerably increased if such a risk
is taken into account. Furthermore, the risk premium due to institutional
risk is found to be significantly higher for developing than for developed
countries.
A third chapter, by Simon Deakin and Ajit Singh, (‘The stock market,
the market for corporate control and the theory of the firm: legal and
economic perspectives and implications for public policy’) takes up the
question of how important an active market for corporate control is for
economic efficiency. The authors have severe doubts about whether hostile
takeovers have positive effects on efficiency and growth in developed
countries. Their discussion of the pros and cons of a market for corpo-
rate control starts with the observation that shareholders do not ‘own a
company’ in the sense of being entitled to ‘a particular segment or portion
of the company’s assets, at least while it is a going concern’. Furthermore,
directors’ fiduciary interests of loyalty and care are owed to the company.
Even though in practice it is foremost the interests of the shareholders that
are catered to, other stakeholders’ interests are to a differing degree also
recognized. This is especially the case in civil law systems. It is argued that
it cannot be taken for granted that company law and articles of associa-
tion that serve as obstacles to takeovers are at the expense of economic
efficiency.
Two strands of thought in the economic literature are referred to in
Deakin and Singh’s economic analysis; On one hand, there is the principal–
agent view of the market for corporate control that is used in financial eco-
nomics. On the other hand, there is a more antitrust oriented analysis used
Introduction 5
in industrial organization. The views of these schools differ. While financial

economists have focused on takeovers and mergers as a mechanism to dis-
cipline managers, industrial economists also stress their negative effects on
the overall economy. Balancing different views of efficiency implications,
Deakin and Singh come to the conclusion that hostile takeovers are likely
to harm the prospects for growth in developing and transition economies.
IV. OWNERSHIP STRUCTURE, BOARD

COMPOSITION AND FIRM PERFORMANCE
Part IV contains chapters that examine how the composition of the

board, management relations and ownership structure affect firm per-
formance. A first chapter by Daniel Wiberg (‘Institutional ownership and
dividends’) studies the relationship between institutional ownership and
dividends. Wiberg wants to see both whether there is a positive relation
between institutional ownership and dividends, and whether there are
more rational reasons than ‘short-termism’ for explaining such a relation.
Swedish data are used to test the hypotheses. The Swedish institutional
framework is interesting as there is widespread use of dual-class shares and
the tax rules make dividends more attractive to institutional than to other
ownership categories. Through the use of dual-class shares, ownership
can be separated from control, leading to pronounced agency problems.
One way to overcome these agency problems is to insist on dividends. If
such a relationship exists it implies that dividends are higher in firms with
greater separation between ownership and control due to dual-class shares.
Wiberg finds this to be the case, and that institutional ownership has a posi-
tive impact on dividend growth.
Camille Madelon and Steen Thomsen (‘Contracting around ownership:
shareholder agreements in France’) use data from large, French listed firms
to examine the effects and determinants of shareholder agreements. These
agreements represent a way to contract around the official ownership
structure. While the relationship between observable formal ownership
and behaviour/performance has been extensively studied, there has been
no study of the relationship between real ownership structure (consider-
ing contracts between shareholders as well) and behaviour/performance.
Madelon and Thomsens’s study is one of the first steps towards ‘filling this
void’. It is an explorative study that analyses agreements from a trans-
action cost approach view. The costs and benefits of acquiring control
through contracting amongst shareholders are compared with the alterna-
tive of outright ownership. Several theoretical propositions are derived
that consider ownership and industry characteristics and network ties as
explanations as to why contractual agreements are chosen. Propositions

about the impact of shareholders’ agreements on economic performance
are also derived.
‘Board governance of family firms and business groups with a unique
regional dataset’, by Lluís Bru and Rafel Crespi, is both a methodological
paper about how to empirically study family business and a description of
what family businesses look like in the Balearic region of Spain. They have
managed to trace family ownership and management by use of the Spanish
‘two-surnames’ system. This system has two features. Married women
usually do not change their name and newborns have both the father’s and
the mother’s surname. This surname system has made it possible to trace
both ownership and involvement in boards and management by family
members. Besides family companies, it has been possible to trace business
groups under the control of associated families. The importance of family
firms and groups in the Balearic economy and the characteristics of the
diversification patterns of family business groups are described.
Reidar Øystein Strøm (‘Better firm performance with employees on
the board?’) uses data from Norwegian listed firms to analyse how
co-determination affects performance. He distinguishes between direct
and indirect effects of employee directors. In the theoretical literature both
positive and negative effects of employee directors on performance are
envisioned. Employee directors might contribute to positive performance
by bringing more information about how the firm functions and enhanc-
ing the incentives to invest in firm-specific human capital. On the other
side, owners’ and employees’ interests might not be aligned, producing
a negative effect on performance. Most empirical studies find a negative
impact on performance. Strøm takes the analysis one step further by taking
account of the reactions of the shareholders to anticipated negative effects
of employee directors. By adjusting the composition of the board and the
financial leverage of the firm, these negative effects can be counteracted.
This indirect effect is taken into consideration in a simultaneous equations
framework. A three-stage least squares methodology with fixed effect is
used to estimate both the direct and indirect effects. Even though indirect
endogenous effects are taken into account, the results of the empirical
analysis show a negative impact of employees on the board.
Wolfgang Drobetz, Klaus Gugler and Simone Hirschvogl (‘The determi-
nants of German corporate governance ratings’) analyse corporate govern-
ance rating in Germany. As in many other European countries, Germany
has since 2002 had a Corporate Governance Code of a ‘comply or explain’
kind. Instead of assessing the impact of code fulfilment on performance of
firms, Drobetz, Gugler and Hirschvogl choose to analyse the determinants
of corporate governance rating. One advantage with this approach is that
Introduction 7
an endogeneity problem due to self-selection is avoided. The analysis is

to a large extent based on the assumption that there is a positive relation
between firm performance and a high corporate governance rating. The
determinants of performance studied are ownership concentration, the
size of the supervisory board, choice of strict accounting rules, and the
use of an option-based remuneration plan. Ownership concentration is
hypothesized to be non-linearly related to ratings. The rationale is that it
is only at high levels of ownership concentration that the entrenchment
effect of ownership is balanced by the rewards associated with better per-
formance. For the other determinants, a negative effect is found for board
size, stricter accounting rules are positively related to performance, and
stock-option schemes have a positive relation to rating. All the hypotheses
are corroborated in the empirical analysis based on survey data from 91
German firms.
Mogens Dilling-Hansen, Erik Strøjer Madsen and Valdemar Smith
(‘Top management, education and networking’) use Danish data to study
how management can benefit from networking. Networking takes place
through board participation by top management. They look at network
ties between firms linked by ownership and between independent firms.
The former ties are labelled internal ties while the latter are called external
ties. Networking through external ties can increase the top management’s
knowledge of the competitive and technological environment of the firm. It
can also facilitate collusion. Networking can then be expected to improve
performance. Networking of an internal character can improve the control
of subsidiaries. The extent to which networking will have a positive influ-
ence on performance can be expected to be dependent on education. An
empirical analysis of a large sample of Danish firms finds a significant
positive effect of internal network activities on firm performance, and
that education implies a positive attitude towards networking. No other
significant relationships can be traced.
PART I
Key issues
2. Opening the black box of firm and
market organization: antitrust*
Oliver E. Williamson
The task of linking concepts with observations demands a great deal of

detailed knowledge of the realities of economic life.
– Tjalling Koopmans
Opening the black box of firm and market organization and examining
the mechanisms inside is a defining characteristic of the transaction cost
approach to the study of economic organization (Arrow, 1987, 1999; Dixit,
1996; Kreps, 1990). But questions remain. Do the details matter for a wide
range of phenomena or only a few? Which, among the endless number of
details that could be recorded, have conceptual and operational signifi-
cance? What, if any, are the public policy ramifications?
My responses to these queries are that the details matter for a wide range
of phenomena, that many relevant details are uncovered by examining
economic organization through the focused lens of contract/governance,1
and that public policy toward business has been a beneficiary. Antitrust
applications are developed here. Regulatory applications are examined
elsewhere (Williamson, 2007a).
I begin with a statement of the crisis in antitrust as of 1970. A synopsis
of the microanalytic setup is then sketched in Section 2. The paradigm
problem for transaction cost economics is the intermediate product market
transaction, as described in Section 3. Antitrust applications are developed
in Sections 4–8. Concluding remarks follow and there is an Appendix on
the antecedents on which transaction cost economics builds.
1. THE CRISIS IN ANTITRUST
Victor Fuchs opens his foreword to the National Bureau of Economic

Research 50th anniversary volume, Policy Issues and Research Opportunities
in Industrial Organization, with the query ‘Whither industrial organiza-
tion?’, to which he opines that ‘all is not well with this once flourishing field’
11
12 Key issues
(1972, p. xv). Of the various answers that could be advanced to explain this
decline, the ones to which I attach the greatest weight are the all-purpose
reliance by industrial organization economists (and others) on a black
box theory of the firm and a plain vanilla theory of markets. Because the
firm was described as a production function that transformed inputs into
outputs according to the laws of technology, non-technological or non-
price theoretic explanations for reshaping the boundary of the firm were
thought to be deeply problematic. Contractual deviations from simple
market exchange were likewise regarded as suspect.
Since economists were dismissive of the possibility that the internal
organization of transactions had important economizing consequences,2
vertical integration and other organizational practices that lacked a ‘physi-
cal or technical aspect’ were presumed to have the purpose of increasing
the ‘market power of the firms involved rather than reduction in cost’
(Bain, 1968, p. 381). Vertical market restrictions (and other deviations
from simple market exchange) were also regarded as deeply problematic.
As the then head of the Antitrust Division of the US Department of Justice
put it, ‘I approach customer and territorial restrictions not hospitably in
the common law tradition, but inhospitably in the tradition of antitrust.’3
Indeed, some protectionist antitrust enforcement officials regarded pro-
spective efficiency gains from a merger to be anticompetitive because less
efficient rivals would be disadvantaged.4 Such upside-down reasoning
encouraged respondents to merger litigation to disclaim that any efficiency
benefits would accrue.5 Ronald Coase summarized the prevailing state of
disarray as follows: ‘If an economist finds something – a business practice
of one sort or other – that he does not understand, he looks for a monopoly
explanation. As in this field we are very ignorant, the number of ununder-
standable practices tends to be rather large, and the reliance on monopoly
explanation, frequent’ (1972, p. 67).
An altogether different lens through which to examine complex con-
tracting and economic organization would be needed to break the grip of
such convoluted thinking. As described in Section 2, the lens of contract/
governance describes firms and markets as governance structures, the dif-
ferent mechanisms of which matter in efficiency respects. An economics
of organization takes shape in the process as monopoly is reduced to an
important but special case.
Opening the black box of firm and market organization 13
2. THE MICROANALYTICS: A SYNOPSIS

2.1 General
As Herbert Simon observes (1984, p. 40):
In the physical sciences, when errors of measurement and other noise are
found to be of the same order of magnitude as the phenomena under study the
response is not to try to squeeze more information out of the data by statistical
means; it is instead to find techniques for observing the phenomena at a higher
level of resolution. The corresponding strategy for economics is obvious: to
secure new kinds of data at the micro level.
Inasmuch, however, as the social sciences are ‘hypercomplex’ (Wilson,

1998, p. 183; Simon, 1957, p. 89), the details proliferate. Where precisely
do the relevant microanalytics reside? That will vary with the phenomena
to be investigated and the lens through which the phenomena are viewed.
2.2 The Rudiments6
Rather than operate out of the neoclassical lens of choice (with emphasis
on prices and output, supply and demand, in relation to which organiza-
tion is held to be unimportant), transaction cost economics works out
of the lens of contract/governance. The building blocks are transactions
and governance structures and the efficient alignment thereof, whereupon
organization is not only important but is susceptible to analysis.7 In addi-
tion to simple market exchange (contract as legal rules), provision is made
for hybrid contracting (contract as framework, for which continuity of
the exchange relationship is important) and hierarchy, each of which is
described as an alternative mode of governance. Note that the decision to
use one mode of governance rather than another depends on the transac-
tions for which governance support is required. Hitherto neglected trans-
action costs take their place in the analytical firmament.
If both transactions and governance structures differ, then the relevant
microanalytics for describing both of these will need to be worked out.
Herbert Simon’s advice, to little discernible effect, that ‘Nothing is more
fundamental in setting our research agenda and informing our research
methods than our view of the nature of the human beings whose behavior
we are studying’ (1985, p. 303) is pertinent in this connection. Cognitive
competence is especially relevant, but so too is the manner in which self-
interest is described.
If, for example, human actors possess the cognitive ability to imple-
ment comprehensive contingent claims contracting, then we are in the
14 Key issues
world of Arrow–Debreu and, in such a contractual world, organization is

unimportant. If instead the list of six assumptions that are made by Drew
Fudenberg, Bengt Holmstrom and Paul Milgrom (1990) apply, then we
are in a world where a sequence of short-term contracts can implement
an optimal long-term contract.8 More generally, the point is this: differ-
ent assumptions about cognition lead into different theories of contract
and organization (and the same holds for descriptions of self-interest
(Williamson, 1985, pp. 64–7)).
Transaction cost economics describes both cognition and self-interest in
a two-part way. Specifically, cognition combines bounded rationality with
feasible foresight while self-interest joins benign behavior with opportun-
ism. Thus all complex contracts are unavoidably incomplete (by reason of
bounded rationality) yet human actors are assumed to have the capacity
to look ahead, recognize hazards, work out the mechanisms, and, albeit
imperfectly, factor the ramifications back into the ex ante contractual
design (which is a manifestation of feasible foresight). Also, most human
actors will do what they agree to and some will do more most of the time
(benign behavior), but outliers for which the stakes are great will elicit
defection and/or posturing (which are manifestations of opportunism)
with the purpose of inducing renegotiation.
Whether contractual incompleteness (bounded rationality) and defec-
tion hazards (opportunism) pose serious governance issues depends on
the attributes of transactions. Transactions for which continuity of the
exchange relationship is important and for which coordinated adaptations
are needed to restore efficiency are those for which the efficacy of simple
market exchange breaks down. Behavioral attributes in combination with
transactional attributes thus underpin the need for added governance
supports (or not) – where governance is defined as the means by which to
infuse order, thereby to mitigate conflict and realize mutual gain.
The three attributes of transactions that are especially important for
preserving continuity by implementing coordinated adaptations are asset
specificity (which is a measure of bilateral dependency, to which maladap-
tation hazards accrue), uncertainty (the disturbances, small and great, to
which transactions are subject), and the frequency with which transactions
recur, which has a bearing on both reputation effects (in the market) and
private ordering mechanisms (within firms).
Governance structures are described as discrete structural syndromes
of attributes that differ in their adaptive capacities, of which two types
are distinguished: autonomous adaptation to changes in relative prices as
described by Friedrich Hayek (1945) and coordinated adaptations of a con-
scious, deliberate, purposeful kind as described by Chester Barnard (1938).
Incentive intensity, decision and administrative control instruments, and
contract law regimes are the defining attributes with respect to which gov-
ernance structures are described.
As discussed in Section 3, the three main modes of governance for organ-
izing intermediate product market transactions are market, hybrid, and
hierarchy. Interestingly, but not surprisingly, spot markets and hierarchies
are polar opposites – in that spot markets are characterized by high-pow-
ered incentives, negligible administrative control, and a legal rules contract
law regime, thereby to support autonomous adaptation, whereas hierar-
chies use low-powered incentives and hands-on administrative control, and
settle internal disputes administratively under a forbearance law regime9 in
support of coordinated adaptation. Hybrid contracting is located between
market and hierarchy in all three attributes and in both adaptation respects
and thus can be thought of as a compromise mode.
The discriminating alignment hypothesis provides the predictive link
between transactions and governance structures – to wit, transactions,
which differ in their attributes, are aligned with governance structures,
which differ in their costs and competences, so as to effect a transaction
cost economizing match.
3. TRANSACTIONS IN THE INTERMEDIATE

PRODUCT MARKET: THE PARADIGM
TRANSACTION
The intermediate product market transaction (or in more mundane terms,

the make-or-buy or outsourcing decision) is the obvious paradigmatic
transaction for transaction cost economics for two reasons. First, this is
the transaction to which Coase referred in pointing up a lapse in economic
theory in 1937: ‘The purpose of this paper is to bridge what appears to
be a gap in economic theory between the assumption (made for some
purposes) that resources are allocated by means of the price mechanism
and the assumption (made for other purposes) that this allocation is
dependent on . . . [hierarchical mechanisms]. We have to explain the basis
on which, in practice, this choice between alternatives is effected’ (Coase,
1937, p. 389). Secondly, intermediate product market transactions are
simpler than are labor market, capital market, and final product market
transactions because they are less beset with asymmetries of information,
budget, legal talent, risk aversion, and the like. The simple contractual
schema, as described herein, focuses on the intermediate product market
transaction but applies (with variation) to the study of transactions more
generally.
Thus assume that a firm can make or buy a component and assume
16 Key issues
A (unassisted market)
h=0
B (unrelieved hazard)
s=0
C (credible
commitment)
h>0
market safeguard
s>0
administrative
D (integration)
Figure 2.1 Simple contractual schema
further that the component can be supplied by either a general purpose

technology or a special purpose technology. Letting k be a measure of
asset specificity, the transactions in Figure 2.1 that use the general purpose
technology are ones for which k 5 0. In this case, no specific assets are
involved and the parties are essentially faceless. Transactions that use the
special purpose technology are those for which k . 0. Such transactions
give rise to bilateral dependencies, in that the assets cannot be redeployed
to alternative uses and users without loss of productive value. The parties
therefore have incentives to promote continuity, thereby to safeguard
specific investments. Let s denote the magnitude of any such safeguards,
which include penalties, information disclosure and verification proce-
dures, specialized dispute resolution (such as arbitration) and, ultimately,
integration of the two stages under unified ownership. An s 5 0 condition is
one for which no safeguards are provided; a decision to provide safeguards
is reflected by an s . 0 result.
Node A in Figure 2.1 corresponds to the ideal transaction in law
and economics: there being an absence of dependency, governance is
accomplished through competition and, in the event of disputes, by court
awarded damages. Node B poses unrelieved contractual hazards, in that
specialized investments are exposed (k . 0) for which no safeguards (s
5 0) have been provided. Such hazards will be recognized by farsighted
players, who will price out the implied risks.10 Confronted with the added
costs of these hazards, buyers have the incentive to mitigate the hazards (in
cost-effective degree), which is to say that node B is an inefficient mode of

governance for ongoing (as against episodic) supply purposes.
Added contractual supports (s . 0) are provided at Nodes C and D.
Node C governance corresponds to what Karl Llewellyn referred to as con-
tract as framework, as distinguished from contract as legal rules, where the
former better preserves continuity of the transaction through ‘a framework
highly adjustable, a framework which almost never accurately describes
real working relations, but which affords a rough indication around which
such relations vary, an occasional guide in cases of doubt, and a norm of
ultimate appeal when the relations cease in fact to work’ (1931, pp. 736–7).
This is the aforementioned hybrid transaction where credible contracting
mechanisms are introduced in support of cooperative adaptation. Such
hybrids are not, however, ‘indefinitely elastic. As disturbances become
highly consequential, . . . an incentive to defect [arises]. The general propo-
sition here is that when the “lawful” gains to be had by insistence upon
literal enforcement exceed the discounted value of continuing the exchange
relationship, defection from the [cooperative] spirit of the contract can be
anticipated’ (Williamson, 1991a, p. 273). Benjamin Klein subsequently
describes ‘the self-enforcing range’ similarly: if and as ‘changes in market
conditions move outside the self-enforcing range, . . . the one-time gain
from breach [will] exceed the private sanction’ (1996, p. 449).
But this is not the end of the governance story. As the expected mal-
adaptation costs of hybrid contracting progressively mount, best efforts
to craft cost-effective credible commitments notwithstanding, transaction
cost economics predicts that transactions will be removed from the hybrid
and organized under unified ownership (vertical integration). Inasmuch
as added bureaucratic costs accrue upon taking a transaction out of the
market and organizing it internally, hierarchy is usefully thought of as
the organization form of last resort: try markets, try hybrids, and have
recourse to the firm (Node D) only when all else fails.
Node D governance (hierarchy) involves (1) unified ownership of succes-
sive stages, (2) coordinated adaptation at the interfaces by the application
of routines (to manage disturbances in degree) and by the use of hierarchy
(to manage disturbances in kind), (3) internal dispute resolution for settling
disputes that cannot be resolved by the parties by appealing these to a
common ‘boss’, and (4) the aforementioned bureaucratic cost burdens.
Transaction cost economics thus predicts that generic (k 5 0) transac-
tions will be assigned to Node A (the market mode, where continuity is of
no importance and disputes are settled in court), more complex transac-
tions (k . 0) to Node C (the hybrid mode, where continuity matters and
adaptations are accomplished under the more elastic concept of contract
as framework), that very complex transactions (k . . 0) will be taken
18 Key issues
out of the market and organized within hierarchy at Node D, and that
few transactions (mistakes or adventitious transactions) will be located at
inefficient Node B.
What is furthermore noteworthy is that empirical tests of the predictions
of the theory have ensued and have been broadly corroborative. Indeed,
‘despite what almost 30 years ago may have appeared to be insurmount-
able obstacles to acquiring the relevant data [which are often primary
data of a microanalytic kind], today transaction cost economics stands
on a remarkably broad empirical foundation’ (Geyskens, Steenkamp and
Kumar, 2006, p. 531). This applies, moreover, not merely to the tests of
the paradigm problem of vertical integration but to a vast variety of other
phenomena that are interpreted as variations on a theme (Macher and
Richman, 2006). There is no gainsaying that transaction cost economics
has been much more influential because of the empirical work that it has
engendered (Whinston, 2001).
4. APPLICATIONS TO ANTITRUST: GENERAL
The over-reaching excesses of monopoly reasoning during the 1960s

contained the seeds of their own destruction. Confronted with escalat-
ing implausibility, Supreme Court Justice Potter Stewart, in a dissenting
opinion, observed that the ‘sole consistency that I can find is that in [merger]
litigation under Section 7, the Government always wins.’ 11 Alarmist excesses
of monopoly reasoning eventually elicited a series of challenges – to include
both allocative efficiency and transaction cost reasoning,12 where the latter
made express provision for economies of organization, the myopic quality of
entry barrier reasoning was confronted with remediableness considerations,
nonstandard and unfamiliar contracting practices that had been declared to
be anticompetitive under the inhospitality tradition were re-examined and
found, often, to serve credible contracting purposes, and selective appeal to
zero transaction costs was supplanted by an insistence that positive transac-
tion costs be recognized wheresoever they may reside.13
Antitrust scholars from the ‘Chicago School’ (Stigler, 1968; Demsetz,
1974; Posner, 1976; Bork, 1978) receive and deserve much of the credit, but
transaction cost economics was also a contributing factor. Thus whereas
‘the Chicago School focused on explaining why vertical integration and
nonstandard vertical contracts did not create or enhance market power . . .
transaction cost economics focused on why these vertical arrangements
emerged as cost-reducing responses to certain transactional characteris-
tics’ (Joskow, 1991, p. 56; emphasis added). Without such an affirmative
rationale,
it is hard to believe that the Chicago critique of antitrust policies regarding

vertical arrangements would have had as much influence, especially among
professional economists and antitrust scholars, . . . for [whom] the theoretical
and empirical work in transaction cost economics . . . demonstrated that previ-
ously suspect vertical arrangements often could be explained as contractual and
organizational responses motivated by a desire to reduce the cost of transacting.
(Joskow, 1991, p. 57)
As between critiques of wrong-headed reasoning and explanations for

the practices in question for which the mechanisms have been expressly
worked out, the latter is the more demanding.
Interestingly, Timothy Muris, during his term as chair of the Federal
Trade Commission, held that much of the New Institutional Economics
‘literature has significant potential to improve antitrust analysis and
policy. In particular, . . . [the transaction cost branch has] focused on
demystifying the “black box” firm and on clarifying important determi-
nants of vertical relationships’ (2003, p. 15). Opening the black box and
acquiring an understanding of the mechanisms inside has had an impact,
moreover, on practice:
The most impressive recent competition policy work I have seen reflects the
NIE’s teachings about the appropriate approach to antitrust analysis. Much
of the FTC’s best work follows the tenets of the NIE and reflects careful, fact-
based analyses that properly account for institutions and all relevant theories,
not just market structures and [monopoly] power theories. (Muris, 2003, p. 11;
emphasis in original)14
A comprehensive examination of the applications of transaction cost

economics to antitrust is beyond the scope of this chapter. My purpose
is merely to illustrate the ways in which examining the microanalytics of
complex contract and economic organization through the lens of contract/
governance has served to alter and deepen our understanding of many
antitrust related phenomena. I successively examine applications to verti-
cal market relations, price theoretic issues, credible contracting, and the
modern corporation.
5. VERTICAL MARKET RELATIONS
Lateral integration into components, backward into raw materials, and

forward into distribution are successively examined. The analysis through-
out tracks the logic of the simple contractual schema – in that the move
from market to hybrid to hierarchy is predicted as asset specificity and
outlier disturbances increase. Asset specificity refinements − as among
20 Key issues
physical, human, site, dedicated, and brand name capital – are also con-
sequential. With respect, for example, to mobile physical assets (such as
specialized dies), it may be possible for the specialized investments to be
made by the buyer, who relieves bilateral dependency by assigning the spe-
cialized dies to the winning bidder for the duration of the supply contract
and repossessing and reassigning these to a successor if the original bidder
does not win the renewal contract.15 The need for unified ownership is also
relieved by the use of credible commitments to support hybrid contract-
ing – as with exchange agreements, or for organizing distribution through
a large number of geographically dispersed outlets by franchising rather
than by forward integration (although there is also merit in dual distri-
bution). As, however, asset specificity and disturbances increase, unified
ownership is predicted.
5.1 Lateral Integration
Economies are commonly ascribed to the integration of successive stages

in the ‘technological core’, an example of which is the unified ownership of
iron- and steel-making stages by reason of thermal economies (Bain, 1968,
p. 381). By contrast, lateral integration into components that lack such a
‘physical or technical aspect’ is (under technological reasoning) believed to
be deeply problematic. As discussed above, monopoly purpose and effect
were commonly ascribed to these.
Transaction cost economics disputes such reasoning. All that is implied
by thermal economies (or, more generally, by the physical or technical
aspects to which Bain refers) is that the two stages be located adjacent to
each other. The governance issue is whether the exchange of product across
these co-located stages should be mediated by market or by hierarchy.
Unless contractual problems are projected, there is no reason why each
stage could not be independently owned and the two stages joined by an
interfirm contract. If, therefore, co-located stages are integrated, that is
because transaction cost economies are thereby realized: unified owner-
ship relieves the contractual hazards that would otherwise arise between
independent, site-specific trading entities.
But there is more: transaction cost economics also selectively offers
an economizing interpretation for transactions that lack the ‘physical or
technical aspects’ to which Bain refers. As discussed in Section 3 above,
the outsourcing of separable components of a non-site-specific kind is
the paradigm problem on which transaction cost economics is based and
to which empirical tests were first applied (Monteverde and Teece, 1982;
Masten, 1984).16 The upshot is that the same comparative contractual
logic applies to the organization of asset-specific transactions of all kinds,
site-specific or not. The contrast with earlier antitrust predilections is

stark.17
5.2 Raw Materials Procurement
Except perhaps for very atypical cases, an efficiency case for vertical
integration backward into raw materials is believed to be rare if not non-
existent. Surely the lesson of the Ford Motor Company’s ‘fully integrated
behemoth at River Rouge, supplied by an empire that included ore lands,
coal mines, 700,000 acres of timberland, sawmills, blast furnaces, a glass
works and coal boats, and a railroad’ (Livesay, 1979, p. 175) is that this
was vertical integration run amok.
Exactly right: maybe comprehensive vertical integration has the appear-
ance of being an engineer’s dream, but it is not an economic ideal. As
John Stuckey’s examination of backward integration from the refining
into the raw materials stage in the Australian aluminum industry reveals,
the transactional details matter. Bauxite ore, it turns out, is not a uniform
mineral but, instead, is ‘a heterogeneous commodity, . . . [where] the ore in
any deposit has unique chemical and physical properties’ (Stuckey, 1983,
p. 290). That is consequential: the cost difference of processing a mixed-
hydrate bauxite, which is efficiently processed with a high-temperature
technology, in a low-temperature refinery instead, comes to almost 100
percent (Stuckey, 1983, pp. 53–4). Other details also matter. Bauxite
storage covers are needed for some ores and not for others (p. 49); residue
processing costs vary greatly (p. 53); and air pollution equipment is tailored
to the attributes of the bauxite (p. 60). Moreover, although smelting is less
idiosyncratic, there is, nevertheless, an ‘art part of smelting’, which is upset
if the aluminum supply is varied (p. 63).
Not every refinery, however, is dependent on a specific bauxite deposit.
Thus, whereas most of the above described economies are realized by spe-
cializing the characteristics of a local refinery to a local bauxite deposit (as
in Australia), the same cannot be said for remotely located refineries, as
in Japan, where a general purpose refinery that can process bauxite ores
procured on the world market has countervailing advantages.
Interestingly, regulatory concerns sometimes get in the way of back-
ward integration – an example of which is the bilateral dependency that
sometimes arises between fuel source and operating stages in electricity
generation by coal-burning generators (Joskow, 1987). Lest utilities ‘inte-
grate backward into coal production to shift profits from a regulated to an
unregulated activity, the regulatory process has discouraged this’ (Joskow,
1987, p. 284, n. 17).
As with bauxite, ‘The type of coal that a generating unit is designed to
22 Key issues
burn affects its construction and its design thermal efficiency’ (Joskow,
1987, p. 284). In some regions, as in the Eastern United States, coal of
relatively uniform quality is available from a large number of small nearby
mines; in other regions, as in the West, deposits are large and coal quality
variation among mines and the distances for shipment are great (1987, p.
284). ‘Mine mouth’ generating plants of specific design are often observed
for the latter. More generally, comparative contractual reasoning predicts
that longer-term and more nuanced contracts will be observed for the West
than in the East, which is borne out by the data: ‘as relationship-specific
investments become more important, the parties . . . find it advantageous
to rely on longer-term contracts that specify the terms and conditions of
repeated transactions ex ante, rather than relying on repeated bargaining’
(Joskow, 1987, p. 296).
5.3 Forward into Distribution
A huge franchising literature in economics and marketing examines the

decision of whether producers should own some or much of their distribu-
tion system or contract with others to manage the distribution of goods
and services instead. In the event of the latter, vertical market restrictions
often apply, a common purpose being to protect the network against brand
name devaluation (Klein and Leffler, 1981).
Many economizing issues are posed by forward integration into market-
ing and the uses of vertical market restrictions, of which asset specificity
(especially in the form of brand name capital) is only one. Transaction
cost reasoning nevertheless plays a central role in the marketing decision
(Coughlan et al., 2005) as to which contractual mode to choose and, if the
market, whether contractual restrictions should be imposed. Contrary to
the ‘inhospitality tradition’ in antitrust,18 vertical market restrictions will
yield social benefits if the requisite transaction cost pre-conditions are
satisfied.
6. PRICE THEORETIC ISSUES
6.1 Price Discrimination
The price theoretic argument in favor of price discrimination (especially

perfect price discrimination) is that discrimination permits parties whose
valuation is below a uniform monopoly price but above marginal costs
to buy the good or service in question, as a result of which allocative
efficiency benefits accrue. A problem with the argument is that perfect
price discrimination assumes that the transaction costs of discovering

true customer valuations and of policing against arbitrage are zero,
which are heroic assumptions. Upon taking the costs of discovering
price valuations and enforcing arbitrage restrictions into account, it
can be shown that costly price discrimination can lead to both private
benefits (monopoly profits increase) and social losses (Williamson, 1975,
pp. 11–13).19
6.2 Robinson-Patman
Transaction cost economics also has a bearing on the Robinson-Patman

Act, which has been interpreted as an effort ‘to deprive a large buyer of [dis-
counts] except to the extent that a lower price could be justified by reason of
a seller’s diminished costs due to quantity manufacture, delivery, or sale, or
by reason of the seller’s good faith effort to meet a competitor’s equally low
price.’ 20 The concern, plainly, is that large buyers will use their muscle to
extract better deals from suppliers, as a result of which smaller buyers will
be disadvantaged. To this, however, should be added the possibility that
different buyers are prepared to offer different contractual supports for the
same good or service. With reference to Figure 2.1, suppose that a supplier
uses specialized assets to produce the same good or service for two buyers.
Assume that one of the buyers refuses to offer contractual safeguards while
the other does offer safeguards. These two correspond to Node B and Node
C contracting, respectively. Plainly, the supplier will sell on better terms to
the Node C buyer than to the Node B buyer.
The upshot is that quantity and meeting competition considerations do
not exhaust the legitimate reasons for offering lower prices to some buyers
than to others. Application of the lens of contract/governance, as against
all-purpose reliance on textbook micro theory, serves to uncover these
additional purposes.
6.3 Predatory Pricing
Transaction cost economics disputes the merits of the marginal cost pricing
test for predatory pricing, as advanced by Philip Areeda and Donald
Turner (1975), in two respects. First, although marginal cost pricing can be
thought of as a hypothetical ideal (second best considerations aside), such
an ideal is a deceptive standard if the measurement of marginal costs invites
accounting manipulation and deceit in the courtroom. Additionally,
Areeda and Turner apply the same marginal cost pricing test to price
reductions of both continuing and temporary kinds – which is to say that
they make no provision for strategic price reductions: now it’s there, now
24 Key issues
it isn’t, depending on whether a new entrant has appeared or been van-

quished. That is unwarranted, since the welfare benefits of temporary price
cuts are at best small and could easily be net negative.
Here as elsewhere, however, objections to a proposed criterion do not,
alone, carry the day. There is an obligation to advance a superior feasi-
ble alternative. The output test proposed in Williamson (1977) has three
advantages over the marginal cost pricing test: (1) repositioning, (2) meas-
urement, and (3) contingent versus continuing responses. Repositioning
makes allowance for the possibility that parties to which predatory pricing
rules apply will adapt (reposition) in relationship to them. Areeda and
Turner ignore this incentive, yet it is noteworthy that their test has infe-
rior repositioning properties in comparison with the output test. Output,
moreover, is much easier to measure than is marginal cost. And the output
test expressly favors continuing over contingent supply – now it’s here,
now it isn’t, depending on whether an entrant has appeared or perished –
by the established firm. The upshot is that transaction cost considerations
are very relevant for uncovering the efficiency ramifications of two price
theoretic tests for predation.
6.4 Over-searching
The market for gem-quality uncut diamonds employs two nonstandard

contracting practices that are puzzling at best and are easily interpreted as
efforts by de Beers to exercise muscle in its dealings with the buyers of uncut
diamonds. The two trading restrictions in question are the ‘all-or-none’
and ‘in-or-out’ trading rules. Inasmuch as de Beers had market power in
the supply of uncut diamonds, these trading rules were believed to have the
muscular purpose of extracting profit from diamond cutters.
Although the web of cooperative practices among diamond cutters in
New York (Richman, 2006) might be interpreted as collusive, the de Beers
trading rules applied to a global market. Consider therefore the possibility
raised by Roy Kenney and Benjamin Klein (1983) that these rules have
efficiency purposes.
Whereas uncut diamonds are classified into more than two thousand cat-
egories, significant quality variation in the stones evidently remains. How
can such a market be organized so as to reduce the oversearching costs that
would be incurred if buyers were to evaluate every stone, or at least every
grouping of stones, offered by de Beers? The combination of all-or-none
with in-or-out trading rules arguably serves to reduce over-searching.21
The all-or-none trading rule requires that a buyer accept the entire
grouping of diamonds assembled by de Beers (a ‘sight’) or none at all.
Buyers are thereby denied the opportunity to pick and choose among
individual diamonds, yet nonetheless have the incentive to inspect each

sight very carefully. Refusal to accept a sight would signal that the sight
was over-priced – but no more.
Suppose now that an in-or-out trading rule is added. The decision to
refuse a sight now has much more serious ramifications. To be sure, a
refusal could indicate that a particular sight is egregiously over-priced.
More likely, however, it reflects a succession of bad experiences. It is a
public declaration that de Beers is not to be trusted. In effect, a disaffected
buyer announces that the expected net profit of dealing with de Beers under
these constrained trading rules is negative.
Such an announcement has a chilling effect on the market. Buyers who
were earlier prepared to make casual sight inspections are now advised that
there are added trading hazards. Everyone is put on notice that a confi-
dence has been violated and is warned to inspect more carefully.
On this interpretation, the in-or-out trading rule is a way of encouraging
buyers to regard the procurement of diamonds not as independent trading
events but as a related series of trades. If, overall, things can be expected to
‘average out’, then it is not essential that the payment made for value received
corresponds exactly on each sight. In the face of systematic under-realiza-
tions of value, however, buyers will be induced to quit. If, as a consequence,
the system is moved from a high to a low trust trading culture, then the costs
of marketing diamonds increase. That is an adverse outcome to the system
which de Beers has strong incentives to avoid. Accordingly, in a regime where
both all-or-none and in-or-out trading rules apply, de Beers will take greater
care to present sights such that the legitimate expectations of buyers will be
achieved. The combined rules thus infuse greater integrity of trade.
7. CREDIBLE COMMITMENTS
Although credible contracting is the core purpose served by hybrid modes

of governance, such a purpose was slow to register in antitrust enforcement
– mainly because of the monopoly predisposition with which nonstandard
and unfamiliar contracting practices were viewed. But whereas ‘traditional
market power theories [were so predisposed], . . . TCE can [frequently] . . .
illuminate the meaning of facts – particularly in the context of complex
contractual relations – that cannot otherwise be explained, or worse, are
explained incorrectly’ (Muris, 2003, p. 18). Credible commitment reason-
ing (of a Node C versus Node B kind) has been applied to a wide range
of contractual practices – including franchise restrictions, exchange agree-
ments, take-or-pay agreements, and a host of other nonstandard con-
tracting practices (Masten, 1996). Exchange agreements are an especially
26 Key issues
interesting illustration of opening the black box and interpreting the pur-
poses served by the mechanisms inside.22
Petroleum exchanges have puzzled economists for a very long time and
have been routinely challenged in antitrust cases and investigations of the
petroleum industry. The 1973 case brought by the United States Federal
Trade Commission against the largest petroleum firms maintained that
exchanges were instrumental in maintaining a web of interdependencies
among major firms, thereby helping to effect an oligopolistic outcome in
an industry that was relatively unconcentrated on normal market struc-
ture criteria.23 A later study, The State of Competition in the Canadian
Petroleum Industry, likewise held that exchanges were objectionable.24 The
Canadian Study, moreover, produced documents – contracts, internal
company memoranda, letters, and the like – as well as deposition testimony
to support its views that exchanges are devices for extending and perfect-
ing monopoly among the leading petroleum firms.25 Such evidence on the
details and purposes of contracting is usually confidential and hence una-
vailable. But detailed knowledge is clearly germane – and often essential
– to a correct assessment of the transaction cost features of a contract.
Engineers, managers, and lawyers in the major petroleum companies all
had a benign interpretation of exchanges. If X has a surplus of product in
region A and a deficit in region B while Y has a surplus of product in region
B and a deficit in region A, and if both wish to market their product in
both areas, then the exchange of product will save on cross-hauling. That,
however, omits another possibility: why not create a central market into
which each firm can report its surpluses and deficits and procure in an anon-
ymous rather than bilateral way? Petroleum industry engineers, managers,
and lawyers found this query unsettling, yet the critical issue that needs to
be faced is why bilateral exchange rather than simple market exchange?
The Canadian Study lists four objections to exchanges, the first two of
which I will pass over here (but see Williamson (1985, p. 148)). The other
two are more intriguing: competition is impaired by conditioning supply
on the payment of an ‘entry fee’ (pp. 53–4) and by exchange agreements
that impose limits on growth and supplementary supply (pp. 51–2).
The antitrust concerns posed by the entry fee are supported by the fol-
lowing documentation and interpretation (pp. 52–3; emphasis added):
Evidence of an understanding that a fee relating to investment was required for

acceptance into the industry can be found in the following quotation from Gulf:
‘We do believe that the oil industry generally, although grudgingly, will allow a
participant who has paid his ante, to play the game; the ante in this game being
the capital for refining, distributing and selling products.’ (Document #71248,
undated, Gulf)
The significance of the quotation lies equally in the notion that an ‘entry fee’
was required and in the notion that the industry set the rules of the ‘game.’ The
meaning of the ‘entry fee’ as well as the rules of the ‘game’ as understood by
the industry can be found in the actual dealings between companies where the
explicit mention of an ‘entry fee’ arises. These cases demonstrate the rules that
were being applied – the rules to which Gulf was referring. Companies which
had not paid an ‘entry fee,’ that is, companies which had not made a sufficient
investment in refining capacity or in marketing distribution facilities would
either not be supplied or would be penalized in the terms of the supply agreement.
Once a comparative contractual perspective is adopted, a different inter-

pretation of these practices presents itself. So as to keep the comparison
simple, suppose that there are two would-be buyers and that each places an
order for a significant and identical amount of product for delivery over the
same time interval with the same supplier. The buyers differ, however, in
that one of the buyers is prepared to create a safeguard to deter premature
termination while the other is not. It is elementary that the seller will charge
a higher (Node B) price to the latter.
But wherein do exchange agreements relate to such trades? Given that
the amount of product to be supplied is significant, and assuming that the
supply interval is long and that the surplus/deficit geographic relations
described above apply, then buyers and sellers so situated will find that an
exchange agreement between them not only saves on cross-hauling costs
but, additionally, provides a reciprocal credible commitment – in that ter-
mination by one party is deterred by the expectation that it will be answered
in kind. Especially if both parties to the exchange agreement experience
correlated disturbances, in which event both will want to adapt similarly,
exchange agreements have good adaptation and security properties.
Assuming that each party to such a supply agreement constructs and main-
tains a larger plant than it otherwise would, the specific investments made by
these firms take the form of ‘dedicated assets’ – large incremental additions to
plant, the output from which is earmarked for a specific buyer – as secured by
an exchange agreement. Little wonder that petroleum firms will contract on
better terms with other petroleum firms that have ‘paid the ante’ to ‘play the
game’ than they will with buyers whose purchases are unsecured.
Consider therefore the use of growth and supplementary supply
restraints, an example of which is the Imperial–Shell exchange agreement,
under which Imperial supplied product to Shell in the Maritimes and
received product from Shell in Montreal (p. 51):
The agreement between Imperial and Shell, originally signed in 1963, was rene-
gotiated in 1967. In July 1972, Imperial did this because Shell had been growing
too rapidly in the Maritimes. In 1971–72, Imperial had expressed its dissatisfac-
tion with the agreement because of Shell’s marketing policies. Shell noted:
28 Key issues
‘[Imperial’s] present attitude is that we have built a market with their facilities,
we are aggressive and threatening them all the time, and they are not going to
help and in fact get as tough as possible with us.’ (Document #23633, undated,
Shell)
Specifically, Imperial renewed the agreement with Shell only after impos-
ing a price penalty if expansion were to exceed ‘normal growth rates’ and
furthermore stipulated that ‘Shell would not generally be allowed to obtain
product from third party sources’ to service the Maritimes (p. 52; emphasis
added).
The Canadian Study notes that Gulf Oil also took the position that
rivals receiving product under exchange agreements should be restrained
to normal growth: ‘Processing agreements (and exchange agreements)
should be entered into only after considering the overall economics of the
Corporation and should be geared to providing competitors with volumes
required for the normal growth only.’ 26 It furthermore sought and secured
assurances that product supplied by Gulf would be used only by the recipi-
ent and would not be diverted to other regions or made available to other
parties (p. 59).
Limits on ‘normal growth’ and prohibitions on ‘third parties’ could
well have anticompetitive purpose and were so regarded by the Canadian
Study. Examined, however, through the lens of contract/governance, it
is also possible that these same restrictions had the purpose and effect of
preserving symmetrical incentives between the parties to exchange agree-
ments, thereby allowing them to reach Node C credible commitments.
Without use restrictions, bilateral dependence could become unbalanced.
Also, symmetry could be placed under strain if one party was to grow ‘in
excess of normal’ – in which event it might be prepared to construct its own
plant and scuttle the exchange agreement. Marketing restraints that help to
forestall such outcomes encourage parties to participate in exchanges that
might otherwise be unacceptable.
To be sure, credibility benefits that are valued by the parties may not
be equally valued by society. Such restraints may in some cases have both
market power and secure transaction purposes. My purpose is merely to
emphasize that, whereas the Canadian Study viewed these entirely in a
one-sided (monopoly) way, the perspective of credible contracting adds
another. To repeat, transaction cost economics can sometimes ‘illuminate
the meaning of facts [and words] – particularly in the context of complex
contractual relations – that otherwise cannot be explained, or worse, are
explained incorrectly’ (Muris, 2003, p. 14).27
8. THE MODERN CORPORATION

The lens of contract/governance applies to the modern corporation in
numerous ways: limits to firm size, scaling up, divisionalization, horizontal
merger, conglomerate mergers, corporate governance, Japanese outsourc-
ing practices, disequilibrium forms of organization, and the list goes on.
My discussion here is restricted to limits to firm size, scaling up (to include
corporate governance), and horizontal and conglomerate mergers.28
8.1 Limits to Firm Size
The puzzle of firm size was posed by Frank Knight in 1921 when he
observed that the ‘diminishing returns to management is a subject often
referred to in economic literature, but in regard to which there is a dearth
of scientific discussion’ (Knight, 1965, p. 286, n. 1). He elaborated in 1933
as follows (1965, p. xxxi; emphasis added):
The relation between efficiency and size of firm is one of the most serious prob-
lems of theory, being, in contrast with the relation for a plant, largely a matter of
personality and historical accident rather than of intelligible general principles.
But the question is peculiarly vital, because the possibility of monopoly gain
offers a powerful incentive to continuous and unlimited expansion of the firm,
which force must be offset by some equally powerful one making for decreased
efficiency.
Tracy Lewis’s later remarks that large established firms will always
realize greater value from inputs than small potential entrants are apposite
(1983, p. 1092; emphasis added):
The reason is that the leader can at least use the input exactly as the entrant
would have used it, and earn the same profits as the entrant. But typically, the
leader can improve on this by coordinating production from his new and existing
inputs. Hence the new input will be valued more by the dominant firm.
If the dominant firm can use the input in exactly the same way as the
entrant, then the larger firm can do everything the smaller firm could. If it
can improve on the input usage, it can do more. Applied to vertical integra-
tion, the parallel argument is that the acquisition of an independent com-
ponent supplier is always preferred to outsourcing because the combined
firm will never do worse (by reason of replication) and will sometimes do
more if the acquiring stage always but only intervenes when expected net
gains can be projected (by reason of selective intervention).
The puzzle of firm size thus reduces to this: what are the obstacles to
the implementation of replication and selective intervention? As I discuss
30 Key issues
elsewhere (Williamson, 1985, Chapter 6), promises to replicate and selec-

tively intervene are not costlessly enforceable. An acquired supplier can
neither trust the acquirer to do the accounting (on which the supplier’s
net receipts are calculated) in an unbiased way nor trust the acquirer to
intervene always but only for good cause; and the acquirer cannot trust
the supply stage to operate the plant and equipment (now owned by the
acquirer) with unchanged due care and to adapt appropriately to autono-
mous disturbances. The upshot is that neither replication nor selective
intervention can be implemented without cost, as a result of which the gov-
ernance mechanisms of markets and hierarchies differ in kind (Williamson,
1991a). The recurrent point to which I call special attention, however,
is this: the bureaucratic burdens of integration are discerned only upon
opening the black box and examining the microanalytics.
8.2 Scaling Up
Solow observes that ‘The very complexity of real life . . . [is what] makes
simple models so necessary’ (2001, p. 111). The object of a simple model is
to capture the essence, thereby to explain hitherto puzzling practices and
make predictions that are subjected to empirical testing. But simple models
can also be ‘tested’ with respect to scaling up. Does repeated application
of the basic mechanism out of which the simple model works yield a result
that recognizably describes the phenomenon in question?
The test of scaling up is often ignored (possibly out of awareness that
scaling up cannot be done) or is sometimes scanted (possibly in the belief
that scaling up can be accomplished easily). The influential paper by
Michael Jensen and William Meckling, ‘Theory of the Firm: Managerial
Behavior, Agency Costs, and Capital Structure’ (1976), is an exception.
The authors work out of a simplified setup where an entrepreneur (100
percent owner-manager) sells off a fraction of the equity of the firm, as a
result of which his incentive intensity is reduced and efficacious monitoring
arises as a response. What the authors are really interested in, however,
is not entrepreneurial firms but the ‘modern corporation whose manag-
ers own little or no equity’ (1976, p. 356). Although the latter project was
beyond the scope of their paper, they expressed belief that ‘our approach
can be applied to this case . . . [These issues] remain to be worked out in
detail and will be included in a future paper’ (1976, p. 356).29
Alas, Jensen and Meckling never produced the follow-up paper, but
many others have since examined the efficacy of the board of directors as
monitor in the large corporation where the ownership is diffuse. The jury is
still out, but I ascertain that serious obstacles stand in the way of acquiring
the relevant information to support vigilant monitoring and, furthermore,
contend that the advisability of assigning the role of vigilant monitor to the
board of directors is extremely problematic (Williamson, 2007b). In that
event, corporate governance does not scale up from the entrepreneurial
firm to the diffusely owned modern corporation.
Scaling-up issues relevant to the modern corporation are also posed by
the theory of the firm as team production (Alchian and Demsetz, 1972)
and the theory of the firm as governance structure. The theory of team pro-
duction works through technological nonseparability, which Alchian and
Demsetz illustrate with the example of manual freight loading: ‘Two men
jointly lift heavy cargo into trucks. Solely by observing the total weight
loaded per day, it is impossible to determine each person’s marginal pro-
ductivity’ (1972, p. 779). Accordingly, rather than each person being paid
his (unmeasurable) marginal product, such activities are organized cooper-
atively, with a team whose members are paid as a team and are monitored
by a boss lest they engage in shirking. This is instructive, but does techno-
logical nonseparability scale up to explain the modern corporation?
One possibility is that the large corporation is a vast, indecomposable
whole, in which event everything is connected with everything else and the
model of technological nonseparability goes through. Another possibility
is that, as Simon describes in ‘The Architecture of Complexity’ (1962),
large hierarchical systems evolve from nearly decomposable subsystems
– within which subsystems interactions are extensive and between which
they are attenuated.30
Simon’s examination of social, biological, physical, and symbolic
systems as well as the logic of complexity supports the proposition that
decomposability ‘is one of the central structural schemes that the architect
of complexity uses’ (1962, p. 468). Inasmuch as such decomposability
relieves the condition of technological nonseparability on which Alchian
and Demsetz rely, scaling up from small groups to which nonseparability
applies (such as manual freight loading and, possibly, groups as large as the
symphony orchestra) does not extend to the decision to join a series of tech-
nologically separable stages, thereby to form the modern corporation.
So how does that transaction cost economics setup fare in scaling-up
respects? Does successive application of the make-or-buy decision, as it
is applied to individual transactions, scale up to describe something that
approximates a multi-stage firm? Note in this connection that transaction
cost economics assumes that the transactions of interest are those that take
place between technologically separable stages. This is the ‘boundary of
the firm’ issue as described elsewhere (Williamson, 1985, pp. 96–8). Upon
taking the technological ‘core’ as given (possibly as derived from site specific
investments, of which thermal economies are an example (see Section 5.1
above)), attention is focused on a series of separable make-or-buy decisions
32 Key issues
− backward, forward, and lateral – to ascertain which should be outsourced

and which should be incorporated within the ownership boundary of the
firm. So described, the firm is the inclusive set of transactions for which
the decision is to make rather than buy – which does appear to implement
scaling up, or at least is a promising start (Williamson, 1985, pp. 96–8).31
8.3 Horizontal Mergers
My initial inclination was to regard oligopoly to be outside the scope of

transaction cost reasoning, mainly because I had become accustomed to
thinking about oligopoly in terms of the prevailing structure–conduct–
performance paradigm, where concentration ratios and barriers to entry
were the coin of the realm. Upon viewing oligopoly as a cartel problem,
however, its contractual nature is immediately evident.
Consider in this connection the claim that monopoly and oligopoly are
nearly indistinguishable in competitive respects.32 Such a claim fails to make
allowance for (1) the advantages of hierarchy (within a monopoly) as com-
pared with interfirm contracting (among oligopolists) for dispute settlement
and coordinating purposes and (2) the differential incentives and the related
propensity to cheat that distinguish internal from interfirm organization.
Examining the cartel as a five-stage contracting process – contract specifica-
tion, joint gain agreement, implementation under uncertainty, monitoring
contract execution, and penalizing contract violations – is instructive.
As discussed elsewhere (Williamson, 1975, pp. 238–44), oligopolies
differ in their ‘complexity’ in all five of these contractual respects. Simple
oligopolies – where numbers are few and products are homogeneous,
shares are easy to agree upon, disturbances are small, price and output are
public knowledge, and penalties for violations are assuredly meted out –
will surely recognize their interdependence and behave accordingly. As,
however, deviations from these simple conditions arise, cartel contracts
become progressively more complex and undergo slippage and fracture
during contract execution. Interestingly, even in the 1870s and 1880s,
when express collusion was not unlawful, repeated efforts by the railroads
to curb competitive pricing – first by informal alliances, then by managed
federations – were undone by cheating.33 When the railroads ‘found to
their sorrow that they could not rely on the intelligence and good faith of
railroad executives’ to manage the cartels (Chandler, 1977, p. 141), they
gave up on interfirm agreements and turned to merger.
Contractual reasoning is thus instructive in making oligopoly–monopoly
comparisons. Because, however, the predictions of the contractual approach
to oligopoly are very similar to many other oligopoly theories, empirical
research on oligopoly has been little affected.
8.4 Conglomerates
The conglomerate form of organization was a matter of grave concern in

the 1960s, especially among those with populist predilections, of which
H.M. Blake (1973) was one. According to Blake, the anticompetitive
hazards of conglomerate mergers, in potential competition and other
respects, were ‘so widespread that [these] might appropriately be described
as having an effect upon the economic system as a whole – in every line of
commerce in every section of the country’ (1973, p. 567). So regarded, the
conglomerate was a menace.
Can a contractual approach to conglomerate diversification help to
inform the issues? The basic proposition is this: whereas vertical inte-
gration is viewed as taking transactions out of the intermediate product
market and organizing them internally, the conglomerate can be inter-
preted as taking transactions out of the capital market and organizing
them internally. So described, the conglomerate experiences a breadth for
depth tradeoff in managing capital market transactions.
The argument relies on part in the distinction between centralized (unitary
or U-form) and decentralized (multidivisional or M-form) corporations, as
developed by Alfred Chandler (1962) and interpreted in efficiency terms in
Williamson (1970). Specifically, the conglomerate can be understood as
a logical outgrowth of the divisionalized strategy for organizing complex
economic affairs. Thus, once the merits of the M-form structure for manag-
ing separable, albeit related, lines of business (such as different automobile
brands or different chemical divisions) were recognized and digested, its
extension to manage less closely related activities was natural, although
that is not to say that the management of diversification is without prob-
lems of its own. The basic M-form logic, whereby strategic resource alloca-
tion and oversight are assigned to the general office and operating decisions
are the responsibility of the operating divisions, nevertheless carries over.
To the degree to which conglomerates employ the M-form logic (as
against the go-go conglomerates of the 1960s) and possess deep knowl-
edge (as compared with the capital market) within a large but delimited
set of diversified investment opportunities, then the indicia for an effi-
cient resource allocation interpretation of the conglomerate take shape.34
Plainly, however, not all conglomerates qualify to be so described.
9. CONCLUSIONS
Opening the black box of firm and market organization is accomplished

by taking transaction cost economizing to be the main case, in relation to
34 Key issues
which adaptations (of autonomous and coordinated kinds) are especially

important, and examining economic organization through the lens of con-
tract. The transaction is made the basic unit of analysis and governance
is the means by which to infuse order. In conformity with Simon’s advice
that our research agenda and research methods are shaped by our descrip-
tion of human actors, the cognitive and self-interestedness attributes of
human actors that bear on contracting are expressly identified, after which
the ramifications of human actors as these relate to the key attributes of
both transactions and governance structures are worked out. Aligning
transactions, which differ in their attributes, with governance structures,
which differ in their cost and competence, so as to effect a transaction cost
economizing outcome is where the predictive content resides.
The key features of the foregoing are these:
(1) The lens of contract/governance is an instructive way by which to

open the black box of firm and market organization and examine the
mechanisms inside.
(2) This project subscribes to Jon Elster’s dictum that ‘explanations in
the social sciences should be organized around (partial) mechanisms
rather than (general) theories’ (1994, p. 75; emphasis omitted).
(3) Especially relevant to public policy analysis is that nonstandard con-
tractual practices and organizational structures that were believed to
be anticompetitive when examined through the lens of price theory
are often revealed to serve efficiency purposes as well or instead.
(4) Subsequent uses of the lens of contract/governance to examine
complex contract and economic organization reveal that many
‘superficially disconnected and diverse phenomena . . . [are] mani-
festations of a more fundamental and relatively simple structure’
(Friedman, 1953, p. 33).35
Such applications notwithstanding, many conceptual, empirical, and

public policy challenges await.
NOTES
* This is the first of two papers dealing with ‘opening up the black box’. This paper
deals with applications to antitrust. The other paper describes applications to regula-
tion (Williamson, 2007a). The introduction and Section 2 of this chapter overlap with
Section 1 of Williamson (2007a).
1. The importance of a focused lens is crucial. The distinction here is between promising but
sprawling concepts that invite ex post rationalizations for any outcome whatsoever (which
is a chronic problem with vaguely defined concepts – of which ‘power’ is one (March,
1966)). A focused lens both delimits the set of factors that can be invoked to explain
complex phenomena and reveals the mechanisms through which these factors work. The
promising but vague concept of transaction costs which Coase introduced in his 1937
article, ‘The Nature of the Firm’, remained in a state of disuse 35 years later (Coase, 1972,
p. 63) precisely because the key ideas had not been operationalized (Coase, 1992, p. 718).
2. As Harold Demsetz observes, it is ‘a mistake to confuse the firm of [neoclassical] eco-
nomic theory with its real-world namesake. The chief mission of neoclassical economics
is to understand how the price system coordinates the use of resources, not the inner
workings of real firms’ (1983, p. 377).
3. The quotation is attributed to Donald Turner by Stanley Robinson (1968), p. 29.
4. The Federal Trade Commission’s opinion in Foremost Dairies states that the necessary
proof of violation of Section 7 ‘consists of types of evidence showing that the acquiring
firm possesses significant market power in some markets or that its overall organization
gives it a decisive advantage in efficiency over its smaller rivals’ (In re Foremost Dairies,
Inc., 60 FTC, 944, 1084 (1962), emphasis added).
5. See Williamson (1985, pp. 366–7) for an elaboration upon the convoluted status of
antitrust enforcement during the 1960s.
6. This terse summary is elaborated elsewhere (Williamson, 1985, 1991a, 2002, 2005). The
intellectual antecedents are set out in the Appendix.
7. R.C.O. Matthews describes the New Institutional Economics (with emphasis on trans-
action cost economics) in precisely these terms in his Presidential Address to the Royal
Economic Society (1986, p. 903).
8. Because I judge several of the listed six assumptions to be implausible (Williamson,
1991b, pp.172–6), I take the lesson of Fudenberg et al. (1990) (which is an intellectual
tour de force) to be that a sequentially optimal contract is infeasible. Especially prob-
lematic are their assumptions of three-way costless knowledge of public outcomes (by
principal, agent, and arbiter) and common knowledge of both technology and preferences
over action-payment streams. If and as the attainment of logical consistency (in theory)
yields infeasibility (in practice), applied economists will understandably be chary of the
operational significance of the theory.
9. For a discussion of contract law regimes as these relate to governance, see Williamson
(1991a).
10. Note that the price that a supplier will bid to supply under Node C conditions will be less
than the price that will be bid at Node B. That is because the added security features at
Node C serve to reduce the contractual hazard, as compared with Node B, so the con-
tractual hazard premium will be lowered. One implication is that suppliers do not need
to petition buyers to provide safeguards. Because buyers will receive goods and services
on better terms (lower price) when added security is provided, buyers have the incentive
to offer credible commitments.
11. United States v. Von’s Grocery Co., 384 U.S. 270, 301 (1966) (Stewart, J., dissenting).
12. As, for example, in ‘Economies as an antitrust defense: the welfare tradeoffs’ (Williamson,
1968).
13. This is an insistent theme in Coase (1960, 1964, 1972).
14. Stephen Stockum’s summary of Muris’s position is as follows (2002, p. 60):
Muris describes his economic approach as neither Chicago School nor Post-
Chicago, but rather ‘New Institutional Economics’, which combines theory with a
study of real world institutions, . . . [is] heavily empirical, . . . [and provides relief from
economic ideology in favor of] more practical discussions of how economic analysts
can contribute to rational enforcement of the antitrust laws.
15. This relieves problems of valuing such dies if they are owned by the supplier, although
user-cost abuses of dies become a concern if the buyer owns them.
16. For discussions, see Williamson (1979, 1987).
17. Thus whereas industrial organization specialists and the Antitrust Merger Guidelines
once advised that an antitrust issue is posed should a firm with a 20 percent market
share acquire a 5 or 10 percent share in any industry from which it buys or to which it
36 Key issues
sells (Stigler, 1955, p. 183), transaction cost economics counsels that the attributes of
the transaction tell us a lot more about the purposes of integration, especially for such
small market shares.
To be sure, vertical integration sometimes serves strategic purposes. As Alfred
Marshall observed, if, in a small country, spinning and weaving were joined, ‘the
monopoly so established will be much harder to shake than would either half of it
separately’ (1920, p. 495). Bain warned that vertical integration can be used as a means
by which to ‘disadvantage, weaken, eliminate, or exclude non-integrated competitors’
(1968, pp. 360–62). And Stigler advised that integration ‘becomes a possible weapon
for the exclusion of new rivals by increasing the capital requirements for entry into the
combined integrated production processes’ (1955, p. 224). I do not disagree. Because,
however, strategic entry deterrence is so easy to invoke, those who would make such
claims should describe the details of the underlying mechanisms and explain when we
should expect alleged adverse effects to rise to the level of public policy significance.
18. For a discussion of both the Jurisdictional Statement and the Brief for the United States
in United States v. Arnold, Schwinn & Co., 388 U.S. 365 (1967), see Williamson (1979;
1985, pp. 183–9).
19. Applied welfare economics apparatus is used to display these two effects. The tradeoffs
had gone unnoticed, however, until positive transaction costs were expressly introduced
into the calculus.
20. FTC v. Morton Salt Co., 334 U.S. 37 (1948); emphasis added.
21. The remainder of this subsection is based on Williamson (1996, pp. 77–8).
22. The remainder of this subsection is based on Williamson (1985, pp. 197–201).
23. FTC v. Exxon et al. Docket No. 8934 (1973).
24. Robert J. Bertrand, Q.C., Director of Investigation and Research, Combines
Investigation Act, coordinated the eight-volume study, The State of Competition in the
Canadian Petroleum Industry (Quebec, 1981). All references in this chapter are to Vol. V,
The Refining Sector. That study will hereinafter be referred to as the Canadian Study.
25. Page numbers here and below that do not name the source all refer to Vol. V of the
Canadian Study (see note 24, above).
26. The Canadian Study (p. 59) identifies the source as Document #73814, January 1972.
27. Muris (2003, pp. 15–23) discusses a variety of other applications of transaction cost
economics to complex contracting. Also see Joskow (2002).
28. For discussions of divisionalization, see Williamson (1970, 1985, Chapter 11); for
Japanese economic organization, Williamson (1985, pp. 120–123); for corporate govern-
ance, Williamson (1988, 2007b); for disequilibrium contracting, Williamson (1991a).
29. Other examples where scaling-up tensions are posed include Thomas Schelling’s treat-
ment of the evolution of segregation in the ‘self-forming neighborhood’ (Schelling, 1978,
pp. 147–55), the expansive uses sometimes made of the so-called paradox of voting
(Williamson and Sargent, 1967), and the move from project financing to composite
financing in the modern corporation (Williamson, 1988).
30. ‘The loose . . . coupling of subsystems . . . [means that] each subsystem [is] independent of
the exact timing of the operation of the others. If subsystem B depends upon subsystem
A only for a certain substance, then B can be made independent of fluctuations on A’s
production by maintaining a buffer inventory’ (Simon, 1977, p. 255).
31. In consideration of the difficulties and importance of scaling up, it is judicious to hold
theories of the modern corporation for which scaling up has not been demonstrated in
public policy abeyance.
32. John Kenneth Galbraith took the position that ‘the firm, in tacit collaboration with
other firms in the industry, has wholly sufficient power to set and maintain prices’ (1967,
p. 200).
33. Note that while the courts tolerated collusion, they refused to enforce price setting
agreements.
34. There is an additional contractual wrinkle, in that conglomerates once posed an acquisi-
tion threat to underperforming firms, including firms that had allowed their debt–equity
ratio to fall below the optimal level (Williamson, 1988). Leveraged buyout specialists
such as Kohlberg-Kravis-Roberts are precisely attuned to such opportunities and have
since taken over many of these takeover functions.
35. In the spirit of pluralism, we will benefit from any theory that deepens our under-
standing of complex phenomena and satisfies the precepts of pragmatic methodology
(Williamson, 2007c).
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American Economic Review, 77 (1), 168–85.
Joskow, P. (1991), ‘The Role of Transaction Cost Economics in Antitrust and
Public Utility Regulatory Policies’, Journal of Law, Economics, and Organization,
7 (March), 53–83.
Joskow, P. (2002), ‘Transaction Cost Economics, Antitrust Rules and Remedies’,
Journal of Law, Economics and Organization, 18 (1), 95–116.
Kenney, R. and B. Klein (1983), ‘The Economics of Block Booking’, Journal of
Law and Economics, 26 (October), 497–540.
Klein, B. (1996), ‘Why Hold-Ups Occur: The Self Enforcing Range of Contractual
Relationships’, Economic Inquiry, 34 (3), 444–63.
Klein, B. and K. Leffler (1981), ‘The Role of Market Forces in Assuring Contractual
Performance’, Journal of Political Economy, 89 (August), 615–41.
Knight, F. (1965), Risk, Uncertainty, and Profit, New York: Harper & Row,
Publishers, Inc.
Kreps, D. (1990), A Course in Microeconomic Theory, Princeton, NJ: Princeton
University Press.
Lewis, T. (1983), ‘Preemption, Divestiture, and Forward Contracting in a Market
Dominated by a Single Firm’, American Economic Review, 73 (December),
1092–1101.
Livesay, H.C. (1979), American Made: Men Who Shaped the American Economy,
Boston: Little, Brown.
Llewellyn, K.N. (1931), ‘What Price Contract? An Essay in Perspective’, Yale Law
Journal, 40, 704–51.
Macher, J.T. and B. Richman (2006), ‘Transaction Cost Economics: A Review and
Assessment of the Empirical Literature’, unpublished manuscript.
March, J.G. (1966), ‘The Power of Power’, in David Easton (ed.), Varieties of
Political Theory, Englewood Cliffs, NJ: Prentice-Hall, pp. 39–70.
Marshall, A. (1920), Principles of Economics, 8th edn, New York: Macmillan and
Co., Ltd.
Masten, S. (1984). ‘The Organization of Production: Evidence from the Aerospace
Industry’, Journal of Law and Economics, 27 (October), 403–18.
Masten, S. (1996), Case Studies in Contracting and Organization, New York:

Oxford University Press.
Matthews, R.C.O. (1986), ‘The Economics of Institutions and the Sources of
Economic Growth’, Economic Journal, 96 (December), 903–18.
Monteverde, K. and D. Teece (1982), ‘Supplier Switching Costs and Vertical
Integration in the Automobile Industry’, Bell Journal of Economics, 13 (Spring),
206–13.
Muris, T. (2003), ‘Improving the Economic Foundations of Competition Policy’,
George Mason Law Review, 12 (1), 1–30.
Posner, R. (1976), Antitrust Law, Chicago: University of Chicago Press.
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Diamond Merchants in New York’, Law and Social Inquiry, 31 (2), 383–420.
Robinson, S. (1968), ‘Comment’, New York State Bar Association, Antitrust
Symposium.
Schelling, T. (1978), Micromotives and Macrobehavior, New York: Norton.
Simon, H. (1957), Models of Man, New York: John Wiley & Sons.
Simon, H. (1962), ‘The Architecture of Complexity’, Proceedings of the American
Philosophical Society, 106 (December), 467–82.
Simon, H. (1977), Models of Discovery, Boston: D. Reidel Publishing Co.
Simon, H. (1984), ‘On the Behavioral and Rational Foundations of Economic
Dynamics’, Journal of Economic Behavior and Organization, 5 (March), 35–56.
Simon, H. (1985), ‘Human Nature in Politics: The Dialogue of Psychology with
Political Science’, American Political Science Review, 79 (2), 293–304.
Solow, R. (2001), ‘A Native Informant Speaks’, Journal of Economic Methodology,
8 (March), 111–12.
Stigler, G. (1955), ‘Mergers and Preventive Antitrust Policy’, University of
Pennsylvania Law Review, 104, 176–85.
Stigler, G. (1968), The Organization of Industry, Homewood, IL: Richard D.
Irwin.
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Timothy Muris’, Antitrust (Spring), 60.
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Cambridge, MA: Harvard University Press.
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of the Firm’, American Economic Review, 91 (2), 184–99.
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Tradeoffs’, American Economic Review, 58 (March), 18–35.
Williamson, O.E. (1970), Corporate Control and Business Behavior, Englewood
Cliffs, NJ: Prentice-Hall.
Williamson, O.E. (1975), Markets and Hierarchies: Analysis and Antitrust
Implications, New York: Free Press.
Williamson, O.E. (1977), ‘Predatory Pricing: A Strategic and Welfare Analysis’,
Yale Law Journal, 87 (December), 284–340.
Williamson, O.E. (1979), ‘Assessing Vertical Market Restrictions’, University of
Pennsylvania Law Review, 127 (April), 953–93.
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Press.
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New Palgrave Dictionary of Economics, Vol. IV, London: Macmillan, pp. 807–
12.
40 Key issues
Williamson, O.E. (1988), ‘Corporate Finance and Corporate Governance’, Journal

of Finance, 43 (July), 567–91.
Williamson, O.E. (1991a), ‘Comparative Economic Organization: The Analysis of
Discrete Structural Alternatives’, Administrative Science Quarterly, 36 (June),
269–96.
Williamson, O.E. (1991b), ‘Economic Institutions: Spontaneous and Intentional
Governance’, Journal of Law, Economics, and Organization, 7 (Special Issue):
159–87.
Williamson, O.E. (1996), The Mechanisms of Governance, New York: Oxford
University Press.
Williamson, O.E. (2002), ‘The Theory of the Firm as Governance Structure: From
Choice to Contract’, Journal of Economic Perspectives, 16 (Summer), 171–95.
Williamson, O.E. (2005), ‘The Economics of Governance’, American Economic
Review, 95 (2), 1–18.
Williamson, O.E. (2007a), ‘Opening the Black Box of Firm and Market Organiza-
tion: Regulation’, working paper, University of California, Berkeley.
Williamson, O.E. (2007b), ‘Corporate Boards of Directors: In Principle and In
Practice’, Journal of Law, Economics, and Organization, 24 (October), 247–72.
Williamson, O.E. (2007c), ‘Pragmatic Methodology’, working paper, University
of California, Berkeley.
Williamson, O.E. and T. Sargent (1967), ‘Social Choice: A Probabilistic Approach’,
The Economic Journal, 77 (308), 797–813.
Wilson, E.O. (1998), Consilience, New York: Alfred Knopf.
APPENDIX 2.1 INTELLECTUAL ANTECEDENTS

TO THE LENS OF CONTRACT/
GOVERNANCE
The comparative contractual approach to economic organization is
inspired by a series of key ideas, many of which first surfaced in the 1930s
(or thereabouts). Of special importance are these:
(1) The organization of economic activity as among firms, markets, and

other modes of governance should be derived rather than taken as
given (Coase, 1937).
(2) Such a derivation should make explicit allowance for positive trans-
action costs (Coase, 1937, 1960).
(3) Unstated assumptions about the nature of the human beings whose
behavior we are studying should be revealed (Simon, 1957, 1985).
(4) The unit of analysis should be named, of which the transaction is a
candidate (Commons, 1932), and dimensionalized.
(5) Moving beyond the economics of simple market exchange, ongoing
contractual relations should also be brought under scrutiny – with
emphasis on the triple of conflict, mutuality, and order (Commons,
1932).
(6) Provision also needs to be made for the contract law differences
between modes. Simple market exchange (to which the concept of
contract as legal rules applies) gives way to long-term contracting (to
which the more elastic concept of contract as framework (Llewellyn,
1931) applies) and to hierarchy (whereby internal organization
becomes its own court of ultimate appeal).
(7) The central problem of economic organization to which transaction
cost consequences accrue is that of adaptation, of which two kinds
are distinguished: autonomous adaptations (Hayek, 1945) and coor-
dinated adaptations (Barnard, 1938).
(8) Going beyond the neoclassical lens of choice, complex economic
organization is also usefully examined through the lens of contract/
governance, where the latter implements the proposition that ‘mutu-
ality of advantage from voluntary exchange . . . is the most fundamen-
tal of all understandings in economics’ (Buchanan, 2001, p. 29).
References
Barnard, C. (1938), The Functions of the Executive, Cambridge, MA: Harvard

University Press.
Buchanan, J. (2001), ‘Game Theory, Mathematics and Economics’, Journal of
Economic Methodology, 8 (March), 27–32.
42 Key issues
Coase, R. (1937), ‘The Nature of the Firm’, Economica, N.S., 4, 386–405.

Coase, R. (1960), ‘The Problem of Social Cost’, Journal of Law and Economics, 3,
(October), 1–44.
Commons, J. (1932), ‘The Problem of Correlating Law, Economics, and Ethics’,
Wisconsin Law Review, 8, 3–26.
Hayek, F. (1945), ‘The Use of Knowledge in Society’, American Economic Review,
35 (September), 519–30.
Llewellyn, K.N. (1931), ‘What Price Contract? An Essay in Perspective’, Yale Law
Journal, 40, 704–51.
Simon, H. (1957), Models of Man, New York: John Wiley & Sons.
Simon, H. (1985), ‘Human Nature in Politics: The Dialogue of Psychology with
Political Science’, American Political Science Review, 79 (2), 293–304.
3. The corporation: an economic
enigma
Dennis C. Mueller
The Anglo-Saxon version of corporate organization – widely dispersed

ownership, and professional managers with small ownership stakes – has
been somewhat of an enigma throughout its 200 or so year history. Some
economists have thought it to be an inefficient organizational structure;
others have proclaimed its superiority over all other ways to organize busi-
ness activity. The performance of US corporations during the 1970s and
1980s seemed to confirm the judgments of the corporate form’s critics. One
market after another was lost to companies from Japan or Europe. Articles
and books appeared proclaiming the ‘German model’ or the ‘Japanese
model’ superior to the Anglo-Saxon model.1 One student of American capi-
talism even predicted ‘the eclipse of the public corporation’ (Jensen, 1989).
The impressive performance of the United States’ economy during the
1990s, alongside the stumbling performances of the Japanese and the
German and some other European economies, has led some to now claim
that it is the Anglo-Saxon model which is superior and toward which all
others must converge.2
In this chapter I review some of the arguments and evidence regard-
ing the efficiency of the corporate form. I shall argue that one reason for
the different views of economists about corporations is that they tend to
see what they want to see. Although most of the evidence cited seems to
support the position of the critics of the corporate form, I shall close the
chapter with the suggestion that developments over the last decade or two
have altered the environments in which corporations operate in such a way
as to justify the efficiency claims of their defenders. I begin, appropriately
enough, with Adam Smith.
1. THE EARLY ECONOMISTS
Corporations, or joint stock companies as they were commonly called at

the end of the 18th century, were relatively rare when Adam Smith wrote
43
44 Key issues
The Wealth of Nations. But Smith had seen enough of them to offer the
following observations:
The directors of such companies . . . being the managers rather of other people’s
money than of their own, it cannot well be expected, that they should watch over
it with the same anxious vigilance with which the partners in private copartnery
frequently watch over their own. Like the stewards of a rich man, they are apt
to consider attention to small matters as not for their master’s honour, and very
easily give themselves a dispensation from having it. Negligence and profusion,
therefore, must always prevail, more or less, in the management of the affairs
of such a company . . . It is upon this account that joint stock companies for
foreign trade have . . . very seldom succeeded without an exclusive privilege;
and frequently have not succeeded with one. Without an exclusive privilege they
have commonly mismanaged the trade. With an exclusive privilege they have
both mismanaged and confined it. (1776, p. 700)
John Stuart Mill regarded this conclusion as ‘one of those overstatements

of a true principle, often met with in Adam Smith’ (1885, p. 140). Nevertheless,
he also thought the principle to be true. After discussing the advantages of
joint stock companies, Mill took up ‘the other side of the question’.
[I]ndividual management has also very great advantage over joint stock. The
chief of these is the much keener interest of the managers in the success of the
undertaking.
The administration of a joint stock association is, in the main, administration
by hired servants. Even . . . the board of directors, who are supposed to super-
intend the management . . . have no pecuniary interest in the good working of
the concern beyond the shares they individually hold, which are always a very
small part of the capital of the association, and in general but a small part of the
fortunes of the directors themselves; and the part they take in the management
usually divides their time with many other occupations, of as great or greater
importance to their own interest; the business being the principal concern of no
one except those who are hired to carry it on. But experience shows, and prov-
erbs, the expression of popular experience, attest, how inferior is the quality of
hired servants, compared with the ministration of those personally interested in
the work, and how indispensable, when hired service must be employed, is ‘the
master’s eye’ to watch over it. (Mill, 1885, pp. 138–9)
Smith and Mill were, of course, giants in the development of econom-

ics. That each had a brilliant mind goes without saying. But their genius
stemmed not only from their capacity to reason. Each was also a keen
observer of people and institutions. Each could draw generalizations
from what he saw that others would recognize to be true upon hearing.
Another good example of this is Smith’s statement that ‘People of the
same trade seldom meet together, even for merriment and diversion,
but the conversation ends in a conspiracy against the public, or in some
The corporation 45
contrivance to raise prices’ (1776, p. 128). As with his statements about

corporations, what is particularly interesting about this famous passage
is that it is not a proposition about what businessmen under certain
assumptions will do. It is a statement about what they do do. Smith’s
classic treatise is not a series of hypotheses about how individuals and
markets will behave, but rather a treasure chest of observations of how
they do behave.
Alfred Marshall was first and foremost a keen observer of the world
of business. He, too, had some doubts about the efficiency of joint stock
companies. In a section entitled ‘Temptations of joint stock companies to
excessive enlargement of scope’ in Industry and Trade (1923), Marshall
notes that ‘unfortunately many [outside directors] are unable to give the
large time and energy needed for obtaining a thorough mastery of the
affairs of the companies for which they are responsible’ (p. 321). The
slack thereby created can lead to ‘excessive enlargement of scope’, because
company managers ‘cannot always approach a proposal for enlarging an
existing department, or starting a new one, without some bias’ (p. 322).
Nevertheless, he was much less concerned about the potential inefficien-
cies of the corporate form than Smith and Mill, for he judged there to be a
countervailing development that protected the ‘powerless’ position of the
shareholders.
It is a strong proof of the marvellous growth in recent times of a spirit of honesty

and uprightness in commercial matters, that the leading officers of great public
companies yield as little as they do to the vast temptations to fraud which lie in
their way . . . There is every reason to hope that the progress of trade morality
will continue . . . (Marshall, 1920, p. 253)
The founders of neoclassical economics on the western side of the

Atlantic were also sanguine in their views about the newly emerging cor-
porations and trusts formed through merger. Anticipating the reasoning
underlying transaction costs economics and the ‘new learning’ in industrial
organization by 80 years, they deduced that Darwinian competition could
be relied upon to select only the most efficient combinations of assets.3
The next landmark in our intellectual history is The Modern Corporation
and Private Property. As with many of the arguments contained in The
Wealth of Nations, much that Berle and Means (1932) wrote about the
corporation was known at the time they wrote. But they combined their
thesis with an exhaustive history of the evolution of the corporate legal
form, and amassed data demonstrating the extent of the separation of
ownership from control, and the rise in aggregate concentration that had
occurred in the first third of the 20th century. If the dangers of dispersed
46 Key issues
shareownership forewarned by Smith and Mill were real, Berle and

Means’s book suggested that the United States had much to fear.
The bulk of The Modern Corporation and Private Property must have
been written in the late 1920s, and thus the book cannot be construed as
an account of the collapse of 1929. But the timing of the book’s publication
could not have been better. The arguments put forward by Berle and Means
about the potential for managerial abuse of discretion created by the sepa-
ration of ownership and control resonated with the thunder of falling stock
prices and profits. The handful of examples of abuse of managerial power
in the book were duplicated and dwarfed by the accounts appearing daily
in the business press.4 The modern corporation appeared to have fulfilled
the worst fears of Smith and Mill, and dashed the hopes of Marshall. The
Victorian noblesse oblige that Marshall saw protecting shareholders as late
as 1920 had by 1930 vanished, at least in the United States.
2. THE ‘MARGINALIST’ CONTROVERSIES
With the publication of The Modern Corporation, the Great Crash and its
aftermath of revelations of misuse of position by managers, the issue of
corporate efficiency could not be ignored, or so it would seem. But most
economists did ignore it.5 For by the 1930s the neoclassical revolution, in
which Alfred Marshall had played such an important part, had triumphed.
When a new issue arose, the economist would no longer turn to his first-
hand knowledge of the relevant facts and institutions for addressing this
issue, or lacking first-hand knowledge proceed to gather it. The economist’s
first reaction would now be to turn to one of the models he had used to
analyze similar problems in the past. The neoclassical models had proved
themselves to be insightful analytic tools for laying bare the basic elements
of certain economic problems. To achieve their pedagogic potential they
needed to be kept simple, however, and so it was often the case that indi-
viduals were assumed to choose a single instrument (for example, price) to
achieve a single goal (profit). Thus, although the managerial corporation
was by the 1930s the dominant economic institution of Western capitalism,
the firm (entrepreneur) remained the main business actor in the economics
literature, and it (he) maximized profit.
The 1930s were difficult for mainstream economics to digest. Much
seemed to be happening that the newly developed neoclassical models could
not explain. Keynes’s response is the most famous reaction, of course. But
attacks on the micro front were also afoot. A number of economists were
troubled by the failure of prices to fall to eliminate significant amounts of
excess supply. Gardiner Means (1935) attempted to account for this with
The corporation 47
the thesis that large corporations in oligopolistic markets enjoyed consider-

able freedom to administer prices independently of market forces. Hall and
Hitch were struck by interview evidence that revealed a gross inconsistency
between ‘the way in which business men decide what price to charge for
their products and what output to produce’ and the behavior assumed
in neoclassical models (1939, p. 12). They concluded that the evidence
‘casts doubt on the general applicability of the conventional analysis of
price and output policy in terms of marginal cost and marginal revenue,
and suggests a mode of entrepreneurial behavior which current economic
doctrine tends to ignore’ (p. 12). They offered as an alternative to marginal
analysis a ‘full cost’ or mark-up model of pricing. Richard Lester was left
with ‘grave doubts as to the validity of conventional marginal theory and
the assumptions on which it rests’ from answers given by 58 entrepreneurs
from the South to a questionnaire circulated in the mid-1940s (1946, p.
81). Kaplan et al. (1958) conducted interviews of chief executives in the
late 1940s and mid-1950s and uncovered a variety of objectives and rules
of thumb for setting prices that did not resemble marginal cost equals
marginal revenue. Thus, evidence gathered over two decades and two
countries on how managers actually do set prices directly contradicted the
assumptions upon which most economic modeling of pricing was at that
time, and is today, based.
Not surprisingly these challenges to the mainstream view were vigor-
ously repelled (Machlup, 1946, 1947; Kahn, 1959).6 What is interesting
is that the defenders of the neoclassical model offered neither contradic-
tory interview and questionnaire evidence to support their positions nor
empirical evidence that would allow one to reject one hypothesis and not
the other. Rather the argument was made that it was not important that
individuals consciously maximize as posited in economic models, but that
they act as if they did. Examples from the interview/questionnaire evidence
or from everyday life were then used to suggest that the data, indeed, would
sustain, if systematically garnered, the neoclassical model.
Although the direct rejoinders to the attacks on marginalist pricing
models did not present data to support their positions, others did. Among
these, the most famous perhaps is George Stigler’s (1947) demolition of the
Hall–Hitch–Sweezy kinked-demand schedule explanation of price rigidity
in the 1930s. Stigler argued quite correctly that a kink should only exist
for oligopolies, and thus that the relationship between price changes and
concentration or number of sellers should be U-shaped. Only oligopo-
lies should change price less frequently than profit maximization would
imply. Stigler presented data on numbers of price changes in markets with
different numbers of firms that dramatically rejected the U-shape predic-
tion. The number of price changes in a market increased directly with the
48 Key issues
number of sellers. In the two markets with one seller, aluminum and nickel,
there were respectively two and zero price changes between June of 1929
and May of 1937.7
It is difficult to believe that, in a decade as unusual as the 1930s, the
demand for a basic industrial product like nickel did not shift sufficiently to
induce at least one change in the profit-maximizing price for this monopo-
list, especially since the coefficient of variation of output for this industry
was the sixth largest of the 21 industries Stigler examined. The Stigler
results, while destroying the kinked-demand schedule hypothesis, raised
the puzzling question of why price rigidity increases with concentration, and
Stigler admitted ‘that the neoclassical theory does not provide a satisfactory
explanation for this extraordinary rigidity of monopoly prices’ (1947, p.
428). The lesson drawn by the profession from Stigler’s paper was, however,
only that the data had rejected the challenges to neoclassical theory offered
by Hall and Hitch (1939) and Sweezy (1939). That the data were equally
inconsistent with what neoclassical theory predicted was ignored.
In the mid-1940s one would not have had to cast about far to find a
hypothesis that fit these results, however. Gardiner Means’s administered
price hypothesis argued that large corporations held prices constant for
long periods in markets dominated by a ‘relatively small number of con-
cerns’ (National Resources Committee, 1939, p. 143, as quoted in Scherer,
1980, p. 350). That George Stigler would not immediately seize upon the
administered price hypothesis to explain his results is not surprising. Indeed,
a generation later he and James Kindahl (1970) were to publish a major
empirical study that claimed to refute the administered price thesis. In fact,
the price rigidities that were observed could be reconciled with ‘traditional
theory’ if the latter was appropriately modified by additional assumptions
regarding long-term contracts and transaction costs (Stigler and Kindahl,
1973, p. 719). Both Means (1972) and Leonard Weiss (1977) followed with
empirical studies that they claimed were consistent with the administered
price thesis. Many additional studies examined the flexibility of prices. I
shall not dwell on this literature,8 but merely assert that the work of that
period did not produce a resounding victory for the marginalist model in
any standard form. But the profession proceeded ahead as if it did.
3. THE MANAGERIALIST CHALLENGE
The attacks on economic orthodoxy just discussed all questioned the

implications of profits maximization with regards to pricing decisions. In
the 1950s and 1960s studies appeared that directly questioned the profits
maximization assumption and neoclassical predictions regarding decisions
The corporation 49
other than price. William Baumol (1959, 1966) hypothesized that managers
maximized sales; Oliver Williamson (1963) added staff and emoluments to
the managers’ objective function; Robin Marris (1963, 1964), the growth
of the firm. Cyert and March (1963) posited four objectives in addition to
profits pursued by the firm. Most fundamentally, Herbert Simon (1957,
1959) argued that managers did not maximize any objective function at
all; they satisficed.
What needs to be stressed about these examples is that they all stemmed
from observations about how managers and corporations actually behave.
Simon’s satisficing hypothesis originated from his work in psychology
and his study of organizational behavior. His colleagues, Cyert and
March, built on Simon’s behavioralist approach and set out to describe
the decision-making processes in actual, large corporations rather than to
model an ideal, representative firm. To do so they constructed program-
ming models of actual corporate decision structures. Williamson, a student
of Simon, was also seeking a more realistic description of the ‘managerial
preference function’ than existed at that time. Baumol’s hypothesis arose
from observations about the importance of sales to managers as an index
of the health of their firm, and as a source of status (1966, pp. 44–8). Marris
launches his study with a lengthy review of the literature on organizational
behavior, which dwells on motivation, compensation formulae and the
like.9 Thus each was seeking to model in a more accurate way the behavior
of managers as they had actually observed it, or as they had come to under-
stand it from reading a literature that came from outside of economics.
These challenges to economic orthodoxy were dismissed with arguments
similar to those used to repel the attacks against marginalist price theory
(Baldwin, 1964; Peterson, 1965; Machlup, 1967).
In 1970 William Baumol and colleagues published estimates of rates of
return on reinvested cash flows during the 1950s and 1960s ranging from
2 to 6 percent. These returns were significantly below both the returns
shareholders were earning over this period and the returns Baumol et al.
estimated on new debt and equity issues. They corroborated the hypoth-
esis that managers not subject to the discipline of external capital markets
would, relative to what was optimal for their shareholders, overinvest their
internal cash flows. As with every study that seemingly contradicts the con-
ventional wisdom in economics, the Baumol et al. results were immediately
challenged, and several additional studies followed.10 In one of these Henry
Grabowski and I brought in a life-cycle hypothesis (1975). Mature firms
in industries with mature technologies earned significantly lower returns
than young firms in industries with newer technologies. Our results also
cast light on another paradoxical finding in the literature – the seemingly
‘irrational’ preference of shareholders for dividends over retained earnings.
50 Key issues
For our sample, it was only the shareholders of mature companies earning
relatively low returns on investment who preferred dividends to retentions.
The preference for dividends tended to disappear for firms earning high
returns on investment. Shareholders were not so irrational after all.
In the late 1960s Dale Jorgenson and Calvin Siebert (1968) developed and
tested a neoclassical theory of investment. The key determinant of invest-
ment for the shareholder-wealth-maximizing firm was the Modigliani and
Miller cost of capital. Cash flow had no place in a neoclassical investment
equation.11 Of course Jorgenson was right. But cash flow did belong in the
investment equation for the managerial firm, since it was this source of
capital over which managers could exercise the most discretion. Although
the neoclassical cost of capital invariably outperformed cash flow in
Jorgenson’s articles, other studies (Elliot, 1973; Grabowski and Mueller,
1972) continued to find that cash flow was superior to measures of the
neoclassical cost of capital.
Thus, a pattern of empirical results was visible in the 1970s that was
fully consistent with a managerial discretion/size-growth maximization
hypothesis about the corporation. The greater a corporation’s cash flow,
the more it spent on capital equipment and R&D; reinvested cash flows
earned relatively low rates of return; mature corporations earned lower
returns than young companies or those with new technologies; the market
priced the shares of mature firms in a way that implied a preference for
greater dividends and less reinvested cash flows. At the same time evidence
was accumulating to suggest that the conglomerate merger wave of the
1960s had reduced corporate efficiency. The wealth of the shareholders
of acquiring firms steadily declined relative to other shareholders as the
market learned more and more about the conglomerate mergers.12
But this pattern of evidence either went unnoticed or, if it was discerned,
failed to dislodge the view that managers maximized profits or shareholder
wealth. The managerial theories joined the mark-up pricing models that had
preceded them as valiant but futile attempts to replace the simplistic view
of managerial decision making that characterized the neoclassical model of
the firm. It should be noted that this outcome is not peculiar to the field of
industrial organization. Robert Frank (1985) focuses on the inadequacy
of neoclassical theory in explaining wage patterns within firms, but notes
also, citing Mayer (1972), that ‘the evidence for [a] relationship [between
income and savings] is so strong and so consistent that it would appear
difficult for proponents of the permanent income and life-cycle [saving]
theories to continue to insist that savings rates are unrelated to income.
Yet these claims persist in all major undergraduate and graduate texts in
macroeconomics’ (Frank, 1985, p. 160). Thus, despite a broad consensus
among economists that hypotheses should be formulated in such a way
The corporation 51
that they can be ‘rejected by the data’, no empirical evidence is ever deemed
strong enough to reject a hypothesis that assumes that agents maximize one
of the standard behavioral objectives, that is, in the case of the firm, profits
or shareholder wealth, or at least so it seemed up into the 1970s.
4. CONSTRAINTS ON MANAGERIAL DISCRETION
In trying to explain why managers maximize profits or shareholder wealth,

economists have offered essentially five different arguments. Four rely on
the existence of a particular market.
4.1 Product Market Competition
The most obvious way to curb managerial discretion and force managers
to maximize profits is to ensure that product markets are perfectly competi-
tive. If managers have to maximize profits simply so that their company
survives, they will maximize profits.
4.2 An Efficient Capital Market
It should be obvious to potential shareholders that the incentives managers

have to maximize shareholder wealth are attenuated if the managers own
only a fraction of a company’s shares. If the capital market is efficient, it
will recognize when an owner-manager first announces a sale of shares that
the owner-manager will engage in more on-the-job consumption following
the sale – purchase more staff and emoluments, pursue growth to a greater
degree, and so on. The assumption of capital market efficiency implies
that the share price drops immediately upon the sale’s announcement to
reflect the manager’s additional on-the-job consumption. All of the agency
costs from a separation of ownership and control are thus borne by the
original owner-manager and s/he therefore has an incentive to minimize
these costs.13
4.3 The Market for Managers
Eugene Fama (1980) has claimed that agency problems are eliminated
through the workings of the market for managers. Managers will wish to
develop a reputation for maximizing profits (not engaging in on-the-job
consumption) to improve their chances for promotion within the firm that
they currently work for, and to generate attractive job offers from other
companies.
52 Key issues
4.4 The Market for Corporate Control
Robin Marris (1963, 1964) hypothesized that the constraint upon growth-
maximizing managers which prevented them from ignoring shareholders’
interests entirely was the threat of takeover by outsiders if the share price
fell too low, and subsequent loss of job. Henry Manne (1965) coined the
term ‘market-for-corporate-control’ and claimed that it tended to solve the
agency problems created by the separation of ownership and control.
4.5 Principal–Agent Contracts
The fifth constraint on managerial discretion emphasized in the literature

comes through the incentives built into the manager’s compensation con-
tract. The principal, that is, the shareholder, is assumed to be concerned
only with his wealth or the utility of his wealth. The agent gets utility from
his wealth and disutility from the effort expended on behalf of the princi-
pal. One or both may be risk averse. The principal cannot fully monitor
the agent and thus must try to induce the agent to maximize the principal’s
wealth or utility by incorporating the proper incentives into the employ-
ment contract. The optimal contract typically does not maximize share-
holder wealth, because it needs to insure the agent from some of the risks
of the company.
5. HOW STRONG ARE THE CONSTRAINTS?
In this section, I briefly question each of the hypothesized constraints on

managerial discretion put forward in the previous section.
5.1 Product Market Competition
Few industrial organization economists believe that all or even most

markets are perfectly competitive. Neither Microsoft’s nor Coca-Cola’s
managers need lie awake at night worrying about whether their firm can
survive the intense competition it faces.
5.2 An Efficient Capital Market
The initial share offerings of most companies occur when they are young
and small. The main concern of potential buyers of these shares at that
time is not over managers’ on-the-job consumption, but whether the young
firm will survive. If it does, and if it grows big, a day will come when its
The corporation 53
managers can engage in on-the-job consumption at their shareholders’

expense. But by this time the company will most likely have ceased issuing
shares. It presses the assumption of rational expectations on the part of the
capital market very hard to assume that a possible share price drop upon
the initial sale of a company’s shares in anticipation of managerial on-the-
job consumption in the distant future can curb this activity.
5.3 The Market for Managers
The market for managers seems more likely to be an effective disciplinary

force for middle managers than for senior managers, at least for large com-
panies. Once a manager has become CEO or president of a BP or a General
Electric their next job is likely to be hitting golf balls. Should they choose
to engage in a little on-the-job consumption or empire-building they are
unlikely to worry about the effects on their future employment activities.
Potential agency problems with respect to the top managers of large corpo-
rations are unlikely to disappear because of the market for managers.
5.4 The Market for Corporate Control
If a corporation has a potential market value of $100 billion and a current

market value of $80 billion, then a potential gain exists from taking over
the company and replacing the current managers to realize the company’s
potential value. If the managers of the undervalued firm are unwilling to
sell out through a friendly merger, a tender offer must be made. This would
require raising $40 billion at the current share price, and even more consid-
ering that a premium will have to be paid to acquire at least 50 percent of
the shares. Few potential bidders have that amount of money, and it may
be difficult to raise from banks if the assets of the potential target cannot
be quickly turned into cash once control is gained.
5.5 Principal–Agent Contracts
The basic problem with the principal–agent incentive contract story is

that we do not observe managerial compensation contracts with the
characteristics that this story implies. If the shareholders were to design
an incentive contract to mitigate the principal–agent problem, they would
tie managerial compensation to some combination of reported profits
and share price, as perhaps with stock bonuses. The measure of profits
or share price in the contract would be some estimate of the increase in
profits or share price caused by the managers. Compensation contracts
typically reward managers, however, with stock options and bonuses that
54 Key issues
go up with general market swings. A wise shareholder would also retain

the authority to fire the manager for poor performance, for example, by
giving managers only nonvoting shares. However, if nonvoting shares
are issued, they typically go to the shareholders. Increasingly popular
among managers in recent years have been multiple-vote, super shares.
Perhaps, the clearest evidence of the failure of managerial compensation
contracts to provide proper incentives to managers has been the practice
following the drop in stock prices at the end of the late 1990s bull market
of revaluing mangerial stock options downward. Why the discrepancy
between theory and fact? It arises because the fundamental premise of
the principal–agent model, in the case of the shareholder and manager, is
false. Shareholders do not write the contracts that define managerial com-
pensation, and do not hire and fire managers. To a considerable degree
managers select themselves and design their own contracts (Vancil, 1987;
Bebchuk and Fried, 2004).
6. DEVELOPMENTS OVER THE LAST TWENTY

YEARS
In 1993 Elizabeth Reardon and I published a study in which we estimated

marginal qs (ratios of returns on investment to costs of capital) for 699
companies over the period end of 1969 to end of 1988. A firm which
maximizes its shareholders’ wealth should have a marginal q equal to or
slightly greater than 1. Our estimates were less than 1 for eight out of ten
companies. The median estimated marginal q was 0.71. Cumulated over
the 19-year period, the 699 companies have collectively destroyed roughly
$1 trillion by investing in projects with returns less than their costs of
capital. General Motors alone, with a marginal q of 0.48 destroyed
around $150 billion. These figures vividly reveal the significant agency
problems in US corporations that existed during the 1970s and part of
the 1980s with respect to investment policies. Shareholders in the 699
large companies in our sample would have been $1 trillion richer if the
managers of these companies had invested in the way that economics
textbooks say they do.
Others observed the poor performance of US corporations and com-
mented upon it at the time. As late as 1983, in a survey of the merger lit-
erature with Richard Ruback, Michael Jensen requested more ‘knowledge
of this enormously productive social invention: the corporation’ (Jensen
and Ruback, 1983, p. 47). By 1989, Jensen had acquired the requested
knowledge and predicted that the inefficiencies of the corporation with
ownership and control separated were so significant that it was destined
The corporation 55
to disappear. A more rapid conversion had not taken place since Paul
journeyed to Damascus. Even as Jensen was predicting the corporation’s
demise, however, developments were taking place that would enhance its
efficiency.
Many economists refer to a merger wave of the 1980s in the United
States. Compared with merger activity in the 1990s, that of the 1980s was
barely a ripple. It is legitimate, however, to speak of a wave of hostile takeo-
vers in the mid to late 1980s. Tender offers, of which hostile takeovers are
an important part, rose to 25 percent of all mergers during this period, a
figure never before or since seen (Gugler et al., 2007). Moreover, many of
the hostile takeovers were headline-grabbing takeovers of major US com-
panies. The business and popular press was filled with stories about them,
and they even became the subject for a popular movie, Wall Street. For
the first time in US history, the takeover constraint that Marris and Manne
had postulated existed began to have some real teeth.
Managers reacted. Unprofitable and unrelated divisions were sold off.
Managers began buying back their companies’ shares rather than under-
taking bad investments or mergers. Terms like ‘back to core competences’,
‘downsizing’ and ‘shareholder value’ began to fall from managers’ lips.
Managers’ concerns about shareholder wealth changed radically following
the hostile merger activity of the 1980s.
The constraint on managers from product market competition can also
be said to have increased in recent years due to globalization. Forty years
ago a US corporation needed to worry only about the response of other
US companies to an innovation or price change. Today, Schumpeter’s
gale of creative destruction storms over the innovator from around the
world.
A third development that has increased constraints on managers is the
growth of institutional shareholdings. In 1950, only one in ten shares was
held by a pension fund, mutual fund, or some other institutional share-
holder. By the mid-1990s the figure was one in two (Friedman, 1996). The
managers of these institutional portfolios are full-time stockholders who
appear to be increasingly willing to intervene to block a merger or other
management decision that the portfolio managers believe will lower share
price.
These developments have had a noticeable impact on the investment
performance of US companies. Estimates of marginal q for the United
States over the period 1985–2000 yield a mean of 1.02, a dramatic improve-
ment over the 1970–88 period (Gugler et al., 2004). Thus, at a point in time
when many economists are finally beginning to acknowledge the existence
of agency problems and to take them seriously, institutional changes may
be making them less important.
56 Key issues
7. AN END TO MANAGERIAL DISCRETION?

