Review of Financial Economics 10 (2001) 191 – 212

Twenty-five years of corporate governance research

. . . and counting
Guest Editor: Diane K. Denis*
Krannert Graduate School of Management, Purdue University, West Lafayette, IN 49707, USA

Abstract

In this paper, the field of corporate governance in the US from the perspective of financial
economists is reviewed. It begins with a discussion of the fundamental agency problem from which
that field emanates, which is the separation between the owners (the shareholders) and the controllers
(the managers) of the modern public corporation. Relying primarily on survey papers, the current
evidence on the various mechanisms that have been proposed as potential solutions to this agency
problem is then reviewed. The contributions made by the other three papers that comprise this Special
Issue on Corporate Governance are also highlighted. Finally, suggestions — my own and those of
others— regarding the direction of future corporate governance research are offered. D 2002 Elsevier
Science Inc. All rights reserved.

Keywords: Governance; Agency; Board of directors; Compensation; Ownership; Corporate control

1. Introduction

The past 25 years have witnessed an ongoing proliferation of research in the area of
corporate governance. While the term ‘‘corporate governance’’ had not yet been coined 25
years ago, it has since become common in the modern business lexicon, used by academics,
practitioners, and the popular press.
The sheer volume of papers that have been written on the subject makes the prospect of
surveying corporate governance a daunting task. Fortunately for me, it is a task that has
already been undertaken—quite successfully—by other authors. A number of surveys have

* Tel.: +1-765-494-8265.
E-mail address: dianedenis@mgmt.purdue.edu (D.K. Denis).

1058-3300/02/$ – see front matter D 2002 Elsevier Science Inc. All rights reserved.
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192 D.K. Denis / Review of Financial Economics 10 (2001) 191–212

been done in recent years and thus bring us fairly well up to date. These include Shleifer and
Vishny (1997) on the general subject of corporate governance; Core, Guay, and Larcker
(2001) and Murphy (1999) on executive compensation; Hermalin and Weisbach (2001) on
boards of directors; Holderness (2001) on blockholders; and Karpoff (1998) and Romano
(2000) on shareholder activism.
In general, these papers survey the work that has already been done while also making
suggestions/predictions about the direction that research in corporate governance is—or
should be—heading. In addition, thought-provoking recent articles by Bradley, Schipani,
Sundaram, and Walsh (2000), and Rajan and Zingales (2000) suggest that the changing nature
of firms and markets may challenge the more fundamental bases on which our current ideas
about corporate governance are built.
As the guest editor of this special issue of the Review of Financial Economics, I have the
opportunity to pull these ideas together—to survey the surveyors and the prognosticators—
while also interjecting some thoughts of my own. In addition, I highlight the contributions of
the three papers chosen to appear in this special issue, and put those contributions into context
in the literature on corporate governance.
As with any survey, some caveats are in order. A thorough discussion of any one of the
topics included in this survey could be—and, in most cases, has been—a significant paper in
and of itself. The scope of this work is such that I can only highlight what we have and have
not learned to date about the more basic issues of corporate governance. Many important
details and many individual papers are lost in this process. Even with respect to survey
papers, I highlight here only those written most recently. To the extent that this paper serves to
whet your interest in some or all of these topics, I urge you to seek out the survey papers
referenced here, as well as the multitude of papers referenced within those survey papers.

2. Corporate governance: an overview

The fundamental insight from which the field of corporate governance emanates is that
there are potential problems associated with the separation of ownership and control that is
inherent in the modern corporate form of organization. Corporate governance, then,
encompasses the set of institutional and market mechanisms that induce self-interested
managers (the controllers) to maximize the value of the residual cash flows of the firm on
behalf of its shareholders (the owners).
One thing common to most papers written on corporate governance is the fact that they
point out that this fundamental insight dates back at least as far as 1776. During that year,
Adam Smith, writing about professional managers in his Wealth of Nations, stated that:
‘‘Being the managers of other people’s money [rather than their own] . . . it cannot be
expected that they should watch over it with the same anxious vigilance . . ..’’ In 1932,
Adolph Berle and Gardiner Means went so far as to suggest that this problem made the
corporation an untenable form of organization.
Why, then, do I refer to the study of corporate governance as being 25 years old? I
certainly do not mean to discount the contributions of Smith, Berle and Means, or others
 D.K. Denis / Review of Financial Economics 10 (2001) 191–212 193

who expanded on this basic idea in the early 1970s. However, I think that it is fair to say
that the groundswell of research on corporate governance by financial economists began
with the 1976 publication of Michael Jensen and William Meckling’s treatise on the theory
of the firm, in which they apply agency theory to the modern corporation and formally
model the agency costs of outside equity.1 Jensen and Meckling demonstrate that a
manager who owns anything less than 100% of the residual cash flow rights of the firm
has potential conflicts of interest with the outside shareholders. Financial economists since
then have worked to understand, define, measure, and minimize these conflicts—or, more
precisely, to minimize their impact on firm value.