Despite the institutional developments discussed in the previous section,
and the much better investment performance of US companies, it may still
be too early to declare all managerial discretion issues to be totally resolved.
The study that reported the 1.02 estimate for the 1985–2000 period in the
United States reported much lower figures for Continental European and
Latin American countries. Thus, even if agency problems seem to have
become less important in the United States and some other Anglo-Saxon
countries, they appear to be alive and well in many other countries.
The first phrase that comes to mind when trying to describe the merger
wave of the late 1990s is not ‘back to core competences’ or ‘downsizing’.
The merger wave looked to be fueled by soaring stock prices much like
all other waves. And, as in other merger waves, the shareholders of the
acquiring companies appear to have suffered substantial losses (Gugler et
al., 2007; Moeller et al., 2005). This wave also illustrated that institutional
shareholders are not as powerful a check on managers as some think. They
appear to have been just as swept up by the euphoria of the bull market,
and just as willing to believe the various ‘theories’ about why this or that
merger will generate synergies – theories which, as with other merger
waves, have not received a lot of empirical support.
Finally, it must be noted that managerial salaries continue to climb to
unprecedented heights despite all the attention that they have received.
NOTES
1. See Gilson and Roe (1993), and Charkham (1994).

2. See Hansmann and Kraakman (2000).
3. See in particular the quote of John Bates Clark in Letwin (1965, p. 74) and Stigler (1950,
p. 76).
4. On these see Galbraith (1972).
5. When not ignoring it, the economist would often ridicule it. As late as 1982, at a con-
ference held ostensibly to ‘celebrate’ the fiftieth anniversary of the publication of The
Modern Corporation and Private Property, the tenor and tone of the papers reveals that
many came not to praise the book but to bury it (see special issue of Journal of Law and
Economics, June 1983). Douglass North’s (1983) comment is a nice exception.
6. Friedman’s (1953) and Becker’s (1962) famous essays could also be cited here.
7. Stigler’s initial findings have been substantiated in several other studies; for example,
Simon (1969); Primeaux and Bomball (1974); and Primeaux and Smith (1976).
8. For a survey, see Scherer (1980, pp. 350–62), and a more recent re-examination (Carlton,
1986).
9. I also know from personal conversations with him that his thinking on these matters has
been importantly influenced by personal experiences with a firm in his family.
10. This literature is reviewed in Mueller (2003a, pp. 145–8).
11. The pioneering study of the role of cash flow in an investment equation is of course
The corporation 57
that of Kuh and Meyer (1957). Although they interpret the strong performance of cash
flow in their investment equations as consistent with the profits maximization hypoth-
esis, cash flow enters their list of possible explanatory variables not as a result of the
application of the marginal analysis, but because ‘by far the most outstanding aspect of
. . . direct inquiries [about the determinants of investment] is their virtual unanimity in
finding that internal liquidity considerations and a strong preference for internal financ-
ing are prime factors in determining the volume of investment’ (p. 17). The third of the
three reasons they give for the strong preference for internal funds is ‘the hierarchical
structure and motivations of corporate management which make outside financing
asymmetrically risky for the established or in-group’ (pp. 17–18).
12. See the extensive references in my surveys (Mueller, 1977, 2003b, pp. 163–70).
13. See Jensen and Meckling (1976).
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PART II
The theory of the firm from an organizational

perspective
4. A contractual perspective of the firm
with an application to the maritime
industry
Per-Olof Bjuggren and Johanna Palmberg*
1. INTRODUCTION
In 1776 Adam Smith developed a theory for markets as the coordinating

device in an economy. However, economic activities are not only coordi-
nated through the price mechanism of the market but are also guided by
firms within which the production of goods and services takes place. In
contrast to markets the firm is not so well developed in economic theory.
This is reflected, for example, in basic economic textbooks that usually
assume the firm as something exogenously given that need not be explained
or analyzed. After acknowledging the existence of firms, textbooks quickly
turn to the market and analyze its importance for a well-functioning
economy.1
However, since the early 1970s there has been rapidly expanding
research on the theory of the firm, largely inspired by an article dating back
to 1937 about the nature of the firm written by the Nobel laureate, Ronald
H. Coase. However, it took more than thirty years for researchers to draw
inspiration from the ideas put forward by Coase. In the 1970s (primarily)
Oliver E. Williamson continued along the line of research that Coase had
outlined. Since then theories of the firm have been a new expanding area
of research in economics. In this chapter, a contractual perspective on the
firm is used, with the concept of institution being an important corner-
stone, and a synthesis of different contractual perspectives on the firm as
the coordinating institution within the maritime industry.
This chapter recognizes the fact that the firm itself can enter into con-
tracts with other firms and physical persons. In a competitive environment
there is a strong tendency for the most cost-efficient composition of con-
tracts within a given institutional environment to survive (see, for example,
Fama and Jensen, 1983). We will apply such a contractual view. In addi-
tion to the production costs (remuneration to suppliers of different kinds
63
64 The theory of the firm from an organizational perspective
of inputs such as labor and capital services) these costs include information
costs and the costs for negotiating and monitoring contracts.
In line with transaction cost economics, we consider all transactions
to be costly. These transaction costs can then be used to explain market
structures as well as firms and other institutions (see, for example, Chapter
2 in this volume). The focus in this chapter is on the relationship between
contracts and transaction characteristics. The maritime industry offers an
interesting area of research for economists. Different theories developed
within the fields of financial economics, institutional economics, corporate
governance and industrial organization can be applied with good analyti-
cal results. A quick glance through the volumes of Maritime Policy and
Management illustrates this. Furthermore, the maritime industry is inter-
esting for contract theory since all different types of contracts ranging from
spot contracts to vertical integration are used in the industry. Also, the
organization of the shipping company is affected by third-party manage-
ment which in its extreme form separates ownership from control.
In the early 1990s an article by Stephen Pirrong demonstrated how
transaction cost analysis could be applied in the analysis of contracting
practices in maritime transport (Pirrong, 1993). We extend Pirrong’s anal-
ysis by applying transaction cost analysis both to the freight contract and
to the firm. The idea behind this chapter originates from a larger research
project on the Swedish shipping industry (see Johansson et al., 2006).2
Therefore the Swedish maritime industry is used for illustration. The mari-
time industry is a truly global industry; the Swedish ship-owners and their
counterparts all act on international markets. Hence, characteristics valid
for Sweden also apply to larger shipping nations.
Section 2 of the chapter starts with a presentation of our contractual view
of the firm, with maritime illustrations, and Section 3 offers a brief presenta-
tion of maritime transport and the different types of firms that operate in the
market. A closer look at different contractual compositions that character-
ize maritime transport firms with transaction cost and institutional explana-
tions is presented in Section 4, and Section 5 concludes the chapter.
2. A CONTRACTUAL PERSPECTIVE ON THE FIRM
In neoclassical economics the firm is often treated as a ‘black box’, but

viewing the firm as a ‘nexus of contracts’ (Jensen and Meckling, 1976;
Ståhl, 1976) results in a much richer analysis of market processes and
the allocation of resources in an economy. In this section the firm is dis-
cussed from a contractual perspective. First, an overview of the relation
between specialization and productivity and the need for coordination
A contractual perspective of the firm 65
Increased Mutual Coordination Institutional

productivity by dependence required solutions
division of labour
(specialization)
Figure 4.1 Specialization and institutions
and institutions (Section 2.1) is presented. Section 2.2 discusses the firm as
a contractual entity in depth. Section 2.3 concludes with an analysis of the
relation between contracts, markets and firms.
2.1 Specialization and Institutions
In an analysis of the organization of an industry, specialization is a crucial

concept since it fosters increased productivity. This is an important message
of the first chapter of Adam Smith’s Wealth of Nations (1776). With the
help of the famous pin factory example, Smith demonstrates in detail how
productivity is increased by specialization. However, specialization implies
increased mutual dependence and hence production must be organized in a
fashion that solves this mutual dependency. In Figure 4.1 this is expressed
as demands on proper institutional solutions created by the coordination
problem caused by mutual dependence due to specialization. (Institutions
are thereby defined as rules for individual interactions/cooperation.)
Firms and markets are alternative institutional solutions to the coor-
dination problem. We will start by looking at the firm as an institu-
tional arrangement to solve the coordination problem caused by factor
specialization.
2.2 The Firm as a Nexus of Contracts
An important feature of a firm is that it is a legal entity and can, just like
a physical person, enter into binding agreements (contracts) with other
physical and legal persons (see Ståhl, 1976). From this perspective the firm
can be seen as a ‘nexus of contracts’ that coordinates financial investors,
suppliers of intermediate goods, services and labor, and customers in the
production of goods and services. Figure 4.2 shows the firm from such a
contractual perspective.
The production factors human capital (H) and physical capital (K) can
serve as a starting point in a description of this contractual view of the
firm. These are the independent variables commonly used in production
functions such as Cobb–Douglas and CES. The firm can choose either
to own or to rent its physical capital. Ownership implies property rights
Shareholders
Suppliers of raw Creditors

The firm as a
material and goods production unit
and a nexus of
Suppliers of human contracts Users/
capital services customers
Suppliers of physical
capital services
= Guaranteed contracts = Residual contract
Figure 4.2 The firm as a nexus of contracts
with an exclusive right to use physical capital and the return from its use.
Furthermore, private property right is associated with an exclusive right
to transfer the property right through an agreement (contract) to another
person. A rental agreement implies a much more limited scope for deci-
sions about the use of the physical asset. In the maritime sector the most
important physical capital is the vessel. Both ownership and rental agree-
ments and combinations of these two alternatives are common amongst
ship-owners.
For labor there is a choice between an employment contract and hiring
of a consultant. An employment contract is much more open than a
contract with a consultant with regard to use of labor. The employment
contract makes it possible to use a hierarchical type of decision making
regarding the use of human capital, and thereby provides an opportunity
to replace the price mechanism of the market with administrative decisions
about resources allocation (see, for example, Coase, 1937; Masten, 1988).
One could say that the invisible hand of the market is replaced by the
visible hand of an organization.
In the shipping industry a wide range of contracts with labor can be
found. A phenomenon of special interest that will be discussed in more
detail below is the so-called third-party ship management, where the owners
of physical capital, the vessel, hire parts of or all labor and management
services from another company. (See Section 4.1 for further discussion.)
A firm’s financial contractual relations have governance implications.
The shareholders are considered the owners of the firm. Their contrac-
tual relation with the firm is characterized by a claim on the residual that
remains when all other contractual obligations of the firm have been met.
(They are residual claimants.) The return on their investment is therefore
directly related to how well the firm is managed. This dependency makes
it important to have a mechanism through which shareholders can control
how the corporation acts as a legal person. In most cases it is the board
of directors and the CEO who, on behalf of the firm, enter into binding
contracts with, for example, suppliers, employees and customers. It is thus
logical (understandable) that the shareholders directly or indirectly choose
who will have these positions.3
On the financial side of the firm there are also lenders (investors) with
fixed claims contracts (banks and bondholders). In contrast to the share-
holders they have specified claims on the firm in terms of mortgage plans,
maturity and interest claims. If the firm cannot meet these fixed claims it
can be forced into liquidation/bankruptcy. The remuneration that lenders
and also suppliers can get is then dependent on the value of assets to enti-
ties other than the bankrupted (liquidating) corporation. Fungible assets
with a well-functioning second-hand market are valuable to others and
can therefore serve as collaterals for loans. Consequently firms that have
such assets can to a larger extent than other firms use loans as a source of
finance (see Williamson, 1988).
In the maritime sector the vessel is in most cases a fungible asset. There
are well-functioning second-hand markets for vessels. The number of
alternative carriers and customers for carrier services is for some types
of vessels large enough to make the second-hand market competitive
(Stopford, 1997).
Finally, we turn our attention to the firm’s contractual relation with
suppliers and customers (contracts to be found on the input and output
sides of the firm in Figure 4.2). Value added chains, vertical integration and
supplier-specific/customer-specific specialization are important concepts
here.4 A value added chain shows the different stages in the processing of
a raw material to final consumer product; for example, from axe to loaf,
from stone to house, from iron ore to car. In a value added chain there are
several technologically separate stages. Between all these stages it is pos-
sible to envisage transport by ship that brings the output of one stage to
a succeeding stage. Just as a number of different contractual relations can
be found by the supplier and user in a value added chain, an equally rich
flora of contracts is found for the shipping of raw materials, intermediate
goods and consumer goods.
If the automotive industry is taken as an example, shipping can enter into
the value added chain in different stages of the processing of raw material
such as iron ore and steel in the manufacturing of a car for sale to a final
customer. Raw material such as iron ore might have to be transported by
a dry bulk carrier to a steel mill. Different automotive parts made of steel
might have to be transported over the sea in containers to the car manu-
facturer. The ready-made cars in turn have (if exported) to be shipped in
specially designed vessels to other countries.
2.3 Contracts, Markets and Firms
What is especially important from a contractual perspective is whether there

are assets whose productive value is dependent on uninterrupted transac-
tions between a specific supplier and customer.5 As indicated in Figure 4.1
it is usually specialization of assets that is the source of the mutual depend-
ence. Here, it is important to note the problems of sunk costs and quasi-
rents associated with investment in transaction-specific assets. A bilateral
dependence evolves immediately after the investment has been made and
there is no alternative equally attractive transaction partner within a spe-
cific price span. Klein et al. (1978) call this span the ‘appropriable quasi-
rent’ as it amounts to the part of the value of a specialized investment that
can be taken away without a change of employment of the factor.6
A rational supplier or customer is not prepared to make an investment in
an asset of a transaction-specific character without at least some guarantee
in the form of a long-term contract with a price that makes the investment
profitable. But, as pointed out by Williamson (1985), it is sometimes difficult
to construct such a long-term contract sufficiently watertight in terms of
no loopholes and at the same time sufficiently flexible to allow for changed
circumstances. This is especially the case if uncertainty and complexity char-
acterize the business in which the supplier and the customer are engaged.
Both of the requirements ‘water tightness’ and flexibility have to be met if
the long-term contract is to serve as a perfect institutional solution to the
problem of mutual dependence. But the rationality of human beings sets, as
noted by Williamson (1975, 1985 and 1996), a limit to what can be achieved
in terms of ‘water tightness’ and flexibility (the assumption of bounded
rationality). In a complex world, contracts are therefore bound to be more
or less incomplete with loopholes that invite opportunistic behavior.7
In transactions between firms with different owners there are conflict-
ing profit incentives in contract negotiations. While the supplier has a
profit incentive to obtain as high a price as possible, the customer’s profit
incentive is to get as low a price as possible. The conflicting profit incen-
tives make transactions costly if an appropriable quasi-rent due to asset
specificity exists. Hence, a long-term contract could be preferred to a spot
contract and, if the transactional problems are severe, vertical integration
(joint ownership) could be the most cost-efficient solution. At the same

time the strong (high-powered) incentives of independent firms to mini-
mize cost have to be factored in when the decision to vertically integrate is
contemplated. The cost minimization incentive is likely to be less powered
for a salaried manager than for an owner-manager (see Williamson, 1985,
and Chapter 2 in this volume).
With vertical integration, transaction costs may be avoided, as the incen-
tives are different in a firm and in the market. An employee-manager of a
division X, which supplies inputs to a division Y within the same firm, will
not be rewarded if she/he engages in costly negotiations that increase the
profit of division X at the expense of division Y and at the expense of the
overall profit of the firm. Instead the manager runs the risk of being fired.
Within the firm it is behavior of co-operation and not costly rival behavior
that will be rewarded.
The structure of vertical integration can take different paths, as can be
seen in the structure of shipping services in relation to cars and car manu-
facturers. For instance in cases such as that of container traffic there might
be a need of vertical integration forward with terminals in ports and train
carriers in order to secure smooth transport of parts to the car manufac-
turer. If, for example, parts of a car produced in Asia are transported on
a larger container vessel for assembly on the American East Coast there
might be the problem that the vessel cannot pass through the Panama
Canal. Consequently, the vessel has to go through a Californian port and
land transport might have to be used over the continent from west to east.
In order to speed up the handling in the port, special equipment might be
needed and it may thus be more efficient to use special railway wagons.
These are so-called dedicated assets that have to be available when the
vessel arrives.8 Vertical integration with terminals and wagons is therefore
an attractive solution (see Midore et al., 2005). In other cases, such as
oil tankers, there has instead been a trend of vertical disintegration (see
Veenstra and De la Fosse, 2006).
To summarize, a contractual relation depends on the nature of the asset
invested in. If assets are designed in one way or another to complement
each other, it is unlikely that the coordination of the use of assets in suc-
cessive stages of a supply chain will be left to an atomistic market. Some
safeguard is needed in order to make transactions efficient in such cases.
Vertical integration is one solution where the assets are controlled under
the same ownership. In other cases it will be sufficient to have some hybrid
contractual solutions aligning the interests of supplier and customer.9
Without any safeguard the conflicting profit incentives of supplier and
customer are a source of costly transactional problems. Mutual depend-
ence means that the interest of the supplier to increase revenue through
a higher price and the reverse interest of the customer to decrease cost
through a lower price will lead to clashes. If there are no alternative trans-
action partners to turn to, conflicts will have to be solved within a con-
tinuing transactional relation. Otherwise costly investments will lose value.
The vertical integration of container carriers can be explained in this way.
Terminals and wagons are dedicated assets that are necessary for keeping
down the costs of the vessels at ports (see Midore et al., 2005).
3. CHARACTERISTICS OF MARITIME TRANSPORT

– MARKET AND FIRMS
The maritime sector offers a wide spectrum of institutional arrangements,

which makes it an interesting field for contractual research. Economists with
a background in financial economics, institutional economics and corporate
governance will find contracts and organizational solutions a prospec-
tive area for empirical research. This section gives an overview of the rich
contractual and organizational pattern that can be found in the maritime
sector.10 Moreover, it attempts to give a transaction economics explanation
for the wide array of institutional arrangements in that sector.
3.1 The Freight Market
The maritime sector can roughly be divided into four types of markets (see
Figure 4.3). First there is tramp shipping. The tramp market is trafficked
primarily by tankers and bulk carriers. In this market, spot contracts and
forward contracts are the most commonly used contracts. Long-time char-
ters are also used but they are less common. The bulk market is diversified
with respect to various types of cargo, such as coal, ore, grain, and forest
products. Some of these products demand specially constructed (designed)
vessels; this implies that the ship-owner becomes more specialized and
more vulnerable to long-term changes in the market structure. Magirou et
al. (1992) give an excellent review of the freight market.
A second market is liner shipping. The goods shipped in this market are
higher up in the value added chain and are often transported in contain-
ers and various types of ro-ro vessels. In this market the shipper–client
relationship is more long-term than in tramp shipping. Moreover, vertical
integration forward in the logistic chain is found in the form of ownership
of terminals in ports and special train wagons. Some of the goods have to
be delivered just in time, which increases the mutual dependence of the
assets in these later stages of the logistic chain. Another contractual dif-
ference between the tramp and liner markets is that the freight contract in
Ship-owners
Liner shipping Ferry traffic

Tramp market Special cargo
Perfect competition Markets are often shipping
cartelized Long-term contracts
Tank Bulk
Standard cargo
General cargo
(Container-, ro-ro vessels)
Spot contracts or time charters
(forward contracts)
Source: Johansson et al. (2006) based on Magirou et al. (1992).
Figure 4.3 Structure of the freight market
the tramp market is focused on the vessel whereas in the liner market the
contract is focused on the transport.
There are differences also in terms of the market structure between the
tramp and the liner market. The tramp market is characterized by (almost)
perfect competition. Sea transport is supplied by ship-owners and bought
by charterers. In contrast to the tramp market the liner market is to a large
extent cartelized. Groups of shippers come together in so-called liner con-
ferences in order to negotiate prices and to supply sea transport to different
trades. The ship-owners therefore have to compete on factors other than
price such as service and times of transport. Due to containerization the
liner conferences have declined in importance to the pricing strategy.
A third shipping market is the ferry/cruise market. A strong parallel
can be drawn between this market and the aircraft industry. A certain
route is used. Terminals and other dedicated assets have to be invested in.
However, the assets (the vessels) are not transaction specific to a specific
route. They can rather easily be transferred to another ferry route.
Finally there is special cargo shipping, to which car carriers and forest
sea transport belong. Special shipping is characterized by long-term cus-
tomer adaptation; usually the COA (contract of affreightment) is applied.
Swedish ship-owners mainly operate within the tramp market or special
cargo shipping. These vessels are designed for goods that are processed so
far that they are downstream near the end of the value added chain. The
receiver of the good is a retailer selling a good to the final consumer. Here,
we find long-term contracts and vertical integration.11
3.2 The Freight Contract
The shipping industry is characterized by at least four types of market

structures, ranging from almost perfect competition on the tramp market
to cartelization on the liner market. The different types of markets also
use different types of freight contracts. This section focuses on the bulk
market. (The other types of markets are to a larger extent characterized
by long-term freight contracts.) In principle there are three types of freight
contracts used in the bulk market: (i) the voyager charter, (ii) the time
charter and (iii) the contract of affreightment (COA). The time span and
the intensity in the contract between the shipper and the carrier depend
partly on the type of freight contract and partly on the extent to which the
carrier uses the same shipper (Pirrong, 1993).
The voyager charter implies that the shipper transports a single cargo or
a series of shipments during a given time period. This freight contract has
the shortest time span. The charter is directed at the vessel, which means
that the ship-owner transports one cargo from one port to another. The
contract is traded on the spot market and ceases, in normal cases, directly
after the cargo has been discharged at the port. The time charter, on the
other hand, is used by a carrier who wants to carry out the transport
process on their own. The time charter implies that the carrier exercises
command over the vessel for a specified time period. The charterer is
responsible not only for the commercial operation of the vessel but also
for the variable costs of the vessel such as port charges, canal dues, costs
for loading and discharging, stowing, and so on. The ship-owner is, on the
other hand, responsible for the maintenance and the nautical operation of
the vessel and for the fixed costs of the vessel, interest on equity, deprecia-
tions, and so on (Gorton et al., 1989; Johansson et al., 2006).
The third type of freight contract is the COA. This is a long-term con-
tract spanning between 3–4 years and 15 years. The COA implies that it
is only the vessel that is leased. The charterer is responsible for the crew,
insurance, maintenance, inspections, and all variable costs. The contract
is often detailed and specifies the type of cargo, minimum and maximum
volumes carried over specific time periods, destination and origin ports,
and so on (Pirrong, 1993).
3.3 The Shipping Company
The organization of the shipping company is decided by factors such as

type of shipping activities, type of market on which the company operates,
and the size of the company. The structure of a company operating on
the spot market differs from the structure of a liner shipping company. A
Liner department
– Operational department Tramp department
– Freight booking – Affreightment
– Freight office and accounting – Calculation
– Reloading – Operational department
– Marketing/sales
The shipping
company
Administrative department
Technological department
– Financial and accounting
– Construction
– Personnel department
– Operating
– Law
– Inspection
– IT
– Maintenance
–‘Ship management’
– Commissariat service
– External and internal information
Source: Based on Nya Sjöfartens Bok, 2006 (2005).
Figure 4.4 Business structure of a large shipping firm
shipping company operating on the tramp market has, in general, only two
departments: administrative and technical. Shipping companies that time-
charter their vessels for shorter time periods also have an affreightment
department. The liner shipping company has the largest administrative
department, with many employees and agents across the globe. Smaller
shipping companies usually have a small administrative department and
it is common that the onboard crew takes many of the decisions regarding
the firm (Nya Sjöfartens Bok, 2006).
Figure 4.4 shows how a shipping company can be organized. It is only
the larger shipping companies that have all the different departments dis-
played in the figure. In general, the shipping company operates on either
the liner market or the spot market. Smaller shipping companies purchase
administrative and technical services instead of providing them internally
in the company, as shown in the figure.
The liner department is responsible for all the regular traffic that the ship-
ping company controls. The business is carried out both from the head office
and from subsidiaries. In addition, the liner shipping company purchases
services from shipping agencies (brokers) in ports where it is not located.
The tramp department is responsible for all the vessels that are leased on the
open spot market. That is, the department is responsible both for the charter-
ing and for the commercial operation of the vessels. It is also responsible for
the purchasing and the selling of vessels. The administrative department is,
in the ideal case, dynamic and well able to follow the fast development that
characterizes the shipping industry. In general, one can say that the larger
the shipping company the more of the administrative services are handled
internally in the company; smaller shipping companies purchase various

administrative services to a larger extent (Nya Sjöfartens Bok, 2006).
4. THE ECONOMIC ORGANIZATION OF

MARITIME TRANSPORT AND MARITIME
FIRMS FROM A CONTRACTUAL PERSPECTIVE
A general finding is thus that the contractual relation seems to depend on
the good’s place in the value added chain. Raw material is transported
according to spot contracts. In these markets perfect competition can be
recognized. When we go further up the value chain and come closer to the
final consumer good, the contractual relations exhibit more of a long-term
character and asset specificity explanations can be found.
The distinction between firm and market also varies in an interesting
way. Third-party management is a phenomenon that illustrates the fact
that labor (the crew) is not tied to the asset (the vessel) to the same extent
as in other industries. Instead, it is possible to have an arm’s-length relation
between labor and capital to an extent not found in other industries.
4.1 Third-party Ship Management
Third-party management is a denomination for a complete separation of

ownership and control in maritime transport. That is, a professional man-
agement company manages ships owned by another company. In our con-
tractual model (see Figure 4.2) it is at its extreme the same as breaking up
the firm into two halves. Ownership and financing of physical capital are
put in one company that contracts with another company for the supply
of human capital services and other inputs necessary for the production of
maritime transport services. There is no employment relation connecting
capital ownership and labor. The ship-owner cannot influence the use of
the ship through fiat. A contract between two separate firms decides how
the use of capital and labor shall be coordinated. Contract (market) has
replaced the firm as a coordination mechanism.
In the extreme case, a ship-management company takes over all the
activities outlined in Section 3.3 (Figure 4.4). Mitroussi (2003) describes
it thus:
once a ship owner assigns activities, like crewing, technical and freight manage-
ment, insurance, accounting, chartering, provisions, bunkering operations and
sale and purchase of a vessel, in essence he or she gives up, together with the
full management, control of his assets to third parties with no ownership rights
in them. (p. 81)
However, in practice ship managers seldom go to this extreme. In

another study Mitroussi (2004) shows that in the majority of cases the firms
assign crewing, technical management, service, accounting and operations
to independent managers. The extreme division of ownership and control
indicates that the asset specificity in the relationship between capital and
labor is not large. The crew of a tanker, a bulk carrier or a container ship
can serve equally efficiently on vessels owned by different firms. In line
with Williamson (1996, Chapter 3), the high-powered incentives in an
arm’s-length (market) relation can be used and the price for transport
services is in most cases given. With a given price, cost minimization
becomes important. A ship-management company has higher-powered
incentives to minimize cost than an employee. Furthermore, as also noted
by Williamson (1996, Chapter 3, p. 66), ‘markets can sometimes aggregate
demands to advantage, and thereby realize economies of scale and scope’.
The possibilities to reap economies of scale and scope are mentioned by
Panayides and Cullinance (2002) as the main rationale for use of third-
party management.
The ship-management companies are usually subsidiaries of larger ship-
owners. The knowledge and the experience from operating vessels thereby
remain within the company. Important customers of the ship-management
firms are large multinational oil and manufacturing companies that have
built up their own fleet. The rationale behind owning a fleet is lower costs
of transport as well as the possibility to control the supply of sea transport.
Furthermore, the cost of letting a ship-management company operate the
vessel is often lower than the cost of developing a department within the
existing company. It is also common that the ship-owner purchases man-
agement services in order to learn how to operate a vessel (Nya Sjöfartens
Bok, 2006; Branch, 1988).
4.2 A Wide Array of Contracts in Maritime Transport
The prevalence of the diversity of contracts in maritime transport cannot

fully be explained by the types of asset specificity enumerated in Williamson
(1985), for example, site, physical asset and human asset specificity.
Vessels, in general, are not built to serve a specific shipper (customer), with
the exception of vessels used in special shipping. Most of the vessels used in
bulk shipping are, as pointed out by Pirrong (1993), not customer-specific
in the same sense as site specificity and asset specificity. Furthermore, the
use of third-party management indicates that human asset specificity is
not as important as in other industries. Instead time and space consid-
erations give rise to what Masten et al. (1991) call ‘temporal specificities’
and Pirrong (1993) claims that this type of specificity is common in bulk
shipping. Temporal specificities are, according to Pirrong, the explanation

as to why some contracts are more commonly used at some freight markets
than at others. Appropriable quasi-rents exist because ‘delays in shipment
cause great harm on the shipper and the carrier’s next best cargo shipping
opportunity is sufficiently distant’ (Pirrong, 1993, p. 942). This temporal
specificity can be costly to handle in spot market transactions. Some type
of safeguard represented by a long-term contract or other type of binding
between shipper and carrier has to be imposed.
In markets where forward and time contracts are common a second
type of specificity can arise due to the time span of the contract, namely
contractual specificities. These arise in the vacuum after the expiration of
the contract when all other vessels and cargos are engaged in other freight
contracts. During this time period, when all other shippers and carriers
are tied up in other contracts, the previously contractually related carrier
and shipper are in a bilateral monopoly situation. The transaction costs
of entering into a new agreement then increase considerably and there are
incentives for strategic behavior. The cost of contractual specificities can,
however, be mitigated by an increasing number of contracts that expire
repetitively. Both the shipper and the carrier then have a number of poten-
tial new partners. Costs associated with forward contracting, such as cost
of lower flexibility and the cost of opportunistic behavior, increase with the
time span of the contract, whereas contractual specificities lead to longer
freight contracts and vertical integration (Pirrong, 1993).
In freight markets where specialized vessels are common, for example,
for car transports and wooden products, the probability of long-term gaps
between expiration dates of different short- and medium-term contracts
is high. From a transaction costs perspective the shipper can then gain by
buying its own vessel, that is, be independent of ship-owners. Long-term
contracts are yet another way of reducing the transaction cost.
Temporal and contractual specificities do determine the design of the
freight contract. Spot contracts are used at markets where temporal spe-
cificities lack importance, whereas long-term freight contracts and vertical
integration exist on markets associated with significant temporal specifici-
ties caused by ‘i) market thinness, ii) the unavailability of supplies of the
shipped commodity from non-firm specific resources, or iii) efficiencies
arising from the use of specialized tonnage’ (Pirrong, 1993, p. 951). In
Table 4.1 the different types of bulk markets are analyzed from a contrac-
tual perspective.
Spot contracts should be used when there is no temporal specificity
apparent, that is, when there is a no in each of the three boxes following
each commodity respectively. Accordingly spot contracts are used for
freights for commodities such as grain, oil (post-1973), fertilizers and
Table 4.1 Contracting practices in bulk shipping
Commodity Firm-specific Specialized Thin Typical contract

supplies vessels market
Grain No No No Spot
Oil post-1973 No No No Spot
Oil pre-1973 Yes No No MTC or VI
Thermal coal pre- No No No Spot
1980
Thermal coal Yes Yes/No No LTCOA for large
post-1980 ships, MTC for
others
Coking coal Yes Yes/No – LTCOA for large
ships, MTC for
others
Fertilizer No No No Spot
Scrap No No No Spot
Iron ore Yes Yes Yes LTCOA or VI
Great Lakes ore Yes Yes Yes LTCOA or VI
Wood chips Yes Yes Yes LTCOA or VI
Lumber Yes Yes Yes LTCOA or VI
Cement Yes Yes Yes LTCOA or VI
Bauxite Yes Yes Yes LTCOA or VI
Liquified natural Yes Yes Yes LTCOA or VI
gas
Autos Yes Yes Yes LTCOA or VI
Note: LTCOA 5 long-term contracting, VI 5 vertical integration, Spot 5 spot

chartering, and MTC 5 medium term chartering.
Source: Adopted from Pirrong (1993, p. 974).
scrap, transported with general vessels, in thick markets and without firm-
specific supply. Various kinds of time charters are used when the market is
characterized by firm-specific supplies, specialized vessels or thin market.
In these markets both time specificities and contractual specificities are
significant.
Freight market characteristics can change over time; for example, the
characteristics of the market for oil shipping changed considerably during
the late 1970s, from forward contracts and time charter (MTC or VI)
into spot contracts.12 This change displays the major role that temporal
specificities play in contracting practices. Also, the change in contracting
practices took place when firm specificity became less important. Before
1973 most of the contracting with crude oil producers consisted of forward
and time charters. At this time the crude oil producers in the Middle
East, West Africa, and Indonesia supplied the major oil refiners – British
Petroleum, Exxon, Gulf, Mobil, Royal Dutch Shell, Socal and Texaco –
with crude oil on equity contracts or preference agreements. These market
conditions resulted in temporal specificities. At the same time there was an
excess supply of tankers which mitigated contractual specificities. During
the 1970s political as well as economical changes took place in countries
belonging to the Organization of Petroleum Exporting Countries (OPEC).
These changes resulted in a drastic reduction in the use of forward con-
tracts and time charters. The process, towards spot contracts, was sup-
ported by the development of spot oil markets in the Netherlands, the US
and the UK.
To summarize, the above reasoning demonstrates that firm specificities
can create temporal specificities which in turn give rise to the use of forward
contracts, time charters and vertical integration. The increased use of spot
contracts increased the flexibility, which lowered the transaction costs of
spot contracting.
5. CONCLUDING REMARKS AND DISCUSSION
This chapter presents a contractual perspective of the firm that highlights

the function of the firm as a common contracting partner to suppliers,
customers, labor, capital and financiers. The nature of contracts concluded
is in our model dependent on the degree of mutual dependency. A high
degree of mutual dependency requires safeguards that can be provided in
the form of long-term contracts, an employment relation or joint owner-
ship of assets in different stages of a value added chain.
The maritime industry is analyzed from a contractual perspective with
special focus on the link between the carrier and the shipper. We present a
synthesis of different contractual perspectives on the firm as a coordinating
institution. The maritime industry is interesting due to the wide variation
of contracts used, ranging from spot contracts, forward contracts and time
charters to vertical integration. It is also interesting that in comparing dif-
ferent freight markets there is a large variation going from one extreme to
another. The tramp market is characterized by (almost) perfect competi-
tion whereas the liner market is characterized by cartels.
In general there are three types of freight contracts, the spot contract,
the time-voyager and the contract of affreightment (COA). The choice of
contract depends not only on the position of the commodities in the value
added chain but also on the existence of temporal specificities. The spot
contract is used on tramp markets mainly for raw material such as oil and
grain where no temporal specificities prevail. Commodities higher up in

the value added chain are most often transported with forward contracts
or time charters. In addition, these markets are characterized by temporal
specificities due to political and economic changes in the contract practices
over time, such as in the shipping of oil. This example highlights the fact
that firm specificities can create temporal specificities which induce the use
of forward contracts and time charters in an industry that due to its char-
acteristics normally should apply spot contracts.
The existence of third-party ship management in the maritime industry
is also an interesting phenomenon. It sheds light on complete separation
of ownership and control. In this case the relation between physical and
human capital is regulated by a contract. This in turn indicates that there is
a relatively low degree of asset specificity regarding capital and labor in the
maritime sector. When third-party management is applied, the allocation
of resources is replaced by a contract.
There is also a strong relation between commodity specialization and
firm structure. For example, firms operating mainly on the spot market
are usually smaller whereas firms on the liner and ferry markets usually
are relatively large. The existence of temporal specificities therefore affects
both the firm structure and the design of the freight contract.
NOTES
* Corresponding author.
1. However, it is a plain vanilla theory of markets. No attention is paid to differing con-
tractual aspects of markets (see Williamson, Chapter 2 in this volume).
2. The report has benefited from excellent comments and branch-specific knowledge sup-
plied by P.A. Sjöberger, Swedish Shipowners’ Association.
3. In many cases CEO, chairman and largest shareholder can be one and the same person.
4. Value added chains can be used to show the different stages in shipping. For example the
Swedish shipping companies Broström AB and Wallenius AB use comprehensive freight
contracts that include several steps in the supply chain. Instead of buying these serv-
ices from other logistic firms the ship-owners develop them internally in the company
(Johansson et al., 2006).
5. Williamson (1985, 1996 and Chapter 2 in this volume) uses the term ‘asset specificity’ in
his description of such a dependency.
6. Klein et al. (1978) make a distinction between use and user when defining an appropri-
able quasi-rent. While the concept quasi-rent according to them refers to how much
the value of an asset in current use exceeds the value of an asset in its best alternative
use, appropriable quasi-rent denotes the difference in value in relation to what the next
highest valuing user is prepared to pay for the service of the asset.
7. According to Williamson (1975, 1985, 1996) bounded rationality refers to the limited
capacity of the human mind to conceive and evaluate all alternatives pertinent to a
decision. Opportunistic behavior in turn means to give false or self-disbelieved prom-
ises about the future or self-interest seeking with guile; to include calculated efforts to
mislead, deceive, obfuscate, and otherwise confuse.
8. According to Williamson (1996, p. 105) dedicated assets are ‘discrete investments in

general purpose plant that are made at the behest of a particular customer’.
9. By hybrid one means ‘Long-term contractual relations that preserve autonomy but
provide added transaction-specific safeguards, compared with the market’ (Williamson,
1996, p. 378).
10. Section 3 is based on Johansson et al. (2006).
11. See for example the Swedish companies Wallenius Wilhelmsen Line and SCA.
12. The following discussion is based on Pirrong (1993).
REFERENCES
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Chapman & Hall, London.
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in O.E. Williamson and S. Winter (eds) (1991), The Nature of the Firm: Origins,
Evolution, and Development, New York: Oxford University Press, pp. 18–33.
Fama, E.F. and Jensen, M.C. (1983), ‘Separation of Ownership and Control’,
Journal of Law and Economics, 26:301–26.
Gorton, L, Ihre, R. and Sandevärn, A. (1989), Befraktning, edition 3–1, Liber
Hermods, Läsprodukter AB, Halmstad.
Jensen, M. and Meckling, W. (1976), ‘Theory of the Firm: Managerial Behavior,
Agency Costs, and Capital Structure’, Journal of Financial Economics, 3:305–60.
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ekonomiska och geografiska nätverk och kluster, Institutet för Näringslivsanalys,
http://www.ihh.hj.se/doc/3707.
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Appropriable Rents, and the Competitive Contracting Process’, Journal of Law
and Economics, 21:297–326.
Magirou, E., Psaraftis, H.N. and Christodoulakis, M.N. (1992), ‘Quantitative
Methods in Shipping: A Survey of Current Use and Future Trends’, Centre for
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Masten, S. (1988), ‘A Legal Basis for the Firm’, Journal of Law, Economics, and
Organization, 4:181–98.
Masten, S., Meehan Jr., J. and Snyder, E. (1991), ‘The Cost of Organization’,
Journal of Law, Economics, and Organization, 7:1–22.
Midore, R., Musso E. and Parola, F. (2005), ‘Maritime Liner Shipping and the
Stevedoring Industry: Market Structure and Competition Strategies’, Maritime
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Mitroussi, K. (2003), ‘Third Party Ship Management: The Case of Separation of
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Mitroussi, K. (2004), ‘The Ship Owners’ Stance on Third Party Ship Management:
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Pirrong, S.C. (1993), ‘Contracting Practices in Bulk Shipping Markets: A

Transaction Cost Explanation’, Journal of Law and Economics, 36(2):937–76.
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(1976), Harmondsworth: Penguin Books.
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Group, London.
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of Finance, 43:567–91.
Williamson, O.E. (1996), The Mechanisms of Governance, New York: Oxford
University Press.
5. The use of managerial authority in
the knowledge economy
Kirsten Foss
1. INTRODUCTION
This chapter contributes to the ongoing debate in diverse literatures,

including management, sociology and economics, on the issue of the use
of authority. The debate has re-surfaced with the focus on the emerging
knowledge economy. In that debate a number of management academics
and sociologists have argued that authority relations will strongly dimin-
ish in importance or at least change significantly in character.1 More spe-
cifically, these writers have argued that the exercise of authority is, if not
outright impossible, at least not efficient and will be substituted by different
means of organizing the production of knowledge intensive goods and
services. More discretion will be granted to knowledge workers and this
will result in an eruption of the hierarchical structures of organizations.
Such predictions are a serious concern for those theories, notably trans-
action cost theories (Coase, 1937; Williamson, 1985) and property rights
theory (Hart and Moore, 1990; Hart, 1995, 1996), that place emphasis on
authority relations as the mode of coordination that primarily character-
izes firms. Thus, explanations of the existence and boundaries of firms that
rely on authority are challenged. Part of the reason behind the prediction
of the decline of the importance of authority relations is the assertion that
firms will experience a tension between the exercise of authority by supe-
riors based on their position in the hierarchy and the exercise of authority
by knowledge workers based on their great expertise in certain areas. As
superiors come to lack information about the tasks that are carried out
by knowledge workers, and as knowledge workers gain bargaining power
because of their control of crucial information, the economic importance
of the authority of the position in a hierarchy will diminish.
However, this claim is based on a much too narrow conception of what it
means to exercise the authority of the position. Orders are merely one way
of exercising authority; superiors may, for example, also define goals, set
restrictions for employees regarding the use of firm resources, or implement
82
The use of managerial authority in the knowledge economy 83
various restrictions (N. Foss, 2001). If all such uses of authority decline in
importance as means of coordinating activities in firms, we should be able
to find an economic rationale for this. However, in order to do so we must
first understand the economic rationale for the use of authority as a means
of coordinating economic activities in order to discover whether the condi-
tions for the use of such authority have changed. In this chapter I provide
efficiency explanations for the use of different forms of authority in firms
and argue that we may expect the use of different types of authority of the
office in conjunction with experts who may possess authority based on their
expertise. The questions to be addressed in this chapter are the following:
● Can the use of authority co-exist with the delegation of discretion

within a contract?
● If so, what factors can change the use of authority relative to the use
of market contracts as a means of organizing productive activities?
● Is it likely that a move from the capital intensive to the knowledge
intensive economy will change the relative use of authority?
2. WHAT IS AUTHORITY?
The concept of authority is closely linked to the sociological literature

on bureaucracy (for example, Weber, 1946, 1947) and organization
and behavioral theories, usually drawing on sociology and psychology,
present a number of interpretations of authority (Simon, 1951; Blau, 1956;
Thompson, 1956; Grandori, 2001). It would be a hopeless task to present a
full review and critical evaluation of the multitude of definitions and ideas
regarding the concept of authority. For the purpose of this chapter the
concept of authority as defined by Barnard (1938) and Simon (1951, 1991)
serves as a starting point for the development of the terminology adopted
here. Both Simon and Barnard employ the concept of ‘willingness to obey’
(Simon, 1951, p. 126).
Simon (1951) defines authority as obtaining when a ‘boss’ is permitted
by a ‘worker’ to select actions, A0 , A, where A is the set of the worker’s
possible behaviors. More or less authority is then defined as making the set
A0 larger or smaller. Simon develops a model (specifically, a multi-stage
game in the context of an incomplete contract with ex post governance),
where, in the first period, the prospective worker decides whether to accept
employment or not. In this period, none of the parties know which actions
will be optimal, given circumstances. In the next period, the relevant cir-
cumstances as well as the costs and benefits associated with the various
possible tasks are revealed to the boss. The boss then directs the worker to
a task, which – for the latter to accept it – must lie within his or her ‘zone
of acceptance’.
An important feature of authority thus is that the authority of a superior
is constrained by the subordinate’s acceptance of it. ‘A subordinate may
be said to accept authority’, Simon (1951, p. 22) explains, ‘. . . whenever
he permits his behavior to be guided by a decision reached by another,
irrespective of his own judgment as to the merits of that decision.’ Simon’s
use of the notion of authority is akin to that of Coase (1937), who defines
an authority relation as ‘one whereby the factor, for a certain remunera-
tion (which may be fixed or fluctuating), agrees to obey the directions of
an entrepreneur within certain limits. The essence of the contract is that it
should only state the limits to the powers of the entrepreneur. Within these
limits, he can therefore direct the other factors of production’ (idem, p.
242). Coase (1937), Bernard (1938), and Simon (1951) all linked the notion
of authority to entering into an employment contract. Others, however,
have argued that an employment relation is not a necessary condition for
the use of authority (Alchian and Demsetz, 1972; Cheung, 1983).
3. AUTHORITY IN FIRMS AND MARKETS
Many contributions to the understanding of authority share the – some-

times implicit – assumption that if complete contingent markets existed,
price coordination would suffice. This was indeed Coase’s point of depar-
ture in ‘The Nature of the Firm’ where he posed the question, ‘Why do
firms exist?’ The reason for the existence of firms is that there are costs of
using the price mechanism and that ‘[t]he most obvious cost of “organiz-
ing” production through the price mechanism is that of discovering what
the relevant prices are’ (Coase, 1937, p. 21). When there are high transac-
tion costs firms pose an alternative to markets as a means of achieving
coordination, because the firm allows for the use of authority as a means
of allocating resources comparable to bargaining and contracting in
markets.
In parts of the economic literature, authority has been linked to the
employment contract (Coase, 1937; Simon, 1951; Williamson, 1985) and
firm coordination is seen as different from market coordination due to the
use of employment contracts. According to Coase an employment contract
is preferred: ‘owing to the difficulty of forecasting, the longer the period of
the contract is for the supply of the commodity or service, the less possible,
and indeed, the less desirable it is for the person purchasing to specify what
the other contracting party is expected to do’ (Coase, 1937, p. 21). Thus,
the employment contract is a long-term contract for an unspecified labor
service. Managed direction of resources substitute for price direction of

resources when parties to transactions realize that contingencies of dif-
ferent sorts may in an unpredictable manner disrupt the choice of action
or the timing and sequencing of interdependent activities (see Wernerfelt,
1997).2
However, there are also costs of using authority (that is, managed
direction) which define the efficient limits for the use of authority. In an
economy characterized by uncertainty with respect to the actions that
need to be taken, the main costs of using authority stem from the ‘increas-
ing opportunity costs due to the failure of entrepreneurs to make the best
use of the factor of production’ (Coase, 1937, p. 23). According to Coase
(1937),
the costs of losses through mistakes will increase with an increase in the spatial
distribution of transactions organized, in the dissimilarity of the transactions,
and in the probability of changes in the relevant prices. As more transactions
are organized by an entrepreneur, it would appear that the transactions would
tend to be either different in kind or in different places. (p. 25)3
Managers, in other words, have limited capacity to ‘discover the relevant

prices’ and this increases mistakes as more dissimilar transactions are
organized in a firm.
Simon (1951) also links firms and authority to the use of the employ-
ment contract. Like Coase, he perceives of the employment contract as
a contract for unspecified labor services. Uncertainty also constitutes the
essence in the explanation provided by Simon (1951) of the use of employ-
ment contracts and authority as a means of coordination. The employment
contract grants the right to the employer to postpone the decision about
what services to demand from the employee until he obtains the relevant
information on which to base the decision. However, limits to the use of
authority are not due to managerial mistakes, as in Coase, but to the differ-
ences in costs of fulfilling the participation constraints of an employee and
an independent contractor. Therefore the use of authority is efficient only
when contractual adaptation is critical to one party while the other party
is nearly indifferent as to the actions he carries out.
The Coase–Simon view compares adaptations to uncertainty by means
of authority and by means of re-contracting among independent agents.
Authority differs from bargaining power in that authority is voluntarily
granted by one party to another on the basis of efficiency considerations.
This clear-cut distinction between bargaining power and authority is not
present in later developments of the concept of authority within property
rights theory as defined by, for example, Hart (1991, 1995). This theory is
based on the assumption that the main problem of coordination is that of
providing the right incentives for investing in situations where there are
high costs of describing the relevant investments to be made and the output
to be delivered. This kind of transaction cost makes it impossible for the
contracting parties to use a third party (courts) as a means of enforcing
original promises, thus creating a situation where the parties expect re-
contracting over the created surplus. Firms represent an efficient choice
of enforcement of contracts because of the bargaining power they posses
in the re-contracting situation. For example, Hart defines the firm as the
physical assets over which a legitimate owner has formal residual user
rights. Having residual user rights over assets provides the firm with a bar-
gaining power that is different from that which characterizes transactions
that take place between individual owners of assets. The limits to the use
of authority depend on the parties’ incentives to invest in non-contractible
assets when ownership of assets is centralized as in firms and when it is
dispersed as in markets.
The property rights theory shares its strong focus on incentive alignment
as the central coordination issue with agency theory. Both assume that the
best uses of resources are already known and that the problem of coor-
dination arises due to asymmetric information on some relevant aspects
relating to the contractual execution. In principal–agency literature asym-
metric information introduces the need for different contractual designs, of
which some may include ‘authority’. In the work of Alchian and Demsetz
(1972) teamwork creates one of the situations in which the use of authority
serves the purpose of improving the efficient use of labor inputs for given
ends. With teamwork it is costly to separate the contribution of each par-
ticipant, creating incentives for moral hazard. The solution to such a team
problem is to set up an organization (but not necessary a firm) which will
economize on metering costs so as to better allocate rewards in accord with
the effort delivered. A monitor specialized in metering effort is granted by
the members of the team the authority (or right) to alter membership of
the team in order to improve incentives for work effort.4 Thus, specializa-
tion advantages in monitoring and more advanced incentive schemes than
those that can be devised for re-contracting between independent indi-
viduals (with definite time horizons) help overcome incentive problems.
Authority in this conception is based on a granted right (as in Coase and
Simon) but it is not necessarily related to the use of employment contracts,
nor is it granted because of the need to adapt to unforeseen changes.
These ideas are similar to those of Cheung (1983), who emphasizes
that there is a wide spectrum of contracts, ranging from pure spot market
contracts to order contracts, from piece rate contracts to employment con-
tracts. All contracts, with the sole exception of pure spot market contracts,
include some instructions or restrictions or are accompanied by orders.
As Coase (1937) did, Cheung (1983) stresses the cost of discovering the
relevant prices as the reason for this wide spectrum of contracts. However,
the reasons he provides as to why prices are substituted by other means
of coordination differ somewhat from those of Coase (1937), since he
stresses the cost of measuring the relevant attributes of goods and services
as the main reason for lack of complete contingent contracts. According
to Cheung, such measurement costs are likely to be high ‘[i]f the activities
performed by an input owner change frequently [and] if these activities
vary greatly’ (Cheung, 1970, p. 7). Moreover, it may simply be too costly
to separate the contribution of each party to the production of a consumer
good. In other words, measurement costs may cause team problems. In
contractual relations characterized by high measurement costs, ‘it tends to
be more economical to forgo any direct measurement of these activities and
substitute another measurement to serve as a proxy’ (ibid.). For example,
instead of contracting for the use of a secretary to type a certain letter at a
certain place at a certain time, one may contract for the unspecified labor
service of the secretary for a given period of time and a given pay per time
period. However, when a price for each job to be done by the secretary
cannot be specified, the contract needs to be supplemented by directions/
instructions (or orders). The relation between remuneration of the input
and the valued attributes of the output may be more or less imprecise
and therefore require more or less instructions.5 We should, according to
Cheung, expect an extensive use of orders where measurement costs makes
it efficient to use flat wages rather than payments that more fully reflect the
contribution of the subordinate to the quality of the final consumer good.
The principal–agency literature on firms (Cheung, 1970; Alchian and
Demsetz, 1972) emphasizes that orders and restrictions are not unique
to the employment relation and the exercise of authority not confined to
firms. Nor does it view differences in bargaining power as discriminating
firms (or employment contracts) from markets. This point of view is most
clearly expressed in Alchian and Demsetz (1972), who claim that ‘[i]t is
common to see the firm characterized by the power to settle issues by fiat,
by authority, or by disciplinary actions superior to that available in the
conventional market. This is a delusion’ (p. 72). An employer has, in their
opinion, no different means at his disposal for punishing disobedience than
individual contractors have. According to this view every single instance
of the exercise of authority is based either on implicit agreements or on the
bargaining power of the parties in the relation. The conclusion one may
derive from Cheung (1970) and Alchian and Demsetz (1972) is that author-
ity exists in the same form and to the same degree in markets and in firms.
This view is contrasted by those who emphasize the differences in
the legal conditions that support the private exercise of authority (as
enforcement of contracts) within firms compared with the use of market

contracts (Williamson, 1985; Masten, 1991; Vandenberghe and Siegers,
2000). First, employment law requires that orders or instructions are
carried out, restrictions implemented by an employer are respected and
disputes about their merits and legitimacy are settled after the completion
of the order. Williamson (1985), for example, describes firms as their own
ultimate court of appeal. Second, the rights of the employer to monitor and
sanction actions differ in employment and market contracts (Masten 1991).
The extended right to monitor employees complements the functioning of
authority as a means of solving disputes. For example, an employer may
have better access to knowledge of relation-specific non-contractible invest-
ments than courts. Thus, although restrictions, directions and orders can
be found in market contracts, they differ from employment contracts in the
legal frame that supports the contracts. Market contracts do not provide
one of the parties with the formal (and legally supported) right to make
decisions without the consent of the other party. Adaptations can be made
if there is no conflict of interest between the parties or a verifiable mecha-
nism (such as elevator clauses) of contractual adjustment is agreed on in the
contract.6 That is, measurement costs explain why contracts contain more
stipulations than just the price and the item. However, only uncertainty or
partly unpredictable volatility makes it necessary to use managerial discre-
tion to make ex post adaptation of these instructions and stipulations.
3.1 Formal and Real Authority
The notion of authority as supported by firm governance structure does

not imply that firms (or more precisely managers) are always able to exer-
cise the authority they are legally entitled to exercise. That is, employees
may exercise discretion and avoid the restrictions, instructions and orders
issued by managers. This introduces a distinction between formal and real
authority (Aghion and Tirole, 1997, p. 1). Whenever there is a legally rec-
ognized employment relation we find formal authority in the sense of an
attribute that is attached to the role of an employer (for example, Weber
uses the notion of bureaucratic authority or authority of the office). The
employment relation supports the use of authority of the position (formal
authority) but formal authority does not necessarily convey real authority
which is ‘an effective control over decisions, on its holder’ (Aghion and
Tirole, 1997, p. 1).7 That is, employees may exercise discretion within the
authority relationship.
Discretion can broadly be defined as the ability of an agent to control
or consume resources over which he/she does not have formal ownership.
Discretion includes instances where an agent behaves morally hazardously
or exerts influence indirectly or where peers in a group voluntarily agree to

have their points of view represented by a group member or to have conflicts
resolved by one member of the group.8 The exercise of discretion by employ-
ees does not fully preclude their recognition of the formal authority granted
to an employer through employment law. For example, an employee may
recognize the legitimacy of the formal authority relation with a superior
and be willing to accept the limits within which the superior can direct the
actions of the subordinate, while not fulfilling the agreement when given
specific directions in areas where he is not subject to effective control. Also,
the employee may recognize the legitimacy of the formal authority relation
and the specific ways in which the authority is exercised, while spending
resources on altering the guidance to which he is subject to by influencing
superiors to change the way in which the authority is carried out.
Employees’ ability to exercise discretion depends on the employer’s
costs of monitoring and on their bargaining power. For example, a knowl-
edge worker’s technical competences and expertise may be an important
constraint on the ability of the employer to exercise his formal authority
– this is the assertion that seems to underlie the prediction that knowledge
workers are less likely to be subject to the authority of office and more
likely to possess discretion or authority themselves due to their specific
qualifications.
Authority and discretion may be delegated to one employee or a group
of employees. Delegated (or formal) discretion can be defined as instances
where an agent is delegated the rights by a superior to allocate resources
(including his own labor services) to those ends he desires without the
formal approval of an owner or employer.9 Delegated authority is to be
distinguished from delegated discretion by the fact that the discretion does
not include formal rights to direct the actions of other members of the
firm. Both delegated authority and delegated discretion are limited by the
formal rights of a superior to overrule the decisions made by a subordinate
(Baker et al., 1999) as well as by the real discretion exercised by lower-level
employees.
Delegation of discretion and authority is a means of overcoming
the inefficiencies that stem from centralized decision making (Jensen
and Meckling, 1992). In the Coase–Simon–Cheung view it is implicitly
assumed that the superior receives the relevant information and has the
relevant knowledge to make use of the information by ordering the sub-
ordinate to carry out a specified action. With such a narrow conception of
authority there is no room for the use of dispersed knowledge or informa-
tion that rests with employees within the employment relation. Thus, the
use of centralized decision making by an authority becomes inefficient in a
knowledge economy where employees or subordinates (at least at certain
points in time) have the relevant information or the relevant knowledge

that makes them superior in using the information.
However, Simon (1991, p. 31) himself pointed out four decades after his
paper on authority, ‘[a]uthority in organizations is not used exclusively,
or even mainly, to command specific actions.’ Instead, he explains, it is
a command that takes the form of a result to be produced, a principle to
be applied, or goal constraints, so that ‘[o]nly the end goal has been sup-
plied by the command, and not the method of reaching it.’10 The concept
of authority introduced by Simon (1991) sets focus on the many ways in
which contractual relations can be altered ex post contracting. Moreover,
the definition allows for the delegation of discretion to subordinates with
respect to their choice of actions. Authority on the part of the superior
may then be interpreted as the right to unilaterally change the degree of
delegation ex post contract agreement and to veto decisions made by the
subordinate (see also Aghion and Tirole, 1997; Baker et al., 1999).
It does not alter the economic rationale for formal authority if it is
broadened from the narrow focus on orders to encompass situations where
the superior ex post contracting vetoes decisions or implements restrictions
that prevent the subordinate from picking the actions most preferred by
him. In accordance with Coase and Simon, formal authority still serves
the overall purpose of achieving coordination of productive activities in a
setting where it is economically efficient for the parties to adapt the con-
tractual relation to unpredictable changes in contractual circumstances.
Adaptation must be costly to obtain through re-negotiations or by means
of contingent plans (Coase, 1937).
Given the above, I put forward the following definition of authority.
Authority is a formal right granted to a superior to use managerial judg-
ment to unilaterally decide on changes or maintenance of aspects of the
term of contract ex post contracting irrespective of the contracting party’s
judgment as to the merits of that decision. In employment relations the
formal right to exercise authority is supported by labor law.
4. CAUSES OF CHANGE IN THE RELATIVE USE OF

AUTHORITY
4.1 The Use of Authority from an Incentive Perspective
The tension between real and formal authority is center stage in some of the
writings on the diminishing importance of authority compared with, for
example, market contracts (or hybrids such as collaborative arrangements
supported by, for example, norms (Grandori, 2001)). Two different types of
arguments support this idea. First, a move toward the knowledge economy
may be expected to increase the relative importance of investments in
knowledge assets compared with investments in capital. With this change,
employers’ costs of monitoring and bargaining with knowledge workers
over the actions to be chosen may increase. In turn, this leads to increased
costs from moral hazard (Jensen and Meckling, 1992) and from bargaining
in all transactions dealing with knowledge workers. Also, investments in
knowledge assets and allocation of bargaining power change endogenously
(Hart, 1995). That is, in order to create efficient incentives for knowledge
workers to invest in knowledge assets we should expect a reallocation of
the real authority that follows from ownership of co-specialized physical
assets from managers to knowledge workers.
If we hold everything but the discretion and costs of bargaining with
employees constant we should expect the benefit function from the use of
formal authority to move downward, causing a relative decrease in the use
of formal authority. However, there are also factors that can offset this
move. For example, increased investments in knowledge assets may create
more assets specificity, which in turn raises costs of market contracting and
introduces a need for private courts that can handle the specific types of
conflicts that arise in incomplete contract situations (Williamson, 1985).
Thus increasing knowledge workers’ discretion (or authority) does not nec-
essarily imply more market transactions. However, the formal authority of
the employer may to a lesser extent be accompanied by real authority.
A second type of argument focuses on how information is differently
dispersed in the knowledge economy compared to the capital intensive
one. Grandori (2001), for example, has forcefully stated that changes in the
distribution of information may cause ‘authority [as a centralized decision-
making system] to fail in all its forms’ (p. 257). Along with the differently
dispersed knowledge, the choice set of actions available to knowledge
workers may become much greater than that available to workers in the
capital intensive economy. In such a situation it may be too costly for a
central manager to be informed about the entire choice sets of an employee.
Knowledge workers then become better able to select actions that create
joint value than the employer. However, the employer may interpret
the employees’ choices as morally hazardous when they do not benefit the
employer and he may not allow these choices although they maximize the
joint satisfaction function. If as Simon (1951) argues the employee cannot
make the employer commit to choose actions that maximize their joint
satisfaction function, the use of authority becomes inefficient. For a given
level of uncertainty (variance) employees will demand a higher compensa-
tion (compared with the compensation they get from market transactions)
in order to meet their participation constraints.11 The increased costs of
meeting employee participation constraints raise the costs of using author-

ity relative to market contracting. Thus, the diminished use of authority
in a knowledge economy should be attributed to an increased conflict of
interests leaving little scope for the use of authority that satisfies the par-
ticipation constraints of both the employer and the employee. A limited
scope within which the participation constraints of both employee and
employer are fulfilled may also arise if changes in work content produce a
wider gap between the preferences of the knowledge workers and those of
their employers (with no changes in the size of the choice set). For example,
it may well be the case that knowledge workers to a greater extent prefer to
work on projects that add to their general (non-relation-specific) stock of
human capital, whereas an employer to an increasing extent wants employ-
ees to work on projects that mainly build relation-specific experience.
Two mechanisms can ease the problem. One is to introduce differenti-
ated pay for activities in accordance with the merits to the employer and
the costs to the employee. It has in fact been argued that in the knowledge
economy we see an increasing use of high-powered incentives within firms.
Of course this re-introduces the issue raised by Coase (1937), Cheung
(1983) and others of the costs of discovering the relevant prices. Another
mechanism is for the firm to delegate some discretion to knowledge
workers and build a reputation for allowing the employee to select actions
that maximize the joint satisfaction function (Aghion and Tirole, 1997).12
The reputation has to be robust to evolving changes in the pay-off to the
employer and employee of emerging actions (see, for example, Kreps,
1990). The recognition of firms as legal entities and the legal protection of
corporate identity are factors that ease the use of reputation mechanisms
as a means of private enforcement of implicit promises within firms as com-
pared with across spot markets. Thus, increased distribution of knowledge
and the accompanying need for delegation need not result in a relative
diminished use of formal authority.
However, as delegation of discretion introduces costs in the form of
moral hazard, there will have to be limits to the delegation that takes place
within firms. The optimal delegation of discretion is, according to Jensen
and Meckling (1992), one that balances ‘the costs of bad decisions owing
to poor information and those owing to inconsistent objectives’ (p. 264). In
order to constrain moral hazard, restrictions are often used in employment
relations where assets have many different uses and where only a subset
of these uses optimize the joint satisfaction function. This conclusion is in
line with the work of Holmstrom and Milgrom (1994), Barzel (1989) and
Holmstrom (1999), who argue that employers use restrictions in order to
avoid costs of morally hazardous behavior when incentive payments are
too costly to implement. Thus, the employer may replace direct monitoring
of work effort by supervision of a set of constraints that the employer

has imposed on the employee with respect to the use of the labor services
and capital assets (Barzel, 1989). However, since contracting takes place
in a dynamic setting in which new opportunities for value creation and
for moral hazard arise, the constraints and restrictions may need to be
changed over time. The employment contract ensures that the employer
has the formal rights to make these changes unilaterally, thereby saving
contracting costs. Thus, an increased need for delegation need not imply a
diminished role for authority.
To sum up: writers on the knowledge economy have emphasized the
importance of increasing misalignment of preferences between employer
and employee or the relative increase in employees’ ability to discover value-
creating actions which in turn should diminish the relative importance of
the use of authority. However, there is no reason to assume that there is
a diminished need for the role of formal authority as supported by a firm
governance structure. It may still be efficient to use authority supported
by firm governance to solve conflicts of interest in situations of incomplete
contracting (as argued by Williamson, 1985) and to support the building
of a credible reputation for delegating discretion. Moreover, delegation
of discretion within an employment contract allows for different types of
monitoring compared with market contracts, making it easier to counter
moral hazard within the firm governance structure. Finally, the firm gov-
ernance structure allows for a flexible adaptation of constraints to delega-
tion as employers have the right to make these decisions unilaterally.
The above discussion has centered on how incentive issues influence the
relative use of authority in the knowledge economy holding the nature of
the coordination problem constant. However, it is also possible that the
nature of the coordination problem changes with a move from a physical
capital to a knowledge intensive economy. In the following, I make use
of an example of a coordination problem that arises between a marketing
and a product development function in order to illustrate how changes
in the nature of the coordination problem influence the relative costs and
benefits of the use of authority under different conditions of dispersion of
information and knowledge between an employer and two employees. For
the moment I leave aside the discussion of the incentive issues, thus taking
common goals as the standard assumption throughout the example.
4.2 The Use of Authority from a Production Coordination Perspective
The coordination problem consists in carrying out a product develop-

ment project. Two employees (in marketing and product development
respectively) and a manager are engaged in the project. The choice set for
the marketing employee contains two different product concepts and the
choice set for the product developer contains two different technical solu-
tions. The coordination problem is that of selecting the concept and the
technological solution that under the prevailing contingencies generate
the greatest revenue to the firm (which in this example is the choice that
maximizes joint value). The contingencies facing the firm consist of the
values (which enter as parameters in the revenue function) for the state of
customer preferences and for the state of technological knowledge. Both
customer preferences and technological knowledge can change over time.
The way in which the coordination problem can be solved depends on
the nature of interdependencies and on the distribution of information
and knowledge between the employer and the two employees. Information
refers to information about a realized state and the solutions available,
while knowledge refers to the ability to specify the revenue function and
solve for the optimal solution. Either the superior or the two employees in
the firm may posses information regarding the choice sets and the kind of
states that have emerged. Moreover, either the superior or the subordinate
or both may have the knowledge needed to select the optimal combination
of product concept and technical solution, given the information available
on customer preferences and technological knowledge.
When the informational interdependencies between the choice of product
concept and technical solution are complex, coordination requires that the
decision maker has information about the contingencies and the solutions
facing both design and product development. The coordination problem is
characterized by decisiveness when decisions on product concept and tech-
nical solution can be made sequentially by different decision makers. For
example, customer preferences may be decisive for the choice of product
concept and for the choice of technique. This implies that the marketing
employee (who selects product concepts) can make a decision without
information about the state of technological knowledge or technical solu-
tions. Moreover, he only needs to communicate his choice of concept to the
employee in product development, who selects the technical solution on the
basis of his investigation of the state of technological knowledge. Finally,
the coordination problem can be characterized by complete independ-
ence, in which case the marketing employee only needs information about
the state of consumer preferences and product concepts and the product
development employee only needs information on the state of technologi-
cal knowledge and technical solutions.
Centralized authority in a setting of complex interdependencies

The employer is the only one who can make the relevant decision if he
is the one who possesses all relevant information of states and solutions
available and the knowledge needed to use that information. Some ex

ante communication of the information possessed by the employer will
be necessary though, as employees will be unwilling to accept an employ-
ment contract unless it specifies the nature and limits of the choices that
the employer can make (Simon, 1951). However, compared with the use of
market contracting, which requires a more detailed specification of actions
and instructions, the use of order in employment contracts may save some
communication costs (Demsetz, 1995). If contingencies or the choice set of
actions change, the benefits from the use of formal authority supported by
firm governance structure to make adaptations increase, as more transac-
tion costs are saved compared with carrying out the adaptation by means
of spot market transactions (Coase, 1937).13
The arguments presented above indicate at least three important vari-
ables that may influence the relative use of centralized decision making
(assuming there are no conflicts of interest). First, the costs of complet-
ing contracts over markets in the knowledge economy could have been
reduced. For example, the introduction of IT technology in the knowledge
economy and the embodiment of information needed for coordination,
as well as the development of interface and measurement standards, are
factors that reduce costs of re-contracting. However, these factors may
influence firm internal costs of using centralized decision making to the
same extent. Second, uncertainty may have been reduced. In the example
above, this would be the case if the states of consumer preferences or tech-
nological knowledge did not change or if no new product concepts and
solutions could be identified. However, a reduction in the level of uncer-
tainty is contrary to what most writers on the knowledge economy assume.
Finally, the costs to the central manager of obtaining relevant information
and of using this may have increased. The latter falls in line with the argu-
ments presented in much of the literature on the use of authority in the
knowledge economy, where many writers argue that an increased disper-
sion of knowledge makes it increasingly difficult for the holder of formal
(and centralized) authority to reach efficient decisions (see, for example,
Minkler, 1993; Cowen and Parker, 1997; Hodgson, 1998; Radner, 2000).
For example, an increase in specialization in production and knowledge
in the knowledge economy results in more diverse types of transaction (in
terms of choice sets, contingencies and sources of interdependencies) and
this increases the costs to managers of ‘discovering the right prices’, result-
ing in a reduction of the efficient size of firms and an increase in the relative
use of market transactions.
Part of the confusion about the status of authority in a knowledge
economy seems to arise because the use of authority is confused with highly
centralized decision making. Indeed, the costs that arise due to the limited
mental capacity of managers can be reduced if some discretion and author-

ity is delegated to lower-level employees. Delegation has been mentioned
in the organization literature as a means of improving decision making
under uncertainty (Miller, 1992), economizing on principals’ opportunity
costs (Salanié, 1997) and avoiding decision delays under circumstances
of volatility and uncertainty (Thompson, 1956; Burns and Stalker, 1961;
Mintzberg, 1983). The underlying idea is that delegation of discretion
provides an efficient use of distributed knowledge in firms (Jensen and
Meckling, 1992) that is costly to communicate to a central decision maker
(Casson, 1994).14 Uncertainty, unpredictable volatility and some level of
distributed knowledge and information create the conditions under which
there is an economic rationale for the coexistence of authority and del-
egation of discretion within hierarchies. This conclusion is based on the
assumption that the coordination problem is at least partly decomposable
(Simon, 1962). One such situation arises if the coordination problem is
characterized by decisiveness.
Delegation in a setting of decisiveness, dispersed information and centrally

or dispersed knowledge
When the coordination problem is characterized by decisiveness it is
possible to achieve the optimal solution with delegation of discretion to
employees. The employer can delegate decisions to the employee who has
the relevant information about states and solutions and the knowledge
needed to make the choice. When marketing information is decisive for
the coordination problem the marketing employee can make the deci-
sion and communicate it to the employer, having them select the optimal
technique, or they can communicate their decision directly to the product
development employee who has obtained information about the state of
technology. The choice between centralized decision making and decen-
tralized corporation (through markets or within the hierarchy) depends on
the trade-off between benefits from specialization in decision making and
costs of communicating to the employer the states and solutions that have
been observed by marketing and product development.
In cases where the design problem is not characterized by natural
decisiveness, it may sometimes be efficient to have the employer impose
decisiveness on problems by dispensing with the communication of the
decision premises. As an example, the employer can choose to take cus-
tomer preferences or technological knowledge as given and make that
the ‘normal state’. Decisions will only be made in a consultative manner
when the employer or the employee in a marketing department discovers
an unusual state. In all other situations they will be made in a sequen-
tial manner. An even stricter way of imposing decisiveness is to restrict
employees from all examination of states. In the latter case decisions are
taken in a routine manner and the only role for a central authority is to
monitor the adherence to and feasibility of this restriction.
Restrictions on the delegation of discretion may be needed as long as
there is some level of interdependence. Costs from delegation of discre-
tion arise when knowledge workers do not possess all relevant knowledge.
Employees’ exercise of discretion can produce spillover effects (that is,
‘externalities’) due to unintended consequences of the actions taken. These
harmful spillover effects include coordination failures, such as schedul-
ing problems, duplicative efforts (for example, of information gathering,
R&D), cannibalization of product markets and other instances of decen-
tralized actions being inconsistent with the firm’s overall aims, and so on.
The use of authority to restrict harmful consequences is efficient if
the employer is better able to form a judgment regarding what types of
actions are appropriate. The employer defines constraints that only allow
the knowledge workers to choose among actions he deems appropriate
(Armstrong, 1994). In this way the employer prevents the knowledge
worker choosing actions that he knows or believes to be infeasible. If the
employer does not know where to set the restrictions ex ante to contracting,
he may instead overrule or veto decisions made by the employee (as in, for
example, Aghion and Tirole, 1997). That is, even with perfect alignment of
incentives between employer and knowledge there is a role for employers
as monitors and enforcers of restrictions. The use of restrictions and veto
brings attention to the function of authority as a means of constraining ‘the
method[s] of reaching’ an end goal, in Simon’s (1991) terminology. Under
conditions of uncertainty where the choice set of the knowledge worker
and interdependencies in decision change over time, constraints will have
to be adjusted. Thus, the role of authority in a setting of distributed knowl-
edge and uncertainty may well be that of unilaterally altering constraints
on decisions made by lower-level knowledge workers and adjusting criteria
for accepting or rejecting decisions made by such knowledge workers.15
The way in which delegation of discretion can ease the constraints on
the use of authority in settings characterized by disperse information and
knowledge move the focus from the discussion of authority versus market
contracts to a discussion of centralized versus decentralized decisions
within the employment relation. From the above it is clear that the role of
the employer as one who solves coordination problems decreases as one
moves from coordination problems characterized by interdependency to
those characterized by (imposition of) decisiveness. Changes in production
techniques can cause a shift in the nature of interdependencies. Moreover,
it may have become more attractive to impose decisiveness on coordina-
tion problems with the move to the knowledge economy. This is the case
if the costs of investigating states increase drastically compared with the

benefit of reaching the optimal solution. However, a move away from the
use of centralized authority toward more decentralized decisions may also
be a consequence of a relative change in the importance of knowledge
workers’ information about actions in the choice set and contingencies
compared with employers’ knowledge of interdependencies. That is, some
interdependencies are ignored or suppressed at the expense of achiev-
ing the optimal fit between subsets of the solution. The movement in the
knowledge economy toward the design of modular products is an example
of the latter. Firms imposed decisiveness on problem solving, dispensing
with some interdependencies in the product design, and the interfaces that
are specified ex post detailed product development constitute the natural
state of the environment which is to be taken for granted in the choice of
the specific design solutions.
5. CONCLUSION: IS THE USE OF AUTHORITY

DIMINISHING IN THE KNOWLEDGE
ECONOMY?
The notion of authority is an important one in economics. In particular,

it underlies important contemporary theories of economic organization
(Williamson, 1985; Hart, 1995). Given this, it is surprising that so few fun-
damental discussions of the notion are to be found in the literature. This
is problematic, because the notion of authority has recently been subject
to much discussion in neighboring fields, such as sociology and business
administration. Economists have had difficulties entering this discussion
because of their relatively crude conception of authority, in which authority
is seen as synonymous with either bargaining power or the use of ordered
direction by a highly informed employer (Simon, 1951). However, the
theory of economic organization is in no way necessarily limited to those
notions of authority. Thus, the theory suggests other possible, yet comple-
mentary, understandings of authority, such as the unilateral right to set
and change constraints on the activities of subordinates, overrule decisions
made by subordinates, and implement and change reward systems. Seen in
the light of this latter understanding of authority, it is not so apparent that
authority will strongly decline in importance in the emerging knowledge
economy, as asserted by a number of writers. Although knowledge workers
may have more bargaining power and be more knowledgeable about the
activities they carry out than ‘traditional’ industrial workers, they too will
be subject to authority, as long as productive activities are characterized
by uncertainty and measurement costs which make complete contracting
prohibitively costly. It may be conjectured that under these circumstances

delegation will be more widespread. However, because of differing prefer-
ences, asymmetric information and externalities in decision making, such
delegation is likely to be circumscribed.
The literature on authority points to several factors that can diminish the
relative use of authority in the knowledge economy:
● changes in the distribution or importance of information and knowl-

edge held by employees and employers respectively
● less need for adaptation – more interface standards, more modular
products, and so on
● increased complexity and diversity in transactions
● increased conflict in preferences over actions between employer and
employee
● more bargaining power to employees
● less asset specificity
● greater importance of knowledge workers’ investments in knowledge
compared with employers.
In order to fully answer the question of whether or not authority is dimin-

ishing in importance, one must empirically investigate how changing from
the capital intensive to the knowledge intensive economy affects all of these
variables.
NOTES
1. Some representative sources are Boisot (1998), Foss (2001), Ghoshal et al. (1995),
Grandori (2001), Harrison and Leitch (2000), Hodgson (1998), Liebeskind et al. (1995),
Matusik and Hill (1998), Minkler (1993), Vandenberghe and Siegers (2000), and Zucker
(1991).
2. For example, the employer can be ignorant about the best use of different labor services
as in the case of innovative activities (N. Foss, 2001). Also, in cases of rather complex
production or product innovations, it may be desirable to conduct a number of control-
led experiments before one decides on what labor service is required for a certain task
(K. Foss, 2001)
3. Richardson (1972) has a very similar argument for the boundaries of firms
4. Agency theory, a body of literature to which Alchian and Demsetz (1972) belongs,
ascribes all contracting costs to the costs of observing variables. Monitoring denotes
‘measur[ing] output performance, apportioning rewards, observing the input behavior
of inputs as means of detecting or estimating their marginal productivity and giving
assignments or instruction in what to do and how to do it’ (Alchian and Demsetz, 1972,
p. 782). However, the reason for the last kind of activity is left unexplained.
5. Barzel (1989) argues that orders are used in conjunction with flat wages, not because
employees lack information, but because they have no incentives to devise ways of exer-
cising use rights over assets that would produce utility.
6. In market contracts one party may allow the other party to make some specific type of
decision ex post contracting. For example, a painter who enters a market contract with a
customer may allow the customer to decide on the color and type of paint ex post contract-
ing. This can be interpreted as an instance where the painter is indifferent between colors
and types of paint to be used and therefore implicitly negotiates and accepts the order.
7. Thompson (1956) distinguishes between authority and power as the basic means of
obtaining obedience. He defines power as ‘the ability to determine the behavior of
others, regardless of the bases of that ability’, and authority as ‘that type of power which
goes with a position and is legitimated by the official norms’ (p. 290).
8. For example, an employee or a group of employees may formally be delegated rights to
decide, among themselves, on the use of resources that influence their decisions about
how to carry out certain activities. I reserve the notion of delegation of authority to
those instances where a superior has formal rights to influence the decisions made by
subordinates, whereas I consider it an instance of delegation of discretion when a group
of employees are to decide among themselves on the use of resources.
9. The authorization to give well-defined orders under well-defined circumstances does not
fall under the definition of discretion.
10. In fairness to Simon, it should be noted that the more expansive notion of authority in
the 1991 paper can be found already in Simon (1947). Thus, Simon’s views of authority
did not change between 1951 and 1991. What arguably happened was that Simon in the
1951 paper developed a formal model of authority and that tractability of the formal
analysis required that a relatively simple concept of authority be employed.
11. In a reinterpretation of Simon (1951), one may consider restrictions on the subordinate
as a means of reducing the set of actions that the employee has the discretion to choose
at a given wage. The authority relation should then be preferred when it is efficient to
allow the superior to postpone the decision about the preferred type of work activity
and/or the preferred set of restrictions on the work activity.
12. For example, Aghion and Tirole (1997) have investigated the use of authority in a setting
in which the agent has asymmetric information about his expected private benefits
from various projects. The principal may veto projects to protect him from the agent’s
adverse selection of projects that reveals high private benefit to the agent and little or no
benefit to the principal. However, in such situations the superior must be able to credibly
commit to choose projects that do not generate negative expected benefits to the agent
(see also Baker et al., 1999).
13. The employment contract could be interpreted as providing a stock of labor services
that within limits could be allocated to different uses by the direction of a manager in
response to unforeseen contingencies (Coase, 1937; 1991). However, managers only
need to bear the cost of carrying such a stock if they cannot appropriate the benefits
of their knowledge as new contingencies emerge. Three factors may explain why they
cannot sell their knowledge in markets. First, there is the well-known problem of infor-
mation as a public good that, if revealed before the transaction, cannot be protected
from capture (Arrow, 1962); second, negotiations may take longer time than direction
by orders and, because of this, the opportunity for profitable action may be gone; and
third, managers’ knowledge may be specific to particular transactions.
14. Employers also grant discretion to employees for a number of other reasons, including
improving motivation through ‘empowerment’ (Conger and Canungo, 1988), fostering
learning by providing more room for local explorative efforts, and improving collec-
tive decision-making by letting more employees have an influence on decisions (Miller,
1992). However these reasons arise also if there is no uncertainty.
15. The rather considerable literature on delegation in organizations (for example,
Galbraith, 1974; Fama and Jensen, 1983; Jensen and Meckling, 1992) does not explain
why delegation should be associated with the exercise of authority. Part of the reason
may lie in the static nature of the analysis: all costs and benefits associated with delega-
tion are given (hence, optimum delegation is known immediately to decision-makers),
and there is no role for authority, except perhaps monitoring the use of delegated deci-
sion rights.
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6. Competence and learning in the
experimentally organized
economy1
Gunnar Eliasson and Åsa Eliasson
1. INFORMATIONAL ASSUMPTIONS FOR A

THEORY OF INDUSTRIAL DEVELOPMENT
The single most important empirical assumption in economic theory

concerns the totality of all possible states the economy can be in. This
universal state space of the model of the economy, or what we call the
business opportunities space (Eliasson, 1990a) sets the limits both of what
actors can do, and of how informed about their environment they can
be. We introduce the knowledge based economy (Eliasson 1987b, 1990a, b;
OECD, 1996), which establishes as a necessary assumption an economic
opportunities space of immense complexity that is theoretically impos-
sible to comprehend more than fractionally from any one place. Each
actor understands only a miniscule fraction of the total opportunities
space. Together, however, the understanding of all actors in the markets
is much larger, but still only encompasses a fraction of the whole, and the
tacitness of their knowledge or competence effectively restricts expansion
of that understanding through collective coordination. Attempts to speed
up exploration of the opportunities space through rivalrous competition
in markets encounter rapidly escalating information and communications
(transactions) costs in the short run. Such exploration, however, offers
opportunities for learning and increases the number of creative encoun-
ters such that the opportunities space expands, and probably faster than
it is being explored. Hence, we may all be growing increasingly ignorant
of what is theoretically possible to know about. This information paradox,
or what we will call the Särimner effect,2 is a fundamental, sustained and
distinguishing property of the experimentally organized economy (EOE)
and the rational basis for the existence of a competence bloc (Eliasson
and Eliasson, 1996).
104
Competence and learning in the experimentally organized economy 105
1.1 The Grossly Ignorant Actor
Under these circumstances ‘boundedly rational’ (Simon, 1955) and

myopic, bordering on grossly ignorant actors will constantly partici-
pate in a positive sum economic game, trying to orient themselves in
the immense opportunities set, their success rates depending on their
competence to discover and capture the new opportunities, constantly
making more or less serious mistakes in the process (Day et al., 1974).
Hence, each decision can be seen as a more or less well designed ‘eco-
nomic experiment’ to be tested in the market in confrontation with all
other actors. Both successful and mistaken experiments involve elements
of learning and the creation of new combinations on which competitors
can set up new economic experiments. Economic mistakes (to be defined
below) then define the ultimate transactions cost (Eliasson and Eliasson,
2005). Economic mistakes escalate if actors intensify their exploration of
the state space to capture larger profits, and the reason is the problem,
recognized already by Wicksell (1923) and repeated by Arrow (1959),
that it is difficult, and perhaps impossible, to model the simultaneous
determination of structures (quantities or organizations) and prices. In
the highly non-linear micro (firm) based macro model that we will refer
to below as an approximation of the theory of the EOE, both quanti-
ties and prices become increasingly destabilized as actors are pushed
on by market competition, and prices become increasingly unreliable
signals to guide quantity adjustments towards a both unreachable and
perhaps indeterminate equilibrium. The economy will constantly be in a
‘Heisenbergian flux’ (see also Eliasson, 1991a, and Eliasson et al., 2005).
Since experimentation aimed at exploring and learning about state space
also expands the opportunities space through learning and the creation
of new opportunities (innovation), we have to reckon with the possibil-
ity that the total economic opportunities space is not only immense but
also indeterminate at any point in time. Demsetz (1969) recognized this
possibility when criticizing the neoclassical doctrine as being subject to a
‘Nirvana fallacy’ in the sense that the best of all worlds that the neoclass-
ical economists can calculate within their model make them miss the
possibility of even better worlds beyond their prior assumptions.3 One
property of the EOE to be explained below also is that there always exist
better allocations than the current one, meaning that the economy will
always be operating (far) below its production frontiers.4 Referring to
Demsetz, Kirzner (1997) observed that economies will always fall short
of their potential, a potential, Kirzner argued, that could be approached
with the help of discoverers/entrepreneurs.
1.2 The Särimner Effect
The informational assumptions are a distinguishing feature of both the neo-

classical model and the theory of the EOE. They are embodied in the state
space assumed for the model. The assumptions of the neoclassical model are
normally tailored such that (1) a unique optimum exists, (2) it can be identi-
fied and (3) it can be reached at zero or negligible transactions costs.
Convexity assumptions of some sort, of course, have to be imposed to
prevent the model economy from exploding or ceasing to exist altogether.
The assumption of strict convexity and continuous derivatives ensures
that a unique cost minimum, profit maximizing optimum exists.5 Finding
it is always possible if the information and communications (transactions)
costs needed are (assumed to be) zero or negligible. If transactions costs are
large they will have to influence both the position and the existence of the
optimum as conventionally defined. And in reality the transactions costs
are very large (Eliasson et al., 1985, p. 53; Eliasson, 1990a, b; Bergholm and
Jagren, 1985; Pousette and Lindberg, 1986; Wallis and North, 1986).
The informational assumptions of the EOE are embodied in its state
space or in what we call its business opportunities space. Initially it is
assumed to be large and populated with grossly ignorant actors posi-
tioned somewhere inside it. The problem, however, is that it has to stay
that way for ever for the theory of the EOE not to converge upon the
neoclassical or WAD (Walras–Arrow–Debreu) model. Large transactions
costs in the form of business mistakes that escalate the closer you get to a
stationary process keep the operating domain of the EOE away from the
optimum.6 This is, however, not sufficient for the economy to grow. For
endogenous growth to occur this situation has to be for ever maintained
and the actors kept grossly ignorant about circumstances that are critical
for their business. This can be solved mathematically (Eliasson, 1990b, pp.
46 ff) by assuming the opportunities space to be initially sufficiently large,
and that it grows from being explored through innovative discovery and
learning. This establishes the positive sum game of the EOE that we call
the Särimner effect, and the possibility (the paradox) that in a dynamic
EOE actors may grow increasingly ignorant about what is important to
them because the business opportunities space grows faster than it can be
explored and learned about.
In this experimentally organized economy (Eliasson, 1991a, 1996) eco-
nomic growth will be shown to be moved by innovative project creation
and competitive selection, or the Schumpeterian creative destruction process
of Table 6.1.7 The capacity of the economic system to identify winners and
carry them on to industrial scale production and distribution determines
economic growth. Hence, the dynamic efficiency of selection becomes
Table 6.1 The four investment and divestment mechanisms of

Schumpeterian creative destruction and economic growth
Innovative entry
enforces (through competition)
Reorganization
Rationalization
or
Exit (shut down)
Source: ‘Företagens, institutionernas och marknadernas roll i Sverige’, Appendix 6 in A.