2.1. Conflicts of interest between managers and shareholders

In order to understand the situation in which managers’ and shareholders’ interests can
conflict, we must understand the nature of each group’s interests. While it can be
dangerous to make sweeping generalizations about large groups of people, financial
economists assume that shareholders’ interests with respect to their common stock
investments are purely financial. Thus, the shareholders of a firm simply want the value
of their shares to be as high as possible. The managers, while certainly not inherently
averse to a high share price, may also look to their positions to satisfy their desires for
recognition, power, the thrill of a challenge, the chance to make a difference in the world,
etc. By virtue of their control over the operations of the firm, managers have some ability
to realize these private benefits, even when they are inconsistent with the goal of
maximizing share value.
The agency problem between managers and shareholders is often illustrated with
straightforward, fairly simplistic examples of managerial shirking (golf games) and
managerial consumption of perquisites (plush offices, expense account meals, corporate
jets, etc.) These are items that clearly benefit managers. They may also benefit shareholders;
however, if they do not, their costs effectively come out of shareholders’ pockets ex post. Of
course, shareholders realize the potential for such problems ex ante and adjust the price that
they are willing to pay for shares accordingly; thus, agency costs are, in fact, borne by the
original shareholders.
There are somewhat less obvious but much more important potential conflicts of interest
between managers and shareholders—more important in the sense that they can lead to much
greater reductions in shareholders’ wealth and, therefore, much greater agency costs. There
are three basic sources of such conflicts.

1. Managers’ desire to remain in power.

2. Managerial risk aversion.
3. Free cash flow.

1
Jensen and Meckling model the agency costs of debt in this same paper. However, for our purposes in this
paper, it is the agency costs of equity that are relevant.
194 D.K. Denis / Review of Financial Economics 10 (2001) 191–212

2.1.1. Managers’ desire to remain in power

People generally do not like to lose their jobs, and top corporate managers are no different
than the rest of us in this regard. If a particular firm’s management team is the best one
available to run that firm, then shareholders will prefer that they retain their jobs and
management’s desire to do so will not present any conflict of interests. That desire creates a
serious conflict of interests, however, if and when it becomes clear that firm value could be
increased under the direction of an alternative management team.
There are many reasons why a manager or management team may need to be replaced. A
management team that was hired or promoted with high expectations may turn out to lack the
willingness and/or ability to run the firm well. Alternatively, a management team that was
effective in the past may be unwilling and/or unable to adapt to changing circumstances. Firm
value maximization requires the right management team at the right time—and when the
right management team is not the one that is currently in power, a serious conflict of interest
between managers and shareholders may result.

2.1.2. Managerial risk aversion

Managers and shareholders potentially bear quite different levels of risk by virtue of their
association with a particular firm. Shareholders invest financial capital in a firm. The typical
shareholder holds a well-diversified financial portfolio; thus, his holdings in one particular
firm represent a relatively small portion of his overall wealth. The advantage of this is that a
project failure in any one firm has a relatively small negative effect on his wealth.
The manager of that firm, however, has the majority of her human capital tied up in the
firm (and possibly some of her financial capital as well.) In general, then, a manager stands to
lose much more if a project fails than does the typical shareholder, and this creates the
potential for conflicts of interest with regard to investment policy. Well-diversified share-
holders have a simple preferred investment policy: Invest in all positive net present value
(NPV) projects. Managers, however, because they have more to lose if a project fails, may
also be concerned about how likely failure is and how badly the project could fail. If that
downside risk is great enough, a manager may be unwilling to take on a project that is
worthwhile from the shareholders’ point of view.

2.1.3. Free cash flow

Jensen (1986) defines free cash flow as cash flow generated by the firm in excess of the
amount required to fund all available positive NPV projects. What to do with this free cash
flow presents serious potential conflicts of interest between managers and shareholders.
There are really three basic categories of actions that management can take with free cash
flow: Pay it out to the firm’s investors, reinvest it into new or existing projects, or hold onto it,
perhaps investing it passively in financial securities of some type. To the extent that a firm has
debt outstanding, a certain amount of free cash flow will be paid out to investors because
management is contractually obligated to make interest and principal payments to the
debtholders at specified times.
The remaining free cash flow belongs to the shareholders as the holders of the residual
cash flow rights of the firm—at least in theory. Thus, it is from shareholders’ perspectives
 D.K. Denis / Review of Financial Economics 10 (2001) 191–212 195

that the choices should be viewed. Reinvesting cash into good projects (i.e. projects that have
a positive NPV) should certainly be attractive to them. However, by definition, we are not
talking about good projects—if there are positive NPV projects available, then the cash flow
is not free cash flow. Shareholders clearly do not want cash invested into negative NPV
projects, as such investments reduce the value of their shares. Cash held by the firm seems
innocuous enough, assuming that it is earning a reasonable return. However, shareholders are
perfectly capable of making their own investments into other financial securities—and
should prefer to choose the securities that best fit their individual portfolio needs. Further-
more, cash that is still under management’s control is cash that can be wasted on a bad
investment at a moment’s notice. Thus, shareholders will prefer that free cash flow be
returned to them, whether through dividends or share repurchases.
A manager, on the other hand, may prefer to hold on to the cash flow and/or invest it in
negative NPV projects rather than return it to shareholders. He may mistakenly believe that
there are good projects available. Alternatively, he may wish to maximize the amount of
assets under his control. Managers, like many of the rest of us, value power and prestige, and
it is more prestigious to run a firm that has US$10 billion in sales than to run one that has
US$10 million in sales. Even a bad investment will generate an increase in sales. In addition,
executive compensation plans often explicitly reward firm size.
Clearly, the potential for conflicts of interest between firm management and the share-
holders that they represent is potentially great. As I mentioned earlier, it was this fact that led
Berle and Means (1932) to question whether the modern corporation is a tenable form of
organization. More recently, Jensen (1989) expresses a similar view. He argues that the public
corporation is not a suitable form of organization in maturing industries, and that it has been
and will continue to be replaced with firms financed by debt and private equity.
These arguments are certainly not without merit. It is in the firms that Jensen describes that
the agency costs associated with the separation of ownership and control are highest.
However, the corporate form to date has exhibited amazing resiliency. The bottom line is
that, over its lifetime, a successful business will require varying degrees of entrepreneurial
skill, managerial skill, and financial capital, each of which is present to varying degrees in
different people. The ability to separate ownership of firms from control of firms allows many
economic agents to maximize the return on their own particular endowments.
The survival of the corporate form suggests that, in many cases, its benefits outweigh the
costs associated with the resulting separation of ownership and control. This is due, in part,
to the fact that the potential benefits are high. However, it is also due to the fact that
various mechanisms have evolved that help reduce—though never completely eliminate—
the costs associated with the separation of ownership and control. These are the corporate
governance mechanisms.