Lindbeck (ed.), Nya villkor för ekonomi och politik (SOU, 1993, p. 16) and G. Eliasson
(1996, p. 45).
Table 6.2 Competence specification of the experimentally organized firm
Orientation
1. Sense of direction (business intuition)
2. Risk willing
Selection/Flexibility
3. Efficient identification of mistakes
4. Effective correction of mistakes
Operation/Efficiency
5. Efficient coordination
6. Efficient learning feedback to (1)
Source: Eliasson, G. (1996, p. 56).
critical for economic growth. The organization of efficient selection and the
definition of efficiency in an EOE with no exogenous equilibrium are dealt
with in competence bloc theory, of which the theory of the firm can be seen
as a special case. Competence bloc theory is presented in this chapter as an
integral part of the EOE.
Access to the business opportunies space is regulated by institutions
that determine the incentives for actors to look for business opportunities
there and to compete. In fact, the competence of a firm or an actor is best
characterized as in Table 6.2.
1.3 Competence Specification of the Firm in the EOE – the Tacit Dimension
Table 6.2 represents a typical situation of a firm in reality and in the EOE
(Eliasson, 1996, p. 56, 1998a, p. 87). First, no actor, including government,
can survey the entire economic opportunities space from one point. The
assumptions of the economic opportunities space make it impossible for
each actor to be more than fractionally aware of its interior structures and
contents and notably about what now and then may become critical for
survival. Hence, business mistakes will be made by all actors all the time.
Such business mistakes, however, also involve learning about the opportu-
nities space and should be regarded as a normal cost for economic develop-
ment, a transactions cost (Eliasson and Eliasson, 2005). One common form
of learning is being confronted with a superior competitor and understand-
ing that for better business solutions than one’s own are possible. Second,
some actors may hit upon the absolutely best solution by chance, but they
will never know, and nobody else will either. Hence, third, the economy will
always be operating far below its production possibilities frontier, a viola-
tion of a standard assumption of neoclassical theory. In fact, such frontiers
may even be indeterminate.
Fourth, as a business actor you must always believe in your proposed
business experiment. If not, you cannot act decisively and forcefully in
dynamically competitive markets. Fifth, however, whatever you have
invented, you know one thing with almost certainty: there will be many
potential solutions that are much better. Therefore, sixth, you have to rec-
ognize that among your many competitors you cannot be alone with such a
good idea as yours. The business firm has to act decisively and prematurely
on the basis of the competent judgment of its top competent team (intui-
tion, Eliasson, 1990a) before somebody else has acted successfully. Each
new solution, therefore, has the character of a business experiment, and the
competence of a business firm is well categorized in Table 6.2. The firm in
the EOE needs a good business intuition (orientation), it needs to be able
to identify and correct mistakes (flexibility) and it needs to be operation-
ally efficient. This is a tall order and all three categories of competencies
can neither be embodied in one individual nor be assumed to be more than
fractionally communicable between participating actors. They are tacit in
the sense of limited communicability (Eliasson, 1990a). This problem of
multidimensionality and tacitness of competence characteristics is solved
in practice through organization, coordination being achieved to the extent
possible by the top competent team of the organization and/or through
competition in markets (Eliasson, 1976, 1990a). As demonstrated by
Coase (1937), the mix between hierarchy and market is determined by the
relative transactions costs of coordination within and between hierarchies,
tacitness being one factor pushing for market solutions, dynamic efficiency
another (see below).
The competence and behavioral characteristics of the firm follow directly
from the assumptions made about the business opportunities space and the
EOE. It is no coincidence, however, that development of this basic idea

has grown upon us during many interactions with business firms (begin-
ning with Eliasson (1976) and currently during a study in progress on the
economics of health care (Å. Eliasson, 2007; Eliasson and Eliasson, 2007))
and frequent participation in internal firm educational programs with the
purpose of relating the internal life of firms to their external economic
environment. In such reality settings you are in a hopeless situation trying
to explain how the mainstream neoclassical model can be of any use.
1.4 Macro Dynamics through Experimental Selection – Going from

Micro to Macro
When something radically new is introduced, it almost always occurs

through the launching of a new product, the establishment of a new divi-
sion or through the entry of a new firm. A new product may be a com-
plement to existing products or a substitute, in the latter case subjecting
existing producers to competition and forcing them to reorganize and/
or rationalize, or die (exit). When a competitor introduces a radically
new product, a firm often cannot cope with the new situation through
reorganization, because it is staffed with the wrong human capital. It
then has to contract or shut down, and possibly recruit new personnel to
establish a new firm. The entry process, hence, is critical for long-term
economic growth, pushing performance of the entire industry upwards
through the four creation and selection mechanisms (‘investments and
disinvestments’ of Table 6.1). But entry will not result in growth unless
accompanied by a viable exit process.8 If superior entrants and success-
fully reorganizing firms (the ‘winners’) are supported by the market and
allowed to force inferior firms to exit, growth will follow. Hence, the
major information cost, again, is business mistakes in the form of ‘lost
winners’ and the losses of inferior firms that are allowed to continue for
too long.9 Under normal circumstances, therefore, an economy will be
reasonably fully employed and the thrust of firm turnover will be to real-
locate resources. Hence, the question of the employment contribution
of new firm formation and self-employment is normally irrelevant, and
if asked (as in Blanchflower, 2004) it has to be related to a well-defined
unemployment situation.10
The optimum or the benchmark for efficiency measurements will be
obtained by minimizing the cost of committing the two types of errors in
Table 6.3a. Under the opportunities space assumption of the EOE there
will always exist better allocations than the current one.11 This optimum,
hence, does not exist under the assumptions of the EOE and a unique
efficiency reference cannot be determined. With lost winners defining the
Table 6.3a The dominant selection problem
Error Type I: Losers kept too long

Error Type II: Winners rejected
Source: G. Eliasson and Å. Eliasson (1996).
potential of the economic system not reached, optimum performance

cannot be determined even theoretically, since the benchmark for deter-
mining efficiency cannot be identified. One aspect of efficiency, however,
is to make sure that the customer, or demand, is a determining force in
setting directions. The optimal organization of the economy, hence, is
determined by a delicate balancing of decentralized incentives, information
processing and competition in markets (Eliasson and Taymaz, 2000). For
a successful economic outcome actors and resource providers have to be
competently guided and disciplined by signals from the ultimate end users,
the customers. The competence bloc performs those functions of guidance
and resource provision.
2. COMPETENCE BLOC THEORY
Critical competencies are tacit in the sense of being limitedly communi-

cable12 (Eliasson, 1990a). While the nature of tacit knowledge cannot be
represented analytically, it can be functionally defined. A competence bloc
lists the minimum number of actors with such competence that are needed
to successfully create, identify, select and commercialize new business ideas
and to carry them on to industrial scale production and distribution, that
is, to initiate and develop a new industry (Eliasson and Eliasson, 1996).
This also confirms that the competence bloc has a pronounced end product
or market definition, as distinct from a technical definition, making the
customer the ultimate arbiter of economic value.
2.1 The Nature of Business Competence and the Efficiency of Project

Selection
Competence bloc theory is structured around three nodes of actors; the

customers, the technology suppliers and the commercializers. In between
them there are three markets: the markets for products, innovations and
factors of production (see Figure 6.1). The commercialization process in
turn is intermediated through authority within hierarchies and through
three types of asset markets – the venture capital market, the private
1. Competent customers
2. Innovators Markets for

(technology supply) innovation
Commercializing agents
3. Entrepreneurs
4. Venture capitalists
Strategic Choose
5. Exit market agents
6. Industrialists Tactial Coordinate
Operational Manufacture
and subcontract
Source: Eliasson (2005a, p. 255).
Figure 6.1 Decision structure of the competence bloc
equity market and the market for strategic acquisitions – and through the
regular stock markets. Trading in intangible knowledge assets, however,
poses particular property rights problems that we come back to in Section
3 below.
The different functions of the actors in the competence bloc can be iden-
tified as relay stations in the innovation, creation and commercialization
processes and are needed as a minimum. Sometimes they are all internal-
ized within one hierarchy or in a planned economy. This was almost the
case for IBM during its heyday in the 1970s (Eliasson, 1996, pp. 175ff).
IBM was then to a large extent its own customer in intermediate products.
Normally, however, most functions are carried out by specialized actors in
the market; call them firms. The determination of the mix between market
and hierarchy within the competence bloc not only becomes a Coasian
(1937) type dynamic theory of the firm but also determines the dynamic
efficiency of the entire economy (Eliasson and Eliasson, 2005).
The efficiency of project selection in terms of identifying and support-
ing (commercializing) winners and forcing the exit of losers, as interme-
diated through the competence bloc (first crudely sketched in Eliasson
and Eliasson, 1996), determines the efficiency of resource allocation and
growth through the Schumpeterian creative destruction process of Table
6.1. Efficient selection in the EOE is defined as the ‘minimizing’ of the
economic incidence of two types of errors (Table 6.3a), that is, keeping
losers on for too long and ‘losing the winners’. This minimization can,
however, only be performed analytically if the business opportunities
space of the model can be made fully transparent from at least one
central point, all information and communications costs kept very small,
and all winners identified. The presence of critical tacit and incom-
municable knowledge in the decision process makes this theoretically
impossible in the EOE. The optimal coordination of production has to
be organized as an endogenously determined combination of hierarchies
(firms) and markets.
The limits of hierarchies are determined where the costs on the margin
in the form of lost winners exceed the gains in coordination costs achieved
through expanding the hierarchy. The mechanism behind this determina-
tion is simple. Centralizing knowledge at one point and ordering outcomes
top-down through authority is limited (1) to the part of knowledge that
can be coded as information and interpreted centrally at a determinable
transactions cost and (2) by the reach of and power to impose authority
(compare Simon, 1945; Williamson, 1975; Foss, Chapter 5 in this volume).
If that centralization is extended to the parts of the total knowledge (prob-
ably the most important parts) that are tacit and not communicable to the
intelligence center (the corporate headquarters) of the firm, an error bias
in the central analysis will be introduced because some of it will be misin-
terpreted along the way, owing to a lack of receiver competence (Eliasson,
1976). This can be shown to reduce the total knowledge that enters each
decision. Distributing tacit knowledge (or human or team embodied com-
petencies) over the market, on the other hand, can be shown to maximize
the exposure of each project to a competent evaluation, and minimize a
transactions cost measure that includes an economic value of the loss of
winners (Eliasson and Eliasson, 2005).13 Competence bloc theory, hence,
is an organizational solution to the efficient allocation of tacit, human
embodied competencies on business problems.
If economic competence consists significantly of tacit knowledge, the
same characteristics must also apply to consumer choices. If consumer
choices are experience based ‘tacit knowledge’, exhibiting preferences for
novelty, convergence on an exogenous optimum can in no way be guar-
anteed (Day, 1986b). The (also experience based) competence of all actors
of the competence bloc to visualize the unpredictable change in consumer
preferences, however, should to some extent keep the economic system
from becoming erratic, as proposed by Georgescu-Roegen (1950) and
modeled by Benhabib and Day (1981).
The competence of the customers to appreciate quality and the com-
petence of firms to produce new qualities go hand in hand. The perhaps
most important quality demanded in an advanced market, furthermore, is
product or quality variation.14 Only the customers can individually decide
which variant they prefer. One critical function of the competence bloc,
hence, is to make sure that customers’ preferences and competencies filter

down to the actors in the competence bloc that create and select innova-
tions. Customer receiver competence (Eliasson, 1990a) is decisive for the
existence of a market. With no customer receiver competence for sophisti-
cated products there will be no market for the same products.
2.2 The Actors in the Competence Bloc
First, the products created and chosen in the experimental process never
get better than what customers (item 1 in Table 6.3b) are capable of appre-
ciating and willing to pay for. The long-term direction of technical change,
therefore, is always set by the customers. Sophisticated customers define
a competitive advantage of a sophisticated industry.15 Without competent
customers there are no sophisticated markets. This is so even though the
innovator, entrepreneur or industrialist may take the initiative to launch
a new sophisticated product. But quite often the customer takes the initia-
tive. Technological development, therefore, requires a sophisticated cus-
tomer base, capable of appreciating new products (Eliasson and Eliasson,
1996). The more advanced and radically new the product technologies, the
more important customer quality becomes.
In one sense, the customer analysis of competence bloc theory opens up the
Keynesian macro demand schedule. But as you peek inside that ‘black box’
you will find that the customer dynamic of the competence bloc has little to
do with Keynesian demand. The actors of the competence bloc contribute
(commercial) competence in the technological choice process. They accept
or reject products offered to them in the market, thereby signaling what
they want. But customers may also be directly involved in some phases of
the development of the product. This is normally the case when it comes to
very advanced and complicated products such as military and commercial
Table 6.3b Actors in the competence bloc
1. Competent and active customers

Technology supply
2. Innovators who integrate technologies in new ways
Commercializion of technology
3. Entrepreneurs who identify profitable innovations
4. Competent venture capitalists who recognize and finance the entrepreneurs
5. Exit markets that facilitate ownership change
6. Industrialists who take successful innovations to industrial scale production
Source: G. Eliasson and Å. Eliasson (1996).

airplanes (Eliasson, 1995, 2001b). This fact also serves as a rationale for
competent purchasing and acquisitions, including public purchasing in
areas where goods and services are supplied by public authorities.
Second, technology supply is internationally available, but the capac-
ity to receive it and make a business of it requires local competence. Part
of this receiver competence (Eliasson, 1987b, 1990a, 1996, pp. 8, 14) is
the ability to create new winning combinations of old and new technolo-
gies (innovation). A rich and varied supply of subcontractor (technology)
services is part and parcel of the innovation process and the competence
bloc. The innovation gate into the competence bloc (item 2 in Table 6.3b),
hence, is served by many technologies, or technological systems to use the
terminology of Carlsson (1995), that are integrated innovatively.
Third, technology supply is not synonymous with industrial progress or
growth. In between comes the competence to commercialize new technolo-
gies, a far more resource demanding activity than innovation. So between
innovation supply and commercialization, representing the demand for
innovations, we find the market for innovations in which winners and losers
are sorted out (see Figure 6.1). The problem with new growth theory and
evolutionary theory is that they do not distinguish between the innovator,
the entrepreneur and the competent venture capitalist, and hence do not
model that sorting process.
Commercialization competence is experience based and, hence, more nar-
rowly defined than the creative innovation supply process (Eliasson and
Eliasson, 2005).16 As a consequence there will always (ex definitione) be a
loss of winners along the way. By explicitly modeling the commercialization
process we break the linearity between innovation supply and economic
growth commonly entered as a prior assumption in the different versions
of new growth theory and in evolutionary theory. We find that increasing
supplies of technology do not lead to faster growth and that growth can
be radically increased on a sustainable basis under improved commerci-
alization at given technology supplies.17 First among the commercializing
agents come the entrepreneurs. The task of the entrepreneur is to identify
commercial winners among the suppliers of technically defined innovations
and to get his/her choice of technology on a commercial footing.18 The
understanding may be of a long-run nature, or more temporary in the sense
that entrepreneurs may have to reconfigure their thoughts soon, or make
a business mistake (see Table 6.2). The main thing is that the entrepreneur
acts on the perceived economic opportunity (entre prendre in French).
A brief sidestep here. New growth theory is a sub-branch of neoclassical
theory and neoclassical theorists tend to order their assumptions such that
entrepreneurship has no economic role beyond innovation or technol-
ogy supply. Innovation supply, furthermore, is commonly represented
as drawings from a lottery, the participation in which is free of charge.

This process, furthermore, is staged within a rational expectations setting
or as a stationary process such that the differences between ex ante plans
and ex post outcomes cancel out in expectation over time as white noise.
A stochastic exogenous equilibrium can be defined. On this the Swedish
economic tradition, heralded by the Stockholm School economists, takes
a contrary position, more in line with Austrian economics and us (see
Eliasson, 1992, p. 256).19 The enormous and varied expanses of the business
opportunities space of the EOE, which keeps opening up new vistas as a
consequence of its exploration by the entrepreneurs, make the assumptions
of the mainstream neoclassical model empirically unreasonable. The math-
ematical reason is that the underlying structures of the assumed stationary
process change constantly, radically redefining the distributions.20 This
means that the standard assumptions of statistical learning do not hold.21
Learning under item 6 in Table 6.2 becomes unreliable.
The entrepreneur, however, rarely has resources of his own to move the
business project forward. He, therefore, (fourth) needs funding from an
industrially competent venture capitalist, that is, a provider of risk capital,
capable of understanding innovators of radically new technology and able
to identify business needs and provide context. The money is the least
important thing. What matters (Eliasson and Eliasson, 1996; Eliasson,
1997b, 2005c) is the competence to understand and identify winners and,
hence, provide reasonably priced equity funding.22 There is an asymmetry
problem here that relates to the risk willingness item in Table 6.2. The
entrepreneur believes s/he has understood the business situation (business
intuition, item 1).23 S/he therefore considers the risks low and is willing to
take them on. The outsider, for instance the venture capitalist, does not
have the same insight, and therefore considers the same situation more,
usually much more, uncertain.
Implicit in this statement is that the industrially incompetent venture
capitalist does not understand the project and, therefore, charges an
unreasonable (to the entrepreneur) price for his/her services. The supply
of industrially competent venture capitalists is extremely scarce (Eliasson,
1997b, 2005c). They constitute the critical link in the overall selection
process and, if lacking in performance, this is liable to result in the ‘loss of
winners’.
The issue of competent venture capital has long been politically sensi-
tive in some European countries since it signals the need for privately rich
and industrially competent people to move new industry formation. Such
signals run counter to political ambitions to even out income and wealth
distributions. The low rate of new entry in continental European countries,
including Sweden (Braunerhjelm, 1993), can have two explanations; low
entrepreneurial competence or lack of competent venture capital. The

argument in Sweden for a long time focused on the lack of entrepreneurial
spirit. It was often heard from banking circles that there was plenty of
money but very few good projects to invest in. The most credible expla-
nation, however, (Eliasson and Eliasson, 1996; Eliasson, 2005c) has been
lack of industrially competent bankers and venture capitalists. Without a
rich variety of such financial competence, you will not see many entrepre-
neurs. Hence, the venture capitalist and his escape (exit) market (fifth) are
the most important incentive supporting actors. With no understanding
venture capitalists the price of new capital will be prohibitively high, or
funding will not be forthcoming, and winners will be ‘lost’. With badly
functioning exit markets the incentives for venture capitalists will be small
and, hence, also for the entrepreneurs and the innovators.
With the rapid securitization of the global financial system the
markets for ownership or corporate control have gained in importance
(Rybsczynski, 1993). New actors have emerged trading in risks and the exit
markets have gained in sophistication and importance as private equity
investors with the capacity to mobilize very large financial resources have
entered the scene. In growing markets for strategic acquisitions small high
technology firms and large industrial firms (item 6) are trading in knowl-
edge assets.
Sixth, and finally, therefore, when the selection process has run its course
and a winner has been identified, a new type of industrial competence is
needed to take the innovation on to industrial scale production and distri-
bution. We cannot tell in advance what the formal role of the industrialist is
(CEO, chairman of the board, an active owner, or other). He or she figures
in the competence bloc on account of his or her capacity to contribute
functional competence. The capacity to identify, select and move winners
to industrial scale production is the most important growth promoting
property of the competence bloc. It defines a competitive advantage of
an economy. This innovative dynamic is what endogenizes growth in the
theory of the EOE.
Vertical completeness of the competence bloc, hence, is a necessary
requirement for the viable incentive structures that guarantee increas-
ing returns to a continued search for winners, that is, for new industry
formation. The extreme diversity of the opportunities space of the EOE
means that the competence needed to identify winners cannot be speci-
fied in advance. Hence, an efficient project identification and selection in
the competence bloc requires that a large number of each type of actor in
the competence bloc be present, so that if one actor does not understand
there will be others who might. Such horizontal diversity in competence is a
necessary condition for maximum exposure of each project to a competent
evaluation. Vertical completeness and horizontal diversity make the com-

petence bloc complete. Seeing to it that the competence blocs are complete
must, therefore, be the prime task of industrial policy (Eliasson, 2000).
None of the ‘pillars’ (the actors) of the competence bloc can be missing, or
the whole incentive structure will fail to develop.
In the EOE a premium is placed on flexibility. Actors all the time have
to take premature decisions on scant and unreliable information. As a
consequence they constantly commit more or less serious business mistakes
and have to be prepared to change their minds constantly. Flexibility in
the EOE is achieved in three ways. First, and most important, is to have
the right business idea (item 1 in Table 6.2). Second, and decisive when you
are on the wrong track, is early identification and correction of mistakes
(items 3 and 4). Third, when the first two criteria fail, the competence bloc
enforces flexibility through exit by withdrawing support. But this occurs
only after the project has been exposed to a varied and maximum com-
petent evaluation, thus minimizing the risk of losing a winner. The more
widely distributed over the market the competence bloc, the more flexible
the allocation process.
When vertical completeness and sufficient horizontal variety have been
achieved, critical mass has been reached. Then:
(1) Increasing returns to continued search for resources prevail. The loss
of winners is minimized.
(2) Competition among all actors in the competence bloc for the gains
that otherwise will be lost as lost winners ensures that less competent
actors exit.
The competence bloc will now function as an investment attractor such

that new entry takes place in such a way that the competence bloc benefits
from the new entrants, but (because of competition) only new entrants that
contribute to the competence bloc enter and/or survive.
The competence bloc then functions as an industrial spillover generator
and will begin to develop endogenously through its internal momentum
(critical mass). We have a positive sum game. These spillovers will diffuse
along many paths and both further reinforce the internal development
forces of the bloc and contribute serendipitously to other related and unre-
lated industries. Endogenous growth will occur (Eliasson, 1997a).
2.3 The Theory of the Firm Revisited
Compared with the internal project evaluation in a large firm, project

evaluation over the competence bloc draws much larger direct transactions
costs, since the evaluation is done in a distributed fashion involving many

independent actors in the market. Narrowing down the evaluation to an
internal procedure within a hierarchy, therefore, may lower direct transac-
tions costs, but the more narrow evaluation also raises the risk of losing
winners and therefore both raises total transactions costs and lowers the
efficiency of project selection. Hence, a relevant analysis of the optimal
organization of production has to include the loss of winners as a transac-
tions cost (Eliasson and Eliasson, 2005).24
A large firm, such as IBM in the 1980s, internalized most of its compe-
tence bloc. For a long time IBM was unable to get out of its mainframe
mentality due to lack of internal experience from the new industrial markets
of distributed computing and came close to disaster during the last years
of the 1980s, during its attempts to transform itself away from mainframe
technology. Business history is full of near losses based on narrow-minded
internal business judgment in large hierarchies, the only ones that can be
identified (Eliasson, 1996).
The contrary solution with all functions distributed over the market,
however, has other problems, even though Fama (1980) argued that there
was no need for an entrepreneur in economic theory, since the services of
the entrepreneur could always be rented in the market. Most of economic
literature and debate, furthermore, neglects the commercialization compe-
tence altogether and we have a neo-Schumpeterian literature that comes
very close to neoclassical literature in presenting the firm or an industry as
a direct linear R&D, technology supply and growth machine. And socialist
thinking on the matter has been even more negligent in understanding any
merit in the competitive functions of markets.
Competence bloc theory has no role to play under the assumptions of
the static general equilibrium (neoclassical) model in which all knowledge
has the qualities of codable and communicable information that can
be centralized to one place for a complete overview. Competence bloc
theory, however, has a decisive role to play in project selection within and
between hierarchies when tacit, non-codable knowledge embodied in indi-
viduals and hierarchies has to be mobilized within hierarchies and through
markets. Once this has been said, we know that the nature and distribu-
tion of knowledge determine the ‘optimal’ combination of hierarchies and
markets through which the total knowledge base can be mobilized for
particular business problems. We have a dynamic version of Coase’s (1937)
theory of the firm in which the hierarchical structure of markets is not only
endogenized as an equilibrium property but also changes as a consequence
of the constantly ongoing project selection in an experimentally organized
economy.
In that setting the critical task of the top competent team of a firm
is to identify the best organizational structure for the particular busi-

ness problem at hand (Eliasson, 1990a). Since that structure constantly
changes, new organizational structures constantly have to be identified.
This is not at all easy and management mistakes are constantly made.
Hence, learning feedback (item 6 in Table 6.2) is limited. Such limited
learning possibilities are typical of the theory of the EOE. It has also been
a typical experience in the recent ongoing outsourcing business culture
(Eliasson, 2005d). A systematic test of the limitations of business learning
is presented in Eliasson (2005b) in which business planning and manage-
ment methods during and between the three periods of post-World War II
development are compared: (1) the pre-oil crisis steady state experience of
1969–75, (2) the post-oil crisis sobering-up through most of the 1990s and
(3) the rapid emergence of globally distributed production from the mid
1990s, blurring the notion of the firm/hierarchy to be managed. In general,
management experience did not carry over reliably between the periods,
and business mistakes occurred on a grand scale during those transitions.
Furthermore, distributed production and unstable hierarchies undermine
the whole notion of the central authority of a corporate headquarters
(Eliasson, 2005a, Chapter V). Top-down push-through of orders does not
work when the hierarchy responds by changing its structure. This problem
of endogenous hierarchies or organization poses the same analytical
problem as that discussed already by Wicksell (1923), mentioned above,
and provides a rational argument for integrating the theory of organiza-
tion with that of allocation.25
Through the early 1990s Sweden featured an extreme concentration of
historically grown and successful large-scale and international manufac-
turing companies. For decades this was considered synonymous with an
equally rich endowment of business leadership competence that could be
carried over from generation to generation (Eliasson, 1990b, 2005b). To
some extent this was of course true, but this competence had been acquired
in traditional mature industries that innovate slowly. The management
of innovation in the new type of industries like biotech is radically differ-
ent from that in mature industries such as engineering. Experience is that
leadership competence acquired in traditional industries is of limited use
in the radically new industries and sometimes outright dangerous to apply.
The learning feedback (item 6 in Table 6.2) is correspondingly unreliable
(Eliasson, 2005b). For some reason the large Swedish companies exhibited
unusual organizational innovation capacity coming out of the oil crises of
the 1970s and carrying Swedish manufacturing growth in the 1980s, but
it was concluded in Andersson et al. (1993) that this was a story that no
one should count on to be repeated. True enough. When Swedish industry
entered the ‘New Economy’ of globally distributed production during the
second half of the 1990s the giants began to stumble, presumably because
the earlier management experience was not a reliable management guide
into the future (Eliasson, 2005a). Presumptuous big business leaders who
enter radically new businesses with an air of authority, therefore, may
even be a negative factor for development. Hence, Swedish manufacturing
industry perhaps no longer features the rich and varied competence blocs
needed for the efficient project selection that worked well for decades but
does not seem to work at all that well as we currently attempt to enter a
radically New Economy.
3. INSTITUTIONS, TRADE IN PROPERTY RIGHTS

AND SOCIAL CAPITAL/COMPETENCE
Project selection over markets always involves trade in knowledge assets

between actors in a competence bloc. Competence bloc theory explains
those transactions explicitly, why large resources (transactions costs)
are needed and why transactions competence is critical for dynamically
efficient allocations in the theory of the EOE, but not in the mainstream
neoclassical model. We therefore have to relate the competence bloc theory
just introduced back into the economic environment of the EOE.
3.1 Institutions, Incentives and Competition
None of the economic dynamics discussed so far can occur without a

minimum of supporting institutional infrastructure needed to establish
the required tradability in knowledge assets. Institutions define incentives
to act on business opportunities that fuel competition. In general, if com-
plete contracts that define the transfer of ownership associated with trade
cannot be formulated, trade will be correspondingly limited and under-
supply will follow (Williamson, 1985). Resource allocation in the experi-
mentally organized economy involves trade in intellectual property rights
across the competence bloc, notably throughout the markets for venture
capital, the exit markets and the markets for strategic acquisitions on its
commercialization side. For the full macroeconomic growth potential of
innovative project creation and selection in Table 6.1 to be realized, this
trade will have to occur with a minimum of risks and transactions costs.
For this to be realized property rights to these intellectual assets have to be
well defined. Those property rights are not needed for the same transac-
tions to be organized within a hierarchy. For all projects to be exposed to a
maximum competent evaluation over the competence bloc, efficient prop-
erty rights of this kind thus have to be in place. Only then will the relative
superiority of the broad market exposure of competence on each project

be fairly compared with the narrow exposure within a hierarchy, and the
key factor will be the tradability of intangible knowledge in financial asset
markets (Eliasson and Wihlborg, 2003).
3.2 Social Capital/Competence
Competence bloc theory has been shown to be needed to explain the effi-
ciency of project selection in the EOE. Under the informational assump-
tions of the EOE, the selection and allocation processes supporting stable
economic growth at the macro level become unpredictable and socially
demanding at local micro levels. This suggests that the overriding welfare
and policy concern should be to design institutions that support the ability
of individuals to cope with environmental unpredictability and the expo-
sure to arbitrary change that increases with economic efficiency and growth
(Day, 1986a, 1993, notably p. 77; Eliasson, 1983, 1984). This suggests that
what we call social capital should be defined in terms of how it supports
individuals’ ability to cope (Eliasson, 2001a)26 and in doing so we also
recognize that the support of social capital development becomes a criti-
cal part of both industrial and social policy, to be elaborated in another
context (Eliasson, 2000, 2006b).
4. ENDOGENOUS GROWTH THROUGH

COMPETITION – THE DYNAMICS OF GOING
FROM MICRO TO MACRO AND BACK
Endogenous growth in the theory of the EOE is explained with reference

to the Schumpeterian creative destruction process of Table 6.1 and how
it works in the Swedish micro-to-macro model (Eliasson, 1991a, 1996, p.
45). Competition there keeps the entrepreneurial and commercialization
processes in motion and the Särimner innovation/learning effect keeps the
investment opportunities space expanding to sustain growth. But compe-
tition has to be activated. It may be prohibited or regulated. Actors may
enjoy monopoly conditions and earn more by colluding than competing.
Incentives to compete are therefore not sufficient to activate competition.
The rational foundation of endogenous growth through the
Schumpeterian creative destruction process of Table 6.1, therefore, has to
explain why each actor in a market of the EOE constantly has to innovate
and improve its performance, or perish. The reason is that each actor lives
in a constant state of fear of being overrun by new and old competition.
The opportunities space or the Särimner effect combined with unrestricted
55
50
45
40
35
Rate of returns (percent)
30
25
20
15
10 1990
5
0
–5
1983
–10
–15
–20
–25
0 10 20 30 40 50 60 70 80 90 100
Cumulative capital stock (percent)
Note: The vertical columns show the position on the Salter curve of one firm, the width
measuring its size in percent of total industry capital.
Source: MOSES Database (1992) and updatings.
Figure 6.2a Salter curve distribution of rates of return on total capital in

Swedish manufacturing in 1983 and 1990
free entry keeps experimental exploration of the opportunities space active

as a necessary means of survival. The rationale for this is that each actor
is constantly challenged in the market, from above by superior (‘more
profitable’) competitors that can pay more for factors of production or
lower prices, and from below by inferior firms that have to innovate and
leapfrog superior competitors to prevent them from competing them out
of business.
The Salter curves (1960) in Figures 6.2a and 6.2b illustrate how this
endogenization of growth has been specified in the Swedish micro-to-macro
model (Eliasson, 1977, 1985). The Salter curves rank firms (or divisions of
large firms) in Swedish manufacturing industry in 1983 and 1990 by returns
to capital and labor productivity. It is part of the micro database used to
initiate simulations on the Swedish micro-to-macro model. The spread of
the Salter distributions illustrate the great opportunities for improvement
Labour productivity
650
600
550
500
450
400
350
300
250
200 1990
150
100 1983
50
0
0 10 20 30 40 50 60 70 80 90 100
Percent
Note: The columns indicate the same firm as in the previous figure, the size now being measured
in percent of total employment. The shaded areas measure unused capacity for each firm.
Source: MosesDataBase (1992) and updatings.
Figure 6.2b Salter curves of labor productivities in Swedish

manufacturing in 1983 and 1990
in macro performance through reallocation of resources. This reallocation

can be set in motion through competition.
The firm is indicated by a column, its width measuring its size in percent
of the total capital or the total employment of the firm population. This
firm is challenging the less profitable or productive firms to the right, by
being able to outbid them for resources. But these firms being challenged
also challenge the firms to their left by attempting to leapfrog them through
innovation and investment.
The Salter curves in Figures 6.2a and 6.2b are snapshots at one point in
time. At each point in time entrants wait behind the scene. New entrants
on average exhibit lower performance than incumbents, but the spread is
much wider. This is empirically well established. Hence, there will always
be a few winners in the entry flow of firms that survive and grow into major
players, provided the local commercialization competence is sufficient. The
underperforming entrants are sooner or later competed out of business.
The outcome for the firm indicated in Figure 6.2a in 1990 has been an
improvement in profitability, but a loss in ranking. As a consequence the
Salter curves ranking productivities in Figure 6.2b shift outward. Growth
occurs.
For this competitive process, spurred by fear, to be sustained and result
in sustainable growth it is, of course, possible to introduce the standard
stochastic innovation lottery that are commonly found in the new growth
models. We have done that in the Swedish micro-to-macro model (Hanson,
1986, 1989; Taymaz, 1991), but a more satisfactory solution is to model
the innovation process explicitly by making it possible for firms to learn to
upgrade their productivity from superior competitors when exploring the
opportunities space and to model creative encounters during that explora-
tion which create new and superior combinations that in turn expand the
opportunities space and open possibilities for others to discover and learn
from, and so on. This Särimner creativity process has been based on the
Ballot and Taymaz (1998) genetic learning mechanism in the model. The
distributions that define innovation supplies will then be endogenously
determined, explicitly derived and deterministic, and not entered as an
assumed stochastic process as in Aghion and Howitt (1992, 1998), Pakes
and Ericson (1998) and Nelson and Winter’s (1982) evolutionary model
(on the last see in particular Winter, 1986). Competence bloc theory in
combination with Ballot and Taymaz (1998) has made it possible to avoid
the less satisfactory approach of modeling the source of economic devel-
opment as draws of productivity gains in a given lottery (from a stationary
distribution) that represents the combined outcome of innovators, entre-
preneurs and venture capitalists, a lottery that does not even charge you
for your participation and that is presumably organized by the state. Our
approach is still a crude approximation of what we aim for, focusing on
the role of industrially competent venture capital provision (Ballot et al.,
2006), but it is sufficient to overcome the logical but false linearity between
innovation supply (through the lottery) and economic growth27 that short-
circuits the commercialization process in new growth literature.
5. ALLOCATION AND ECONOMIC GROWTH
The Schumpeterian creative destruction process of Table 6.1 does not

guarantee macroeconomic growth. Destruction may dominate over crea-
tion for considerable time and with permanent long-term consequences.
Reorganization of firms (item 2) might very well be guided by caution
and mistaken perceptions and result in a general contraction of output
among firms. The main thing is that institutions are organized such that
winners are created and identified in the competence bloc and carried on
to industrial scale production and distribution, while losers are pushed
out. In the Swedish micro-to-macro model (Eliasson, 1991a), choice algo-
rithms determine the decisions of individual firms in this respect. Since
the competence bloc not only creates, identifies and selects winners but
also supports winners by directing (financial) resources to them, this also
illustrates the role of the competence bloc, not only as a creator and an
identifier of winners but also as an organizer of the allocation of tacit,
human embodied knowledge, and as a financial resource provider. Since
all actors in the competence bloc embody a rich variety of tacit competen-
cies, the competence bloc becomes an allocator of its own competence.
The competence bloc becomes the core resource allocator in an EOE.
5.1 Technological Diffusion
The diffusion of new technology as directed by the competence bloc occurs

along six distinct channels (Table 6.4): (1) when people with competence
move over the labor market, (2) through the entry of new firms when
people with competence leave established firms, (3) through mutual learn-
ing between subcontractors and the systems coordinator, (4) when a firm
strategically acquires other firms to integrate their particular knowledge
with its own competence base, (5) when competitors imitate the products
of successful and leading firms (the ‘Japanese approach’), and (6) through
organic growth of and learning in incumbent firms.
Items 3 and 4 are particularly important for the advanced mature indus-
trial economies. Some of them, but not all of them, have the capacity to
develop and produce very advanced and technologically complex systems
products such as aircraft, submarines and large trucks. Such products
embody so many different technologies that change rapidly and so many
Table 6.4 New technology is diffused
1. when people with competence move (labor market)

2. through new establishment by people who leave other firms (innovation
and entrepreneurship)
3. when subcontractors learn from the systems coordinating firm, and vice
versa (competent purchasing)
4. through strategic acquisitions of small R&D intensive firms (strategic
acquisitions)
5. when competitors learn from technological leaders (imitation)
6. through organic growth and learning in incumbent firms
Source: G. Eliasson (1995).

specialist components that it is impossible to develop and produce them

within one company. Both development and manufacturing have to be
distributed over subcontractors in the market (Eliasson, 2001b). All actors
have to understand how to operate as a sophisticated participant in the
‘whole’. Hence, mutual learning within such a systems product complex
is an important part of the technological diffusion process of the very
advanced economies.28
One observation can be made from a close study of Table 6.4: efficient
diffusion of new technology requires effective market support, notably
in the labor market (item 1 in Table 6.4) but also in the venture capital
market and the markets for mergers and acquisitions (M&A) (Eliasson
and Eliasson, 2005). Completeness of the competence bloc again becomes
a critical requirement for the introduction of radically new technology.
Efficient diffusion is also a necessary condition for spillovers and compe-
tence bloc development, but it is not sufficient. For new technology to be
introduced in production receiver competence (Eliasson, 1987b, 1990a) is
needed. Entrepreneurial and venture capital competencies are part of this,
but the general and rapid introduction of new technology also requires a
varied and competent labor force at all levels (workers, engineers, manag-
ers and executive people).
5.2 The Informational Assumptions Revisited
The distinguishing features of the theory of the EOE hinge on its informa-
tional assumptions. Under the assumptions of the EOE, tacit knowledge or
competence in the sense of limited communicability can be shown to exist
(Eliasson, 1990a). The coordination of actors guided by tacit competencies
can never be perfect. It is costly, the largest cost being not resources used
directly in information processing but the ‘profits lost’ when business mis-
takes are being committed.29 It also involves the selection and coordination
of tacit competencies for the same coordination, a task that unavoidably
leads to an infinite regress and no determinate best or optimum outcome
(read exogenous equilibrium).
A competence bloc, hence, can also be defined as an organization of
institutions and actors with (tacit) competence such that incentives and
competition contribute to as efficient an allocation of total resources as is
possible. This includes the allocation of the tacit competencies embodied
in the actors. Hence, under the informational assumptions of the EOE,
the best possible allocation cannot be determined. There will always be
unknown better allocations. This conclusion only requires our assumption
of an immense, non-transparent business opportunities space, an assump-
tion30 that places us, and the EOE, in the early Austrian tradition of Carl
Menger (1871), who emphasized the ignorance of actors and the frequent
incidence of business mistakes (Alter, 1990).
It may be considered presumptuous to modify the standard informa-
tional assumptions of mainstream economic theory such that the all-
powerful mathematical tool of calculus appears to be rendered useless.
But there are good reasons. First, it is easy to quote a massive empirical
evidence in favor of the assumptions of the EOE. Second, attempts to
penetrate the inner mechanics of new growth models, such as Pakes and
Ericson (1998), that are based on a Walrasian, Arrow and Debreu (1954)
type equilibrium platform tell a story that is not less complex than the
story of the EOE or the mathematics of its model approximation, MOSES.
A possible objection might, however, be (third) that, even though not
correct, the informational assumptions of the neoclassical model work
well as a reasonable approximation and generate good predictions in the
spirit of Friedman (1953). Of what? It is difficult to find good examples.
However, fourth, a reasonable argument for being methodologically con-
servative is that one might as well keep the familiar mathematical tool box
until someone has come up with something better (Clower, 1986).31 Now,
that has been done and it appears that the properties of the theory of the
EOE that are obtained after some marginal modifications of the assump-
tions of the WAD model require simulation mathematics in order to be
satisfactorily investigated.
Removing the devotion to calculus in economics would therefore help
make way for the powerful simulation tool and more relevant economic
theory, a prediction voiced about fifty years ago by Koopmans (1957,
p. 174).
NOTES
1. This chapter merges the theory of the experimentally organized economy (EOE)
(Eliasson, 1991a) with that of competence blocs (Eliasson and Eliasson, 1996). The
theory of the EOE has grown out of many years of experimenting with the Swedish
micro-to-macro model (Eliasson, 1977, 1991a; Albrecht et al., 1992, Ballot and Taymaz
1998) to the extent that the model should now be seen – as will be explained in the text
– as a quantitative approximation of the theory of the EOE. As such the text is very
empirical and based as well on several hundred interviews carried out by one of us, or
the two of us together, and on analyses of data assembled for the model (see Albrecht et
al., 1992). To keep the theory of the EOE and its model approximation in the sustain-
able Austrian/Schumpeterian state that distinguishes it from the standard neoclassical
model, certain assumptions relating to the nature of the state space of the model (its size,
complexity and heterogeneity) have to be made.
2. From the pig in the Viking sagas that was eaten for supper in Valhalla, only to return
the next day to be eaten again, and so on. The difference from the situation in Valhalla,
which we make a point of, is that the opportunities space not only stays large; it grows
from being explored. We are confronted with a positive sum game. By being concerned
not only with the neoclassical problem of how to manage a given endowment of scarce
resources but also with the Aristotelian problem of how resources are created, we face
the positive sum game of the EOE that endogenizes growth (Eliasson, 1987a, p. 28f,
1990b, p. 46f). During the year 2007, when the 300th year birthday of the Swedish
botanist Linnaeus was celebrated, it felt appropriate to mention (Frankelius, 2007) that
Linnaeus, in his until now not translated (from Latin), but frequently quoted, main
work Systema Naturae Sive Regna Tria Naturae Systematice Proposita Per Classes,
Ordines, Genera & Species (Leyden, 1735), considered economics to be the greatest of
all sciences. And his concern was to create economic value through exploration of, and
discoveries in, nature.
3. The Nirvana complex has a long history. In his Candide (1759) Voltaire poked fun at
Leibnitz’s vision of the best of all worlds. Leibnitz, by the way, laid the foundation of
the mathematics used by neoclassical economists today.
4. To the extent that they can be determined.
5. Hence, starting from any place, as long as you walk uphill you will eventually reach the
peak. There are hundreds of mathematical algorithms that approximate that task in
economic modeling.
6. This feature of the EOE has been investigated on a quantitative micro-based macro
model of the EOE in which structures and prices are simultaneously determined in an
interactive fashion, using up transactions resources in the process. In static equilibrium
that can only be achieved under very restrictive assumptions, notably zero transactions
costs, duality prevails and prices reflect exactly quantities, and vice versa. The further
away from ‘static equilibrium’, the more unreliable prices are as signals of future
optimum quantities and the more frequent and larger the mistakes. If you push the
economy closer to an approximate equilibrium the entire model structure is destabilized
and eventually collapses (Eliasson 1991a; Eliasson et al., 2005).
7. The theory of the EOE is not structured as a mathematical model. The micro assump-
tions, therefore, can only be linked to macro through verbal reasoning. The Swedish
micro(firm)-to-macro model (Eliasson, 1991a), on the other hand, is a mathematical
model that can be said to approximate the EOE. Common to both, and the source of
endogenous growth, is the dynamic of the Schumpeterian creative destruction process of
Table 6.1. In fact, the theory of the EOE was inspired by experimenting with that model
(Eliasson, 1987a).
8. This reasoning can be nicely illustrated using a Salter (1960) curve; see Figures 6.2a and b
in Section 4, and Eliasson (1991a, 1996, p. 44f). This is also the way growth occurs in the
Swedish micro-to-macro model (Eliasson, 1991a), which is based on empirically deter-
mined Salter curves and firms constantly shifting position on the Salter curves as they are
induced by incentives and pushed by competition. Competence bloc theory explains how
this competitive process can be organized differently and more efficiently. It is particularly
important to observe that innovative entry subjects incumbent firms to competition and
forces them to respond. Their response in the form of reorganization and rationalization
may mean either expansion or contraction, depending upon incentives embodied in the
institutions of the economy and the individual competence capital of firms.
9. Growth through competitive experimental selection through innovative entry is explic-
itly modeled in the micro-based macro Model Of the Swedish Economic System
(MOSES) (Eliasson, 1977, 1985, 1991a) in which learning costs through business mis-
takes are explicit. The early, simple expectations functions have been complemented
with genetic learning mechanisms in Ballot and Taymaz (1998).
10. Which may be a relevant situation for continental Europe where such a large number
of people are prematurely retired, on sick leave or outright unemployed, but much less
in the US where growth to a larger extent occurs through the reallocation of employed
people (G. Eliasson, 2006a, b).
11. This is the case in the Swedish micro-to-macro model (Eliasson, 1977, 1991a) which
approximates the EOE. Whatever output trajectory over the long run that you simulate,
you can be fairly sure that better outcomes exist.
12. Most definitions of tacit knowledge are much broader than this. For our purpose,
however, this narrow definition is sufficient. A broader definition will only strengthen
the empirical implications of our analysis.
13. Note that this is the exact opposite conclusion to the standard view of the Walras–
Arrow–Debreu model, in which the Walrasian superauctioneer is assumed to be capable
of achieving a complete and costless central overview of the entire economic landscape,
and to identify the one superior position of the economy that is there by assumption for
instance as modeled by Malinvaud (1967).
14. This constitutes a second information paradox of economics referred to earlier, namely
that we are becoming less and less informed about what is becoming more and more
important, namely the quality of inputs and outputs (Eliasson, 1990b, p. 16).
15. As pointed out already by Burenstam-Linder (1961). Burenstam-Linder, however,
carried out his argument in terms of static international trade theory and called it com-
parative advantage.
16. On this Granstrand and Sjölander (1990a, b) observe that a broad internal technology
base makes the firm more efficient in acquiring and implementing new complementary
knowledge, for instance through the acquisition of innovative technology firms.
17. This was a property of the Swedish micro-to-macro model as early as Eliasson (1979,
1981) when the property was ‘discovered’ as part of a crudely modeled commercializa-
tion process.
18. This distinction between the innovator and the entrepreneur originated in Mises (1949).
Schumpeter was not clear on this and often used the term innovator to signify what we
mean by an entrepreneur. With our definition we do not need the third concept, the
inventor, which Schumpeter frequently used to emphasize the technical dimensions of
an innovation.
19. Stationarity means that distributions have constant (over time) mean and variation.
A stationary process will keep generating data such that the parameters of the statisti-
cally defined entrepreneur will eventually be known for sure with any precision desired.
Besides being an absurd representation of ‘the entrepreneur’, it has been demonstrated
that such statistical learning requires a hopelessly narrow specification of the state space,
expressed as a stationary process, to allow any learning at all (Lindh, 1993).
20. In a huge Las Vegas gaming hall à la Rothschild (1974) the analogy would be each
actor rushing around between the one-armed bandits using his or her personal criteria
to change console. Even though each bandit is governed by a particular stationary
process for ever, the activity going on in the entire gaming hall (the ‘market’) cannot be
approximated by a stationary process that does not change over time.
21. Which are identical to those of rational expectations and efficient market theory.
Antonov and Trofinov (1993) demonstrate how simple statistical learning through fore-
casting a non-linear environment with linear economic prediction models of a standard
Keynesian or neoclassical type produces worse macroeconomic outcomes than the use
of completely ad hoc individual experience-based relationships.
22. The venture capitalists also contribute managerial, financing and marketing competence
through their network, but this comes after the ‘understanding’. Such services are nor-
mally available in the market and, consequently, are less critical.
23. Knight (1921) would say that the entrepreneur converted an uncertain situation
into a situation of calculable risks. See also LeRoy and Singell (1987) and Eliasson
(1990a).
24. Even though the economic value of the loss of winners is indeterminate in the theory of
the EOE. This is no problem in the neoclassical model in which business mistakes and
loss of winners do not exist by assumption, with the possible exception of random losses
in stochastic equilibrium models which are outright irrelevant in an industrial economics
analysis.
25. An anonymous referee pointed out that this problem of ‘seemingly endless reorgani-
zation’ and unpredictable market behavior has already been discussed by Ilinitch et
al. (1996). It would, however, mean a new chapter to address also the problem of
‘hypercompetition’ here. True, however, and in keeping with my argument, standard

neoclassical theory has little to say on this.
26. This is a more narrow definition of social capital than the broad, empirically difficult
categories of Coleman (1988), Putnam (2000), Ritzen (2001) and Woolcock (2001). We
are, in fact, much closer in definition to the abilities to cope that Wolfe and Haveman
(2001) relate to educational capital.
27. Which by accident has its origin in Schumpeter (1942). Schumpeter was a great admirer
of Walras. He sometimes ‘pedagogically’ began his argument by making the innovator
an exogenous disturber of the Walrasian equilibrium. By postulating that once success-
ful the routine R&D/innovation department of a firm would then for ever make that
firm the dominant player in its market, Schumpeter invoked the perennial problem of
economies of scale in the Walrasian model. This corner solution troubled Marshall. He
invented the concept of an ‘industrial district’ where the scale economies originated in
the district as a whole rather than with individual firms. Romer (1986, 1990) formulated
this mathematically in macro under the title of ‘new growth theory’, however without
quoting Marshall.
28. It is also obvious that as long as the distributed production system remains within the
borders of a nation it offers a protective shield against foreign ‘competitive imitation’
(under item 5).
29. In fact, accounting for the implicit cost of ‘lost profits’ is what distinguishes our model
from the standard neoclassical model. For an interesting early discussion of this see
Dahlman (1979).
30. Note that Arrow and Debreu (1954), pioneering modern mathematical economics,
carefully crafted their assumptions to avoid this result. There is no mention of Austrian
economics and Hayek (1937, 1940, 1945), which, though by far the most penetrating
treaties on information economics at the time, are not even quoted.
31. In the discussion of Herbert Simon’s presentation at the conference on ‘The Dynamics of
Market Economies’, organized by the IUI, 1983 (see Day and Eliasson, 1986, pp. 42ff).
BIBLIOGRAPHY
Aghion, Philippe and Peter Howitt (1992), ‘A Model of Growth through

Schumpeterian Creative Destruction’, Econometrica, 60 (2) (March), 323–51.
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PART III
Investments and the legal environment

7. Corporate governance and
investments in Scandinavia –
ownership concentration and
dual-class equity structure*
Johan E. Eklund
1. INTRODUCTION
In essence, the corporate governance system in a country is the institutional
framework that supports the suppliers of finance to corporations and
enables firms to raise substantial amounts of capital (Shleifer and Vishny,
1997).1 By protecting suppliers of capital and safeguarding property, sound
governance systems facilitate mobilization and allocation of capital to
useful investments. Corporate governance systems are of outmost impor-
tance for the allocation of capital to its highest value use. It can be argued
that the corporate governance system in a country determines the speed of
structural change and economic development by affecting allocation and
reallocation of capital. Therefore the crucial question is whether the cor-
porate governance system induces managers of corporations to make good
value enhancing investments decisions, or not. In particular, the ownership
concentration and composition appear to matter for firm performance, as
shown by Morck et al. (1988).2 This chapter looks at corporate governance
and the rate of return on corporate investments in Scandinavia. The struc-
ture of ownership and its effects on performance are examined.
Taking an outsider’s view of Scandinavia, the corporate governance sys-
tems in the Scandinavian countries, Sweden, Finland, Norway and Denmark,
arguably display more similarities than differences. The countries share a
number of important features that unify them in comparison with other
countries. It has, for example, been hypothesized that the common origin of
the legal systems in Scandinavia is still reflected in the quality of corporate
governance (La Porta et al., 1997). Furthermore, Scandinavian firms are typi-
cally controlled by a dominant owner and only a small minority of firms are
characterized by dispersed ownership structure. Finally, the Scandinavian
countries can also be said to have a common political orientation, with strong
139
140 Investments and the legal environment
social democratic traditions (for example, Högfeldt, 2004), which, according

to Roe (2003), matters for corporate governance.
Such apparent homogeneity of the Scandinavian countries in combina-
tion with the importance of well functioning corporate governance systems
motivates a comparison of corporate returns and ownership structure in
Scandinavia. The purposes of this chapter are therefore the following. First,
the returns on investments made by the largest firms in Scandinavia are
assessed. Second, the effect of ownership structure on investment decisions
is examined as a factor explaining variation in performance and in returns
on investments. Finally, and perhaps most importantly, the chapter analyses
how deviations from the one-share-one-vote principle affect this ownership–
performance relationship. Outright expropriation of corporate assets and
investor funds by managers is likely to be small in developed economies, such
as the Scandinavian ones. Over-investment in pursuit of ends other than profit
maximization and misallocation of assets is more likely to be a problem.
The chapter is organized in six sections. Relevant literature on invest-
ments, corporate governance and ownership is reviewed in Section 2. In
Section 3 the method is derived and the data are described. In Section 4,
the return on corporate investments in Scandinavia is assessed. The fifth
section examines how ownership and the extensive use of dual-class shares
affect investment decisions. Section 6 provides the conclusions.
2. CORPORATE CONTROL AND INVESTMENT
Neoclassical investment theory suggests that investments are expanded up

to the point where the expected marginal rate of return equals the oppor-
tunity cost of capital. This condition would be satisfied in a friction-free
world without any informational asymmetries, agency problems or trans-
action costs. Capital would flow automatically to the most efficient use
and thereby guarantee that welfare is maximized. However, in the modern
corporation, with its separation of owners and financiers from the manage-
ment, there arises a set of agency problems that can cause investment deci-
sions to deviate from what is predicted in neoclassical models (see Mueller
(2003) for a review of investment theories).
Berle and Means (1932) were the first to call attention to the potential
agency costs.3 They argued that corporate ownership in large listed firms
would become dispersed up to a point where professional managers would
become unaccountable to the shareholders. Later, Jensen and Meckling
(1976) provide a more theoretical underpinning to the linkages between
agency costs and ownership structure. Jensen and Meckling analyse how the
interests of utility maximizing owner-managers and minority shareholders
Corporate governance and investments in Scandinavia 141
diverge as ownership structure becomes more dispersed. Their basic argument

is that the owner-manager will not bear the full cost of on-the-job consump-
tion.4 Potential minority investors will realize this and subsequently the share
price will reflect the divergence of interests between owner-managers and
minority shareholders. Arguably the conflict of interests becomes more severe
as the equity stake of owner-managers decreases. Jensen and Meckling (1976)
argue that investors with high stakes will also have incentives to maximize firm
value. This is referred to as the incentive effect. Hypothesis 1 is therefore:
H1 Ownership concentration will improve investment performance.
In this view, agency costs increase as ownership is diluted and becomes dis-
persed. However, not all have seen the separation of ownership and control
as a potential problem, where the counter-hypothesis is that control and
ownership separation may improve allocation. Thorstein Veblen (1921),
for example, argues that this separation would lead to the control being
turned over from ‘monopoly’-seeking owners/businessmen to growth and
efficiency-seeking management. Veblen claims for example that if
industry were completely organized as a systemic whole, and were then managed
by competent technicians with an eye single to maximum production of goods
and services; instead of, as now, being manhandled by ignorant business men
with an eye single to maximum profits; the resulting output of goods and serv-
ices would doubtless exceed the current output by several hundred per cent.
(Veblen, 1921)
Recognizing that owner-managers are also guided by utility maximiza-

tion and not pure profit maximization, Demsetz (1983) argues that it is
not clear that diffusion of ownership will automatically have a detrimental
effect. In fact, it has been argued that as the stake of owner-managers
increases, so does their ability to misallocate resources (Stulz, 1988). This
effect is referred to as the entrenchment effect (see Morck et al., 1988,
and Stulz, 1988). Morck et al. (1988) find a non-monotonic relationship
between ownership and Tobin’s q. They find that performance initially
increases with ownership concentration, then declines and finally increases
again, which is consistent with an entrenchment effect. McConnell and
Servaes (1990) find similar results.5 Expecting a managerial entrenchment
effect leads to the second hypothesis:
H2 Ownership concentration will have a non-linear effect on performance.
The generality of the Berle and Means (1932) observation is, however,
empirically challenged. Looking at ownership structure around the world,
most corporations have concentrated ownership and are controlled by

families (Morck et al., 2005; La Porta et al., 1999). Faccio and Lang
(2002) study the ownership in Europe and find that corporations are
predominantly controlled by families in continental Europe. This control
is achieved without corresponding capital by means of primarily three
different control enhancing mechanisms (CEM): vote-differentiation of
shares, pyramid ownership and cross-holdings. This means that the divi-
sion between what Berle and Means (1932) call ‘nominal ownership’ and
the corporate control is further enhanced by separating the capital stake
and the voting power, making it possible for a small group of investors,
often the founding family, to maintain control of the firm.
Burkart and Lee (2008) review the theoretical literature on one-
share-one-vote arguing that there are both positive and negative effects
associated with dual-class shares. Adams and Ferreira (2008) review
the empirical literature and find the empirical evidence inconclusive.6
Bebchuk et al. (1999), on the other hand, argue that these control
mechanisms distort the incentives of the controlling owners and there-
fore potentially may cause a sharp increase in agency costs. When the
incentives are distorted, this may potentially have a negative impact on
the optimal choice of investments, scope of the firm and transferral of
control. Separation of control rights and cash-flow rights not only alters
the control structure of the corporation but also changes the incentives
of owner-managers. An effect one can expect from the separation of
cash-flow and control rights is that the positive incentive effect will be
weakened whereas the entrenchment effect will be enhanced. From this,
hypothesis 3 follows:
H3 Control mechanisms such as dual-class equity structure will weaken

the incentive and enhance the entrenchment effect.
Using a market-to-book measure of Tobin’s q, Claessens et al. (2002)

find evidence that is consistent with this hypothesis. They examine a large
number of firms in East Asia and find that cash-flow rights are positively
correlated with performance. However, control rights in excess of cash-
flow rights have a negative effect on firm value. A large number of studies
also establish a link between ownership structure and concentration on
the one hand and performance on the other. Countries with weaker inves-
tor protection tend to have a more concentrated ownership structure (see
for example La Porta et al., 1997). In fact, the two most common ways of
dealing with the agency aspects of corporate governance are, according to
Shleifer and Vishny (1997), first, legal and regulatory protection of investor
and minority rights, and second, large and concentrated owners.
2.1 Corporate Governance in Scandinavia
The corporate governance systems in Scandinavia have some unique fea-

tures that change the prediction of the Jensen and Meckling model. Like
most firms in continental Europe, the Scandinavian firms very often have
controlling owners that have maintained their control even when their
capital stake has declined and the firms have grown. Most European coun-
tries allow at least one of the three principal instruments for enhancing
ownership control: cross-holdings, pyramid ownership and vote-differen-
tiation (Söderström et al., 2003).
In particular, the extensive use of vote-differentiated shares has had a
substantial impact on the way in which the ownership structure has evolved
in Scandinavia. In Norway about 14 percent of listed firms use dual-class
shares, in Denmark and Finland more than 30 percent, and in Sweden it
is as high as 55 percent (Bøhren and Ødegaard, 2006; Söderström et al.,
2003). Many countries in Europe do not allow for dual-class share systems,
so this is one of the prominent distinguishing features of the corporate
governance systems in Scandinavia. The frequent use of dual-class shares,
with strong separation of voting rights and equity claims, has produced
very strong and stable ownership structures in Scandinavia (Högfeldt,
2004; Henrekson and Jakobsson, 2006). By using vote-differentiation,
the founding families may retain control of firms even with a very small
equity share. Most firms in Scandinavia have a single controlling owner
and very few firms are characterized by dispersed ownership. Bennedsen
and Nielsen (2005) report significant differences in the frequency of control
mechanisms for a sample of 4096 European firms (see Table 7.1).
Cronqvist and Nilsson (2003) examine a large sample of Swedish listed
firms and find that controlling owners have a negative effect on Tobin’s
average q. These controlling owners are also more likely to use control mech-
anisms. Maury and Pajuste (2004) examine a sample of Finnish firms and
show that a more uniform distribution of votes among large block holders is
positive for firm valuation. They also find that divergence between cash-flow
rights and control rights have a negative effect on firm value. An additional
consequence of the strong separation of ownership claims and control is that
the so-called market for corporate control (Manne, 1965) virtually does not
exist in Scandinavia. Successful hostile bids are therefore very rare.
Supposed advantages of strong and stable owners provide the under-
pinning argument for the Scandinavian legislation that allows for vote-
differentiation of share and pyramid ownership. In this chapter, ownership
concentration is measured as the share of capital and votes controlled
by the largest owner (CR1 & VR1) and the five largest owners (CR5 &
VR5). About 40 percent of the firms in the aggregate Scandinavian sample
Table 7.1 Corporate control mechanisms in European countries
Dual-class shares Pyramid structures Cross-holdings

Sweden 0.62 0.27 0.01
Switzerland 0.52 0.06 0.00
Finland 0.44 0.07 0.00
Italy 0.43 0.25 0.00
Denmark 0.29 0.17 0.00
UK 0.25 0.22 0.00
Ireland 0.25 0.18 0.00
Austria 0.23 0.26 0.01
Germany 0.19 0.24 0.03
Norway 0.11 0.33 0.02
France 0.03 0.15 0.00
Belgium 0.00 0.27 0.00
Portugal 0.00 0.13 0.00
Spain 0.00 0.16 0.00
European average 0.24 0.20 0.01
Scandinavian average 0.37 0.21 0.01
Note: The figures represent the percentage of firms that use dual-class shares, pyramid
structures and cross-holdings, respectively.
Source: Bennedsen and Nielsen (2005).
separate control and cash-flow rights; see Table 7.2. The ownership data
have been collected from the annual reports for each firm.
Ownership concentration is very high in Scandinavian listed firms, espe-
cially compared with those in the Anglo-Saxon countries. Demsetz and
Lehn (1985) examine the ownership structure in 511 large US firms. They
report that, on average, the five largest owners together hold 24.8 percent
and the top 20 shareholders 37.7 percent. Frequently 20 percent is assumed
to be more than enough to control a firm (Morck et al., 2005).
La Porta et al. (1997) have hypothesized that the legal origin of a
country determines the efficiency of the country’s financial system.
Scandinavia can in this respect be regarded as being relatively homoge-
neous. Scandinavia has a long tradition of cooperation in drafting new
legislation (Carsten, 1993). Interestingly, there are still important differ-
ences with respect to deviations from the one-share-one-vote principle.
Denmark, Finland and Sweden all allow dual-class shares. In Norway
deviations from the proportionality principle need government approval
(Faccio and Lang, 2002).
Table 7.2 Ownership concentration in Scandinavia (2004)
All firms
Mean Std. dev. Min Max No. firms Skewness
Capital share 23.5 15.5 0.4 82.4 214 0.90
one owner, CR 1
Capital share five 44.8 19.6 1.5 95.1 214 0.33
owners, CR 5
Voting rights one 29.4 19.7 0.4 89.3 211 0.89
owner, VR 1
Voting rights five 52.0 22.6 1.5 96.5 211 0.08
owners, VR 5
Vote-differentiated firms
Capital share 23.5 13.7 2.9 60.4 90 0.70
one owner, CR 1
owners, CR 5
owner, VR 1
Voting rights five 64.8 19.8 18.6 96.5 87 −0.33
owners, VR 5
Firms with one-share-one-vote
Capital share 23.2 16.7 0.4 82.4 124 1.01
one owner, CR 1
owners, CR 5
owner, VR 1
Voting rights five 42.9 19.9 1.5 95.1 124 0.32
owners, VR 5
3. METHODOLOGY
This chapter applies a method developed by Mueller and Reardon (1993)

to assess the rate of return on investments. The measure produced is a
marginal version of Tobin’s q. Tobin’s q is defined as the market value
of a firm over the replacement cost of its assets, which translates to the
average return on total assets. The marginal version of Tobin’s q, on the
other hand, measures the return on investments, or the marginal return

on capital relative to the cost of capital (Mueller, 2003). This is in effect a
measure of what Tobin (1982) calls the ‘functional form’ of stock market
efficiency.7 Marginal q is also a more appropriate measure of performance
since average q contains infra-marginal returns.8
Marginal q can be derived from the simple insight that any investments
should ex ante be evaluated against the discounted present value of future
cash flows that the investment generates. Obviously, only projects that
have a positive net present value should be carried out. Consider an invest-
ment, It, made by a firm in period t. This investment generates cash flows,
CFt1j in j periods. The present value, PVt, of this cash flow is as follows:
n
PVt 5 a CFt1j / (1 1 rt) j (1)
j51
where rt is the discount rate. Note that the present value is the discounted
expected value of future cash flows. This equation can be expressed in the fol-
lowing way, where it can be regarded as a quasi-permanent rate of return:
PVt 5 Itit /rt (2)
For investments to be efficient from a shareholder perspective the invest-

ment being considered must generate future cash flows which, discounted
to the present value, equal or exceed the investment cost.
The ratio i/r is essentially a marginal version of Tobin’s q (Mueller,
2003) which measures the return on a marginal investment, and will there-
fore henceforth be referred to as qm. Equation (2) can be rearranged and
expressed as follows:
PVt
5 it /rt 5 qm,t (3)
It
For investments to be meaningful, we must have that PVt $ It. This implies
that qm $ 1. If firms are investing at qm 5 1, investments are efficient. This
implies that there are no further profitable investment opportunities (see
Figure 7.1). Whereas if qm , 1, firms are receiving a return on their invest-
ments that is less than the cost of capital, which can only be interpreted as
over-investment and a managerial failure of some sort.
At the end of period t the market value of a firm may be decomposed
into the market value in period t 2 1 (Mt-1), the present value of investments
made in period t (PVt), the change in market value of the old capital stock
(dt), and an error term for the errors the market may make in its evaluation
of the firm (mt).9
Mt ; Mt21 1 PVt 2 dtMt21 1 mt (4)

r, i
q m > 1 > q m* qm* = 1 q m< 1 < qm* It
Figure 7.1 Marginal rate of return on capital, i, cost of capital, r, and

marginal q
By replacing Mt-1 in equation (4) in each subsequent period, the following

expression is obtained:
n n21 n
Mt1n 5 Mt21 1 a PVt1i 2 a dt1iMt1i 1 a mt1i (5)
i50 150 i50
In a single period, the error in the market’s evaluation of the firm can be sub-
stantial, assuming efficient markets: E (mt) 5 0 and E (mt, mt21) 5 0, which
n
implies E ( g i50mt1i) 5 0. Thus, as n grows the last term will approach zero.
From equation (3) we get the following expression:
n n
a qm,t1iIt1i a PVt1i
i50 i50
qm 5 n 5 n (6)
a It1i a It1i
i50 i50
Using equation (5) this expression can be formulated in the following

way:
n n
(Mt1n 2 Mt21) a dt1iMt1i21 a mt1i

i50 i50
qm 5 n 1 n 2 n (7)
a It1i a It1i a It1i
i50 i50 i50
This can be used to calculate a weighted average qm for each firm.10

Assuming that qm and d both are constant over time and across firms, we
can use equation (4) to estimate qm and d directly. Taking equation (4) and
subtracting Mt-1 from both sides we get:
Mt 2 Mt21 5 2dMt21 1 qmIt 1 mt (8)
Dividing by Mt-1 we normalize the equation and get the following relation-
ship that can be empirically estimated:
Mt 2 Mt21 It mt
5 2d 1 qm 1 (9)
Mt21 Mt21 Mt21
Mueller and Reardon’s (1993) methodology can be applied to test the

agency hypotheses. In contrast to the average Tobin’s q, this method meas-
ures the marginal return on investments, which makes it more appropriate
when testing the agency hypotheses.
To study the effects of ownership structure or various institutional factors
on investment decisions, measures of ownership may be added as interac-
tion terms with It /Mt21 in equation (9). If interaction terms are added, the
functional form will be: Y 5 a 1 b1X 1 b2XZ, and qm is the economic
interpretation of the marginal effect, ⭸Y/⭸X 5 b1 1 b2Z. This method has
been applied by Gugler and Yurtoglu (2003) and by Bjuggren et al. (2007).
The equations estimated have the following functional form:
Mt 2 Mt21 It It It
5 2d 1 b1 1 b2Z1 1 . . . 1 bi11Zi 1 ei
Mt21 Mt21 Mt21 Mt21 (10)
where the Z’s denote the explanatory variables. Thus, the marginal effect,
qm, of equation (10) is:
qm 5 b1 1 b2Z1 1 . . . 1 bi11Zi (11)
The total market value of a firm is defined as the total number of out-
standing shares times the share price at the end of year t, plus total debt.
Investments are approximated as:
I 5 After tax profit – Dividends 1 Depreciation 1 DEquity
1 DDebt1 R&D 1 Advertising & Marketing
The market and accounting data have been collected from Compustat
Global database.11 The firms included were listed at one of the four stock
exchanges in Scandinavia (Copenhagen Stock Exchange in Denmark,
Helsinki Stock Exchange in Finland, Oslo Stock Exchange in Norway and
Stockholm Stock Exchange in Sweden) between 1998 or 1999 and 2005,
in total 292 firms (2004 observations). All figures have been adjusted by
harmonized consumer price indexes to 2005 constant prices. The indexes

used have been compiled by Eurostat. Naturally, the standard caveats
apply to the data.
To use equation (7) to calculate qm, it is also necessary to determine the
size of the deprecation rate d. That is, the rate at which the value of the
firm’s assets is declining over time. According to Mueller and Reardon
(1993), most estimates are around 10 percent. Naturally, the actual depre-
ciation rate varies across firms and industries, depending on the durability
of employed assets. Even within firms, we have reason to believe that the
depreciation rate differs across the capital stock.
Equation (9) has the advantage that no assumption regarding the size of
d is necessary. In an empirical estimation of equation (9) the intercept (d)
will capture the depreciation rate plus any systematic changes in market
valuations of the stock of old capital. The estimated d has no bearing on
the interpretation of qm.
4. CORPORATE RETURN IN SCANDINAVIA
This study covers 292 large Scandinavian firms that are listed at one of
the four stock exchanges. This accounts for about 40 percent of all listed
firms. In 2004, the top 100 of these 292 firms (25 largest in each country)
accounted for approximately 42 percent of the total stock market capitali-
zation (33 percent of GDP).12 The firms approximately follow a rank–size
distribution, where the second largest firm is about half the size of the
largest.13
As a first step, equation (7) is used to calculate a qm for each individual
firm. For Scandinavia, the estimated average marginal q, excluding the
upper 95 percentile and the lower 5 percentile, is 1.19. This means that
during the period 1999–2005 the Scandinavian firms had an average
return on investments that was 19 percent above the cost of capital.
However the median qm is 1.03, which implies a return that is 3 percent
above cost of capital. Neither the average qm nor the median qm give any
reason to believe that Scandinavian firms are under-performing. This
is based on the assumption that the depreciation rate was 10 percent
per annum. Equation (7) is sensitive to the choice of depreciation rate.
Consequently, a more rapid deprecation will translate into a higher qm,
all else equal.
Investments as defined in this chapter can be negative. This will be the
case if a firm is making losses that are larger in absolute terms than new
equity and debt. It is not meaningful to ask what the returns on investment
are if investments are negative. Nor does equation (7) make any sense when
Table 7.3 Cumulative distribution of marginal q
Denmark
Range of qm 1999 2000 2001 2002 2003 2004 2005
qm ≥ 2.00 10 9 6 2 4 5 5
1.50 ≤ qm < 2.00 3 2 3 4 3 4 8
1.00 ≤ qm < 1.50 3 3 3 5 3 6 6
0.50 ≤ qm < 1.00 10 14 12 9 11 13 13
0.00 ≤ qm < 0.50 11 19 23 26 25 23 22
−0.50 ≤ qm < − 0.00 9 5 5 8 8 5 3
−1.00 ≤ qm < − 0.50 4 4 1 0 2 1 0
qm < − 1.00 4 4 6 6 4 4 2
Number of firms 54 60 59 60 60 61 59
Number of qm ≥ 1 16 14 12 11 10 15 19
Number of qm < 1 38 46 47 49 50 46 40
Finland
Range of qm 1999 2000 2001 2002 2003 2004 2005
qm ≥ 2.00 20 17 9 11 13 12 15
1.50 ≤ qm < 2.00 5 1 9 5 5 4 4
1.00 ≤ qm < 1.50 9 6 2 9 10 16 22
0.50 ≤ qm < 1.00 8 11 17 16 15 11 9
0.00 ≤ qm < 0.50 3 13 10 8 8 9 3
−0.50 ≤ qm < − 0.00 3 3 4 1 1 1 1
−1.00 ≤ qm < − 0.50 0 3 2 3 1 2 2
qm < − 1.00 3 4 5 5 6 4 3
Number of firms 51 58 58 58 59 59 59
Number of qm ≥ 1 34 24 20 25 28 32 41
Number of qm < 1 17 34 38 33 31 27 18
Norway
Range of qm 1999 2000 2001 2002 2003 2004 2005

qm ≥ 2.00 23 19 13 8 12 17 23
1.50 ≤ qm < 2.00 5 6 3 4 6 5 7
1.00 ≤ qm < 1.50 7 10 15 10 13 15 9
0.50 ≤ qm < 1.00 5 3 7 15 7 3 2
0.00 ≤ qm < 0.50 0 4 2 3 4 4 2
−0.50 ≤ qm <− 0.00 1 3 1 2 0 0 0
−1.00 ≤ qm < − 0.50 1 0 3 0 0 0 1
qm < − 1.00 2 2 3 6 4 1 1
Number of firms 44 47 47 48 46 45 45
Number of qm ≥ 1 35 35 31 22 31 37 39
Number of qm < 1 9 12 16 26 15 8 6
Table 7.3 (continued)
Sweden
Range of qm 1999 2000 2001 2002 2003 2004 2005
qm ≥ 2.00 36 26 14 5 12 15 18
1.50 ≤ qm < 2.00 4 3 7 2 5 5 12
1.00 ≤ qm < 1.50 12 16 9 11 12 15 14
0.50 ≤ qm < 1.00 4 20 25 27 26 28 28
0.00 ≤ qm < 0.50 23 26 31 36 32 30 29
−0.50 ≤ qm < − 0.00 6 4 9 6 9 7 3
−1.00 ≤ qm < − 0.50 0 4 3 6 3 3 1
qm < −1.00 3 8 10 13 10 6 2
Number of firms 88 107 108 106 109 109 107
Number of qm ≥ 1 52 45 30 18 29 35 44
Number of qm < 1 36 62 78 88 80 74 63
Note: Assuming d 5 10 percent.
investments are negative or equal to zero. Accordingly, such firms have

been excluded from Table 7.3.
As can be seen from Table 7.3, returns on investments are approximately
normally distributed around a mean of 1 in all of the four Scandinavian
countries, except Norway. As the estimated qms are cumulated over 1999 to
2005 the distribution seems to become more concentrated around 1.
There are a few extreme values that have a large impact on the average qm
across firms. These are typically smaller firms that, for some reason, have
either a very high return on invested capital or a massive loss in market
value. There are several plausible explanations for these extreme values.
Firms may for example introduce radical innovations that do not require
any substantial investments but nevertheless substantially increase firm
value. Average qm is, for this reason, also calculated excluding 5 percent in
both ends of the distribution.
Dropping 5 percent in both ends of the distribution, the average qm is
0.76 for Denmark, 1.27 for Finland, 1.83 for Norway and 1.11 for Sweden.
The median qm is 0.57 for Denmark, 1.18 for Finland, 1.86 for Norway and
0.85 for Sweden. If the assumption that d 5 10 percent is approximately
correct, this means that all four of the Scandinavian countries, with the
exception of Denmark, have average returns equal to or above the cost of
capital.
Bjuggren and Wiberg (2008) find that qm is sensitive to stock market
swings and that, depending on period selection, the qm may either be over-
or under-estimated. The choice of a 5–6 year period, which approximately
coincides with the average length of a business cycle, reduces this

problem.
Table 7.4 reports the value of marginal q for the ten largest firms in each
Scandinavian country. The first two columns report the total market values
in 2005 and 1998 adjusted to 2005 constant prices. Total investments made
during this period are reported in column 3. Since equation (7) is sensitive
to choice of depreciation, qm has been calculated assuming 5, 10 and 15
percent depreciation of old capital (columns 4, 5 and 6). Furthermore, the
implicit d can be calculated from equation (7) by assuming that qm 5 1. This
implicit depreciation rate is reported in column 7.
A few firms in Table 7.4 have implicit deprecation rates that are nega-
tive, which indicates that these firms all had returns in excess of their
cost of capital. The dominant firm in Finland, Nokia, for example, has
performed well over a long period and consequently has a qm around or
slightly above 1. This can be compared with the Swedish telecom firm
Ericsson, one of Nokia’s main competitors. Ericsson seems to have a lower
qm given any depreciation rate, but remains approximately equal to 1. It is
plausible to assume that the differences in returns can be attributed to dif-
ferences in performance, since Nokia and Ericsson can be assumed to have
approximately the same depreciation rate. The dominant firm in Denmark,
Möller-Maersk, with its high marginal q, appears to be under-investing.
Finally, the dominating Norwegian firm Norsk Hydro seems to have a
marginal q approximately equal to 1.
Assuming that the marginal rate of return (qm) and the depreciation
rate (d) are the same across companies and over time, these can be esti-
mated by equation (9). Since the data consist of a cross-sectional time
series, a fixed effect model is used (industry and time fixed effects model).
The stock market may fail to make a correct valuation in a single period,
but assuming efficient markets, this error will approach zero as the time
span increases. To take the possibility of market errors into account, time
dummies were used in the estimations. Both industry and time dummies
are restricted to sum to zero, so that the effects are measured as the devia-
tion from the average depreciation rate. The results are reported in Table
7.5.
In order to remove outliers, some of the observations have been removed
from the data set. The absolute deviation between the dependent variable
and the explanatory variable, |(Mt – Mt-1)/Mt-1 – It/Mt-1|,14 has been used to
identify outliers. Observations that had an absolute deviation above 2 (41
observations) were removed. This captures, for example, firms that have
large swings in market value without corresponding changes in invest-
ments. The excluded firms are predominantly found among relatively
small high-tech firms within the biotechnology and ICT sectors. Bjuggren
Table 7.4 Ten largest companies in each Scandinavian country (2005)
1 2 3 4 5 6 7
Company a qm qm qm
M2005a M1998a ∑ INV (d 5 5%)b (d 5 10%)b (d 5 15%)b dc
Denmark
A.P. MÖLLER – MAERSK 47702.9 7211.4 27433.4 1.668 1.860 2.052 −0.124
TDC 13932.1 15676.0 12303.0 0.244 0.630 1.016 0.148
NOVO NORDISK 13124.1 8752.7 17150.9 0.481 0.706 0.932 0.048
CARLSBERG 6842.0 4706.6 19592.3 0.199 0.289 0.378 0.113
H. LUNDBECK 3904.8 2607.8d 5400.0 0.515 0.790 1.065 0.138
DANISCO 5105.6 3728.0 6866.8 0.395 0.590 0.784 0.205
WILLIAM DEMANT HOLDING 3165.8 962.1 2303.6 1.288 1.620 1.951 0.007
153
COLOPLAST 2486.8 1326.3 1998.2 0.869 1.157 1.444 0.073
COPENHAGEN AIRPORTS 2479.6 1441.4 811.0 1.870 2.460 3.049 −0.024
DE SAMMENSLUTTENDE 2411.3 292.3 1215.6 1.972 2.201 2.430 −0.162
Finland
NOKIA 64861.2 68445.3 14966.5 0.619 1.293 1.966 0.078
STORA ENSO 15108.7 13268.3 3364.9 0.690 1.214 1.739 0.080
UPM-KYMMENE 13964.4 11361.0 1818.2 0.650 1.073 1.495 0.091
METSO 4061.7 1415.5 16770.9 0.429 0.537 0.644 0.315
SANOMA-WSOY 4050.2 789.6 658.2 2.072 2.517 2.963 −0.070
M-REAL 3914.6 2933.6 16027.0 0.476 0.752 1.029 0.014
RAUTARUUKKI 3304.8 1953.9 1406.0 1.806 2.396 2.986 −0.018
WARTSILA 2752.5 1662.5 1287.0 1.770 2.381 2.993 −0.013
TIETOENATOR 2739.7 2298.9 2135.4 0.968 1.615 2.263 0.052
YIT CORP 2589.4 409.8 662.4 3.530 3.902 4.275 −0.289
1 2 3 4 5 6 7
Company a qm qm qm
M2005a M1998a ∑ INV (d 5 5%)b (d 5 10%)b (d 5 15%)b dc
Norway
NORSK HYDRO 24942.5 12014.9 19283.6 0.986 1.302 1.617 0.052
ORKLA 9539.4 5729.7 3582.9 1.698 2.332 2.967 −0.005
NORSKE SKOGINDUSTRIER 5043.3 2355.1 1477.6 1.573 1.599 1.624 −1.050
HAFSLUND 3135.1 1156.5 1823.6 1.448 1.811 2.174 −0.012
FRED. OLSEN ENERGY 2152.9 641.2 610.7 3.019 3.563 4.107 −0.136
SCHIBSTED 1900.9 1121.6 495.6 2.462 3.352 4.241 −0.032
DNO 1867.4 46.8 474.2 3.971 4.104 4.236 −1.071
TOMRA SYSTEMS 1056.9 1399.7 336.8 3.677 4.130 4.584 −0.245
154
FARSTAD SHIPPING 950.9 263.6 791.9 1.111 1.355 1.598 0.027
Sweden
ERICSSON 49367.6 49661.1 62411.5 0.355 0.714 1.073 0.140
VOLVO 24244.6 18240.9 32494.6 0.376 0.568 0.760 0.213
H & M HENNES & MAURITZ 21244.0 15067.1 14736.6 0.825 1.232 1.638 0.071
ATLAS COPCO 12599.3 5329.9 11514.7 0.850 1.069 1.287 0.084
SCA 11652.2 7553.9 8847.4 0.860 1.257 1.654 0.068
SANDVIK 11038.2 5502.1 12743.4 0.648 0.862 1.076 0.132
SCANIA 9262.2 6128.1 11352.3 0.528 0.780 1.032 0.144
ELECTROLUX 7426.0 9994.2 22765.3 0.019 0.150 0.281 0.424
SECURITAS 6787.2 5421.3 7191.6 0.525 0.860 1.195 0.121
SKF 5940.4 2348.3 7975.8 0.591 0.731 0.872 0.196
SOLSTAD OFFSHORE 623.3 139.2 675.0 0.922 1.111 1.301 0.071
a
Note: Million euros, 2005 constant prices; b qm calculated assuming that d is 5, 10 and 15 percent, respectively; c depreciation rate calculated
given qm 5 1; d market value 1999.
Table 7.5 Average qms in Scandinavia (1999–2004)
Dependent variable: (Mt 2 Mt-1)/Mt-1

Constant (5 d) −0.034** −0.039**
(−2.25) (−2.52)
It / Mt-1 0.868*** 0.794***
(27.79) (34.06)
Denmark* It / Mt-1 −0.205***
(−5.32)
Norway* It / Mt-1 0.244***
(4.87)
Finland* It / Mt-1 0.057
(0.88)
Sweden* It / Mt-1 −0.097***
(−2.85)
No. obs. 1963 1963
No. firms 292 292
R2 0.48 0.47
R2-adjusted 0.46 0.45
F-value 32.45 32.78
Note: *** indicates significance at 1 percent, ** at 5 percent and * at 10 percent level;

t-values in brackets.
and Wiberg (2008) have shown that the marginal q measure is sensitive to
swings in valuation of new high-tech firms.
The regressions in Table 7.4 were estimated with different intercepts,
d, for the different countries; these were, however, insignificant and were
therefore dropped out of the regression. In order to test for country
effects, country dummy variables were interacted with It/Mt-1. These too
were estimated under the restriction to sum to zero so that the country
effects measure the deviation from the average Scandinavian marginal q.
The Scandinavian average reported in Table 7.5 is significantly below 1.
Marginal q is 0.66 for Denmark, 1.07 for Norway, 0.93 for Finland and
0.77 for Sweden. These findings seem to corroborate previous estimates of
marginal q for the Scandinavian countries.
In a large cross-country study, Gugler et al. (2002) found similar
estimates for Scandinavia. Between 1985 and 2000, they estimated 0.65
for Denmark, 0.96 for Finland, 1.04 for Norway and 0.65 for Sweden.
Bjuggren et al. (2007) have also estimated an average qm of 0.65 for Sweden.
The findings reported in Table 7.4 are, in other words, consistent with
previous estimates for Finland and Norway. Gugler et al. (2002) have esti-
mated the Scandinavian average at 0.78. Their findings support the legal
origin hypothesis. Anglo-Saxon countries perform best with qm 5 1.02.

Average qm for Germanic and French origin is 0.74 and 0.59, respectively.
However, there is considerable variation in the returns in all four
Scandinavian countries, where a large number of firms deviate from the
average marginal return on investments. This can have several causes; it
might for example be plausible to believe there are industry differences.
This is supported by the variation of the implicit deprecation rates in Table
7.4.
In the following section the relationship between ownership concentra-
tion, separation of cash-flow rights and control rights, and performance is
examined.
5. CORPORATE RETURN AND OWNERSHIP

STRUCTURE
In this section, equation (10) is used to test the effects of ownership concen-
tration and separation of control from cash-flow rights on performance.
As measures of ownership concentration, the share of capital (cash-flow
rights) held by the largest owner (CR1) and the five largest (CR5) are used.
Control rights are measured by the share of votes (control rights) held
by the largest (VR1) and five largest owners (VR5). Dummies are used to
control for dual-class shares. In the sample, 49 percent of the firms use a
dual-class share structure. Matching accounting and market data with the
ownership data leaves 142 firms out of 292. Correlations are reported in
Table 7.6.
Naturally all ownership variables display high and significant correla-
tions. Sales are negatively correlated with all ownership variables, but
weaker for VR1 and VR5 than for CR1 and CR5. In other words, owner-
ship concentration measured by cash-flow rights is inversely related to firm
size. This means that controlling owners remain in large firms by resorting
to dual-class equity structure. It is also interesting to note that investments
are significantly correlated with control rights and vote-differentiation, but
not with cash-flow rights.
In order to control for unobserved, time-invariant heterogeneity across
firms, a fixed effect model with firm and time effects is applied. The time
fixed effect is motivated by the efficient markets hypothesis; a firm may,
in any single period, be under- or over-valued but over time this error is
expected to be zero. The firm fixed effect controls for differences in depre-
ciation rates across firms and industries.
To identify non-linear effects on performance, the ownership variables
are also estimated in quadratic and cubic form. In Tables 7.7a and b, merely
Table 7.6 Correlation matrix
Sales It/Mt-1 Mt-Mt-1/Mt-1 CR1 CR5 VR1 VR5

Sales 1
It/Mt-1 0.012 1
Mt-Mt-1/Mt-1 −0.043 0.422* 1
CR1 −0.088* 0.069 0.033 1
CR5 −0.224* 0.068 0.022 0.847* 1
VR1 −0.031 0.118* 0.019 0.812* 0.710* 1
VR5 −0.119* 0.102* 0.014 0.678* 0.835* 0.817* 1
Vote- 0.082* 0.071* −0.049 −0.053 0.033 0.310* 0.422*
differen-
tiation
Note: * indicates significance at 5 percent.
3 out of 24 estimated ownership parameters are significant. However, a

deviation from one-share-one-vote creates large negative effects. Firms
with only a single class of equity do not significantly under-perform, that
is, qm is not different from 1, whereas firms that rely on dual-class equity
shares on average have a return on dual-class shares that is 30 percent
below the opportunity cost of capital.
The fact that vote-differentiation has a significant negative effect on firm
performance indicates that the ownership–performance relationship may
differ between firms with one class of shares and those having separated
cash-flow rights and control rights. This negative effect increases in equa-
tions A to G when the ownership variables are added. One possible inter-
pretation is that the ownership variables are picking up a positive incentive
effect. This, in turn, suggests that the ownership effects differ between the
two categories of firms.
In Table 7.8 ownership variables are interacted with the dummy variable
for dual-class share structure (1 for vote-differentiation and zero for single-
class share structure). Different specifications of the functional form have
been estimated. The results are relatively robust with respect to choice of
fixed effect, random effect or simply pooled OLS model. A previous study
has also found estimates of qm to be stable to model specification (Bjuggren
et al., 2007).
The results are robust with respect to the choice between simple pooled
OLS with year dummies, fixed effect model with year and firm effects, and
random effects model. The estimates are robust with respect to model spec-
ification. Since the number of firms with available ownership data is limited
Table 7.7a Concentration of cash-flow rights and performance
Dependent variable: (Mt-Mt-1)/Mt-1
Equation A Equation B Equation C Equation D Equation E Equation F Equation G
Constant, (5d) −0.088*** −0.088*** −0.087*** −0.087*** −0.087*** −0.088*** −0.087***

(−3.82) (−3.84) (−3.78) (−3.78) (−3.80) (−3.82) (−3.79)
It/Mt-1 0.929*** 0.982*** 0.711*** 0.734*** 0.853*** 0.948*** 0.583
(14.95) (9.41) (4.61) (3.27) (6.68) (4.14) (1.58)
Dual-class Shares −0.312*** −0.327*** −340*** −0.335*** −0.307*** −0.304*** −0.344***
(−3.67) (−3.71) (−3.86) (−3.55) (−3.60) (−3.56) (−3.78)
CR1 −0.002 0.026** 0.022
(−0.63) (2.16) (0.69)
CR12 −0.001** −0.000
(−2.38) (−0.27)
CR13 −0.000
158
(−0.14)
CR5 0.002 −0.003 0.031
(0.68) (−0.33) (1.07)
CR52 0.000 −0.001
(0.50) (−1.17)
CR53 0.000
(1.27)
No. obs. 794 794 794 794 794 794 794
No. firms 142 142 142 142 142 142 142
F-value 12.69 12.39 12.32 12.03 12.40 12.11 11.88
R2 0.42 0.42 0.42 0.42 0.42 0.42 0.42
Average qm 0.785 0.790 0.894 0.890 0.796 0.769 0.702
Dual-class qm 0.617 0.614 0.711 0.710 0.630 0.605 0.516
Single-class qm 0.929 0.941 1.051 1.044 0.937 0.909 0.860
Note: *, ** and *** indicate significance at 10, 5 and 1 percent respectively; t-values in brackets.
Table 7.7b Concentration of control/voting rights and performance
Dependent variable: (Mt-Mt-1)/Mt-1
Equation B Equation C Equation D Equation E Equation F Equation G
Constant, (5d) −0.088*** −0.085*** −0.084*** −0.085*** −0.089*** −0.090***

(−3.80) (−3.69) (−3.63) (−3.72) (−3.86) (−3.90)
It/Mt-1 0.911*** 0.818*** 0.709*** 0.702*** 0.966*** 0.649*
(9.56) (6.02) (3.60) (5.51) (4.29) (1.82)
Dual-class −0.317*** −0.317*** −0.331*** −0.390*** −0.396*** −0.404***
Shares (−3.62) (−3.61) (−3.69) (−4.19) (−4.26) (−4.33)
VR1 0.001 0.007 0.022
(0.24) (0.99) (1.07)
VR12 −0.001 −0.001
(−0.96) (−0.92)
VR13 0.000
159
(0.76)
VR5 0.005** −0.007 0.021
(2.03) (−0.82) (0.80)
VR52 0.000 −0.001
(1.42) (−0.92)
VR53 0.000
(1.15)
No. obs. 794 794 794 794 794 794
No. firms 142 142 142 142 142 142
F-value 12.38 12.12 11.86 12.54 12.32 12.08
R2 0.42 0.42 0.42 0.42 0.42 0.42
Average qm 0.812 0.836 0.836 0.774 0.728 0.730
Dual-class qm 0.612 0.657 0.665 0.564 0.514 0.512
Single-class qm 0.929 0.988 0.982 0.954 0.910 0.916
Note: *, ** and *** indicate significance at 10, 5 and 1 percent respectively; t-values in brackets.
Table 7.8a Dual-class shares, ownership and performance

Equation H Equation I
Constant, (5d) −0.087*** Constant, (5d) −0.084***
(−3.80) (−3.67)
It/Mt-1 0.521*** It/Mt-1 0.404***
(3.61) (2.60)
CR1 0.053*** VR1 0.063***
(3.79) (4.34)
CR12 −0.001*** VR12 −0.001***
(−3.93) (−4.43)
CR1*Vote differentiation −0.045*** VR1*Vote −0.053***
(−4.43) differentiation (−5.07)
CR12*Vote 0.001*** VR12*Vote 0.001***
differentiation (3.79) differentiation (4.67)
No. obs. 794 No. obs. 794
No. firms 142 No. firms 142
F-value 12.27 F-value 12.35
R2 0.42 R2 0.43
Average qm 0.933 Average qm 0.993
Dual-class qm 0.652 Dual-class qm 0.721
Single-class qm 1.199 Single-class qm 1.226
Note: *, ** and *** indicate significance at 10, 5 and 1 percent, respectively; t-values in
brackets.
to 143, the firm effects capture possible industry effects. Consequently, all
equations have been estimated with two-digit industry SIC codes.
The stock market may be under- or over-estimated in any single period,
but for a longer period of time the expected error in stock market evalu-
ations is zero, E(mt) 5 0. To control for this possibility, annual dummy
variables are included and estimated under the restriction that they
summarize to zero. Annual deviations in stock market evaluations are
therefore measured as deviations from the average. To control for the
possibility that the Scandinavian countries have systematic differences
in returns, country dummies are also included. These are also estimated
under the restriction that they summarize to zero, so that any deviation is
measured as the deviation from the Scandinavian average. Time, industry
and country effects are not reported.
Hypotheses 1 and 2 (H1 and H2) cannot be rejected. For all measures
of ownership concentration (CR1, CR5, VR1 and VR5) a positive non-
linear relationship is found. In firms with one-share-one-vote, increasing
Table 7.8b Dual-class shares, ownership and performance

Equation H Equation I
Constant, (5d) −0.091*** Constant, (5d) −0.092***
(−3.93) (−3.99)
It/Mt-1 0.336 It/Mt-1 0.050
(0.89) (0.12)
CR5 0.067** VR5 0.089***
(2.06) (2.64)
CR52 −0.002** VR52 −0.002***
(−2.31) (−2.84)
CR53 0.000*** VR53 0.000***
(2.45) (2.94)
CR52*Vote differentiation 0.002*** VR52*Vote 0.003***
(2.82) differentiation (3.55)
No. obs. 794 No. obs. 794
No. firms 142 No. firms 142
F-value 11.58 F-value 11.91
R2 0.42 R2 0.43
Average qm 0.808 Average qm 0.889
Dual-class qm 0.656 Dual-class qm 0.784
Single-class qm 0.952 Single-class qm 0.978
Note: *, ** and *** indicate significance at 10, 5 and 1 percent, respectively; t-values in
brackets.
ownership has a positive but marginally diminishing effect on performance.

For the two concentration measures of the single largest owner, CR1 and
VR1, a quadratic form gives the best fit, whereas for the concentration of
the five largest owners, CR5 and VR5, a cubic form provides the best fit.
The average qm for single class equity firms lies between 0.95 and 1.23.15
In firms with vote-differentiated shares, the effects are similar but much
weaker. By comparing the parameters in equations H and I in Tables 7.8
a and b, one can see that in vote-differentiated firms the positive effect of
ownership concentration is significantly lower than in other firms. The
average qm’s estimate for firms with dual-share class structure lies between
0.65 and 0.78 (equations H and I respectively). As in equation A, firms with
dual-class shares seem to be investing at approximately 30 percent below
their cost of capital. From equations H and I in Tables 7.8 a and b, it is

clear that the separation of cash-flow and control rights reduces the posi-
tive effect of ownership and enhances the entrenchment effect. Examining
listed firms in Sweden, Bjuggren et al. (2007) found similar negative effects
of vote-differentiation and positive effects of ownership concentration on
investment performance of firms.
Controlling for ownership characteristics and dual-class equity weakens
the country effects (not reported here), but remains significantly negative
for Sweden and positive for Norway. However the effects of ownership and
deviations from one-share-one-vote cut across national boundaries.
The intercept will, as discussed in Section 2, capture both the deprecia-
tion rate and any systematic changes in market evaluations. In equations A
to I, the intercept is estimated at approximately 9 percent. This is a reason-
able estimate and is in line with previous estimates of depreciation rates.
Furthermore, the intercept does not affect the marginal effect, and is thus
not of any importance for the interpretation of the results.
6. CONCLUSIONS
This chapter examines the linkage between corporate investments, returns

and ownership structure in the Scandinavian countries. Marginal q is used as
performance measure. Marginal q measures the marginal return on capital
relative to its cost. This return to cost of capital ratio (r/i 5 qm) is a measure
of what Tobin (1982) labelled the functional efficiency of capital markets.
When studying firm performance, this method has some clear advantages
over the conventional market-to-book measures of Tobin’s average q.
Few Scandinavian firms can be characterized as having dispersed own-
ership as described by Berle and Means (1932). Vote-differentiation is a
common tool for creating and maintaining strong and concentrated own-
ership structures. Scandinavian firms make more frequent use of control
mechanisms than firms in comparable countries. On average the largest
owner holds more than 20 percent of the capital (CR1) and close to 30
percent of the voting rights (VR1).
The hypothesis that ownership concentration improves resource alloca-
tion is supported in this chapter. The effect of ownership on investment
performance is, however, found to be non-linear: cubic or quadratic in
form. This is consistent with the entrenchment hypothesis. Strong support
of the hypothesis that control mechanisms are detrimental to firm perform-
ance is also found.
Ownership concentration is found to have a non-linear effect on firm
performance. This is consistent with previous studies that find both
positive incentive effects and negative entrenchment effects of ownership

concentration. For firms with one-share-one-vote ownership has a positive
impact but marginally diminishing, whereas for firms controlled by dual-
class shares this effect is weaker. These firms have a systematically worse
performance than other firms. Dual-class shares drive a wedge between
cash-flow rights and control rights. Not only does this change the control
structure, but it also changes the incentive structure. Firms with only one
equity class are, on average, investing efficiently, whereas firms with dual-
class equity structure are over-investing. The separation of cash-flow rights
and control rights reduces the positive incentive effect and enhances the
negative entrenchment effect. By impairing capital reallocation, corporate
control mechanisms are in the long run harmful for industry dynamics and
economic renewal.
Vote-differentiation creates massive entrenchment effects and destroys
large values. In the long run, they are likely to harm the functional effi-
ciency of the Scandinavian capital markets. On average, ‘entrenched’ firms
have returns on investments that are approximately 30 percent below their
cost of capital.
Differences in investment performance across firms can largely be
explained by differences in ownership structure and, in particular, to what
extent corporate control is upheld by dual-class equity structure. Separation
of cash-flow rights from control appears to distort the incentives of the
controlling owner by significantly reducing the incentive effect.
NOTES
* Acknowledgments: Financial support from the Ratio Institute and Sparbankernas fors-
kningsstiftelse is gratefully acknowledged. This chapter was initiated during a six-month
visit to George Mason University, and subsequently benefited a great deal from valuable
comments and suggestions given by a large number of people. In particular, I am grate-
ful for comments provided by Robin H. Hansson. Furthermore, I greatly appreciate
valuable discussions during workshops and seminars held at Jönköping International
Business School. In particular, I thank Åke E. Andersson, Tom Berglund, Per-Olof
Bjuggren, Börje Johansson, Agostino Manduchi, Dennis C. Mueller, Ajit Singh, Steen
Thomsen and Daniel Wiberg for valuable insights and helpful comments. Naturally,
any remaining errors are my own.
1. For a review of the corporate governance literature see, for example, Shleifer and Vishny
(1997), Morck et al. (2005), Mueller, (2003) and Denis and McConnell (2003).
2. There is a large literature on ownership and firm performance/value emanating from the
work of Morck et al. (1988). See e.g. McConnell and Servaes (1990). For critique see
Demsetz and Lehn (1985).
3. Agency costs are costs that arise from the principal–agent problem, that is, divergence
of managerial objectives from the objectives of shareholders.
4. Jensen and Meckling (1976) also point out that the most serious problem of not
having equity claims is probably that the incentive to seek new profitable investment
opportunities and engage in innovative efforts will fall.
5. Cho (1998) criticizes these findings and shows that market value affects ownership con-
centration. See also Loderer and Martin (1997).
6. In an external study commissioned by the European Commission the proportionality
between ownership and control of listed firms in the EU is examined. Among other things
this study reports the results from a survey sent to institutional investors with €4.9 trillion
of assets under management. A clear majority of the investors expect a discount of 10 to
30 percent of the share price of firms using CEM. See for further details ECGI (2007).
7. Functional stock market efficiency is related to but different from the standard term
market efficiency. Functional efficiency refers to the way in which capital markets are
allocating resources to the most efficient usage (Tobin, 1982). Morck et al. (2005) survey
a literature that shows how the functional efficiency of capital markets depends on the
structure and composition of corporate control.
8. When firms are price takers and perfectly competitive, marginal q and average q will be
equal. Firms with market power will have a higher average q. For a derivation of the
relationship between average q and marginal q, see Hayashi (1982).
9. If the market makes errors in their valuation of the firm, the error component, m, may
contain a revaluation factor in the following period.
10. See Mueller and Reardon (1993) for a description of the methodology and an account
of the properties of qm.
11. Accounting data and market prices have been collected from Standard & Poor’s
Compustat Global Database, 2006 version. The following variables have been collected
from Compustat (mnemonics in brackets): after-tax profit (IB), depreciation (DP)
dividends (DVT), total debt (DT), research and development (XRD), market price
(MKVAL), advertising and marketing expenditures (XSGA), D equity (SSTK minus
PRSTKC).
12. These 292 firms represent all non-financial firms for which sufficient ownership informa-
tion was available. In 2004, there were a total of 796 listed firms in Scandinavia (194 in
Denmark, 143 in Finland, 177 in Norway and 282 in Sweden).
13. The formula, Mi 5 M 1/i where M 1 is the largest firm and i the firm rank, approximates
the size distribution of the firms in the sample.
14. In practice this excludes variables that have missing observations or contain accounting
errors. Observations that were excluded were only among the small firms in the sample.
Using a robust estimation technique yields consistent results.
15. The marginal effects have been calculated based on the average ownership concentration
in the data set (CR1 5 22.24, CR5 5 44.52, VR1 5 28.58 and VR5 5 52.85).
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8. The cost of legal uncertainty: the
impact of insecure property rights
on cost of capital
Per-Olof Bjuggren and Johan E. Eklund*
1. INTRODUCTION
In the required rate of return on investments a special risk premium labeled

institutional risk should be included. Different countries represent institu-
tional risks for investors. It is various risk factors tied to the institutional
framework that give the rules of the game facing investors. The rules can
be of a supportive nature or make long-term investments hazardous due to
the lack of secure property rights. It is more or less evident that investors
must use a higher discount rate in evaluations of investments in countries
where property rights are weakly protected.
How to account for the political risk has not received much attention in the
finance literature, even though the concept ‘political risk’ is sometimes men-
tioned. However, a formal treatment is not offered. An exception is Faure
and Skogh (2003), who have shown how ‘political risk’ can be incorporated
in investment analysis. It is their approach that has inspired this chapter.
But it is one thing to propose the necessity to add an ‘institutional risk
premium’ and another thing to prove the existence of such risk premiums
and estimate their size. One reason why few attempts have been made so
far is the difficulty of empirically quantifying and pricing institutional risk.
The purpose of this chapter is to show the existence of property risk pre-
miums and measure their magnitude.
As measures of institutional risk we use two indexes; one on property
right protection provided by the Heritage Foundation, and one on investor
right protection provided by the Political Risk Group. With these indexes
we use a type of CAPM (capital asset pricing model) to estimate the effect
of property rights uncertainty on the cost of capital.
The chapter starts, in Section 2, with a discussion of what is meant by
institutional risk. Section 3 provides the theoretical underpinning to rational
investment decisions. How to calculate capital costs and risk premiums for
167
assets with political risk is the subject matter of Section 4. The data used in
our empirical analysis are presented in Section 5. The empirical findings are
analysed in Section 6. The chapter ends with conclusions in Section 7.
2. POLITICAL RISK, PROPERTY RIGHTS,

CONTRACTS AND LEGAL UNCERTAINTY
Growth, prosperity and welfare are a function of the investments made in
a country. Investments add to the capital stock which is a basic produc-
tion factor. However, investments are risky. A cost in the form of a capital
outlay is paid today, while the benefits represented by positive net cash
flows lie in the future. It is like a deferred exchange where a payment is
made today in return for enhanced future consumption. When the future
unfolds it might turn out that the products produced by the new capital
(the investment) cannot be sold at profitable prices.
This is a risk that every entrepreneur has to face. But in addition to this
risk there might be an institutional risk caused by insecure property rights
and a defective judicial system that makes it difficult to enforce contracts
in an effective way. Secure property rights and contract enforcement were
put forward long ago by David Hume and Adam Smith as two of the most
important institutional factors for the prosperity of a nation. According
to Kasper and Steit (1999, p. 20) David Hume and Adam Smith stressed
three institutions of fundamental importance for progress and welfare:
‘the guarantee of property rights, the free transfer of property by volun-
tary contractual agreement, and the keeping of promises made’. In other
words, secure property rights, freedom of contracts and enforcement of
agreements are basic cornerstones in the quest for prosperity.
Secure property rights, freedom of contracts and enforcement of agree-
ments are basic parts of the institutional framework within which an
economy is organized. It is the task of the state to develop a well function-
ing and adequate institutional framework through formal rules. According
to North (1990, p. 47) ‘formal rules include political (and judicial) rules,
economic rules, and contracts’. By economic rules North means property
rights, which are defined as ‘the bundle of rights over the use and the
income to be derived from property and the ability to alienate an asset or a
resource’ (p. 47). The link to investments is clear as investments mean the
creation of new assets. Furthermore, North ascertains a hierarchical order
between rules in the sense that ‘the rules descend from polities to property
rights to individual contracts’ (p. 52). According to, for example, North
(1990) and Williamson (2000) these institutions are very stable over time.
Hernando de Soto (2000) has argued powerfully that the varying degree
The cost of legal uncertainty 169
to which countries succeed to support capital formation and accumulation

is to be found in the legal structure of the property rights system of the
western world. De Soto claims that:
When advanced nations pulled together all the information and rules about
their known assets and established property systems that tracked their economic
evolution, they gathered into one order the whole institutional process that
underpins the creation of capital. If capitalism had a mind, it would be located
in the legal property system. (de Soto (2000) p. 65)
Furthermore, de Soto argues that informal institutions are far less impor-
tant than formal institutions in this respect.
In other words it is through polity that a nation can influence the insti-
tutional framework to stimulate investments and growth. The institutional
framework might be of a kind that makes investors feel secure that no one
else will appropriate the fruits of their investments or the framework might
be one that makes investors think that there is a risk that someone else will
reap the benefits. If the property rights are insecure, long-term investments
will be hampered and come at the cost of lower welfare.
3. RISK, RETURN, PORTFOLIO THEORY AND

INVESTMENT
Conventional investment theory holds that investors will evaluate alterna-

tive investments on the basis of the net present value (NPV). According to
the NPV rule investments should be evaluated according to the expected
cash flows (CF) minus the expected investment costs (I). Only projects
with expected positive net present values should be initiated (NPV 5 PV −
I). When calculating the present value of cash flows generated by an invest-
ment one uses a discount factor, 1/(1 1 r), where r is the discount rate. The
discount rate is also referred to as the required rate of return or as the cost
of capital. For risk-free projects the required rate of return equals the risk-
free interest rate, which also serves as a reference when valuing risky assets.
The PV of future cash flows is calculated as follows:1
T
CFt
PV 5 a t (1)
t51 (1 1 r)
The discount rate will depend on the riskiness of the future cash flows. If
the risk is that the actual cash flow will be lower than predicted, the dis-
count rate will be accordingly higher than for a more certain future cash
flow. As the discount rate, r, increases the present value declines, hence the
aggregate number of investments also declines.
The crucial question is therefore how to determine the size of the dis-
count rate and the risk associated with various assets. We argue that the
discount rate can be broken down to a multitude of components, among
which property rights protection is one. Accordingly the discounted rate r
in the formula above should be:
r 5 rf 1 RPo 1 RPp (2)
where rf is the risk-free interest rate, RPp the risk premium associated with
weak property rights protection, and RPo a ‘general’ risk premium.2 Note
that the ‘general’ risk premium can presumably be broken down further
into different risk factors.3
The conventional capital asset pricing model (CAPM) makes a distinc-
tion between diversifiable firm specific risk and non-diversifiable systemic
risk (see Section 3). The specific risk can be diversified away. It is only the
remaining non-diversifiable risk that matters for the pricing of the asset
(that is, investors are only compensated for the systematic non-diversifiable
risk). As a consequence, the return r that investors require depends on the
systematic risk of the investment (see Section 4).
On a global capital market even much of the country specific risk can
be diversified away. One exception is, however, the institutional risk
of insecure property rights and contracts. This is a risk associated with
the institutional framework of the rules of a country. This institutional
framework is made up of both informal rules like norms, customs, tradi-
tion and religion and formal rules like property and contract laws and the
enforcement of these rules. It is, as pointed out above, primarily the formal
rules that polity can exert an influence on. To change informal rules is a
much tougher task. According to North (1990) and Williamson (2000)
this institutional framework changes very slowly over time. Even changes
in the formal rules (like property rights rules) and their enforcement tend
to take decades to implement. As an investor you are more or less stuck
with the institutional framework for a considerable time. The prospects
of balancing changes in the security of property rights by having an inter-
national portfolio are small. Hence, insecure property rights represent a
truly systematic risk that, according to the theory (see next section), will
increase the cost of capital (the required return on investment, r). The rise
in the cost of capital will, as shown in standard investment theory, decrease
investment.4
According to the CAPM the expected return on a security can be
calculated as:
E (ri) 5 rf 1 bi (E (rm) 2 rf) (3)

where bi measures the sensitivity of a security to market risk (systemic

risk) and rm the return on a market portfolio m. The model holds that
the expected rate of return should equal the risk-free interest rate plus a
risk premium that varies with b. The expected rate of return, E(ri), that is
obtained is simply the discount rate r used in equation (4) to calculate the
present value of future cash flows. The term E(rm) − rf is the market price
of risk for efficient portfolios (see for example Elton and Gruber, 1995).
In this model it is only one factor, the market portfolio, that matters in
calculation of the risk premium.
This standard CAPM can be extended into a so-called multi-beta
CAPM by including other factors that influence the size of the risk
premium. Merton (1973) was among the first to include a number of
uncertainty factors that could influence the price of an asset. Friend et
al. (1976) used the market portfolio inflation uncertainty as an additional
factor that determined cost of capital. We follow their approaches and add
legal uncertainty in the form of the degree of security of property rights as
a risk factor.
4. ESTIMATIONS OF RISK AND RETURN
Roll (1977) has in a seminal article levelled criticism at a general equilib-

rium model of the form of the CAPM. One of Roll’s points is that all assets
in the entire world should be included in the market portfolio m. However,
in the empirical literature national stock indices like Standard and Poor’s
500 and the New York Stock Exchange index are used as market portfolios
(see, for instance, Elton and Gruber (1995) for examples). This is clearly
an incorrect measure according to Roll’s critique. A step towards a more
‘correct’ market portfolio measure is to use an index containing all securi-
ties in the entire world. Such an index for traded corporate shares is the
Morgan Stanley world market index. That is the index that will represent
the market portfolio in the present study.
Estimation of beta and the risk premium can be made according to a
two-pass procedure.5 In a first-pass regression, time series analysis is used
to estimate bi in equation (4).
rti 5 ai 1 bi 3 rmt 1 eit (4)
The estimated betas (b^ i) are then used in a second-pass regression
ri 5 ai 1 RPm 3 b^ i 1 ei (5)
where ai is an estimate of the risk-free interest rate, ri is the average return

of a security or portfolio of securities, RPm is the risk premium of the
market portfolio and b^ i is the estimated beta-coefficient.
Since the institutional framework influencing investments tends to be
extremely stable over time, the institutional risk stemming from flaws in the
protection of property is not diversifiable and thus is systematic. However,
the stability of these institutional types of risk factors offers an empirical
challenge to estimation. An ideal way of estimating various risk factors’
influence on return is the so-called arbitrage pricing theory (APT). The
APT model comes from an entirely different tradition from the CAPM.6
In contrast to the CAPM, the APT model emphasizes surprise effects; that
is, sudden unexpected changes in macro variables can be used to explain
return. This is not an option in the present case. The stability of institutions
means that there is virtually no variation across time so one needs to focus
on the cross-sectional variation. As a consequence it is not possible to use
indexes of institutional risk factors in the first-pass estimation procedure.
A number of tests of the CAPM using the two-pass procedure have
been performed. Several of these indicate that a two-factor model (a multi-
CAPM) can be used.7 Consequently, there is some empirical support for
use of a model where legal uncertainty as well as a market portfolio is
included as a factor in the calculation of cost of capital. In that case the
second-pass regression will contain a second factor representing institu-
tional risk and look like:
ri 5 ai 1 RPm 3 b^ i 1 RPp 3 Institutional Risk 1 ei (6)
where RPp is the right risk premium due to insufficient safeguarding of

property and investor rights.
5. DATA
To calculate the impact of institutional risk on risk premium and the

required return on investments stock exchange data, risk data and data
of a global market portfolio are needed. Table 8.1 shows the data we have
used for these variables.
Monthly stock market indexes compiled by Morgan Stanley are used to
calculate the rate of return on national stock markets and the world market
portfolio.8 The stock market indexes cover a ten-year period, 1995 to 2005
(129 months more exactly), are expressed in US dollars, and are corrected for
dividends. This ensures that the indexes are consistently defined and include
all relevant returns. As a proxy for the market portfolio the world stock
Table 8.1 Description of the variables
Country stock Measures the stock price performance including dividends.

market indexes Expressed in US dollars. Source: Morgan Stanley
World market Measures the stock price performance including dividends
index for 49 developed and developing countries. Source: Morgan
Stanley
Property right Assessment of the protection and certainty of property rights.
protection Annual index ranging from 1 to 5, with a higher number
(PRPit) meaning weaker protection of property rights. Source:
Heritage Foundation Index of Economic Freedom
Investor right Investor profile. Assessment of a number of factors
protection influencing the risk of investments. Monthly index ranging
(IRPit) from 1 to 12, with a higher number meaning stronger
protection of investors. The index assesses contract viability,
risk of expropriation, payment delays and profit repatriation.
Source: International Country Risk Guide
Returns Different forms of return are calculated.
rit Monthly stock market return on country level. National stock
market indexes corrected for dividends and in US dollars are
used. Source: Morgan Stanley
rmt World market return calculated with monthly world market
index. Source: Morgan Stanley
market index from Morgan Stanley is used, which includes 49 developed and
emerging country market indexes. These are the countries examined.
As measures of institutional risk the Heritage Foundation index of prop-
erty rights protection (PRP) and the index of investor rights protection
(IRP) provided by the International Country Risk Guide (ICRG) are used.
The Heritage index ranges from 1 to 5, where 1 indicates strong protection
of property rights. It is an annual index which is available for the period
1995 to 2005. The property right index is an assessment of the quality of
contract enforcement, legal protection of property, existence of corruption
in the judicial system and the probability of expropriation. The ICRG index
ranges from 1 to 12, where 1 indicates strong protection. This is a monthly
index that here is used for the period 1995 to 2005. This index also measures
factors that have to do with protection of property rights and enforcement
of contracts. (For a further description of the two indexes used here, refer
to the Heritage Foundation and the Political Risk Group.)
In Table 8.2 the 49 developed and emerging countries that are included
in Morgan Stanley’s world market are shown. Three variables are pre-
sented. The first variable, R2-values from first-pass regression, shows the
proportion of the national rate of return that can be explained by variation
Table 8.2 Country data for 1995–2005 (129 months)
Developed R2-values Property right Investor right Average rate

countries from 1st-pass protection protection of return
regression (PRPit) (IRPit)
(average)* (average)*
Australia 0.53 1.00 7.52 0.128
Austria 0.22 1.00 9.16 0.122
Belgium 0.40 1.00 8.68 0.127
Canada 0.68 1.00 8.52 0.160
Denmark 0.47 1.00 8.21 0.150
Finland 0.40 1.00 8.74 0.221
France 0.69 2.00 8.44 0.125
Germany 0.65 1.00 8.50 0.105
Greece 0.20 2.36 6.89 0.164
Hong Kong 0.38 1.00 7.63 0.108
Ireland 0.48 1.00 8.87 0.107
Italy 0.39 2.00 7.99 0.131
Japan 0.37 1.36 8.49 0.011
Netherlands 0.68 1.00 8.94 0.106
New Zealand 0.30 1.00 8.47 0.106
Norway 0.48 1.18 8.23 0.140
Portugal 0.32 2.00 7.89 0.107
Singapore 0.37 1.00 8.79 0.045
Spain 0.59 2.27 8.96 0.178
Sweden 0.60 1.64 8.12 0.172
Switzerland 0.45 1.27 8.95 0.124
United Kingdom 0.69 1.00 8.85 0.103
United States 0.87 1.00 8.96 0.121
Emerging R2-values Property right Investor right Average rate
economies from 1st-pass protection protection of return
regression (average) (average)
Argentina 0.16 2.73 5.56 0.165
Brazil 0.43 3.00 6.06 0.200
Chile 0.38 1.00 7.73 0.083
China 0.17 4.00 6.68 0.017
Colombia 0.05 3.36 6.34 0.179
Czech Republic 0.09 2.00 8.52 0.205
Egypt 0.04 3.09 6.31 0.274
Hungary 0.26 2.00 7.75 0.287
India 0.10 3.00 6.36 0.108
Indonesia 0.16 3.45 6.12 0.101
Israel 0.33 2.00 6.92 0.135
Emerging R2-values Property right Investor right Average rate

economies from 1st-pass protection protection of return
regression (average) (average)
Jordan 0.01 2.36 6.76 0.158
South Korea 0.24 1.27 7.85 0.149
Malaysia 0.14 2.45 7.26 0.044
Mexico 0.44 2.91 7.72 0.175
Morocco 0.00 3.09 6.84 0.115
Pakistan 0.02 3.18 4.94 0.141
Peru 0.12 3.45 6.12 0.156
Philippines 0.20 2.73 6.32 −0.061
Poland 0.27 2.27 7.34 0.166
Russia 0.23 3.36 5.59 0.413
South Africa 0.35 2.91 7.55 0.114
Taiwan 0.26 2.09 7.03 0.022
Thailand 0.25 1.36 9.06 0.028
Turkey 0.26 2.36 6.43 0.322
Venezuela 0.09 3.45 5.28 0.172
Note: * The two indexes are inverse to each other. For the PRP index a low value is good,
whereas for the IRP index a high value is good.
of the rate of return in a world market portfolio. It is evident that there is a

clear difference between developed and emerging countries in this respect.
In most cases the stock exchanges in developed countries are more influ-
enced by variations in the world market portfolio than those in emerging
countries are. The very low R2-values for many countries could be seen as
an indication that there is a need for more factors than our market portfo-
lio to explain the rate of return on assets in different countries.
The average value on the Heritage index of property rights for the exam-
ined period differs also a lot for the countries. With a few exceptions the
developed countries have more secure property rights (lower values). With
regard to average rate of return there are not similar systematic differences
between the two types of countries. One observation is that there is more
variation in the rate of return for emerging than for developed countries.
The negative rate of return for the Philippines is troublesome from a theo-
retical perspective. According to the CAPM model this rate of return would
indicate a negative risk-free interest rate, which is not possible. We will
therefore exclude the Philippines when the risk premiums are calculated.
Table 8.3 is a table of summary statistics that confirms the picture given.
Table 8.3 Summary statistics for the aggregates of developed and emerging economies 1995–2005 (129 months)
R2 from 1st-pass Property right Investor right protection Rate of return

regression protection
Developed Emerging Developed Emerging Developed Emerging Developed Emerging
economies economies economies economies economies economies economies economies
Mean 0.487* 0.194* 1.307* 2.649* 8.426* 6.786* 0.124 0.149
176
Standard 0.170 0.128 0.473 0.749 0.556 0.984 0.043 0.101
deviation
Minimum 0.2 0 1 1 6.89 4.94 0.011 -0.061
Maximum 0.87 0.44 2.36 4 9.16 9.06 0.221 0.413
Count 23 26 23 26 23 26 23 26
Note: * indicates that z-test shows significantly different means at less than 5 per cent level.
Table 8.4 Correlation matrix
R2 Property Investor Average

rights rights returns
R2 1
Property rights −0.652 1
Investor rights 0.675 −0.827 1
Average returns −0.086 0.205 −0.254 1
The world market portfolio is a significantly better explanatory factor of

rate of return in developed than in emerging countries. Property rights
protection is significantly higher in developed countries. Also, property
rights protection and the rate of return show a much higher variation in
emerging countries.
Finally, Table 8.4 shows that the correlation between the variables is
especially high between property rights and R2-values. This result does also
point to an interpretation that in countries with insecure property rights
the market portfolio alone does not explain as much of the rate of return as
in countries with secure rights. And for obvious reasons the property right
and investor right indexes are highly correlated.
To test whether there is a significant link between the R2-values from the
first-pass regression and the institutional framework we regress the indexes
on the R2-values. We find a highly significant link in both cases and the
explanatory power is relatively high. The results are reported in Table 8.5.
These results suggest that in countries with weak institutional protection
of property rights the systematic economic factors influencing the world
market return have less explanatory power. In comparison, Roll (1988)
has examined the R2s for individual stock in the US and found that there
is no systematic difference in the explanatory power across industries. This
seems to suggest that the CAPM provides a less adequate tool for under-
standing asset pricing in less developed financial markets. Therefore we
believe that the R2-values can be used as proxies for financial development;
countries in which the CAPM displays a lower explanatory power might
be interpreted as less developed financially.
6. MODELS AND RESULTS
In the first step monthly data were used to estimate the first-pass regression
as in equation (4). In the second-pass regression the average Heritage and
International Country Risk Guide indexes of property rights protection
were included:
Table 8.5 First-pass R2-values and protection of property
Property right protection Investor right protection

(PRP) (IRP)
Estimation method OLS OLS
Dependent variable:
R2(first-pass) Coefficient t-value Coefficient t-value
Property rights (PRPi ) 20.147† 25.84*

Investor rights (IRPi) 0.122† 6.22*
R2 0.42 0.45
Adj. R2 0.41 0.44
F-value 34.1 38.7
No. observations 49 49
Note: * indicates significance at 1 percent. † The differences in sign and intercept are due
to the fact that the two indexes are inverse to each other (see Table 8.1).
ri 5 ai 1 RPm 3 b^ i 1 RPPRP 3 PRPi 1 ei (7a)
ri 5 ai 1 RPm 3 b^ i 1 RPIRP 3 IRPi 1 ei (7b)
where PRPi is the average value of the Heritage Foundation property right
index and IRPi is the International Country Risk Guide index of investor
right protection for a country i. We identify the Philippines as an outlier
and consequently exclude it from our regression.
Significant coefficients, RPPRP for the average value of the Heritage
index and RPIRP for the average value of the ICRG index, indicate that the
market portfolio is not the only important explanatory variable in calcula-
tions of a risk premium.
The result of the estimation of the second-pass equation is shown in
Table 8.6. The security of property rights is important. The coefficient for
PRP is almost significant at the 5 percent level and the coefficient for IRP
is significant at 5 percent. A higher degree of insecurity is consistent with
a higher cost of capital.
With the conventional CAPM we find that the world risk-free interest
rate, (a^ ), was on average 8 percent. However, assuming that the countries
with the best values on the property right index (PRP 5 1) and the investor
protection index (IRP 5 9.16) have virtually no uncertainty with regard to
property rights, we find lower risk-free interest rates. Using the best values
of the two risk factors we estimate the risk-free rate to be 5.7 percent for
the property right index and 4.8 percent for the investor right index. The
Table 8.6 Risk premium factors: property rights and investor protection
Property right protection Investor right protection Conventional CAPM

(PRP) (IRP)
Estimation method OLS OLS OLS
Dependent variable: ri Coefficients t-values Coefficients t-values Coefficients t-values
Intercept (a) 0.036 1.06 0.240 3.36* 0.08 2.92*
Property rights PRPi 0.021 † 1.98** – – – –
179
Investor rights IRPi −0.021 † −2.41* – –
b^ 0.059 2.55* 0.056 2.45* 0.06 2.47*
R2 0.19 0.22 0.12
Adj. R2 0.15 0.18 0.10
F-value 5.18 6.27 6.08
No. observations 48 48 48
Note: * and ** indicate significance at 5 percent and 10 percent respectively. † The differences in sign and intercept are due to the fact that the
two indexes are inverse to each other (see Table 8.1).
influence of security of property rights is significant whichever of the two

indices we use. The traditional beta stays approximately the same whatever
index is used. This suggests robustness in the result that security of prop-
erty rights does matter for the cost of capital.
Estimated risk premiums for property right protection and investor right
protection (plus the estimated risk-free interest rate) are reported in Table
8.7. We find an average 3 percent difference in interest rates, which can be
explained by differences in institutional quality. A z-test shows that these
differences are significant. The general beta does not differ in a significant
fashion between developed and emerging countries. Hence, the develop-
ing countries have a much lower risk premium on investments due to the
systematic risk that the institutional framework represents. Improvement
in the institutional framework will probably be conducive to more invest-
ments and higher welfare.
For the conventional CAPM Ramsey’s regression specification error
test (RESET) indicated a problem of omitted variables (F-test 8.65), which
supports the inclusion of further variables in the model. This is consistent
with the fact that the R2 and R2-adjusted almost double with the inclusion
of the two indexes.
7. CONCLUSIONS
David Hume and Adam Smith stressed the importance of secure property
rights for prosperity and growth. A link in the form of a formal treatment
of how secure property rights lead to lower cost of capital and thereby
more investment has not been established. Portfolio theory in corporate
finance theory provides such a link. In portfolio theory as represented by
CAPM and APT, systematic risk and surprise changes in fundamentals are
determinants of cost of capital.
The rationale is that an investor can get rid of unsystematic risk through
portfolio diversification. A time perspective is used where unsystematic risk
is avoided by combining assets that show different patterns of change over
time, implying a correlation of less than 1. Insecure property rights have
to do with what institutional framework a country has. The institutional
framework changes slowly over time. Hence it is difficult to diversify away
from the systematic risk that the institutional framework represents.
The specificities of institutional frameworks of countries make it impossi-
ble to use traditional APT and CAPM methodologies to estimate the impact
of insecure property rights on cost of capital. There is not much variation
over time in the institutional frameworks. The variation is between coun-
tries. This makes it difficult to apply APT methodology. Instead, a multi-
Table 8.7 Risk-free rate plus risk premiums
Developed Property right Investor right b^ i

economies premium (PRP) premium (IRP)
+ a^ + a^
Australia 0.058 0.084 0.87
Austria 0.058 0.050 0.61
Belgium 0.058 0.060 0.80
Canada 0.058 0.063 1.11
Denmark 0.058 0.070 0.84
Finland 0.058 0.059 1.62
France 0.079 0.065 1.07
Germany 0.058 0.064 1.26
Greece 0.087 0.097 0.95
Hong Kong 0.058 0.082 1.20
Ireland 0.058 0.056 0.85
Italy 0.079 0.074 0.94
Japan 0.066 0.064 0.87
Netherlands 0.058 0.055 1.08
New Zealand 0.058 0.064 0.81
Norway 0.062 0.069 1.07
Portugal 0.079 0.076 0.82
Singapore 0.058 0.058 1.15
Spain 0.085 0.054 1.14
Sweden 0.072 0.072 1.42
Switzerland 0.064 0.054 0.79
United Kingdom 0.058 0.056 0.77
United States 0.058 0.054 1.00
Averages 0.064* 0.065* 1.00
Emerging
economies
Argentina 0.095 0.125 1.12
Brazil 0.101 0.114 1.85
Chile 0.058 0.080 1.02
China 0.122 0.102 1.14
Colombia 0.108 0.109 0.52
Czech Republic 0.079 0.063 0.63
Egypt 0.103 0.109 0.46
Hungary 0.079 0.079 1.30
India 0.101 0.108 0.65
Indonesia 0.110 0.113 1.46
Israel 0.079 0.097 1.07
Jordan 0.087 0.100 0.15
Emerging
economies
South Korea 0.064 0.077 1.59
Malaysia 0.089 0.089 0.94
Mexico 0.099 0.080 1.44
Morocco 0.103 0.098 0.06
Pakistan 0.105 0.138 0.41
Peru 0.110 0.113 0.69
Philippines 0.095 0.109 1.06
Poland 0.085 0.088 1.37
Russia 0.108 0.124 2.13
South Africa 0.099 0.083 1.11
Taiwan 0.081 0.094 1.10
Thailand 0.066 0.052 1.63
Turkey 0.087 0.107 2.15
Venezuela 0.110 0.131 1.01
Averages 0.093* 0.099* 1.08
Note: * indicates that the z-test shows significantly different means at 1 percent.
factor CAPM approach has been used with a world market portfolio as one
systematic factor and indices over secure property rights and contracts. The
security of property rights and contractual agreements is introduced in a
second-pass regression that looks at differences between countries.
If a CAPM type of analysis is used an indication of higher risk premi-
ums in countries with insecure property rights is also found. We find that
a significant part of the required rate of return in developing countries can
be explained by weak institutional protection of property and contracts.
Our two measures of the institutional safeguarding of property rights seem
to capture the same effect and indicate that institutional risk needs to be
included in capital asset pricing. The conventional single-factor CAPM
seems to be less useful in countries where the institutional framework is
weak.
NOTES
* Acknowledgements: Financial support from Föreningssparbankernas Forskningsstiftelse

to Johan Eklund’s dissertation work is gratefully acknowledged. A research grant from
the Ratio Institute and the Marcus and Amalia Wallenberg Memorial Fund Foundation
is also gratefully acknowledged. Furthermore we acknowledge valuable comments
provided by Åke E. Andersson, Göran Skogh and participants at the 2005 conference of
the European Association of Law and Economics.
1. The present value of future cash flows from all investments made by a firm is equal to the
value of a firm set by the capital markets.
2. A political risk premium is proposed by Faure and Skogh (2003).
3. It can in line with the arbitrage pricing theory be argued that the discount factor RP0 can
be broken down further into a multitude of components (see, for example, Ross, 1976).
The problem is however to isolate the different factors that influence the rate of return.
4. See, for example, Mueller (2003) for a pedagogical exposition of the relationship between
cost of capital and investment.
5. See, for example, Elton and Gruber (1996, Chapter 2) for a description of the
procedure.
6. The wide use of and support for the CAPM can, according to Roll and Ross (1980), be
ascribed to the empirical regularity of common variation of securities, and according to
the CAPM this common variation can be ascribed to a single factor, plus an error term.
Even though the rationale behind the CAPM is, as noted earlier, based on the separability
of systemic non-diversifiable risk and non-systemic diversifiable risk, Roll and Ross argue
that
There are two major differences between the APT and the original Sharpe ‘diagonal’
model, a single factor generating model which we believe is the intuitive grey eminence
behind the CAPM. First, and most simply, the APT allows for more than just one
generating factor. Second, the APT demonstrates that since any market equilibrium
must be consistent with no arbitrage profits, every equilibrium will be characterized
by linear relationship between each asset’s expected return and its return’s amplitudes,
or loadings, on the common factors. (Roll and Ross, 1980, p. 1074)
7. See, for example, Sharpe and Cooper (1972), Douglas (1968) and Black et al. (1972).
8. MSCI total return indexes with gross dividends.
REFERENCES
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Some Empirical Tests’, in M.C. Jensen (ed.), Studies in the Theory of Capital
Markets, New York: Praeger.
De Soto, H. (2000), The Mystery of Capital – Why Capitalism Triumphs in the West
and Fails Everywhere Else, New York: Basic Books.
Douglas, G. (1968), Risk in the Equity Markets: An Empirical Appraisal of Market
Efficiency, Ann Arbor, MI: University Microfilms, Inc.
Elton, E.J. and Gruber, M.J. (1995), Modern Portfolio Theory and Investment
Analysis, 5th edn, New York: John Wiley & Sons, Inc.
Faure, M. and Skogh, G. (2003), The Economic Analysis of Environmental Policy
and Law – an Introduction, Cheltenham, UK and Northampton, MA, USA:
Edward Elgar.
Friend, I., Landskroner, Y. and Losq, E. (1976), ‘The Demand for Risky Assets
and Uncertain Inflation’, Journal of Finance, 31, 1287–97.
Kasper, W. and Streit, M.E. (1999), Institutional Economics – Social Order and
Public Policy, Cheltenham, UK and Northampton, MA, USA: Edward Elgar.
Merton, R.C. (1973), ‘An Intertemporal Capital Asset Pricing Model’, Econom-
etrica, 41, 867–87.
Mueller, D.C. (2003), The Corporation – Investments, Mergers and Growth,

London: Routledge.
North, D.C., (1990) Institutions, Institutional Change and Economic Performance,
Cambridge and New York: Cambridge University Press.
Roll, R. (1977), ‘A Critique of the Asset Pricing Theory’s Tests: Part I: On Past and
Potential Testability of the Theory’, Journal of Financial Economics, 4, 129–76.
Roll, R. (1988), ‘R2’, Journal of Finance, 43 (2), 541–66.
Roll, R. and Ross, S.A. (1980), ‘An Empirical Investigation of the Arbitrage
Pricing Theory’, Journal of Finance, 35, 1073–1103.
Ross, S. (1976), ‘The Arbitrage Theory of Capital Asset Pricing’, Journal of
Economic Theory, 13 (3), 341–60.
Sharpe, W.F. and Cooper, G.M. (1972), ‘Risk-Return Class of New York Stock
Exchange Common Stocks, 1931–1967’, Financial Analysts Journal, 28, 46–52.
Williamson, O.E. (2000), ‘The New Institutional Economics: Taking Stock,
Looking Ahead’, Journal of Economics Literature, 38 (3), 595–613.
9. The stock market, the market for
corporate control and the theory
of the firm: legal and economic
perspectives and implications for
public policy
Simon Deakin and Ajit Singh1
1. INTRODUCTION
In this chapter we consider the relationship between shareholder value, the

market for corporate control, and economic and legal theories of the firm.
We argue that, contrary to current conventional wisdom, support for an
active market for corporate control is neither a core principle of company
law nor an essential ingredient of financial and economic development.
Indeed, the opposite could well be the case – an important element of
reform should be the prevention of the emergence of a market for corpo-
rate control. The absence of such a market in coordinated market systems,
such as Germany and Japan during their modern economic development,
was not an evolutionary deficit but an effective and positive institutional
arrangement. The unravelling of that arrangement, which is currently
being encouraged by regulatory changes and which some commentators
see as a necessary part of adjustment to globalization, has the potential
to destabilize existing production regimes, although so far it has failed to
have this effect. Aspects of a regulatory regime favourable to the market
for corporate control, such as a mandatory bid rule, have been adopted in
many developing economies over the past decade; however, in the absence
of countervailing power for employees of the kind found in most European
systems, it is possible that these developments could impose significant
economic and social costs associated with restructuring.
The chapter is ordered as follows. Section 2 outlines the relationship
between shareholder value and the core principles of company law in
the common law and civil law worlds. It is argued here that company
law systems, regardless of legal origin, tend to recognize the principle of
185
managerial autonomy from shareholder control, and provide managers

with discretion to run the company in such a way as to maximize returns
to all stakeholders and not simply shareholders. Section 3 turns the focus
to takeover regulation, which we suggest is the pivotal factor that has led
to the prioritization of shareholder interests in common law systems. We
explore the different approach to takeover bids in civilian regimes and
discuss the implications of attempts to encourage a market for corporate
control through regulatory changes in continental Europe and Japan,
before looking at the adoption of similar regulatory moves in emerging
and transition systems.
Having reviewed the common law and civil law approaches to the market
for corporate control, we turn in Section 4 turn to economic analysis. The
takeover mechanism plays a pivotal role in many branches of economic
theory including the theory of the firm, the theory of industrial organiza-
tion and welfare economics. It is also critical to an analysis of economic
and industrial policy. We, however, confine ourselves in this chapter to
analysing the relationship between the market for corporate control and
the theory of the firm. This subject is examined in Section 4, together with
a discussion of alternative views on the efficiency of takeovers, and the need
or otherwise for government regulation. Section 5 contains a discussion of
the pricing process and the takeover mechanism on the stock market. It
provides empirical evidence on aspects of the market for corporate control.
Section 6 briefly concludes.
2. SHAREHOLDER VALUE AND THE LEGAL

CONCEPTION OF THE FIRM IN THE COMMON
LAW AND CIVIL LAW
The idea that the managers of private-sector companies should act as the
agents of shareholders is a focal point of the contemporary corporate gov-
ernance debate. According to this view, the pursuit of shareholder value
is the single ‘corporate objective function’ which drives organizational
and allocative efficiencies (Jensen, 2001). Its influence is increasingly felt
in civilian systems that have, up to now, enjoyed a different tradition, and
its adoption in transition economies and in the developing world is on the
policy agenda there. This apparent convergence is occurring in large part
as a result of ‘the recent dominance of a shareholder-centred ideology of
corporate law among the business, government and legal elites in key com-
mercial jurisdictions’ (Hansmann and Kraakman, 2001: 439).
Too close a focus on the supposed efficiency of prevailing institutions is
liable to make us forget the often tortuous and uneven path by which they
The stock market and market for corporate control 187
came to acquire their apparent dominance. Britain’s industrial revolution

took place during a period when few businesses enjoyed limited liability.
In the US, many states allowed personal claims to be brought against
shareholders for corporate debts late into the nineteenth century and some,
including California, into the twentieth. Yet corporate law scholars today
assert that limited liability and the partitioning of corporate from per-
sonal assets are essential parts of the legal ‘bedrock’ supporting enterprise
(Hansmann and Kraakman, 2001). This view arguably ascribes ‘survival
value’ to institutions whose endurance may have more to do with histori-
cal contingency than efficiency (Deakin, 2003). Is the same true of today’s
norm of shareholder value?
It is surprisingly difficult to find support within core company law for
the notion of shareholder primacy. It cannot be found by referring to the
rhetorical claim, associated with today’s pension funds and other institu-
tional investors, that shareholders ‘own the company’. No legal system
acknowledges the claims that shareholders ‘own the company’. If we
understand the company to be the fictive legal entity which is brought into
being through the act of incorporation, it is not clear in what sense such
a thing could be ‘owned’ by anyone. But, more pertinently, nor does the
ownership of a share entitle its holder to a particular segment or portion
of the company’s assets, at least while it is a going concern (see Parkinson,
2003).
The law on directors’ duties is no more helpful. In the English-law
based common law systems, with only a few exceptions, directors’ fiduci-
ary interests of loyalty and care are owed to the company, not directly to
the shareholders. In practice, the company’s ‘interests’ will often be syn-
onymous with those of its members, that is, the shareholders. However,
shareholders are not entitled to engage directly in the management of the
enterprise; this is the responsibility of the board. According to Delaware
corporate law, ‘the business and affairs of every corporation . . . shall be
managed by or under the direction of a board of directors’ (see Millon,
2002: 92). Many of the formative cases of English company law, dating
from the nineteenth and early twentieth centuries, make the same point
(see Davies, 1997: 183–8).
Company law does not say anything about the level of returns to
which shareholders are entitled, nor about the time scale over which their
expectations are to be met. This ambiguity enabled the Company Law
Review Steering Committee, in the review of UK company law which
was concluded in 2002, to express its support for the idea of ‘enlightened
shareholder value’. This implies ‘[a]n obligation on directors to achieve the
success of the company for the benefit of the shareholders by taking proper
account of all the relevant considerations for that purpose’ including
‘a proper balanced view of the short and long term, the need to sustain
effective ongoing relationships with employees, customers, suppliers and
others; and the need to maintain the company’s reputation and to con-
sider the impact of its operations on the community and the environment’
(Company Law Review Steering Group, 2000: 12; see also Company Law
Review Steering Group, 2001: 41).
The Steering Group regarded its proposal as a compromise between
the ‘enlightened shareholder value’ position and a ‘pluralist’ point of view
which would have seen management as having multiple commitments to a
range of stakeholder groups. The Steering Group accepted the position of
agency theory that making management formally accountable to a diverse
body of stakeholders might limit the effectiveness of managerial deci-
sion-making and blur lines of accountability. Nevertheless, the Steering
Group’s proposal was based on the proposition that ‘companies should
be run in such a way which maximizes overall competitiveness and wealth
and welfare for all’ (Company Law Review Steering Group, 2000: 14–15,
emphasis added). The means chosen to achieve this end were the ‘inclusive
duty’ and ‘broader accountability’:
The proposed statement of directors’ duties requires directors to act in the

collective best interests of shareholders, but recognizes that this can only be
achieved by taking due account of wider interests. The transparency element
provides the information needed to underpin this approach to governance. Just
as importantly, we believe that [a] wider reporting requirement – particularly
for large companies – will be an important contribution to competitiveness.
Companies are increasingly reliant on qualitative and intangible, or ‘soft’ assets
such as the skills and knowledge of their employees and their corporate reputa-
tion. The reporting framework must recognize this and ensure that companies
provide the market and other interests with the information they need to
understand their companies’ business and assess performance. (Company Law
Review Steering Group, 2000: 14–15).
Section 172 of the Companies Act 2006, which is headed ‘Duty to

promote the interests of the company’, now provides that:
(1) A director of a company must act in the way he considers, in good faith,
would be most likely to promote the success of the company for the benefit of
its members as a whole . . .
(3) In fulfilling the duty imposed by this section a director must (so far as reason-
ably practicable) have regard to –
(a) the likely consequences of any decision in the long term,
(b) the interests of the company’s employees,
(c) the need to foster the company’s business relationships with suppliers,
customers and others,
(d) the impact of the company’s operations on the community and the
environment,
(e) the desirability of the company maintaining a reputation for high standards
of business conduct, and
(f) the need to act fairly as between the members of the company.
Such a position is by no means as contrary to US corporate law as many

writings on that system might make it seem. According to Leo Strine, a
leading Delaware company law judge, writing extra-judicially but express-
ing a view which is arguably quite compatible with the general thrust of
Delaware law (as opposed to corporate governance practice) on the issue
of shareholder value,
Most American workers obtain the bulk of their wealth from their labor and
even most top American managers can trace their wealth (including the equity
they have accumulated) to their labor as executives. Therefore, both manage-
ment and labor might be thought to have more concern than trust fund babies
or investment bankers do for the continued ability of American corporations to
support domestic employment. Likewise both management and labor are likely
to view a public corporation as something more than a nexus of contracts, as
more akin to a social institution that, albeit having the ultimate goal of produc-
ing profits for stockholders, also durably serves and exemplifies other societal
values. In particular, both management and labor recoil at the notion that a cor-
poration’s worth can be summed up entirely by the current price equity markets
place on its stock, much less that the immediate demands of the stock market
should thwart the long-term pursuit of corporate growth. (Strine, 2007: 4)
The idea that the company is an organization or ‘entity’ with a distinct

set of interests above and beyond those of all the stakeholder groups com-
bined is even more clearly articulated in the civil law systems. These recog-
nize the ‘enterprise’ as a legal form that corresponds to the organization.
This is distinct from the concept of the ‘company’ that essentially describes
a set of claims to income streams and property rights. The explicit recogni-
tion of the company’s organizational dimension has implications for the
way in which stakeholder interests are regarded, as this quotation from the
Viénot report on French corporate governance recognizes:
In Anglo-Saxon countries the emphasis is for the most part placed on the objec-
tive of maximising share values, whilst on the European continent and France in
particular the emphasis is placed more on the human assets and resources of the
company . . . Human resources can be defined as the overriding interest of the
corporate body itself, in other words the company considered as an autonomous
economic agent, pursuing its own aims as distinct from those of its sharehold-
ers, its employees, it creditors including the tax authorities, and of its suppliers
and customers; rather, it corresponds to their general, common interest, which
is that of ensuring the survival and prosperity of the company. (Viénot, 1995,
cited in Alcouffe and Alcouffe, 1997)
Various versions of this concept of the ‘company interest’ have been

expressed in continental European law and practice since the period
of industrialization in the second half of the nineteenth century; it was
articulated in the ‘communitarian’ concept of the enterprise advanced by
the German jurist Otto von Gierke in the 1890s, and in the corporatist
model popularized by the industrialist and politician Walther Rathenau in
the 1920s. Although German corporate law scholarship has been increas-
ingly influenced by agency theory since the 1990s, a significant strand
of it remains sceptical of the US-inspired model, and theories based on
the varieties of capitalism approach, stressing the importance of firm-
specific human capital in coordinated market systems, have recently been
deployed to explain and defend the core civilian model (see Gelter (2007)
on Germany, and Rebérioux (2007) on France).
3. THE LEGAL REGULATION OF TAKEOVER BIDS:

COMMON LAW AND CIVILIAN APPROACHES2
3.1 The Origins of Takeover Regulation
The vital factor in institutionalizing the shareholder value norm in the

common law or ‘liberal market’ systems has been the encouragement given
to the hostile takeover bid by regulatory changes which have often been
in tension with the core principles of company law. Takeover regulation is
a comparatively recent phenomenon. Following the economic depression
of the inter-war years, there was intense discussion of the responsibilities
of companies, the role of the financial system, and the need for public
regulation of the economy. The solution argued for by Adolf Berle, in
particular in his debate with E. Merrick Dodd in the mid-1930s, was to
reverse the ‘separation of ownership and control’ (which at that point was
a comparatively new development in the US: see Hannah, 2007) by return-
ing control to the shareholders (see Dodd, 1932; Berle, 1932). But this
route was thought to be impractical during a period when it was generally
considered that the large enterprise was the norm, family ownership was
in decline, and further dispersion of ownership could be expected. Rather,
the outcome was a combination of managerial and public control of the
corporation, much as Dodd had advocated, and as Berle came belatedly to
accept (Berle, 1962; see Ireland, 1999).
From the mid-1970s onwards, the intellectual climate in Britain and
North America began to turn away from public and social control of
industry, with results which are now familiar: the privatization of the large,
state-owned corporations and utilities, and the so-called deregulation of
many areas of economic life. As part of this policy turn, and as a result of
the changes to industry and the economy that flowed from it, the corporate
governance debate was relaunched. Corporate finance scholars argued
that, in place of the state, the market should provide the principal mecha-
nism for controlling the managers of large corporations. These authors, in
common with Berle and Means, argued that dispersed share ownership –
the fracturing of share capital among hundreds, sometimes thousands, of
individual holdings – freed management from direct supervision by inves-
tors. The solution, however, lay in the activation of the very instrument
which the legislation of the New Deal era in the United States, and of the
post-war regulatory state in many other countries, had sought to constrain
in the interests of economic stability: the capital market.
The mechanism by which this was achieved was the hostile takeover
bid. By offering to buy shares in a company at a premium over the existing
stock market price, so-called corporate raiders or predators could obtain
control of the enterprise, remove the existing managerial team, and install
one of their own. If the shareholders had no greater interest in the company
than the financial investment represented by their shares, they could be
induced to sell in return for the premium offered by the raider, in particular
if they felt that the incumbent managerial team was not looking after their
interests. For the bidder, the cost of mounting the bid and buying out the
shareholders could be recouped, after the event, by disposing of the com-
pany’s assets to third parties. If the company had not been well run before,
these assets would, by definition, be worth more in the hands of others.
Thus the hostile takeover bid performed a number of tasks. It empowered
shareholders, who now had a means to call management to account if it
was underperforming. Conversely, the hostile takeover disciplined mana-
gerial teams, who knew that their jobs and reputations were on the line if
a bid was mounted. In addition, it provided a market-led mechanism for
the movement of corporate assets from declining sectors of the economy to
more innovative, growing ones. That, at least, was the theory.
The rise of the hostile takeover can be traced back to the late 1950s and
early 1960s in the UK and the US. There had always been mergers and
acquisitions of firms; what was relatively new was the idea of a bid for
control directed to the shareholders, over the heads of the target board. In
the inter-war period, incumbent boards would ‘just say no’ to unwelcome
approaches from outsiders, often without even informing shareholders
that a bid was on the table (Hannah, 1974; Njoya, 2007). At this stage,
accounting rules had not evolved to the point where companies were under
a clearly enforceable obligation to publish objectively verifiable financial
information. This changed in the post-war period as a consequence of the
legal and accounting changes that were put into place in both Britain and
America by way of response to the financial crises of the 1930s. Greater

transparency made it easier for unsolicited bids to be mounted and more
difficult for incumbent boards to resist them. Institutional protection for
minority shareholders followed, with the adoption in Britain in 1959 of the
Bank of England’s ‘Notes on Reconstructions and Amalgamations’ and, in
1968, the City Code on Takeovers and Mergers; 1968 was also the year in
which the US Congress adopted the Williams Act, instituting a system of
regulation for hostile tender offers for US listed companies.
3.2 The US Model
The Williams Act sets time limits on tender offers and requires bidders with
5 per cent of a company’s stock to disclose their holdings and to give an
indication of their business plan for the company, but it does not explicitly
rule out two-tier or partial bids as it does not contain a mandatory bid rule
along the lines of the City Code. It regulates fraudulent activity, broadly
defined, but does not place target directors under a clear-cut duty of care to
provide independent financial information to shareholders in the way that
the Code does. At state level, US courts have accepted that, under the ‘busi-
ness judgment’ rule, target directors can take steps to resist a hostile takeo-
ver where they act in good faith and with ‘reasonable grounds for believing
that a danger to corporate policy and effectiveness existed’; specifically,
they can take into account the ‘inadequacy of the price offered, nature and
timing of the offer, questions of illegality, the impact on “constituencies”
other than shareholders (i.e., creditors, customers, employees, and perhaps
even the community generally), the risk of non-consummation, and the
quality of the securities being offered in exchange’.3 The Delaware courts
have nevertheless vacillated between an ‘auction rule’ which would require
the board to take steps to maximize shareholder returns in the event of a
proposed change of control,4 and the ‘just-say-no’ defence under which
the target board would be ‘obliged to charter a course for the corporation
which is in its best interests without regard to a fixed investment horizon’
without being ‘under any per se duty to maximize shareholder value in the
short term, even in the context of a takeover’.5
US corporate law has permitted the growth of a battery of anti-takeover
defences of the type that are virtually never adopted in the case of publicly
quoted companies in Britain. Shark repellents enable the composition of
the board to be structured so as to make it difficult for an outsider to gain
control. For example, company byelaws may stipulate that directors are
elected for three-year terms, with only part of the board coming up for
renewal each year. It is also common for byelaws to prohibit greenmail
(a raider forcing the target board to buy back its shares at a premium), to
prevent shareholders from voting by proxy, to lengthen the gaps between

general meetings, and to require supermajority decisions to change these
and other rules. Poison pills – various devices whereby insider shareholders
acquire rights which are triggered when a hostile takeover bidder makes
its entry – have been permitted, including the flip-in (where if the raider
increases its shareholding above a certain level the target board declares a
high dividend for existing shareholders, or existing shareholders are given
the right to buy additional stock at half the market price) and the flip-over
(shareholders get the right to buy stock of the new parent at a 50 per cent
discount).
In addition, most states have enacted anti-takeover statutes that enable
companies to adopt internal rules aimed at fending off hostile bids. The
first wave of such statutes was ruled unconstitutional in Edgar v. MITE
Corp.6 on the grounds that the Williams Act preempted them. In this case,
an Illinois statute that extended the bid timetable beyond that set by the
Williams Act and gave state-level competition authorities the right to
nullify offers was struck down. However, a second generation of ‘share
control’ statutes (providing the incumbent shareholders with the power
to decide on whether a raider with a controlling stake should retain the
voting rights of its shares) was upheld in CTS Corp. v. Dynamics Corp.7 at
around the same time as the Supreme Court gave a restrictive ruling to the
Williams Act, deciding that it did not bar defensive actions such as ‘crown
jewel’ options or sales.8 This simultaneously limited the scope of federal
regulation and opened the way for further pro-defensive laws at state
level. A ‘third generation’ of state laws followed, which, broadly speaking,
validated various poison pill defences and introduced ‘constituency’ or
stakeholder provisions into the definition of directors’ fiduciary duties.
These ‘stakeholder statutes’ vary in strength. Certain of them include
provisions for profit disgorgement, whereby the state imposes a high tax
on any short-term profits by raiders acquiring shares in connection with
a bid, for example as a result of greenmail (selling their shares back to the
company at a premium to the market). Modifications to directors’ duties
include provisions to the effect that fiduciary duties are owed solely to the
corporation and that no party, not even the shareholders, can enforce
them directly; that directors may consider the long-term interests of the
corporation; and that the directors need not regard any one constituency’s
interest as dominant. The stakeholder statutes, together with the adoption
of poison pills by a majority of large public corporations, are credited with
having helped to restrict the number and volume of takeovers at the end
of the 1980s: by the mid-1990s, over two-thirds of large US public corpo-
rations had adopted poison pills, and acquisitions of public corporations,
which had been running at over 400 per annum in the late 1980s, had fallen
to half that figure (Useem, 1996: 27–8). However, the stakeholder statutes
did little to deflect the wider impact of shareholder pressure on corporate
management, which today increasingly takes the form of pressure from
activist hedge funds and private-equity-led restructurings, and which
has been reflected in continuing high levels of lay-offs and restructurings
(Uchitelle, 2006).
3.3 The British Model
The City Code, like the Williams Act, dates from the late 1960s but, unlike
the US measure, it did not until recently have statutory backing. The Panel
on Mergers and Takeovers, a self-regulatory body set up by the financial
and legal professions and financial sector trade associations based in the
City of London, had no direct legal powers of enforcement. Its provisions
were strictly observed, however, since UK-based financial and legal pro-
fessionals who were found to have breached the Panel’s rulings could be
barred from practising as a consequence. As a result of the adoption by the
European Union of the Thirteenth Company Law Directive,9 the Panel has
recently acquired a statutory underpinning,10 but the substance of the Code
remains essentially the same as it was before, and it continues to be based
on the Panel’s deliberations and rulings. The expectation of both the UK
government and the Panel is that the implementation of the Directive will
not have a major impact on the Panel’s mode of operation.11
The City Code reflects the strong influence of institutional shareholder
interests within the UK financial sector, and their capacity for lobbying to
maintain a regulatory regime, which operates in their favour (Deakin and
Slinger, 1997; Deakin et al., 2003). Its most fundamental principle is the
rule of equal treatment for shareholders: ‘all holders of the securities of an
offeree company of the same class must be offered equivalent treatment’.12
This is most clearly manifested in the Code’s ‘mandatory bid’ rule which
requires the bidder, once it has acquired 30 per cent or more of the voting
rights of the company, to make a ‘mandatory offer’ granting all share-
holders the chance to sell for the highest price it has paid for shares of the
relevant kind within the offer period and the preceding 12-month period.13
Partial bids, involving an offer aimed at achieving control through pur-
chasing less than the total share capital of the company, require the Panel’s
consent, which is only given in exceptional circumstances.14 During the bid,
information given out by either the bidder or the target directors must be
made ‘equally available to all offeree company shareholders as nearly as
possible at the same time and in the same manner’.15
The Code also imposes on target directors a series of specific obliga-
tions that can be thought of as clarifying their duty to act bona fide in the
interests of the company but in some respects extend this duty. The target
directors must first of all obtain competent, independent financial advice
on the merits of the offer,16 which they must then circulate to the sharehold-
ers with their own recommendation.17 Any document issued by the board
of either the bidder or the target must be accompanied by a statement that
the directors accept responsibility for the information contained in it.18
While the point is not completely clear, the likely effect of this is to create
a legal duty of care owed by the directors to the individual shareholders to
whom the information is issued (and not to the company as is the case with
their general fiduciary duties).19
All this places the directors of the target in the position of being required
to give disinterested advice to the shareholders on the merits of the offer,
and makes it more difficult for them to resist a bid simply on the grounds
that it would lead to the break-up of the company. In a case where the
board considers that a hostile bid would be contrary to a long-term strategy
of building up the company’s business in a particular way, it can express
this opinion, but it must be cautious in doing so, since it still has a duty to
provide an objective financial assessment of the bid to the shareholders.
In the case of the takeover of Manchester United FC by the US business-
man Malcolm Glazer in 2005, the board took the view that Glazer’s offer,
because it would impose a high debt burden on the company, was not in
its long-term interests. However, the board was also aware that the offer
could well be regarded as a fair one, since it was by no means clear that
the shareholders would not be better off by accepting it. The board issued
this statement:
The Board believes that the nature and return requirements of [the proposed]
capital structure will put pressure on the business of Manchester United . . . The
proposed offer is at a level which, if made, the Board is likely to regard as fair
. . . If the current proposal were to develop into an offer . . . the Board considers
that it is unlikely to be able to recommend the offer as being in the best interests
of Manchester United, notwithstanding the fairness of the price.
Following this statement, a majority of the shareholders accepted Glazer’s

bid.
General Principle 9 of the Code used to state that ‘it is the shareholders’
interests, taken as a whole, together with those of employees and credi-
tors, which should be considered when the directors are giving advice to
shareholders’. This provision, like section 309 of the Companies Act 1985,
was less significant in practice than it appeared to be on paper, since it
provided no basis on which employees or creditors, who had (and have)
no standing before the Takeover Panel, can challenge a board’s decision.
Case law on fiduciary duties from the 1980s also suggested that, during a
contested takeover, only the interests of the shareholders could be taken

into account.20 As a result it probably matters little that, following recent
revisions to the Code, the relevant General Principle, which is based on
the parallel provisions of the European Union’s Thirteenth Company Law
Directive, now simply states that ‘the board of an offeree company must act
in the interests of the company as a whole and must not deny the holders of
securities the opportunity to decide on the merits of the bid’.21
The Code used to require the bidder to state, in its offer document,
‘its intentions regarding the continuation of the business of the offeree
company; its intentions regarding any major changes to be introduced in
the business, including any redeployment of the fixed assets of the offeree
company; the long-term commercial justification for the proposed offer;
and its intentions with regard to the continued employment of the employ-
ees of the offeree company and its subsidiaries’. This meant little in practice;
it simply required the bidder to issue a general statement of its intentions,
which generally took the form of a standard-term or ‘boilerplate’ provi-
sion in offer documents. However, as a result of changes made to the Code
following the implementation of the Thirteenth Directive, more prescrip-
tive provisions concerning the potential impact of takeovers on employees
have been introduced. The bidder must now provide detailed information
on its strategic intentions with regard to the target, possible job losses, and
changes to terms and conditions of employment,22 and the target must
give its views, in the defence document, on the implications of the bid for
employment.23 Breach of these provisions is a criminal offence. They also
have potentially significant implications for employees’ consultation rights
under labour law.24 In addition, employee representatives of the target
have the right to have their views of the effects of the bid on employment
included in relevant defence documents issued by the target.25
The Code contains extensive provisions controlling the use of defences
against hostile bids (or ‘frustrating measures’ in the terms used by the
Thirteenth Directive). Once an offer is made or even if the target board has
reason to believe that it is about to be made, the target board cannot issue
new shares; issue or grant options in respect of any unissued shares; create
securities carrying rights of conversion into shares; sell, dispose or acquire
assets of a material amount, or contract to do so; or ‘enter into contracts
otherwise than in the ordinary course of business’.26 General company law
is also relevant here. The ‘proper purposes’ doctrine prevents the board
issuing shares for the purpose of forestalling a hostile takeover, even well
in advance of any bid being made.27 Other advance anti-takeover defences,
such as the issue of non-voting stock or the issuing of new stock to friendly
insiders, have been discouraged by a combination of the Listing Rules of the
London Stock Exchange and institutional shareholder pressure. Protection
of pre-emption rights, or the rights of existing shareholders to be granted

preference when new stock is issued, is recognized by legislation28 as well as
by guidelines issued by stock exchange and financial industry bodies.29 The
issue of non-voting stock is permissible under general company law, but is
vigorously opposed in practice by institutional shareholders.30
Thus the Takeover Code, taken in conjunction with related aspects of
company law, can be seen to provide strong protection for the interests
of the target shareholders; that, after all, has been its main purpose (see
Johnston, 1980). An important side effect of this protection, however, is to
encourage hostile takeover bids by placing limits on the defensive options
available to the target management. An incumbent management is not
required to be completely passive, and is permitted to put a case in its own
defence, but opportunities for defence only arise in the context of an over-
riding responsibility to see that the shareholders’ interests are safeguarded.
The effect is not far removed from that of an ‘auction rule’ which requires
the incumbent management to extract the highest possible price for the
target shareholders, if necessary by making it possible for rival offers to
be made. The entry of second bidders is facilitated by the bid timetable
imposed by the Code and by the effective ban on two-tier and partial bids
which might otherwise be used to strong-arm the target shareholders into
accepting the terms of the first bid.
These regulatory features might be thought to deter bids, by increas-
ing the risk that either the target shareholders or any second bidder will
free-ride on the efforts of the initial bidder. However, the possibility of
free-riding by the shareholders is alleviated by the right of the bidder com-
pulsorily to purchase the last 10 per cent of shares in the event of taking
control; in the language of the European Directive, a ‘squeeze-out’ rule
(on its economic effects, see Yarrow, 1985). Other factors which serve
to reduce the risk of an initial bid failing due to free-rider effects are the
concentration of voting shares in most UK publicly quoted companies in
the hands of a relatively small number of institutional shareholders (so
reducing the number of shareholders who need to be persuaded to sell) and
the right of an initial bidder to raise its offer price during the bid period
(thereby enabling it to over-bid a second bidder). While there may, then, be
a certain screening-out of partial bids which, given their oppressive nature,
are arguably not efficiency-enhancing in any event (see Yarrow, 1985), the
effect of the Code is to reduce the autonomy enjoyed by the management
of the target company in relation to its shareholders and thereby to limit
the defensive options it has available to it.
This suggestion is borne out by empirical research carried out in
Cambridge in the late 1990s (Deakin et al., 2003). In this study, the objec-
tive was to construct a sample of bids which contained examples of both
hostile and agreed bids and of cross-border bids by UK companies and

for UK companies mounted during the period 1993–96. In interviews we
put this question to company directors, lawyers, merchant bankers, insti-
tutional shareholders and employee representatives:
Did directors’ duties to consider interests of creditors and employees as well as

those of shareholders affect the preparations for, the conduct of and the after-
math of the bid?
On the central question of directors’ duties, the response was almost

invariably that, while directors might consider employees’ and creditors’
interests, the outcome of a bid was determined by shareholder value.
Shareholder value took precedence over all other considerations. The
responses to the question are separated out below by group, with advis-
ers first, followed by directors, institutional investors, and employee
representatives.
A typical comment from an adviser was as follows:
Directors do consider employees’ interests, but no one really knows what that
means. At the margin the touchy-feely things matter, but the board of directors,
faced with two people offering £1 and £1.10, must go for the higher. The deci-
sion, of course, is not usually put like that, but I don’t know of any cases where
employees’ interests have come first.
Employees were only mentioned out of lip service to the obligation of the
offeror company to state its intentions with regard to employment:
Directors’ duties to consider other interests are rarely an issue unless the
company is near to insolvency. These clauses together are a bit of a sop. Rule 24
of the Code requires a statement of intentions towards employees, which always
gets reduced to the standard phrase: ‘the bidder will ensure that all rights of the
target employees will be met in full.’ Sometimes people do say more – sometimes
a target will screw a stronger statement out of the bidder. And where companies
intend not to make redundancies, they will tend to say it.
More pithily, we were told: ‘much is spoken about directors’ duties

to employees, but it is rarely relevant’, and ‘the Takeover Code and
Companies Acts just muddle these issues up: directors have to recommend
“the deal” when they are really just recommending the price.’
Directors told us that their focus was on the financial aspects of a bid:
The one thing that [our merchant bankers] kept saying was that ‘you have to
be sure that when you say that a price is inadequate, you mean it and can back
it up.’ Were we advised that we could take into account the interests of the
company as a whole? No – the primary advice was that ‘there is a price at which
you have to say yes.’
In particular, non-executive directors were identified as advocates for the

shareholder interest, even where this meant dismembering the corporate
enterprise:
Were we advised of our legal obligations to our shareholders? Yes – there was
lots of advice. One of the non-executive directors did push us hard to consider
closure and selling up as an option to get maximum shareholder value (about
five years before the bid).
Institutional investors likewise thought that directors should focus on

shareholder concerns. One was ‘happy with the idea that directors owe
duties to “the company”’ but was of the view that ‘during a bid, especially,
the directors understand this as being a duty to shareholders’. Another
considered that for directors to perform according to their fiduciary duties,
‘they had to show that it was in the interests of shareholders to sell’. The
pursuit of stakeholder interests was not seen as a viable alternative to
shareholder value:
It is hard to make a case that [the duty to further the interests of the company
as a whole] affected the bid greatly. In principle a defending company might put
employees’ interests before those of shareholders but they are basically serving
shareholders’ interests first. If directors have a duty, it is to ensure that employ-
ees have marketable skills. I see directors’ duties to employees as being more like
pension rights protection than long-term employment safeguards.
Employee representatives were less clearly opposed to bids than might

have been thought. Hostile bids were sometimes seen as shaking up incum-
bent managerial teams with which the employees had little by way of
common interest. Hence employee representatives commented unfavour-
ably on the tendency of target directors to be excessively well rewarded,
even before bids, in pay and share options, and on the negative effect that
this had on the workforce. Particular criticism was reserved for the practice
of linking managerial remuneration to the number of workers dismissed:
The other thing that caused trouble was the directors’ incentives schemes. They
had a bonus system which had work completed according to certain targets
divided by the number of staff that they employed to do it. So what they did was
to sack a lot of staff, and employed outside contractors, to fulfil their conditions
and increase their bonuses.
None of the employee representatives were convinced that a higher

commitment from management to consultation would have materially
affected the bids in which they were involved. In part this was out of a
frank recognition that the decision was in the hands of shareholders and
hence was ‘purely a commercial thing’. The priority was to keep lines of
communication open after the bid in an attempt to avoid compulsory
redundancies and smooth the way of the new owners. This was a typical
comment:
We take the view now that we’re not going to be able to prevent [the takeover]
– so we try to get the best deal we can. Given the current industrial relations
climate, I don’t think that even a ‘requirement to consult’ would make much
difference.
For target directors, the nature of the advice received was of paramount
importance. During bids, they saw their duty in terms of maximizing the
potential value of the company as a financial asset of the shareholders.
This obligation stood before any requirement to consult employees, to con-
sider their interests, or to further the interests of the company as a whole.
Even outside the bid period, the perceived ‘duty’ to focus on shareholder
value could lead a non-executive director to see it as their role to force
management to consider closing down the enterprise. Correspondingly,
institutional investors applauded directors who saw their responsibilities
in these terms.
The attitudes of employee representatives are best described as prag-
matic. They expected little from target managers whose interests were seen
to be tied up with share options and remuneration packages that would
leave them better off whatever the outcome of the bid. There was no expec-
tation of consultation with the target management, and no prospect of it
making a difference to the outcome of the bid if it did take place. By con-
trast, the intervention of bidders could be seen in a positive light, particu-
larly where there had already been a breakdown of trust with incumbent
management. Informal links could be established with the bidder at an
early stage, and a relationship constructed with a view to the future, even
though it was recognized on both sides that the most immediate issue was
likely to be the management of redundancies.
In 1974 Leslie Hannah wrote that the takeover bid had ushered in ‘an
economic system whose logic is still being developed and is still only imper-
fectly understood’ (Hannah, 1974). We now see more clearly what kind of
system it is. The takeover revolution was a catalyst for a raft of other meas-
ures and devices aimed at ensuring that managers of large corporations
acted first and foremost in the interests of their shareholders. However, it
is important to stress that, even in the UK context, the current focus on
shareholder value is therefore the consequence not of the basic company
law model but of those institutional changes which have occurred in capital
markets and securities law with increasing rapidity, in particular since the
early 1980s, namely the rise of the hostile takeover bid and the increasing
use of share options and shareholder value metrics. Thus the contemporary
‘norm’ or reference point of shareholder primacy is the result of a mix of
institutional changes, the emergence of new forms of self-regulation and
soft law, and shifts in corporate culture.
3.4 The Civil Law Model: Mainland Europe
In the civil law world, there has, until recently, been no equivalent to the
rules on takeover regulation that are found in common law systems. This
is not to say that there is no record, historically, of hostile takeover activ-
ity in civil law countries; as Hannah (2007) points out, takeovers by share
purchase did take place in Germany in the early years of the twentieth
century. However, for much of the twentieth century, they were actively
suppressed, particularly in the post-World War II period when they were
seen as incompatible with economic reconstruction in Germany, France
and Japan. The growth of corporate cross-shareholdings and the rise of
bank-led governance in these systems led to stabilization of share owner-
ship, but also to the sterilization of the external capital market as a mecha-
nism for controlling management.
A major change appeared to be about to take place in the early 2000s as
a result of the adoption of the Thirteenth Directive in the EU and changes
in the Japanese system which encouraged the revival of hostile takeover
activity, but a closer inspection also shows that there has been resistance
to attempts to institutionalize a market for corporate control. The first
significant document in the current round of initiatives was the report of
the High Level Group of Experts on takeover bids, published in October
2002. This argued that what the EU needed was ‘an integrated capital
market’ in which ‘the regulation of takeover bids [would be] a key element’
(High Level Group, 2002a: 18). The report noted that ‘the extent to which
in a given securities market takeover bids can take place and succeed is
determined by a number of factors’, including general or structural factors
affecting financial markets, and company-specific factors such as rules of
company law and articles of association affecting voting rights, protection
of minority shareholders, and the legitimacy of takeover defences. It then
observed that ‘there are many differences between the Member States in
terms of such general and company specific factors’, with the result that the
EU lacked a ‘level playing field’.
The substantive content of state-level company laws was also an issue
for the High Level Group. The essence of the problem was that the laws of
most member states did not sufficiently conform to a model of corporate
governance in which managers understood their principal duty to be to

return value to shareholders, and in which takeovers played a crucial dis-
ciplinary role in reminding them of this obligation:
Actual and potential takeover bids are an important means to discipline the
management of listed companies with dispersed ownership, who after all are the
agents of shareholders. If management is performing poorly or unable to take
advantage of wider opportunities the share price will generally under-perform
in relation to the company’s potential and a rival company and its management
will be able to propose an offer based on their assertion of their greater compe-
tence. Such discipline of management and reallocation of resources is in the long
term in the best interests of all stakeholders, and society at large. These views
also form the basis for the Directive. (High Level Group, 2002a: 19)
The High Level Group could not have been clearer: they were proposing
a measure based on the standard finance theory or ‘principal–agent’ view
of the role of hostile takeover bids in enhancing shareholder value. The
assertion that managers are ‘after all’ the agents of shareholders is one
based on a particular economic-theoretical position, and has no grounding
in the legal conceptions of the company that the High Level Group might
have looked for in the laws of the member states. Even UK company law
does not go this far; it has not followed the Delaware practice of sometimes
referring to duties owed by directors to the shareholders rather than to the
company as a separate entity. Be that as it may, it was very largely to the
UK that the EU experts looked to fill out the content of the Directive. Even
more so than its many predecessors, this draft of the Thirteenth Directive
drew on the model of the City Code on Takeovers and Mergers, a text
notable, as we have seen, for the high level of protection it gives minority
shareholders and for its restriction of poison pills and other anti-takeover
defences that US law, which is otherwise takeover-friendly, by and large
allows (see Deakin and Slinger, 1997).
The High Level Group’s second report, in November 2002, struck a
similar note in stressing the role of non-executive directors in monitoring
management, which is a feature of British and American practice, but is
relatively underdeveloped in other member states:
Good corporate governance requires a strong and balanced board as a monitor-

ing body for the executive management of the company. Executive managers
manage the company ultimately on behalf of the shareholders. In companies with
dispersed ownership, shareholders are usually unable to closely monitor manage-
ment, its strategies and its performance for lack of information and resources.
The role of non-executive directors in one-tier board structures and supervisory
directors in two-tier board structures is to fill this gap between the uninformed
shareholders as principals and the fully informed executive managers as agents by
monitoring the agents more closely (High Level Group, 2002b: 59).
Again, the standard finance or ‘principal–agent’ model was stressed, and

a feature of the British and American systems was presented as if it had
universal validity. Features of national systems that did not conform
to the principal–agent approach, such as the distinctive role of worker
directors and community representatives in two-tier boards, were simply
shoehorned into the supposedly universal model. The High Level Group’s
second report set out a series of objectives for reform of corporate govern-
ance (among other things) which reflected this point of view, and which
were then incorporated into the Commission’s Action Plan on company
law, with effect from 2003.31
What happened next, and in particular the fate of the Thirteenth
Directive, is instructive. Although the Directive was eventually adopted,
in 2004,32 this was only after a series of compromises had been agreed,
which considerably diluted the draft presented by the Commission in
2002. Contrary to the expectation that the Directive would roll out a
liberal-market model of takeover regulation along similar lines to those of
the UK’s City Code on Mergers and Takeovers, in its final form it allows
member states to retain laws which permit multiple voting rights and limit
shareholder sovereignty in various ways, such as allowing anti-takeover
defences to be put in place in advance of bids.
Some of the derogations in the Thirteenth Directive are transitional;
its general thrust is in favour of the principle of one-share-one-vote, and
proportionality between investment risks and decision-making powers is
clear. However, rather than impose a single model on member states, the
Directive can be seen as setting out an ‘experimentalist’ framework for
law-making at state level. This was far from being its original objective.
Nevertheless, the result of the rough-hewn compromises which informed
the final text of the Directive is that the liberalization of takeover rules can
be achieved in one of several different ways, which may take into account
specific features of the legal and institutional environments of the different
member states.
Both Germany and France have taken advantage of the derogations in
the Directive. In Germany, the supervisory board of a listed company has
the power to authorize poison-pill-like defences. In France the board of
directors can issue warrants granting new stock to existing shareholders
in the face of a hostile takeover bid, subject only to majority shareholder
approval at an ordinary meeting. Germany is moving in the direction of a
one-share-one-vote rule but this principle is not recognized by most large
listed companies in France. Cross-shareholdings in both countries are not
as strong as they were. In France, over 40 per cent of shares in the top
40 listed companies (the CAC 40) are now held by overseas pension and
mutual funds (mainly based in the UK and the US), a considerable shift
from just a decade ago. However, in neither country has a market for cor-
porate control to match the British or American model yet emerged.
Another significant feature of the Thirteenth Directive is that it enabled
the reformed takeover rules to make provision for information and consul-
tation of employees. An element of employee consultation was present in
earlier drafts of this Directive, and the provisions on this issue which were
included in the final text are not especially far-reaching, and do not go as
far as the laws of a number of member states. However, the Thirteenth
Directives set a pattern, in that mandatory employee consultation provi-
sions were then included in other company law directives, including the
directive on cross-border mergers, as well as the Societas Europaea (or
‘European company’) measures (where again there has been a long debate
on this issue). This illustrates the complexities involved in translating the
principal–agent model of corporate governance into specific legal provi-
sions. The finance theory espoused by the High Level Group finds no room
for managerial engagement with employees on issues of corporate govern-
ance, regarding it as a qualification of the principle of shareholder-based
control of the firm. However, the issue of employee involvement is una-
voidable when it comes to legislating at EU level. This is not just because
organized labour interests have numerous possibilities for presenting their
view when directives are being formulated, but also because the principle
of employee consultation in the event of corporate restructurings has come
to be recognized, over several decades, as an important point of reference
within the EU legal order, as it is embodied in numerous labour law direc-
tives as well as in the EU Charter of Fundamental Rights. Thus the inclu-
sion of employee voice rights in the new EU takeover regime is consistent
with the wider structure of EU law in the company and labour law fields,
although the extent to which these rights provide real countervailing power
to that of the capital markets remains to be seen.
3.5 The Civil Law: Japan
Most large Japanese enterprises are listed companies with (by international
standards) a relatively high degree of dispersed ownership. In the immedi-
ate post-war decades, cross-shareholdings were common, and indeed were
actively deployed as means of limiting the influence of foreign investors.
Between the mid-1960s and the mid-1970s the ‘stable shareholding ratio’
across the listed company sector as a whole, including cross-shareholdings,
rose from 47 per cent to 62 per cent (Miyajima and Kuruoki, 2005: 5–6).
However, the ratio had declined again to 45 per cent by 1993 and was only
24 per cent in 2003. Cross-shareholdings of the traditional type represented
only 7.6 per cent of the total in 2003 compared with 17.6 per cent in 1993
(NLI Research, 2004). Foreign shareholdings have risen from 11.9 per cent
of the market in 1996 to 26.7 per cent in 2005 (National Stock Exchanges,
2006). In 2006 around 8 per cent of the first (main) section of the Tokyo
stock market, 196 companies in total, were more than 30 per cent owned
by overseas investors (TSE, 2007: 4).
At the same time, large Japanese companies continue to stress their role
as social institutions or ‘community firms’ which provide stable employ-
ment to a core of long-term employees, in return for a high level of commit-
ment and identification with the goals of the firm. This tension between the
legal form of the enterprise and its changing ownership structure, on the
one hand, and its aspect as a social institution, on the other, has recently
been thrown into sharp relief by a series of hostile takeover bids.
The most controversial of these involved the planned takeover of Nippon
Broadcasting System (NBS) by the Internet service provider Livedoor,
which was launched in February 2005 (see Whittaker and Hayakawa,
2007). NBS had a cross-shareholding agreement with Fuji Television Ltd,
which in turn dominated a corporate group, the Fuji-Sankei media con-
glomerate. Livedoor’s intentions were widely interpreted as being based
on ‘greenmail’. When NBS attempted to issue new stock in order to dilute
Livedoor’s holdings and frustrate its bid, the courts declared the move
unlawful. In granting Livedoor an injunction, the Tokyo District Court
ruled as follows:
It is inappropriate for the board of directors of a publicly listed company, during

a contest for control of the company, to take such measures as the issue of new
shares with the primary purpose of reducing the stake held by a particular party
involved in the dispute, and hence maintain their own control. In principle the
board, which is merely the executive organ of the company, should not decide
who controls the company, and the issuing of new shares, etc., should only be
recognized in special circumstances in which they preserve the interests of the
company, or the shareholders overall.
When this judgment was appealed, eventually, to the High Court, it was
upheld:
The issue of new shares, etc., by the directors – who are appointed by the share-
holders – for the primary purpose of changing the composition of those who
appoint them clearly contravenes the intent of the Commercial Code and in
principle should not be allowed. The issue of new shares for the entrenchment
of management control cannot be countenanced because the authority of the
directors derives from trust placed in them by the owners of the company, the
shareholders. The only circumstances in which a new rights issue aimed pri-
marily at protecting management control would not be unfair is when, under
special circumstances, it aims to protect the interests of shareholders overall.
However, the High Court also ruled that defensive measures would be
potentially legitimate in four situations: greenmail, asset stripping, a lever-
aged buy-out, and share manipulation. This was an approach based in part
on the jurisprudence of the Delaware courts (Milhaupt, 2006). Unable to
make a new rights issue, NBS instead lent shares, minus voting rights, to
two friendly parties, and Livedoor subsequently agreed to drop its bid. It
sold its shares in NBS to Fuji Television, with Fuji Television, in its turn,
buying around 12 per cent of the shares in Livedoor.
Around the same time, the economics ministry (METI) and the Ministry
of Justice (MOJ) issued takeover guidelines that drew in part on the report
of METI’s Corporate Value Committee (CVC). The report of the CVC
refers to the concept of ‘corporate value’ in the following terms:
The price of a company is its corporate value, and corporate value is based on the
company’s ability to generate profits. The ability to generate profits is based not
only on managers’ abilities, but is influenced by the quality of human resources
of the employees, their commitment to the company, good relations with suppli-
ers and creditors, trust of customers, relationships with the local community, etc.
Shareholders select managers for their ability to generate high corporate value,
and managers respond to their expectations by raising corporate value through
creating good relations with various stakeholders. What is at issue in the case of a
hostile takeover is which of the parties – the bidder or the incumbent management
– can, through relations with stakeholders, generate higher corporate value.
The Guidelines (METI and MOJ, 2005) take a more shareholder-

orientated view, referring to corporate value as ‘attributes of a corporation,
such as earnings power, financial soundness, effectiveness and growth poten-
tial, etc., that contribute to shareholder interests’. However, they also rec-
ommend giving scope for companies to put anti-takeover defences in place
to deal with what could be regarded as opportunitistic or predatory bids. In
2006 a new law, the Financial Instruments and Exchange Law, amending
basic securities legislation, came into effect. This introduced a version of the
mandatory bid rule: a party purchasing 10 per cent of a company’s stock
over a three-month period would be required to make a public tender offer
or be limited to holding no more than one-third of the company’s issued
share capital. In 2006 changes to company law came into effect that formally
allowed companies to put in place anti-takeover defences. These include the
powers to issue special class shares with limited voting rights or which can
be compulsorily repurchased by the company (thereby depriving a potential
bidder of its stake), to make rights issues which exclude a bidder, and to
issue golden shares which confer certain rights such as the power to appoint
directors or restrain voting rights. The latter type of provisions requires
two-thirds majority support from existing shareholders.
The response to these developments has been complex and multi-layered
(see Whittaker and Hayakawa, 2007; Buchanan and Deakin, 2007). On

the one hand, a large number of companies have put in place takeover
defences. By February 2007, 197 listed companies had announced anti-
takeover strategies of various kinds (Nikkei, 2007). Some large companies,
such as Toyota, have strengthened intra-group cross-shareholdings in an
attempt to deflect Livedoor-type bids, and others, such as the three main
steel producers, have announced anti-takeover defence pacts.
At the same time, there has been some resistance to the growing use
of anti-takeover defences. One of the main institutional investor bodies,
the Pension Fund Association (PFA), has made clear its opposition to
takeover defences that do not have the approval of a simple majority of
shareholders. The Tokyo Stock Exchange (TSE) has also been hostile to
poison pill type defences, seeing them as a barrier to stock market trans-
parency and to accountability. In March 2006 the TSE amended its own
guidelines to allow golden shares, after the main employers’ federation, the
Keidanren, criticized the Exchange’s previous opposition to this type of
arrangement, but the TSE guidelines continue to stress the need for major-
ity shareholder approval, in line with the PFA position. Further evidence
of growing shareholder pressure comes in the form of dividend increases,
which in a number of cases can be traced to activist shareholder pressure
in the companies concerned.
Having said that, the current position of Japanese law is a long way from
the model of the City Code. Notwithstanding the introduction of a version
of the mandatory bid rule, the Japanese position is closer to Delaware law,
which permits poison pills, but with a clearer authorization for takeover
defence in the face of ‘greenmail’ or asset restructuring. The concept of
‘corporate value’ is being distinguished from the US-inspired ‘shareholder
value’ in contemporary debates. Managerial practice, too, continues to
prioritize the model of the community firm, with only a few exceptions.
This statement, made to one of the present authors by the president of a
large company in the course of empirical research on Japanese corporate
governance during the autumn of 2006 (see Buchanan and Deakin, 2007),
is typical of current attitudes:
I’m not quite sure whether shutting out these sorts of opportunities [i.e. bid
approaches] can really be called ‘corporate defence’. However – this is a
Japanese sort of environment – the fact is that 6,000 people are working in
our group and hitherto they have always had a great feeling of confidence and
attachment towards the management. Accordingly, with regard to philosophy,
even if for the sake of argument someone were to appear with a philosophy that
was even more elevated than ours, I would be very worried and doubtful as to
whether these employees who are currently contributing their confidence and
attachment to us would continue to do so in the same way for them.
3.6 Takeover Regulation in Emerging and Transition Systems
In the economies of the common law world, there is growing evidence of

shareholder rent extraction. A curious effect of successive takeover waves
from the 1970s onwards is that, in Britain and America, the net contribu-
tion of new equity to the financing of the corporate sector as a whole has
become negative. This is the result of share buy-backs and the ‘retirement’
of capital following mergers. The phenomenon has led to questioning of
the sustainability of the current model from within the business school
community, as in Allen Kennedy’s afterword to his 2000 book The End of
Shareholder Value:
How many companies would spend their wealth on stock buyback programs if
their objective was to create wealth? How many companies would see fit to cut
R&D expenditures if their objective was to build wealth? How many companies
would cavalierly shed long-term, loyal employees, their heads crammed full of
information valuable to the company, if their objective was to create wealth?
In a similar vein, Marjorie Kelly (2002), writing in the pages of the Harvard
Business Review, argued that:
stock-market investors have become, collectively, an extraordinarily unpro-

ductive force in business. Indeed, for the last two decades, their contribution
to corporations has been literally negative . . . it’s wrong to shovel money out
to shareholders in ever larger scoops and force other stakeholders to pay the
price.
The shareholders’ role is no longer simply to supply finance to companies.