2.2. General solutions to the agency problem

There are three general ways in which to increase the likelihood that management acts in
the interests of shareholders: Bond them contractually to do so, monitor them to ensure that
they do so, and/or provide them with incentives such that it is in their own interest to do so.
196 D.K. Denis / Review of Financial Economics 10 (2001) 191–212

2.2.1. Bonding solutions

The most obvious solution to an agency problem would seem to be a contract that bonds
the agent to do as the principal would like. Therefore, for example, corporate managers could
sign contracts indicating that they will always take the action that maximizes shareholder
wealth. Unfortunately, this is, at best, a partial solution. In order for such a contract to be
complete, it would need to spell out every possible eventuality and specify what action the
manager should take in that situation. This, of course, is impossible. In an uncertain world,
no one can foresee every possible eventuality. In addition, corporate shareholders cannot be
presumed to know what is the value-maximizing action in every situation. Indeed, managers’
expertise is presumably one of the primary reasons for which they were hired to begin with.
The bottom line is that we cannot make managers do everything that shareholders want them
to do by writing a perfect contract—though we may be able to make them do some of the
things shareholders want them to do by writing less-than-perfect contracts.

2.2.2. Monitoring solutions

An alternative to contractually specifying in advance what managers must do is to
monitor their actions, with the understanding that they will be judged after the fact on the
extent to which they maximize shareholder wealth. Monitoring solutions require effective
monitors who present credible threats to management. Shareholders, as the principals,
would seem to be the obvious choice. However, there are two important drawbacks to most
shareholders as monitors. First, as discussed above, the average shareholder lacks industry
expertise. Managerial actions may turn out badly because they were bad decisions to begin
with. However, good decisions can turn out badly as well, for reasons outside of managers’
control. An effective monitor must be able to tell the difference.
The second drawback to relying on shareholders to monitor managers is that the average
shareholder does not have the proper incentive to do so. The average shareholder owns
relatively small amounts of common stock in each of many different firms, is likely to be
physically removed from all of them, and has plenty of other things to worry about. Thus,
monitoring managers is a practical impossibility. More importantly, monitoring managers is
a costly activity. Because the average shareholder owns a very small portion of the firm, the
cost of monitoring managers very likely outweighs the benefit.
Fortunately, however, there do exist a number of potential monitors of a firm’s top
management, including the board of directors, creditors, and large shareholders, as well as
competing management teams, whether from inside or outside of the firm.

2.2.3. Incentive alignment solutions

Bonding and monitoring solutions to agency problems can be thought of as sticks—
management is induced to act in shareholders’ interests either contractually or by threat.
Incentive alignment solutions can be thought of more as carrots. We know that agency
problems stem from conflicts of interest between principal and agent. Incentive alignment
mechanisms seek to reduce the degree of that conflict. If shareholders want the maximum
expected financial return on their common stocks, then they will benefit from anything that
 D.K. Denis / Review of Financial Economics 10 (2001) 191–212 197

makes management want that same thing, i.e. anything that makes management benefit—
financially or otherwise—from an increase in the value of the firm’s common stock.

3. Corporate governance mechanisms

Jensen (1993) outlines four basic categories of individual corporate governance

mechanisms:

1. Legal and regulatory mechanisms.

2. Internal control mechanisms.
3. External control mechanisms.
4. Product market competition.

While the lines between these categories are not perfectly distinct, they do provide a useful
base categorization scheme, and I will use them to organize a review of the theory and
evidence on the individual mechanisms—i.e. what we do know about corporate governance.
When analyzing any particular corporate governance mechanism, there are really two
questions of primary importance. First, does the mechanism in question serve to narrow the
gap between managers’ and shareholders’ interests (and, if so, how)? Second, does the
mechanism in question have a significant impact on firm performance and/or firm value?
Shleifer and Vishny (1997) point out that most of the evidence that managers do not always
act in the interests of their shareholders comes from the many event studies that have been
done. In these studies, researchers gauge the abnormal stock price reaction to the announce-
ment of a particular type of event. If the reaction is, on average, significantly negative—as it
is for bidders when they announce an acquisition, for example—then this suggests that the
particular action is generally not in shareholders’ interests (and vice versa).2 Such knowledge
then allows us to address the first question above, regarding whether a particular corporate
governance mechanism narrows the gap between managers’ and shareholders’ interests. If a
particular mechanism decreases the likelihood that a manager will undertake a shareholder-
value-reducing action, then that mechanism would seem to align the interests of managers and
shareholders, at least to some degree. The same can be said if the stock price reaction to a
particular event is positively related to the presence of a given governance mechanism.
In theory, if the answer to the first question is yes, then the answer to the second question
should be yes as well. If a governance mechanism leads managers to take actions that are
more in line with shareholders’ interests, then that mechanism should have a positive impact
on firm value. However, it can be difficult to find empirical evidence consistent with this