Most trades of shares in listed companies consist of movements from one
shareholder to another with no new capital being supplied to the company.
Rather, as agency theory prescribes, the function of shareholders is to dis-
cipline corporate management. Thanks to the takeover revolution and the
changes associated with it, the managers of listed companies must maintain
shareholder approval. If they do not, they face the prospect of a takeover
bid. In practice, this means that companies have to satisfy, on a continuing
basis, shareholders’ expectations for high rates of return on equity. If they
can do this, a rising share price becomes an asset in its own right, which can
be deployed to fund growth through acquisitions (Millon, 2002).
The position is, however, different in civil law systems and in the devel-
oping world. The net contribution of equity capital has been positive in
those systems that have not followed the Anglo-American shareholder
primacy norm: mainland Europe, Japan, and developing world economies
such as Brazil and India (Singh et al., 2002).
Is this going to change as a result of shifts in takeover regulation in devel-

oping and transition economies? One of the central features of the British
(and now, to a degree, the EU) model is the mandatory bid rule. This is at
the core of the City Code system, which aims to protect the right of minor-
ity shareholders to access, in proportion to their holdings, the surplus gen-
erated by a takeover bid. It is an important stimulus to the fragmentation
and dispersion of ownership while also discouraging the construction of
cross-shareholdings. Influenced by a mixture of British and EU practice,
many systems have adapted a version of the mandatory bid rule in the past
ten years as part of a general realignment of takeover regulation in favour
of the protection of minority shareholder interests: in 1987 in Malaysia,
1994 in India, 2000 in Pakistan, 2000 in Chile, 2002 in Argentina, 2005 in
Mexico (Siems, 2007).
A similar trend can be observed in transition systems as a result of the
adoption of the Thirteenth Company Law Directive (Commission, 2007).
Two important aspects of the Directive are the ‘board neutrality rule’,
which limits the scope for takeover defences both ex ante and during a
bid, and the ‘breakthrough rule’ under which poison pills and golden
shares can be overridden during a bid. Most western European systems
have taken up the opportunity provided by the Directive to derogate
from both these rules, but the rate of take-up of derogations is lowest in
the Central and Eastern European (CEE) countries which constitute the
‘accession’ member states: the board neutrality rule has been adopted in
the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Slovakia and
Slovenia, and the breakthrough rule has been adopted in Estonia, Latvia
and Lithuania. Of the CEE accession states, only Poland has followed the
lead of Germany and other western European countries in rejecting both
the breakthrough rule and the board neutrality rule. This suggests that
the approach which began in the City Code is on the way to becoming a
global standard. Is this in the long-run interests of developing and transi-
tion systems?
4. THE ECONOMIST’S VIEW OF THE MARKET FOR

CORPORATE CONTROL
From a discussion of the alternative legal approaches to the question of

takeover bids, we now turn to economic analysis. In terms of the language
of the agency theory and the theory of asymmetric information, the central
issue may be stated in the following terms. The modern corporations are,
it is suggested, characterized by serious principal–agent problems, particu-
larly between shareholders (principals) and managers (agents); asymmetric
information between the two; and incomplete contracting. The operation

of these factors provides analytical justification for the proposition that
managers have scope to pursue their own ends.
One branch of the literature has pointed to the difficulties involved in
limiting managerial discretion through a more rigorous analysis of corpo-
rate governance, that is, the internal governance mechanisms of the cor-
poration, including shareholder voting and the effectiveness of the board
of directors. The alternative means available to the shareholders to limit
such discretion is to attempt to align managers’ interests with their own by
devising appropriate incentive contracts. All such efforts, however, have a
cost (the so-called ‘agency cost’). Within the framework of these concepts,
the takeover selection argument can then be deployed in two ways. The
strong form would suggest that only firms that are able to devise and imple-
ment optimal incentive contracts will be selected for survival; others will
be taken over. In a weaker form, this theory would propose that, while in
the real world substantial agency costs are inevitable and it is not always
possible to design satisfactory incentive contracts, the takeover mechanism
nevertheless helps to reduce agency costs and thus promote economic
efficiency. The implication of this weaker proposition is that, other things
being equal, the greater the agency costs, the more likely it is that the firm
will be taken over.
In this paradigm, in normative terms, the free operation of the takeover
mechanism can benefit society through two distinct channels: (a) the threat
of takeovers can discipline inefficient managements and reduce ‘agency
costs’; (b) even if the firms are working efficiently, takeovers may lead to
a reorganization of their productive resources and thereby enhance share-
holder value.
There is a sharp dispute between industrial organization economists
and specialists in finance about the efficiency of mergers and takeovers.
The former believe that takeovers do not lead to increased efficiency; at
best they are neutral, but most likely they reduce efficiency. The industrial
organization economists use accounting data to arrive at this conclusion
(Scherer, 2006; Mueller, 2003). This leads these economists to advocate
regulation of mergers since they are likely to enhance the monopoly power
of the amalgamating firms without, on average, increasing their efficiency.
In contrast, the finance specialists believe, on the basis of stock market data
and events studies methodology, that mergers enhance economic and social
efficiency. These scholars are therefore opposed to regulation of mergers.
A leading exponent of this view is Professor Jensen (2005). He and his col-
leagues regard anti-takeover legislation, which, as mentioned before, many
individual American states have instituted in reaction to the successive huge
merger waves of the last three decades, as being misconceived and promoted
by special interests. Some scholars belonging to this school would go even

further. They not only oppose any new anti-merger regulatory measures
but also suggest that the extant institutional obstacles to takeovers should
be eliminated. There are at present a number of stock exchange provisions
both in the US and the UK whose main purpose is to afford protection to
minority shareholders and to ensure ‘fair play’ and transparency in share
transactions connected with the takeover process. For example, in the UK,
a corporate raider is obliged to disclose its stake in the victim company
after it has purchased 3 per cent of the victim’s shares. Moreover, as we
have seen, the raider is required to make a full cash bid for all the shares of
the company after it has purchased 30 per cent of the victim’s stock. The
exponents of the market for corporate control believe that such regulations
constitute imperfections in the free functioning of the market; they are,
therefore, ipso facto inefficient, and hence should be removed.
This very positive finance specialists’ view of the market for corporate
control is vigorously contested by industrial organization economists.
Their reservations are best conveyed by a critical analysis of the US busi-
ness model of shareholder wealth maximization subject to the constraints
of liquid stock markets (including the takeover mechanism). This model is
being promoted for emerging countries by the IMF and the World Bank,
and indeed is recommended as a universal standard for the whole world
by these institutions and orthodox policy makers. Ironically, as we shall
see below, this model has risen from the shadow of strong criticism in the
early 1990s, when it was held responsible for the sluggishness of the US
economy, to its current acclaim for having engineered the US lead in the
information and technology revolution and for fostering faster growth in
the US economy.33 The extent to which the US corporate model facilitates
technological dynamism is perhaps the central issue in any assessment of
its merits.
However, it is now accepted that since 1995 there has been an increase
in the US economy’s long-term rate of growth by perhaps as much as one
percentage point, from 2.5 to nearly 3.5 per cent per annum. This strong
performance is attributed by leading scholars such as Jorgenson (2001,
2003) to the US lead in information technology. This success, in turn,
is attributed by many economists and, particularly, by the media to the
pivotal role played by US stock markets and venture capital markets in
financing this technological revolution.34 It is suggested that not all econo-
mies with stock markets are able to achieve these feats. Black and Gilson
(1998) have argued that other advanced economies such as Germany have
tried to imitate the US venture capital market but have not been success-
ful. The American success is due in part to its having a highly efficient and
effective market for corporate control. This allows a timely ‘exit option’,
making it possible for the American-type venture market to flourish. There

are also other advantages attributed to the US stock market, such as the
widespread use of stock options in technology industries that bring indi-
vidual managers’ incentives in line with corporate objectives.
Larry Summers (1998, 1999), who in the past has been critical of the
short-term focus of the stock market, has changed his mind. He now sug-
gests that the increasing stock market pressure for performance has played
a key role in the US economic success of the last decade. Further, the huge
investment in new technology firms in the US during the technology boom
of the 1990s, despite their zero or negative short-term profits, is regarded
as an obvious refutation of the short-termism alleged by critics of stock
markets (however, see below).
Nevertheless, taking into account the above facts, a critical examination of
the functioning of the stock market in the last ten years raises the following
questions. Does the experience of the last decade warrant a complete reversal
of the conclusions reached by Michael Porter and his colleagues in 1992?
Does the so-called ‘new’ US economy constitute a conclusive proof of the
superiority of the country’s financial system over all others? Is there adequate
analysis and empirical evidence to indicate that the Anglo-Saxon model of
corporate governance outlined above is the one that all countries, including
developing ones, should adopt? Singh et al. (2005) have carried out a detailed
analysis of these issues and they report the following conclusions:
● The experience over the last decades in the US capital markets pro-
vides little justification for revising the unfavourable 1992 verdict of
Michael Porter and his colleagues, although the reasons for this are
not necessarily the same now as they were then.
● Instead of maximizing shareholder wealth, developing country com-
panies should pay no attention to their market valuations. Rather,
they should pursue their traditional objective of increasing market
share or corporate growth within the overall framework of the coun-
try’s industrial policy.
● The stock market based model of shareholder wealth maximization
does not represent the ‘end of history’ or the epitome of corporate
law as some suggest.
The main reasons for these conclusions lie in the severe deficiencies of
two market processes which are central to the efficient operation of stock
markets: first the pricing process and second the market for corporate
control. It will further be appreciated that the last decade of applause for
the US stock market must at least be tempered by the fact that during this
period there was not only a boom but also a very significant bust. The
NSDAQ index of share prices of new technology companies is still well

below half the value that it reached at its peak in 2000.
5. STOCK MARKET PRICES AND THE MARKET

FOR CORPORATE CONTROL
5.1 The Pricing Process on the Stock Market
It will be observed that during the last two decades the orthodox efficient
markets hypothesis concerning share prices has suffered fundamental set-
backs. These are specifically due to the following events: (a) the 1987 US
stock market crash, (b) the meltdown in the Asian stock markets in the
late 1990s and (c) the bursting of the technology stocks bubble in 2001.
Following Tobin (1984) a useful distinction may be made between two
kinds of efficiency of stock markets. First, there is ‘information arbitrage
efficiency’ (IAE), which ensures that all information concerning a firm’s
shares immediately percolates to all stock market participants, ensuring
that no participant can make a profit on such public information. Second,
there is ‘fundamental valuation efficiency’ (FVE), whereby share prices
accurately reflect a firm’s fundamentals, that is, its long-term expected
profitability (Tobin, 1984). The growing consensus view is that stock
market prices may at best be regarded as efficient in the first sense above
(IAE), but are far from being efficient in the economically more important
second sense (FVE) (Singh, 1999). This point hardly needs labouring today
in the light of the burst of the technology bubble in leading stock markets
in 2001 and almost two decades of stock market stagnation and decline in
Japan. It will be difficult to preach an EMH gospel to citizens in Thailand
and Indonesia, who suffered a virtual meltdown of their stock markets
during the Asian crisis of 1997–99 (see further Singh et al., 2005).
5.2 The Market for Corporate Control as an Evolutionary Mechanism35
There are good theoretical reasons as well as a large body of empirical

evidence to suggest why the markets for corporate control in advanced
countries, including the UK and the US, do not work at all well. A central
point of this research is that the takeover selection process does not simply
punish poor performance and reward good performance. The evidence
indicates that selection in this market does not take place entirely on the
basis of performance but much more so on the basis of size. A large rela-
tively inefficient firm has a greater chance of survival than a small efficient
firm (Singh, 2008).
Further, there are good theoretical reasons as well as empirical evidence

for suggesting that takeovers may lead to ‘short-termism’, and/or specula-
tive buying and selling of shares. In addition, more broadly, they may result
in economic rewards being given for financial engineering rather than for
entrepreneurial effort in improving products and cutting costs. Empirical
research indicates that the takeover disciplinary process is very noisy and
is often arbitrary and haphazard (Ravenscraft and Scherer, 1987; Scherer,
1998, 2006; Tichy, 2001; Singh, 2000). The deficiencies of the pricing and
takeover processes are compounded in the case of developing countries
because of their regulatory deficits and the relative immaturity of their
stock markets. Singh (1998) argues for restrictions on the development of
a market for corporate control for these countries. Rather, he suggests that
developing countries should find cheaper and less haphazard mechanisms
to change managements than the above stock market process.
5.3 The Technology Boom, the Mispricing of Shares and the Market for
Corporate Control
It is generally accepted that there was a widespread mispricing of shares

during the technology boom of 1995–2000. There was also a huge over-
investment in technology companies. Importantly, in addition to the fore-
going, there was evidence of significant resource misallocation through the
working of the market for corporate control. In essence, grossly overpriced
technology companies bought up underpriced old economy companies to
the detriment of both and to the detriment of social welfare. Jensen (2003)
drew attention in this context to the case of Nortel, a large US company that
between 1997 and 2001 acquired 19 companies at a price of US$33 billion.
Many of these acquisitions were paid for in Nortel shares whose value
had skyrocketed during that period. When the company’s price fell 95 per
cent in the technology stock burst, all the acquisitions had to be written
off. Jensen observed, ‘Nortel destroyed those companies and in doing so
destroyed not only the corporate value that the acquired companies – on
their own – could have generated but also the social value those companies
represented in the form of jobs, products and services.’ (p. 15)
Although Jensen suggests various ways of reducing the mispricing of
shares, in Keynesian analysis such mispricing is inherent in any asset valu-
ation pricing process via the stock market. In this paradigm, stock market
players base their investment decisions not on fundamentals but on specu-
lative and gambling considerations. With such pricing, shareholder wealth
maximization is clearly not a useful objective for corporate managers who
have the firm’s interest in view. Kay (2003) therefore rightly suggests that
corporate managers should pay no attention to the stock market at all.
Indeed, the creation of shareholder value should not be a corporate goal.

The Keynesian view of pricing process is supported by a large body of
analytical and empirical studies: see, for example, Shiller (2000, 2004) and
Shleifer (2000).
6. CONCLUSION
In orthodox economic analysis, the market for corporate control is thought

to be the evolutionary endpoint of stock market development. This propo-
sition has been seriously questioned in this chapter from the perspective of
both legal and economic analysis.
Takeovers are a very expensive way of changing management. There
are huge transaction costs associated with takeovers in countries like the
US and the UK, which hinder the efficiency of the takeover mechanism
(Peacock and Bannock, 1991). Given the lower income levels in develop-
ing countries, these costs are likely to be proportionally heavier in these
countries. It may also be observed that highly successful countries overall,
such as Japan, Germany and France, have not had an active market for
corporate control and have thus avoided these costs, while still maintain-
ing systems for disciplining managers. Significantly, the lack of a market
for corperate control has not imposed any great hardship on these econo-
mies as their superior long-term economic record, say over the last 50
or 100 years, compared with that of Anglo-Saxon countries, indicates.
Furthermore, there is no evidence that corporate governance necessarily
improves after takeovers. This is for the simple reason that not all takeo-
vers are disciplinary; in many of them the acquiring firm is motivated by
empire-building considerations or indeed by asset-stripping.
In summary, contrary to current conventional wisdom, an active market
for corporate control is not an essential ingredient of either company law
reform or financial and economic development. The economic and social
costs associated with restructuring driven by hostile takeover bids, which
are increasingly seen as prohibitive in the liberal market economies, would
most likely harm the prospects for growth in developing and transitional
systems. Developing countries simply cannot afford the burden of the
extremely expensive, and hit and miss system of management change that
takeovers represent.
The following argument might be raised against the claims that we have
made here: if two mechanisms were available, an internal one based on
corporate governance and an external one represented by takeovers, why
not use them both to improve corporate performance? One immediate dif-
ficulty with this argument is that acquiring companies may themselves be
empire builders rather than disciplining shareholder value maximizers, as

was noted above. It was also seen that, at a more macro-economic level, the
takeover mechanism may subvert capitalist values by rewarding financial
engineering rather than enterprise. In a survey carried out by Cosh, Hughes
and Singh in the 1980s, it was found that 60 per cent of the time of the chief
executives of Britain’s top companies was spent on roadshows to investors,
rather than promoting new products or reducing costs, the essential tasks
of enterprise. The authors also found that a great deal of time was spent by
the chief executives and financial directors in either avoiding takeovers or
trying to take over other companies themselves (Cosh et al., 1990).
Perhaps our suggestion that developing country corporations should
pay no attention to their market valuations is somewhat extreme. But our
essential argument here is that stock market valuations are a highly inaccu-
rate guide to the fundamental valuations of companies. This is especially so
in developing countries, where theory predicts that the share price volatility
is even greater than in advanced countries. With the kind of meltdown in
share prices observed in East Asia during the crisis years of 1997–99, it was
scarcely useful to ask corporations to judge their performance by changes
in share prices. As mispricing of shares cannot be forecast with any accu-
racy, and as historical evidence suggests that such mispricing may continue
over long periods of time, it does not auger well for companies to use stock
market values as the main criterion for judging success or failure.
Finally, it could be argued against us that all we have offered here is a
critique, when what is needed is practical answers to the question of how
to design institutions for the market for corporate control. A clear con-
clusion of our argument is that the mandatory bid rule and other similar
aspects of the UK model, which are now being very widely exported
around the world, will not aid the cause of economic development; we
do not favour these rules. This does not mean that takeovers should be
entirely unregulated – far from it. Not only developing countries but also
those in Continental Europe, which have long operated without a market
for corporate control, should seek alternative institutional mechanisms for
disciplining errant managements rather than adopting the Anglo-Saxon
takeover mechanism. Instead of concentrating on shareholder value, these
countries should be actively promoting new institutional mechanisms for
inclusive development of the company and its diverse constituencies.
NOTES
1. This chapter was originally a paper presented at the conference on ‘The Economics of
the Modern Firm’, University of Jönköping, 21–22 September 2007. We are very grate-
ful for comments received at the conference and from a referee.
2. This section updates, in part, material first set out in Deakin and Slinger (1997) and
Deakin et al. (2003), and draws on Deakin (2009).
3. Unocal v. Mesa Petroleum 493 A.2d 946, 955 (1985).
4. Revlon Inc. v. McAndrews & Forbes Holdings Inc. 506 A.2d 173 (1986); Paramount
Communications Inc. v. QVC Network Inc. 637 A.2d 34 (1994).
5. Paramount Communications Inc. v. Time Inc. 571 A.2d 1140 (1989). On Delaware’s ‘zig-
zags’, see Roe (1993) and Blair (1995: 220–22).
6. 457 US 624 (1985).
7. 481 US 69 (1987).
8. Schreiber v. Burlington Northern Inc. 475 US 1 (1985).
9. Directive 2004/25/EC of the European Parliament and the Council of 21 April 2004 on
Takeover Bids, L 142 Official Journal of the European Union 30.4.2004).
10. The Takeovers Directive (Interim Implementation) Regulations 2006 (SI 2006/1183),
which came into force on 20 May 2006, provide a statutory basis for the Panel’s
operation and empower it to issue rules on takeover bids. These Regulations have more
recently been superseded by the relevant provisions of the Companies Act 2006.
11. See DTI (2005) and Takeover Panel (2005).
12. City Code, General Principle 1.1.
13. Ibid., rule 9. See also Companies Act 1985, s. 430A providing a statutory right to sell
where the bidder and its associates control 90 per cent in value of the relevant shares;
s. 428 grants the bidder a right of compulsory purchase of the last 10 per cent of the
shares.
14. City Code, rule 36.
15. City Code., rule 20.1.
16. Ibid., rule 3.1.
17. Ibid., rule 25.1(a).
18. Ibid., rule 19.2.
19. A claim in tort might well be made out notwithstanding the restrictive decision of the
House of Lords (on auditor liability) in Caparo Industries plc v. Dickman [1990] 2 AC 6,
and it is also possible that directors who provide misleading advice on the sale of shares
may commit a breach of statutory duty actionable by the shareholders: Gething v. Kilner
[1972] 1 All ER 1166.
20. Heron International Ltd. v. Grade [1983] BCLC 244.
21. General Principle 3.
22. City Code, rule 24.1.
23. Ibid., rule 25.1(b).
24. See below, Section 3.
25. City Code, rule 30.2(b). This is however subject to the target board receiving the
employee representatives’ views in good time, which may not always be straightforward.
See Takeover Panel (2006: 32–3) for discussion.
26. City Code, rule 21.
27. See Howard Smith Ltd. v. Ampol Petroleum Ltd. [1974] AC 821, discussed by Parkinson
(1995: 143).
28. Companies Act 1985, ss. 85–9.
29. These Guidelines were first issued on 21 October 1987 by the International Stock
Exchange’s Pre-emption Group, consisting of members of the ISE and officers of
the principal representatives of institutional shareholders, namely the Association of
British Insurers and the National Association of Pension Funds. Under Guideline 1.2,
the Investment Committees of the ABI and the NAPF agreed to advise their members,
under normal circumstances, to approve resolutions for annual disapplication of pre-
emption rights, as long as the non-pre-emptive issue did not exceed 5 per cent of the
issued ordinary share capital as shown in the most recent published accounts of the
company.
30. Guidelines published by the Institutional Shareholders Committee (a body represent-
ing a number of financial industry interests and trade associations) in December 1991,
‘The Responsibilities of Institutional Shareholders in the UK’, stated that ‘institutional

shareholders have for many years been opposed to the creation of equity shares which
do not carry full voting rights and have sought the enfranchisement of existing restricted
voting or non-voting shares’ (para. 3).
31. See High Level Group (2002a: 10–12). On the Action Plan, and its development since
2002, see Commission (2003) and the company law website of the Internal Market
Directorate: http://ec.europa.eu/internal_market/company/index_en.htm.
32. Directive 2004/25/EC.
33. Porter (1992) reported on the findings of a US Blue Ribbon Commission (comprising
22 leading US economists including Larry Summers) on the country’s business model
and the associated system of allocating capital. The Commission made serious criticisms
of America’s capital markets, indicating that they were misallocating resources and
jeopardizing the American position in the world economy. It is indeed true that the US
economy stagnated between 1973 and 1995, registering hardly any overall increase in
productivity growth.
34. This is not necessarily Professor Jorgenson’s view. He attributes the rapid uptake of
information technology in the US to the sharp fall in the price of semiconductors as a
result of increased competition. This in turn arose from a reduction in the product cycle
from three to two years.
35. This section is based on and updates some of Singh’s previous contributions in this area
including Singh (1992, 2000, 2006).
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PART IV
The board, management relations and

ownership structure
10. Institutional ownership and
dividends
Daniel Wiberg*
1. INTRODUCTION
During the late 1990s firms’ dividend payout ratios reached unprecedented
low levels despite high earnings and price-to-dividend ratios. Recently
however, with a continuing institutionalization of capital, dividend payout
ratios have soared. At present many multinational firms pay out special
dividends and buy back shares on a scale previously unseen. What role
does the increasing institutionalization of capital play in this development?
This chapter addresses this issue by investigating the effect of institutional
ownership on dividend changes.
A large body of research exists on how corporate ownership structure
influences financing, investments and dividend decisions. The relationship
between management ownership and dividend policy has been especially
well documented (see, for example, Rozeff, 1982; Jensen et al., 1992;
Eckbo and Verma, 1994; Moh’d et al., 1995). The link between institu-
tional investors’ ownership and dividend policy is, however, somewhat
neglected (for dividends decisions see Short et al. (2002) and Gugler and
Yurtoglu (2003)). This lack of research is remarkable since there has been
such an increase in the importance and presence of these types of investor
in recent decades. Although studies exist they are predominantly done on
US or UK data (for example, Short et al., 2002) which, although central,
fail to provide comprehensive insights when the institutional framework
is different from what is usually referred to as the Anglo-Saxon corporate
governance system. In Continental Europe and Scandinavia the general
corporate governance structure is characterized by a much more concen-
trated ownership, often in combination with control instruments such as
dual-class shares and pyramidal ownership structures. The Swedish corpo-
rate governance system is particularly interesting from this point of view,
since it allows for the use of both vote-differentiated shares and corporate
pyramid structures, which have jointly produced a remarkably persistent
and concentrated ownership structure.
225
226 The board, management relations and ownership structure
The purpose of this chapter is to investigate the impact of ownership

on dividends. In particular, institutional ownership, and its relation to
dividends, is considered in the context of an earnings trend model. This
model allows both for partial adjustments of dividends to changes in
earnings and for trends in the firms’ dividend behaviour. By examining
Swedish listed firms the chapter also provides empirical evidence on
the effects of control instruments such as dual-class shares on dividend
policies.
In line with the assumption that institutional investors may play a moni-
toring role, mitigating agency problems related to separation of ownership
and control, the results show that institutional ownership has a positive
effect on dividend payout policies. The relation is found to be positive but
diminishing, which supports previous research concerning non-linearity
and ownership structure. The chapter also provides empirical support for
a negative impact of dual-class shares on dividends. The result, in line with
agency cost theory, is that control instruments, such as vote-differentiated
shares, induce investors to demand higher levels of dividends as compensa-
tion for the increased agency costs.
Utilizing a panel data methodology which accounts for firm-specific
effects and time effects, unobservable heterogeneity is controlled for.
Furthermore, the chapter contributes to the literature by looking par-
ticularly at the Swedish case. In fact, Sweden is a very interesting case
because it is a civil law country which, according to La Porta et al.
(1999), has weaker protection of minority owners than common law
countries such as the UK and the US. Opportunistic behaviour of the
controlling owners is therefore more likely vis-à-vis minority owners
(Miguel et al., 2004; Pindado and de la Torre, 2006). By European
standards Sweden also has a vital capital market with a substantial part
of the stock market equity controlled by both foreign and domestic
institutional investors.
The chapter is organized as follows. Section 2 continues with a discus-
sion about the possible relations between institutional ownership and
dividend policy. In particular, the importance of agency conflicts and sig-
nalling is discussed. The statistical models for dividend payout behaviour
are provided in Section 3, together with definitions of the variables used
in the regressions. Summary statistics and ownership concentration by dif-
ferent types of owners in the sample firms are examined in Section 4. The
empirical method, estimation results and analysis are provided in Section
5. Conclusions end the chapter in Section 6.
Institutional ownership and dividends 227
2. OWNERSHIP AND CORPORATE GOVERNANCE

Given the divergence of ownership and control in listed firms, shareholders
cannot perfectly control the managers’ actions in the strict interest of the
shareholders. Hence principal–agent problems arise. Managers may divert
funds in their own interest at the expense of the shareholders (Williamson,
1963, 1964). This diversion of funds, usually referred to as managerial
discretion, may include expropriation1 or diversion of cash flows to unprof-
itable projects. It might be that these alternative investments provide a
positive return. In relation to the shareholders’ cost of capital, however, the
return is too low and, therefore, in terms of shareholder value maximiza-
tion, it is unprofitable (Mueller, 2003).
With a separation of votes from capital, as in many firms in Sweden,
agency costs might be substantial for the minority shareholders. A key
feature in any corporate governance system is therefore the legal protection
of minority shareholders. The effectiveness of the corporate governance
system however, may also require the presence of large investors other than
the controlling owner(s) or management2 (La Porta et al., 2000; Burkart
et al., 1997). They can influence the managers to distribute profits to the
shareholders, thus limiting the recourses available for managerial discre-
tion. The downside to large investors of this kind is of course that they
might just as well override the interest of minority shareholders (La Porta
et al., 1999). Indeed, Morck et al. (1988) find that profitability is higher for
firms with shareholders that have up to 5 per cent ownership; beyond that,
profitability drops. This pattern indicates that larger block-holding inves-
tors might seek to generate private benefits of control that are not shared
by minority shareholders.
A constraint on institutional investors is that they are often limited,
either by regulation or by a desire to maintain liquidity, to holding a rela-
tively small ownership stake in the firm’s equity (Davis and Steil, 2001).
Indeed, in Sweden mutual funds, which constitute the largest part of the
institutional owners, are regulated by the mutual funds act of 2004.3 In
this act it is stipulated that no single mutual fund can invest more than 5
per cent of its capital in a single equity issuer. The presence of institutional
investors in the ownership structure of firms might nevertheless influence
managers to be more focused on shareholder value maximization. It is also
likely that this relationship between institutional ownership and dividend
payout is non-linear (Miguel et al. 2004; Bjuggren and Wiberg, 2008;
Bjuggren et al., 2007). That is, although the effect in general might be posi-
tive it is most likely marginally diminishing. A non-linear relation between
ownership and dividend also indicates that the direction of causality goes
from ownership to dividends and not the opposite.
2.1 Institutional Ownership and Dividends
The increasing number of institutional investors and their growing domi-

nance as owners has had a substantial influence on corporate governance
(for extended discussion of agency costs and institutional owners see
Davis and Steil, 2001). Compared with Anglo-Saxon countries such as the
US and the UK, Continental European and Scandinavian firms pay out
relatively little in dividends or via repurchase of shares (La Porta et al.,
2000), despite high profitability and a very mature corporate structure.
One principal reason for the low levels of dividends in Sweden is the tax
system, which persistently disfavours dividends in favour of investments
made with retained earnings (Högfeldt, 2004; Henrekson and Jakobsson,
2006). A stated purpose of this tax policy is to foster so-called long-term
investment. The effect, however, is that substantial funds have been made
available for managers to invest with little or no scrutiny from the external
capital market.
So, even if high desired levels of dividends can be seen as a sign of ‘short-
termism’ in the institutional owners’ attitudes (see, for example, Hutton
1995; Haskins 1995), it might just as well be an effect of these owners’
attempts to reduce the free cash flow available to management.
2.2 Taxation Arguments
Institutional owners might prefer dividends for other reasons as well. First
of all, many institutional owners are tax-exempt with regard to dividends,
and might thus prefer dividends to capital gains. In Sweden the majority
of institutional owners are in fact tax-exempt mutual fund companies and
insurance companies that manage pensions and other types of savings
on behalf of the general public. Foreign ownership on the Swedish Stock
Exchange is also predominantly made up of these types of institution.
The Swedish corporate taxation system is a classical company tax
system in which the companies are taxed separately from their sharehold-
ers. While firms pay a flat4 rate of corporation tax on their profits, indi-
viduals pay a slightly higher dividend gains tax on dividend incomes. The
dividend gains tax is higher than the corporate tax rate, and individual
owners might thus prefer to postpone taxes rather than pay a dividend tax
immediately. Mutual fund companies and similar institutional investors
are, however, tax-exempt in the sense that they do not pay tax on incomes
received as dividends. The effect of this system is of course that indi-
viduals and company owners might prefer retained earnings and capital
gains, whilst tax-exempt institutional owners are either neutral or positive
towards dividends.
A related issue is the need of many institutional owners for funds on

an ongoing basis. That is, institutions invest in order to provide returns
to fund their liabilities. Regardless of the tax bias in favour of dividends,
institutions can therefore not rely entirely on capital gains to fund their
activities, and hence they require dividends. For institutional owners as a
group, and particularly in the case of Sweden, a positive relation to divi-
dend payout must consequently be expected.
2.3 Agency Arguments
A second reason for why institutional owners in particular might favour

dividends over reinvestments within the firm is that they might serve to
curb the agency problems between controlling owners/managers and the
minority shareholders, as suggested by Jensen (1986). Again, by high divi-
dend payout ratios less funds are available for managerial discretion, and
more funds will be allocated through the external capital market subject
to market scrutiny.
Empirically the predictions of agency theories on dividend payout
(Rozeff, 1982; Easterbrook, 1984; Jensen, 1986; Eckbo and Verma, 1994)
support a positive association between dividends and institutional owner-
ship. The prediction is basically that dividends substitute for poor monitor-
ing by the firms’ shareholders. Institutional owners might act as influential
principals who are able to impose their preferred payout policy upon firms.
The result is less cash available within the firm for managerial discretion
and a somewhat mitigated agency problem.
Based on the arguments above, Zeckhauser and Pound (1990) suggest
that institutional owners might act as a substitute monitoring device, which
would also reduce the need for external monitoring by the capital markets.
However, the well-known incentives for institutional shareholders to free-
ride on monitoring activities suggests that institutional shareholders are in
fact unlikely to provide direct monitoring themselves.
2.4 Signalling Arguments
A third reason why institutional owners might favour dividends is the poten-
tial information asymmetries that exist between owners and managements.
Given these asymmetries and the equity market’s preference for liquidity,
dividends can act as a signal about the future prospects of the firm.
A way for managements to signal their private information regarding
the future earnings of the firm would be through dividends (Bhattacharya,
1979, 1980; Miller and Rock, 1985). A somewhat alternative hypothesis is
put forward by Zeckhauser and Pound (1990). They argue that the presence
of large outside shareholders, such as institutions, can act as a signal of

the firm’s good performance. The presence of such shareholders might
therefore lessen the use of dividends as a signalling device. This would
then to some extent change Zeckhauser and Pound’s (1990) agency theory
prediction. It is however unclear in what way institutional shareholders
would act as a signal of future prospects. Is it a signal of reduced agency
costs due to monitoring of the institutional shareholders? According to
the free-rider arguments mentioned before, probably not. The alternative
is then that the institutional shareholders have some superior information
regarding the future prospects of the firm. Although this explanation has
some appeal, there is little evidence to support this scenario. Insider laws
may, for instance, make institutional shareholders very careful in handling
this type of information (if they get hold of it to start with). Also, the rapid
increase of indexation, especially with respect to institutional sharehold-
ings, implies that the presence of an institutional shareholder might not
necessarily mean that the particular institution believes that the firm has
better than average prospects (Short et al., 2002). While possible, the
notion that dividends and institutional shareholders may act as substitut-
ing devices is not very convincing. The expected results with respect to the
relationship between institutional ownership and dividends in terms of
signalling would subsequently be mixed as well.
These three main considerations, taxation, agency costs, and signalling,
are now summarized in order to construct empirically testable hypotheses
regarding the association between ownership and dividends.
2.5 Summary and Hypotheses
The association between ownership and dividends seems to depend cru-

cially on three factors related to the corporate governance system. The
first is the consideration of taxes. In a country like Sweden, with a clas-
sical company tax system, dividend payments are essentially taxed twice,
both as profits within the firm and then as capital gains for the individual.
Tax-exempt shareholders might for various other reasons (liabilities, and
so on) prefer dividends to capital gains. Consequently one would expect
a positive or at least neutral attitude to dividends relative to capital gains
for this type of investor.
The second factor decisively linking the corporate governance system to
dividends is agency problems related to the separation of ownership from
control. In corporate governance systems, such as the Swedish, where
ownership is further separated from control via control instruments, such
as vote-differentiated shares, the agency conflicts described by Jensen
and Meckling (1976) are aggravated. From this perspective influential
shareholders such as institutions may demand higher levels of dividends in

order to force firms to go to the capital market for external funding, and
hence be subject to monitoring by the external market, a notion that would
hold particularly when there is a separation between ownership in terms
of capital and control. The reduced levels of cash flow will thus mitigate
the free cash flow problem as described by Jensen (1986) and thus lead
to less inefficiency, in terms of managerial discretion. Based on the argu-
ments of the agency theory, therefore, the hypothesized relation between
institutional shareholdings and dividends is positive when capital rights are
separated from control rights.
Research by, amongst others, Miguel et al. (2004), Pindado and de la
Torre (2006) and Crutchely et al. (1999) has shown that the relationship
between dividends and institutional ownership is non-linear, and margin-
ally diminishing. Although positive, the impact of increasing ownership
leads to a convergence of the monitoring and entrenchment effects. This
notion has also been widely supported by previous literature (Morck et
al., 1988; McConnell and Servaes, 1990; Gedajlovic and Shapiro, 1998).
One would therefore expect that any impact of institutional ownership on
dividend policy is positive but diminishing.
The causal relation between dividends and ownership in terms of signal-
ling is, as mentioned, more complex, if existent. A distinct empirically test-
able hypothesis of this relationship is thus hard to formulate. Based on this
and the arguments above about taxation concerns and the agency theory,
hypotheses 1a and 1b are formulated.
Hypothesis 1a Institutional shareholdings have a positive effect on divi-

dend changes.
Hypothesis 1b Institutional shareholdings have a positive but marginally

diminishing effect on dividend changes
Hypotheses 1a and 1b are expected to hold for ownership in terms of both

votes and capital.
As the agency problems related to the separation of ownership from
control would be aggravated by the use of control instruments such as
vote-differentiated shares, institutional owners and outside investors will
demand higher dividends where such control instruments are in place. A
positive relationship can therefore be expected between dividend changes
and vote-differentiated shares. The next hypothesis is therefore:
Hypothesis 2 The use of vote-differentiated shares has a positive relation

to dividend changes.
Again, this relationship is expected to hold for ownership in terms of votes

as well as capital.
As the current period’s earnings are of primary importance to any
eventual dividend payout, an earnings component will be incorporated in
the estimated dividend model, as suggested by Fama and Babiak (1968).
The interpretation of this component is straightforward: higher earnings
mean more funds available for dividends and consequently a positive
impact on dividend changes can be expected. To control for the previous
period’s earnings, an earnings trend component will also be included in
the model.
In addition to earnings another variable which must be controlled for
is the previous period’s dividends. The parameter estimate of this variable
represents the speed of adjustment of dividends to new levels of earnings
and is thus expected to be negative, meaning that there is some reluctance
to change dividends immediately in response to changes in earnings (Short
et al., 2002).
3. METHOD AND VARIABLES
To test the relation between institutional ownership and dividends, a

partial adjustment model which accounts for earnings trends is used. The
model is modified by interacted shareholdings of the different ownership
types. A similar approach used by Short et al. (2002) is limited to using
interactive dummy variables due to the lack of ultimate ownership data. In
this chapter, however, the continuous shareholdings of the different owner-
ship categories, focusing on institutional ownership, are used.
Following Short et al. (2002) the derivation of the model is based on
four related models for the dividend–earnings relation; the full and partial
adjustment models by Lintner (1956), the Waud model (1966) and the
earnings trend model by Fama and Babiak (1968).5
3.1 The Modified Earnings Trend Model
Assuming that for any year, t, the target level of dividend D* for firm i at
time t is related to the long-run expected earnings, E*ti, of firm i at time t
earnings, by a desired payout ratio, r:
D*
ti 5 rE*
ti (1)
Based on the Waud model (1966) it is further assumed that the formation
of expectations follows an adoptive expectation process of the form:
E*ti 2 E*(t21)i 5 d (Eti 2 E*(t21)i) (2)
Then if ownership structure, by for example institutions (Inst representing

the ownership of institutional investors), alters the desired payout ratio (r)
firms would have another D*ti, so the model becomes:
D*
ti 5 rEti 1 rIEti 3 Inst (3)
where rI is the impact on the firm’s dividend payout policy related to insti-
tutional ownership.
This earnings generating process can then be combined with the adjust-
ment models of dividends developed by Lintner (1956). The partial
adjustment model in particular assumes that, in any given year, the firm
adjusts only partially to the target dividend level, as follows:
Dti 2 D(t21)i 5 a 1 c (D*ti 2 D(t21)i) (4)
where a is a constant representing the resistance to change dividends, and

c is the ‘speed of adjustment’ coefficient which represents management’s
reluctance to adjust the dividends to the new target level immediately. With
the target dividend level D* for firm i at time t, as in equation (1), we can
substitute in equation (4) and get the following model:
Dti 2 D(t21)i 5 a 1 c (rE*ti 2 D(t21)i) 1 mti (5)
where the term uti is the usual residual term.

So far the specification has yielded a partial adjustment model. But one
would also like to consider that earnings can follow a firm’s specific trend
or process (Fama and Babiak, 1968). Assume that the specific profit gen-
erating process, for firm i at time t, is of the form:
Eti 5 (1 1 g) E(t21)i (6)
where g is an earnings trend factor. If the firms’ ownership structures also

have a significant influence on the earnings of the firms it seems reason-
able to assume a possible difference in the earnings trend factor. The profit
generating process thus becomes:
Eti 5 E(t21)i 1 gE(t21)i 1 gIE(t21)i 3 Inst (7)
It is then possible to combine the Waud model’s adoptive expectation

process in equation (2) with the partial adjustment model of equation (4)
to get:
Dti 2 D(t21)i 5 a 1 c (r (d (Eti 2 E*(t21)i) 1 E*(t21)i) 2 D(t21)i) 1 mti (8)
Assuming that there is full adjustment of dividends to the expected change

(c 3 d 5 1), and partial adjustment to the reminder, equation (8) can
be rearranged and reduced. The reduced and empirically testable model
accounting for both trends in earnings and adjustments to target dividend
levels, equation (9), is consequently:
Dti 2 D(t21)i 5 a 1 rcEti 1 rg (1 2 c) E(t21)i 1 rgI (1 2 c) E(t21)i
3 Inst 2 cD(t21)i 1 uit (9)
Note that the term Inst is an example of an interaction term made up of an

ownership variable (institutional ownership). In the same way other owner-
ship variables can be tested by inserting another interaction term made up of
the relevant ownership variable (for example, VotDiff, which is a dummy of
vote-differentiated shares interacted with previous period’s earnings).
3.2 Variables
All data on the firms’ book values and earnings are provided by the
Compustat-Global database. The period covered is 1996 until 2005. The
time period in the regressions is 1997–2005, due to the first difference in
the dependent variable. Financial firms are removed from the sample,
due to the particular nature of their investments. The ownership data are
provided by Ownership and Power in Sweden,6 which is a unique database
covering ownership structure, on a yearly basis, for all firms listed on any
of the three major lists at the Stockholm Stock Exchange.
All aspects considered, the setup requirements produced a sample of
189 Swedish quoted firms. The sample firms correspond to an aggregate
share of more than 90 per cent of the total market capitalization at the
Stockholm Stock Exchange, and approximately 80 percent of the total
Swedish export value.
The variable institutional ownership is made up of the aggregate owner-
ship controlled by institutions, in terms of both cash flow rights (IC) and
vote rights (IV). The same notation applies for foreign ownership (FC) and
(FV) and so on; see Table 10.2. The group institutional investors consist of
banks, pension and mutual funds, insurance companies and endowment
foundations.7 The different ownership categories and how they are defined
and grouped are summarized in Table 10.1.
Table 10.2 provides a list of the variables used in the descriptive statistics
and the regressions, together with their definitions.
Table 10.1 Ownership categories
Owner type Definition

Private All shares controlled by individuals as well as other firms. The
private owner can be either the founder of the firm or an investor
who has acquired control.
Foreign These owners can be institutions as well as individuals since it is
hard to separate these two groups with certainty.
Institutional All shares controlled by Swedish financial institutions belong to
this category. In all cases the institution belongs to one of the
three following types.
Insurance company
Insurance company-controlled shares are all firms that have
an insurance company as their largest owner. Note however
that mutual funds belonging to an insurance company make a
separate group of controlling owners.
Mutual fund
As the name indicates, all shares controlled by a mutual fund; a
fund can belong to a bank, an insurance company or the state-
owned pension funds.
Foundation
This category includes foundations donated by private
individuals as well as, for example, various types of profit-sharing
funds and pension funds tied to individual companies.
4. DESCRIPTIVE STATISTICS AND OWNERSHIP

CONCENTRATION
Before continuing to the estimation results, a more thorough assessment

of the descriptive statistics is warranted. Descriptive statistics for the vari-
ables in the regressions are provided in Table 10.3. In addition to the vari-
ables used in the regressions, statistics of the firms’ sales/turnover, R&D
expenses, and working capital are provided in Table 10.3. Also, descriptive
statistics of the five largest owners in terms of capital share (C5) and votes
(V5) are included in the table. All figures, both in the descriptive statistics
and in the regressions, have been deflated to 2006 price level.
It is interesting to note that in the sample firms the largest shareholder on
average controls 34.84 per cent of the votes (V1); see Table 10.3. This con-
centrated ownership is remarkable, not only because of the concentrated
ownership compared with other European and Anglo-Saxon countries, but
also because of the relative size of the Swedish firms in the sample (mean
sales 11 231.43 million SEK8). The sample of firms is therefore consistent
with the view that the Swedish economy to a large extent is dominated by
Table 10.2 Variables
Variable name Definition

Dti Total amount of dividends paid by firm i in period t (million
SEK)
Dti-D(t-1)i Change in total amount of dividends paid by firm i between
periods t-1 and t.
Prstkcti Purchase of firm i stocks by firm i in period t (million SEK)
TPayti Total payout, dividends and repurchase of shares, by firm i
in period t
TPayti-TPay(t-1)i Change in total payout, dividends and repurchase of shares,
by firm i between periods t-1 and t.
Et Earnings, calculated as net profits from ordinary trading
activities after depreciation and other operating provisions
(million SEK)
Et-1 Earnings of firm i in period t-1
C1 Share of capital owned by the largest owner (cash-flow
rights), per cent
V1 Vote rights controlled by the largest owner (control rights),
per cent
FC Share of capital owned by foreign investors, per cent
FV Vote rights controlled by foreign investors, per cent
IC Share of capital owned by institutional investors, per cent.
IV Vote rights controlled by institutional investors, per cent
VoteDiff Dummy variable for vote-differentiated shares, 1 if dual-
class shares, 0 if one-share-one-vote
Sales Total sales (million SEK)
Employed Total number of persons employed by the firm i in time t
R&D-exp Research and development expenses if reported (millions
SEK)
WCap Working capital (millions SEK)
closely held, relatively large, often old industrial and multinational firms
(Agnblad et al., 2001; Högfeldt, 2004; Henrekson and Jakobsson, 2005).
When considering cash flow rights (C1), the share controlled by the
largest owner is on average 23.77 per cent, substantially lower than the vote
rights (V1534.84 per cent), but still remarkably high in an international
comparison. The median values for these two variables also support this
notion, that the single largest owner controls the firm to a large extent
by vote-differentiated shares (median C1520.50 per cent and median
V1531.30 per cent).
For the foreign and institutional owners cash flow rights seem to be
more important than control, in line with the expectation. The ownership
of vote rights for foreign and institutional owners (FV518.12 per cent
Table 10.3 Descriptive statistics all firms
Mean Median Std. dev. Min Max Obs

Dt 261.26 9.29 789.66 0 7862 1190
Dt-D(t-1) 31.74 0 395.72 −5169.44 4939.99 1190
Prstkcti 28.10 0 318.10 0 6518.13 1190
TPayti 289.36 9.51 895.15 0 8996.52 1190
TPayti- 31.74 0 395.15 −5169.44 4939.98 1190
TPay(t-1)i
Et 714.62 45.10 2797.37 −34 529.32 30 724.00 1190
Et-E(t-1) 78.53 8.71 2038.43 −40 652.38 37 146.87 1190
C1 23.77 20.50 15.16 1.00 74.50 1190
V1 34.84 31.30 20.75 2.50 95.10 1190
C5 47.01 45.9 18.40 6.40 97.60 1190
V5 58.15 59.75 20.99 6.40 98.80 1190
FC 20.59 16.20 17.47 0.00 79.60 1190
FV 18.12 11.30 18.25 0.00 93.50 1190
IC 14.11 11.5 12.28 0.00 54.90 1190
IV 11.14 8.10 10.94 0.00 67.6 1190
VoteDiff 0.62 1 0.48 0 1 1190
Sales 11 231.43 1204.26 31 099.15 0.04 298 428.10 1190
Employed 6.93 0.45 20.76 0.01 216.99 1190
R&D-exp 406.07 0 3010.69 0 49 553.76 1190
WCap 1954.50 166.15 8535.88 −10 884.00 110 201.90 1190
Note: All ownership variables, votes (V) and capital (C), are given in percentage. The
vote-differentiation dummy variable (VoteDiff) takes the value 1 if the firm has vote-
differentiated shares, 0 otherwise. Sales are given in millions of Swedish kronor (SEK).
and IV511.14 per cent) is substantially below the level of cash flow rights
(FC520.59 per cent and IC514.11 per cent). For both ownership types the
difference is around 3 per cent, which supports the assumption that the two
ownership types are in fact very similar. That is, the majority of the foreign
owners are in fact institutions. The incentive structure and the influence of
ownership on the performance should therefore be similar for foreign and
institutional owners, as expected by hypotheses 1a and 1b.
Dividing the sample according to whether or not the firms have vote-
differentiated shares reveals some additional insights. Table 10.4 shows
the descriptive statistics of the group of firms with only one type of share
(one-share-one-vote). This group represents 37 per cent of the total sample
of 189 firms, or 445 observations. It also seems that this group on average
represents smaller firms, compared with the group of firms that have
vote-differentiated shares described in Table 10.5.
Table 10.4 Descriptive statistics firms without vote-differentiated shares

Dt 130.14 0 544.10 0 5656.38 445
Dt-D(t-1) 18.55 0 186.74 −1006.33 2812.53 445
Prstkcti 9.62 0 89.04 0 1158.50 445
TPayti 139.76 0 555.14 0 5656.38 445
TPayti- 18.55 0 186.74 −1006.33 2812.53 445
TPay(t-1)i
Et 312.20 10.69 1588.51 −5823.43 17 972.37 445
Et-E(t-1) 44.32 7.77 1210.15 −14052.01 18 860.71 445
C1 22.09 19.4 13.78 2.50 74.50 445
V1 22.09 19.4 13.78 2.50 74.50 445
C5 43.91 42.3 17.63 6.40 89.20 445
V5 43.91 42.3 17.63 6.40 89.20 445
FC 22.39 18.2 17.94 0 77.00 445
FV 22.39 18.2 17.94 0 77.00 445
IC 14.03 11.3 12.01 0 54.90 445
IV 14.03 11.3 12.01 0 54.90 445
VoteDiff 0 0 0 0 0 445
Sales 4646.75 650.63 12 093.59 0.05 87 661 445
Employed 2.48 0.39 5.96 0.03 39.61 445
R&D-exp 81.49 0 287.87 0 2875 445
WCap 565.97 113.95 1832.96 −6236.19 13 727.85 445
The group of firms with vote-differentiated shares consists of 745 observa-

tions which represent 63 percent of the total number of firms in the sample.
Looking at the figures for sales, R&D, and working capital, and comparing
Tables 10.4 and 10.5, confirms that the firms with vote-differentiated shares
on average are larger than the firms without vote-differentiated shares.
The correlation between the different variables is provided in Table
A10.1 in Appendix 10.1. The correlations confirm the negative relation-
ship between both foreign ownership of capital and votes (FC and FV)
and institutional ownership of capital and votes (IC and IV) relative to
vote-differentiation. Also, a high correlation between dividends and earn-
ings is evident, as expected.
Repurchase of shares (Prstkcti) only constitutes a fractional part of the
total payout by the sample firms. Due to regulation, this way of distributing
funds back to the shareholders has previously been closed for Swedish firms.
Table 10.5 Descriptive statistics of firms with vote-differentiated shares

Dt 339.58 18.53 896.33 0 7862 745
Dt-D(t-1) 39.62 0 478.83 −5169.44 4939.98 745
Prstkcti 39.14 0 395.79 0 6518.13 745
TPayti 378.72 18.54 1036.95 0 8996.52 745
TPayti- 39.62 0 478.83 −5169.44 4939.98 745
TPay(t-1)i
Et 954.99 69.40 3293.19 −34 529.32 30 724 745
Et-E(t-1) 98.97 9.75 2401.13 −40 652.38 37 146.87 745
C1 24.77 20.90 15.86 1 74.10 745
V1 42.43 40.70 20.51 2.90 95.10 745
C5 48.86 48.50 18.61 8.90 97.50 745
V5 66.58 69.50 18.09 9.60 98.80 745
FC 19.51 15.30 17.10 0 79.60 745
FV 15.54 9.00 17.94 0 93.50 745
IC 14.15 11.60 12.45 0 54.70 745
IV 9.42 6.80 9.85 0 67.60 745
VoteDiff 1 1 0 1 1 745
Sales 15 164.57 1613.46 37 642.09 1.02 298 428.10 745
Employed 9.58 0.97 25.47 0.01 216.99 745
R&D-exp 599.97 0 3786.24 0 49 553.76 745
WCap 2783.89 204.42 10 611.02 −10 884.00 110 201.90 745
The correlation matrix (Table A10.1, Appendix 10.1) nonetheless confirms a

positive correlation between institutional ownership and this type of payout.
As few firms in the sample have made use of this method to distribute cash to
the shareholders, the focus of this chapter is on dividend changes.
5. EMPIRICAL RESULTS AND ANALYSIS
In order to test if there is any linear relationship between institutional own-

ership and dividends, the policy adjustment model is estimated with inter-
action terms; in Table 10.6, Model 1. The estimation is made in the form of
a pooled OLS, and ownership is measured as percentage of both votes and
capital. The results are presented in Table 10.6., Models 1a and 1b. The
results support hypothesis 1, with a positive effect of institutional ownership
Table 10.6 Pooled-OLS estimations: Model 1 linear and Model 2 non-

linear institutional ownership (votes and capital)
Dependent variable Model 1a Model 1b Model 2a Model 2b

(Divt-Div(t-1)) (votes) (capital) (votes) (capital)
Et 0.1247* 0.1248* 0.1236* 0.1233*
(26.69) (26.60) (26.30) (26.16)
E(t-1) −0.0612* −0.0616* −0.0777* −0.1072*
(−5.21) (−4.89) (−5.49) (−5.07)
E(t-1)*Inst 0.0007* 0.0007 0.0028* 0.0055*
(2.56) (1.45) (2.71) (2.95)
E(t-1)*Inst2 −0.00005** −0.0001*
(−2.09) (−2.68)
E(t-1)*VoteDiff 0.0133 0.0110 0.0193*** 0.0112
(1.26) (1.02) (1.76) (1.05)
Div(t-1) −0.2122* −0.2067* −0.2224* −0.2081*
(−10.30) (−10.02) (−10.52) (−10.12)
constant 13.9757 13.8101 13.5043 15.5981
(1.48) (1.46) (1.43) (1.65)
Number of R250.3990 R250.3967 R250.4012 R250.4004
obs51190 R2adj50.3965 R2adj50.3942 R2adj50.3982 R2adj50.3973
Number of
groups5189
Note: t-statistics are in parentheses. * denotes significance at the 1% level, ** denotes

significance at 5%, and *** denotes significance at the 10% level.
on changes in dividends, for institutional ownership measured by votes.

Although robust in terms of size and sign, the coefficient on institutional
ownership is insignificant when ownership is measured in terms of capital.
The estimated coefficient on previous periods’ dividends, Div(t-1), is negative
and significant, which suggests that the firms adjust dividends slowly to
changes in earnings, which confirms the findings in Short et al. (2002).
In order to account for a potential non-linear effect of institutional
ownership, another interaction term of squared institutional ownership
and earnings is added (Grier and Zychowicz, 1994; Schooley and Barney,
1994; Crutchley et al., 1999); see Table 10.7, Models 2a and 2b. This
allows for a marginally diminishing effect of institutional ownership on
dividend changes. Pindado and de la Torre (2006) use a somewhat differ-
ent approach with optimal breakpoints of the value–ownership relation
estimated in Miguel et al. (2004). As institutional ownership is measured
as the aggregate ownership share by this type of investor, this specification
seems unwarranted. Each individual institutional owner has its specific
breakpoint associated with its investment profile and so on. Consequently
only a diminishing effect of aggregate institutional ownership is tested.
Table 10.7 Cross-sectional time-series FGLS estimations: Model 3

institutional ownership (votes and capital)
Dependent variable Model 3a Model 3b

(Divt-Div(t-1)) (votes) (capital)
Et 0.0817* 0.0821*
(23.21) (21.47)
E(t-1) −0.0412* −0.0395*
(−6.15) (−4.89)
E(t-1)*Inst 0.0007*** 0.0009
(1.82) (1.50)
E(t-1)*Inst2 −9.59e-06 −1.4e-05
(−1.06) (1.08)
E(t-1)*VoteDiff 0.0244* 0.0217*
(4.21) (3.47)
Div(t-1) −0.1878* −0.1906*
(−8.79) (8.57)
constant 7.1562* 8.0771*
(7.75) (7.60)
Number of obs51190
Number of groups5189
Notes: t-statistics are in parentheses. Panels: heteroscedastic. Correlation: panel-specific

AR(1).
* denotes significance at the 1% level, ** denotes significance at 5%, and *** denotes
significance at the 10% level.
The estimates of the non-linear specification of Model 2 again reveal a pos-

itive and significant relation between institutional ownership and changes
in dividends. Correctly specified, institutional ownership, both in terms of
votes (Model 2a) and capital (Model 2b), is found positive and significant.
For ownership measured in votes the coefficient related to the use of vote-
differentiated shares is also significant. This suggests that firms using vote-
differentiated shares have higher levels of dividends, confirming hypothesis
2. The speed of adjustment coefficient, related to previous periods’ dividends,
is again significant and negative, as expected. The same holds for this period’s
earnings. Consistent with the equality and stability conditions of the model,
the estimated parameter for previous period’s earnings is negative.
As displayed by the descriptive statistics there are substantial size and
scale effects in the sample of firms. For the OLS regression to produce effi-
cient estimates under such conditions we need to control that the data are
homoscedastic. The Breusch-Pagan/Cook-Weisberg test,9 however, reveals
that the sample suffers from severe heteroscedasticity, and consequently we
cannot rely on the results of the OLS estimation for inference. To account
for this heteroscedasticity in the data a GLS methodology is required.

Utilizing both the cross-sectional and time-series properties of the data, an
FGLS regression will allow heteroscedasticity in the panels (firms) as well
as panel-specific correlation (AR(1)).
By including a time-specific dummy variable it is also possible to control
for temporal effects, that is, the effects of macroeconomic variables that
might influence the firms and their dividend behaviour, as well as their
ownerships structures.
Table 10.7 provides the results of the FGLS estimations, where owner-
ship is measured in terms of both votes (Model 3a) and capital (Model
3b). As expected, institutional ownership is found to have a significantly
positive effect on dividend payout, when ownership is measured in terms
of votes, which support hypothesis 1. The presence of institutional owners
is thus associated with positive dividend changes. For institutional owner-
ship in terms of capital share, the results are insignificant but positive, as
expected. The use of vote-differentiated shares is again found to be posi-
tively related to dividend changes, in support of hypothesis 2. This relation
holds for ownership measured in terms of both votes and capital.
In order to investigate the role of institutional owners in the context of
the agency conflict related to the separation of ownership and control, the
sample of firms is separated into two groups depending on whether or not
they have vote-differentiated shares. Naturally the interaction term with
the dummy for vote-differentiation is taken out of the regressions, as it
would have produced collienarity.
Table 10.8 presents the results from the FGLS estimations when the firms
are dividend into groups depending on whether or not they have a vote-dif-
ferentiated share structure, Model 3aI and 3bI (without vote-differentiated
shares) and Model 3aII and 3bII (with vote-differentiated shares). The esti-
mations are made for ownership in terms of both votes and capital.
As can be seen from Table10.8, comparing Model 3aI and 3bI with
Model 3aII and 3bII, institutional ownership only has a positive effect on
dividend changes if the firms have vote-differentiated shares. This means
that firms that separate cash flow rights from control rights suffer more
from agency problems, and that institutional owners require these firms to
pay higher dividends in order to reduce the cash available for management.
This result is in accordance with the predictions of the agency theory argu-
ments (Rozeff, 1982; Easterbrook, 1984; Jensen, 1986; Eckbo and Verma,
1994; Zeckhauser and Pound, 1990). No significance is found with respect
to the non-linear parameter (E(t-1)*Inst2).
The coefficient of earnings in period t (Et) and in period t−1 (E(t−1)) is
also significant at the 1 percent level. Previous period’s dividend payout
(Div(t-1)) is again significant, both statistically and in real economic terms.
Table 10.8 Cross-sectional time-series FGLS estimations: Model 3a firms

with vote-differentiated shares, Model 3b firms without vote-
differentiated shares
Dependent variable Model 3aI Model 3bI Model 3aII Model 3bII
Et 0.0528* 0.0529* 0.0840* 0.0876*
(9.71) (9.71) (19.76) (18.41)
E(t-1) −0.0237* −0.0235* −0.0206* −0.0215*
(−3.09) (−3.07) (−4.17) (−2.58)
E(t-1)*Inst −0.0013 −0.0012 0.0012** −0.0015**
(−1.48) (−1.57) (2.35) (−1.97)
E(t-1)*Inst2 3.0e−05 3.2e−05 −9.15e−06 −2.9e−05
(1.52) (1.60) (−0.74) (−1.60)
Div(t-1) −0.0613*** −0.0598*** −0.2090* −0.2282***
(−1.80) (−1.75) (−7.97) (−7.80)
constant 2.9757* 2.9029* 8.7769* 9.9986*
(3.15) (3.11) (7.38) (6.49)
No. obs Model 4a 5 443A
No. groups Model 4a 5 85
No. obs Model 4b 5 742B
No. groups Model 4b 5 116
Notes: t-statistics are in parentheses. Panels: heteroscedastic. Correlation: panel-specific

AR(1).
A
2 obs dropped because only 1 obs in group. B 3 obs dropped because only 1 obs in group.
This indicates that the firms only partially adjust the dividends to meet
changed target dividend levels.
A key assumption which must hold if the FGLS method is to provide
reliable estimates is that the errors are randomly distributed. Most likely,
the errors are in fact correlated with the regressors, or in other words there
are individual firm effects. To test whether this is true, a fixed-effects model,
which allows not only time effects but also individual firm effects, is tested
(Model 4 in Table 10.9). The Hausman test confirms that the suspicion
of individual effects and the Hausman-H0 of non-correlated errors can be
soundly rejected.
As the Hausman test confirms the existence of significant firm effects
correlated to the regressors, the fixed-effects estimation method is appro-
priate. Table 10.9 presents the results from this estimation with individual
firm and time effects. As before, the estimation is made with ownership in
terms of both votes (Model 4a) and capital (Model 4b).
Table 10.9 Fixed-effects estimations: Model 4 institutional ownership

(votes and capital)
Dependent variable Model 4a Model 4b

(Divt-Div(t-1)) (votes) (capital)
Et 0.1060* 0.1065*
(7.86) (8.76)
E(t-1) −0.1100* −0.1320*
(−2.85) (−2.34)
E(t-1)*Inst 0.0066* 0.0079**
(2.77) (2.23)
E(t-1)*Inst2 −0.0002* −0.0002*
(−2.69) (−2.76)
E(t-1)*VoteDiff 0.0774* 0.0514*
(3.08) (2.17)
Div(t-1) −0.6094* −0.5582*
(−2.96) (−2.81)
Fixed effects significant? Yes* Yes*
Number of obs51190 R2 R2
Number of groups5189 within50.5054 within50.4913
between50.4884 between50.4980
overall50.1774 overall50.1965
Notes: Robust t-statistics are in parentheses.

The results of the fixed-effects estimation in Table 10.9 are highly signifi-
cant. The coefficient of earnings in period t (Et) is significant and positive,
and that of earnings in t−1 (E(t-1)) is significant and negative. As expected,
there is a significant earnings component related to dividends. The coef-
ficients related to dividends in previous period (Div(t-1)) are likewise again
significant and negative with respect to dividend change. Recall that this
term represents the ‘speed of adjustment’ of dividend changes. The results
for the estimation with institutional ownership in terms of both votes and
capital share are in fact remarkably stable with regard to the size of the
coefficients and so on. The elasticity of dividends with regard to changes
in earnings is around 30 percent, which seems highly plausible. This again
confirms the robustness of the model formulation.
In both estimations vote-differentiated shares have a significantly posi-
tive effect on dividend changes. Again, this is an indication that investors
demand higher dividends in firms which allow vote-differentiated shares.
Hence hypotheses 1a, 1b, and 2 are corroborated.
As before, the sample of firms is separated into two groups depending on

whether or not they have vote-differentiated shares. The interaction term
made up of earnings and the dummy for vote-differentiation is taken out of
the regressions, as it would produce collinearity. Table 10.10 provides the
results for the fixed-effects estimation with institutional ownership when the
sample of firms is divided in two groups depending on whether or not they
have vote-differentiated shares (Model 4aI and 4bI and Model 4aII and 4bII).
Looking at the results in Table 10.10, there is as expected a positive but
non-linear relation between institutional ownership and dividend changes
if the firms have a vote-differentiated share structure (Model 4aII and
4bII). Based on the arguments of Miguel et al. (2004) and the discussion
about institutional owners’ incentives, hypothesis (1b) of non-linearity
between institutional ownership and dividend behaviour was formulated.
To control for this eventual non-linearity additional interaction terms
of squared institutional ownership are added.10 The significance of these
parameters confirms hypotheses 1a and 1b of a positive and diminishing
effect of institutional ownership on dividend changes, for ownership in
terms of both votes (Model 4aII ) and capital (Model 4bII ). For large inves-
tors in general, Mork et al. (1988) find that profitability is higher for firms
with shareholders that have up to 5 per cent ownership stakes; beyond that,
profitability drops (see Section 2 for further discussion).
As the sample is divided between firms with vote-differentiated shares
(Model 4aI and 4bI) and firms without (Model 4aII and 4bII), the estimated
parameter on previous periods’ earnings loses its significance in the group
of firms that have vote-differentiated shares (Model 4aI and 4bI).
The results for all the estimations are remarkably robust in terms of the
sign and size of the coefficients. The pooled OLS results strongly support
the results in the FGLS estimation. However, as there are significant indi-
vidual firm effects, the fixed-effects method is more appropriate, although
the FGLS results point in the same direction. Furthermore the use of
institutional ownership measured continuously, and not simply by dummy
variables related to fixed levels of ownership percentages, provides a more
thorough understanding of the non-linear relationship between ownership
and dividend policies.
As much of the analysis is based on reported earnings, the usual caveats
related to accounting figures apply. Ownership, however, is a very stable
variable over time, even though institutional ownership belongs to the cat-
egory of ownership that is perhaps most volatile. This and the inclusion of
time and firm effects in the estimation give a good indication of the robust-
ness in the results. All estimations have also been made with total payout.11
These results, although limited by the small number of firms involved in share
repurchases in the sample, support the estimation results for dividends.
Table 10.10 Fixed-effects estimations: Model 4a firms without vote-differentiated shares, Model 4b firms with vote-
differentiated shares
Dependent variable Model 4aI Model 4bI Model 4aII Model 4bII
Et 0.1285* 0.1285* 0.0988* 0.1011*
(3.73) (3.73) (6.79) (7.91)
E(t-1) −0.0835*** −0.0835*** −0.0243 −0.0737
(−1.71) (−1.71) (−1.01) (−1.44)
E(t-1)*Inst 0.0006 −0.0006 0.0069* 0.0079**
(−0.11) (−0.11) (2.61) (1.98)
246
E(t-1)*Inst2 5.37e-06 5.38e-06 −0.0002** −0.0002**
(0.04) (0.04) (−2.45) (−2.35)
Div(t-1) −0.4287*** −0.4287*** −0.6594* −0.5920**
(−1.68) (−1.68) (−2.76) (−2.61)
Fixed effects significant? Yes* Yes* Yes** Yes**
No. obs Model 4a5445 R2 R2 R2 R2
No. groups Model 4a587 within50.6961 within50.6961 within50.4990 within50.4815
No. obs Model 4b5745 between50.5934 between50.5934 between50.3745 between50.3778
No. groups Model 4b5119 overall50.0827 overall50.0827 overall50.1902 overall50.2178
Notes: Robust t-statistics are in parentheses.

* denotes significance at the 1% level, ** denotes significance at 5%, and *** denotes significance at the 10% level.
6. CONCLUSIONS
This chapter investigates the relationship between institutional ownership
and dividends. To test this relationship a version of the so-called earnings
trend model is utilized, with the inclusion of interaction terms made up of
institutional ownership. Using a panel data methodology which accounts
for firm-specific effects and time effects, unobservable heterogeneity is
controlled for. Furthermore the relationship is tested by extending the
investigation into a non-linear setting in which incentives, monitoring and
agency-cost effects can be more accurately accounted for.
The results clearly show that institutional ownership, in terms of both
votes and capital, where these two are separated, has a positive effect on
dividend payout policies. So even if high desired levels of dividends can be
seen as a sign of ‘short-termism’ (Hutton, 1995; Haskins, 1995), it might
just as well be an effect of these owners’ attempts to reduce the free cash
flow available to management, as argued by Jensen (1986). Institutional
owners might thus play a monitoring role, and in doing so mitigate the
problems associated with the separation of ownership and control in listed
firms. The relation is found to be positive but diminishing, which supports
previous research concerning the relation between dividends and owner-
ship structure. The use of a comprehensive database covering institutional
ownership continuously allowed for this additional test and also the
rejection of other functional forms of the ownership–dividend relation-
ship. Furthermore, and in line with expectations, earnings have a positive
impact on dividend changes.
By examining Swedish listed firms, the chapter also provides empirical
evidence on the effects of control instruments such as dual-class shares on
dividend policies. The result, in line with agency cost theory, is that control
instruments such as vote-differentiated shares induce investors to demand
higher levels of dividends as compensation for the increased agency costs.
This means that firms using this type of control instrument suffer more
from subsequent agency problems.
NOTES
* Acknowledgments: Financial support from Sparbankernas Forskningsstiftelse to

Daniel Wiberg’s dissertation work is gratefully acknowledged. A research grant from
the Centre of Excellence for Science and Innovation Studies (CESIS), Royal Institute
of Technology, Stockholm, is also gratefully acknowledged.
1. Beyond the obvious cases of theft, transfer pricing, and asset sales, expropriation may
take the form of perquisites, high salaries, diversion of funds to pet projects, and general
entrenchment even in cases in which the managers are no longer competent or qualified
to run the firm.
2. In this chapter managerial ownership is not considered. Ownership by the largest

shareholder in terms of votes is thus considered in alignment with managerial
ownership.
3. Law concerning investment funds; Swedish reference, SFS 2004:46; (following European
Union Directive EGT L 375, 31.12.1985, s. 3, Celex 31985L0611).
4. In fact a myriad of different tax rates are applied dependent on the type of firm, that is,
limited liability, private, partnership, and so on. For the sake of brevity this discussion
is not extended beyond this note, as it is far beyond the scope of this chapter to analyse
the impact of various tax rates on dividends.
5. For extended discussion and derivation of the four models see Short et al. (2002).
6. SIS-Ägarservice.
7. Note that the typical Swedish ownership spheres, large-scale conglomerates combining
a number of control-enhancing mechanisms and often controlled by a foundation, are
not included in this definition. The incentives of this type of owner are probably sub-
stantially different from those of what are usually referred to as institutional investors,
that is, financial intermediaries.
8. Approximately €1.2 billion, or $1.6 billion as of June 2007.
9. Breusch-Pagan/Cook-Weisberg test for heteroscedasticity
H0: constant variance Variables: fitted values of Divt-Div(t-1)
Chi2(1) 5 171.96 Prob.chi2 5 0.0000
Breusch-Pagan/Cook-Weisberg test for heteroscedasticity
H0: constant variance
Variables: fitted values of Et E(t-1) E(t-1)*Inst (votes) E(t-1)*Inst2 (votes) E(t-1)*VoteDiff
Dummy Div(t-1)
Chi2(1) 5 171.96 Prob.chi2 5 0.0000
Each of these tests indicates that there is a significant degree of heteroscedasticity in this
model. In order to get efficient estimators and account for this heteroscedasticity GLS
estimation is thus required.
10. A cubic specification of the model has been tested but yields no significant results.
11. For the sake of brevity these results are available from the author upon request.
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APPENDIX 10.1
Table A10.1 Correlation matrix pairwise correlation
Variable Divt DDiv Prstkc TPt DTP Et DE C1 V1 C5

Divt 1.000
DDiv 0.518* 1.000
Prstkc 0.152* 0.032 1.000
TPayt 0.936* 0.450* 0.490* 1.000
DTP 0.508 1.000* 0.032 0.460* 1.000
Et 0.778* 0.107* 0.216* 0.763* 0.481* 1.000
DE 0.197* 0.112* 0.066* 0.197* 0.518* 0.470* 1.000
251
C1 −0.021 0.007 −0.064* −0.042 0.010 −0.050 0.018 1.000
V1 0.034 −0.033 −0.067* 0.006 0.010 −0.009 −0.017 0.780* 1.000
C5 −0.092* −0.013 −0.083* −0.111* −0.037 −0.114* −0.063* 0.792* 0.660* 1.000
V5 0.029 −0.028 −0.079* −0.002 −0.011 0.017 0.029 0.636* 0.823* 0.789*
FC 0.192* −0.001 0.072* 0.195* 0.060* 0.191* 0.048 −0.212* −0.207* −0.219*
FV 0.062* 0.018 0.044 0.070* 0.043 0.095* 0.047 −0.151* −0.269* −0.145*
IC 0.203* 0.042 0.103* 0.216* 0.056 0.180* 0.029 −0.216* −0.163* 0.197*
IV 0.209* 0.040 0.151* 0.238* 0.056 0.192* 0.019 −0.242* −0.328* −0.239*
VoteDiff 0.128* −0.016 0.045 0.129* 0.026 0.111* 0.013 0.086* 0.473* 0.130*
Sales 0.734* 0.027 0.176* 0.710* 0.150* 0.541* −0.015 0.115* −0.010 −0.157*
Emp 0.523* 0.113* 0.117* 0.503* 0.113* 0.433* 0.022 −0.139* −0.014 −0.143*
R&D 0.409* 0.022 0.060* 0.382* 0.022 0.175* −0.110* −0.119* −0.004 −0.134*
WCap 0.579* 0.149* 0.128* 0.556* 0.149* 0.356* 0.055 −0.133* −0.015 −0.171*
Table A10.1 (continued)
Variable V5 FC FV IC IV VoteDiff Sales Emp R&D-exp WCap

Divt
DDiv
Prstkc
TPayt
DTP
Et
DE
C1
V1
252
C5
V5 1.000
FC −0.208* 1.000
FV −0.268* 0.920* 1.000
IC −0.152* −0.001* −0.011 1.000
IV −0.321* 0.058* 0.064* 0.899* 1.000
VoteDiff 0.520* −0.080* −0.182* 0.005 −0.203* 1.000
Sales 0.039 0.245* 0.050 0.184* 0.208* 0.164* 1.000
Emp 0.034 0.295* 0.108* 0.158* 0.154* 0.166* 0.743* 1.000
R&D 0.075* 0.164* −0.031 0.027 0.033 0.083* 0.668* 0.395* 1.000
WCap 0.045 0.204* −0.003 0.097 0.117* 0.126* 0.790* 0.500* 0.902* 1.000
Note: * Correlation coefficient significant at the 5% level.

11. Contracting around ownership:
shareholder agreements in
France1
Camille Madelon and Steen Thomsen
1. INTRODUCTION
A wealth of studies in economics, strategy and finance have examined the

relationship between corporate ownership structure and performance (Hill
and Snell, 1988, 1989; Holderness and Sheehan, 1988; McConnell and
Servaes, 1990; Gedajlovic and Shapiro, 1998, 2002; Thomsen and Pedersen,
2000; De Miguel et al., 2004; Anderson and Reeb, 2003; Villalonga and
Amit, 2006). Other studies have examined the effect of ownership structure
on strategic decisions (Amihud and Lev, 1981; Hill and Snell, 1988, 1989;
Graves, 1988; Baysinger et al., 1991; Lane et al., 1998; Denis et al., 1997,
1999; Allen and Phillips, 2000; David et al., 2001; Hoskisson et al., 2002;
Lee and O’Neill, 2003; Desai et al., 2004; Lerner and Rajan, 2006; Mathews,
2006). Overall, this literature finds that corporate ownership structures
matter to company behavior and value creation (for example, Shleifer and
Vishny, 1997). Yet, there is a distinction to be made between the publicly
observable formal ownership structure and what we are tempted to call the
real ownership structure, namely the allocation of control, cash flow, and
transfer rights, which results from implicit or explicit contracting among
the various owners. Take for example Publicis, the world’s fourth largest
communication group. The formal ownership structure points to two large
owners in 2006: Dentsu, a Japanese based communication group, with circa
15 per cent of the equity, and Mrs Badinter, the founder’s daughter with
10 per cent of the equity. However, a closer look reveals a different picture.
In 2002, Mrs Badinter and Dentsu signed a binding agreement in which
Dentsu committed to act in unison with the founder’s family for decisions
related to corporate strategy and board member nominations. While the
formal structure indicates two blockholders with no majority power, the
shareholder agreement reveals a dominant owner with a majority in terms
of voting power. This case is not isolated and points to the importance of
253
an in-depth understanding of ownership arrangements when studying the

relationship between ownership and firm outcomes. Real ownership struc-
ture may supersede the formal structure.
Surprisingly, this ‘contracting around’ phenomenon has received almost
no attention in the literature. We have no idea (1) why the owners of
publicly listed firms would resort to shareholder agreements and (2) how
this might influence company behavior and value creation. One stream
of literature broadly termed financial contracting has studied the deals
between fund providers and those needing the funds (Hart, 2001), yet it
has empirically focused on private companies and more particularly on the
vertical relationships between venture capitalists and small entrepreneurial
firms (Kaplan and Strömberg, 2003) in contrast to the horizontal contracts
between shareholders. Another stream of literature tracks corporate stra-
tegic alliances and ownership ties between companies (Allen and Phillips,
2000; Gomes-Casseres et al., 2006), but does not include contracts between
shareholders, To our knowledge, there are no studies explicitly examin-
ing the antecedents of agreements among shareholders in listed firms or
their impact on value creation. In this chapter, we seek to take a first step
towards bridging this gap.
Given that the literature is still at an early stage, we chose to conduct
an exploratory study. To this end, we performed a qualitative multi-case
analysis on a selection of listed French firms with shareholder agreements.
France offers a unique empirical setting to study shareholder agreements
for three main reasons. First, shareholder agreements are quite common
among listed firms and equally so among the very largest firms (which are
part of the benchmark CAC 40 stock index). Second, the French market
authority (AMF) requires that owners publicly disclose their agreements.
All contracts are stored in the AMF database and their detailed content is
readily accessible. Third, because of the public nature of these agreements,
we may study how markets react to the announcement of agreements, thus
capturing a measure of value creation.
From our exploratory analysis, we propose several conditions under
which shareholders are more likely to opt for agreements. They are linked
respectively to the nature of ownership, the nature of the industry and the
nature of the problems facing the firm. In these cases, we argue that the
overall cost of signing and enforcing shareholder agreements will be offset
by the benefits. In addition, we suggest that shareholder agreements are
highly idiosyncratic and may create or destroy value, depending on the
scope and nature of the agreement.
The remainder of the chapter is organized as follows. First, we lay out
the background to this study by briefly reviewing the existing arguments
on shareholder agreements. Second, we describe the empirical setting and
Contracting around ownership 255
methods. Third, using an extended transaction cost framework we propose

hypotheses on the antecedents and effects of shareholder agreements.
Finally, we discuss our findings and conclude.
2. BACKGROUND
2.1 Definition of Shareholder Agreements
Shareholder agreements can be broadly defined as written or unwritten

contracts between shareholders. In this chapter, we choose to focus only on
written contracts because unwritten contracts are hard to document. They
involve rights or obligations beyond what is prescribed by law. Standard
components include (Chemla et al., 2007):
(i) Options or limitations on the right to buy or sell shares, for example,
preemption rights (call options at a specified ‘fair’ price), collective
action clauses, such as tag-along rights (the rights to go with other
investors) or drag-along rights (the obligation to do so)
(ii) Control rights, for example, rights to appoint a member of the board
or veto certain critical decisions or the obligation to vote with another
shareholder
(iii) Cash flow rights, for example, catch-up clauses which specify rights to
parts of the proceeds in case the company is sold to a third party
(iv) Procedures for dispute resolution in case of disagreement.
Just like other private contracts, shareholder contracts are enforceable in

court.
One particular stream of literature, called ‘financial contracting’, has
been concerned with the financial deals between financiers and those
needing the funds (Hart, 2001). Yet, it has mainly addressed fundamen-
tal questions such as the nature of debt and equity or optimal capital
structure. There has been very little empirical work done on the contracts
themselves, and even less on the role of these contracts for strategy and
management. Notable exceptions are Kaplan and Strömberg’s (2003)
research on shareholder contracts in venture capital firms and Chemla
and colleagues (2007) on closely held firms. Kaplan and Strömberg (2003)
analyze the characteristics of the ‘real world’ contracts between venture
capital firms and entrepreneurs with respect to board rights, liquidation
rights, voting rights and cash flow rights. They find those features to be in
line with the existing financial contracting theories such as principal–agent
and control theories (for example, Aghion and Bolton, 1992) but with
much more internal complexity. Chemla and colleagues (2007) argue that
the inclusion of strong clauses such as tag-along and drag-along clauses in
the contracts protects investors from opportunism and thus ensures some
efficient ex ante investments in the firm.
2.2 Related Literature
Although there has been little attention to shareholder agreements in listed

corporations in previous work, there are several interesting streams of
research, which may contribute to theory development: general contract
theory (for example, Shavell, 2004, Chapters 13–14), financial contract-
ing theory (Hart, 2001), transaction cost theory (Williamson, 1985, 2005),
research on strategic alliances and joint ventures (Kogut, 1988; Mowery
et al., 1996; Doz and Hamel, 1998; Gomes-Casseres et al., 2006), theories
of relational contracting (Macaulay, 1963; Ellickson 1991; Mnookin and
Komhauser, 1979; Zaheer and Venkatraman, 1995; Poppo and Zenger
2002; Carson et al., 2006), takeover theories (Scharfstein, 1988; Danielson
and Karpoff, 1998; Mikkelson and Partch, 1997; Adams and Ferreira,
2007; Burkart and Lee, 2007) and macrostudies of law and finance (La
Porta et al., 2000; Djankov et al., 2007). We draw on these contributions
in the following.
3. EMPIRICAL SETTING AND METHODS
France offers a unique empirical setting to study shareholder agreements.

First, shareholder agreements are quite common among listed firms.
Second, the French market authority requires that owners publicly dis-
close their agreements. All contracts are stored in the market authority’s
database and their detailed content is readily accessible. Third, because of
the public nature of these agreements, we may study how markets react
to the announcement of agreements, thus capturing a measure of value
creation.
In this section, we briefly describe the nature of shareholder agreements
in French listed companies and explain the sources and methods used. We
then provide a short description of each of the cases.
3.1 Shareholder Agreements in France
Shareholder agreements (pactes d’actionnaires) are relatively common

among listed firms in France. Among the 749 listed firms on Euronext
Paris,2 268 firms had had at least one shareholder agreement between 1997
and 2007. Over the same period, an average of 38 new shareholder agree-
ments were announced each year (see Appendix 11.1). These contracts are
prevalent across all sizes of listed firms including the very largest (CAC
40).
A typical contract is a 1–6-page document that specifies the nature of
the agreement between the signing shareholders. It starts by stating the
names of the shareholders and their respective equity and voting shares. It
goes on to describe the allocation of power between the parties, notably in
terms of voting rights and allocation of board seats. It then describes the
obligations and rights of the signing parties in case of events such as the
nomination of new board members, corporate strategy decisions, takeo-
vers and equity selling.
The shareholder agreements used by listed firms appear to be much less
detailed than the ones used by private firms and in particular by private
equity funds. As an illustration, take Legrand, one of the leading world-
wide manufacturers of electrical equipment. In 2002, the company was sold
to two private equity funds, KKR and Wendel; in 2006, part of the equity
was floated, with KKR and Wendel keeping 59 per cent of the equity. The
2006 (publicly available) agreement between KKR and Wendel is a 6-page
contract. We interviewed one of the directors at Wendel, who revealed that
the initial contract between the two private equity funds and subsequent
partners was more than a hundred pages long with a large amount of
detail. Why? We hypothesize that complex contracts among shareholders
in closely held firms substitute for the standard form contracts of listing
requirements and securities law which listed companies implicitly rely on.
In the private setting, there is a higher level of expropriation risk for share-
holders, requiring in turn a tighter control of the allocation of power and
cash flow rights between shareholders. In addition, in the absence of public
information requirements, shareholders of private firms often add detailed
specifications of the information they will get from management (such as
the detailed monthly reports). Last but not least, shareholder agreements
among private equity firms usually include the compensation packages of
top management and profit-sharing schemes.
Shareholder agreements among publicly traded companies are most
often signed for periods ranging from two to five years with tacit renewals
for the shortest periods. Clauses usually specify how the parties can put a
halt to the contract without suffering penalties.
Shareholder contracts are officially enforceable in a commercial court
(article I. 233-11 of commercial law). Yet, in case of disagreements, the
contract parties rarely resort to court. They use private settlements. Why?
According to the lawyers and contract parties we interviewed, private
settlements are more discreet than going to court. Nothing is published.
The common practice is to go through what is called a ‘referee’ (arbitre).

Referees are not judges; they are appointed by the chamber of commerce.
They act as ‘go-betweens’ and ‘tension soothers’ to prevent escalation
between the signing parties. While private settlements keep shareholders
from the spotlights, they are reported to be very costly, suggesting in turn
that the benefits of privacy are highly valued by the contract parties. In
fact seeking private agreements rather than enforcing contracts through
the courts is quite common for many types of contract (Macaulay, 1963).
The parties bargain in ‘the shadow of the law’ (Mnookin and Komhauser,
1979).
3.2 Disclosure Requirements
The French market authority (Autorité des Marchés Financiers) requires

that shareholders of listed companies disclose the details of the contracts
they have signed with other shareholders (article I-233-11 of commercial
law). There is an additional notification when shareholders choose to act
in concert (article I-233-10 of commercial law).3 Those breaking the law
face the risk of being deprived of their shareholder rights. The detailed
contracts of French listed firms are compiled in a database and made acces-
sible to the general public on the AMF website (www.amf-france.org) for
the period 1997–2007.
3.3 Sources and Methods
Faced with the need to develop new theory we decided on an explora-

tive approach which derives theoretical propositions from case studies
and related research. We chose multiple cases because more cases tend to
increase the degree of generalizability of the results (Yin, 1984) through
the use of a replication logic. The emerging theory is tested by confronting
it with new cases which force it to distinguish between the common and
idiosyncratic features of the cases. We followed an ‘abductive’ approach
(Peirce, 1935) rather than a grounded approach (Glaser and Strauss, 1967)
as we did not start with a blank slate but with some knowledge of share-
holder agreements – although not directly related to our setting of listed
firms – drawing on the theory of financial contracting, transaction theory,
general contract theory and the theory of relational contracting.
We focused on five different cases, all involving large listed firms.
Whereas in a quantitative study the sampled firms need to be representative
of the population, in a multiple-case-study design, firms are selected for
theoretical reasons (Einsenhardt and Graebner, 2007). We purposely chose
cases from different settings. This selection was made after reading through
the 380 or so contracts available for the listed firms in the AMF database.
We focus on the following five cases, which are described in greater detail
in the following section:
● The Pernod Ricard agreement is an unbalanced contract between a

large founding family and a small minority investor.
● The Publicis deal features a large blockholder ready to give up
control to the founding family.
● The Club Med agreement is a complex contract between multiple
small owners with different interests (institutional investors, a hotel
group and a real estate firm).
● The Legrand agreement involves two large private equity funds
which initially took over the company privately.
● The Schneider Electric agreement reveals complex ownership link-
ages between banks, insurance companies and large non-financial
corporations.
For each case, we proceeded in the following way. We first read the
shareholder agreements in detail, classifying the content of the agreements
into several categories (see Appendix 11.2). Second, we used a variety of
secondary sources, including annual reports, analysts’ reports, press search
and internet search to substantiate the context and content of the contracts.
For data on ownership structure, we used the Dafsaliens database. Third,
we carried out interviews with the firms’ signing parties and lawyers. At this
point interviews are accepted and performed for two of the cases.
For the second research question on the value impact of shareholder
agreements, we examined share price reactions around announcement
dates (1/2 1 month and 1/2 2 months around the publication) using
Datastream financial data.
3.4 Description of the Cases
We now give a short description of each case covering key facts on the firm,
the context to the shareholder agreement and the summarized content of
the agreement (details are available in Appendix 11.2).
Pernod Ricard
Pernod Ricard is the world’s second largest operator in wine and spirits
(2005 sales: €3674 million; 2005 net profit: €475 million). It owns brands
like Chivas Regal, Ballentin’s, Malibu, Ricard and Mumm. The company
originates from the 1975 merger between two traditional French com-
panies, Pernod and Ricard (respectively held by the families Pernod
and Ricard). Between 1975 and 2001 it grew through both external and
organic growth. In 2001, it bought a large part of the Seagram’s wine and
spirits activities. In 2005 it acquired Allied Domecq in partnership with
Fortune brands and became number two worldwide. In March 2006, a
shareholder agreement was signed between the Ricard family (10 percent
equity) and Kirin Corporation, Japan’s largest spirits operator (3 percent
equity). In a nutshell, the agreement states that both shareholders should
act in concert and that Kirin commits to vote in favor of the board rec-
ommendations on a stated number of issues. The question is, why? In
the following section, we examine why Kirin would want to enter such
an agreement.
Publicis
Publicis is the world’s fourth largest communication group (2005 sales:
€4127 million; 2005 net profit: €386 million), operating in Europe (40
percent sales with a leading market share) and the US (42 percent sales).
Publicis was initially founded by Marcel Bleustein-Blanchet in 1926. The
company acquired Saatchi and Saatchi (UK) in 2000, and subsequently
Nelson Communication (US) in 2002. In 2002 (March), Publicis merged
with Bcom 3, a large US communication network including Leo Burnett,
D’Arcy and media buying company Starcom MediaVest. Bcom 3 was
created in 2000 through the merger of the Leo Group and the MacManus
Group with a capital investment from Dentsu, one of Japan’s largest
communication companies. In May 2002, Elisabeth Badinter, Marcel
Bleustein-Blanchet’s daughter, Publicis’ main shareholder (28 percent
of the equity in 2001; 20 percent of the equity of the new ‘merged’ entity
in 2002) and chairwoman, signed an agreement with Dentsu (18 percent
equity). In this contract, Dentsu agrees to follow Elisabeth Badinter’s
‘voice’ on all major strategic issues including board nomination. It also
commits not to sell its shares before 2012.
Club Med
Club Med is one of the leading operators of holiday villages and tours
(2005 sales: €1590 million; 2005 net profit: €4 million). The company was
founded in 1950 by two entrepreneurs, and grew mostly organically over
the subsequent years. In 2004, Accor, one of the largest worldwide hotel
chains acquired a 29 percent stake in Club Med from the Agnelli family
(Italian family and former dominant owner) and from institutional inves-
tor CDC. It became the dominant (so-called ‘reference’) owner. In 2006,
after a CEO change, Accor partly exited Club Med and sold a portion of
its shares to several investors: Icade (the real estate arm of French govern-
ment-backed CDC), Air France Finance (finance arm of Air France) and
Fipar (CDC equivalent for Morocco). In June 2006, a shareholder agree-

ment was signed between Accor and the investors. The newly formed coali-
tion totaled 22 percent equity. In a nutshell, the investors committed to act
in concert and support the management’s decisions. The agreement defines
the right of the parties for board representation and in case of takeover.
Legrand
Legrand is one of the leading worldwide manufacturers of electrical
equipment (2005 sales: €3248 million; 2005 net profit: €101 million). In
2001, Legrand was acquired by its competitor Schneider. However the
deal was blocked by the anti-trust authorities and Schneider had to find
a new owner. In December 2002, Legrand was acquired through LBO by
equity funds KKR and Wendel (investing arm of the Wendel family). In
2006 (April), circa 20 percent of Legrand’s equity was floated again on
the Euronext stock exchange. In March 2006, KKR and Wendel (total-
ing 59.1 percent equity and voting rights, with individual shares of 27.4
percent and a joint entity, Lumina Participation, owning 4.3 percent)
published their new shareholder agreement in which they carefully allocate
the firm’s board seats, cash flow rights, voting rights, equity shares and
obligations.
Schneider Electric
Schneider Electric is one of the world’s leaders in the design and distribu-
tion of electrical equipment (2005 sales: €11679 million; 2005 net profit:
€494 million). The company was founded in 1836 by the Schneider family
and was initially focused on steel production. Over the years, it divested
the steel business and invested in electricity-related activities. In 1999,
it changed its name to Schneider Electric to signal its strong focus on
electricity. Over the past decade, it has acquired a range of companies in
various electricity related areas. Between 1993 and 2006, Schneider signed
a number of agreements with French institutional investors (banks and
insurance companies) and large French corporations. In 1993, it signed a
contract with insurance companies (AXA, AGF), banks (Paribas, Société
Générale) and a large energy company (Elf). In 1998, the contract was
renewed between AGF (3.3 percent voting rights), AXA (9.6 percent
voting rights) and BNP-Paribas (5.4 per cent voting rights). In 2002, the
contract was modified again (avenant), updating the respective shares
of the signing parties. In 2002, AXA, AGF and BNP-Paribas broke the
agreement. In 2006 (May), AXA and Schneider signed an agreement in
which AXA committed to keep a certain number of shares in Schneider
while Schneider reciprocally committed to maintain a minimum number
of shares in Schneider.
4. ANTECEDENTS OF SHAREHOLDER
AGREEMENTS
Why would shareholders in listed companies resort to shareholder agree-
ments rather than use other types of governance mechanisms such as own-
ership concentration or financial hedging? Also, why would shareholders
bother to enter into contracts rather than use the standardized provisions
of company charters?
We need to understand the conditions under which the benefits of con-
tracting between shareholders outweigh their costs. The costs of shareholder
agreements span both transaction costs (such as the costs of negotiating,
renegotiating, concluding and enforcing the contracts) (Williamson, 1979,
2005) and the costs of ‘lock in’ (shareholders agreeing to bind themselves
in a contract and thus to lose some degree of flexibility).
In the following sections we examine the determinants and effects of
shareholder contracts in an extended transaction cost framework, which
draws on advances in the theory of financial contracting, contract theory,
relational contracting, law and finance, research on strategic alliances and
M&A (mergers and acquisitions) as well as Williamsonian transaction cost
theory. The basic argument is that ownership and shareholder contracts
are alternative means of exercising control and that both may under certain
circumstances be more transaction cost efficient than market solutions.
4.1 Nature of the Ownership
Prior research on governance mechanisms suggests that ownership con-

centration is a way to address agency issues between owners and managers
(Shleifer and Vishny, 1986, 1997; Holderness and Sheehan, 1988). With
increased concentration comes the power and motivation to discipline
managers. Yet, in some cases, shareholders may prefer not to increase their
stake in the firm. They may be capital constrained or risk averse; alterna-
tively, they may expect a control loss and lower efficiency if they take over
the firm from its present owners. Moreover, ownership concentration may
not be necessary if owners can achieve their objectives by other (contrac-
tual) means like shareholder agreements that possibly allow them to act in
unison and thereby exercise effective control.
Our cases suggest that shareholder agreements are more prevalent for
firms with intermediate levels of ownership concentration, that is, with no
majority owner, yet with several large shareholders. Table 11.1 summarizes
the findings. In all of the cases, there are at least two large shareholders
(with more than 3 percent equity) in the ownership base. As shown by the
cases, the contract is made between two or more large shareholders.
A simple explanation is transaction costs of writing and enforcing con-

tracts, which may be too large to be worthwhile for smaller shareholders.
In addition, small shareholders would expect to gain relatively little by
entering into such agreements, because they have limited bargaining power
except for rare cases where they can influence the balance of power between
competing blockholders. In firms with a highly fragmented ownership
base, small shareholders have no interest in signing an agreement because
the costs of joining forces outweigh the benefits. In firms with high levels of
ownership (for example, majority ownership or dominant owner), share-
holder agreements are less critical because the need to establish control is
absent. However, dominant owners may be interested in entering agree-
ments in a dynamic context when ownership changes are expected and
when, for example, they plan to sell out part of their shares. In the Club
Med case, Accor was initially the dominant owner with 28.9 percent of
equity shares. In 2006, when it wished to partly exit its investment (down to
an 11.4 percent share), it signed a contract with three institutional owners
who, in addition to buying Accor’s pending shares, agreed to act in unison
and create a ‘virtual dominant’ owner. Accordingly, we propose:
Proposition 1 Shareholder agreements are more likely to be found in

companies with intermediate levels of ownership concentration.
Another striking feature is the identity of the owners entering the agree-
ments. Findings are reported in Table 11.1. Signing owners are mostly
family owners, corporations and active financial investors such as private
equity funds. In both Publicis and Pernod Ricard, the two signing parties
are the founder’s family and a corporation. In Club Med, the coalition
is led by hotel group Accor. In Legrand, the contract parties are the two
private equity funds and their joint entity. As argued above, these owners
may not have the incentive to increase their ownership share in the firm.
Having a controlling stake can be too risky or too costly (for families such
as Pernod who need external funding to sustain the strong external growth
of the firm) or outside of their scope (for corporations such as Accor
whose main business is hotels). The common characteristic of these share-
holders is their long-term involvement in firms. Shareholder agreements
are signed for an average of three to five years and create some ‘lock-in’
for the signing parties. The cost of lock-in is likely to be much lower for
shareholders with a long-term interest than for financial investors – such as
mutual funds – whose managers are evaluated on the short-term perform-
ance of their funds (Graves, 1988; Hoskisson et al., 2002; Verstegen Ryan
and Schneider, 2002, 2003) and who value flexibility. Thus we make the
following proposition:
Table 11.1 Shareholder agreements and the nature of ownership
Firm Date Validity period Contract parties Ownership Identity of main owners
concentration1
Pernod 2006 3.5 years Founder’s family Intermediate ● Founder’s family (Ricard): 9.1%2
Ricard March (March 2006 (Ricard) – 9.1% – ● 3 owners with more ● Institutional investor (Franklin
to Dec. 2009) and corporation than 3% equity Resources): 4.0%
(Kirin International) shares (total: 19.9%) ● Corporation (Kirin): 3.6%
– 3.6% ● Auto-control (3.3%) ● Institutional investor (CDC): 3.2%
Publicis 2002 10 years Founder’s family Intermediate ● Founding family (E. Badinter3): 19.7%
May (May 2002 to (Badinter) – 19.7% ● 2 owners with more ● Corporation (Dentsu): 18.2%
July 2012) – and corporation than 5% equity
(Dentsu) – 18.2% shares (total: 37.8%)
264
● Auto-control (6.7%)
Club 2006 3 years (tacit Corporation (Accor) Intermediate ● Institutional investor (Richelieu
Med June renewal every – 11.4% and selected ● 6 owners with more Finance): 26.4%
year); no institutional investors than 3% equity ● Corporation (Accor): 11.4% (from
longer valid (Fipar holding – 10% shares (total: 60.1%) 28.9% in 2005)
if investors – and Icade – 4%) ● Institutional investor (Fipar holding):
collectively 10%
own less than ● Family (Agnelli family via Rolaco): 4.7%
15% ● Institutional investor (Icade): 4%
● Insurance company (Nippon life): 4%
Legrand 2006 Until the date Between private Intermediate ● Private equity fund (Wendel): 27.7%
March of the first of equity funds (Wendel ● 5 owners with more ● Private equity fund (KKR): 27.7%
these 2 events – 27.7% – and KKR than 3% equity ● Private equity fund (Lumina
(1) KKR – 27.7%) shares (total: 68.6%) Participation4): 4.3%
and Wendel and their joint ● Top management: ● Wendel and KKR did an LBO on
jointly own venture Lumina 3.8% Legrand in 2002
less than 33% Participation – 4.3% ● Private equity fund (Montagu): 4.8%
of Legrand’s ● Institutional investor (Goldman Sachs
equity, or Capital Partners): 4.1%
(2) one of
the 2 parties
individually
owns less than
5%
Schneider 2002 Tacit renewal Between banks Low ● Institutional investors (CDC): 3.9%
Electric March of the contract (BNP-Paribas) and ● 2 owners with more ● Insurance company (AXA): 3.5%
(1) every year insurance companies than 3% equity
(AXA, AGF) – 3.5% (total: 7.4%)
265
● Auto-control &
employees (9.9%)
Schneider 2006 Tacit renewal Between Schneider Low ● Institutional investors (capital group):
Electric Septem- of the contract and Axa ● 3 owners with more 5%
(2) ber every year than 3% equity ● Institutional investors (CDC): 4.4%
(total: 12.7%) ● Insurance company (AXA): 3.5%
● Auto-control and
employees (9.9%)
Notes:
1
Ownership concentration at the time of the contract. Criteria: Intermediate concentration: some large owners (> 3% equity), yet no majority
owner; High concentration: existence of a majority owner; Low concentration: some large owners but the sum of large owners is lower than 10%
2
16.7% of voting rights.
3
Elisabeth Badinter, daughter of the founder, Marcel Bleustein-Blanchet.
4
Equally owned by Wendel and KKR.

companies in which shareholders have a long-term interest (for example,
families, corporations).
The heterogeneity of goals of shareholders is well established in the

management literature (for example, Bushee, 1998 and 2001; Verstegen
Ryan and Schneider, 2002, 2003, for institutional investors; Thomsen
and Pedersen, 2000, for a large range of owner identities). Prior research
suggests that owners have different objectives and strategic preferences
according to their identities (Bethel and Liebeskind, 1993; Hoskisson et
al., 2002: Tihanyi et al., 2003; Gaspar et al., 2005). Our data indicate that
shareholder agreements are more likely to be signed between owners who
have non-financial objectives. By non-financial objectives, we mean objec-
tives that are not strictly linked to the value maximization of the share-
holders’ equity. They span personal and strategic objectives. For example
founders’ families such as Pernod or Badinter (the founders’ children)
may want to keep the culture and values of the founders alive in the firm.
Corporations such as Kirin and Dentsu appear to have strategic reasons
to surrender their external control rights.
Kirin is the largest spirits company in Japan with a long tradition of joint
ventures to access markets and technology. In the 1970s, it signed a joint
venture with Seagram to distribute its whisky brands in Japan. Shortly
after Seagram’s spirits division was sold to Pernod Ricard and Diageo
in 2002, Kirin signed an agreement with the two companies to retain and
acquire sales rights in Japan for the former Seagram portfolio’s brands.
Thus Kirin’s equity share (3 percent) in Pernod Ricard seems to serve other
purposes than financial returns, such as expanding in the non-beer busi-
ness. Figuratively speaking, Pernod Ricard became part of the ‘keiretsu’.
Similarly, it is hard to understand why Dentsu would assent to sign an
agreement that strongly limits its controlling power over Publicis (when
it has formally 18 percent of the equity) for purely financial reasons.4
Secondary data suggest that at the time of the agreement (2002) Dentsu
was facing growth imperatives – just after its introduction on the stock
market – and was struggling with a downward advertisement market in
Japan. Two years before, Dentsu had made some diversification invest-
ments abroad, particularly in Bcom 3, a large US agency network. In 2002,
it sold its dominant share in Bcom 3 to Publicis – officially to free up some
cash – and signed what was described by the top management of the firms
as a ‘strategic alliance’ or ‘business tie up’ with Publicis.5 Dentsu was prob-
ably agreeing to trade off control over Publicis for a business alliance that
would possibly offset the slow growth of its Japanese activity and enhance
its global offer of communication services.
A slightly different logic applies to the Club Med agreement. Why would
Accor set up a contract with several new institutional investors at the time
when it exited from Club Med? Secondary data, notably press articles,
suggest that Accor may have been pressured by the French government to
find a ‘substitute’ owner that would replace Accor (as the reference owner)
and thus protect Club Med from a takeover by foreign investors. Club Med
is commonly considered one of the ‘national corporate jewels’ of France,
one that needs to be protected against hostile bids.
Another important non-financial objective – which we have not seen
documented in previous research – is what we could call ‘preventive owner-
ship’ or ‘preventive control’, which consists in preventing third parties from
acquiring control. To be sure, preventive control is not equal to protection
against takeovers. It is a way for corporate owners to prevent their direct
competitors from expanding their footprint. For example, in the Club Med
case, it is likely that Accor did not want a foreign competitor like Hilton
to establish a strong position in the leisure business by taking over Club
Med. Similarly, in the Publicis case, it was probably important for Dentsu
to prevent Publicis from being acquired by competitors like WPP or Grey.
In this case, control over management is less important than preemption
over competitors. Hence, we make the following proposition:

companies in which owners have non-financial objectives (for example,
strategic alliance interests for corporate owners, continuity for family
ownership, ‘national protectionism’ for government owners, preemption –
in contrast to investors who prefer to avoid the loss of flexibility).
Our cases also suggest that the leading shareholder of the agreement,
that is, the one initiating the agreement and managing the negotiation
process, has a strong historical link with the firm and seeks to maintain this
link. For example, in Publicis and Pernod Ricard, the leading negotiating
shareholders are the founders’ families. We argue that they tried to main-
tain their historical control over the firm. As both firms grew over the years,
they needed additional financial back-up and went public, with a strong
share of the firm remaining in the founders’ hands (in 2000, the Badinter/
Bleustein-Blanchet family still had 40 percent of the firm’s equity; in 2001,
28 percent). Both shareholder agreements followed just after major exter-
nal acquisitions (BCom 3 for Publicis in 2002; Allied Domecq for Pernod
Ricard in 2006) suggesting that the founders’ families used the contracts to
protect themselves against a loss of power in the new entity.
The Legrand contract also indicates that the incumbent shareholders
(the two private funds) sought to maintain their control of Legrand after
the firm was introduced on the stock market. Initially, in 2002, at the time
of the LBO, KKR and Wendel had signed a very detailed agreement on
Legrand. Once they floated part of the equity, they were required to reveal
their agreement, and thus turned to a simplified version. One of our inter-
viewees told us very strongly that ‘[they] use shareholder agreements to
maintain [their] power in the firm’.
These cases suggest that when incumbent owners seek to maintain their
power in the firm, the costs of contracting may be offset by the benefits of
control. Thus:

companies in which an incumbent shareholder (for example, family,
private equity) seeks to maintain dominant control.
4.2 Nature of the Industry
Prior studies show that firms’ ownership structures vary across industries
(Demsetz and Lehn, 1985; Pedersen and Thomsen, 1997; Villalonga,
2005). For example, family ownership is more prevalent in industries such
as food manufacturing and media while government ownership – to take
extreme examples – is more frequent in the weapon and aircraft industries.
Similarly we would expect that shareholder agreements are not equally dis-
tributed across all types of industries. There are two main reasons for this.
First, as previously shown, there are ownership conditions (related to own-
ership concentration and identity of owners) under which the benefits of
shareholder agreements exceed the costs, and these conditions may change
across industries. Second, shareholder agreements generate costs of ‘lock-
in’ because they tie up the signing parties for several years without much
flexibility. Lock-in is less costly in relatively stable and certain industries
than in dynamic industries where short-term changes may be required. Our
cases show that all of the firms in our sample operated in mature industries
(wine and spirits, electrical equipment, advertising). Findings are reported
in Table 11.2. We formally state this proposition as follows:

companies that operate in relatively stable businesses in which the costs of
lock-in for a couple of years are small.
This finding departs from previous research on interfirm ownership

and strategic alliances which suggests that equity arrangements among
firms are more frequent in knowledge intensive industries with high R&D
intensity (Allen and Phillips, 2000) such as biotechnologies and electronics.
Table 11.2 Shareholder agreements and the nature of industry
Firm Industry Industry development

Pernod Ricard Wine and spirits Mature
Publicis Communication and Mature
advertising
Club Med Leisure and holiday Mature
village operator
Legrand Electrical equipment Mature
Schneider Electric Electrical distribution Mature
Here, the main role of interfirm shareholdings is to facilitate knowledge

flows between firms (Mowery et al., 1996, Gomes-Casseres et al., 2006). In
contrast, in our cases, knowledge sharing does not appear to be a dominant
motive in transactions between shareholders.
4.3 Nature of the Contract Items
The benefits of shareholder contracts will be particularly high (and exceed

the costs) when no other mechanism effectively addresses the issues
included in the contract. One of our interviewees told us:
We do not use shareholder agreements on a standalone basis but in conjunction

with other elements such as charters and commercial law. We see shareholder
agreements as one of the tools of a larger toolbox which help protect our inter-
ests in the firm. Yet, these contracts are useful because we have a lot of flexibil-
ity in the content, and we may address issues that are not explicitly taken into
account by charters or by commercial law.
What are these issues? Our cases point to different categories, related to
equity rights, control rights and non-control and equity issues. Table 11.3
provides a summary of the issues while the details of the contracts are in
Appendix 11.2. Three categories of issues are distinguished: equity rights,
control rights, and other (non-equity and control) issues.
Equity rights relate to the control of the equity by the signing sharehold-
ers. They encompass preemption clauses, tag-along and drag-along rights
(respectively the right of joint exit and the obligation of joint exit) and rights
of approval (clauses d’agrément) which allow the current shareholders to
avoid ‘undesirable’ new shareholders entering the firm. As an illustration,
the Publicis (2002) shareholder agreement states that Dentsu will not be
able to transfer or sell its equity shares in Publicis until July 2012; after July
2012, Mrs Badinter has a preemptive right to buy Dentsu’s shares.
Table 11.3 Shareholder agreements and the nature of the contract items
Firm Control rights Equity rights Non-equity

and control-
related issues
Board Voting Rights to sell Cash flow Strategic
structure rights and acquire rights alliances/
shares business deals
Pernod X X X
Ricard
Publicis X X X X
Club Med X X X X
Legrand X X X X
Schneider X
Notes:
Board structure refers to the rules attached to the composition of the board of directors
and its sub-committees. Shareholders’ agreements encompass the following board-related
items: number of board seats granted to the signing shareholders, total number of members
on the board, including total number of independent board members; nomination process
for board members and chairman; rights to propose nominees and obligation to accept the
appointments made by some of the signing parties.
Voting rights refer to (1) the rights given to the contract parties relative to the strategic
decisions and (2) the total voting rights granted to each of the parties. In the first case, the
shareholders’ agreement will specify the type of strategic decisions for which the signing parties
agree to vote in concert and those for which they may express an individual opinion. In the
second case, it will specify the maximum number of votes given to each of the contract parties.
Rights to sell and acquire shares refer to the rules attached to the sale and purchase of
equity shares. Shareholders’ agreements specify the minimum holding period of shares,
the preemptive rights given to the signing shareholders, and the process that needs to be
followed in case of sell-out. They also define the rights and obligations in case of takeover
attempts. Includes clauses for joint exit, rights of approval, tag-along and drag-along rights.
Cash flow rights refer to the allocation of cash flows between the signing parties, in
particular when the firm is sold to a third party or goes public.
Strategic alliances refer to agreements between the signing parties about some joint
activity, which may range from common distribution channels to joint production and
knowledge transfer.
Business deals refer to more ad-hoc transactions between the firm and one of the signing
investors.
Control rights pertain to the allocation of board seats, the nomination

process of the directors and the committees, the allocation of voting rights
and the obligation to ‘act in concert’ with respect to strategic decisions.
Legrand provides a good illustration. The shareholder contract specifies
that the board will comprise 11 members: three representatives of KKR,
three representative of Wendel, two independent board members and
three top managers. It also stipulates that the strategic committee will be
chaired by a KKR representative while the compensation committee will

be chaired by a Wendel representative. As for Club Med, the contract
explicitly states that all signing shareholders will support the strategy of
the current management.
Non-equity and control issues relate to business relationships either
among the shareholders or between the shareholders and the firm. For
example, in the Club Med contract, Fipar, a real estate institutional inves-
tor and one of the signing parties, is granted the right to strike a deal with
Club Med for its real estate assets.
Our findings suggest that the equity and control rights issues included
in the shareholder agreements cannot easily be addressed by standard
open market transactions like hedging or financial options, partly because
they are conditional on what other parties contract do, and partly because
of the relatively long time horizon which they cover. Thus the following
proposition:

companies in which shareholders need to address complex and conditional
issues characterized by an intermediate level of information asymmetry
(which can benefit from third-party arbitration in case of disagreement).
Previous research suggests that market mechanisms do not fully address

expropriation issues between shareholders (Shleifer and Vishny, 1997;
Johnson et al., 2000; Djankov et al., 2008) such as tunneling and self-
dealing. Two types of expropriation issues (also called principal–principal
issues) need to be distinguished: expropriation of minority shareholders by
large shareholders, and expropriation among the large shareholders.
La Porta et al. (1999) indicate that legal protection of minority inves-
tors is scarce in countries with French civil law origin. Although French
law based investor protection has been more favorably regarded in recent
research (Djankov et al., 2008), we find it interesting to examine whether
French shareholder agreements are substitutes for limitations in legal
investor protection, using mechanisms such as the granting of board seats
and additional voting power to minority investors. But our cases do not
provide evidence of this. The rights of the minority investors signing the
contracts tend to be linked to the interests of the dominant owner, with no
rebalancing taking place. For example, Kirin, a minority investor, clearly
agrees to be on the backseat, leaving the Ricard family with the full deci-
sion and control power.
However, our cases point to the relevance of shareholder agreements
to mitigate expropriation among large shareholders. As an illustration,
the shareholder contract between KKR and Wendel (which have equal
stakes in Legrand) stipulates how the two owners will share the control
and profits of the firm after the IPO. It forbids one of the parties to pursue
an opportunistic behavior at the expense of the other. A revealing quote
from our interviewee:
When we sign a shareholder agreement, we act as complete paranoiacs. We

investigate all possible scenarios under which we could lose control and money
because of the other party’s opportunism. We make sure all the scenarios are
included in the contract, with clear resolution processes. Never trust another
shareholder!
Under these circumstances, shareholder agreements may represent an effi-

cient instrument to moderate potential conflict of interests between large
shareholders. Hence, we propose:
Proposition 7 Shareholder agreements are more likely to be initiated by

large investors seeking to protect their bargaining power than by small
shareholders seeking substitute mechanisms for weak legal protection.
Prior studies have shown that firms are more likely to adopt anti-
takeover measures when managers have high discretion and low owner
control (Brickley et al., 1988). We found that shareholder agreements are
commonly used by large insiders to protect themselves against the entry of
‘undesirable’ shareholders. Schneider Electric and Axa for example have
cross-ownership. In the event of a hostile takeover of Schneider, AXA has
the right to purchase all AXA shares still owned by Schneider; and con-
versely for Schneider. As for the Club Med shareholder agreement, it stipu-
lates that, in case of takeover, investors are allowed to sell their shares only
if Club Med’s board of directors has given its agreement on the takeover.
Another good example of the use of agreement against takeover is Pernod
Ricard. The shareholder agreement with Kirin reinforced the family’s
equity share by increasing its equity block; yet it did not seem safe enough to
secure family control. The following year (2007), a new blockholder, Albert
Frère, who is reported to be a ‘40-year-old friend of the family’, entered the
firm. Albert Frère had been on Pernod Ricard’s board of directors from
1991 to 1995. In addition, in line with the new finance law ‘Breton’, Pernod
Ricard adopted a measure whereby convertible bonds can be given for free
to existing shareholders (maximum 50 percent capital) in case of a hostile
takeover, consequently increasing the cost of the takeover. Thus:

companies in which there is a takeover risk (for example, companies with
large free cash flows).
4.4 Nature of the Network Ties
A stream of research has examined the ties between directors and top man-
agers and has revealed that the nominations of directors are not random
but linked to social and professional networks (Davis et al., 2003; Conyon
and Muldoo, 2006; Kirchmaier and Kollo, 2007). In France in particular,
there are strong ‘small world’ effects mostly related to top management’s
membership of the ‘elite’ schools (Nguyen-Dang, 2006). In such a context,
it is likely that the choice of partners for shareholder agreements follows
some network rules. Our cases show that this is often so.
For example, in the Club Med agreement, all signing shareholders
have somewhat tight connections. Accor had close links with the govern-
ment, both through its founders (notably Mr Pelisson, who also became
the mayor of Fontainebleau, a ‘posh’ city on the outskirts of Paris), and
through Mr Espalioux, the CEO, who studied at ENA, the top administra-
tive school in France. Accor sold part of its equity in Club Med to a consor-
tium of investors who were related to the French government. Icade is the
real estate arm of CDC, a ‘hybrid’ institutional investor strongly connected
with the government.6 Fipar Holding is the CDC equivalent for Morocco.
Air France Finance is the finance arm of Air France, the former national
French airline company, still partly owned by the French government
and with a strong connection to Accor (for example, they have a common
payment card and share part of their loyalty programs). While ex ante the
network ties probably facilitated the signature of the contract, ex post they
also increased the enforcement of the contract because of potential social
sanctions in case the contract is breached.
A close look at the Schneider Electric agreement also reveals many informal
relationships among the signing shareholders (Axa, Schneider Electric, BNP-
Paribas, and AGF for the 2002 agreement), in particular, board ties. Over the
period 2000–07, the board of AXA (one of France’s top insurance companies)
included Michel Pebereau (CEO of Bank BNP-Paribas, one of France’s top
banks) and Henri Lachman (CEO and subsequently chairman of Schneider
Electric) as members. Until 2002, Claude Bebear (CEO of AXA) was a direc-
tor on the board of Schneider Electric. Directors and managers have mutual
board ties which possibly give them more scope for ‘gentlemen’s agreements’
not to interfere in the strategic decisions of socially connected parties for
fear of retaliation. The Schneider Electric agreement seems to reflect a social
arrangement between managers of top French corporations, banks and insur-
ance companies. From these various cases, we propose the following:

companies whose leading officers and directors have social ties, such as
belonging to the ‘elite’ network (where formal contacts can be backed up

by social sanctions).
In the case of Kirin–Ricard and Dentsu–Publicis it is relatively clear

that the foreign firms did not have the same strong social ties. But recent
research has indicated that alliances may be a means to achieve social
ties and legitimacy (Koka and Prescott, 2002; Dacin et al., 2007). Since
minor ownership shares have been used to express a commitment to
future business relations among Japanese firms (in the so-called keiretsu
system), the contractual relations with the French firms could be seen as
an international extension of a traditional Japanese practice. In addition,
a closer look at the Dentsu–Publicis deal reveals the existence of significant
informal ties – although not at the CEO level – between the two companies.
Secondary sources indicate that the founder of Publicis (Marcel Bleustein-
Blanchet) and the founder of Dentsu (Hideo Yoshida) knew each other
from the 1960s. The CEO of Publicis, Maurice Levy, made a revealing
comment when announcing the arrangement with Dentsu: ‘Friendly ties
were established in the sixties between Marcel Bleustein-Blanchet, our
founder, and Mr Hideo Yoshida. I am glad that this partnership offers us
new opportunities to build on this tradition.’
5. IMPACT OF SHAREHOLDER AGREEMENTS
Shareholder agreements bias the formal ownership structure by intro-

ducing idiosyncratic arrangements between selected shareholders. This
phenomenon of ‘contracting around ownership’ may constitute an impedi-
ment to the efficiency of the markets because it introduces some complexity
in the allocation of control and cash flows among shareholders. Yet, the
conflicting perspectives of the finance and strategic management streams
of literature suggest that we still have no clear view on the effects of share-
holder agreements.
On the one hand, the finance literature indicates that protections
against takeovers such as poison pills (included in company charters)
destroy value (Gompers et al., 2003). Takeovers and particularly hostile
takeovers are demonstrated to be an important source of value creation
for target firm shareholders (for example, Schwert, 2000). Accordingly,
we would expect a similar negative effect to apply to shareholder agree-
ments, given that they restrict hostile takeovers and deter entry of new
shareholders.
On the other hand, concentrated control is believed to create value
under some circumstances (Thomsen and Pedersen, 2000) and the
Table 11.4 Impact of shareholder agreements
Firm Announcement +/−1 month +/−2 months

date of the
Change in Change in Change in Change in
shareholder
company the CAC 40 company the CAC 40
agreement
stock price index (%) stock price index (%)
(%) (%)
Pernod 27 March +4.9 +1.9 +3.9 +2.4
Ricard 2006
Publicis 24 May 2002 −9 −7.7 −22 −15
Club Med 21 June 2006 −12.7 +0.7 −16.6 −1.2
Legrand 27 April 2006 4.8 −1.1 N.A. (IPO
occurring on
7 April 2006)
Schneider 15 March 2002 −3.2 −2.8 −2.6 −2.9
Electric (renewal)
Schneider 19 May 2006 −11.6 −6.8 −10.9 −6.4
Electric
Notes:
Variations of the firm’s stock price +/−1 month or +/−2 months around the announcement
date of the agreement.
The CAC 40 index reflects the stock price variation of the 40 largest companies in France.
The source for the stock price data is Datastream.
strategic management literature suggests that equity arrangements

between shareholders may be positive for the firm. They can promote
strategic alliances – complementary or additive – between firms (Allen
and Phillips, 2000), ultimately creating firm value. In addition, long-term
shareholders, such as banks, corporations and government, may be in
a better position to expand the firm’s resource base and access critical
resources for the firm (for example, bank loans, lobbying of governmen-
tal bodies, R&D funding) (Pfeffer and Salancik, 1978). Accordingly, we
would expect some positive reaction of the markets over shareholder
agreements.
Our cases suggest that the impact of shareholder agreements is highly
contingent upon their content. Findings are reported in Table 11.4. Market
reactions to the announcement of the Club Med and Schneider Electric
(2006) deals were clearly negative, while they appear to be positive for the
Pernod Ricard and Legrand agreements.
As explained in the previous section, the Club Med and Schneider
Electric contracts function as defense mechanisms against takeovers (see
also details of contracts in Appendix 11.2). The first one points to the
creation of a coalition that replaces the ‘reference’ owner and protects Club
Med against takeovers. The later one (2006 version) is largely focused on
protection against takeovers, with mutual preemption rights between Axa
and Schneider in case of hostile bids.
In comparison, Pernod Ricard and Publicis’ agreements combine
both strategic and financial components. Kirin seems to have traded
its investor power for some potential business agreement with Pernod
Ricard, thus expanding out of its traditional (slow growth) Japanese
beer business. Dentsu went for a global alliance with Publicis following
the sell-out of Bcom 3. It thus gave up its role as an external shareholder
for a larger financial and strategic agreement. As officially announced
by Dentsu:
Dentsu Inc. has reached today a basic agreement to form a strategic global
alliance with a new company created through the merger of Bcom3, a U.S.
based communications group and Publicis Groupe . . . In addition, Dentsu and
Publicis will discuss working together on specific projects on a global basis.
(Dentsu’s website)
We may argue that the Publicis agreement was not positively greeted
because the positive perspective of a strategic alliance was probably
already included in the announcement of the deal between Publicis, Dentsu
and Bcom 3.
Finally, the Legrand agreement seems to follow a different logic. KKR
and Wendel were the company’s two main shareholders at the time of the
IPO (initial public offering). The renewed commitment in the firm and the
willingness to ‘bind their fate’ over a somewhat longer period of time can
be a reassuring signal for the markets, which may be especially important
in IPOs. Private equity funds are known to be focused on value maximi-
zation and to exert strong monitoring over the firm management. Thus
their agreement communicates to the financial markets that agency issues
related to adverse selection will be minimal. In addition, long-term inves-
tors and particularly those with a strong financial objective in mind bring
additional value through some continuity in strategies.
Overall, our cases indicate that the markets are ‘smart’ enough to distin-
guish between various types of contracts and to value those that promise a
positive long-term effect on the firm. Thus, we propose the following:
Proposition 10 Shareholder agreements are more likely to be negatively

perceived when they are primarily defense mechanisms against takeovers.
Proposition 11 Shareholder agreements are more likely to be positively

perceived when they offer additional strategic benefits.
Proposition 12 Shareholder agreements are more likely to be positively

perceived when they signal an increased commitment to value creation
objectives.
We propose that these hypotheses are empirically testable in event

studies which distinguish between alternative types of shareholder agree-
ments based on industry and firm characteristics. For example, companies
characterized by substantial free cash flow, low debt and low valuation
ratios and companies in newly deregulated industries with restructuring
potential are more likely to be takeover targets. In such firms we expect
news of shareholder agreements to be associated with negative abnormal
returns. In contrast we expect that shareholder agreements with a business
case – which extend the technological or sales capacity of the companies
involved – will tend to generate positive abnormal returns. Moreover,
shareholder agreements among owners with clear value-maximizing objec-
tives – such as private equity funds – are also more likely to be associated
with positive abnormal returns.
6. DISCUSSION AND CONCLUSION
This chapter explores the determinants and consequences of shareholder

agreements among large listed firms in France. Shareholder agreements are
contractual instruments that organize the relationships between sharehold-
ers ‘backstage’, that is, behind the formal ownership structure. Because of
their confidentiality, they are often hard to study. Yet, without access to
these ‘backstage’ agreements, it is difficult to understand what is going on
in the firm. The formal ownership structure may provide an inadequate
picture of the allocation of power between shareholders and between
shareholders and managers.
Using a sample of shareholder agreements among listed firms in
France, we look at the cost/benefit trade-off of these contracts versus
other governance instruments such as increased ownership and market
discipline. We define the costs of shareholder agreements as the transac-
tion costs (negotiating, renegotiating and enforcing the contracts) and the
costs of lock-in. The benefits of shareholder agreements vary according
to the issues faced by the shareholders. We propose that shareholder
contracts are particularly effective instruments for firms with specific
ownership patterns (intermediate concentration of ownership, long time
horizons and non-financial goals) and in certain (mature) industries. In
addition, we conjecture that shareholder agreements are more likely to be
considered when there are expropriation risks between large shareholders
(principal–principal issues) and takeover risks. Finally, we propose

that shareholder agreements will be more effective and frequent among
members of the same ‘elite’ network, as the enforcement of the contract
can be backed by social sanctions.
With respect to the economic performance, we propose that the value
of shareholder agreements is highly contingent upon the content of the
contract. Agreements emphasizing protection against hostile takeovers will
tend to destroy value. In contrast, agreements including both strategic and
financial components and those signaling long-term commitment by value-
maximizing owners will tend to increase shareholder value. We conjecture
that shareholder agreements are likely to create value when stability of
ownership is required to give the firm a secure strategic direction. Despite
remarkable changes in stock ownership – the average holding period for
common stock has fallen significantly over the past decade – we have seen
very little research on the importance of the stability of ownership to the
continuity of strategy and financial results. We would argue that stability of
ownership may under certain circumstances provide the right background
for firms to progress, and that shareholder contracts can be an instrument in
this regard. Moreover, we find reasons to believe that firms can occasionally
benefit from having the shareholders assign ownership (control) rights to a
competent owner who can then exercise authority to the benefit of the share-
holders as a group. Shareholder contracts provide a flexible framework for
this, because they have limited duration and need to be renewed at regular
intervals.
We regard this chapter as a first step towards improving our understand-
ing of the relatively unexplored domain of shareholder agreements in listed
firms. Obviously, there are limitations to this study that need to be made
explicit.
First, we chose to focus on a very limited number of ‘different’ cases.
Expanding our sample would improve the generalizability of the findings.
Second, because of the availability of the agreements, we focus on the
French institutional context. Research looking at cross-country compari-
sons of ownership structures and corporate governance practices under-
lines the importance of the institutional context and more particularly
of company law (La Porta et al., 1999; Gedajlovick and Shapiro, 1998;
Pedersen and Thomsen, 1997). Thus, we should test our propositions in
other contexts, for example in both countries with similar French civil law
origin and in countries with common law origin. The protection of minor-
ity investors, which is held paramount in common law countries, may limit
the scope for agreements between blockholders. For example, Roe (1991)
demonstrates how US law has historically blocked cooperation between
minority investors because of a fear of insider trading and cornering the
market. Countries with other legal traditions – like France – may be more
amenable to contracts between shareholders.
Nevertheless, we think this chapter contributes to the current debate on
ownership from both the financial contracting literature and the govern-
ance literature perspectives.
The emerging theory of financial contracting has understandably been
preoccupied with fundamental issues like differences in generic types of
debt and equity and what these imply for firm behavior and perform-
ance. But the fact is that the real-world financial contracts are often more
complicated because they combine generic liability types with specific
contractual provisions which influence the allocation of decision, control
and cash flow rights. This chapter demonstrates that shareholder contracts
tailor-make the relationships between shareholders. Thus we highlight the
need for a systematic analysis of these contracts for fear that an important
dimension of the financial structure should be missed. In addition, we
provide indications of the conditions under which shareholder agreements
are more likely to be efficiently used.
The governance stream of literature has been relatively silent on share-
holder agreements. In particular, cross-country studies have often over-
looked this dimension when studying ownership structures in French civil
law origin countries (for example, Gedajlovic and Shapiro, 1998; La Porta
et al., 1999; Faccio and Lang, 2002). This chapter points to the importance
of an in-depth understanding of less visible contextual variables such as
shareholder agreements when studying governance systems as well as
individual firms. As it turns out, theories emphasizing relational capitalism
seem quite right; some of the relationships can be documented by studying
interfirm contracts.
We see several possible avenues for future research. First, one could
test the propositions on a larger sample of firms within France (circa 300
detailed contracts available). Another analysis would be to measure the rel-
ative influence of the formal and real controls on firm outcomes. Thirdly, it
would be interesting to test the propositions in other institutional contexts.
As explained earlier, we expect shareholder agreements to be particularly
frequent in countries characterized by intermediate degrees of ownership
concentration such as France, Germany and Belgium, but less common in
countries like the USA and the UK (firms with low ownership concentra-
tion) or Italy (firms with high ownership concentration).
Finally, these findings have implications for corporate governance
guidelines. On the premise that all materially relevant information (that is,
with the potential to influence stock prices) should be disclosed quickly in
a well-functioning stock market, shareholder agreements should be made
public information, since they can influence corporate strategy and stock
prices. In this respect, we believe that the French approach (a public reg-
ister) is a good solution.
NOTES
1. This chapter originated as a paper prepared for the Workshop on ‘The Economics of the
Modern Firm’, Jönköping, Sweden , 21–22 September 2007. It has benefited from com-
ments by Benito Arunada and an anonymous referee.
2. In 2005. Source: AMF. Note that some companies have been delisted while others have
gone public over the period 1997–2007.
3. These two disclosure requirements tie in with a third requirement on ownership thresh-
olds (‘declaration de franchissement de seuils et declarations d’intentions’ – article I-233-7
of commercial law) which asks shareholders to notify the market authority when their
shares in a firm go above the 5, 10 and 15 percent voting or equity thresholds.
4. The contract between the Badinter family and Dentsu states that Dentsu will commit
to nominate ‘all management team members proposed by E. Badinter’ as well as ‘all
supervisory board members who have been chosen by E. Badinter’. In addition, it will
‘vote in favor of E. Badinter’s decisions in the cases of change of Publicis’ charters, M&A,
distribution of dividends, capital offerings and share repurchase’.
5. ‘Dentsu Inc. announced today that it has reached an agreement to form a strategic
global alliance with a new company created through the merger of Bcom3 Group, Inc.,
a U.S. based communications group and Publicis Groupe S.A., a major European com-
munication group headquarted in France’ (published in Dentsu’s website – Investors’
relations – 7 March 2002. Emphasis added). Yukata Narita, Dentsu’s president, further
commented: ‘We aim to provide the very best marketing communication services cover-
ing every domain in the world market by integrating the power of the three corporations.
By doing so, we believe we can win the confidence of clients and establish the very best
global network’ (emphasis added).
6. CDC invests funds collected through the ‘Livret A’ (typical non-risk placement for
French households) and acts as a long-term owner in a large number of French firms.
The CDC director is nominated by the French president.
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APPENDIX 11.1 SHAREHOLDER AGREEMENTS IN

FRENCH LISTED FIRMS
Table A11.1 Number of shareholder agreements
Year Number of (new) shareholder

agreements1
1997 16
1998 26
1999 34
2000 56
2001 37
2002 66
2003 45
2004 Not available
2005 16
2006 58
2007 25
Note: 1 Including changes in shareholder contracts (avenants) and changes in equity shares
held by shareholders included in shareholder agreement. Excluding breach and end of
contracts (résiliation, declaration de fin de concert, fin de clauses, caducité d’une convention)
as mentionned in the ‘comment’ section of the database.
Source: amf-france.org
APPENDIX 11.2 DETAILED CONTENT OF

SHAREHOLDER AGREEMENTS
Table A11.2
Firm Agreement
Pernod Agreement on the voting patterns/voting rights
Ricard ● Both investors agree to vote in concert
● In case of disagreement between parties, Kirin commits to vote
in favor of all resolutions proposed by the board of directors of
Pernod Ricard and to equally vote against resolutions that were not
accepted by the board on issues related to:
● Nomination and compensation of directors
● Modification of the firm’s charters
● M&A
● Extraordinary dividends
● Measures against takeovers
Agreement on the sale and purchase of shares
● Kirin commits not to sell its shares before the end of the agreement
(31 Dec. 2007)
● After Dec. 2007, Pernod Ricard has a preemptive right to buy Kirin’s
shares at the following price: the average between (1) the average
weighted stock price over the 30-day period before Kirin announced
its willingness to sell out and (2) the average weighted stock price
over the 30-day period before Kirin effectively sells its shares.
Publicis Agreement on the board structure
● Dentsu will be granted 2 seats on the supervisory board (as long
as it owns at least 10% of the equity); in case the total number
of directors increases, Dentsu will be granted additional seats in
proportion to its voting rights.
● Dentsu commits to nominate or maintain all supervisory board
members who have been chosen by E. Badinter
● Dentsu commits to nominate E. Badinter or any representative
(proposed by her) as the chairman of the supervisory board
● Dentsy commits to nominate all management team members
proposed by E. Badinter
● A strategic committee (named ‘special committee’ will be formed.
Members will be nominated by E. Badinter and Dentsu (with
E. Badinter having the discretion to nominate the majority of
members)
Agreement on the voting patterns/voting rights
● Dentsu will not be able to own more than 15% of voting rights
(33.5% for E. Badinter)
● Dentsu commits to vote in favor of E. Badinter’s decisions in the
following cases:
Firm Agreement
Change of Publicis’ charters
●
M&A
●
● Distribution of dividends
● Capital offerings
● Share repurchases
● Dentsu may freely vote (after consultation with E. Badinter) on
the related topics
● Transfer of assets
● Granting of subscription rights
● ‘Reserved’ capital offerings
● Transaction involving E. Badinter, Dentsu or a subsidiary of
Publicis
● Dentsu commits to vote in favor of the certified accounts, after
Dentsu’s comments have been taken into account by the financial
auditors
● In case of seasoned offers (that is, share issues by companies
who have already listed shares), Dentsu will be granted an anti-
dilution right. Yet it will not be able to participate in the offer
through preferred subscription rights
● Dentsu will not be able to transfer or sell its equity shares in
Publicis until July 2012
● After July 2012, E. Badinter has a preemptive right to buy
Dentsu’s shares
● Dentsu commits not to make any special arrangements with
Publicis’ management without prior notice of E. Badinter.
Conversely for E. Badinter
Club Med Agreement on the board structure
● Fipar is granted the right to propose the nomination of one
director (as long as it owns 4% equity)
● All investors commit to vote in favor of this nominee, and ‘fire’
the directors that would be requested by Fipar
● Accor will keep one representative on the board of directors
Agreement on the voting patterns/voting rights
● All investors confirm to support current management’s strategy
● Investors agree not to sell any of their shares without informing
the other investors for a period of 2 years
● Investors agree not to increase their ownership level (on an
individual or collective basis) until either the agreement or the
date when the group of investors will own less than 20% of Club
Med’s equity or voting rights
Firm Agreement
● After two years, investors have the preemptive right on the
purchase of shares sold by other investors
● The parties may unanimously decide to lift the ban on additional
share purchases so as to increase their shares in Club Med’s
equity
● Agreement on takeovers: in case of takeover, investors are
allowed to sell their shares only if Club Med’s board of directors
has given its agreement on the takeover. If one of the parties
wishes to make a competitive offer, it may terminate the
agreement
Non-equity and control issues
● Icade (real estate arm of institutional investor CDC) has joined
the agreement under the specific condition that it will conclude a
contract with Club Med related to real estate issues
Legrand Agreement on the board structure
● The board will include 11 members
● Until the initial period (2 years and 3 months after the IPO date),
the parties agree that the board will be composed of:
● 3 representatives of each signing party
● 2 independent board members
● 3 top managers
● After the initial period, Wendel and KKR commit that the board
will be constituted by a majority of board members nominated by
both parties
● In addition, Wendel and KKR will be granted seats in proportion
to their respective voting rights
● The governance structure will include
● A strategic committee, chaired by a KKR representative
● A compensation committee, chaired by a Wendel
representative
● An audit committee, chaired by an independent board member
Agreement on voting patterns/voting rights
● Wendel and KKR forbid to vote in favor of granting dual rights
to shareholders holding Legrand’s shares for more than two years
● The chairman of the board will be granted significant discretion
with respect to the daily management of the firm, except on
decisions relative to
● Share offer and buy back
● Subscription of new debt or early pay back
● Acquisition of equity shares in other firms, acquisition of other
businesses and JV for deals above €50m
Firm Agreement
Sell-out of businesses asset or participation above €50m
●
Agreement or modification of Legrand’s 3-year strategic plan
●
and annual budget
● Firing or nominating auditors
● Any projects that would entail the full or partial transfer of
Legrand’s assets
● Any deal that would result in equity increase of equity reduction,
including convertible debt or preferred shares
● The cancelling out of double voting rights or any decision that
would modify the voting rights attached to Legrand’s shares
● Any modification of the governance rules, such as the
composition of the board
● The introduction of Legrand’s shares in a stock market other
than Euronext
● A voluntary liquidation of the firm or any decision that would
generate a collective procedure against Legrand
● Any modification of Legrand’s charters that would favor one of
the parties
● Any transaction or treaty if amounts at stake exceed €50m
● The parties commit that Lumina White (Lumina Participation) will
vote in accordance with KKR and Wendel. In case of disagreement
between the parties, Lumina White will conform to instructions
given its owners in relation to their respective shares
● Wendel and KKR both commit not to sell their equity shares
before the end of the ‘restrictive’ period (the minimum between (1)
18 months after the expiration of the lock-up period for syndicate
loans and (2) date when the parties have jointly agreed they could
sell a portion of their stocks)
● Some transactions will however be allowed:
● Cessions in favor of entities which are fully owned by either
Wender or KKR (sociétés apparentées)
● Cessions that do not exceed €10m, in so far as the other party
has been informed at least the day before the transaction
● Cessions of shares in favor of a board member of Legrand, to the
extent that it does not exceed what is written in the charters
● After the restriction period, the sell-out of Legrand’s shares will be
unrestrained as long as it is consistent with
● The right of preemptive offer
● The ban on block sell-out and joint sell-out (‘tag along’)
applicables to blocks
● Cessions that are forbidden by the investors’ agreement contract
Firm Agreement
● The stipulations of ‘offering rights agreement’ and ‘tag along
agreement’
● Preemptive right: each party commits to inform the other party when
it wishes to sell its shares. The remaining party has the right to make
a preemptive offer (at a price which equals or is superior to the one
offered by the selling party)
● Block sell-out: when one of the parties wishes to sell out its shares in
‘blocks’, it is required to inform the other party through a letter. The
recipient has 5 days to also inform the seller that it equally wishes
to sell its shares. The seller commits to inform the other parties in
advance of the conditions of the block sell-out
● Under the ‘tag along agreement’, if the informed party does not wish
to sell its shares, the seller will be authorized to sell all of its shares. If
the second party also wants to sell its shares, a specific rule of ‘share
allocation’ will be enforced. Each party will be authorized to sell only
a specific portion of their shares.
● Each party has agreed not to sell its blocks of shares to an industrial
firm above a value of €100m
● The above conditions do not hold for:
● Cessions of shares authorized along prior conditions
● Cessions sold within a seasoned offer led by a banking syndicate
(following a guarantee contract)
● Swaps by one of the parties between Legrand securities and
Legrand stocks or other financial instruments
● Cessions in the context of a takeover
● All cessions ruled by the ‘tag along agreement’ (agreement relative
to the joint cession of Legrand’s shares after the IPO)
● Agreement on takeovers by one of the parties
● Each party commits to get the written consent of the other party
before its proceeds to a takeover offer. The informed party has
three days to give its answer. Beyond this period, agreement is
assumed. In case of disagreement, the ‘takeover’ party is expected
to incur all costs related to the offer
● If after the takeover offer, one of the parties becomes a majority
owner and the other one a minority owner, a new investors’
agreement will be concluded. In any case, this new agreement will
give the minority investor a veto right on all strategic decisions
on Legrand as long the minority investor holds 20% of the voting
rights
● In addition, a joint ‘exit right’ will be implemented if the majority
owner wants to sell its block equity
Firm Agreement
Schneider 2002. Agreement on the sale and purchase of shares
Electric ● Second modification (avenant) of the investors’ agreement
contract signed in 1993 between AXA, BNP-Paribas & AGF.
Updates the respective equity shares included in the agreement,
i.e. 3%, 1.4% and 0.4% of capital
2006. Agreement on the sale and purchase of shares
● AXA commits to keep at least 2.5m equity shares in Schneider
● Schneider commits to keep at least 8.8m equity shares in AXA
● In case of a hostile takeover of Schneider, AXA has the right to
purchase all AXA shares still owned by Schneider; conversely for
Schneider
12. Board governance of family firms
and business groups with a unique
regional dataset
Lluís Bru and Rafel Crespí
1. INTRODUCTION
This study is a detailed description with methodological contribution to

the measurement of a set of family business groups in the Balearics region
in Spain that belong to either the Balearic Family Business Association
(ABEF) or the nationwide association, the Spanish Family Business
Institute (IEF).
Before we discuss the object of our study, we will examine the main aspects
that characterize the family business as an economic organization. Next, we
will display their economic activity and relevance in the region’s economy.
Subsequently, we will take a closer look at the economic behaviour
and organization of the 556 companies that belong to the 50 family busi-
ness groups. In our description we will examine these companies on two
levels. First, each individual company will be contemplated as a separate
economic entity. Second, we will offer a specific description of each family
business group.
For this, we have used the data we have on the family companies and
their boards of directors as the essential basic information for our study.
The main methodological innovation of our study is that the Spanish
‘two-surnames’ system allows us to analyse in detail the family ties among
administrators at both the firm and the business group level.
2. OUR DEFINITION OF THE FAMILY BUSINESS
What is understood by the term ‘family business’? We might define the

family business as a company that fulfils two basic requirements: persistent
belonging to individuals within a single family circle, and being governed
by one or more of the members of that family.
292
Board governance of family firms and business groups 293
When applying this definition to specific companies, to avoid ambiguity

it is important to be more precise about what we exactly mean by a family
company. Three factors are taken into consideration in our attempt to
define a family business.1
First, the ownership of the company by a family is essential for such
company to be defined as a family business. Typically we use the term
‘family firm’ when the majority of the capital, with the corresponding
voting rights, is owned by individuals from a single family circle, in such a
manner that we can be sure that the family do govern the fate and future
of the company. Whilst the control of the company can occasionally be
attained with a minority of shares, it is most common to see most of the
share capital in the hands of the family. To possess the majority of the
voting rights means having the power to take all sorts of strategic and
operative decisions within the company. Of course, the greater the per-
centage of ownership, the stronger the family’s influence on the fate of the
company.
The second defining feature of the family business is that the manage-
ment of the company is controlled by the family members, who are also
the primary decision makers. However, when analysing any firm, we know
it is important to distinguish between the management of the company
and its control. In the family company, when it is said that one or more
members of the family take part in the management, this could mean that
such members undertake the control and management activities simul-
taneously – this is frequently the case in first-generation companies and
small businesses – or it may imply that they only undertake the control
of the company, while the business is managed by professional managers
who do not belong to the family. This latter case is more typical of com-
panies in which the ownership is distributed among many members of the
third and subsequent generations of a family and is also commonly seen
in the case of large companies. Although the management activities of the
family company are frequently conceived of as remaining in the hands of
the family members, it is no less true that, if the family actively controls
the company, this would be enough of a determining factor in the com-
pany’s decision-making process, and thus in the path that the company
will follow.
The third defining characteristic of the family company is the family’s
continuous involvement over time, through successive generations of
the same family. It makes no sense to speak of a family business if the
company does not continue to be a long time under the control of the
family circle.2 This aspect greatly limits the scope of enterprises that we
refer to when we speak of a family company and defines certain aspects
of business organization as distinguishing features of the family business.
Thus, the transmission of the ownership, the requirements established to

enable family members to become a part of the company, the leadership
in the successive generations and the necessary attraction of professionals
who are not family members are relevant issues in any study of the family
business.
3. DATA SOURCES AND METHODOLOGY
The quantitative information used in this study comes from the Spanish
section of the Amadeus database, created by Bureau Van Djick, which
basically compiles data that Spanish companies are required to record
with the Companies Registry. Because this database is computerized, its
contents can be processed, as we will see below. The large number of com-
panies included in the database (virtually all of the Spanish companies)
has enabled us to cover information on large, medium and small compa-
nies throughout Spain over several years. In fact, the number of Spanish
companies included in the last database update was 830,000, and for the
autonomous region of the Balearic Islands this figure was 26,747.
There are essentially four types of information in the database that are
relevant to our study: (i) the financial statements, (ii) information on the
activities that the companies are engaged in, (iii) the list of administrators
of the companies and the positions they hold, and finally (iv) the ownership
listings, including both company shareholders and companies partially
owned by other companies.
The financial statements, including the balance sheets and operating
statements, give us information on the size of the companies analysed
and offer us an approach to the structure of their share capital. Certain
proportions of business debt and earnings can also be compared among
companies.
The information on the business line of activity of each company is
primarily based on that company’s assigned NACE (economic business
activity) code. This classification makes it possible to assign each company
a highly specific economic activity code, up to four digits, gradually adding
in three-, two- and one-digit codes, to progressively specify the economic
activity, while at the same time enabling companies with similar economic
activities to be grouped together.
The list of company administrators is essential to our purpose, as it
allows us to measure the extent to which family businesses entrust the
seats on their boards of directors (and therefore the firms’ governance and
management powers) to family members. Here we can make use of the
information that the Spanish ‘two-surnames’ incorporate. This surname
system is very suitable for genealogical purposes, because it has two features
that help to establish kinships. First, married women usually do not change
their name; and secondly, every newborn has two surnames or family names
(apellidos in Spanish): the first is the father’s first surname, and the second is
the mother’s first surname.3 Having the names and surnames of the admin-
istrators makes it possible to process family ties on the computer, using first
two surnames (enabling us to infer whether or not two administrators are
siblings) and then one surname, which allows us to trace the generational
family ties among administrators of different generations (parents and chil-
dren, grandparents and grandchildren, uncles/aunts and nieces/nephews,
and so on) as well as among those of the same generation (cousins).
By way of example, consider the very simple board of directors of
Barcelo Corporacion Empresarial SA, a firm pertaining to the Barcelo
family included in our sample:
Board of directors of Barcelo Corporacion Empresarial SA

Barcelo Vadell, Simon Pedro
Barcelo Tous, Guillermo
Barcelo Vadell, Francisca
Gonzalez Rodríguez, Raul
The names of the board’s members are stated in the following order:
father’s surname, mother’s surname, and finally Christian name (possibly
two, as in Simon Pedro). The coincidence of two surnames in exactly the
same order (Barcelo first, then Vadell) allows us to infer that Simon Pedro
and Francisca are siblings; whereas the fact that there is only one surname
that coincides between them and Guillermo Barcelo Tous allows us to infer
that they either pertain to a different generation or are cousins (the order
also allows us to discard some family ties; for instance, Guillermo cannot
be Francisca’s son, since Barcelo would then appear in second place).
Finally, the fourth member of the board is not identified as a member of
the family, since there is no coincidence whatsoever of surnames.
Finally, the lists of company shareholders show the proportions of
share capital held by the individual shareholders of the firms, establishing
who the last shareholder is. This information is not available for all of the
companies included in the database. Another relevant type of information
is the structure of the companies that control other subsidiary companies,
with information on the percentage of their interest in their affiliates. This
information is particularly useful to ascertain business groups and shed
light on the relations between the companies and the ties between their
administrators.
Based on the personal information of the members of the ABEF and the
Balearic families that belong to the IEF, we have used the Amadeus data-
base to outline the different business groups in the Balearics. Our starting
point was the notion that a company belongs to the family group whenever
it is controlled by the family. To establish the business groups, we applied
the following steps: (i) initially the family group included the companies in
which the corporate partner who was a member of the above-mentioned
associations figured as a company board member with significant owner-
ship of the companies; (ii) subsequently, the group came to include com-
panies in which its direct family members also figured as board members;
(iii) this extended to the companies that were partially owned by the above
companies, with the condition that such ownership consisted of at least
one-fourth of the share capital; (iv) once firms were identified, we checked
with representatives of the family firms associations the identification of
firms within family business groups, correcting case by case any possible
error which stemmed from the automated processes described in steps (i)
to (iii).
Finally, different controls were applied to the data to ensure that the
companies analysed were indeed engaged in an actual economic activity.
We eliminated from our sample any companies in the process of liquida-
tion, those with no existing income and asset volume data for 2004 finan-
cial year, which was the last year fully published in the database, as well as
the companies in which either of these two measures did not reach €60 000.
Following the application of these selection criteria, the resulting number
of sample companies was 556.
Below we will describe the group of companies analysed. Prior to a
detailed description of the family businesses, the object of our study, we
offer some aggregate figures on these companies that show the significant
amount of economic activity that they generate, and thus the importance
of studying them. Subsequently, we explore these companies in some
detail by applying two different procedures: first, we will analyse the com-
panies individually; next, we group the companies according to the family
that controls them, which gives us a group of companies for each of the 50
families of the Balearic Islands that form part of the ABEF or IEF.
3.1 The Relevance of Associated Family Companies in the Region
To address the relative importance of the member companies of the family

business association in the Balearics, we can compare the figures of their
economic activity with the economic activity volume generated in the
autonomous region at large, namely the regional gross domestic product
(GDP), or we can consider the number of workers employed by these
Table 12.1 Aggregate values of the main magnitudes of the sample family
companies
Total value in thousands of €

Total assets 14 200 000
Revenue 10 600 000
Employees (number) 70 269
Added value 2 867 307
Equity 6 599 452
Earnings before taxes 486 969
Corporation tax 139 261
companies compared with the number of active workers in the Balearic

Islands.4
In Table 12.1 we see that the 556 companies in our sample had a total
asset volume of more than 14 200 million euros in 2004. If we add up the
income volume generated by each of the 556 sample companies, our total is
10 060 million euros. By way of reference, for the year 2004 the value of the
gross domestic product for the Balearic Islands was approximately 20 900
million euros. Obviously these figures are not comparable in the sense that
the asset is a stock measure and the GDP a flow measure. To attain a figure
that can be compared with the regional GDP we must refer to the added
value generated by the companies in our sample. For this item, the value
was 2867 million euros.
As to the employee volume, the aggregate figure for 372 of the 556 com-
panies that we have information on comes to more than 70 000 workers.
Once again and to attain a point of reference, according to the statistics of
the INE (Spanish Institute of Statistics), the employment volume for the
year 2004 in the Balearic Islands was 455 000.5
Table 12.1 describes some aggregated data of interest on our sample
of family businesses, including the value of their equity, which comes to
nearly 6600 million euros; the earnings before taxes, which are approxi-
mately 486 million euros; and the total corporation tax, which comes to
139.26 million euros.
Another aspect worth bearing in mind is the organization and control
of the companies. All in all, the 556 companies have structured their gov-
erning bodies with a total of 2244 board members, and an average of 4.04
members, where 77.6 per cent of them are men, in 4.5 per cent of the cases
another company figures as a board member in the official register, and
nearly 18 per cent of board members are women. This first approach to
associated family companies in the Balearic Islands gives us an idea – albeit
a rather imprecise one – of their relative importance, and thus reveals their
most salient magnitudes. A more in-depth study will enable us to charac-
terize them according to what we might refer to as the typical or average
company.
4. COMPANIES UNDER THE CONTROL OF

ASSOCIATED FAMILIES
4.1 The Representative Company
Characterizing the typical business based on our sample of 556 compa-

nies is by no means easy, given their vastly diverse sizes and the different
sectors of activity that they belong to. Nevertheless, we see that the average
company has assets of around 25.5 million euros, a revenue volume of
19.6 million euros and equity of approximately 5.19 million euros for the
year 2004, as shown in Table 12.2. However these average values repre-
sent a great deal of dispersion among the 556 companies in the sample.
The standard deviations are more than five times higher than the average
values, which points to the bias introduced by several extreme observa-
tions, due to their very high values, for any of the financial magnitudes that
we are contemplating.
Hence, the median of the 556 sample companies can better characterize
the typical company. We can now see that the observation of the company
holding the central position in our sample is smaller than what the average
of the observations could lead us to believe: it has an asset value of 2.6
million euros and a revenue volume of 1.27 million euros, it generates an
added value of 543 million euros, and its equity is approximately 1 million
euros.
Panel B of Table 12.2 informs us about the boards of directors of these
firms. The representative company has an average of four board members,
one of which is a woman and the rest of which are men, with the exception
of several seats assigned to legal entities (companies). The average business
age of the 556 sample companies is 17.5 years. This is not excessively far
from the median, which is 14 years.
Panel C of Table 12.2 displays data on the average number of employ-
ees, which represents a great deal of dispersion, making the interpretation
of this item quite difficult. Nevertheless, by examining the average data
we can see that a third of the income from operations is allocated to staff
salaries, and that the average return for shareholders is 10.4 per cent. This
value goes down to 2.4 per cent when placed in relation to the return on
assets. Finally, we can give information on the solvency ratio, which takes
Table 12.2 Descriptive statistics of average values of the main magnitudes

of the sample family companies (2004)
Values in thousands of €
Panel A average median standard
deviation
Total assets 25 519 2 683 142 167
Revenue 19 683 1 278 100 152
Added value 5 194 543 30 035
Equity 11 870 1 001 69 350
Earnings before taxes 889 23 5 414
Corporation tax 255 4 1 456
Panel B
Size of board of directors 4.04 4 2.8
Men on board of directors 3.13 3 2.28
Women on board of directors 0.721 0 1.06
Companies on the board of 0.182 0 0.647
directors
Panel C
Employees (number) 189 27 1 033
Company age (years) 17.5 14.0 12.9
Staff costs/income from 33.2 22.3 53.2
operations (%)
Solvency ratio (%) 43.7 42.2 40.2
Return on shareholders’ 10.4 5.2 84.5
investments (%)
Return on assets (%) 2.4 1.3 18.8
in the proportion of the company’s assets in relation to its net worth. In

this case, the average value is 43.7 per cent, which is very similar to the
median for the same item. This review of the financial magnitudes and
administrative bodies enables us to make an initial approach. However,
the high variability on the observed magnitudes suggests that a more
detailed study is in order, distinguishing the characteristics of the compa-
nies according to their size or their sector of activity, as we shall see in the
sections below.
4.2 Differences According to Size
In this section we have established the parameters for company compari-

sons by grouping them according to their size. To do so, we have divided
the sample into three groups, corresponding to what we shall refer to as

small, medium and large enterprises, according to their asset volume. Each
tertile of the 556 sample companies is made up of 185 companies.6 This
procedure aims to show more homogeneity than the analysis in the above
section, amid the companies of each tertile, and in turn enables us to see
any differences that may emerge among the companies that belong to dif-
ferent size groups.
The values of Panel A in Table 12.3 illustrate the significant differences
between small, medium and large enterprises. Thus, the average small
company has an asset volume of 484 000 euros and a revenue volume of
711 000 euros, generates an added value of 238 000 euros, and its average
earnings before taxes are 7000 euros. As a group, the 185 small companies
only generate 126.6 million euros, for a total asset volume of 89.5 million
euros. Their overall earnings before taxes are around 1.27 million euros.
At the opposite end of the spectrum, large companies together account
for more than 90 per cent of the revenue volume, number of employees
and asset volume for the sum total of all the companies in our sample. On
average, the large companies have 33.8 million euros in equity, and the
earnings before taxes of the average company within this group come to
nearly 2.5 million euros.
The typical medium company generates a revenue volume of 2.7 million
euros, with assets of 3.14 million euros, and equity for a value of 1.46
million euros. As a group, these 186 medium companies account for
approximately 500 million euros in assets and revenue, with aggregate
earnings before taxes of 24.67 million euros.
Beyond the descriptive figures mentioned above it is interesting to
observe the behaviour of the magnitudes associated with the corporate
governing bodies according to their size. In Panel B in Table 12.3 we can
see that, for the same number of companies in each size group, the total
number of board members is 901 for large enterprises, 543 for small enter-
prises, and 803 for medium companies. Indeed, it is plain to see that the
average size of the board of directors goes up as the company grows larger
in size. The average values are 2.94 board members for the small compa-
nies, 4.34 for the medium companies, and 4.84 for the large companies.
This comes as no surprise, if we consider that larger companies may require
a greater participation in their government. For example, the corporate
governance report for Spanish listed companies, Corporate Governance
Report of the Companies with Values Listed in Stock Exchanges for the
2004 year, published by the regulator of the Spanish Stock Exchange,
the Comision Nacional del Mercado de Valores (CNMV), reveals that the
number of board members also rises with the size of the companies listed
on the Spanish Stock Exchange, although the average number of members
Table 12.3 Average and total values of the main magnitudes of the sample family companies for three size levels, based
on assets
small medium large

Panel A (thousands €) average total average total average total
Total assets 484 89 587 3 140 580 901 72 678 13 500 000
Revenue 711 126 629 2 726 493 350 55 101 10 000 000
Employees (number) 16 1 450 28 3 772 440 65 047
Added value 238 43 613 836 153 870 14 431 2 669 824
Equity 210 38 792 1 460 270 012 33 821 6 290 648
Earnings before taxes 7 1 273 135 24 647 2 492 461 049
Corporation tax 7 1 185 53 9 746 694 128 330
301
Panel B (number of persons)
Size of board of 2.94 543 4.34 803 4.84 901
directors
Men on board of 2.40 444 3.38 625 3.62 673
directors
Women on board of 0.41 76 0.74 136 1.02 189
directors
Companies on the 0.12 23 0.22 41 0.20 37
board of directors
Note: Data correspond to the 2004 year, with 185 companies for the small and large tertiles and 186 for the medium company tertile.
Table 12.4 Average values of the proportions of the main magnitudes of

the sample family companies for three size levels, based on
assets
small medium large

Age (years) 13.9 19.9 18.6
Staff cost/income from 38.2 31.2 31.4
operations (%)
Solvency ratio (%) 43.6 46.0 41.4
Return on shareholders’ 22.1 −1.4 10.7
investments (%)
Return on assets (%) 0.6 3.9 2.7
Note: Data correspond to the 2004 year, with 185 companies for the small and large
company tertiles and 186 companies for the medium company tertile.
is not directly comparable with the companies in our sample, as the average
number of board members for the listed companies is 9.7.
While there are differences in the number of board members according
to the size of the family companies, differences can also be seen in their
composition. The proportion of women on the boards of directors of the
small companies is 14 per cent, becoming 16.9 per cent in the medium
companies and reaching 21 per cent in the large companies.
Finally, the size-based classification enables us to observe some propor-
tions regarding the cost, profitability and structure of the family busi-
nesses. Table 12.4 shows no significant difference in the average age of
the medium and large enterprises, standing at approximately 19 years for
both groups. However, the average age of the small companies is markedly
lower: 13.9 years. Moreover, it seems that the small companies tend to be
more labour intensive, as they allocate a larger proportion of their revenue
to staff salaries (38.2 per cent, in relation to the 31 per cent allocated by
medium and large companies). The solvency ratio oscillates between 41 per
cent and 46 per cent, with no apparent pattern related to the average size
of the companies.
The profitability ratios display the greatest differences in the average
values according to company size. The returns for shareholders are higher
for small companies than for large ones, whilst, on the other hand, the
return on assets is greater for the large and medium companies. The medium
companies, in this comparison, present the lowest shareholders’ returns of
the three groups and the highest total returns on assets.7 In any case, we
must proceed with caution when considering these average values, for two
reasons. The first is the heterogeneity of the companies included in each
group, as these average values are not weighted, meaning that they place the
same relative importance on the smallest company within the tertile as they
do on the largest. The second reason lies in the database, which conveys the
information provided by the companies to the Trade Registry. A significant
number of the very small companies present unaudited accounts, as the
regulations in force do not require them to be audited.
4.3 Sector of Activity Diversity
Indeed, the vast disparities in the sizes of the companies allow us to observe
differences in some of their behaviour variables such as profitability and
the composition of their boards of directors. All the same, there are
operational aspects of the companies that could potentially affect their
profitability, and which are tied to their specific business activity. In this
section we present different magnitudes, assessing the companies together
according to their sector of activity at the NACE one-digit level.
Table 12.5 illustrates the main measurement magnitudes of the com-
panies by sector of activity, and shows the distribution of the sample
companies among the eight major sectors into which the sample has been
divided. Most of the economic activity, according to the aggregate values
of asset and revenue volume, resides in three sectors of activity: hotel
and catering, transport and communications, and real estate and busi-
ness services. These three sectors embrace the majority of the companies
associated with tourism, which is characteristic of the Balearic economy.
Along these lines, Table 12.5 suggests that the distribution of economic
activity for family firms follows a similar pattern to that of the Balearic
GDP. Moreover, the distribution of the companies in the sample, which
was calculated with different variables such as the number of companies
in the sample, asset value and revenue level, is similar to the relative
weight of each of the sectors in the Balearic economy, as shown in Table
12.5. The distribution of the number of companies in the sample is to a
large degree in line with the data on the regional GDP composition, with
the exception of the grouping of other activities, which takes in such
diverse activities as education, healthcare and veterinary activities, social
services, personal services and financial intermediation. The figures of the
companies in hotel and catering and in real estate and business services
are representative of the considerable weight of the tourist industry in the
Balearic Islands, as it includes lodging in hotel establishments and other
forms of rentals, and also what is known as the complementary supply.
By asset volume, the average size of the hotel companies is significantly
greater than those of agriculture, industry, construction and trade, despite
the fact that its number is equal to the sum of those that form these other
Table 12.5 Relative relevance of the economic activity sectors in the 556
sample companies
Companies Contribution Companies’ Companies’

in sample of the sector sample sample
(%) to regional assets (%) revenues
GDP (%) (%)
Agriculture, 1.26 3.64 0.12 0.05
livestock, fishing
and power
Industry 6.29 5.75 1.59 2.41
Construction 6.29 10.43 1.75 1.90
Trade and repairs 9.53 9.93 2.70 7.45
Hotel and catering 21.76 25.22 43.74 22.53
Transport and 12.59 8.96 8.03 41.55
communications
Real estate and 35.61 18.16 40.98 23.59
business services
Other activities 6.65 17.92 1.09 0.52
Note: Comparison of relative weights of the magnitudes of asset size and revenue volume,
as well as the number of sample companies, with industry distribution reported by the
National Institute of Statistics (INE) in the regional accounts. The industry groupings are
based on the NACE 1-digit level.
sectors. The high average revenue volume of the companies in transport

and communications is due to the fact that this sector includes the Balearic
Islands’ major travel agencies,8 which are well-established nationally and
internationally and have relatively very high revenues and assets.
To assess profitability, labour expenses and financial structure, Table
12.6 displays the corresponding proportions after weighting these values
according to the size of the companies, which in turn was calculated accord-
ing to the asset volume of each company. This prevents us from attributing
to a small company the same weight that we attribute to the large sample
companies in the same sector. Particularly worthy of note in the column on
staff expenses over income from operations is the high intensity of labour
in the primary sector and the ‘other activities’ group, which is essentially
made up of personal services. As to the solvency ratios, the low values for
the construction companies are salient, which is now typical of this sector
and of the transport and communications sector, given the high debt rates in
relation to their equity. As regards the returns on assets, the values oscillate
within margins that display little dispersion among the sectors. The return
on stockholders’ equity, however, exhibits greater dispersion, although
Table 12.6 Proportions of profit, financial structure and expenses by

activity sector
No. of Return on Return Solvency Staff cost

companies shareholders’ on assets ratio (%) / income
investments (%) from
(%) operations
(%)
Agriculture, 7 25.6 4.0 51.6 43.1
livestock, fishing
and power
Industry 35 2.4 3.6 38.6 24.3
Construction 35 26.3 5.0 23.5 15.7
Trade and repairs 53 16.7 8.5 46.0 8.5
Hotel and catering 121 7.0 3.6 45.0 33.9
Transport and 70 39.5 4.2 18.3 10.9
communications
Real estate and 198 8.0 2.7 60.3 38.5
business services
Other activities 37 −5.6 3.0 54.2 71.5
Total 556 10.5 3.4 48.8 32.6
Note: The proportions were weighted according to the size of each company, bearing in
mind each company’s total assets.
it must be viewed with caution, as some of the companies do not present

audited financial statements, as we have mentioned, and the absence of
certain observations could distort the average values of the sample.
5. BUSINESS GROUPS UNDER THE CONTROL OF

ASSOCIATED FAMILIES
Although we have explored the family companies in the section above,

we have to consider the fact that each family can control more than one
company. Naturally a family will not take a certain business decision for
each company separately, but rather will consider the group of companies
under its control as a whole.
This calls for a description of business groups under the control of each
family in the sample. The key to making this possible resides in the ability
to ‘build’ the group of companies to be assigned to each of the families, so
as to assess the decisions of the associated corporate families in the Balearic
Islands.9 The first issue that we can address by studying the family groups is
the concentration or dispersion of sizes among the different family groups,

and, within them, the differences we observe among the companies within
each group. By individually studying the companies in the above section,
we have seen vast differences in size, sector and even governing body com-
position. By attaching these companies to their respective family groups,
the questions regarding heterogeneity continue to be of application among
companies of a single-family group.
We also explore the families’ corporate diversification strategy, distin-
guishing the degree of sector diversification, according to whether diversi-
fication revolves around a main business activity (related diversification) or
whether sector diversification is more intense, meaning that it is not neces-
sarily linked to any initial core business. Finally, we delve more deeply into
the administrative and management bodies of the business groups and the
degree of involvement of the controlling family.
5.1 Family Group Heterogeneity
Among the family groups studied, the typical one has an average of 11
companies, with a total asset value of 283 million euros and an average
revenue nearing 213 million euros, and provides employment to a total
of 1464 employees. These averages represent a great deal of dispersion,
however. Another way of characterizing the ‘usual’ family group would
be to consider the median of the values mentioned above: 7 companies per
family group, with a total revenue volume of around 29 million euros, and
total assets of nearly 42 million euros. These are family group companies
with an age of around 18 years and are run and controlled by the second
or third generation of the family.
To address the structure of the companies that form the family groups,
we can present two opposite structures. On one hand, there are groups
made up of several companies (on average seven), all of which are equally
important as regards the volume of activity or the asset volume. On the
other hand, there may be business groups that are formed by many com-
panies but there is one of them that generates nearly all of their aggregate
activity, while the other companies are virtually insignificant. What is the
most common structure among the family groups in our sample? What
we see is that they tend more towards the second situation than the first,
although with significant differences.
Indeed, Table 12.7 shows that the largest company of each of the 50
family groups of our study generates 53 per cent of the total asset volume
and 44 per cent of the total revenue of the group.10 The degree to which the
activity is concentrated in a reduced number of companies can also be seen
in the fact that the three largest companies in each group represent three
Table 12.7 Distribution of the importance of the largest and succeeding

companies in each group in the study sample
Importance of the Proportion of total activity (%)

company in the group
Assets Accumulated Revenue Accumulated
largest 53.0 53.0 44.1 44.1
second 17.7 70.7 19.0 63.1
third 6.6 77.3 13.0 76.1
fourth 4.6 81.9 3.8 79.9
fifth 2.9 84.9 2.0 81.9
quarters of the family group activity, both in terms of asset volume and in
terms of revenues. For 36 of the 50 family groups that have formed five or
more companies, the total activity of those five largest companies accounts
for nearly 85 per cent of the group total, while the fifth most important
company represents only 3.6 per cent of the group’s activity.
As regards their legal format, 270 of the 556 are limited companies,
282 are public limited companies and 4 are other types of organizations.
Among the largest companies in the 50 family groups, 34 are public limited
companies and 16 are limited companies.
Thus, we can confirm that the business structure of the associated
family companies in the Balearics is complex, though it is built upon a
small number of companies. In many cases, hidden beneath the number of
companies that sustain the family business structure there is a diversifica-
tion strategy. Indeed diversification into activities that may or may not be
similar to the core activities of the family business is important from the
perspective of the diversification of risks. In the next section we apply the
appropriate method to explore their diversification strategies.
5.2 Measurement of Family Group Diversification
When we speak of business diversification we refer to the entry of a

company, business group or shareholder into a number of different eco-
nomic activities. Alternatively, a non-diversification strategy means focus-
ing on a single activity or line of business.
Moreover, it is common in the business and the economics literature to
distinguish between related and unrelated diversification. Related diversi-
fication implies involvement in several different lines of activity that share
a group of corporate resources and the same organizational abilities or
skills. The sharing of technology, sales forces or distribution activities
might be considered an example of related diversification. When these
technological, commercial or skill-related connections do not exist among

different business units, diversification is understood as being unrelated.11
Undoubtedly, any abstract classification ranging between the extremes
of ‘non-diversification’ and ‘maximum unrelated diversification’ enables
the practice of many different levels or degrees of diversification. The actual
positioning of each company or business group on this scale between the
extremes can be empirically measured thanks to the existence of universally
accepted sectorial classification standards. We will use below the European
sectorial classification (NACE) system implemented by Eurostat, which
uses four-digit codes to classify the different types of activities. There are
also three-digit groupings, and two-digit divisions, which can be broken
down into one-digit divisions for large-scale sectorial grouping. Moreover
the database we use assigns each company a main activity code and another
secondary activity code, which allows us to measure the distance between
the sectorial activities, bringing us closer to the concepts of related and
unrelated diversification.
In the case of family groups, the relevant unit with which to study the level of
diversification is the family group, not the individual company.12 A first simple
way to measure the family business groups’ sectorial diversification consists of
simply counting the number of different activity codes within a group. For the
three- or four-digit NACE codes, a high number of different codes will mean a
high degree of related diversification. A high number of different NACE one-
digit codes, on the other hand, would be indicative of the group’s unrelated
diversification. Obviously, if all of the activity revolves around a single NACE
code, regardless of the number of companies that make up the group, this tells
us that the family group has chosen to focus its economic activity on very few
activities. In other words, it has decided not to diversify.
Table 12.8 illustrates how the median number of activities of the family
business groups is amid three different codes, if measured within the NACE
one-digit code for large sectors. When we further specify the breakdown of
the codes, the averages for two- and three-digit codes are 3 and 4 respec-
tively. The company groups with an average of 6 companies are devoted
to 4 different activities if calculated with the NACE 3-digit code, or to 3, if
the NACE calculation is within the one-digit sphere.
For the values of the average number of activities of the 50 family busi-
ness groups taken together, the number of different sectors increases with
the level of precision (number of digits considered) from 2.76 for a one-digit
NACE to 4.9 for a three-digit NACE. In other words, the 11.2 companies
of the average are devoted to only 2.76 different NACE one-digit activities,
whilst the number of different activities of these companies with greater
sectorial precision is 4.9. However, these levels of diversification provide
little information, as it is difficult to establish points of comparison. Nor
Table 12.8 Family groups and sectorial diversification according to

number of different NACE codes and group size
Number of different
Number of
Panel A: median values NACE codes
companies per
Family group size 1 digit 2 digits 3 digits group
Small 2 2 3 3
Medium 3 3 4 6
Large 3 6 6 16
Overall 3 3 4 6.5
Panel B: average values
Small 2.00 2.31 2.69 3.25
Medium 2.59 3.12 3.76 6.88
Large 3.65 5.82 8.12 22.76
Overall 2.76 3.78 4.90 11.12
can such points of comparison be established with non-family-business

groups, as it becomes difficult to define where these other groups begin and
end. Moreover, there are no references for other studies on family business
groups in other geographic regions, thus making the assessment of these
levels of sectorial dispersion more difficult.
All the same, Table 12.8 displays some interesting results: if we divide
our sample of 50 family business groups into three sub-groups according
to their size, we will see how the small groups form an average of around
3.25 companies per group, the medium family groups have 6.8 companies
and the large groups show an average of 22.7. The overall median value of
these large family groups is 16 companies per group. In other words, we
see that the greater organizational complexity of large family groups by
virtue of their numerous companies is actually based on businesses within
the same activity sector. At the other extreme, for the smaller family groups
each branch of activity appears to be proportionally closer to a different
company, particularly for the three-digit sectorial classification.
This first approach to the diversification strategies of the family business
groups leads us to the conclusion that large groups tend to diversify more
in absolute terms, which is probably explained by the fact that their larger
size entails a large number of companies, in relation to the medium and
small family business groups. We can also conclude that when entering new
economic activity sectors, which may or may not be interrelated, the large
family groups do so with a larger number of companies, whereas the small
family groups tend more towards the structure of companies that are each
associated with a different activity, if they opt for several companies.
A descriptive study based on calculating the number of different activi-

ties that a family business group has become involved in is highly sim-
plistic. Such approach assumes that each and every one of the activities
bears the same weight within the business group, thus skewing the results
towards potentially fictitious diversification rates.
Hence, we next proceed to a more sophisticated analysis that takes into
account the relative importance of each of the companies within the group.
The literature on business diversification often makes use of the entropy
measure to offer a weighted assessment of the degree of sectorial diversifi-
cation, enabling the distinction between related and unrelated diversifica-
tion. Our entropy measure uses a weighted average of the activities within
the business group at a NACE three-digit level in relation to diversification
at a one-digit level.13 This is a typical continuum measurement that assigns
higher values to high diversification levels and lower values to low diver-
sification levels.
By way of example, consider two business groups with construction,
hotel and food activities. Group A has 90 per cent of its activity in hotels,
5 per cent in construction and another 5 per cent in food. Group B has
one-third of its activity in each of the aforementioned sectors. If we only
take into account the different NACE numbers in each case, there are 3 in
both groups, leading to the misleading conclusion that Group A is just as
diversified as Group B. The entropy index instead gives us a value of 0.39
for Group A, whereas for Group B the index is 1.09. The entropy index is
thus a more precise depiction of the concept of business diversification.
As occurs with the NACE number diversification measure, the simple
observation of the entropy index values offers little information on the inten-
sity of diversification. Once again, because we have no non-family business
groups as a control group, our study must be limited to the differences in
behaviour according to the size of the different family business groups.
Panel A of Table 12.9, which shows the entropy index diversification
median values for each of the three family group sizes, does not differ con-
siderably from Panel B, which displays the average of each of these group-
ings. We must point out that related diversification is more important than
unrelated diversification for any family group size. In fact, in Panel B, the
average of the entropy coefficient for all of the business groups together
is 0.93 while the unrelated diversification is 0.56. Hence related diversifi-
cation accounts for 62 per cent of the total diversification, and unrelated
diversification explains the remaining 38 per cent. These values show how
diversification particularly revolves around the group’s core business
areas, though with some dispersion in areas that are not directly related to
such central business activities.
This behaviour is more pronounced in the small family groups, which
Table 12.9 Family groups and entropy coefficient for related and unrelated
diversification according to the size of the business group
Panel A: median values Diversification

Family group size Related Unrelated Total
Small 0.71 0.55 1.38
Medium 0.79 0.60 1.51
Large 0.90 0.68 1.75
Overall 0.81 0.6 1.48
Panel B: average values
Small 0.84 0.44 1.28
Medium 0.90 0.59 1.50
Large 1.03 0.64 1.67
Overall 0.93 0.56 1.49
often hinge two-thirds of their diversification on a main activity. Even

though the entropy measure plots the relative importance of an economic
activity sector within the family group, the diversification value is greater
in large groups than in small groups, for both related and unrelated diver-
sification. As a result, we see that the larger family groups diversify more
than smaller groups, even when the measure of diversification weights the
relative importance of each activity. This effect of diversification is based
more on related diversification for the small groups than for the larger
groups.
The concept of entropy takes in the organizations’ natural tendency to
become more complex through time. In our case, diversification comes to
take on this tendency in connection with the growth and age of the organi-
zations, and particularly for family businesses in which successive genera-
tions are admitted into the company. In the case that this assertion is true,
the level of diversification will grow with the overall age of the companies
that make up the family business group.
In fact, as can be seen in Figure 12.1, the business groups that amass
greater experience, with more consolidated and more numerous compa-
nies, adopt higher levels of diversification. For well-established family
groups with several generations of experience, the evolution through time
that accompanies the years of business experience leads to the decision to
diversify to a greater extent than the diversification generally undertaken
by younger family groups.
This study of diversification gives us a reference of the behavioural
business patterns of the family groups to diversify risks by investing in
Small groups Medium groups Large groups

1000
Accumulated number of years
of companies of the group
Total diversification values

Adjustment
500
0
0.5 1 1.5 2 2.5 0.5 1 1.5 2 2.5 0.5 1 1.5 2 2.5
Figure 12.1 Level of sectorial diversification (entropy) and accumulated

age of the companies within the family group
different sectors of activity. It is not only the reduction of financial risks

that explains the tendency to diversify. Economic efficiency reasons,
such as the attainment of economies of scope, capitalizing on specific
skills or aptitudes within the company, or the mere need to allocate the
funds generated by the business activity can explain this tendency to
diversify.
On the other hand, diversification also brings along potential expenses,
given the need to incorporate new skills into unrelated activities, difficul-
ties in implementing systems of control when the activities are diverse and
even inefficiencies in the allocation of resources outside the discipline of
the capital markets.
The advantages and disadvantages of business diversification are proc-
essed by the controlling shareholders, which by definition in the case of
family groups are the family members. All the same, diversification can
require the incorporation of new skills or simply of new financial partners,
which can lead to the possible dilution of family control. These aspects are
further explored in the next section.
5.3 Business Group Directors and the Family
The control of the companies within a family group can be organized

into many different possible models between two extremes: at one end of
the spectrum, the governing bodies can revolve around a small number
of people who amass offices as board members in each of the companies;
and, at the other end, the administrative bodies can be entrusted to a

large number of individuals that barely repeat from one company to
another.
If we form a hypothetical board of directors of the business group, by
adding up the members of the boards of directors within the family groups,
we can shed some light on these matters. The representative family group of
our sample, made up of 11 companies and 4 board members per company,
could be described, at the lowermost limit, as a family group entrusted to
a number of people that equals the size of the largest board in the group.14
On the other hand, the maximum possible number of board members could
be applied, in which case it would be made up of 44 different people. Table
12.10 illustrates the average and median values for the 50 family groups in
our sample. Panel A shows how the median number of companies per family
group is 6 and the number of board member posts to be covered is 23. On
average, the family groups entrust these 23 board positions to 10 different
individuals. Panels C and D of Table 12.10 contain the proportions of each
type of relative in relation to the size of the board. The median (Panel C) for
the dispersion of individuals is 43 per cent, and the average for such items is
41 per cent, as can be seen in the same column in Panel D.
As we have seen in the previous section, there are significant differences
in the median values for the business groups according to their size per
asset volume. Thus, the small groups with 3 companies use 4 different indi-
viduals to cover the 7 positions. Abounding in this sub-sample of smaller
family groups are companies with sole administrators. This circumstance
makes the proportions to which they become open to different individuals
higher than in larger size business groups.
For the large groups, as illustrated in Panel B, the number of different
individuals is higher, simply due to the larger size of their boards of directors.
However, the proportion of different individuals is the lowest of the three
business group sizes, with a proportion of 38 per cent, as shown in Panel D.
As a result, we can conclude that the associated family groups in the
Balearics rely on a common nucleus of 6 people for every 10 board posi-
tions to be covered. This proportion is smaller in the small family groups
than in the larger ones, which in absolute terms place their posts in the
hands of a larger number of different individuals.
These measures of diversity or dispersion of individuals do not necessarily
comply with the dictates of the family centre of control. Thus, for companies
that have outside members or bring in experts in certain lines of business for
technological reasons, the dispersion rates can vary considerably.
Yet, from the perspective of family groups, the salient question is how
many of the individuals that form part of the boards of directors actually
share family ties. The data available in the public registries, which in this
Table 12.10 Opening of family groups to non-family board members,

for different degrees of kinship, according to the size of the
business group
Panel A: median Dispersion of board members

values (number)
Family group Number of Board Different Different Different
size companies members individuals ‘siblings’ ‘cousins’
per group
Small 3 7 4 3.5 2.75
Medium 6 22 9 7 4.5
Large 16 59 34 29 19
Overall 6 23 10 8 6
Panel B: average Dispersion of board members
values (number)
Small 3.25 10.69 7.13 4.81 3.88
Medium 6.88 24.18 11.12 8.65 6.59
Large 22.76 93.59 35.29 30.29 19.53
Overall 11.12 44.44 18.06 14.78 10.12
Panel C: median Dispersion of board members
proportions (proportion)
Small 0.57 0.50 0.39
Medium 0.41 0.32 0.20
Large 0.58 0.49 0.32
Overall 0.43 0.35 0.26
Panel D: average Dispersion of board members
proportions (proportion)
Small 0.67 0.45 0.36
Medium 0.46 0.36 0.27
Large 0.38 0.32 0.21
Overall 0.41 0.33 0.23
case come from the Trade Registry (information recorded in the SABI
database we use), give us the identities of the members of the different
boards of directors. One way to examine family control and take advan-
tage of the name and two-surname structure in force in Spain is to look
at the number of family ties among board members. Thus, the individuals
who share both first and second surnames will be listed as siblings, and
those who share only one surname will be listed as ‘cousins’. The sibling
kinship listings will seldom lead to an error when considering family ties,
with the exception of situations that stem from second marriages or other
special cases. Undoubtedly however, our cousin listing covers many family
relations beyond those known as cousins in daily language, as it includes,
in addition to actual cousins, parent–child and grandparent–grandchild
relations, and uncle/aunt–niece/nephew relations.
The concurrence of surnames on a board of directors of a family group
is a reasonable indication of the degree of kinship among its members,
and its consideration thus enables us to quantitatively evaluate the extent
to which families keep the control of the business groups in the hands of
family members or the degree to which they are open to the inclusion of
non-family members on their boards of directors.
Among the measures of dispersion of board members, Table 12.10 also
offers the median and average values for the number of ‘different siblings’
in the Balearic family groups. For a typical business group, taking the
median values (Panel A), with 6 companies and 23 board members, the
administrative bodies are made up of 10 different individuals. Eight of
them have different pairs of surnames, suggesting that 2 of the 10 are sib-
lings. Moreover, 6 of the 10 members show no surname concurrence with
any of the other members, leading us to believe that there are 2 individuals
of the remaining 8 who have a family relationship that we have generically
listed as ‘cousins’.
These median measures of dispersion for the family group are not pro-
portionally very different from the values presented by the average, which
can be seen in Panel D of Table 12.10. In fact, every 10 seats on the boards
of directors are covered by a little more than 4 individuals (average 41
per cent proportion). More than 3 of those individuals are not siblings
(average 33 per cent proportion), and nearly 2 of them have no family
relationship that can be inferred from the surname (average 23 per cent
proportion).
Panel D of Table 12.10 also shows us the existing differences between
the small family groups and the larger ones, as regards the proportion of
board members that share family ties. The small family groups incorporate
greater proportions of individuals without sibling or ‘cousin’ family ties
onto their boards of directors. These proportions of outsiders to the family
are considerably lower in the large family groups, despite the fact that the
latter tend to incorporate a larger number of non-family members on their
boards, by virtue of the larger numbers of board seats.
5.4 Sector Diversification and Family Control
There is one last aspect that allows us to find relations between two of the
points that we have discussed thus far: on one hand, diversification as a
relevant aspect of the family group policy, and on the other, the degree to
which the boards of directors are open to include board members from
outside the family.
Here, the relevant question is whether the family groups that opt for
greater sectorial diversification do so through tighter family control over
the governing bodies or whether they rather tend to be more open to the
inclusion of outsiders on their boards of directors. There are numerous
theory-based arguments in favour of and against family control of diver-
sified companies. Family expansion in new business areas may require
the incorporation of new members, whether financial (who contribute
monetary resources) or technological (who bring in new know-how or
organizational skills in order to carry out new activities). For a given size
of the family that controls the business group, embarking on new business
ventures can depend on the family members’ management skills or knowl-
edge of the new sector. If these requirements are fulfilled, one could expect
greater degrees of diversification to be accompanied by a larger number of
members from outside the family, and the proportion of family members
on the boards of the companies within the group would be lower than on
those of the groups that do not diversify.
On the other hand, the expansion into new business areas can also mean
the potential loss of family control over the activities of the group of com-
panies. The incorporation of new executive directors or managers of new
business areas may require greater board supervision and control, which
will be exercised by appointing family members as board members. In these
situations, the mechanisms of trust are what justify a strong family pres-
ence to prevent the loss of control over the important decisions made in the
group’s companies. If this effect is prevalent, we might anticipate that the
higher the degree of diversification, the higher the rates of family members
on the boards of directors in the family business groups.
Table 12.11 shows the average values and proportions of the groups’
openness to non-family members on the boards of directors, and divides
the business groups according to their overall diversification level (meas-
ured by means of the entropy index). The results of Panel A are clear:
greater diversification goes with a larger number of different individuals
as well as a larger number of sibling board members. The cousin-relation
trend follows a similar pattern: the greater the sectorial diversification, the
larger the number of individuals with no surname concurrence. This trend
is explained by the size of the business group: greater sectorial diversifica-
tion also occurs with a higher number of group companies. This necessary
opening of the company to incorporate new talent or new partners into
the diversified activities is explained by how they complement the family
administrators.
Table 12.11 Opening of family groups to non-family board members,

for different degrees of kinship, according to the degree of
sectorial diversification
Panel A: average values Dispersion of board members