2
Shleifer and Vishny point out that it is not strictly true to say that a negative reaction to the announcement of
an event necessarily means that the event is not in shareholders’ interests. It could be instead that the
announcement simply signals other negative information to the market. However, they consider the overall body
of event study results to be fairly compelling evidence that managers sometimes take actions that are not in
shareholders’ interests.
198 D.K. Denis / Review of Financial Economics 10 (2001) 191–212

assertion, even if it is true. In addition, evidence that does suggest a relationship between a
corporate governance mechanism and firm value must also be interpreted carefully, as it could
be spurious. The culprit in both cases is endogeneity, which presents both a curse and an
important set of challenges to researchers in empirical corporate governance.
In trying to relate corporate governance mechanisms to firm performance, researchers are
trying to identify a simple relationship within a complex set of interrelationships. Many
variables potentially influence firm performance, and there are correlations within this set of
variables. Thus, evidence that suggests that the presence of a particular governance
mechanism has a positive influence on firm performance may, in fact, mean just that.
However, it could also arise because the mechanism in question is more common in firms of a
particular type, and firms of this type are higher-valued, on average. Thus, endogeneity can
lead the researcher to see a relationship where one does not actually exist. Further
complicating the issue is the fact that the causality in relationships between firm performance
and governance mechanisms can run in either direction, i.e. firm performance may, in some
circumstances, drive corporate governance mechanisms. We know, for example, that firms are
more likely to add an outside director following poor performance. This could lead to an
observed negative relation between outside directors and performance that could lead the
researcher to conclude—erroneously—that outside directors cause firms to perform poorly.
Endogeneity can also cause researchers to fail to find a relationship where one actually
exists. If all firms are in equilibrium with respect to their corporate governance structures,
then no relation between governance mechanisms and firm performance will appear to exist.
More importantly, the complex set of interrelationships among variables that influence
performance suggests that there does not exist a single set of governance mechanisms that
is optimal for every firm. Without proper controls, a relationship that exists only for a
subsample of firms may not show up empirically in a test using a larger population. For
example, suppose that mature firms with few growth opportunities benefit more from the
monitoring of strong outside directors, while firms in high-growth industries benefit more
from the expertise of insiders. A cross-sectional examination that includes both types of firms
and does not control for growth opportunities could lead researchers to conclude that outside
directors do not enhance firm value for any firm.
Endogeneity problems in empirical corporate governance research are significant but not
fatal. They do, however, require that empirical tests are carefully designed and the results
carefully interpreted. An understanding of the endogeneity issues associated with corporate
governance would also be useful for the broader population, as we sometimes observe a
dangerous tendency on the part of the popular press to prescribe one-size-fits-all
governance solutions.

3.1. Legal and regulatory mechanisms

The most basic corporate governance mechanisms exist outside the firm, in the system of
laws and regulations that govern the firm. Until recently, these mechanisms received
comparatively little attention from financial economists working in the corporate governance
area. Michael Jensen, in his 1993 presidential address to the American Finance Association,
 D.K. Denis / Review of Financial Economics 10 (2001) 191–212 199

characterized this system as being ‘‘. . . far too blunt an instrument to handle the problems of
wasteful managerial behavior effectively.’’ Courts in the US are typically reluctant to question
the judgment of the management of a firm, absent quite strong evidence that decisions were
made in bad faith. While there are good reasons for such an approach, it does afford firm
management fairly wide latitude in its actions. In addition, the legal and regulatory system in
the US is very much intertwined with the political system. Depending upon the relative
influence of various constituencies, the law may serve to exacerbate the agency problems
between managers and shareholders. For example, as of mid-1998, 41 of the 50 US states had
in place various types of antitakeover statutes, all of which explicitly increase management’s
power when under threat of an unwanted takeover—a situation in which the degree of
conflict of interest between managers and shareholders is arguably at its greatest.
More recently, however, research on the influence of the law on corporate governance is
gaining prominence. La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998, 2000) dem-
onstrate that in terms of both the applicable laws and the degree of enforcement of those laws,
US shareholders (and creditors) are among the most protected in the world. La Porta et al. find
that cross-country differences in ownership structure, capital markets, financing, and dividend
policies are all related to the degree to which investors are legally protected from expropriation
by managers and controlling shareholders. They document an inverse relationship between the
degree of such protection in a country and the degree of ownership concentration in firms in
that country. Shleifer and Vishny (1997) argue that in the large corporations of many countries,
the fundamental agency problem is not that between managers and shareholders because
control—and the private benefits that accompany control—rests primarily with large share-
holders. In such countries, the more relevant conflict of interest is that between outside
investors and controlling shareholders. Thus, a country’s legal system appears to be a
fundamental determinant of how its corporate governance structure evolves.

3.2. Internal control mechanisms

Within a firm, the primary mechanisms that influence the degree to which management
represents shareholders’ interests are the board of directors, the compensation plans that they
put into place, and the firm’s ownership and debt structures. Each has been the subject of
much public interest and extensive academic research.