(number)
Sectoral Number of Board Different Different Different
diversification companies members individuals ‘siblings’ ‘cousins’
per group
Low 3.25 10.69 7.13 4.81 3.88
Medium 6.88 24.18 11.12 8.65 6.59
High 22.76 93.59 35.29 30.29 19.53
Overall 11.12 43.46 18.06 14.78 10.12
Panel B: average proportions Dispersion of board members
(proportion)
Sectoral Different Different Different
diversification individuals ‘siblings’ ‘cousins’
Low 0.67 0.45 0.36
Medium 0.46 0.36 0.27
High 0.38 0.32 0.21
Overall 0.42 0.34 0.23
Panel B of Table 12.11, nevertheless, shows that as the business groups

diversify more, they become less open to non-family members. Indeed, the
proportion of non-sibling board members in relation to the total number
of board members for the group is 45 per cent for the family groups with
more limited sectorial diversification, whereas for more diversified groups
the rate is only 34 per cent. A similar result is seen when the type of family
relation taken into consideration is limited to one surname. In such cases,
the less diversified groups display a 36 per cent proportion of ‘non-cousin’
individuals, whereas the more diversified groups only have a 21 per cent
dispersion rate, suggesting that the remaining 79 per cent of the members
share a surname.
This study can lead to the conclusion that the more diversified business
groups incorporate a larger number of new talents into their boards of
directors, and that such new individuals do not necessarily share any family
relations with already-existing members. Nevertheless, the control effect is
also prevalent, as the proportion of non-family members brought into the
group is increasingly lower in relation to the members that share some sort
of family tie.
6. CONCLUSIONS
This chapter presents a general description of the business groups of fami-
lies that belong to the ABEF and IEF associations in the Balearic Islands.
The first thing to be verified, their economic relevance in the general level
of economic activity of the Balearic Islands, has become evident when we
evaluate their weight through aggregate measures such as total regional
employment and GDP.
We have presented a description of the organizational structure of the
companies that belong to the associated families, which are analysed indi-
vidually. Organizational aspects such as the size of the boards of directors
and the most relevant economic information from their annual accounts
reveal large disparities in activity sectors and company size. The relatively
high presence of women in the governing bodies of the companies (by
Spanish standards) is also worthy of note.
The 566 sample companies are not intended to be a representative
sample of the economic activity of the Balearics. However the distribution
of their activities in the different sectors, and particularly those directly or
indirectly associated with tourism, are not significantly different from the
information of the aggregate official statistics.
We also have analysed the characteristics of the business groups that
have been formed around the 50 member families studied. Once again,
the diversity of the sizes has allowed us to undertake a homogeneous
comparison after grouping them according to their asset volume. These
groups of companies are formed around one or two central companies,
which generate nearly 70 per cent of their activity, despite the fact
that the average number of companies per group is eleven. The largest
family business groups present higher degrees of sectorial diversification,
although it is the smallest groups that base a larger proportion of their
diversification on activities that are not related to their main core busi-
ness activity.
The study of the governing bodies of the family groups reinforces the
idea of family control in the sense that these groups rely on a small group
of people to serve as board members in their companies, and the types of
family relations among them are diverse. This phenomenon is more pro-
nounced in the largest family groups: by having larger boards of directors,
the number of different people that they rely on is also larger. However,
these larger groups also show a larger proportion of board members that
share family ties than the smallest family groups do.
The trust effect inherent in the inclusion of officers that share family ties
is predominant over the entry of non-family member officers for the com-
panies with the highest rates of sectorial diversification, demonstrating that
diversification strategies are possible while keeping the family structure of

the business groups intact.
Future studies could enhance the description of these family groups by
following two basic approaches. The first would be to gradually incorpo-
rate new sources of data that would allow us to describe in greater detail
the elements discussed here and explore new aspects of the organization
of the family groups. For example, it would be interesting to look into the
requirements for the degree of participation of women on the boards of
directors of these companies. Could such participation be contingent on
the founding generation’s continued control of the business group or on
successive generations being incorporated into it? We have taken an aggre-
gate approach to family relations, using public information. A detailed
study of the specific posts held by the family members and outsiders might
clarify the concept of family control, while enabling us to ascertain the true
role of the women in this mechanism of control. Secondly, here we have
offered a static description of these family business groups. It would be
interesting to follow their evolution through time, which would allow us to
examine the determining factors of the groups’ business organization deci-
sions in greater detail, their diversification strategies, their organizational
structure and even their profitability.
NOTES
1. See Shanker and Astrachan (1996) and Sharma (2003) for a discussion and different
definitions of family firms, based on the degree of family involvement in the firm.
Another literature develops a typology of family firms along the potential combinations
of three axes: the ownership of the firm, the family structure and the characteristic of the
company (see Gersick et al., 1997; Neubauer and Lank, 1998).
2. Indeed, it has been argued that one main non-pecuniary benefit for family members to
own and control a firm is the satisfaction of transferring the firm to the descendants (see
Casson, 1999).
3. The law has recently been modified in Spain, so that the order of surnames can be
changed: first the mother’s surname, and then the father’s surname. This change can be
done by mutual agreement of both parents, or by the choice of the concerned individual
when he/she reaches the age of majority (18 years). Until now this modification has had
almost no practical impact on the structure of surnames in Spain.
4. In any case, the reader will have to bear in mind that the data on the companies studied
do not exclusively refer to the economic activity or employment generated in the
Balearic Islands. Indeed, when a hotel chain of an ABEF member, for example, has
establishments in Mexico, and its earnings are calculated within a Spanish company that
is included in the database that we have used, such economic activity is under the control
of the member families of the ABEF and is therefore taken into account in our study of
the economic activity of the family businesses under control of ABEF-member families,
although it is not an economic activity in the Balearic Islands. Similarly, our study
calculates the activity of the Banca March, where it is a well-known fact that this insti-
tution has a large number of offices outside of the Balearics that generate employment
and economic activity outside of the Islands. By our definition, this is a new economic
activity under the control of a Balearic family business.
5. Let us recall again that we must proceed with caution when drawing these comparisons,
as the sample includes companies under the control of the families of family business
associations in the Balearic Islands, regardless of where their activity is carried out, and
in some cases a significant part of such activity is undertaken outside of the Islands.
6. Actually, the middle tertile is made up of 186 companies.
7. The univariant study presented does not allow us to reach any conclusions or explana-
tions for the non-monotonic behaviour of a variable, although we could make some
speculations on this significant fact.
8. These also include those of the group Globalia.
9. Section 3 above explains the procedure we follow to assign the companies to Balearic
ABEF- and IEF-member families.
10. If, rather than measuring the importance in relation to the total activity volume, the
average relative importance of the largest company is measured and expressed in the
percentage of each family group, such percentage goes up to 56 per cent.
11. There is a large literature that tries to evaluate the possible benefits of diversification
for firms; see Campa and Kedia (2002), Grant et al. (1988), Hadlock et al. (2001) and
Villalonga (2004). For the particular case of family firms, see Anderson and Leeb
(2003).
12. Anyway, let us mention that, for the family firm, Anderson and Reeb (2003) find that
family firms diversify less than non-family firms.
13. The use of the entropy index for measuring diversification is based on work by
Jacquemin and Berry (1979). For further details, see Appendix 12.1, which displays the
breakdown of the entropy index.
14. For a group of 11 companies with 4 board members each, the minimum number of
people to whom the administration would be entrusted in this case would be 4.
REFERENCES
Anderson, R.C. and D.M. Reeb (2003), ‘Founding-family ownership, corporate

diversification, and firm leverage’, The Journal of Law and Economics, 46, 653–84.
Campa, J.M. and S. Kedia (2002), ‘Explaining the diversification discount’, The
Casson, M. (1999), ‘The economics of the family firm’, Scandinavian Economic
History Review, 47, 10–23.
Gersick, K.E., J.A. Davis, M. Hampton and I. Lansberg (1997), Generation to
Generation: Life Cycles of the Family Business, Boston: Harvard Business School
Press.
Grant, R.M., A.P. Jammine and H. Thomas (1988), ‘Diversity, diversification, and
profitability among British manufacturing companies’, Academy of Management
Journal, 31, 771–801.
Hadlock, C., M. Ryngaert and S. Thomas (2001), ‘Corporate structure and equity
offerings: are there benefits to diversification?’, Journal of Business, 74 (4)
613–35.
Jacquemin, A.P. and C.H. Berry (1979), ‘Entropy measure of diversification and
corporate growth’, Journal of Industrial Economics, 27, 359–69.
Neubauer, F. and A.G. Lank (1998), The Family Business: Its Governance for
Sustainability, London: Macmillan.
Shanker, M.C. and J.H. Astrachan (1996), ‘Myths and realities: family businesses’
contribution to the US economy: a framework for assessing family business

statistics’, Family Business Review, 9 (2), 107–23.
Sharma, P. (2003), ‘Stakeholder mapping technique: toward the development of a
family firm typology’, mimeo, Laurier Business & Economics.
Villalonga, B. (2004), ‘Diversification discount or premium? New evidence from
the business information tracking series’, Journal of Finance, 59 (2), 475–502.
APPENDIX 12.1 THE ENTROPY INDEX

This index is used as a measurement of diversity. In our case, it allows us to
assess the extent to which a family group diversifies its activity in different
economic sectors.
If Pij is the proportion of the assets of a given business group in activity
i (NACE 3-digit code) in industry j (NACE one-digit code), the entropy
index for the total diversification of this business group is calculated as
follows:
m n
Total diversification 5 DT 5 a a [ Pij 3 ln (1/Pij) ] for Pij 2 0
j51 i51
Jacquemin and Berry (1979) propose the following breakdown of the

total diversification into related and unrelated diversification:
m n Pij Pij
Related diversification 5 DR 5 a Pj a c a b 3 lna b d
j51 i51 Pj Pj
m Pij
Non-related diversification 5 DNR 5 a Pj 3 lna b
j51P j
It must be noted that these two measurements and the measurement of

total diversification are consistent in the sense that the measurement of the
entropy of the total diversification is the sum of the related and unrelated
diversification, DT 5 DR 1 DNR.
Reference
Jacquemin, A.P. and C.H. Berry (1979), ‘Entropy measure of diversification and
corporate growth’, Journal of Industrial Economics, 27, 359–69.
13. Better firm performance with
employees on the board?
R. Øystein Strøm*
1. INTRODUCTION
This chapter deals with the impact of co-determination1 upon firm per-
formance. Two conflicting views on the benefits of co-determination exist.
One says that co-determination increases firm performance, either because
employee directors supply outside directors with information they would
otherwise not have access to (Freeman and Reed, 1983; Blair, 1995),
or because co-determination is a safeguard against dismissal, inducing
employees to invest in firm-specific human capital (Zingales, 2000; Becht
et al., 2003). The other view is that owners’ and employees’ interests are
not aligned, and therefore allowing employees into the boardroom means
that conflicting goals are pursued. When decision makers with different
objectives share in the board’s decisions, its focus may become unclear
(Tirole, 2001), its decision time longer (Mueller, 2003), and its decision
quality inferior.2 The prediction is that firm performance will be lower than
it could otherwise be.
Even though co-determination is important in many European coun-
tries,3 few firm-level studies have been made of its firm performance
impact. This chapter is an attempt to bring more academic research to
the still under-researched (Goergen, 2007) comparison of firm perform-
ance in shareholder determined companies and co-determined companies.
Earlier studies give mixed results, showing a negative impact in German
firms (Fitzroy and Kraft, 1993; Schmid and Seger, 1998; and Gorton
and Schmid, 2000, 2004), Canadian (Falaye et al., 2006), and Norwegian
(Bøhren and Strøm, 2008), but a positive impact in a later German study
(Fauver and Fuerst, 2006).
Compared with former literature, the simultaneous equation estimation
of the relationship between firm performance and explanatory variables is
the distinctive feature of this chapter. The need for simultaneous modelling
arises from the fact that the presence of employee directors may induce
shareholders to adjust other governance mechanisms, notably board
323
composition and leverage, in order to neutralize the co-determination

effects (Buchanan and Tullock, 1962). Employee directors may have a
direct impact upon firm performance, but also an indirect effect. This also
means that board composition is at least partly determined by employee
directors. Thus, the chapter necessarily also relates to the board endogene-
ity issue (Hermalin and Weisbach, 2003). And since the data cover several
periods, it is possible to test the reverse causation hypothesis that firm
performance determines board composition (Hermalin and Weisbach,
1998). The simultaneous equation setup allows not only the discovery of
endogeneity in governance mechanisms, but also a quantification of its
importance compared with direct effects. I am unaware of former literature
containing a measure of the endogeneity effects.
The chapter’s results come from a panel data set of non-financial firms
spanning the 14 years from 1989 to 2002, containing financial information,
data on ownership, and board composition data. Employee representation
was mandated by law in 1972 in Norway, and regulations have remained
almost unchanged since (Aarbakke et al., 1999). The data on employee
directors seem to be superior to those pulled from German and Canadian
institutional frameworks. While the employee director in a German board
may be elected from the national labour union, and the Canadian evidence
is from firms where employees have considerable shareholdings, in Norway
the employee director must be employed in the company. Furthermore,
because the mandatory employee director rules only apply to certain firms,
some firms have employee directors, others have none. Thus, the study
avoids the Dow (2003, p. 87) objection that empirical investigations on
the effects of employee directors suffer from a lack of control group. Thus,
unlike previous studies, the Norwegian institutional framework allows
comparison between similar firms with and without employee directors.
This setting allows for sharper estimates of the co-determination effects.
The chapter has relevance for the emerging regulation literature on boards
(Hermalin, 2005). Because the sample includes both the co-determined (by
regulation) and the shareholder determined kind, I can study the effects of
governance regulation by comparing the two sub-samples.
Compared with the related Bøhren and Strøm (2008) study, I introduce
a number of new features. I construct a board structure index that cap-
tures many standard board characteristics in the same manner as Bertrand
and Mullainathan (2001), I add financial leverage and average wage as
new explanatory variables, I perform a system estimation rather than a
single-equation estimation, and I make separate regressions for various
sub-samples, for instance employee director firms only. These steps should
yield better estimations of the employee director impact than the partial
regressions in Bøhren and Strøm (2008), and should also subject the
Better firm performance with employees on the board? 325
co-determination hypothesis to more severe robustness tests. Furthermore,

I confirm their results when using individual board characteristics instead
of the board index.
In order to fully utilize the information in the panel data, I use the fixed
effects model (Woolridge, 2002), employing a three-stage least squares
(3SLS) methodology in system estimations. With the fixed effects method,
I am able to remove firm heterogeneity, as did Palia (2001). Therefore, few
(if any) control variables are needed.
Using Tobin’s Q as the measure of firm performance, the results confirm
the employee directors’ negative relationship to firm performance in earlier
studies, but also show a positive indirect effect on the board index and
leverage. This reflects endogeneity, but the economic significance of the
indirect effects turn out to be much smaller than the direct. The reverse cau-
sation hypothesis also finds confirmation, since lagged firm performance
is significant regarding both the board index and leverage. But again, the
indirect effects of the lagged firm performance are low compared with the
direct. I find clear differences in the various board characteristics’ impact
upon firm performance in sub-samples of co-determined and shareholder-
determined firms. This means that regulations have costs, both in relation
to firm performance and in the remaking of boards. The results stand up
to a number of robustness tests, including alternative performance meas-
ures (stock return and accounting return on assets), and also to dividends
replacing leverage.
The chapter proceeds as follows. In the next section, a brief review of
the literature is given. Then, in Section 3 testable implications are spelled
out. Section 4 contains data sources and institutional background, while
Section 5 discusses estimation methodology. Then Section 6 shows results,
in Section 7 robustness checks are undertaken, and Section 8 concludes.
2. LITERATURE REVIEW
Few empirical studies of co-determination have been undertaken. Evidence

in Fitzroy and Kraft (1993), Schmid and Seger (1998), and Gorton and
Schmid (2000, 2004) shows that co-determination has a negative economic
effect upon firms in Germany, where employees have the right to equal
representation in the Aufsichtsrat with shareholders. Recently, Fauver
and Fuerst (2006) find a positive relationship to performance in a 2003
sample of German companies in information intensive industries. In the
regressions with all industries, however, the relationship is not significant.
The German data often contain two kinds of employee directors, some
elected from among the employees in the company and others, national
union representatives. In contrast, the Norwegian system is such that only

persons employed in the company may be elected. Thus only a company
and not a national union representative may sit on a Norwegian board.
Presumably, company employed persons are more authentic stakeholders
than their national union representatives.
Using Canadian data, Falaye et al. (2006) find that firms giving employ-
ees a greater voice in corporate governance spend less on new capital,
take fewer risks, grow more slowly, create fewer new jobs, deviate more
from value maximization, show greater cash flow problems, and exhibit
lower labour and total factor productivity. This chapter is set in a different
institutional environment. The Canadian employee directors are elected in
their capacity as owners of company shares. The influence of these direc-
tors on firm performance thus picks up two effects, one as a supplier of
labour services, the other as owner. None of these studies use panel data
or simultaneous data estimations.
Using Norwegian data, Bøhren and Strøm (2008) show that the
employee director variable has a negative impact upon Tobin’s Q. They
also find evidence of interdependencies among board characteristics.
However, they do not explore the indirect effects of co-determination, nor
do they carry their analyses into sub-samples of co-determined and share-
holder determined firms. In this chapter, the analysis is extended to include
effects upon average wage, leverage is a new governance variable, and the
board index is defined; I employ simultaneous equations modelling, and
perform regressions in sharply defined sub-samples. The robustness tests
are also more extensive, as I use return on assets and stock return as new
dependent variables, and also vary the definition of the board index.
3. THEORY AND HYPOTHESES
3.1 Stakeholder or Interest Group?
Board decisions include the formulation and control of strategy, larger

investments and disinvestments, and the determination of the company’s
organization. Employee directors’ influence upon these decisions may have
long-time impact upon firm performance. Therefore, an analysis over a
long period of time is needed to detect the effects. The impact upon firm
performance could be positive, non-significant, or negative.
One possibility is that the firm performance and employee link is posi-
tive. Blair and Stout (1999) view stakeholders as members in a team pro-
duction. Since stakeholders make firm-specific investments, it is in their
interest to co-operate. The firm-specific human capital investments make
the employees residual claimants to much the same extent as shareholders

(Zingales, 2000; Becht et al., 2003). The upshot is that employees should
be represented on the board, and that this co-determination will lead to
improved firm performance. The conclusion rests on the argument that the
stakeholders’, including the shareholders’, interests are aligned.
How could this be manifested in the board? Employee directors could
have a dual informational role in bringing inside information to the board
(Blair, 1995, p. 16) but also relating board information to the employees
(Freeman and Lazear, 1995). Since employees are in the middle of the
day-to-day running of the company, they may bring valuable operational
knowledge to the board. The information may expand on or contrast with
information from the CEO. Thus, the information set available to the
outside directors is enlarged. This comes close to viewing the employee
director in the same role as the insider in the Raheja (2005) theory,
although in this model the insider is willing to furnish the outside directors
with information only if this furthers his own career interests. Secondly,
the role as messengers of board information to the employees at large
could be of particular value in the case of personnel reductions or plant
closures, when the board may want to instil an understanding for the need
for drastic measures among employees. The dual informational role of
employee directors should lead to better firm performance (Fauver and
Fuerst, 2006).
Another possibility is that co-determination has no significance for firm
performance. This may come about through co-optation (Pfeffer, 1981, pp.
166–73). In the board employee directors are exposed to fiduciary duties
and conformity pressures to accept the shareholder value logic. Also, since
the employee director is made co-responsible for decisions with adverse
outcomes for employees, the decisions carry higher legitimacy among
employees. If co-optation is the case, interests are again aligned, but this
time because employee directors have taken on the views of shareholders.
The effect upon firm performance should be non-significant.
The third possibility is that the co-determination impact upon firm
performance is negative. It may be hard to accept the premise that stake-
holder interests are aligned. If this were so, co-determination would be
an efficient economic organizational mode, and firms would adopt this
mode voluntarily (Jensen and Meckling, 1979; Hansmann, 1996). But
while shareholders seek to maximize residual income, employees want to
maximize pay and the protection of firm-specific human capital,4 that is,
a part of the residual income. The inconsistency of these two objectives
makes the board decision process longer and more difficult (Mueller, 2003).
The firm’s objectives may become unfocused, and the CEO may develop
capabilities as a compromise maker rather than a shaper of the firm under a
clear objective (Tirole, 2001, 2002). The implied consensual decision model
in co-determination means that the firm pursues stability and predictability
instead of bold new moves (Siebert, 2005). If employee directors are suc-
cessful, they should influence the average wage positively. The unfocused
decision structure should result in weaker firm performance. I call this the
interest conflict model for reference, and hypotheses stemming from the
model are set forth in the next section.
When objectives diverge, shareholders and employees may game against
each other so as to further their own interests. Employees may furnish
information strategically to further their own interests (Pistor, 1999;
Hopt, 1998), and they may use moral arguments in parallel. Information
strategizing could take the form of economizing on the supply of internal
information to the board. For instance, employee directors may not inform
of low productivity units in the organization. Another form could be infor-
mation leakage from the board.5 Employee directors will hardly inform
their fellow workers only on matters that owners and management find
in their interests to inform about. Stakeholder theorists seem to assume
only beneficial information dissemination through employee directors.
Furthermore, moral arguments against, for instance, plant closures or high
management pay may be put forward, too. The shareholder elected direc-
tors may have trouble withstanding such arguments, since they may experi-
ence large personal costs and small personal gains from making decisions
that affect employees adversely (Baker et al., 1988). Taking the issue to the
public attention could make the decision even harder for the shareholder
elected directors. Thus, even though the employees are in a minority posi-
tion in the board, they may influence board decisions to their advantage.
Their access to board information seems to be vital in this respect.
But the presence of employee directors may have indirect effects upon
the use of other governance mechanisms as well. Shareholders may adjust
governance mechanisms in order to neutralize the co-determination impact.
This is analogous to the situation Buchanan and Tullock (1962) point out,
that when an exogenous regulation is imposed upon a (political) committee,
it will try to compensate for the regulatory effect by placing a heavier weight
on the unregulated. These previously unexplored indirect effects make a
simultaneous equations approach necessary. In the remainder of this section
governance mechanisms and hypotheses about interactions are explained.
3.2 Simultaneity and Endogeneity
In a simultaneous equations system some variables are endogenous, others

exogenous. In the present setup, the exogenous variables are the fraction
of employee directors, the lagged firm performance, the firm size, and firm
risk. Since employee directors are imposed from outside the firm, they must
constitute an exogenous variable. These variables determine firm perform-
ance and average wage, but also the intervening governance variables, the
board characteristics and leverage. Thus, the intervening governance vari-
ables and the average wage are at least partly determined by the employee
directors and lagged firm performance. The simultaneous setup gives the
researcher the opportunity to recognize the governance variables’ endo-
geneity, but at the same time also to measure the magnitude of the effect
relative to their direct effects upon firm performance.
Specifically, the co-determination hypothesis says that the mechanism of
employee directors has a negative relationship to firm performance, but a
positive one to average wage, the board characteristics, and leverage. The
reverse causation hypothesis says that lagged firm performance is associated
with governance variables and average wage, but that signs are uncertain.
The remainder of this section concerns explanations of variables and their
relationships.
In this chapter, shareholders may adjust the board characteristics and
the leverage. In order to achieve a reliable measure, and in the interest of
economy, I build an index by including board characteristics that have
proven to be important in board studies. The board index BI is:6
BI 5 DH 1 BN 2 BS 2 G (1)
DH is directors’ holdings, BN is the board network, BS is board size,

and G is gender. The board index construction follows the Bertrand and
Mullainathan (2001) procedure, as each index variable in equation (1) is
standardized to have average zero and standard deviation 1 before sum-
mation. The sum is then standardized. This gives a continuous variable, in
contrast to the Gompers et al. (2003) type of index. Their governance index
is based upon a subjective allocation of categorical points for reasons that
restrict shareholder rights, and then summed over all characteristics. Since
all variables in equation (1) are continuous, the resulting index is continu-
ous as well, and this is an advantage in estimations. Another advantage is
that the index is likely to be more stable in sub-samples than the individual
variables. The interpretation is that the higher the board index, the better
is the board structure. It should be positive towards firm performance and
negative towards average wage. If it is complementary to leverage, a posi-
tive sign will appear.
The choice of variables in the index reflects important board character-
istics that are decision variables for shareholders. Directors’ ownership
represents the need for the board to be aligned with shareholders, the
network variable the need for the board to be informed, the board size
and gender diversity the need for the board to be decisive. The signs in
are common findings in the literature. The ownership literature (Morck
et al., 1988; McConnell and Servaes, 1990) confirms the positive sign on
directors’ ownership share, and so do studies taking other board character-
istics into account, for example, Bøhren and Strøm (2008).7 The network
variable is little used in studies of boards, but Bøhren and Strøm (2008)
find a positive sign.8 It comprises direct and indirect connections to other
listed non-financial firms stemming from directors’ multiple board seats.
A variety of studies, such as Yermack (1996) and Eisenberg et al. (1998),
document that performance decreases with increasing board size. The rela-
tionship between gender and firm performance may be more controversial,
as Shrader et al. (1997), Smith et al. (2006), and Bøhren and Strøm (2008)
report a negative relationship, whereas Carter et al. (2003) find the oppo-
site. I perform robustness tests with other definitions, described in Section
4, to test the choice of index.
Next, I include leverage. A higher leverage will decrease the firm’s
free cash flow, and will, therefore, limit the potential for agency costs
(Easterbrook, 1984; Jensen, 1986). Perotti and Spier (1993) model how the
lower free cash flow may be used as a bargaining tool against employees,
implying better firm performance and lower average wage. Both effects
should point to higher firm performance from higher leverage. However,
the complexity of leverage leads to an indeterminate prediction. On the one
hand, given the presence of employee directors, owners may fear higher debt
may bring even higher decision costs. If, as Easterbrook (1984) supposes,
higher leverage brings the lender into closer oversight of the firm, the firm
may end up with three decision makers with potentially divergent interests.
Furthermore, if the leverage is also used to signal investment prospects
(Myers, 1977), a high leverage used to discipline employees can be taken to
signal weak investment opportunities in the firm. Another aspect is that, as
Tirole (2006, pp. 51–3) points out, higher leverage may cause costs related
to illiquidity and bankruptcy. This complexity of leverage means that the
sign is uncertain. It could be the case that shareholders in co-determined
firms adjust the leverage in an effort to neutralize employee directors to a
greater extent than they do in shareholder determined firms. In a simulta-
neous equations setup, Brick et al. (2005) find a negative relationship.
Thus, I expect employee directors to be associated with better board
composition and higher leverage. If these are successful from the share-
holder point of view, a positive indirect effect may compensate for the
negative direct employee director effect upon firm performance. In the
stakeholder theory, the employee director should be a welcome addition
to the board, and thus carry a positive sign to firm performance, while
the indirect effects should not appear.
In addition to the endogeneity induced by employee directors, the

reverse causation hypothesis says governance mechanisms may be at least
partly determined by past performance (Hermalin and Weisbach, 1998,
2003). The signs on the board index and the leverage may be difficult to
set out. In the Hermalin and Weisbach (1998) bargaining model the CEO
bargains over pay and monitoring intensity. Good past firm performance
gives the CEO a better bargaining position, which he will use to reduce
monitoring. This means that the association between past firm perform-
ance and governance mechanisms should be negative. However, it may
well be that governance mechanisms are improved after a good perform-
ance, for instance, since the firm learns good practices. Since shareholders
may adjust either board composition or leverage, or both, leverage and
board composition may be either complements or substitutes (Agrawal
and Knoeber, 1996). Thus, the sign is ambiguous.
I study the direct and indirect effects of employee directors in a simul-
taneous setup. Since the lagged firm performance is included, the system
is dynamic. Taken together, and with constants suppressed, this results in
the system of equations
(2)
where FP is firm performance, and FPt21 indicates one period lag; W

stands for the average wage, BI is the board index, DE is the leverage
(debt to equity), ED is employee director, FS is firm size, FR is firm risk,
and uit is the error term. The main hypotheses are summarized below the
coefficients. Thus, the co-determination hypothesis is set out for the ED
variable.
4. DATA AND INSTITUTIONAL BACKGROUND
The sample comprises all non-financial firms listed on the Oslo Stock
Exchange (OSE) at year-end at least once during the period 1989 to 2002.9
Board data are collected from the handbook Kierulfs Håndbok for the first
years, and from the national electronic register at Brønnøysund from 1995.
The register provides information on name, date of birth, and director
status (chairman, vice-chairman, ordinary member, and employee direc-
tor). The CEO’s name and date of birth are recorded as well. The CEO or
director name gives gender information. Data on board and CEO owner-
ship, as well as outside ownership concentration, are pulled from the public
securities register, while share price and accounting data come from OSE’s
data provider (Oslo Børs Informasjon). The ownership structure data cover
every equity holding by every investor in each sample firm. By interna-
tional standards, the size and quality of the data are considerable.
The data for this chapter span the period from 1989 to 2002. During
this period, the law regulating the governance of the companies is
from 1972, with amendments in 1987 (‘Aksjeloven’), and a new law
in 1997 (‘Allmennaksjeloven’). The regulations for representation have
been unchanged since 1987. In this respect, there is no before-and-after
situation, as with the Cadbury Committee (1992) report in the UK, in the
sample period.
As a general rule, firms with more than 200 employees must have at
least two employee directors, or at least one-third of the board.10 In the
size bracket 31 to 200 employees, the firm must have labour board seats if
a majority of the employees vote in favour, first with one representative in
the 31 to 50 bracket, then two in the 51 to 200. The employee director must
be employed in the company. A number of important Norwegian indus-
tries are exempted from these rules, that is, the employees have no rights
of representation in these industries. These include newspapers, news agen-
cies, shipping, oil and gas extraction and financial firms. The characteris-
tics of employee board representation mean that some firms have employee
directors, others do not, and also that co-determined firms have different
fractions of employee directors. Thus, an implication of the regulations is
that comparisons of two sets of differently governed but otherwise similar
firms can be made, and that further analyses can be carried out in sub-
samples of, say, co-determined firms with more than 200 employees. This
data property answers the Dow (2003, p. 87) objection that the study of
co-determined firms lacks a proper control group. I define the employee
director variable as the fraction of employee directors, unlike most former
studies, which only use employee directors as a dummy variable.
This institutional framework offers advantages over the German and
Canadian studies referred to in Section 2, since the Norwegian employee
directors represent an authentic stakeholder group. The German regula-
tions are such that one-third of the employee representatives on German
boards need to be labour union officials (Siebert, 2005). Presumably, the
union officials are supposed to look after the interests of workers in general,
not only those in the firm. No such minimum is required in Norway, and
the employee directors need to be employed in the firm. The Canadian
co-determination comes about when workers are also shareholders in the
company. This might cause a conflict of interests, when the optimal policy
from the shareholder point of view is detrimental to the optimal policy for
workers. In Norway, employee directors are elected in their capacity as
workers in the firm, not through their shareholdings.
The initiative for employee representation came from a joint committee
of the Labour Party and the major employee union (LO) in the early 1960s.
However, concurrent with this initiative, LO and the employer associa-
tion (NAF) ran a ‘co-operative project’ together with researchers to study
co-determination in selected companies. This was in the consensus and co-
operation spirit that arose from common war-time experience. The ques-
tion was not only about co-determination, but also about new production
methods. Later, the need for co-determination in order to improve pro-
ductivity was the guiding principle of the official document NOU (1985:1),
whose recommendations were unanimous, as opposed to the original 1971
report. The insider information argument was behind the codification of
employee board representation in Norway. Thus, it seems as if the lawmak-
ers were familiar with stakeholder theory. Bråthen (1982, p. 14) interprets
the law on co-determination to imply that profit maximization is no longer
the single objective of the company. Employees’ interests now become one
of several objectives the firm has to consider. Thus, a harmony of interests
model is behind the regulations on co-determination in Norway.
Next, I report some descriptive statistics on employee directors. Table
13.1 shows the number of employee directors in firms according to
employment size. The table shows the percentage of firm-year observa-
tions of employee directors in various employment sizes. It turns out that
in firms where employees may demand representation, few do so. In the
101–200 employees category, 61.5 per cent do not have employee directors.
Furthermore, in the highest category, where representation is compulsory
if the industry is not exempted, employees have no board seats in about
one-third of the companies. Among the firms that do have employee direc-
tors, the legal minimum, two representatives, is found in the majority of
cases. Very few have four employee board seats. Thus, the Jensen and
Meckling (1979) conjecture that co-determination requires law backing
seems to be supported in our Norwegian data.
Next, Table 13.2 shows the distribution of employee directors according
to industry, and also the percentage of firms with no employees on the board
in each year. Exempted industries such as Energy and Transport (including
shipping) have no employee directors to a higher degree than average. The
Table 13.1 The percentage of firms with zero or more employee directors
by employment size
Employees Employee directors

N
0 1 2 3 4
0–30 98.4 0.5 0.5 0.5 0.0 190
31–50 95.8 2.1 2.1 0.0 0.0 48
51–100 73.5 5.3 18.6 2.7 0.0 113
101–200 61.5 4.5 24.4 9.6 0.0 156
200+ 33.5 8.1 30.0 27.1 1.3 1006
Total 49.5 6.3 24.0 19.3 0.9
N 749 96 363 292 13 1513
Note: The table shows the percentage of firms having employee directors, according to
employment categories. N is the number of firms in the employee directors or the number
of employees category. The number of employees category reflects the regulations on
co-determination (Aarbakke et al., 1999). With more than 200 employees co-determination
is compulsory. In the 31 to 200 bracket co-determination is realized if an employee majority
demands it, with a larger proportion of representation with a larger workforce. In all
categories, including the above 200 employees, firms in some industries are exempted from
the rules.
low representation in Hotels, restaurants and entertainment is perhaps due

to high labour turnover. The two industries Health care equipment and sup-
plies and Software and supplies also have a lower than average representa-
tion. These are industries where the human capital element should be above
average, and co-determination of extra value, according to stakeholder
theory. Yet, obviously, employees do not demand board seats to a great
extent. The time trend is that firms with no employee directors increase in
relative importance. Thus, nothing in the overall descriptive statistics shows
that co-determination is a preferred organizational mode. Firms seem to
avoid it if they can, and keep it to a minimum if they cannot.
Variable definitions are shown in Table 13.3, which also presents the
main characteristics of variables in the analysis in the two main sub-
samples of co-determined and shareholder determined firms. The table
shows that a large number of variables are distributed differently in the
two sub-samples. The firm performance variables Tobin’s Q and stock
return are not significantly different, while the ROA in co-determined firms
is significantly higher than in shareholder determined firms. Apart from
directors’ holdings, all other variables are significantly different at the 5.0
per cent level or better. Obviously, the two types of firms are different.
The table shows that the fraction of employee directors is 0.301, or
slightly below the minimum requirement for the 2001 employee size group.
Table 13.2 The percentage of firms with zero or more employee directors by industry and the percentage with zero by year
Industry Employee directors

% of N Year % no N
0 1 2 3 4
total empdir
Energy 77.7 1.1 8.2 12.7 0.3 16.0 354 1989 50.5 95
Materials 17.8 8.5 39.5 34.1 0.0 5.8 129 1990 49.5 99
Capital goods 34.5 2.8 35.3 27.0 0.4 11.4 252 1991 48.4 93
Commercial services 49.4 8.9 25.3 16.5 0.0 3.6 79 1992 45.3 95
Transport 77.1 5.8 5.6 11.6 0.0 18.8 414 1993 48.4 91
Autos and components 0.0 4.3 69.6 26.1 0.0 1.0 23 1994 52.4 103
Consumer articles, clothes 24.0 18.0 48.0 10.0 0.0 2.3 50 1995 61.3 186
Hotels, rest., entertainment 90.9 0.0 9.1 0.0 0.0 2.5 55 1996 60.9 192
Media 24.3 8.1 35.1 21.6 10.8 3.4 74 1997 62.8 215
335
Retailing 46.2 6.2 24.6 23.1 0.0 2.9 65 1998 59.0 217
Food/staples Retailing 50.0 0.0 50.0 0.0 0.0 0.4 8 1999 57.3 213
Beverages 36.4 0.0 36.4 27.3 0.0 3.5 77 2000 58.4 209
Health care equip./supplies 75.0 0.0 5.0 20.0 0.0 0.9 20 2001 60.9 202
Pharmaceuticals biotech. 55.2 3.4 24.1 13.8 3.4 1.3 29 2002 61.8 199
Real estate 88.5 3.1 8.5 0.0 0.0 5.9 130
Software/supplies 71.4 5.8 15.3 6.9 0.5 8.6 189
Hardware/equipment 40.2 14.5 23.2 20.7 1.2 10.9 241
Telecom. 15.8 5.3 31.6 47.4 0.0 0.9 19
Total 57.4 5.7 20.0 16.3 0.7 100.0 2208 57.4 2209
Note: The table shows the distribution of employee directors across industries. The Global Industry Classification Standard (GICS) is used. The
whole or parts of the industry may be exempted, for instance the Energy (hydro power and petroleum) sector. Transport contains the important
shipping segment. Media is exempted as well, but in some firms co-determination comes about through union negotiations. ‘Empdir’ is short-hand
for employee directors.
Table 13.3 Definitions of various board measures and their main statistical properties
Shareholder determined Co-determined

F sign
Mean Median Std N Mean Median Std N
Tobin’s Q 1.461 1.105 1.156 867 1.501 1.162 1.064 773 0.459
Stock return 16.109 −1.700 121.515 774 17.666 2.520 78.204 724 0.770
ROA 3.272 6.220 18.840 838 6.531 8.210 13.883 771 0.000
Average wage 558.442 340.878 1516.360 677 355.909 316.306 222.129 762 0.000
Directors’ holdings 0.065 0.000 0.189 966 0.063 0.000 0.187 825 0.828
Network 0.180 0.198 0.115 1264 0.191 0.208 0.075 942 0.015
336
Size1 4.834 5.000 1.330 1267 5.341 5.000 1.271 942 0.000
Gender1 0.024 0.000 0.078 1267 0.045 0.000 0.101 942 0.000
Board index 0.192 0.233 1.877 965 −0.271 −0.078 1.956 825 0.000
Leverage 2.387 1.165 5.955 857 1.903 1.044 3.216 761 0.046
Div. payout rate 0.197 0.000 0.747 960 0.261 0.085 0.564 822 0.042
Empdir 0.000 0.000 0.000 1267 2.282 2.000 0.707 942 0.000
Empdirfrac 0.000 0.000 0.000 1267 0.301 0.300 0.082 942 0.000
Firm size 5.427 5.462 0.788 905 6.071 6.021 0.725 801 0.000
Systematic risk 0.828 0.724 0.749 888 0.707 0.690 0.535 794 0.000
Volatility 0.918 0.646 1.200 885 0.738 0.584 0.597 788 0.000
Notes:
Tobin’s Q is market value divided by book value of assets; Stock return is the raw stock return corrected for dividend and stock split; ROA is
accounting profits on book value of assets; Average wage is the logarithm of total wages divided by the number of employees; Directors’ holdings
is the percentage of directors’ ownership; Network is a summary measure of the board’s direct and indirect relations to other firms through
multiple directorships (see endnote 8); Size1 is the board size of shareholder elected directors; Gender1 is the fraction of women of the shareholder
elected directors; Board index is a summary measure of the above board variables; Leverage is the book value of debt on book value of equity;
Dividend payout rate is dividends on net income; Empdir is the number of employee directors divided by the number of directors; Empdirfrac is
337
the fraction of employee directors in the total board; Firm size is the natural logarithm of accounting income; Systematic risk is the company’s
exposure to market changes (equity beta); Volatility is the firm’s total risk measured as its yearly standard deviation.
The ‘F sign’ shows the significance of the test of the null hypothesis that the two group means are equal, estimated from an analysis of variance
(ANOVA). Low values indicate rejection of the null hypothesis. The F value is found by dividing the Between Groups Mean Square by the Error
Mean Square (Johnson and Wichern, 1988, p. 235).
Like the findings in Table 13.2, this is evidence that the firms attempt to
minimize the employee director importance.
The two firm groups differ in background variables, notably firm size.
The co-determined firms are larger on average. This warrants paying par-
ticular attention to the largest firm size groups in regressions, in order to
control for firm size biases.
5. ESTIMATION AND METHOD
I estimate the relationships in equation (2) with simultaneous equations

regressions on the full samples as well as sub-samples. The equations spell
out behavioural relationships between variables. Since the equilibrium
model of governance is not known, reduced form estimation is not pos-
sible (Greene, 2003, section 15.2). The equations are behavioural, but not
structural in the sense of belonging to an equilibrium model.
The fixed effects method (Woolridge, 2002) is common to all regressions.
Fixed effects estimation amounts to removing the individual heterogeneity
of firms contained in the fixed effect ci.11 Remember the error term in the
system equation (2) is uit, which contains the fixed effect ci and a idiosyn-
cratic effect vit, which varies over time and companies; i refers to the firm
number, and t is the time period. When demeaning the variables, the fixed
effect element disappears. So does the constant term.
I use the three-stage least squares (3SLS) methodology in estimations.
The 3SLS is an instrumental variables estimation method where the instru-
ments are the predicted values of the dependent variable in a regression
on all the explanatory variables in the system (Greene, 2003, p. 398). The
predicted values are found from GLS regressions, and iterations are taken
until convergence is achieved. Meaningful overall measures, such as R2 in
OLS regressions, are not available. Instead, I include a Wald test (Greene,
2003, p. 107) to study whether all coefficients in a given equation are zero.
The danger in simultaneous equation estimation lies in the model speci-
fication (Greene, 2003). If, for instance, a misspecification has occurred in
the first equation, the mistake may contaminate all other equations as well.
To investigate if this propagation of misspecification is a serious problem,
I perform several robustness tests.
I perform estimations in the full sample and for sub-samples. First, the
model in equation (2) is estimated on the full sample with Tobin’s Q as firm
performance, and then on sub-samples of co-determined and shareholder
determined firms. The sub-sample tests will reveal whether results from the
overall sample really apply to co-determined firms alone, or whether the
employee director effect is merely due to difference in sampling. I further
partition the sample to include only firms with more than 200 employees,
when co-determination is compulsory. This will remove firm size effects.
In robustness tests, I perform an estimation with all index variables
included individually (the right hand side of equation (1) on p. 329), as
well as an estimation of a wider definition of the board index,12 this time
including non-significant effects in Bøhren and Strøm (2008) as well.
Further robustness tests include replacing Tobin’s Q with ROA and stock
return as a dependent variable, and replacing leverage with the dividend
payout rate. Also, I remove the lagged firm performance in order to inves-
tigate whether parameter estimates remain stable. The last robustness test
is a test of the Fauver and Fuerst (2006) information hypothesis, which I
interpret to mean that in information intensive industries firm performance
is improved with co-determination. This regression should show whether
their positive employee director result is also the case in Norway.
The explanatory variables are assumed to be simultaneous with firm
performance. Since board members are predominantly elected in the late
spring, the new board should also have had some time to make a noticeable
impact upon firm performance, measured at year-end. This assumption is
reasonable, given some market efficiency.
6. ECONOMETRIC EVIDENCE
Do employee directors improve firm performance, and are governance

mechanisms at least partly endogenously determined? This section reports
simultaneous regression results of the model in equation (2). I estimate
for the whole sample, and then turn to sub-samples of co-determined and
shareholder determined companies, and for firms with more than 200
employees. All regressions are done with standardized values. This means
that comparisons of economic importance can be read off from coefficient
values.
I start with estimations of the model in equation (2) for the entire sample.
Table 13.4 shows the estimation results. The Wald tests show that no equa-
tion supports the null hypothesis that all coefficients are zero. Comparing
the two sections of the table, signs and coefficient values are very much the
same. Thus, I restrict comments to the case of systematic risk in the upper
section.
The co-determination hypothesis says that the employee director vari-
able is negative to firm performance, and positive to the board index and
leverage. Table 13.4 confirms this except for the leverage, where only the
sign is as predicted. Furthermore, the co-determination hypothesis implies
a positive impact on average wage. Here too, only the sign is confirmed.
Table 13.4 Is co-determination associated with negative firm performance

and positive governance mechanisms? Full sample (N51135)
estimations using systematic and firm specific risk
Independent Dependent variable

Variable
Tobin’s Average Board Leverage
Q wage index
Tobin’s Q lagged 0.106** 0.028 0.065* −0.094**
Average wage −0.035 −0.038 0.204**
Board index 0.122** −0.030 −0.191**
Leverage −0.041** 0.145** −0.171**
Employee −0.119** 0.072 0.314** 0.044
directors
Firm size −0.141** −0.027 −0.060 0.129**
Systematic risk 0.004 0.030 0.010 −0.035
Wald c2 test 79.516 39.396 82.612 87.617
p-value 0.000 0.000 0.000 0.000
Tobin’s Q lagged 0.105** 0.032 0.062* −0.082**
Average wage −0.031 −0.036 0.181**
Board index 0.119** -0.029 −0.182**
Leverage −0.034 0.131** −0.167**
Employee −0.123** 0.066 0.311** 0.042
directors
Firm size −0.136** −0.019 −0.066 0.145**
Volatility −0.045** 0.028 −0.003 0.116**
Wald c2 test 85.137 36.095 79.369 103.055
p-value 0.000 0.000 0.000 0.000
Notes:
The table reports the simultaneous equation estimation of the system of equations in (2)
with systematic risk (upper part) and firm-specific risk (lower part).
The dependent variable is Tobin’s Q, which we measure as the market value of the firm
over its book value. Variables are defined in Table 13.3. Each variable is time demeaned
in the regressions. For each firm and each variable, I time demean by subtracting a given
year’s observation from the firm’s overall mean. The table shows the estimates based on the
standardized variables, which we construct by deducting each observation from its mean
value and dividing by its standard deviation.
Fixed effects estimation in 3SLS framework with standardized variables. All non-
financial firms on Oslo Stock Exchange 1989 to 2002.
The Wald test (Greene, 2003, p. 107) is here a test of the null hypothesis that the
coefficients in the given equation are all zero. A low value indicates null hypothesis
rejection. If R is the q 3 K matrix of q restrictions and K coefficients, g the K
vector of coefficients, and r the vector of the q restrictions, the Wald c2 (q) statistic is
c2 (q) 5 (r 2 Rg) r [ RSXRr ] 21 (r 2 Rg) , where SX is the estimated covariance matrix of
coefficients. The test results show that a hypothesis that all coefficients are zero must be
rejected in all relations at the 1% level.
Significant results at the 5% (10%) level are marked with ** (*).
This weaker result may be due to pay being determined by external market
conditions. Thus, the direct and indirect effects of co-determination are
partly confirmed. Consequently, employee directors carry a negative asso-
ciation with firm performance, and shareholders tend to take compensa-
tory actions to alleviate the influence of employee directors. The board
index is at least partly endogenously determined.
Are the board index and the leverage positively related to firm perform-
ance and negatively to average wage? For the board index, this is confirmed
for firm performance, but the only sign is as expected for average wage.
Thus, a better composed board will improve firm performance. On the
other hand, leverage is against the free cash flow hypothesis expectations
in both firm performance and average wage. A higher leverage indicates a
lower firm performance and higher average wage. In conclusion, the gov-
ernance hypothesis is not fully confirmed.
The negative association between leverage and firm performance con-
firms findings in empirical studies (Barclay et al., 1995; Rajan and Zingales,
1995; Brick et al., 2005). I offer two alternative explanations to the free
cash flow hypothesis: the fear of higher decision costs in a situation with
three decision makers, that is, shareholders, employees, and banks; and the
negative signalling effect of a high leverage (Myers, 1977).
Also note the complementarity between the board index and leverage
(Agrawal and Knoeber, 1996). The sign is negative and significant. Thus,
the two governance mechanisms are substitutes rather than complements.
The Hermalin and Weisbach (1998) reverse causation hypothesis is only
partly confirmed, as the board index is positive and leverage is negative.
Lower leverage should bring lower monitoring intensity. The results are
significant, indicating that good performance leads to a better board index
and to an easier debt burden. In all, endogeneity is confirmed, as both the
board index and the leverage are at least partly determined from the pres-
ence of employee directors and from past performance.
Are shareholders able to neutralize the employee director by adjustments
in the board index and the leverage, taking the employee director relation-
ship to average wage into consideration as well? Since the variables are
standardized to have average zero and standard deviation 1.0 in regressions,
coefficients can be compared. They show that the direct effect is stronger
than the indirect effect on the board index. For the negative direct employee
director effect is now 0.119, while the indirect effect upon the board index
is positive and 0.314. Since the board index is now 0.122 to firm perform-
ance, the positive, indirect impact of employee directors through the board
index is only 0.038 (5 0.122 3 0.314), or 31.1 per cent of the direct board
index effect. The shareholders are able to compensate 31.9 per cent of the
negative direct effect of employee directors through adjustments to board
characteristics. Furthermore, the employee director also impacts positively

upon average wage, which is negatively related to firm performance. Even
though the average wage is not significant in the overall sample, it is for co-
determined firms, as I shortly report. The same applies to leverage. Likewise,
the economic significance of the indirect effects from the lagged firm per-
formance is very low, being 0.01 for both the board index and the leverage.
Thus, the economic magnitude of the indirect effects from employee
directors or past firm performance upon firm performance is small com-
pared to the direct effect of the board index and the leverage. Endogeneity
matters, but not very much.
The volatility measure in the lower section of Table 13.4 gives two inter-
esting relationships in the board index and the leverage equations. It turns
out that only leverage has the expected positive and significant sign. The
Raheja (2005) theory of board composition implies that the board index is
positively related to firm risk. For volatility the opposite sign obtains.
Next, the model is studied in sub-samples. If regulation plays a role, a less
than optimal board composition is likely to follow. Therefore, we should
observe stronger and more significant coefficients in the co-determined
firms than in the shareholder determined. Table 13.5 is a report on the two
sub-samples of firms.
Note that the Wald test shows rejection of the null hypothesis that all
variables have zero significance. Furthermore, a Chow dummy variable
test rejects the hypothesis that the coefficients of the sub-samples are
equal to those in the overall sample. Thus, there is a difference between
co-determined and shareholder determined firms.
In the co-determination sub-sample the employee director effects are
even more pronounced than in the overall sample. The negative employee
director impact upon firm performance is about 45 per cent higher than
in the overall sample and the indirect effect on the board index increases
even more. Now, the employee director variable is significant in relation
to leverage and to average wage. Thus, the co-determination hypothesis
is even more strongly confirmed in the sub-sample of only co-determined
firms than in the overall sample.
The board index and the free cash flow hypotheses come out more in
line with expectations in the co-determined firms too. Now a significant
result for the board index towards average wage appears. Leverage turns
out to be negative and significant towards average wage, while positive in
the overall sample. In shareholder determined firms, significant results are
fewer and of different sign. Leverage is positively correlated with average
wage, in contrast to the co-determined firms.
In both sub-samples the board index and leverage are negatively related.
Thus, the substitution result from the overall sample is confirmed in the
Table 13.5 Is firm performance (Tobin’s Q) differently related to

governance mechanisms in co-determined and in shareholder
determined firms?
Independent Dependent Variable

Variable
Q Wage Index
Co-determined firms N5639
Tobin’s Q lagged 0.303** 0.011 0.059 −0.069*
Average wage −0.089 −0.520** −0.156**
Board index 0.118** −0.175** −0.274**
Leverage −0.103** −0.080** −0.414**
Employee −0.173** 0.186** 0.484** 0.140**
directors
Firm size 0.077 −0.001 −0.210** −0.083
Systematic risk 0.034 −0.010 0.027 −0.035
Wald c2 test 112.123 83.056 212.330 89.279
p-value 0.000 0.000 0.000 0.000
Shareholder determined firms N5496
Tobin’s Q lagged −0.072** 0.030 0.041 −0.101
Average wage −0.023 0.032 0.272**
Board index 0.121** 0.035 −0.158**
Leverage −0.018 0.208** −0.109**
Firm size −0.296** −0.077 −0.021 0.237**
Systematic risk −0.048 0.060 −0.006 −0.028
Wald c2 test 57.543 30.281 9.986 45.030
p-value 0.000 0.000 0.076 0.000
Chow dummy c2 (7): 62.160 p-value 0.000
variable test
Notes:
The table reports the simultaneous equation estimation of the system of equations in (2) with
co-determined firms in the upper part and shareholder determined firms in the lower part.
The dependent variable is Tobin’s Q , which we measure as the market value of the firm
The Wald test is explained in Table 13.4. The test results show that a hypothesis that all
coefficients are zero must be rejected in all relations at the 1% level, except one where a 7.7%
level is required.
The Chow (Greene, 2003, Ch. 7) dummy variable test is an exclusion test for the null
hypothesis that variables formed by a co-determination dummy variable interacted with
each of the explanatory variables are all zero. Low value indicates hypothesis rejection. The
test result shows that the hypothesis that the two sub-samples have equal coefficients must
be rejected.
sub-samples. We also see that the past firm performance endogeneity hypothe-
sis gains less support in the sub-samples than in the overall sample. In fact, only
the negative leverage result in the co-determined sub-sample is significant.
Another difference exists for firm size. Firm size is negative and sig-
nificant in the firm performance equation in shareholder determined firms,
while positive in co-determined ones. Also, in the leverage equation the
signs are reversed, and significant in shareholder determined firms only.
The latter confirms ‘stylized facts’ about the positive relationship between
firm size and leverage (Harris and Raviv, 1991).
An interpretation of the difference in sub-samples is that in shareholder
determined firms the board composition is closer to the optimal, and
therefore exogenous characteristics such as firm size play a larger role.
The large differences between samples confirm the Buchanan and Tullock
(1962) theory.
Are the results arrived at so far driven by a firm size effect? Table 13.6
shows regressions for all firms with more than 200 employees in the upper
part, while the lower part is limited to the largest co-determined firms. The
2001 employee sample shows results very similar to those in the entire
sample in Table 13.4 in the upper part, and for the co-determined firms in
Table 13.5 in the lower part. Thus, the former results are not due to some
firm size effect. In fact, even among firms where co-determination is com-
pulsory, the main co-determination hypothesis is confirmed.
Looking back, the co-determination and governance hypotheses are con-
firmed. Tests in sub-samples do not overturn these conclusions; on the con-
trary, they add to their strength. For instance, while the employee director
effect is negative for leverage in the overall sample, it is positive in the co-
determined sub-sample, as the hypothesis predicts. Thus, having representa-
tives of one stakeholder group, the employees, in addition to shareholders on
the board does not improve firm performance, as a stakeholder (Freeman
and Reed, 1983; and Blair, 1995) or a new economy position (Zingales, 2000;
Becht et al., 2003) implies. Instead, the results point to conflict of interests
among the stakeholders. Furthermore, evidence of substitution between the
board index and leverage is present in all regressions. I also find evidence
of endogeneity (or reverse causation) from past firm performance, but
with opposite signs to those predicted in Hermalin and Weisbach (1998).
However, the indirect effects of employee directors and past firm perform-
ance upon firm performance through the board index and leverage are
small compared with the direct effects from the board index and leverage.
Endogeneity counts, but has low economic significance.
The negative relation between employee directors and firm performance
is in agreement with Fitzroy and Kraft (1993), Schmid and Seger (1998),
Gorton and Schmid (2000, 2004), Falaye et al. (2006), and Bøhren and
Table 13.6 Are the employee director direct and indirect (endogenous)
effects upheld in all firms with more than 200 employees and in
co-determined firms with more than 200 employees?

Variable
Q Wage index ratio
200+ employee firms, N5814
Tobin’s Q lagged 0.168** 0.008 0.139** −0.090*
Average wage −0.012 −0.101* 0.075
Board index 0.094** −0.041* −0.145**
Leverage −0.065** 0.041 −0.197**
Employee directors −0.107** 0.049 0.420** −0.006
Firm size −0.083 0.103* −0.093 0.172**
Systematic risk 0.013 0.045 0.025 -0.101**
Wald c2 test 73.709 13.037 85.068 46.726
p-value 0.000 0.042 0.000 0.000
200+ employees co-determined, N5565
Tobin’s Q lagged 0.358** 0.025 0.091* −0.060
Average wage −0.111* −0.478** −0.359**
Board index 0.047 −0.148** −0.256**
Leverage −0.126** −0.180** −0.413**
Employee directors −0.148** 0.093** 0.522** 0.099**
Firm size 0.008 0.031 −0.248** −0.028
Systematic risk 0.017 −0.027 0.008 −0.041
Wald c2 test 110.682 73.992 190.267 99.414
p-value 0.000 0.000 0.000 0.000
Notes:
with all firms larger than 200 employees in the upper part and all co-determined firms larger
than 200 employees in the lower part.
The dependent variable is Tobin’s Q , which we measure as the market value of the firm
coefficients are zero must be rejected in all relations at the 1% level, except one, where a
4.3% level is required.
Strøm (2008), but at odds with Fauver and Fuerst (2006). None of these
studies contain simultaneous equations models, and only the Bøhren and
Strøm (2008) paper investigates the endogeneity of board mechanisms. I
will return to the Fauver and Fuerst (2006) and Bøhren and Strøm (2008)
articles in the following robustness section.
7. ROBUSTNESS CHECKS
I perform robustness checks on the definitions of the board index, firm

performance, and leverage. In addition, I check for the absence of serial
dependence of the firm performance, that is, whether lagged firm perform-
ance is zero. Finally, I check the Fauver and Fuerst (2006) results in two
sub-samples of information industries and other industries. With simulta-
neous equations, changes in one place are likely to propagate throughout
the system. Thus, different coefficient values and significance from the
original formulation are quite likely to appear. Fortunately, the results
largely confirm those in Section 6.
Do the co-determination results survive when the individual board
mechanisms are used in place of the board index? Table 13.7 shows simul-
taneous regressions results when all four board characteristics making up
the board index enter the regressions individually. Former results for co-
determination largely apply. The employee director variable is negative to
Tobin’s Q, and positive to average wage and leverage. For the board charac-
teristics, only the relation to board size is significant. On the other hand, the
hypotheses on governance variables are upheld for all board characteristics
but the gender variable. It turns out to be non-significant in the Tobin’s
Q relation. The other variables are as expected, and their coefficients are
close to those Bøhren and Strøm (2008) find in partial GMM estimations.
These authors also discuss endogeneity. Even though the estimations are
not directly comparable, none of the significant results in Table 13.7 conflict
with the endogeneity results in Bøhren and Strøm (2008). The second endo-
geneity effect from lagged firm performance is significant in the leverage but
not in any of the board variables. However, the signs on the individual board
variables conform to the positive sign of the board index in earlier tables.
Besides these main points, Table 13.7 contains many new details, which
it is beyond this chapter to explore. For instance, the substitution effect
between the board index and leverage in former tables now turns out to
concern network, while leverage is a complement to board size and gender.
Thus, overall the results are well in line with former findings, except for the
lagged firm performance relationship to governance variables.
In Table (13.8) I have modified the board index to include all board
Table 13.7 The employee director direct and indirect (endogenous) effects upon firm performance when the individual
board variables are used instead of the board index (N5 1135)
Variable Tobin’s Average Directors’ Network Board Gender Leverage

Q wage holdings size
Tobin’s Q lagged 0.106** 0.026 −0.022 0.071 −0.030 −0.027 −0.091**
Average wage −0.039 −0.049* 0.127** 0.043 0.097** 0.199**
Directors’ holdings 0.051* −0.057* 0.046 0.131** 0.024 −0.038
Network 0.091** 0.061** 0.019 0.070** −0.067** −0.090**
Board size −0.062** 0.052 0.136** 0.175** 0.122** 0.212**
Gender −0.025 0.124** 0.026 −0.177** 0.129** 0.082**
Leverage −0.041** 0.140** −0.023 −0.131** 0.124** 0.045**
Employee directors -0.114** 0.102** 0.074 0.043 −0.565** −0.005 0.108*
Firm size −0.144** −0.043 0.082 0.044 0.258 0.006 0.089
Systematic risk 0.001 0.022 −0.104** 0.093** 0.034 −0.041 −0.032
347
Wald c2 test 86.300 65.395 45.170 57.520 301.551 58.640 98.443
p-value 0.000 0.000 0.000 0.000 0.000 0.000 0.000
Notes:
The table reports the simultaneous equation estimation of the system of equations in (2) when the individual variables making up the board index
replace the board index. The board index consists of directors’ holdings, network, board size, and gender. The definition of directors’ holdings is
the fraction of ownership for the board as a whole; network is information centrality (Wasserman and Faust, 1994), see note 9; the board size is the
number of shareholder elected directors; and gender is defined as the number of shareholder elected women over board size.
The dependent variable is Tobin’s Q , which we measure as the market value of the firm over its book value. Variables are defined in Table 13.3.
Each variable is time demeaned in the regressions. For each firm and each variable, I time demean by subtracting a given year’s observation from
the firm’s overall mean. The table shows the estimates based on the standardized variables, which we construct by deducting each observation from
its mean value and dividing by its standard deviation.
Fixed effects estimation in 3SLS framework with standardized variables. All non-financial firms on Oslo Stock Exchange 1989 to 2002.
The Wald test is explained in Table 13.4. The test results show that a hypothesis that all coefficients are zero must be rejected in all relations at
the 1% level.
Table 13.8 Does a wide definition of the board index change the
relationship between firm performance, employee directors
and governance mechanisms? (N51135)

Variable
Q Wage Index 2
Tobin’s Q lagged 0.114 ^** 0.027 0.009 −0.109**
Average wage −0.031 −0.136 ^** 0.204**
Board index 2 0.091 ^** −0.102 ^** −0.083**
Leverage −0.048 ^** 0.143 ^** −0.077 ^**
Employee directors −0.094 ^** 0.077 ^* 0.152 ^** −0.004
Firm size −0.129 ^** −0.048 −0.218 ^** 0.126*
Systematic risk 0.005 0.030 0.005 −0.037
Wald c2 test 65.962 54.197 42.933 56.620
p-value 0.000 0.000 0.000 0.000
Notes:
The table reports the simultaneous equation estimation of the system of equations in
(2) when all individual variables enter the board index, and not just directors’ holdings,
network, board size, and gender. The added variables are outside owner concentration,
independence, CEO director, exported and imported directors, and board age dispersion.
Outside owner concentration is the sum of squared equity fractions across all the firm’s
outside owners; independence is the board tenure of the non-employee directors minus the
tenure of the CEO; CEO director equals 1 if the CEO is a member of his company’s board
and zero otherwise; exported CEO is the number of outside directorships held by the firm’s
CEO; imported CEO is the proportion of CEOs from other companies on the board; board
age dispersion is the standard deviation of board age.
coefficients are zero must be rejected in all relations at the 1% level.
variables used in Bøhren and Strøm (2008) as specified in note 12 to check

whether the board index is sensitive to the selection of board character-
istics. The overall Wald tests are strong and the significance of the coef-
ficients are almost similar to what earlier full sample results in Table 13.4
show. We note that the impact of the employee director variable is less in
the new board index, and is now significant in its positive relationship to
average wage. Thus, the co-determination hypothesis is supported with
this new board index, although with lower coefficient values. The endog-
eneity effect of a lagged firm performance loses significance in the board
index relation. The same happens when individual board characteristics
replace the board index, and the effect also disappears in the shareholder
determined sub-sample. Thus, a preliminary conclusion is that the reverse
causation in the board index relation seems to be sensitive to the specifica-
tion of the index and in sub-samples.
The conclusion from the discussion of the two previous tables is that
the results are upheld; in particular, the co-determination hypothesis is
confirmed.
Now I turn to variations on firm performance, using the stock return
and ROA instead of Tobin’s Q. The stock return and ROA may be seen as
two extremes in performance measurement, the one only market based, the
other only accounting based. Bhagat and Jefferis (2002) argue in favour of
accounting measures, noting that market measures may contain an antici-
pation bias, since accounting numbers may be manipulated during a given
year. Since our data span 14 years, this accounting manipulation should be
a minor concern. These two measures of firm performance should together
provide an adequate framework for robustness tests.
The results for the full sample are given in Table 13.9. Since the results
in the sub-samples largely parallel those found for the full sample, the sub-
sample results are not reported. The results in Table 13.9 largely replicate
those already found for Tobin’s Q in Table 13.4. The co-determination
and the governance hypotheses show the same confirmations. As before,
leverage is negative in the firm performance equation. Again, the board
index and leverage are substitutes. Endogeneity (or reverse causation)
is evident in both firm performance specifications, although at different
variables. For the stock return the lagged stock return is significant in firm
performance and leverage, as before. One would expect this to happen
with accounting numbers due to earnings management or conservative
accounting practices (Watts, 2003), which would induce serial correlation.
However, lagged performance is significant for only the board index for the
accounting measure ROA. Overall, Table 13.9 supports earlier findings.
The upshot is that alternative performance measures do not upset con-
clusions reached with Tobin’s Q. Therefore, further robustness tests may
well proceed with Tobin’s Q as the dependent variable.
Next, Table 13.10 shows results when the dividend payout rate replaces
leverage, and Tobin’s Q is the firm performance in the upper part, while in
the lower part the lagged firm performance is removed. Dividend payout
rate is gauged as the annual dividend as a fraction of the earnings before
interest, taxes, depreciation, and accruals (EBITDA). During the period of
study, share buybacks were illegal in Norway.
Table 13.9 The employee director direct and indirect (endogenous)

effects when the stock return and the return on assets (ROA)
define firm performance

Variable
Q Wage Index 2
Stock return, N51019
Stock return lagged −0.242** −0.046** −0.008 −0.072**
Average wage −0.056 −0.057* 0.077**
Board index 0.132** −0.055* −0.223**
Leverage −0.232** 0.056** −0.169**
Employee directors −0.165** 0.052 0.302** 0.039
Firm size −0.112 0.012 −0.026 0.117*
Systematic risk −0.138** −0.003 −0.010 −0.043
Wald c2 test 123.539 15.975 78.542 61.258
p-value 0.000 0.014 0.000 0.000
ROA N51135
ROA lagged −0.008 −0.043 0.063** −0.011
Average wage −0.129** −0.028 0.106**
Board index 0.066** −0.022 −0.195**
Leverage −0.170** 0.077** −0.183**
Firm size 0.033 −0.010 −0.051 0.103
Systematic risk −0.024 0.014 0.025 −0.048
Wald c2 test 68.694 15.739 86.037 57.564
p-value 0.000 0.015 0.000 0.000
Notes:
when the stock return replaces Tobin’s Q in the upper part and the return on assets replaces
Tobin’s Q in the lower part.
The dependent variable is the stock return, defined as the raw stock return adjusted for
dividend and stock splits; alternatively, as the return on assets, gauged as the accounting
profits on book value of assets. Variables are defined in Table 13.3. Each variable is time
demeaned in the regressions. For each firm and each variable, I time demean by subtracting
a given year’s observation from the firm’s overall mean. The table shows the estimates
based on the standardized variables, which we construct by deducting each observation
from its mean value and dividing by its standard deviation.
coefficients are zero must be rejected in all relations at the 1% level, except for the average
wage, where at least a 1.6% level is needed.
Table 13.10 The relationships between firm performance, employee

directors and governance mechanisms when dividend
payout rate replaces leverage ratio and when lagged firm
performance is removed

Variable
Tobin’s Average Board Dividend
Q Wage Index 2 Payout
Dividend payout rate, N51150
Tobin’s Q lagged 0.106** 0.014 0.088** 0.035
Average wage −0.046* −0.075** −0.025
Board index 0.125** −0.059** −0.021
Dividend payout rate 0.005 −0.011 −0.012
Employee directors −0.117** 0.082* 0.317** 0.092
Firm size −0.178** 0.004 −0.106* 0.022
Systematic risk 0.002 0.028 0.020 −0.066
Wald c2 test 79.275 8.236 48.154 4.785
p-value 0.000 0.221 0.000 0.572

Q Wage Index
No lag N51333
Average wage −0.062** −0.018 0.201**
Board index 0.131** −0.014 −0.169**
Leverage −0.058** 0.152** −0.161**
Firm size −0.151** 0.021 −0.066 0.100**
Systematic risk 0.027 0.015 0.017 −0.031
Wald c2 test 71.943 45.253 85.976 84.992
p-value 0.000 0.000 0.000 0.000
Notes:
when the dividend payout rate replaces leverage in the upper part and the lagged firm
performance is removed in the lower part.
over its book value. Each variable is time demeaned in the regressions. For each firm and
each variable, I time demean by subtracting a given year’s observation from the firm’s
overall mean. The table shows the estimates based on the standardized variables, which we
construct by deducting each observation from its mean value and dividing by its standard
deviation.
I use fixed effects estimation in 3SLS framework with standardized variables. The sample
comprises all non-financial firms on Oslo Stock Exchange 1989 to 2002.
coefficients are zero must be rejected in all relations at the 1% level, except for the average
wage and the dividend payout relations in the upper part, where I cannot reject the hypothesis.
The striking results are first that the dividend payout rate is nowhere signifi-
cant as an independent variable, and second, as a dependent variable no vari-
able in the system is related in a significant way. In fact the Wald test cannot
reject the hypothesis that all coefficients in the dividend payout rate equation
are zero. An exclusion test (not reported) for the dividend payout rate cannot
confirm that the variable coefficient is different from zero. Thus, the dividend
payout rate is an inferior substitute for leverage. Moreover, the results for
the other variables are not affected, even though changes in one part of a
simultaneous system may bring about new values in other parts. Therefore,
the results in Table 13.10 increase the confidence in the original model.
The lower part of Table 13.10 shows results when the lagged firm
performance is left out. The reason for the removal is that lagged firm
performance induces bias (Hsiao, 2003, pp. 71–2), since the errors are no
longer independent of the regressors. The smaller the bias, the larger is the
number of periods in the panel and the closer to zero is the auto-correlation
coefficient on lagged firm performance. Furthermore, if the explanatory
variables apart from the lagged firm performance have very persistent
elements, the bias will not disappear. This persistence can be a concern in
governance studies. For instance, the firm’s board size is likely to be fairly
stable. To test for the seriousness of this bias, I include static system regres-
sions, that is, with no lagged performance.
Comparing the results from the no lagged firm performance regres-
sion with the original estimates in Table 13.4, we see that practically all
signs are maintained, and also that coefficient values are quite similar.
The co-determination hypothesis is confirmed. For average wage on firm
performance, the variable is significant in the static specification but not
in the dynamic. But overall the results from the dynamic estimations are
upheld. Apparently, the low auto-correlation coefficient, the rather long
time period and the small persistence in the explanatory variables warrant
the use of the dynamic specification in Table 13.4.
I also run a regression (not reported) with all explanatory variables
lagged one period for the entire sample. This regression shows far fewer
significant results, and, although the signs are the same as before, this
specification is far inferior to the main regression in Table 13.4. Again, this
points to a contemporaneity in governance mechanisms.
Finally, I run a test for the Fauver and Fuerst (2006) information hypoth-
esis in the sub-samples. The authors assume information significance to
trade, transportation, and manufacturing industries. Using the same GICS
industry classification as in Table 13.2, I allocate Capital goods, Transport,
Consumer articles, Retailing, Food and staples retailing, Health care equip-
ment and supplies, and Telecommunications to the information intensive
industries, while the rest are in other industries. Co-determined firms are
distributed in the two sub-samples almost as in the total population, with

61.1 per cent without employee directors in the Other industries category
against 57.4 in the full sample. A test for the Fauver and Fuerst (2006)
information hypothesis is that the employee director variable is positive in
the information intensive industries. Table 13.11 shows the results.
The main interest is in the employee director, that is, the co-determination
hypothesis. Both sub-samples show a negative and significant coefficient on
the employee director variable. The Chow test shows that the two sub-
samples are different, but the main Fauver and Fuerst (2006) hypothesis is
not supported.
Overall, the results for the robustness tests do not invalidate the results
found in Table 13.4.
8. CONCLUSION
In this chapter I pose the question whether board representation of one

group of non-owner, the employees, improves firm performance. I con-
clude it does not. The conclusion runs counter to claims from stakeholder
theorists (Freeman and Reed, 1983; Blair, 1995) and some financial econo-
mists (Zingales, 2000; Becht et al., 2003) that co-determination improves
firm performance. Instead the results support most former findings in the
empirical literature (Fitzroy and Kraft, 1993; Schmid and Seger, 1998;
Gorton and Schmid, 2000, 2004; Falaye et al., 2006; Bøhren and Strøm,
2008) that employee board representation reduces firm performance.
The Norwegian regulations on co-determination provide the institu-
tional framework. Co-determination is required by law for firms with more
than 200 employees, and is an option if an employee majority demands
so in firms having between 30 and 200 employees. A number of industries
are exempted, and in all industries employees exercise their option. Thus,
testing can take place using sub-samples, for instance in co-determined and
shareholder determined sub-samples. For the whole sample, nearly 60 per
cent do not have employee directors. The percentage has been rising during
our period from 1989 to 2002. For firms with more than 200 employees, two-
thirds have employee directors. The resultant data set is of a panel nature.
I estimate a system of simultaneous equations where employee direc-
tors, firm size (sales), firm systematic risk, and one period lagged Tobin’s
Q are the exogenous variables, and Tobin’s Q, average wage, board index,
and leverage are the endogenous. The board index is constructed from
important board characteristics, that is, directors’ holdings, the board’s
network, board size and the female fraction. The free cash flow hypothesis
(Easterbrook, 1984; Jensen, 1986) warrants the use of leverage.
Table 13.11 Firm performance, employee directors and governance

mechanisms in sub-samples of information intensive
industries and other industries

Variable
Q Wage Index
Information industries N5533
Firm performance lag 0.277** 0.210** 0.127 −0.240**
Average wage −0.041 −0.150** 0.440**
Board index 0.015 −0.093** −0.040
Leverage −0.024 0.217** −0.032
Employee directors −0.081** 0.182** 0.197** −0.044
Firm size 0.007 0.167* −0.060 0.141
Systematic risk 0.003 0.055 0.062 0.009
Wald c2 test 60.354 88.323 17.790 61.376
p-value 0.000 0.000 0.007 0.000
Other industries N5601
Firm performance lag 0.069* -0.040 −0.036 −0.088**
Average wage −0.050 −0.113** 0.047
Board index 0.153** −0.131^ ** −0.040
Leverage −0.081** 0.044 −0.033
Employee directors −0.117* −0.033 0.157** −0.016
Firm size −0.215** −0.129^ * −0.145** 0.131*
Systematic risk 0.062 0.013 −0.165** −0.133**
Wald c2 test 41.646 14.737 35.541 15.583
p-value 0.000 0.022 0.000 0.016
Chow dummy variable test c2 (7): 28.362 p-value 0.000
Notes:
when the full sample is sub-divided into informationally intensive industries in the upper
part and other industries in the lower. Using the same GICS industry classification as in
Table 13.2, informationally intensive industries are Capital goods, Transport, Consumer
articles, Retailing, Food and staples retailing, Health care equipment and supplies, and
Telecommunications, while the rest are in other industries.
over its book value. Each variable is time demeaned in the regressions. For each firm and
each variable, I time demean by subtracting a given year’s observation from the firm’s overall
mean. The table shows the estimates based on the standardized variables, which we construct
by deducting each observation from its mean value and dividing by its standard deviation.
I use fixed effects estimation in 3SLS framework with standardized variables. The sample
comprises all non-financial firms on Oslo Stock Exchange 1989 to 2002.
coefficients are zero must be rejected in all relations at the 1% level, except for a 2.3% level
in the average wage relation in the Other industries estimation.
The Chow dummy variable test is explained in Table 13.5. The test result indicates that
coefficient values are different in the two sub-samples.
The setup allows the testing of direct and indirect employee director
effects upon firm performance. The indirect effects constitute a test of endo-
geneity (Hermalin and Weisbach, 2003). The lagged firm performance gives
a test of the reverse causation hypothesis (Hermalin and Weisbach, 1998)
that past firm performance determines current governance. Furthermore,
it allows testing of complementarity between the two governance variables
board index and leverage (Agrawal and Knoeber, 1996).
Regressions are performed on the whole sample, the sub-samples of co-
determined and shareholder determined firms, and then the sub-samples
of firms with more than 200 employees. I use a fixed effects model imple-
mented in a three-stage least squares (3SLS) estimation.
In all regressions, the estimated coefficient for employee directors is
significantly negative. Moreover, the economic importance becomes larger
as regressions proceed from the overall sample to the sub-sample of co-
determined firms, and then to co-determined firms with 200 employees
or more. The result is at odds with Fauver and Fuerst (2006), who find a
positive relationship when a dummy employee director variable is inter-
acted with information intensive industries. In sub-samples of information
intensive and other industries I confirm the negative employee director
correlation to Tobin’s Q. Overall, the results support agency theory and
reject stakeholder theory.
The indirect effects are also present. Employee directors are positively
associated with average wage, the board index, and, in co-determined
samples, leverage. For the board index, this means that shareholders
improve board composition so as to neutralize the negative employee direc-
tor effect, as Buchanan and Tullock (1962) predict. However, this neutral-
izing effect falls far short of the negative direct employee director effect.
The lagged firm performance is significantly positively related to the board
index and negatively to leverage. This result runs counter to the Hermalin
and Weisbach (1998) reverse causation theory that earlier firm performance
determines board composition. Thus, the results show endogeneity effects,
but the economic significance falls far below the importance of the direct
effect. The negative direct effect of employee directors is only partially com-
pensated for by a better board. Endogeneity matters, but not very much.
Furthermore, leverage turns out to be negatively related to firm perform-
ance, contrary to the free cash flow hypothesis (Easterbrook, 1984; and
Jensen, 1986). The negative association with firm performance confirms
findings in empirical studies (Barclay et al., 1995; Rajan and Zingales,
1995; Brick et al., 2005).
Jensen and Meckling (1979) argue that co-determination can only
survive if supported by law. The long-term data set employed here sup-
ports this view. Evidently, owners have good economic reasons for not
choosing the co-determination form of organization if they can. This also

implies that there are costs to maintaining co-determination required by
law. First, I document the negative impact of employee representation
upon firm performance. Second, shareholders try to work around the
regulations by strengthening aspects of board characteristics that are
left unregulated. Thus, co-determination, supported by law, has costs.
Therefore, these results are relevant for the emerging literature on board
regulation (Hermalin, 2005).
NOTES
* Acknowledgements: I have benefited from comments made by Øyvind Bøhren, Ole

Gjølberg, Roswitha King, Gudbrand Lien, participants at the 7th workshop on
Corporate Governance and Investment, Jönköping, 2006, and at the 2nd International
Business Economics Workshop, Majorca, 13–14 September 2007. Pål Rydland and
Bernt Arne Ødegaard have guided me to data.
1. Co-determination is defined as employee board representation (Jensen and Meckling,
1979; Furubotn, 1988).
2. Tirole (2002, p. 118) argues that these ‘[c]onflicts of interest among the board generate
endless haggling, vote-trading and log-rolling. They also focus managerial attention
on the delicate search for compromises that are acceptable to everyone; managers
thereby lose a clear sense of mission and become political virtuosos.’ In a similar vein,
Hansmann (1996, p. 44) states that ‘because the participants [that is, stakeholders] are
likely to have radically diverging interests, making everybody an owner threatens to
increase the costs of collective decision making enormously.’
3. According to the EIRO (1998) full employee representation is found in Austria, the
Nordic countries, and Germany, while the Netherlands and France have systems closer
to a consultative function for employee representatives.
4. In a recent booklet, the long-time employee director Svein Stugu (2006) says that the
main objective is to prevent plant closures. Mergers, takeovers, and outsourcing must
also be prevented.
5. Stugu (2006, p. 63) says that opposition to plant closures was organized in co-operation
with representatives of the local community, but that this could only be done effectively
if labour representatives had access to internal information.
6. The variables are defined as follows. Directors’ holdings is defined as the fraction of
equity owned by the board of directors; board network is the information centrality,
constructed from network theory (Wasserman and Faust, 1994), see note 8 below;
board size is the number of shareholder elected directors; gender is the proportion of
shareholder elected female directors.
7. I keep only a linear specification in the board ownership relation, despite evidence in
Morck et al. (1988) and McConnell and Servaes (1990) pointing towards a concave
relationship. The Bøhren and Strøm (2008) study finds no significance in the squared
term, maybe due to the inclusion of other board characteristics.
8. Network theory uses concepts such as nodes and lines. In our setting, a node is a firm,
and a line between two firms represents a joint director in the two firms. We define
geodesic gjk as the shortest path between two nodes j and k, and G as the total number
of nodes. The node i is designated as ni. Using Wasserman and Faust (1994, pp. 192–7),
our information centrality measure is constructed in the following way. Form the G 3 G
matrix A with diagonal elements aii equal to 1 plus the sum of values for all lines incident
to ni and off-diagonal elements aij, such that aij 5 0 if nodes ni and nj are not adjacent,
and aij 5 1 2 xij if nodes ni and nj are adjacent. xij is the value of the link from firm ni
to nj, that is, 0 or 1. The inverse of A, which is C 5 A21, has elements { cij } , where we
G G
define T 5 g i51cii and R 5 g j51cij. The information centrality index for firm ni is:
1
Ci (ni) 5
cii 1 (T 2 2R) /G
The index measures the information content in the paths that originate and end at a
specific firm.
9. The OSE had an aggregate market capitalization of 68 billion USD equivalents by year-
end 2002, ranking the OSE 16 among the 22 European stock exchanges for which compa-
rable data are available. During the sample period from 1989 to 2002, the number of firms
listed increased from 129 to 203, market capitalization grew by 8 per cent per annum, and
market liquidity, measured as transaction value over market value, increased from 52 per
cent in 1989 to 72 per cent in 2002 (sources: www.ose.no and www.fibv.com).
10. The main sources are Bråthen (1982) and Aarbakke et al. (1999) and a government
report (NOU 1985:1). In order to maintain readability, specific references have been
dropped in tables and text.
11. For every individual firm, an overall average is constructed. Then, from each company
observation the overall individual average is subtracted.
12. In addition to the variables in (2), I include outside owner concentration, independence,
CEO director, exported and imported directors, and board age dispersion. Outside
owner concentration is the sum of squared equity fractions across all the firm’s outside
owners; independence is the board tenure of the non-employee directors minus the
tenure of the CEO; CEO director equals 1 if the CEO is a member of his company’s
board and zero otherwise; exported CEO is the number of outside directorships held by
the firm’s CEO; imported CEO is the proportion of CEOs from other companies on the
board; board age dispersion is the standard deviation of board age.
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14. The determinants of German
corporate governance ratings
Wolfgang Drobetz, Klaus Gugler and
Simone Hirschvogl
1. INTRODUCTION
In recent years many countries have introduced ‘corporate governance

codes’. These codes represent unmistakable improvements in minority
shareholder right protection as well as transparency, and they generally
entail a movement towards Anglo-Saxon institutions. Many of the rules
in these codes are only recommendations, however, and there is much
scepticism that best-practice recommendations and/or principles-based
approaches are effective substitutes for more rule-based approaches, such
as the US Sarbanes-Oxley Act. This is all the more the case since there is
the widespread perception that markets do not function well in punish-
ing deviant behaviour of managers, particularly in Continental Europe,
where regulators tend to rely heavily on principles-based approaches in
their attempts to reform corporate governance. There are many reasons
to believe that markets are less of a constraint on managerial discretion in
Continental Europe than in the US or the UK, in particular. For example,
ownership and voting right concentration is tremendous, liquidity of
shares is low, and there is frequently a separation between cash flow and
voting rights.1 In general, therefore, the ‘exit option’ is less of a threat to
firms’ management, and the ‘voice’ of institutional investors, in particular,
ought to be strengthened.
The existing literature on codes is scant at best, and if it exists it is
on the effects of corporate governance codes on performance.2 Most
recently, Drobetz et al. (2004) construct a corporate governance rating
for 91 German firms and find that the rating of a firm positively affects
market value and the returns to shareholders. Their empirical analysis
reveals that for the median firm a one standard deviation change in the
governance rating results in about a 24 per cent increase in the value of
Tobin’s Q.
361
This evidence notwithstanding, there are problems with the link between
corporate governance code ratings and firm performance. First, there is
the well-known endogeneity problem already mentioned above: if only
‘good’ firms adopt the code (for example, because the costs are low, since
they fulfil the code anyway), one must expect a positive code–performance
relationship.3 Second, a high rating on the code only indirectly affects
performance: a high rating must correlate with the true ‘spirit’ of good
governance, which only then can affect performance.4 In fact, very little is
known about the underlying mechanism that relates corporate governance
practices and firm performance (for example, see Shleifer and Wolfenzon,
2002).
A more cautious approach of analysing corporate governance codes is
adopted in this chapter. We take one step back and do not try to assess
the impact of code fulfilment on the performance of companies (which
is, of course, ultimately the most interesting question). Instead, we use
the corporate governance rating constructed by Drobetz et al. (2004) for
publicly listed German firms and analyse the determinants of this rating.
This approach has the advantage that we do not run into the same endo-
geneity problems with the determinants of code fulfilment that we would
encounter by trying to assess the effects on firm performance. For example,
one cannot sensibly argue that a high or low governance rating affects
the voting rights of the largest shareholder or the size/composition of the
supervisory board. It must be the case that the decision making process
is determined or at least monitored by the largest shareholder and/or the
board, and their decisions naturally affect compliance with the code. The
decision to improve corporate governance practices and attitudes should
be made in awareness of its consequences and obligations (for example, see
Demsetz and Lehn, 1985). However, we only have a cross-section of data
at hand, which may also limit our analysis.
Our results show that there is a non-linear relationship between owner-
ship concentration and the corporate governance rating. Moreover, firms
with larger boards have lower ratings, but firms that apply US-GAAP
or IAS rules or use an option-based remuneration plan have higher
ratings.
The remainder of this chapter is structured as follows. Section 2 devel-
ops our hypotheses, which are subject to empirical testing. Because our
corporate governance rating mainly refers to the rules and recommenda-
tions of the German Corporate Governance Code, we give a brief and
general comparative analysis of the governance codes in place throughout
the European Union in Section 3. Section 4 describes the data, Section 5
presents our empirical results, and Section 6 concludes.
The determinants of German corporate governance ratings 363
2. HYPOTHESES
Germany is the prototype of an insider system of finance and control, and
thus our hypotheses as to the determinants of ratings must reflect its insti-
tutional background. The most striking fact of even large, listed firms in
Germany is that ownership and voting right concentration is tremendous.
While the median largest ultimate voting block in US or UK listed firms is
well below 10 per cent, it is above 50 per cent in Germany, Italy and Austria
(see Becht and Röell, 1999). Therefore, presumably the owner of this block
has ultimate control over the company and can decide which stance to
adopt with regard to the code of good corporate governance. Accordingly,
we hypothesize that the voting power of the largest shareholder affects the
code rating. We also develop the notion that the size of the board of direc-
tors, a firm’s accounting principles, and its method of executive remunera-
tion impact the code ratings.
2.1 Ownership Concentration
In the literature two main effects of large shareholders have been disentan-
gled (for example, see Claessens et al., 2002; Gugler et al., 2003a). First,
with increasing cash flow rights of the largest shareholder, there is a posi-
tive incentive effect. A good code rating – provided it is awarded by the
capital market – increases the value of the firm and, hence, the value of
the ownership stake of the largest shareholder. S/he should therefore have
an incentive to comply with the code. However, there is a second, nega-
tive entrenchment effect. The larger the voting rights of the largest share-
holder, the more entrenched s/he is and the more s/he can influence the
decision making process. A high code rating achieved by making it easier
for small shareholders to cast their votes in general assemblies, increasing
transparency by disclosing information on individual compensation of
management and the supervisory board, or agreeing to strict incompat-
ibility regulation, to give a few examples, is not necessarily in the largest
shareholder’s interest. We summarize the discussion as follows:
Hypothesis 1 Ownership concentration is non-linearly related to the cor-

porate governance rating. At low to intermediate holdings of the largest
shareholder the entrenchment effect outweighs the incentive effect and
we expect a negative relation between ownership concentration and the
corporate governance rating. At high levels of ownership concentra-
tion the incentive effect outweighs the entrenchment effect and, hence,
we expect a positive relation between ownership concentration and the
corporate governance rating.
2.2 Board Size
Our second determinant of code compliance is the size of the supervisory

board. The decision making process in the supervisory board is likely to be
affected by its size for at least two reasons. First, coordination problems are
larger on a large board than on a small board. Jensen (1993) and Lipton
and Lorsch (1992) suggest that large boards can be less effective than small
boards, presuming that the emphasis on politeness and courtesy in board-
rooms is at the expense of truth and frankness. Specifically, when boards
become too big, agency problems (such as director free-riding) increase
and the board becomes more symbolic and neglects its monitoring and
control duties. Moreover, large boards may reflect an inadequate percep-
tion of the true executive function, particularly in firms with public involve-
ment. Supporting this rather ad hoc proposition, Yermack (1996) was
the first to report empirical evidence for a negative relationship between
board size and firm valuation (see also Eisenberg et al., 1998; Beiner et al.,
2004). Second, on a large board it is likely that more conflicting groups of
stakeholders, such as representatives of large shareholders, employees, and
creditors, are represented than on smaller boards. Third, many companies
do have a (and if so, at most one) representative of small shareholders.
However, the larger the board the less weight this representative has at a
ballot. All of these arguments lead us to:
Hypothesis 2 Larger boards tend to be reluctant to adopt ‘good’ corpo-

rate governance practices and, hence, board size is negatively related to the
corporate governance rating.
2.3 Accounting Principles
There are several papers that find significant effects of accounting practices
on the performance of companies as well as on the distribution of profits
among stakeholders, such as dividends or interest payments on debt (see,
for example, La Porta et al., 1997, 1998, 2000; Gugler et al., 2003b, 2004).
In Germany there are three possibilities as to how firms are allowed to
account: US-GAAP (US Generally Accepted Accounting Principles), IAS
(International Accounting Standards) and HGB (‘Handelsgesetzbuch’).
US-GAAP and IAS contain much stricter rules on accounting practices
than HGB, which is the national law standard for accounting, particu-
larly with respect to transparency and details of information. Due to its
conservative approach (for example, historical cost accounting), HGB
accounting appears to favour debtholders and large shareholders versus
minority shareholders.
Accounting according to international standards and compliance with

the code can be viewed as complements for a number of reasons. First,
many of the requirements of code compliance are antedated by the decision
to account according to international principles. Thus the marginal costs
of code compliance are smaller for these firms than for firms using HGB.
Second, firms that account with US-GAAP or IAS may want to signal their
good investment opportunities, and code compliance is one way to achieve
this goal. Finally, although we explicitly account for firm size (total assets)
in the determinants regressions below, part of the co-variation in account-
ing principles and code rating may be attributable to firm size (for example,
due to measurement errors of true firm size), which is a main determinant
of international accounting. Accordingly, we formulate:
Hypothesis 3 Firms accounting according to US-GAAP or IAS have higher

corporate governance ratings than firms accounting according to HGB.
2.4 Executive Remuneration
Our final variable affecting code rating is whether or not the firm has
adopted an option-based remuneration plan. Diamond and Verrechia
(1982) and Holmström and Tirole (1993) developed models that are based
on the interaction of capital markets and contingent compensation. Giving
managers an equity stake in the firm is a solution to ensure that managers
pursue the interests of shareholders without necessarily increasing manage-
rial entrenchment. Provided that a high governance rating is awarded by
the capital market, management of firms using option-based remuneration
has an incentive to comply with the code. Therefore, we formulate:
Hypothesis 4 Firms that use an option-based remuneration plan have

higher corporate governance ratings than other firms.
3. CODES OF GOOD CORPORATE GOVERNANCE
3.1 European Corporate Governance Codes
Recently, all EU member states have adopted at least one governance code
document.5 It is generally acknowledged that the legal framework for corpo-
rate governance is most effective if it aims at ensuring: (i) fair and equitable
treatment of all shareholders, (ii) managerial and supervisory body account-
ability, (iii) transparency as to corporate performance, ownership structure
and governance, and (iv) corporate responsibility. While the codes originate
from countries with very diverse cultures, financing traditions, ownership

structures, and legal origins, they are remarkably similar in their general
notion of ‘best practice’ corporate governance rules. In fact, codes appear to
serve as a converging force in corporate governance practices.
Nevertheless, two observations are noteworthy. First, the coverage
of the codes differs substantially due to differences in legal origins and
frameworks. While some codes address general principles and practices of
corporate governance, other nations establish these in company laws and
securities regulation. Second, while some codes strongly emphasize the
supervisory body holding managers accountable to a broad base of rela-
tively dispersed shareholders (for example, in the UK), other codes focus
on the protection of minority shareholders to ensure equal treatment to a
dominant shareholder (for example, in Germany).
The codes have three stated objectives: (i) stakeholder and/or share-
holder interests, (ii) the work of supervisory and managerial bodies, and
(iii) disclosure requirements. The majority of codes recognize that corpo-
rate success, shareholder profit, employee security and well-being, and the
interests of other stakeholders are strongly interrelated. They generally call
for shareholders to be treated equitably, disproportional voting rights to be
avoided or at least fully disclosed to all shareholders, and removal of bar-
riers to shareholder participation in general meetings, whether in person
or by proxy.6 Despite structural differences between two-tier and unitary
board systems, they all stress that supervisory responsibilities are distinct
from management responsibilities. Many suggest practices designed to
enhance the distinction between the roles of the supervisory and manage-
rial bodies, including supervisory body independence, separation of the
chairman and CEO roles, and reliance on board committees (such as the
nominating committee).7 Finally, all codes contain various disclosure
requirements. An issue that has received specific public attention is the
greater voluntary transparency as to executive and director compensa-
tion.8 In addition, the codes also support the increasing public interest in
disclosure as regards director independence (in both one-tier board and
two-tier board systems), share ownership, and, in many instances, issues
of broader social concerns.
With regards to code enforcement, the prescriptions supplement and
complement the mandatory prescriptions provided by company and secu-
rities laws and listing rules. However, they are non-imperative and lack
mandatory compliance authority. The vast majority of codes merely
require companies to provide greater voluntary disclosure of governance
practices, including disclosure about the extent of compliance with a par-
ticular code recommendation. Listed companies are required to disclose
whether they comply with the specified code and explain any deviations
(‘comply or explain’). Even though compliance with code provisions is

wholly voluntary, reputational market forces can result in significant com-
pliance pressures. Finally, codes are increasingly used by investors and
market analysts, rating agencies, shareholder monitoring groups and com-
mentators to benchmark supervisory and management bodies.
3.2 The German Corporate Governance Code
After a few private interest groups began establishing best practices of

corporate governance in the late 1990s, in June 2000 the German federal
government appointed a commission with the goal to formulate proposals
for modernizing German corporate law. This report prepared the ground
for the development of a national code for improving the management and
control functions of publicly quoted companies. The results were elabo-
rated into the code of conduct by a second, follow-up commission. The
German Corporate Governance Code was finally published on 26 February
2002, and the Transparency and Disclosure Act (TransPuG), which took
effect on 26 July 2002, obliges publicly quoted companies to apply the
code recommendations. The code is an example of self-commitment by
the corporate sector and requires disclosure on the ‘comply or explain’ rule
described in Section 3.1.
The stated goal of the code is to ‘promote the trust of international and
national investors, customers, employees and the general public in the
management and supervision of listed German stock corporations’.9 This
is in contrast to the Anglo-Saxon view of corporate governance, where
there is little room for the general public. Nevertheless, the code constitutes
a regime shift in the German corporate governance system by taking a sur-
prisingly pragmatic view on the ‘fundamental’ differences in stakeholder
and shareholder interests, an issue that has been fiercely debated in particu-
lar in the German literature (for example, see Albach, 2003).
4. DATA DESCRIPTION
4.1 A German Corporate Governance Rating
The corporate governance rating applied in this chapter is from Drobetz et

al. (2003, 2004). They construct a broad, multifactor corporate governance
rating, which is based on responses to a survey sent out to a broad sample
of German publicly listed firms. To qualify for inclusion in the corporate
governance rating, each practice and attitude (i) had to refer to a governance
element that is not (yet) legally required and (ii) needed to be considered as
international market practice from an investor’s perspective. Most proxies

included in the rating represent recommendations and suggestions of the
German Corporate Governance Code. Note that while the former work
according to the comply-or-explain principle, the latter are wholly volun-
tary. A few other governance proxies originate from the DVFA German
Corporate Governance Scorecard,10 from CalPERS German Market
Principles, and from the Deminor Corporate Governance Checklist.
In total, the rating contains 30 governance proxies divided into five
categories: (1) corporate governance commitment, (2) shareholder rights,
(3) transparency, (4) management and supervisory board matters, and (5)
auditing. A representative question from each category is listed below:
● Are there firm-specific corporate governance guidelines set out in

writing?
● Are there measures in place to facilitate the personal exercising of
shareholder voting rights (for example, via internet) and to assist the
shareholders in the use of proxies?
● Are the fixed and variable remuneration elements as well as share
ownership (including existing option rights) of members of the
management and supervisory board published separately and in
individualized form in the notes to the financial statements?
● Are there supervisory board committees to deal with complex
matters (such as audit, compensation, strategy)?
● Are there firm-specific rules to ensure that the auditor does not
perform other services for the firm (such as consulting work)?
A questionnaire with all 30 governance proxies was sent out to all firms
in the four principal market segments of the German stock exchange:
DAX 30 (blue-chip stocks), MDAX (mid-cap stocks), NEMAX 50 (index
of growth firms), and SDAX (small-cap stocks), comprising a total of 253
firms. Data collection was completed at the end of March 2002. Overall,
the survey had a response ratio of 36 per cent, which results in a sample of
91 German firms.
The construction principles of the aggregate governance rating are kept
simple. Twenty-five basis points are added for each acceptance level of the
respective proxy in a five-scale answering range. For each firm the aggregate
rating is an unweighted sum of the basis points across all proxies, ranging
from 0 (minimum) to 30 (maximum).11 Hence, the dependent variables
in our empirical analysis are: OVERALL (aggregate corporate govern-
ance rating), CG_UNT (governance commitment), CG_AKT (shareholder
rights), CG_TRA (transparency), CG_ENT (management and supervisory
board matters), and CG_ABS (auditing).
12
10
Number of firms
0
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30
Corporate governance rating
Note: This figure shows the distribution of the survey-based corporate governance rating
(CGR) for 91 German public firms from Drobetz et al. (2004). The survey was sent out
in February 2002, and the data collection was completed by the end of March 2002. The
rating represents an unweighted sum of the basis points (on a five-scale answering range)
for all governance proxies in five broad categories: (1) corporate governance commitment,
(2) shareholder rights, (3) transparency, (4) management and supervisory board matters,
and (5) auditing. The corporate governance rating ranges from 0 (minimum) to 30
(maximum). The ratings in the figure are rounded to the nearest integer.
Figure 14.1 Distribution of the German corporate governance rating
The histogram in Figure 14.1 shows that the rating over the 91 firms in
our sample is slightly skewed to the right. More than 40 per cent of the
firms have a rating between 20 and 23. Nevertheless, governance proxies
display a sufficiently wide distribution to mitigate a possible sample selec-
tion bias in the survey.
Panel A in Table 14.1 presents summary statistics of the dependent vari-
ables. Due to data limitations for the independent variables, the sample in
our empirical analysis is reduced to 80 firms. The average rating is 19.51,
with firm ratings ranging from 9.75 to 27.25. The sub-indices with the
highest ratings are CG_ENT (management and supervisory matters) and
CG_TRA (transparency), which can be explained by the fact that these
areas are strongly accompanied by laws and regulation.
4.2 Explanatory Variables
The data for ownership structure/voting rights are based on the CD-ROM
‘Wer gehört zu Wem?’ (‘Who owns whom?’, 30 April 2002) or taken
Table 14.1 Summary statistics
Variables Mean Median Minimum Maximum Obs.