3.2.1. The board of directors

Every US corporation is required by law to have a board of directors. Thus, at base, the
board of directors is a legal mechanism. However, the law has little to say about the number
of directors on the board and who they are, both factors that appear to influence the
effectiveness of the board.
The board of directors is elected by the shareholders and its job is to hire, fire, compensate,
and advise top management on behalf of those shareholders. In theory, this is just what all
those small powerless shareholders need—a group of people with the ability and the
authority to keep an eye on management for them. Unfortunately, in practice, it is not clear
that the average board of directors has enough incentive to do the job properly. Management
200 D.K. Denis / Review of Financial Economics 10 (2001) 191–212

typically has a great deal of say about who the directors will be: Nothing in the law prevents
management from stacking the board with individuals sympathetic to management’s interests
and, historically, many of them have done so. More recently, amidst public attention and calls
for change by various parties, many firms are undertaking board reform. The typical reform
includes some combination of reducing board size, increasing the relative proportion of
outside directors (directors who have no business or personal tie whatsoever to firm
management), assigning only these outside directors to such tasks such as nominating new
directors and setting executive compensation plans, separating the positions of chief executive
officer and chairperson of the board, and requiring that board members own stock in the firm.
Hermalin and Weisbach (2001) point out that, while there has been little formal economic
theorizing about boards of directors, there has been a great deal of empirical research on the
topic. They identify three primary questions that this work has sought to address. First, how
are various board characteristics related to profitability? Second, how do various board
characteristics affect the observable actions of the board? Third, what factors affect the
makeup of boards and how they evolve over time?
Two characteristics of the board of directors stand out in the literature as being of the
greatest interest: board size and the relative independence of the board members. With
respect to size, the hypothesis tested has generally been that smaller boards are more
effective because they can hold more candid discussions and make decisions more quickly
and because they are less easily controlled by management than is a large, unwieldy group of
directors. With respect to board composition, the variable of greatest interest has been the
proportion of outside directors on the board. The hypothesis is that directors who are
members of firm management or who are affiliated with those managers (generally termed
inside directors and affiliated/grey directors, respectively) are less effective as monitors of
management than are those directors who have no family or business ties to firm
management (so-called outside directors.)
The studies reviewed by Hermalin and Weisbach (2001) report a number of findings. First,
smaller boards and greater proportions of outside directors each appear to lead management
teams to take actions that are more in line with shareholder interests in some situations.
Boards with greater proportions of outsiders are more likely to remove a poorly performing
manager, as are smaller boards. Firms whose boards have greater proportions of outsiders
appear to make better acquisition-related decisions, whether as acquirers or as targets. They
negotiate higher premiums when their own firms are acquired and make better (i.e. less value-
reducing) acquisitions themselves. Firms with smaller boards set CEO compensation plans
that are more sensitive to CEO performance.
While both board size and proportion of outsiders appear to have a positive effect on some
firm actions, only board size has been shown to have a significant positive effect on firm
performance. Regardless of the performance measurement used, the weight of the evidence
suggests that there is no significant relation between firm performance and the proportion of
outsiders. There are several possible reasons for this. There is the endogeneity issued discussed
earlier. For example, we do know that outside directors are more likely to be brought in
following poor performance; in such firms, it then looks as if outside directors are associated
with poor firm performance. Second, a person who appears to be an outside director may, in
 D.K. Denis / Review of Financial Economics 10 (2001) 191–212 201

fact, have ties to current management through interlocking directorates—i.e. each sits on the
other’s board, reducing the independence of both. Alternatively, it may be that outside
directors are not important in the day-to-day operations of the firm but that they are effective
monitors during important discrete events of the type mentioned in the previous paragraph.
Hermalin and Weisbach also review evidence on the firm-level factors that affect the
makeup of the board of directors. Firms that are more likely to have a board dominated by
outside directors include larger, older firms with small inside ownership stakes, and firms that
have been performing poorly. Tightly held firms in which founders are still active and CEO
ownership is high are more likely to have insider-dominated boards, as are other firms in
which the CEO has greater bargaining power. These findings suggest that board structure is
dynamic and related to other aspects of the corporate governance structure of a firm.

3.2.2. Executive compensation and ownership

Among the tasks specifically assigned to the board of directors is that of determining the
structure and level of compensation of the top executives of the firm. There is perhaps no
other corporate governance issue that has excited as much public controversy, particularly in
the last 20 years. Recent surveys by Core et al. (2001) and Murphy (1999) provide extensive
and up-to-date summaries of the issues and the existing evidence on executive compensation
and ownership. In addition, Holderness (in press) surveys the broader ownership structure
literature; including, but not limited to, ownership by insiders.
Research on executive compensation focuses on two overriding issues: The level of
executive pay and the sensitivity of pay to performance. It is the level of pay that is generally
cited in popular press criticism of executive pay. Murphy (1999) points out that constant-
dollar median cash compensation for S&P 500 CEOs has more than doubled since 1970. If
we look instead at total realized compensation —i.e. including gains from exercising
options—it has more than quadrupled over that same period. In addition, we know that
CEO pay levels vary by industry and are higher in larger firms, and that US executives are
generally paid more than executives in other countries.
The level of compensation is certainly a factor in corporate governance. A manager will
presumably be less likely, ceteris paribus, to risk the loss of a job the greater is the level of pay
expected from that job. However, corporate governance is fundamentally about managements’
incentives to act in shareholders’ interests; thus, the sensitivity of compensation to financial
performance is arguably the more interesting issue from a corporate governance perspective.
Management should be more willing to act to maximize shareholder value if doing so
provides management with greater reward as well. The most straightforward way to
accomplish this is to have management teams hold common stock and/or options on common
stock of the firm.
Management ownership of stock and stock options is not quite as simple as it sounds,
however. First, managers, like most people, are assumed to be risk-averse. The manager of a
firm has a large portion of the value of his human capital tied up in that one firm. Such a
manager may rationally be quite reluctant to tie up a significant portion of his financial capital
in that firm as well. Stock and/or options on stock may also be given to management as
compensation. However, it is important to understand that, ceteris paribus, management will
202 D.K. Denis / Review of Financial Economics 10 (2001) 191–212

prefer cash compensation. Because managers are risk-averse, the value to them of stock or
stock options in their own firm is less than is the cost to the firm of providing it; thus, equity-
based compensation is more expensive to the firm than is cash compensation.
Despite the problems associated with managerial ownership of stock and stock options, the
research covered in both Core et al. (2001) and Murphy (1999) suggests that: (1) the sensitivity
of executive compensation to firm performance has increased over time; (2) the vast majority of
this sensitivity comes through executive ownership of common stock and of options on
common stock; and (3) stock options are the fastest growing component of CEO compensation
and equity ownership.
Core et al. (2001) and Murphy (1999) point to a lack of a sound theory predicting this
increasing reliance on equity-based compensation. However, several practical reasons have
been proposed. First, grants of stock and stock options do not require an outlay of cash by the
firm; thus, they provide a way for cash-constrained firms to compete for managerial talent. In
addition, stock and option grants are treated as deferred compensation, providing both the
executive and the firm with timing advantages for taxation purposes.
Stock option grants have two potential advantages over direct grants of stock. First,
because the rewards from direct stock ownership are linear, executives may have incentives to
avoid risks that their diversified shareholders wish them to take. Stock options add convexity
to managers’ payoff functions. Consistent with this, we do observe that firms with greater
growth opportunities provide more stock options to their management than do more mature
firms. Second, stock option compensation has a financial accounting advantage in that the
value of stock option grants is not generally expensed on the income statement. There is some
evidence that option grants are larger in firms for which low reported earnings would trigger
dividend or debt covenant constraints.
Because we are ultimately interested in the sensitivity to performance provided by
executives’ equity-related holdings, it is necessary that we are able to value these holdings.
While valuing executives’ stock holdings is straightforward, valuing their holdings of stock
options is more problematic. Firms are required to disclose the total number of stock options
held by executives; however, they are only required to disclose the maturity and exercise
prices associated with options granted in the current year. Because maturity and exercise price
are fundamental determinants of the value of an option, researchers have been forced to make
assumptions regarding these parameters for options granted in earlier years.
In this special issue, Martin Conyon and Graham Sadler (this volume) provide evidence
regarding the extent of the problem created by this lack of information. Following recent
reforms in the United Kingdom, the majority of UK firms must now disclose much greater
information regarding executive holdings of stock options than US firms. Thus, for a large
sample of UK firms Conyon and Sadler have data regarding the exact terms associated with all
stock options granted. This allows them to value the options and the pay/performance
sensitivity associated with them both under full information and under the more-limited US
information. Their findings suggest that, to date, little bias has been introduced by the common
assumptions that US researchers have made about the parameters of noncurrent stock option
grants. However, this result is driven by a balance between overestimates for firms whose
CEOs hold out-of-the-money options and smaller underestimates for the larger number of
 D.K. Denis / Review of Financial Economics 10 (2001) 191–212 203

firms whose CEOs hold in-the-money options. Thus, a shift in this balance—due, for example,
to a falling stock market or an increase in the issue of premium options—would result in
systematic overestimates of option value and of executives’ pay/performance sensitivity.
In general, firms do not issue premium stock options to executives. The various parameters
of a stock option provide firms with a great deal of flexibility with respect to their design.
Firms, however, routinely ignore this flexibility; the vast majority of stock options are issued
to executives at the money (i.e. with a strike price equal to the stock price at the time of issue)
and with a 10-year maturity. In this special issue, Chongwoo Choe (this volume) develops a
model of optimal stock option design. His model implies that the optimal exercise price for an
executive stock option increases in the size of the grant and the base salary and decreases in
leverage and the riskiness of the desired investment policy. He concludes that the near-
universal policy of granting stock options at the money causes the set of optimal contracts to
shrink dramatically.
However an executive’s holdings of stock and stock options are accumulated, the end
result is an increase in the sensitivity of the executive’s wealth to firm performance. Murphy
(1999) reports that this sensitivity has increased more than threefold over the last 20 years.
Core et al. (2001) interpret the evidence that they survey as suggesting that, on average, firms
base their equity incentives on systematic and theoretically sensible economic factors. Thus,
while researchers may disagree on how much sensitivity is ‘‘enough,’’ it is clear that top
management is generally rewarded based, in part, on their firms’ financial performance and
that the degree to which this is true has increased over time.
Less clear is the degree to which managerial ownership of stock and stock options leads to
better firm performance. Equity ownership by insiders is a double-edged sword. On the one
hand, such ownership better aligns the financial incentives of managers with those of
shareholders. However, to the extent that managers wish to consume private benefits of
control at the expense of their shareholders, higher ownership may allow them to do so with
less fear of retribution. In other words, at some point, increased managerial ownership can
entrench managers.
Reviews of the evidence on inside ownership are found in Murphy (1999) and Core et al.
(2001), as well as in Holderness (2001). The evidence on the relation between inside
ownership and firm performance is mixed. There exists evidence that firm performance first
increases and then decreases with percentage ownership, suggesting that the incentive
alignment effect of increased ownership is more important at lower levels of managerial
ownership and the entrenchment effect dominates at somewhat higher levels. It is important
to note again that tests of this relation are plagued by endogeneity problems. More recent
work attempts to control for this endogeneity and does not find any significant relation
between ownership and performance.
The survey papers cited above also point out important measurement issues with respect to
inside ownership. In recent years, researchers have debated whether management’s percent-
age ownership or management’s dollar ownership of equity is the appropriate measure of
equity incentives. Murphy (1999) reports that between 1987 and 1996, these measures moved
in opposite directions: The value of own-firm shares held by S&P 500 CEOs increased
substantially, while the percentage of shares held decreased. Thus, it is especially important
204 D.K. Denis / Review of Financial Economics 10 (2001) 191–212