Panel A: Aggregate rating and components
OVERALL 19.51 19.75 9.75 27.25 85
CG_UNT 2.27 2.00 0.00 5.00 85
CG_AKT 3.07 3.00 0.00 5.00 85
CG_TRA 4.55 4.75 2.00 5.00 85
CG_ENT 5.98 6.25 1.25 9.50 85
CG_ABS 3.63 3.75 1.00 5.00 85
Panel B: Aggregate rating by ownership concentration
VR1<25% 21.42 33
25%≤VR1.50% 18.67 21
50%≤VR1.75% 17.30 21
VR1≥75% 19.47 8
Panel C: Independent variables
VR1 37.13 31.85 4.60 100.00 80
VR1^2 2112.94 1014.45 21.16 10,000.00 80
VR1_25 19.80 25.00 4.60 25.00 85
VR1_25to50 12.01 9.10 0.00 25.00 85
VR1_50 6.45 0.00 0.00 50.00 80
BOARDSIZE 10.29 8.00 3.00 21.00 85
GAAP 0.26 0.00 0.00 1.00 85
IAS 0.32 0.00 0.00 1.00 85
OPTION 0.60 1.00 0.00 1.00 85
TA 13.78 13.22 8.26 20.64 85
TQ 1.63 1.17 0.46 8.02 85
Notes:
The variables relating to the corporate governance score are drawn from the study by
Drobetz et al. (2004), estimates on the ownership structure are based on the CD-ROM
‘Wer gehört zu Wem’ (‘Who owns whom?’, 30 April 2002) and from ‘BaFin (Bundesanstalt
für Finanzdienstleistungsaufsicht)’ March 2002; all the rest of the calculations are based
on annual reports as of end 2001. The independent variables are: OVERALL (corporate
governance rating), CG_UNT (governance commitment), CG_AKT (shareholder rights),
CG_TRA (transparency), CG_ENT (management and supervisory board matters),
CG_ABS (auditing). The corporate governance variables are: VR1 denotes the voting
rights of the largest ultimate shareholder, and VR1^2 is the squared value of VR1. VR1_25
equals the voting rights of the largest shareholder if the voting rights are below 25%; in any
other case it is set to 25%. VR1_25to50 is 0 if the voting rights of the largest investor are
below 25%; if the voting rights are beyond or equal to 25% and below 50%, this variable
is calculated as voting rights –25%. VR1_50 is set to 0 if the voting rights are below 50%;
in any other case it is computed as voting rights –50%. BOARDSIZE is the number of
directors on the company’s supervisory board. GAAP is a dummy variable and equals 1 if
US-GAAP are used as accounting standards in the annual reports and equals 0 otherwise.
IAS is a dummy variable and is set to 1 if IAS are used as accounting standards in the
annual reports and equals 0 otherwise. OPTION is a dummy variable and equals 1 if the
firm uses an option-based remuneration plan and 0 otherwise. TA is defined as the natural
logarithm of the book value of total assets. TQ equals the ratio of market value of equity
plus liabilities divided by book value of total assets.
from ‘BaFin’ (Bundesanstalt für Finanzdienstleistungsaufsicht, March

2002). All other variables are based on annual reports as of end 2001. To
appropriately capture the distribution of control rights and decision power
among shareholders, we use voting concentration as a proxy for ownership
concentration. Following the hypothesis formulated in Section 2, we con-
struct several variables related to voting concentration. VR1 denotes the
voting rights of the largest ultimate shareholder. To account for a possibly
non-linear relationship between ownership concentration and the corpo-
rate governance rating, VR1^2 is the squared value of VR1. Alternatively,
we follow Morck et al. (1988) and use the following variables to estimate
piecewise linear regressions:
VR1_25 5 voting rights of the largest shareholder if voting rights

, 25%,
5 25% if voting right of the largest shareholder $ 25%;
VR1_25to50 5 0 if the voting rights of the largest shareholder , 25%,
5 voting rights of the largest shareholder minus 25%
if 25% ≤ voting rights , 50%,
5 25% if voting rights of the largest shareholder $ 50%;
VR1_50 5 0 if voting rights of the largest shareholder , 50%,
5 voting rights minus 50% if voting rights $ 50%.
Panel B in Table 14.1 presents a breakdown of the aggregate corporate

governance rating by four breaking points of ownership concentration.
The average rating is higher than 21 points if the largest shareholder holds
less than 25 per cent in voting rights, but it is lower than 19 (18) points if
VR1 is larger than 25 per cent (50 per cent) but smaller than 50 per cent
(75 per cent). The average rating again increases above 19 points if the firm
is in super-majority control (VR1.75%). This hints at possible non-linear
effects of the largest shareholder on firms’ ratings.
BOARDSIZE denotes the number of directors on the company’s
supervisory board. The data are taken from the firms’ annual reports as
of year-end 2001. GAAP is a dummy variable and equals 1 if a firm uses
US-GAAP as the accounting standards in its annual report, and equals 0
otherwise. Similarly, IAS is a dummy variable and is set to 1 if IAS are used
as accounting standards, and equals 0 otherwise. OPTION is a dummy
variable that equals 1 if the firm uses an option-based remuneration plan,
and 0 otherwise. Finally, we use two additional control variables: (i) SIZE
is defined as the natural logarithm of the book value of total assets, and (ii)
TQ refers to the Tobin’s Q, approximated as the ratio of market value of
equity plus liabilities divided by book value of total assets. Summary statis-
tics of the independent variables are presented in Panel C of Table 14.1.
5. EMPIRICAL RESULTS
5.1 Main Empirical Results
Table 14.2 presents our main results. In equation (1), VR1 and SIZE are
the only independent variables. The corresponding coefficient on VR1 is
negative and statistically significant at the 5 per cent level. Controlling
for size, we observe that larger voting rights are associated with lower
governance ratings, indicating that the entrenchment effect, on average,
dominates the alignment effect. We will explore this relation in more detail
below. As expected, the coefficient on SIZE is positive and statistically sig-
nificant. The explanatory power (adjusted R2) for this simplest regression
specification is almost 20 per cent.
In equation (2), BOARDSIZE is included as an additional explanatory
variable. Confirming our second hypothesis, the relationship between
board size and the governance rating is significantly negative. The analy-
sis again controls for firm size, taking into account that larger firms also
possess larger boards. This result confirms the hypothesis by Jensen (1993)
and Lipton and Lorsch (1992), suggesting that larger boards are hampered
by coordination and communication problems. In addition, the decision
finding process may be complicated by more conflicting groups of stake-
holders on larger boards.
Equation (3) contains the full set of explanatory variables, where the
possibly non-linear relationship between the corporate governance rating
and the voting rights by the largest shareholders is captured using the
three variables related to the breakpoints described in Section 4.2. We
find supporting evidence for all four hypotheses. First, there is some evi-
dence that the relationship between the corporate governance rating and
ownership concentration is non-linear. At intermediate holdings of the
largest shareholder the entrenchment effect dominates the incentive effect,
as indicated by the negative and significant coefficient on the VR25_50
variable. However, with ownership concentration above 50 per cent, the
incentive alignment effect begins to dominate, as reflected by the positive
(albeit insignificant) coefficient on the VR1_50 variable. Together, these
results imply a U-shaped relationship between the corporate governance
rating and ownership concentration. In addition, confirming our second
hypothesis, board size is significantly negatively related to the corporate
governance rating even when we include all our explanatory variables. Our
empirical results further support the third hypothesis, that firms accounting
according to US-GAAP or IAS have higher governance ratings than firms
accounting according to HGB. This is indicated by the significant positive
coefficients on both the GAAP and IAS dummy variables. Finally, we find
Table 14.2 Main equations
Eq. VR1 VR1^2 VR1_25 VR1_25to50 VR1_50 BOARDSIZE GAAP IAS OPTION TA Const. Obs. Adj. R2
(1) −0.0300 0.5457 13.0737 80 0.1965
(−2.18)** (3.72)*** (5.92)***
(2) −0.0296 −0.3429 1.2584 6.7290 80 0.2793
(−2.26)** (−3.14)*** (4.73)*** (2.31)**
(3) 0.0061 −0.0969 0.0468 −0.2536 3.2071 1.6669 1.2759 0.9555 7.4942 80 0.4555
(0.10) (−2.09)** (1.55) (−2.54)** (3.59)*** (2.31)** (1.81)* (3.87)*** (2.76)***
(4) −0.0834 0.0007 −0.2447 3.0942 1.6288 1.2002 0.9627 8.2896 80 0.4470
(−2.08)** (1.75)* (−2.44)** (3.48)*** (2.24)** (1.69)* (3.88)*** (3.06)***
373
Notes:
The estimating sample contains 85 German firms; variations are due to data limitations. Time period: 2002. The table shows the results from
OLS regressions of the corporate governance rating as dependent variable on the main corporate governance mechanisms along with the control
variable. Eq. (1) is a partial model with ownership concentration explaining the corporate governance score. Eq. (2) introduces another corporate
governance mechanism, the firm’s board, into the equation. Eq. (3) includes all corporate governance mechanisms and is similar to the piece-wise
linear regression estimated by Morck et al. (1988); however, other turning points are used. Eq. (4) allows for non-linearities by including a squared
term. The dependent variable refers to the corporate governance rating as calculated by Drobetz et al. (2004). The corporate governance variables
are: VR1 denotes the voting rights of the largest ultimate shareholder, and VR1^2 is the squared value of VR1. VR1_25 equals the voting rights
of the largest shareholder if the voting rights are below 25%; in any other case it is set to 25%. VR1_25to50 is 0 if the voting rights of the largest
investor are below 25%; if the voting rights are beyond or equal to 25% and below 50%, this variable is calculated as voting rights –25%. VR1_50 is
set to 0 if the voting rights are below 50%; in any other case it is computed as voting rights –50%. BOARDSIZE refers to the number of directors
on the company’s supervisory board. GAAP is a dummy variable and equals 1 if US-GAAP are used as accounting standards in the annual
reports and equals 0 otherwise. IAS is a dummy variable and is set to 1 if IAS are used as accounting standards in the annual reports and equals 0
otherwise. OPTION is a dummy variable and equals 1 if the firm uses an option-based remuneration plan and 0 otherwise. The control variable is
TA, the natural logarithm of the book value of total assets. ***/**/* denotes significance at the 0.01/0.05/0.10 error level, respectively.
supporting evidence for our fourth hypothesis, that firms with option-
based remuneration plans have higher governance ratings than other firms.
The coefficient on OPTION is (marginally) significantly positive. Again,
the regression controls for firm size, as measured by TA, confirming that
larger firms exhibit a higher governance rating. The explanatory power is
reasonably high, with an adjusted R-square of 45.5 per cent.
In equation (4) we use VR1 and VR1^2, in addition to all other explana-
tory variables, to measure the non-linear relationship between the govern-
ance rating and ownership concentration. The results confirm our previous
findings. The coefficients on VR1 and VR1^2 are significantly negative (at
the 5 per cent level) and positive (at the 10 per cent level), respectively, again
indicating a U-shaped relationship between the governance rating and
ownership concentration. All other coefficient estimates are as before.
5.2 Robustness Tests
In order to determine the reliability of our results, we conduct two robust-

ness tests for equation (4) in Table 14.2. First, we test whether industry
effects drive the results and estimate a fixed-effects model. Using the Dow
Jones STOXX classification scheme, the model incorporates intercepts for
18 industries. The estimation results are shown in Table 14.3. Compared
with the previous results in Table 14.2, VR1 and IAS are now significant only
at the 10 per cent level, and the squared term VR^2 as well as BOARDSIZE
and OPTION turn insignificant. The notion that industry is a determinant
of board size, compensation packages and accounting standards should
come as no surprise. For example, supervisory boards of traditional indus-
tries tend to be larger, while boards of ‘New Economy’ firms are smaller.
Furthermore, the optimal compensation package is likely to be influenced
by the presence of asymmetric information between principal and agent,
by the riskiness of the firm’s environment and by its ‘asset specificity’ (for
example, see Demsetz and Lehn, 1985). All of these firm characteristics are
likely to be influenced by the industry a firm operates in.
As a second robustness test we include one (so far) possibly omitted
variable, namely the performance of a firm. Firms with better performance
and higher valuations could be more inclined to choose better corporate
governance instruments, since it may be cheaper for them as they fulfil
most of the recommendations anyway. We apply Tobin’s Q as a measure
of firm valuation and use this variable as an additional explanatory vari-
able for the governance rating. To account for endogeneity, we estimate
a two-stage least-squares regression. The first-stage regression involves
a regression of Tobin’s Q on all exogenous variables and the following
instrument variables: industry dummies (18 industry dummies according
Table 14.3 Robustness tests
Industry fixed effects Endogeneity (2SLS)

Coeff. t-value Coeff. t-value
VR1 −0.0880 (−1.79)* −0.0737 (−1.71)*
VR1^2 0.0007 (1.37) 0.0007 (1.52)
BOARDSIZE −0.1000 (−0.72) −0.2776 (−2.58)**
GAAP 3.5001 (2.99)*** 2.5774 (2.40)**
IAS 1.5394 (1.84)* 1.6891 (2.24)**
OPTION 1.1015 (1.13) 1.1029 (1.40)
TA 0.6701 (1.91)* 1.0926 (3.85)***
TQ 0.3518 (0.75)
Const. 11.0366 (2.86)*** 6.2065 (1.71)*
Obs. 80 77
Adj. R2 0.3685 0.4458
Hausman-test:
c2(7) 2.55
p-value 0.9232
Notes:
The estimating sample contains 85 German firms; variations are due to data limitations.
Time period: 2002. The table shows robustness test for equation (4) from Table II. The first
specification applies an industry fixed-effect model to equation (4). The second specification
uses two-stage least squares whereby in the first stage TQ (Tobin’s Q, ratio of market
value of equity plus liabilities divided by total book value of assets) is regressed on the
following instruments: industry (refers to 18 industries from Dow Jones EURO-STOXX
classification), beta value calculated from monthly stock returns over the period from
1998 to 2001, and the natural logarithm of the age of the firm. A Hausman-test accepts
exogeneity. The dependent variable refers to the corporate governance score as calculated
by Drobetz et al. (2004). The corporate governance variables are: VR1 denotes the
voting rights of the largest ultimate shareholder, and VR1^2 is the squared value of VR1.
BOARDSIZE is the number of directors on the company’s supervisory board. GAAP is a
dummy variable and equals 1 if US-GAAP are used as accounting standards in the annual
reports and equals 0 otherwise. IAS is a dummy variable and is set to 1 if IAS are used as
accounting standards in the annual reports and equals 0 otherwise. OPTION is a dummy
variable and equals 1 if the firm uses an option-based remuneration plan and 0 otherwise.
The control variable is TA, the natural logarithm of the book value of total assets. ***/**/*
denotes significance at the 0.01/0.05/0.10 error level, respectively.
to the Dow Jones EURO-STOXX classification), a firm’s beta value calcu-

lated from monthly stock returns over the period from 1998 to 2001, and
the natural logarithm of the age of the firm. The second-stage regression
applies all governance mechanisms and the fitted value of Tobin’s Q as the
explanatory variables. As shown in Table 14.3, Tobin’s Q is insignificant,
a Hausman-test accepts exogeneity, and all the results for the different
corporate governance mechanisms remain essentially the same, both in
the magnitude of the coefficients and their level of significance. Overall,

these results indicate that our previous results for the baseline regressions
in Table 14.2 are not afflicted by the inclusion/exclusion of Tobin’s Q.
5.3 Results for the Components of the Governance Rating
In this section we split the aggregate rating into its five components: (1)
shareholder rights, (2) management and supervisory board matters, (3)
transparency, (4) governance commitment, and (5) auditing. The results
of the regressions using the respective sub-indices as dependent variables
are shown in Table 14.4.
Shareholder rights (equation (1) in Table 14.4) encompass criteria such as
the one-share-one-vote principle, subscription rights for capital increases,
and modern communication (that is, internet) used for the general meeting
and/or the voting process. As can be seen from equation (1) in Table 14.4,
there is no positive part in the relation between this sub-index and VR1.
Regressing VR1 linearly on the shareholder rights rating, VR1 is estimated
significantly (at the 5 per cent level) negative. This indicates that the largest
shareholder is particularly wary of code recommendations that increase
the control rights of minority shareholders.
A significantly negative/positive relationship between VR1 and a sub-
index are obtained for the categories management and supervisory board
matters (equation 2) and auditing (equation 5). Management and super-
visory board matters encompass dimensions such as remuneration and
performance criteria of board members; disclosure of individual board
members’ variable and fixed pay components in the annual reports; selection
process of directors; separate committees within the board; and the number
of board members’ directorships. We therefore argue that this category
(besides shareholder rights) is the most relevant with respect to corporate
governance improvement. Given that board size also has a significantly neg-
ative influence, our main results are confirmed strongest for this sub-index.
None of our corporate governance variables are significant in the
regression for the category transparency (equation 3). Together with the
fact that the average rating is extremely high (4.55 out of a maximum of
5), this reflects the general understanding in Germany as well as in other
Continental European countries that transparency is vital for good cor-
porate governance, and not even large shareholders can oppose this. A
major improvement in transparency legislation was achieved when the
European Union’s Transparency Directive (88/627/EEC) was transposed
into German law and became effective at the beginning of 1995.
The component related to governance commitment (equation 4) investi-
gates whether there are corporate governance guidelines set out in writing,
Table 14.4 Components of the corporate governance rating
Eq. VR1 VR1^2 BOARDSIZE GAAP IAS OPTION TA Const. Obs. Adj. R2
(1) −0.0046 −0.00003 −0.0256 0.1152 0.3189 0.4539 0.2218 0.0721 80 0.313
(−0.38) (−0.23) (−0.83) (0.42) (1.44) (2.09)** (2.93)*** (0.09)
(2) −0.0590 0.0006 −0.1375 1.2683 0.5007 0.4978 0.4001 2.0826 80 0.313
(−2.68)*** (2.52)** (−2.49)** (2.60)*** (1.25) (1.27) (2.93)*** (1.40)
(3) 0.0019 −0.000001 −0.0148 −0.0530 −0.0892 0.1962 0.0864 3.3753 80 0.043
(0.26) (−0.01) (−0.79) (−0.32) (−0.65) (1.47) (1.85)* (6.61)***
(4) 0.0080 −0.0001 −0.0494 0.9239 0.1061 −0.1883 0.1917 −0.0021 80 0.065
(0.41) (−0.69) (−1.01) (2.14)** (0.30) (−0.55) (1.59) (−0.00)
(5) −0.0297 0.0003 −0.0174 0.8397 0.7922 0.2406 0.0628 2.7616 80 0.276
377
(−2.53)** (2.61)*** (−0.59) (3.22)*** (3.72)*** (1.15) (0.86) (3.47)***
Notes:
The estimating sample contains 85 German firms; variations are due to data limitations. Time period: 2002. The table shows the results from
OLS regressions of the components of the corporate governance rating as dependent variables on the main corporate governance mechanisms
along with the control variable. The dependent variables in the different equations are: Eq. (1) shareholder rights (‘Aktionärsrechte’). Eq. (2)
management and supervisory board matters (‘Entscheidungs- u. Kontrollgremien’). Eq. (3) transparency (‘Transparenz’). Eq. (4) governance
commitment (‘Unternehmensausrichtung und Corporate Governance’). Eq. (5) auditing (‘Abschlussprüfung’). The corporate governance variables
are: VR1 denotes the voting rights of the largest ultimate shareholder, and VR1^2 is the squared value of VR1. BOARDSIZE is the number of
directors on the company’s supervisory board. GAAP is a dummy variable and equals 1 if US-GAAP are used as accounting standards in the
annual reports and equals 0 otherwise. IAS is a dummy variable and is set to 1 if IAS are used as accounting standards in the annual reports and
equals 0 otherwise. OPTION is a dummy variable and equals 1 if the firm uses an option-based remuneration plan and 0 otherwise. The control
variable is TA, the natural logarithm of the book value of total assets. ***/**/* denotes significance at the 0.01/0.05/0.10 error level, respectively.
or whether there is a corporate governance representative reporting on

corporate governance issues to the supervisory board. The only significant
governance variable is GAAP. This could be explained by the fact that
firms employing US-GAAP are those which strive for a listing in the US,
where corporate governance is organized more formally, and where it is
more common to structure the corporation according to corporate govern-
ance guidelines.
Finally, the sub-index referring to auditing (equation 5) is based on the
following questions. Do quarterly reports contain segment reporting? Are
there firm-specific rules to ensure that the auditor does not perform other
services for the firm? Does the annual report contain information about the
risk-management system of the corporation? Besides the significant nega-
tive/positive VR1 influence, international accounting standards (IAS and
GAAP) exert a positive and significant influence on auditing. International
accounting standards, which are supposed to reveal more information than
national accounting standards, also raise the quality of auditing.
6. CONCLUSION
There is mounting empirical evidence that there is a relationship between the

quality of firm-level corporate governance and firm valuation. Ultimately,
this is the only reason why corporate governance issues should be of inter-
est for financial economists at all. Unfortunately, all empirical studies are
inherently plagued with endogeneity problems, as causality could well
run from performance to governance. This chapter tries to circumvent
the problem of causality by taking one step back and investigating the
determinants of good corporate governance as measured by the corporate
governance rating of Drobetz et al. (2004). It is ultimately the owners
who decide (or at least monitor the decision) on whether or not to adopt
better governance practices. Ownership structure may thus be regarded as
exogenous and even more so in Continental European countries, where
significant ownership concentration is the rule rather than an exception.
Similarly, the structure of the supervisory authorities can be expected to
affect the governance rating of a firm. The board of directors ultimately
takes the decisions with respect to all governance issues (and, hence, has to
assume responsibility for all corporate governance malfunctions).
While our research question is clearly a lot more modest than directly
exploring the link between corporate governance and firm valuation,
we still uncover several interesting interrelationships within firms. We
confirm the non-linear relationship between ownership concentration and
the quality of firm-level governance familiar from previous governance/
performance studies. We interpret it as being caused by two opposing influ-

ences, incentive alignment and entrenchment, and document a significant
entrenchment effect at intermediate holdings of the largest shareholder
(between 25 and 50 per cent). With increasing holdings of the largest
shareholders (more than 50 per cent), there are positive wealth effects and,
hence, incentive effects start to dominate. Our results hold up strongest
when analysing the sub-index relating to management and supervisory
board matters. In addition, firms with larger board size have lower govern-
ance ratings, but firms that apply US-GAAP or IAS rules and/or use an
option-based remuneration plan have higher governance ratings.
It is worth putting our results into perspective. First, there is a positive and
reassuring message. Corporate governance codes potentially improve the
governance and decision making processes of companies. Otherwise, if pro-
visions were not binding anyway, large shareholders or large boards had no
need to oppose (some of) them (for example, transparency of executive pay).
Second, however, there is a more negative and cautious conclusion that
follows from our results. Large shareholders still have a tight grip on com-
panies in Continental European countries and veto recommendations that
might lead to a loss of their control and power, such as recommendations for
one-share-one-vote or disclosure of individual board members’ pay.
NOTES
1. See Barca and Becht (2001), Becht and Röell (1999), Gugler (2001), and La Porta et al.
(1998) for analyses of ownership and voting right concentration. See Becht (1999) on
liquidity, and see Claessens et al. (2002) and Gugler and Yurtoglu (2003a) on the separa-
tion of voting and cash flow rights. Pagano et al. (2002) show that European markets
having the highest trading costs, lowest accounting standards and poorest shareholder
protection fare worst in attracting and retaining cross-border listings.
2. There is a much more developed literature on the effects of corporate governance mecha-
nisms on performance, though. Using firm-level data from 27 developed countries, La
Porta et al. (2002) find that better shareholder protection is associated with higher valua-
tion of corporate assets. Gompers et al. (2003) report for a broad sample of US firms that
firms with stronger shareholder rights receive higher valuations and have higher profits,
higher sales growth, and lower capital expenditures. Klapper and Love (2003) use firm-
level data from 14 emerging stock markets and also report that better corporate govern-
ance is highly correlated with better operating performance and higher market valuation.
3. On the endogeneity issue and suggestions for cure, see Börsch-Supan and Köke (2002)
and Gugler and Yurtoglu (2003b).
4. For example, Cuervo (2002) argues that especially in civil law countries such as
Germany the codes of good governance can be applied formally, following the letter
but not the spirit of the law, since they cannot be legally enforced.
5. Specifically, a variety of organizations have issued governance codes, including govern-
mental entities, committees and commissions organized or appointed by governments,
stock exchange related bodies as well as business, industry and academic associations.
In addition to national codes, several pan-European and international governance
codes have emerged (such as the OECD Principles of Corporate Governance). For
the codes of almost 40 countries, see http://www.ecgi.org/codes/all_codes.htm. For an
extensive comparative analysis we refer to http://europa.eu.int/comm/internal_market/
en/company/company/news/corp-gov-codes-rpt_en.htm.
6. Baums and Fraune (1994) report that only 58 per cent, on average, of all voting rights
are represented at the annual meeting of a German publicly listed firm.
7. For empirical analysis see Loderer and Peyer (2002).
8. Because two-thirds of the German firms included in the DAX blue-chip index opted
out and do not report the salaries of each director separately, the public discussion has
intensified only recently. There are even suggestions by major political parties to legally
force disclosure of individual compensation (see ‘Keeping stumm’, Economist, 21–27
August 2004).
9. See the German Corporate Governance Code (2002), www.corporate-governance-code.
de.
10. DVFA is the German Society of Investment Analysis and Asset Management.
11. More in-depth analysis in Drobetz et al. (2004) shows that an equal-weighting scheme
is not a restrictive assumption.
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15. Top management, education and
networking
Mogens Dilling-Hansen, Erik Strøjer Madsen
and Valdemar Smith*
1. INTRODUCTION
The corporate governance literature has primarily focused on agent prob-

lems in management and, consequently, on the misallocation of resources
as a result of bad decision making by managers as they do not have an
incentive to behave in the best interests of all share- and debt-holders.
Another important theme in the literature is misallocation of resources as
a result of cash flow expropriation of major shareholders at the expense of
minority shareholders; see, for example Tirole (2006). However, good deci-
sion making is not only a question of the right long-run target or incentives
of the management; it also depends on their knowledge and the level of sig-
nificant information about the competitive and technological environment
of the firm. In that respect personal or professional networks may play an
important role for the firm managers.
The chapter uses a social network approach to analyse the importance
in respect to firm performance of this external network between manag-
ers and board members of different firms by using a data base of the
largest Danish companies. The corporate networking activity is divided
into two types: networking between firms with a common owner struc-
ture and networking between independent firms. We use the Bonacich
centrality approach to measure the networking activity; see Bonacich
(1987). Moreover the primary goal of the paper is to analyse whether firm
performance is affected by the strength of the professional networks with
other firms held by top management, that is, CEOs and members of the
supervisory board of the firm. Recognizing that the strength of network
and firm performance are potentially endogenous, we set up a system of
simultaneous equations in order to explain firm performance and network
strength between firms.
382
Top management, education and networking 383
2. NETWORKING AND FIRM PERFORMANCE

The traditional discussion of the effect of networking is linked to the rela-
tion between ownership structure and performance: a positive effect of
concentrated ownership is found if alignment of incentives is dominant and
a negative effect is found if the entrenchment effect dominates. Although a
substantial part of all small firms is controlled by a family with a majority
share in the company, a lack of formal relations between independent firms
is unlikely. It is often seen that a manager of one firm is associated with
another firm as a board member. Furthermore, as verified by La Porta et
al. (1999), even the majority (70 per cent) of the top 20 firms in 27 developed
countries are controlled by wealthy families or foundations through control
pyramids and other structures. Only in the United States and the United
Kingdom are widely held corporations predominant among large firms.
Moreover, in many countries the ownership structure has developed into
networks by cross-holding of shares between companies, but even without
common ownership structures between two firms, persons employed in
the top management of the firms create formal relations when they are
members of an outside board. If the networking connections between top
managers are clustered in relatively small but concentrated groups a small
world is identified. Conyon and Muldoon (2006) find that there may be
signs of small world characteristics in USA, Germany and UK, but the
concentration found could also have been the effect of a random process.
However, Kogut and Walker (2001) studied the ownership ties in large
German corporations and found that the ownership networks constitute
a small world and that this ‘Rhineland capitalism’ is robust against glo-
balization with increasing foreign direct investment. Using a sample of
Danish firms, Thomsen and Sinani (2005) find the same stability over time
in the corporate network. This study does not control for the existence of
ownership ties as opposed to ties between independent board members or
CEOs.
Ownership and performance have been analysed intensively. It has
been documented that firms with dispersed ownership perform worse than
closely held firms due to the agency problem; see, for example, the survey
by Shleifer and Vishny (1997). And in their survey of the empirical evi-
dence for family controlled firms, Morck et al. (2005) conclude that ‘large
block-shareholdings by a family, and family involvement in management,
need not destroy value, and may even add value for public shareholders’.
However, the finding that the average family firm is doing as well or better
than other firms does not rule out cases where families mismanage their
firms.
Burkart et al. (2003) examined whether the founder of a firm wants to
surrender control of the firm to professional managers. On the one hand,

the family has potential benefit from owner control; on the other hand, by
self-control it misses the opportunity to hire the best qualified manager of
the firm. When the benefit of owner control is smaller than the foregone
benefit of not having a professional management, the family may choose to
hand over control of the firm. However, this may not be an easy decision
for many families/founders and there is some evidence that family owned
firms that appoint an insider family CEO perform significantly worse
than family owned firms that appoint an outside professional CEO; see
Bennedsen et al. (2005).
Very few empirical studies have examined the social networking of
board members and the board of directors (including the CEO) and its
influence on firm decision and performance. As an exception, Booth and
Deli (1996) report a negative correlation between firm performance and
social networking using the simple number of outside directorships. The
argument for this finding is high opportunity cost of spending time at
another firm, that is, external networking may benefit the individual but
the hiring firm does not get a positive spin-off from this activity.
3. NETWORKING ACTIVITY
A social network perspective and social network analysis are an efficient

way to analyse the effect of informal knowledge transfer between firms.
The information flow is created by persons interacting even though they
are employed in legally independent firms, and the overall expectation
is that there is a positive relation between interaction and performance
of the firms involved. A simple example is the process of separation of
ownership and control: handing over the CEO position to an external
manager is a drastic decision and a more gentle way to create a structure
with professional corporate governance is probably to invite an external
manager to take a seat in the boardroom. Of course, this would enhance
the professional decision of the board and leave the family control over
the firm unaltered.
In this chapter, we examine the external ties to other firms of board
members and the management team and calculate a measure of the firm’s
integration in management networks between firms. Our measure covers
both the situation where an external professional is appointed to the board
of a firm and the situation where the CEO of the firm or some of its board
members are appointed to the board of an external firm. The latter case
may also signal that the internal CEO or board member has the profes-
sional qualification to be appointed to an external board.
The expected positive effect on performance of this first step on the

line to professional corporate governance is based on several arguments.
Firstly, firms who invite other professionals into their boardroom may
benefit from the professional managers’ advice and at the same time
retain the documented benefit of owner control, which they could partly
lose by handing over control to an external CEO, who may expropriate
firm value and increase the monitoring cost for the family. Secondly,
in firms with minority shareholders the external board members or the
CEOs may reduce the majority shareholders’ possibility of appropriating
the cash flow at the expense of the minority shareholders and cause the
firm’s value to increase. Next, board members’ and managers’ external
links to other firms may bring in valuable information and knowledge
concerning the competitive environment, best practice and threats from
innovation or other developments of importance for the management of
the firm. Information sharing in the professional networks may increase
firm value also in cases where members of the controlling family are
invited to be part of the management system in another firm. Finally,
information sharing could bring about an understanding between
managers within the market that potentially could promote collusion
in the market and bring in more value to the firm at the expense of the
consumers.
The value of information and knowledge sharing may depend on
the educational level of CEOs and board members. Thus the absorp-
tion capacity concerning the exploitation of information is expected to
depend on the formal education of the managers, meaning that educa-
tion improves the quality of their decisions. This argument is in line with
standard human capital theory. We therefore expect that a higher level of
education of CEOs and board members will increase the performance of
the firm and for managers with many external links the effect may even
be stronger.
Even though the arguments for a positive relation are prevalent there are
also arguments for a negative relation. Booth and Deli (1996) argue that
the negative effect is caused by the opportunity cost of spending time at
another firm: the networking person may benefit from the networking but
the parent firm experiences no spin-off from the board membership (it may
even lose if the person with social relations uses confidential information
from the parent firm). Finally, there may be an ambiguous effect of using
networking as a control mechanism for a parent firm; in line with the clas-
sical entrenchment argument (see Morck et al., 1988), board members of a
subsidiary will pursue the goals of the parent firm and without full informa-
tion of the subsidiary’s market situation these goals may affect subsidiary
performance negatively.
4. IMPLEMENTATION OF THE SOCIAL NETWORK

ANALYSIS
4.1 Firm Interaction
Firms interact with other firms in several ways and naturally the most
important interaction is a consequence of transactions between firms in the
value chain. Even though some of these transactions are automated using
digital technologies, there are still a significant number of transactions
involving human interaction between people in different firms but also
within the firm. Focusing on the firm’s executive level, that is, the board of
managers and the board of executives, the top management, implementa-
tion of strategies is expected to result in communication across various
groups of individuals. Thus, communication between the top management
and other staff within the same firm is part of the management process, but
the fact that there is business-based communication and relations between
separate firms necessitates that it must be explained by other factors such
as exercising control, information seeking, knowledge sharing. Depending
on the reasons for external networking different effects on firm perform-
ance may be expected.
Table 15.1 illustrates the direction of human interaction between firms in
a simple two-firm model. Basically the focus of this chapter is networking
between top managers, that is, the top left corner of the table. In general,
the motive behind human interaction between two firms may be purely
business orientated or personal, but sometimes it is the contact between the
top management in the two firms that is interesting when analysing firms’
long-run performance. Of course, if the two firms are formally related,
there is an ownership structure that may control both firms and, in that
case, the firms can be seen as a joint unit. At the other extreme, there are no
joint owners at all and, in this situation, the interaction between the firms
is defined as purely business related.
4.2 Measuring Power using Social Network Analysis
Measuring the interaction between top managers using a social network

approach is based on data that differ from data used in traditional quan-
titative analysis. Network data is defined by actors (also called nodes) and
by relations (also called links or ties) and in this chapter, we analyse the
effect of relations (ties) created by persons in top management. In a social
network context, firms are the nodes in the network; persons create the rela-
tions or ties between these nodes and the ties are symmetric if the relation
goes in both directions.
Table 15.1 Formal interaction between person employed in a firm and

business partners
Firm B
Top management Other staff
Firm A Top management Joint firms Joint firms
Business related firms Business related firms
Other staff Joint firms Joint firms
Business related firms Business related firms
Notes: Firm A and firm B are defined as ‘joint firms’ if they are legally connected, e.g.
by common owners. Firm A and firm B are defined as ‘business related firms’ if there is no
legal tie between the firms.
A firm without ties to other firms will obviously have no ‘social power’,
and using a full network approach with all firms in the sample (in contrast
to an ego network) these firms will perform worse. A firm with many ties
will, on the other hand, perform better because information will flow more
easily between relevant firms; that is, there will always be a path between
firms with many ties associated. The ‘social power’ of a firm is therefore
directly related to the number of ties connected to the firm and the rela-
tive importance of the nearest neighbours – a firm with many relations to
other (important) firms will benefit from these relations (centrality in social
network analysis).
Other measures, mainly based on distance, connectivity, reachability
and number of paths, are also focused on the assumption that the power
of an actor placed in the ‘centre’ of the network will be greater than the
power of an actor placed on the periphery; see Bonacich (1987), Conyon
and Muldoon (2006), Freeman (1979) and Wasserman and Faust (1994).
Mizruchi and Bunting (1981) find that centrality based network analysis
is superior to examining corporate control. The Bonacich power measure of
centrality (see Bonacich, 1987) is a general measure of power based on cen-
trality and it is used to measure the ‘social power’ of a firm in this chapter.
Actors with more connections are more likely to be powerful because they
can directly contact other actors and, moreover, the power is dependent
on the connections the actors in the neighbourhood have. The Bonacich
measure for node i in a network is a function of two parameters, a and b:
Bonacichi 5 ci(a, b) 5 SAij(a 1 bcj) (1)
The Bonacich measure of centrality is a standard measure of centrality

using the sum of connections (links) weighted with centralities (Aij is the
adjacency matrix describing the tie between nodes and cj is the centrality of
node i). The first parameter, a, is a normalizing parameter, while b reflects
the individual’s status compared with that of the neighbours connected to
the first node.
If b is positive then the power of each node is a positive function of the
status of the connected neighbours. If the power is interpreted as bargain-
ing power then we experience increased power when neighbours are power-
less and this situation is covered by a negative value of b.
The value of a is selected automatically, but choosing the right value
of b has been discussed; see Bonacich (1987) and Bonacich and Lloyd
(2004). Still, the standard application of the Bonacich measure is based on
a positive value of b whose absolute value is less than the absolute value
of the reciprocal of the largest eigenvalue of the adjacency matrix, Aij; see
Borgatti et al. (2002). If b50, formula (1) will no longer take any second-
ary effects into account and the ‘social power’ of the firm will simply be the
number of ties connected to the firm. Both approaches (b50 and optimal
b) are applied in the empirical part of this chapter.
Almost all social network analysis is based on the assumption that power
is closely related to centrality and the discussion about ‘betweenness’,
‘nearness’ and ‘degree’ results in arguments in favour of using Bonacich’s
centrality measure c(a, b); see Bonacich (1987) and Freeman (1979). Firms
(nodes in network analysis) are related to each other through persons in
the top management and the ties are constructed using information on
ownership structure and type of relation (‘betweenness’ and ‘nearness’)
and strength (‘degree’).
We use the full network approach in contrast to a special network using
snowballing methods to select firms; see Hanneman and Riddle (2005).
Using the full network approach, attention is paid to the network structure
between ‘all’ large firms in Denmark and the ties between firms are estab-
lished via persons in the top management. This means that ties between the
large firms in the sample and smaller firms outside are neglected; however
we identify the network structure regardless of the number and strength
of the ties.
4.3 Measuring Ties between Firms using Information on Ownership

Structure
A tie is identified if a person in the top management of one firm has an

equivalent role in another firm; that is, we only define a tie if a person has
a formal position in the other firm. The ownership structure is used to
identify two types of ties, internal and external ties, and a firm may have
both types of ties.
An internal tie or an owner tie is identified if a firm is related by owner-

ship to another firm. The formal link can have different appearances, but
existence of a pyramid structure or information on an owner share larger
than 50 per cent is the most frequent way of identifying an owner tie. This
definition focuses on the actual control over a firm and, even though the
controlling firm has the majority of control, it is not certain that the net-
working person actually owns the majority shares.
Other links between firms without a formal ownership structure are
defined as external ties. Persons in the top management are either manage-
ment board members or board members:
1. chief executive officer

2. other members of the board of management
3. chairman of the board
4. members of the board
and a person with a tie can have any of the four roles in the other firm. If a
person has several involvements with other firms, we identify a tie for each
and we use a symmetric approach, because it is not possible to identify
the primary activity. Using the symmetric approach we do not distinguish
between the effect of a tie between firm 1 and firm 2 and the correspond-
ing tie from firm 2 to firm 1; that is, we implement the same network effect
whether one or two ties are found. Finally, we use binary weights because
there is no objective method to determine the strength of the relations.
5. DATA DESCRIPTION
The empirical analyses are based on a sample of the 1000 largest Danish
firms supplying information on economic performance available. The indi-
vidual relations between persons in the firms are defined by the relations
between persons belonging to the top management. Thus we focus on the
external relations between top managers and members of the supervisory
board (board of directors). Top CEOs can be members of the supervisory
boards of other firms and board members can be members of boards or
CEOs of another firm and so on.
Information on economic performance is based on the official annual
report of the firm, which includes turnover and standard measures of
profitability. The information on the relations between the persons in top
management is based on a private on-line company supplying information
on ownership structure and persons in the top management (CEOs and
board members).1 Only relations between persons in legally independent
firms are recorded and relations between profit-oriented firms and non-
profit organizations are not included.
5.1 Descriptive Statistics
In the sample of large firms used in the network analysis, we end up with
999 firms with valid information for the year 2004 (descriptive statistics are
presented in Table 15.2). The general picture of industry structure and firm
performance is that there is no significant difference between the relatively
large firms (more than 500 employees) and smaller ones. The minimum
efficiency scale (MES) is unchanged, but the average market share is of
course a bit higher for large firms. We find a relatively stable average profit
Table 15.2 Descriptive statistics for small and large firms
Small and medium Large firms All firms

sized firms (≥ 500
(< 500 employed) employed)
Number of firms 747 252 999
(74.8%) (25.2%) (100.0%)
Industry structure
Market share 0.149 0.233 0.170
MES (log (lower 8.47 8.55 8.49
quartile of turnover))
Performance
Profit 0.099 0.103 0.100
Labour productivity 3.43 2.51 3.20
(mill DKK/empl)
Governance structure
Number of persons in 1.4 2.2 1.6
management (0.8) (1.3) (1.0)
Number of persons on 5.7 6.7 5.9
the board (2.5) (3.1) (2.7)
Links from board of 1.9 4.5 2.5
management (3.5) (6.1) (4.4)
– of which external 0.4 1.2 0.6
links (1.2) (2.9) (1.8)
Links from the board 10.0 13.5 10.9
(12.5) (14.4) (13.0)
Note: An external link is defined as a link from the management board to another firm
not owned partially or entirely by the first firm. Standard deviation is shown in brackets.
Information about firm performance and other financial information is based on 999 firms
with valid data. Results on external links between the firm and other firms are based on
valid information from 854 firms.
rate (ROE, defined as net result compared with net capital) even though
this measure is very unstable with a standard deviation about 2½ times
higher than the average.
Information about number of persons on the management board and
the board is based on valid information from 854 firms and there is a clear
difference between relatively large and small firms in respect to the number
of persons on the board. We find a relatively small management board, and
the overall average of 1.6 persons on the board of managers is the result of
a right-skewed distribution with one person as mode value (in about 50 per
cent of all firms, an owner is on the management board) and a few firms
with 6 persons on the management board.
As expected, larger firms tend to have a higher number of persons on the
management board and on average 60 per cent of the managers are repre-
sented in another external firm (an external firm is defined as a firm with
no obvious owner dependency of the first firm). The number of persons on
the board is around 6 and these persons are very active in respect to repre-
sentation on other boards and on average we find 11 links from the board
to another external board. However, these data do not allow us to identify
the relative importance of the other firm, so the networking activity is in
general somewhat overrated.
5.2 Educational Background
The educational background of the CEO and the chairman of the board is
based on the same source, GreensOnline. The information is reported by
the persons themselves and we can therefore expect a relative overrepresen-
tation of persons without any formal educational background as a result
of no information. The results are presented in Figure 15.1 and we do find
a high number of persons in top management without formal education.
Only about 30 per cent of the CEOs or chairmen of the board have a higher
education and about half of the chairmen of the board have a business
related education. The CEOs on the other hand are more oriented toward
a business related education if the person has a higher education.
The relation between the relatively low educational background and a
tendency towards professional CEOs is illustrated in Table 15.3. The table
underlines a number of interesting results. Firstly, we find that a relatively
low level of formal education among managers is prevalent and less than
one-third have a master’s degree. Secondly, there is a significant depend-
ency between the educational background of the chairman of the board
and the CEO. If the chairman has a master’s degree then the probability
of a CEO with a master’s degree is about 50 per cent higher than expected.
If the chairman does not have a higher education we find the opposite
70%
Chief executive
Chairman of the board
60%
Relative distribution in per cent
50%
40%
30%
20%
10%
0%
None listed Commercial Undergraduate Higher Higher
background business education business
education education
Education
Figure 15.1 Educational background of the top management
relation with an almost 20 per cent lower probability of finding a CEO with
a higher education. In other words, we find a significant overrepresentation
of chairmen and CEOs with the same educational background. These find-
ings are especially significant for the group of large firms with more than
500 employees (these results are not shown in Table 15.3).
6. EMPIRICAL MODEL AND RESULTS
The estimation results of the estimated models are listed in Tables 15.5a–c.
A basic productivity model is presented in Table 15.5a and we find the
general translog specification superior to the simple Cobb-Douglas model.
No social networking activity is included and there is no support for a sig-
nificant effect of educational level of the top management. Education and
networking activity may be seen as complementary activities and, if that
is the case, we can still find a positive effect from networking without any
effect from education. The relation between educational level of the top
management and social networking is shown in Table 15.4. The correlation
between internal and external networking is relatively low (below 30 per
Table 15.3 Formal education of executives in large Danish firms: relation

between chairman and executive manager
Chairman of the board

Low education High education
Executive Low education 504 136 640
manager (477) (163) (75%)
High education 132 82 214
(159) (55) (25%)
Total 636 218 854
(74%) (26%) (100%)
Notes: The table shows the highest formal education of 854 executives in the largest
Danish firms. A high education is defined as a university based education (master’s
degree). Numbers in brackets are expected number given independence between the two
characteristics. Row and column totals are presented together with percentages. c2-test of
independence rejects H0; c2 (1)524.6; P(c2 (1).24.6) < 0.0001
Table 15.4 Average number of links (social networking) and education
High educational level All firms

Internal networking 0.66 (1.04) 0.31
External networking 0.71 (0.88) 0.31
Notes: High educational level is defined as at least a master’s degree. The averages
reported are the number of links to other external and internal firms, and the numbers in
brackets are the average numbers for firms with high education for both the CEO and the
chairman of the board.
cent) and, on average, there is an external and an internal link in 30 per

cent of the firms. The average propensity to participate in social network-
ing activities is doubled if only top managers with a higher education are
considered – even though formal education has an effect on performance,
social networking activity complements education.
Concerning firm performance (Table 15.5a), which is measured by the
productivity effect in an augmented production function, 65 per cent of
all variation in firm turnover is explained by the simple model. Of course,
the coefficients for labour and capital are correctly signed and highly
significant and reflect approximately constant returns to scale in the pro-
duction. As we have no data for the firms’ use of raw and other materials,
we include a manufacturing dummy to correct for the fact that the retail
sector especially has a high level of other intermediate inputs. As expected,
the coefficient is negative and highly significant. The negative size effect
Table 15.5a Single equation (OLS) models: firm productivity
Dependent variable Cobb-Douglas Translog specification

Estimation method OLS OLS OLS
Intercept 6.120 8.482 8.620
(0.186) (1.169) (1.277)
Labour 0.670** 0.864** 0.698**
(0.033) (0.303) (0.333)
Capital 0.265** −0.224* −0.153
(0.015) (0.134) (0.133)
Labour*Labour −0.071** −0.060*
(0.032) (0.034)
Capital*capital 0.002 −0.002
(0.005) (0.005)
Labour*capital 0.063** 0.068**
(0.021) (0.021)
Size (dummy) −0.311**
(0.142)
Management size/ 5.270 2.862
employment (6.963) (6.909)
Size* (manag. size/ 110.48**
employment) (37.95)
Manufacturing (dummy) −0.272**
(0.049)
Market share 0.262**
(0.104)
Education of the CEO 0.004
(0.061)
Education of the chairman −0.033
(0.059)
Adj. R2 0.602 0.634 0.649

Number of observations 989 850 850
Notes: Numbers in brackets are standard errors of the estimated parameters. * indicates
that the estimated parameter differs significantly from zero at the 10% level of significance
and ** at the 5% level.
could also reflect a higher degree of in-sourcing for larger firms which have
enough scale in production to pursue even some of the more specialized
tasks in the production.
The number of persons in the management board relative to firm size does
not affect performance directly but the interaction between firm size and man-
agement size has a positive and significant effect on productivity. This result
supports the human capital argument: relatively small firms can be controlled
efficiently by one manager but large firms take advantage of a relatively large
management board with complementary skills. Market share affects firm
performance positively and significantly and this is in line with Demsetz’s
efficiency hypothesis, whereby the most efficient firms gain market shares,
and with Porter’s home based hypothesis, whereby multinational firms need
a strong and competitive home market to be innovative and competitive.
The standard productivity model is enhanced with the external social
networking variables in Table 15.5b. The first column (b50) uses the
simple number of ties as a proxy for social networking power while column
two uses the ‘optimal b’, and it is clear that there is no significant effect on
firm performance from social networking.
External networking activity and firm performance using a SURE
specification allowing for interdependence between firm performance and
networking is reported in the last part of Table 15.5b and their effect on
performance from networking is the same. In the equation for the social
networking activity, the coefficients of educational level are positive and
significant as expected.
The general picture is an insignificant coefficient to all tested variants of
the Bonacich power measure of centrality when we look at the external net-
working. This leads to the conclusion, in line with Booth and Deli (1996),
that persons involved in networking activities may benefit from the activity,
but firms representing these persons are not sharing any of this surplus.
Table 15.5c presents the model with internal networking activities. The
correlation between internal and external networking is relatively low and
therefore there are no significant changes in the results if external network-
ing activity is reported in the same model. The basic model reports the same
results and, while the effect of external networking is insignificant and with
positive and negative signs, the overall picture is that internal networking
activities do increase productivity of the firms involved. Using the optimal
version of the Bonacich power measure (including secondary values of a
network), we find a significant positive effect on performance. However,
the overall picture is not convincing and the significance disappears when
the models are estimated using SURE methodology (last columns in Table
15.5c).
7. CONCLUSION
Networking among persons in top management positions may serve as

a means for sharing knowledge and, furthermore, the educational level
might increase the capacity of gaining advantages from new information.
Table 15.5b External networking effects in models for firm ties and
productivities
Dependent variable Productivity SURE (produc., network)

Model b50 ‘optimal b’ Productivity Network
Intercept 8.62 8.49 8.63 0.028
(1.29) (1.30) (1.29) (0.045)
Labour 0.698** 0.718** 0.697**
(0.334) (0.336) (0.334)
Capital −0.154 −0.141 −0.154
(0.136) (0.135) (0.136)
Labour*labour −0.060* −0.060* −0.060*
(0.034) (0.034) (0.034)
Capital*capital −0.002 −0.002 −0.002
(0.005) (0.005) (0.005)
Labour*capital 0.068** 0.066** 0.068**
(0.022) (0.021) (0.021)
Manufacturing (dummy) −0.272** −0.272** −0.273** 0.029
(0.049) (0.049) (0.049) (0.057)
Market share 0.262** 0.264** 0.262**
(0.104) (0.104) (0.104)
Size (dummy for emp. −0.312** −0.309** −0.313** 0.493**
≥ 500) (0.143) (0.142) (0.143) (0.066)
Management size/ 2.87 2.89 2.85
employment (6.92) (6.91) (6.91)
Size* (man. size/empl) 110.60** 110.17** 110.60**
(38.22) (37.97) (38.22)
Networking (Bonacich −0.001 0.001 0.001
power) (0.028) (0.003) (0.028)
Education of the CEO 0.343**
(0.066)
Education of the 0.387**
chairman (0.065)
Minimum efficiency 0.741**
scale, MES (0.057)
Adj. R2 0.648 0.648 r(produc.,netw.)50.002
and ** at the 1% level. Models for productivity and networking activity are estimated
simultaneously using a SURE (seemingly unrelated regressions) procedure.
Table 15.5c Internal networking effects in models for firm ties and
productivities
Dependent variable Productivity SURE (produc., network)

Model b50 ‘optimal b’ Productivity Network
Intercept 8.51 8.61 8.51 0.140
(1.28) (1.27) (1.28) (0.050)
Labour 0.725** 0.675** 0.724**
(0.334) (0.333) (0.334)
Capital −0.145 −0.133 −0.145
(0.133) (0.132) (0.133)
Labour*labour −0.062* −0.056* −0.062*
(0.033) (0.034) (0.034)
Capital*capital −0.002 −0.002 −0.002
(0.005) (0.005) (0.005)
Labour*capital 0.067** 0.065** 0.067**
(0.021) (0.021) (0.021)
Manufacturing (dummy) −0.269** −0.265** −0.269** −0.110*
(0.049) (0.049) (0.049) (0.063)
Market share 0.264** 0.263** 0.264**
(0.104) (0.104) (0.104)
Size (dummy for emp. ≥ −0.308** −0.297** −0.309** 0.452**
500) (0.142) (0.142) (0.142) (0.073)
Management size/ 2.52 2.01 2.51
employment (6.91) (6.90) (6.91)
Size* (man. size/empl) 109.80** 108.64** 109.79**
(37.95) (37.85) (37.95)
Networking (Bonacich 0.028 0.002** 0.030
power) (0.025) (0.001) (0.025)
Education of the CEO 0.269**
(0.073)
Education of the 0.344**
chairman (0.072)
Minimum efficiency scale, 0.002
MES (0.279)
Adj. R2 0.649 0.651 r(produc.,netw.)5−0.002
and ** at the 1% level. Models for productivity and networking activity are estimated
simultaneously using a SURE (seemingly unrelated regressions) procedure.
In addition, networks among CEOs could facilitate and lead to collusion

among the competitors in the market. Therefore, the expected influence on
firm performance of this networking and education is positive.
The empirical analysis is based on a sample of large Danish firms and it
shows no effect of the educational level of the top management on perform-
ance. On the other hand, we find interdependency between the educational
level of the CEO and the chairman of the board. Education also affects the
overall attitude towards networking positively.
The effect of networking between top managers on their firms’ perform-
ance is in general not found. However, we find a weak significant positive
effect on firm performance regarding internal network activities, which
means that social networking activities may be interpreted as control of
subsidiaries, but we find no support for a conjecture of a positive effect on
firm performance from the ‘old boy networks’.
NOTES
* We would like to thank two anonymous referees and the participants of the 7th Workshop on
Corporate Governance and Investments in Jönköping, April 2006, for helpful comments.
1. Online access: www. GreensOnline.dk
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Index
accounting principles, German backward integration 21
corporate governance ratings Bain, J. 20
364–5 Balearics region (Spain), family firms
Adams, R. 142 in see family businesses, Balearic
administered price hypothesis 48 region
agency bargaining power, and authority 85
costs 140, 141, 163, 210 Barnard, Chester 14, 83
and institutional ownership 229, Baumol, William 49
230 bauxite ore, raw materials
principal–agent contracts 4, 52, procurement 21–2
53–4, 86, 87 Bebchuk, L. 142
principal–agent model 202, 204 behavioral attributes 14
and property rights theory 86 Bennedsen, M.B. 143
theory 86, 99, 188 Berle, A.A.
Alchian, A. 31, 86, 87 The Modern Corporation and Private
allocation and economic growth Property 2, 45, 46
124–7 on ownership concentration 140,
all-or-none trading rule 24 141, 142, 162
Amadeus database 294 and takeover regulation 190
antitrust 4–5 Bertrand, M. 329
crisis in (1970) 11–12 bilateral dependency, asset specificity
general application to 18–19 14
inhospitality tradition in 22 Bjuggren, P.-O. 148, 151, 152, 155
objections to exchanges 26–7 Black, B. 211
appropriable quasi-rent 68, 79 black box of firm, opening
arbitrage pricing theory (APT) 171, antitrust analysis 19
180, 183 exchange agreements 26
‘The Architecture of Complexity’ firm size, limits to 30
(Simon) 31 and market organization 1, 11, 33
Areeda, Philip 23, 24 and neoclassical model 64
Arrow, K.J. 105, 130 Blair, M.M. 326
asset specificity 14, 19–20 Blake, H.M. 33
associated families, Balearic region see board composition 5–7
family businesses, Balearic region board neutrality rule, Thirteenth
auction rule, US 192, 197 Company Law Directive 209
authority board size, German corporate
bureaucratic 88 governance ratings 364
definitions 83–4, 90 Bøhren, O. 324, 326, 330
delegation of 89 Bonacich, P. 382, 387–8
formal and real 88–90, 91 Booth, J. 385
managerial see managerial authority boundary of firm issue, scaling up
automotive industry 67–8 31
401
402 Index
bounded rationality (contractual econometric evidence 339–46, 340,

incompleteness) 14, 79 343, 345
Brick, I.E. 330 employee directors, effects 6
Burkart, M. 142, 383–4 estimation and method 338–9
business judgment rule, US 192 fixed effects estimations 325, 338
business opportunities space (universal lagged firm performance 328, 352
state space) 104, 107, 108 leverage 330, 342, 355
and competence bloc theory 111–12 literature review 325–6
methodology 338, 339
CAPM (capital asset pricing model) reverse causation hypothesis, and
4 co-dermination hypothesis 329
conventional 180 robustness checks 339, 346–53, 347,
institutional risk and uncertainty 350–51
170–71, 175, 178, 182 simultaneity and endogeneity 323–4,
multi-beta 171 328–31
cargo shipping 71 stakeholder or interest group 326–8
Carlsson, Bo 113 theory and hypotheses 326–31
Carter, D.A. 330 three-stage least squares (3SLS)
cash flows methodology 6, 325, 338
cash flow rights and control rights Wald test 342, 352
142, 143, 163 see also employees
cash flow rights and performance cognition, transaction cost economics
142, 158 14
and dual-class shares 163 cognitive competence 13
and neoclassical model 50 commercialization competence 114
rates of return on 49 company interest, concept 190
role in investment 56–7 Company Law Directive (13th),
Chandler, Alfred 33 takeover bids 194, 196, 201, 203,
Cheung, Stephen 86, 87 204, 209
Chicago School, antitrust scholars Company Law Review Steering
from 18 Committee/Group 187, 188
civil law competence 13
shareholder value and legal bloc theory see competence bloc
conception of firm 186–90 theory
takeover bids business, nature of 110–13
Europe 201–4 commercialization 114
Japan 204–7 horizontal diversity 116–17
Claessens, S. 142 receiver 113
Club Med, shareholder agreements and social capital 121
261, 267, 271, 273, 275, 276 specification of firm in EOE 107–9
Coase, Ronald H. 15, 63, 85, 87, 108 venture capital 115
‘The Nature of the Firm’ 84 competence bloc theory 107
co-determination, impact upon firm actors in 3, 110, 111, 113–17
performance 6, 323–54 decision structure of bloc 111
board employee directors 326, 330, definitions 126
331 hierarchies, limits 112
negative employee director effect industrial spillover generator, bloc
327–8, 355 as 117
data and institutional background institutions and incentives/
331–8, 335–7 competition 120–21
Index 403
nature of business competence and contractual specificities 76

efficiency of project selection control enhancing mechanisms (CEM)
110–13 142
theory of firm 117–20 control rights, shareholder agreements
vertical completeness of bloc 115–16 270–71
competition Conyon, M. 383
endogenous growth through 121–4 coordination 93–8
and institutions 120–21 problem 85–6, 94, 96
product market 51 corporate control
Compustat Global database 148 economists’ view of market 209–13
concentration of ownership and investment, in Scandinavia
in Anglo-Saxon countries 144 140–44
and descriptive statistics 235–9 market for 52, 53, 213–14
Germany, corporate governance in stock market prices and market
7, 363 213–16
intermediate levels of 263, 264–5 corporate governance
and investment performance 141–2 Anglo-Saxon model 212, 225
non-linear effects on performance Codes 365–7
141–2, 156, 162–3, 226 French model 189
and ownership structure 142 in Germany 361–79
in Scandinavia 144, 145 governance structures 14–15
see also Scandinavian countries and ownership 227–32
conglomerates 33 principal–agent model 202, 204
contract of affreightment (COA) 71, 72 in Scandinavia 139–40, 143–4,
contracts 145
contract as framework/contract as corporate return, in Scandinavia 149,
legal rules 17 151–6
employment 66, 84–5, 100 cash-flow rights and performance
firm as nexus of 64, 65–8, 66 158
freight 72 concentration of control, voting
hazards, contractual 20 rights and performance 159
insecure, risk of 170 dual-class shares 160, 161
long-term 68 and ownership structure 156–7,
in maritime transport 66, 75–8 160–62
and markets and firms 68–70 corporate value, concept of 206, 207
principal–agent 52, 53–4, 86, 87 corporation
spot 76–7 Anglo-Saxon version 43
wide spectrum of 86, 87 centralized/de-centralized 33
see also contractual perspective of and early economists 43–6
firm; freedom of contracts managerial discretion 51–4, 56
contractual perspective of firm 2, managerialist challenge 48–51
64–70 ‘marginalist’ controversies 46–8
firm as nexus of contracts 64, 65–8, M-form structure 33
66 modern see modern corporation
flexibility 68 recent developments 54–5
maritime industry 2, 74–8 Cosh, A. 216
mutual dependency 2, 69–70, 78 creative destruction process,
specialization and institutions 65 Schumpeterian 106, 121, 124
water tightness 68 credible commitments 25–8
see also contracts Cronqvist, H. 143
404 Index
cross-holdings 142, 143, 203, 204 ownership and performance 160, 161
Cyert, R.M. 49 Sweden 3, 5, 143, 144
de Beers 24, 25 early economists 43–6

de la Torre, C. 240 Easterbrook, F.H. 330
De Soto, Hernando 168–9 economic mistakes, informational
Debreu, G. 130 assumptions 105
dedicated assets 69, 80 educational background, networking
Delaware courts, US 189, 192 391–2
delegation efficient capital market 2, 51, 52–3
of authority 96–8 Eisenberg, T. 330
of discretion 92, 97 Eliasson, G. 108, 109, 119
Deli, D. 385 Elster, Jon 34
Demsetz, H. 35 employees
on experimentally organized on board see co-determination,
economy 105 impact upon firm performance
on managerial authority, knowledge costs of bargaining with 91
economy 86, 87 discretion, exercise of 89, 100
on ownership concentration 141, and hostile bids 198, 199, 200
144 employment contracts 66, 84–5, 100
on scaling up 31 endogenous growth
Denmark competition, through 121–4
dominant firm 152 micro-to-macro model, Swedish
dual-class shares 143, 144 122
networking in see networking: in Salter curves 122–3
Denmark entrenchment effect 141, 142, 163, 383,
descriptive statistics 235–9, 390–91 385
diffusion, technological 125–6 entrepreneurs 114, 115, 168
disclosure requirements, shareholder EOE (experimentally organized
agreements 258 economy) see experimentally
discount rate 169, 170 organized economy (EOE)
discretion equity rights, shareholder agreements
defined 88–9 269
delegation of 89, 97 Ericsson 152
exercise by employees 89 Europe
managerial 51–4, 56 Codes of Corporate Governance
discriminating alignment hypothesis 15 365–7
distribution, vertical market relations takeover bids 201–4
22 Eurostat 149
dividends, and institutional ownership exchange agreements 25–8
see institutional ownership and Canadian Study 26, 28
dividends entry fees 26–7
Drobetz, W. 361, 362, 378 growth and supplementary supply
dual-class shares 3 restraints 27–8
and cash-flow rights/control rights objections to exchanges 26–7
163 petroleum exchanges 26
Denmark 143, 144 executive remuneration, German
effects 142 corporate governance ratings 365
Finland 143, 144 experimentally organized economy
Norway 3, 143 (EOE) 104–27
Index 405
allocation and economic growth Federal Trade Commission, US 26, 35

124–7 Ferreira, D. 142
business opportunities space 104, ferry/cruise market, maritime industry
107, 108, 111–12 71
competence bloc theory see financial contracting 255, 279
competence bloc theory Finland
competence specification of firm in dominant firm 152, 153
107–9 dual-class shares 143, 144
critical mass 117 firm interaction, social network
dominant selection problem 109, 110 analysis 386
efficient selection in 111 flip-in/flip-over, anti-takeover defences
endogenous growth 121–4 193
flexibility 117 Ford Motor Company, raw materials
informational assumptions 104–10 procurement 21
macro dynamics, experimental forward contracts
selection 109–10 contractual specificities 76
MOSES model 127, 128 tramp shipping 70
opportunities space assumption 109 Frank, Robert 50
property rights 120 freedom of contracts 168, 262–74
static equilibrium 128 freight market 70–71
tacit dimension 108 Fuchs, Victor 11
Fudenberg, Drew 14, 35
Faccio, M. 142 Fuerst, M.E. 325, 352, 353
Falaye, O. 326 functional efficiency of capital markets
Fama, Eugene 51, 118 146, 162
family businesses, Balearic region fundamental valuation efficiency
292–319 (FVE) 213
business group directors and family
312–15 General Motors 54
business groups under control of Georgescu-Roegen, N. 112
associated families 305–17 Germany, corporate governance in
companies under control of 361–79
associated families 298–305 accounting principles 364–5
data sources and methodology board size 364
294–8 Code of Corporate Governance
definition of family business 292–4 367
family group heterogeneity 306–7 ‘comply or explain’ kind 6
measurement of family group see also corporate governance:
diversification 307–12 Codes
relevance of associated family concentration of ownership 7, 363
companies in region 296–8 data description 367–71
representative company 298–9 empirical results 372, 373, 374
sector diversification and family executive remuneration 365
control 315–17 explanatory variables 369, 370, 371
sector of activity diversity 303–5 HGB rules 364, 365
size, differences according to 299– hypotheses 363–5
300, 301, 302–3 IAS rules 362, 364, 365
‘two-surnames’ system 6 ownership concentration 363
Faure, M. 167 ratings 367–9
Fauver, L. 325, 352, 353 components of 376, 377, 378
406 Index
robustness tests 374–6 economic mistakes 105

US-GAAP rules 362, 364, 365, 378 grossly ignorant actor 105
Gierke, Otto von 190 industrial development theory
Gilson, R. 211 104–10
Gompers, P. 329 Särimner effect 106–7
governance structures 14–15 innovations, market for 114
Grabowski, H. 49 in-or-out trading rule 24, 25
Gugler, K. 148, 155–6 institutional ownership and dividends
5
Hall, R. L. 47, 48 agency arguments 229, 230
Hannah, Leslie 200, 201 Breusch-Pagan/Cook-Weisberg test
Hart, Oliver 86 241
Hayek, Friedrich 14 concentration, and descriptive
‘Heisenbergian flux’, economy in 105 statistics 235–9
Heritage Foundation 167, 173, 177 earnings trend model, modified
Hermalin, B.E. 331 232–4
hierarchies, governance structures 15 empirical results and analysis
High Level Group of Experts, on 239–45, 246
takeover bids 201, 202, 203, 204 FGLS estimations 241, 242, 243
Hitch, C.J. 47, 48 fixed effects estimations 244
Holmstrom, Bengt 14, 92 full and partial adjustment models
horizontal diversity, competence 232
116–17 Hausman test 243
horizontal mergers 32 hypotheses 230–32
Hughes, A. 216 institutional shareholdings, positive
human capital (production factor) 65 effect on dividend changes 231
Hume, David 168, 180 non-linear relationship 231, 241
hybrid contracting, governance OLS regression 241, 245
structures 15 research methodology 232–4
signalling arguments 229–30
IBM 111, 118 taxation arguments 228–9
Imperial–Shell exchange agreement variables 234, 235
27–8 vote-differentiated shares 231–2,
incentives 242, 244, 245
business opportunities space Waud model 232, 233
(universal state space) 107 see also ownership
concentration of ownership 141 institutional risk and uncertainty
and institutions 120–21 adaptations to 85
in knowledge economy 92 estimations of risk and return 171–2,
Särimner effect 107 180
use of authority from perspective of first-pass regression 173, 177
90–93 freedom of contracts 168
Industry and Trade (Marshall) 45 insecure property rights and
information arbitrage efficiency (IAE) contracts, risk of 170
213 models and results 177–80, 179
informational assumptions net present value 169
allocation and economic growth political risk 168
126–7 portfolio theory and investment
competence specification of firm in 170–71, 180
EOE 107–9 property rights 4, 168–9
Index 407
regression specification error test Klein, Benjamin 17, 24, 68

(RESET) 180 Knight, Frank 29
research data 172–3, 174–5, 176 knowledge economy 3
risk-free rate plus risk premiums centralized decision making 95
181–2 diminishing use of authority in 3,
second-pass regression 177, 178 92, 98–9
transaction attributes 14 information dispersal 91–2
world market portfolio 177 informational assumptions 104
Institutional Shareholders Committee, investment in assets 91
guidelines 217–18 managerial authority in 82–99
institutions Kogut, B. 383
and incentives/competition 120–21 Koopmans, Tjalling 11
institutional environment, Kuth, E. 57
importance 3–5
and specialization 65 La Porta, R. 144, 226, 383
intermediate product market Lang, L.H.P. 142
transaction (paradigm lateral integration 20–21
transaction) 15–18 Lee, S. 142
Node A (unassisted market) 16 legal conception of firm, and
Node B (unrelieved hazard) 16–17, shareholder value, in common
23 and civil law 186–90
Node C (credible commitment) 17, Legrand, shareholder agreements 261,
23 267–8, 276
Node D (integration) 17, 18 Lehn, K. 144
simple contractual schema 16 lens of contract/governance 12, 13, 34
International Country Risk Guide Lester, Richard 47
(ICRG) 173, 177, 178 Lewis, Tracy 29
International Stock Exchange, Pre- life-cycle hypothesis 49, 50
emption Group 217 liner market, maritime industry 71
investor rights protection (IRP) 173 Lintner, J. 232
Llewellyn, Karl 17
Japan, takeover bids 204–7
Jensen, Michael 30–31, 54–5, 92, Magirou, E. 70
140–41, 143 managerial authority
joint stock companies 43 and bargaining power 85
Jorgenson, Dale 50, 211 centralized 94–6
change in relative use of 90–98
Kaplan, A.D.H. 47 diminishing of use, in knowledge
Kaplan, S. 255 economy 3, 92, 98–9
Kasper, W. 168 from incentive perspective 90–93
Kay, John 214 from production coordination
Kelly, Marjorie 208 perspective 93–8
Kennedy, Allen 208 coordination problem 85–6
Kenney, Roy 24 delegating, setting 96–8
Keynes, John Maynard/Keynesian in firms and markets 84–90
economics 46, 113 incentive perspective, use from
Kindahl, James 48 90–93
kinked-demand schedule hypothesis managerial, in knowledge economy
47, 48 82–99
Kirzner, I.M. 105 measurement costs 87
408 Index
orders 82–3, 87, 99 third-party ship management 66,

production coordination 74–5, 79
perspective, use from 93–8 tramp shipping 70, 71
and property rights 82, 85–6 vessel as fungible asset 67
relations between employer/ mark-up pricing model 47
employees 2–3 market
subordinate’s acceptance of 84 corporate control 209–16
see also authority see also corporate control
managerial discretion economists’ view of, for corporate
constraints on 51–2 control 209–13
strength of constraints 52–4 for innovations 114
end to 56 for managers 51, 53
managers ‘pure vanilla’ type 1
managerialist challenge 48–51 and stock market prices 213–16
market for 51, 53 market organization
of private-sector companies 186 antitrust see antitrust
see also managerial authority; credible commitments 25–8
managerial discretion intermediate product market
mandatory bid rule, United Kingdom transaction (paradigm
194, 209 transaction) 15–18
Manne, Henry 52 lens of contract/governance 12, 13, 34
March, J.G. 49 microanalytics 13–15
marginal q, use of 3, 4, 55 and opening black box of firm 1,
agency hypothesis 148 11, 33
cumulative distribution 150–51 price theoretic issues 22–5
definitions 145–6 vertical market see vertical market
measurements 146, 162 relations
ratios 146 see also corporation; modern
in Scandinavia 3, 149, 150–51, 152 corporation
see also Tobin, J./Tobin’s q market-for-corporate control 52
marginalist pricing models 46–8 Marris, Robin 49, 52
maritime industry 2 Marshall, Alfred 2, 45, 46
bulk shipping, contracting practices Masten, S. 75
77 Matthews, R.C.O. 35
carrier and shipper, link between Maury, B. 143
78 McConnell, J.J. 141
characteristics of maritime transport Means, G.C. 46–7, 48
70–74, 77–8 The Modern Corporation and Private
contractual perspective 74–8 Property 2, 45
contracts in maritime transport on ownership concentration 140,
66, 72, 75–8 141, 142, 162
see also contractual perspective Meckling, William 30–31, 92, 140–41,
of firm 143
economic organization 74–8 mergers 32, 208
freight loading, and scaling-up 31 Merrick Dodd, E. 190
freight market 70–71 METI (Japanese economics ministry)
shipping company 72–4 206
structure of shipping services Meyer, J.R. 57
in relation to cars/car micro-to-macro model, Swedish 122,
manufacturers 69 124, 125
Index 409
Miguel, A. 245 Bonacich approach 382, 387–8

Milgrom, Paul 14, 92 data description 389–92
Mill, John Stuart 2, 44, 45, 46 in Denmark 7, 382–98
Mitroussi, K. 74, 75 descriptive statistics 390–91
modern corporation educational background 391–2
conglomerates 33 empirical model/results 392–5
firm size, limits to 29–30 and firm performance 383–4
horizontal mergers 32 network ties
scaling up 30–32 French shareholder agreements
modified earnings trend model, 273–4
institutional ownership 232–4 internal and external 7, 389, 392
Modigliani and Miller cost of capital measuring, using ownership
50 structure information 388–9
The Modern Corporation and Private nodes and lines 356
Property (Berle and Means) 2, social network analysis 386–9
45, 46 translog specification 392
Moller-Maersk 152 new growth theory 114
monopolies, oligopoly–monopoly New York Stock Exchange index 171
comparisons 32 nexus of contracts, firm as 64, 65–8
moral hazard 91, 92 Nielsen, K.M. 143
Morck, R. 139, 141, 227 Nilsson, M. 143
Morgan Stanley world market index Nippon Broadcasting System (NBS)
171, 172, 173 205
MOSES (Model of the Swedish ‘Nirvana fallacy’ 105, 128
Economic System) 127, 128 Node A (unassisted market)
Mueller, D.C. 145, 148, 149 contracting 16
Muldoon, M. 383 Node B (unrelieved hazard) 16–17, 23,
Mullainathan, S. 329 27, 35
Muris, Timothy 19, 35 Node C (credible commitment) 17,
mutual dependency, contractual 23, 35
perspective of firm 2, 69–70, 78 Node D (integration) contracting 17,
18
NACE (economic business activity) Nokia 152
codes 294, 309 Norsk Hydro 152
one-digit level 303 Nortel 214
two- and three- digit levels 308, 310 North, D.C. 168
‘The Nature of the Firm’ (Coase) 84 Norway
NBS (Nippon Broadcasting System) dominant firm 152, 153, 154
205 dual-class shares 3, 143
neoclassical model 2, 45 marginal q, use of 4
assumptions 106 proportionality principle 144
‘black box’ theory 64
corporate control and investment oligopolies 32, 47
140 one-share-one vote principle 142, 144
investment 50 opportunism 14
limitations of 50 organization of economic activities 2–3
and marginalist controversies 46, 47 over-searching 24–5
net present value (NPV) 169 ownership
networking and capital 65–6
activities 384–5 categories 235
410 Index
concentration see concentration of repositioning 24

ownership Robinson-Patman Act 23
and corporate governance 227–32 trading rules 24, 25
institutional see institutional principal–agent contracts 4, 52, 53–4
ownership and dividends principal–agent corporate governance
nature of, and shareholder model 202, 204
agreements 262–8, 264–5 private equity market, competence
nominal 142 bloc theory 110
pyramid 142, 143 product market competition 51, 52
single owners 143 product variation 112
structure see ownership structure production coordination, use of
ownership structure authority from perspective of 93–8
and board composition/firm profit disgorgement 193
performance 5–7 profit maximization 47, 48, 141
and concentration of ownership 142 ‘proper purposes’ doctrine 196
and corporate return, Scandinavia property rights
156–7, 158–9, 160–62 and agency 86
measuring network ties between experimentally organized economy
firms using information on 120
388–9 insecure, risk of 170
institutional risk and uncertainty
Pajuste, A. 143 168–9
Panel on Mergers and Takeovers, UK and managerial authority 82, 85–6
194 nexus of contracts, firm as 65–6
paradigm transaction 15–18 property rights protection (PRP) index
Pernod Richard, shareholder 173
agreements 259–60, 266, 267, 272, proportionality principle, Norway
276 144
Perotti, E. 330 Publicis, shareholder agreements 260,
physical capital (production factor) 65 266, 267, 276
Pindado, J. 240 pyramid ownership 142, 143
Pirrong, Stephen 64, 75–6
poison pills, anti-takeover defence 193 Raheja, C. G. 327
political risk 167, 168 Rathenau, Walther 190
Political Risk Group 167 raw materials procurement, vertical
Porter, Michael 212 market relations 21–2
portfolio theory and investment Reardon, Elizabeth 54, 145, 148, 149
170–71, 180 regression specification error test
Pound, J. 229, 230 (RESET) 180
predatory pricing 23–4 remuneration, German corporate
present value (PV) 169 governance ratings 365
price discrimination 22–3 repositioning, predatory pricing 24
price rigidity 47, 48 RESET (regression specification error
price theoretic issues test) 180
marginal cost pricing test 24 Robinson-Patman Act (Anti-Price
mark-up pricing model 47 Discrimination Act) 1936 23
output test 24 robustness tests
over-searching 24–5 co-determination, impact upon firm
predatory pricing 23–4 performance 339, 346–53, 347,
price discrimination 22–3 350–51
Index 411
German corporate governance Pernod Richard 259–60, 266, 267,

374–6 272, 276
Roe, M. 278 Publicis 260, 266, 267, 276
Roll, R. 171, 177 Schneider Electric 261, 272, 273,
Ruback, Richard 54 275
rules, formal and informal 168, control rights 270–71
170 definition of 255–6
disclosure requirements 258
Särimner effect, informational duration of 257
assumptions 106–7 empirical setting and methods
scaling up 30–32 256–61
Scandinavian countries 3, 139–63 equity rights 269
cash-flow rights and performance in France 256–8
158 impact 274–7
corporate control and investment listed firms, used by 256–7
140–44 minority investors, protection 271
corporate governance in 139–40, more likely to be found, where
143–4, 145 in companies with intermediate
corporate return in 149, 151–6 levels of ownership
and ownership structure 156–7, concentration 263, 264–5
158–9, 160–62 incumbent shareholders seeking to
dual-class shares 142, 160, 161 maintain dominant control
homogeneity of 140, 144 268
hostile bids rare in 143 large investors seeking to protect
largest countries in 153–4 bargaining power 272
marginal q, use of 3, 149, 150–51, long-term interest of shareholders
152 266–7
micro-to-macro model, Swedish 122, non-financial objectives of owners
124, 125 267–8
over-investment 4 shareholders addressing complex
research methodology 145–9 and conditional issues with
vote-differentiated shares in 142, intermediate information
143, 157, 162 asymmetry 271–2
Schneider Electric, shareholder social ties of leading officers and
agreements 261, 272, 273, 275 directors 273–4
Schumpeter, J. 55, 130 stable businesses with small
creative destruction process 106, lock-in costs 268–9
121, 124 takeover risk 272
on innovator and entrepreneur nature of contract items 269–72,
129 270
self-interest, transaction cost nature of industry 268–9
economics 14 nature of ownership 262–8, 264–5
Servaes, H. 141 negatively perceived where 276
shareholder agreements 5, 253–80 network ties 273–4
antecedents of 262–74 non-equity and control issues 271
background 255–6 positively perceived where 276–7
cases related literature 256
Club Med 261, 267, 271, 273, 275, sources and methods 258–9
276 typical contracts 257
Legrand 261, 267–8, 276 written contracts 255
412 Index
shareholder value and legal conception The State of Competition in the

of firm, in common and civil law Canadian Petroleum Industry 26
186–90 static equilibrium, EOE 128
shareholders Stigler, George 47, 48
free-riding by 197, 230 stock market
issues addressed by, with corporate control, market for
intermediate information 214–15
asymmetry 271–2 as evolutionary mechanism
long-term interest of 266–8 213–14
as owners of firm 67 in developed countries 175
primacy, notion of 187, 208 efficiency types 146, 162, 213
see also shareholder agreements mispricing of shares 214–15
shark repellents, anti-takeover defence over- or under- estimation of 160
192–3 pricing process 213
ship-management companies 75 in Scandinavia 148–9
shipping company, and marine swings, sensitivity to 151
industry 72–4 technology boom (1995–2000) 214
see also maritime industry see also takeover bids
Shleifer, A. 142 Stout, L.A. 326
Short, H. 232 strategic acquisitions market,
‘short-termism’ 212, 247 competence bloc theory 110
Shrader, C.B. 330 Streit, M.E. 168
Siebert, Calvin 50 Strine, Leo 189
Simon, Herbert 13 Strøm, R.O. 324, 326, 330
on authority 83–4, 85, 90 Strömberg, P. 255
on knowledge economy 91, 97 Stuckey, John 21
on managers 49 Summers, Larry 212
on scaling up 31 Sweden
Sinani, E. 383 dividends 228, 230
Singh, A. 212, 216 dominant firm 154
size of firm dual-class shares 3, 5, 143, 144
and associated families 299–300, economic tradition 115
301, 302–3 innovation capacity 119
limits to 29–30 micro-to-macro model 122, 124,
Skogh, G. 167 125
Smith, Adam 2, 43–4, 45, 46, 63 MOSES model 127, 128
on property rights 168, 180 mutual funds 227
The Wealth of Nations 44, 65 shipping industry 64, 71
Smith, N. 330 taxation system 228–9
social capital, and competence 121 Sweezy, P.M. 47, 48
social network analysis
firm interaction 386 takeover bids
measuring power using 386–8 anti-takeover defences 192–3, 196,
measuring ties between firms 207
388–9 British model 194–201
Solow, R. 30 City Code 194, 197, 202, 203
specialization 65, 67 civil law model, mainland Europe
Spier, K.E. 330 201–4
spot markets/contracts 15, 70, 76–7 Company Law Directive (13th) 194,
Standard and Poor’s 500 index 171 196, 201, 203, 204, 209
Index 413
High Level Group of Experts on and authority 3

201, 202, 203, 204 cognition and self-interest 14
hostile takeovers 4, 55 costly nature of transactions 64
and employees 198, 199, 200 intermediate product market
rare, in Scandinavia 143 transaction (paradigm
rise of 191 transaction) 17
‘just say no’ defence 191, 192 lateral integration 20
legal regulation of 190–209 lens of contract/governance 13
origins of takeover regulation and managerial authority 82
190–92 predatory pricing 23
regulation in emerging and Robinson-Patman Act 23
transition systems 208–9 scaling up 31
stakeholder statutes 193 shareholder agreements 5
tender offers 55 transactions, attributes of 14
US model 192–4 transparency, and takeover regulation
taxation, and institutional ownership 192
228–9 Turner, Donald 23, 24
teamwork 31, 86
technological core 20, 31 United Kingdom
technological diffusion 125–6 City Code on Takeovers and
temporal specificities 75, 76 Mergers 194, 197, 202, 203
tender offers 55 Companies Act 2006 188
theory of firm 31, 117–20 Company Law Review Steering
thermal economies 20 Committee/Group 187, 188
third-party ship management 66, 74–5, deregulation policy 190–91
79 mandatory bid rule 194, 209
Thomsen, S. 383 networking and firm performance
three-stage least squares (3SLS) 383
methodology 6, 325, 338 privatization policy 190
time charter, freight contract 72 takeover bids 194–201, 203
time contracts, contractual specificities United States
76 corporate law 189, 192
time series analysis 171 Delaware courts 189, 192
Tirole, J. 330 deregulation policy 190–91
Tobin, J./Tobin’s q 143, 146, 162 economy, during 1990s 43
co-determination, impact upon firm Federal Trade Commission 26, 35
performance 325, 326, 343 marginal q, use of 55
definition of Tobin’s q 145 networking and firm performance
Germany, corporate governance in 383
375 privatization policy 190
marginal q distinguished 148 Sarbanes-Oxley Act 361
see also marginal q, use of takeover bids 192–4
measuring 142 utility maximization 141
relationship between ownership and
Tobin’s q 141 value added chains 67–8
Tokyo Stock Exchange (TSE) 207 Veblen, Thorstein 141
total market value of firm, defined 148 venture capital market 110, 115
trading rules 24, 25 vertical integration 36, 67, 69, 70
tramp shipping 70, 71 vertical market relations 19–22
transaction cost economics distribution 22
414 Index
lateral integration 20–21 The Wealth of Nations (Smith)

raw materials procurement 21–2 44
vertical market restrictions 12, 22 Weber, Max 88
Vishny, R. W. 142 Weisbach, M. S. 331
vote-differentiated shares Weiss, Leonard 48
and dividend changes 231–2 Wibert, D. K. 151
institutional ownership and Wicksell, Knut 105
dividends 231–2, 242, 244, 245 Wieberg, D. 152, 155
in Scandinavia 142, 143, 157, 162 Williams Act, US 192, 193
voyager charter, freight contract 72 Williamson, Oliver 49, 63, 68
Walker, G. 383 Yermack, D. 330

Walras, L. 130 Yurtoglu, B. B. 148
Walras–Arrow–Debreu (WAD) model
106, 127, 129 Zeckhauser, R. 229, 230

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The Modern Firm, Corporate Governance

Series Editor: Jonathan Michie, Director, Department for Continuing

The modern corporation has a far-reaching influence on our lives

● corporate governance and corporate responsibility, including

Titles in the series include:

Corporate Governance, Organization and the Firm

The Modern Firm, Corporate Governance and Investment

NEW PERSPECTIVES ON THE MODERN CORPORATION

All rights reserved. No part of this publication may be reproduced, stored in

Edward Elgar Publishing, Inc.

A catalogue record for this book

Library of Congress Control Number: 2009922767

ISBN 978 1 84844 225 2

Printed and bound by MPG Books Group, UK

1 Introduction: the modern firm, corporate governance and

PART I KEY ISSUES

2 Opening the black box of firm and market organization: antitrust 11

PART II THE THEORY OF THE FIRM FROM AN

4 A contractual perspective of the firm with an application to

PART III INVESTMENTS AND THE LEGAL

7 Corporate governance and investments in Scandinavia –

PART IV THE BOARD, MANAGEMENT RELATIONS

10 Institutional ownership and dividends 225

II. ORGANIZATION OF ECONOMIC ACTIVITIES

employees. In transaction cost economics, it is claimed that the possibility

III. IMPORTANCE OF THE INSTITUTIONAL

the marginal q estimate indicates overall efficient investment performance

in industrial organization. The views of these schools differ. While financial

IV. OWNERSHIP STRUCTURE, BOARD

Part IV contains chapters that examine how the composition of the

explanations as to why contractual agreements are chosen. Propositions

an endogeneity problem due to self-selection is avoided. The analysis is

The task of linking concepts with observations demands a great deal of

1. THE CRISIS IN ANTITRUST

Victor Fuchs opens his foreword to the National Bureau of Economic

2. THE MICROANALYTICS: A SYNOPSIS

As Herbert Simon observes (1984, p. 40):

Inasmuch, however, as the social sciences are ‘hypercomplex’ (Wilson,

2.2 The Rudiments6

world of Arrow–Debreu and, in such a contractual world, organization is

3. TRANSACTIONS IN THE INTERMEDIATE

The intermediate product market transaction (or in more mundane terms,

Figure 2.1 Simple contractual schema

further that the component can be supplied by either a general purpose

cost-effective degree), which is to say that node B is an inefficient mode of

4. APPLICATIONS TO ANTITRUST: GENERAL

The over-reaching excesses of monopoly reasoning during the 1960s

it is hard to believe that the Chicago critique of antitrust policies regarding

As between critiques of wrong-headed reasoning and explanations for

A comprehensive examination of the applications of transaction cost

5. VERTICAL MARKET RELATIONS

Lateral integration into components, backward into raw materials, and

5.1 Lateral Integration

Economies are commonly ascribed to the integration of successive stages

site-specific or not. The contrast with earlier antitrust predilections is

5.2 Raw Materials Procurement

5.3 Forward into Distribution

A huge franchising literature in economics and marketing examines the

6. PRICE THEORETIC ISSUES

6.1 Price Discrimination

The price theoretic argument in favor of price discrimination (especially

price discrimination assumes that the transaction costs of discovering

Transaction cost economics also has a bearing on the Robinson-Patman