that we understand which is the better measure of incentives. We also know that at the same
time that percentage ownership of stock has decreased, holdings of stock options have
increased. Thus, it is increasingly important that stock option holdings be considered in
studies relating inside ownership to firm performance.
The relationship between managerial ownership and incentives can also be inferred from
the relation between ownership and the abnormal market reaction to actions taken by
managers. In this special issue, Robert Hull and JuliAnn Mazachek (this volume) relate
inside ownership to the market reaction to pure leverage decreases in firms. They begin with
Myers and Majluf’s (1984) model, which implies that an issuance of new equity by a
shareholder-value-maximizing management is met with a negative stock price reaction
because the decision to issue equity signals negative information about the value of the
firm’s existing assets. Hull and Mazachek hypothesize that if managers’ and shareholders’
interests do diverge and if inside ownership serves to better align those interests, then we
should expect to see a negative relation between inside ownership and the market’s reaction to
the equity issue announcement. Their results are consistent with this hypothesis.

3.2.3. Nonexecutive owners

The literature on ownership structure focuses not only on ownership by managers but also
on nonexecutive shareholders who hold significant equity stakes in a particular firm. By
generally accepted definition, a shareholder who holds 5% or more of a corporation’s
common stock is considered to be a significant shareholder, or blockholder. The basic idea is
that the holder’s share of the firm is significant enough to potentially give them both the
ability and the incentive to monitor and influence what is happening in the firm. These
blockholders may be individuals, corporations, and/or institutional investors. The roles that
they actually play in firms range from passive to very active, and the methods of those who
are active range from informal conversations with management to formal proxy contests.
Shleifer and Vishny (1997) suggest that such large investors play a crucial role in successful
corporate governance systems.
Holderness (in press) surveys the evidence on ownership structure. The evidence that he
surveys related to managerial ownership is covered in the last subsection; in this subsection, I
concentrate on large nonexecutive owners, also referred to as outside blockholders.
The evidence surveyed by Holderness indicates that outside blockholders are not
uncommon: In one study, more than half of the manufacturing firms in a randomly chosen
sample had at least one outside blockholder. Furthermore, block ownership is relatively
stable; firms who have had a blockholder in the past are likely to continue to have one. The
evidence suggests that blockholders seek both to increase firm value (shared benefits of
control) and to enjoy benefits that are not available to other shareholders (private benefits of
control). Such private benefits may come at the expense of the other shareholders but do not
need to. Like other governance mechanisms, the extent of outside block ownership in a firm
varies systematically with other characteristics of the firm; for example, ownership concen-
tration is higher in smaller firms, ceteris paribus.
Holderness (2001) also discusses the evidence regarding the impact of outside block
ownership on managerial actions and/or firm performance. There is some evidence of a
 D.K. Denis / Review of Financial Economics 10 (2001) 191–212 205

positive effect of outside block ownership on firm actions. Outside directors appear to play a
role in monitoring the compensation of top executives. In addition, the presence of an
external blockholder on the board of directors increases the likelihood of a change in control.
The evidence regarding the impact of outside block ownership on firm performance is
mixed and therefore largely inconclusive. Holderness highlights an empirical problem unique
to firms with a large blockholder. While it is firm value in which we are ultimately interested,
the market price of a firm’s stock represents its exchange value, which Holderness argues may
differ significantly from its firm value in the presence of a controlling shareholder. Evidence
that blocks of shares trade at premiums to the exchange prices suggests that there are net private
benefits to control, on average. In addition, it suggests that valuing all of the firm’s shares at the
observed exchange price will result in a calculated firm value that is lower than its actual value.
A separate but related branch of the literature focuses on activism by institutional
shareholders. Such activism generally takes the form either of shareholder proposals or
private negotiations with management. The firms targeted tend to be large firms that have
been performing relatively poorly and the objective of such a targeting is generally to
convince management to alter the firm’s governance structure. Karpoff (1998) and Romano
(2000) survey the existing evidence on shareholder activism. Both surveys conclude that
there is some evidence that shareholder activism results in small changes in some firms’
governance structures. However, the evidence as a whole does not suggest that shareholder
activism leads to increases in firm performance or value.
In sum, there currently exists some evidence that outside blockholders and other activist
shareholders have an impact on firm actions but little evidence that they have any impact on
firm performance. Of course, as with the other corporate governance mechanisms we have
discussed so far, endogeneity is a significant complicating factor in attempting to establish a
causal link between these mechanisms and firm value. For example, outside blockholders are
often attracted to firms that are performing poorly.

3.2.4. Debt
A significant finance literature proposes a role for debt in reducing the conflict of interests
between managers and shareholders. Shleifer and Vishny (1997) survey this literature. While
management may choose to return cash to equity investors via dividends or repurchases,
management is obligated to return specified amounts of cash to debtholders at specified times
or risk the loss of some or all of its control rights. Thus, debt reduces the free cash flow
problem discussed earlier. Furthermore, the need to be able to make ongoing cash payments
gives management greater incentive to operate efficiently, so as to produce greater cash flow.
The leveraged buyout and leveraged recapitalization transactions that were prevalent in the
1980s provide support for the hypothesis that debt is one effective solution to the agency
problems between managers and shareholders. Both types of transaction are financed with
large amounts of debt; in an LBO, the firm is taken private, while in a recapitalization, its
stock remains publicly traded. The typical candidate for either transaction is a large firm in a
relatively mature industry, i.e. a firm likely to be characterized by relatively high agency
problems of free cash flow. The evidence suggests that both transactions create large amounts
of value, on average.
206 D.K. Denis / Review of Financial Economics 10 (2001) 191–212

Two caveats are in order. First, high debt is not the only potential reason for these increases
in value, as both LBOs and recapitalizations are also characterized by increased managerial
ownership of equity. In addition, the LBO form is typically characterized by the presence of a
large outside investor. However, there is evidence that firms that recapitalize were making
negative NPV investments prior to the transaction, and that the debt taken on in the
recapitalizations seriously reduced the cash flow available to them.
The evidence suggests that the high debt levels that result from LBOs and leveraged
recapitalizations are typically temporary, suggesting that this particular set of rather extreme
governance mechanisms is more suited to firms in need of fairly quick and drastic improve-
ments. Nevertheless, the literature on highly leveraged transactions does provide fairly
convincing evidence that corporate governance matters.

3.3. External control mechanisms

To the extent that legal and internal control mechanisms do not lead management to
maximize the value of a publicly traded firm, parties outside the firm may see a profit
opportunity. By acquiring control of the firm by purchasing its common stock, an acquirer
can improve the operations of the firm and realize a profit on the increased value of the
acquired shares. Of course, a premium will generally have to be paid to acquire a controlling
interest; thus, the market for corporate control provides target firm shareholders with another
chance to realize additional value that is not being created by the management of the firm.
Holmstrom and Kaplan (2001) and Shleifer and Vishny (1997) discuss the corporate
takeover market and review the existing evidence. We know that poorly performing firms are
more likely to be targets of takeover attempts and that managers of poorly performing targets
are more likely to be fired. On average, takeovers create value, i.e. the combined value of the
target and acquiring firms rises due to a combination. In addition, the mere threat of losing
control in the external marketplace provides some managers with the incentive not to deviate
too far from value-maximizing behavior.
The external control market does have limitations as a corporate governance mechanism.
Control contests are time consuming and expensive to mount; thus, they are not likely to be
effective ways of dealing with small deviations from maximum value. More importantly,
target firm managers potentially have a significant amount of control over the outcome of an
attempt to take over their firm. When faced with an unwanted offer, a top management team
has at its disposal a wide array of defensive tactics. An offer that is attractive to shareholders
may very well be unattractive to top management, who will generally lose some or all of their
control over the firm. Thus, while the external control market is a potential solution to some
conflicts of interest, it creates additional conflicts as well.
The evidence on the economic effect of acquisitions on acquiring firm shareholders also
illustrates the fact that the external market for corporate control can exacerbate conflicts of
interest between managers and shareholders. Target firm shareholders generally see the value
of their holdings increase upon announcement of an offer for their firm. However, the
majority of the acquirers of these firms appear to pay too much for them—i.e. the premium
they pay exceeds the additional value created by the combination, causing the value of their
 D.K. Denis / Review of Financial Economics 10 (2001) 191–212 207

own shares to fall. Thus, for the average acquirer, an acquisition becomes exactly what its
shareholders wish to avoid: a negative NPV project.
Holmstrom and Kaplan (2001) point out that takeovers have been an important part of the
corporate governance landscape over the last 20 years. However, they identify a shift in the
nature of these transactions over that period. In the 1980s, takeovers were much more likely
to be hostile transactions financed with significant amounts of debt. Following a relative lull
in takeover activity around the early 1990s, the takeover market again surged to record levels
through the rest of the decade. However, these later transactions have been much less likely to
be either hostile or financed with large amounts of debt. Holmstrom and Kaplan (2001)
suggest that stronger internal corporate governance mechanisms in the 1990s have led to an
increased managerial focus on stock price, thereby reducing the need for disciplinary external
control activity.

3.4. Product market competition

Ultimately, a firm must produce products that people want with a cost structure—including
the cost of capital—that allows them to sell the products at a competitive price. Management
wastefulness and/or inefficiency that interferes with the ability to do so will be reflected in
poor performance in its product markets, as will a cost of capital that is high due to the lack of
the protection that a good system of corporate governance will afford investors. In the
extreme, such poor performance can result in financial distress, perhaps even bankruptcy.
However, such extreme outcomes generally occur only slowly, if at all, and a great deal of
value loss can occur along the way. Thus, Jensen (1993) suggests that product market
competition is at best a blunt instrument in the fight for effective corporate governance.

4. Where do we go from here?

Twenty-five years and hundreds of papers later, is there still corporate governance research
left to be done? Fortunately, for those of us who still wish to work in the area, I believe the
answer is a resounding yes. Below, I outline three general directions for future work.

4.1. Fine-tuning and integrating existing lines of corporate governance research

The three studies that appear in this special issue of the Review of Financial Economics all
add to the body of evidence on individual corporate governance mechanisms. For each of the
separate corporate governance mechanisms discussed above, there remain individual issues
worthy of study. For example, both Core et al. (2001) and Murphy (1999) point out that, to
date, there has been little work in the area of relative performance evaluation (RPE). Stock
and stock options reward managers for strong market performance, as well as for strong firm
performance. RPE seeks to evaluate and compensate management relative to a more narrow
benchmark, e.g. other firms in its industry. RPE is both theoretically and intuitively
appealing; thus, its relative lack of use presents an interesting puzzle. They also point out
208 D.K. Denis / Review of Financial Economics 10 (2001) 191–212

that the repricing of deep-out-of-the-money executive options has become increasingly

common and has attracted the attention—much of it negative—of investors and the popular
press. While criticisms of this practice seem reasonable at first glance, the issue is more
complicated than it appears. Work is currently being published in this area and it is worthy of
further study.
In addition to such fine-tuning, however, further work of a more fundamental nature is
needed in order to understand: (1) why various corporate governance mechanisms should be
expected to be solutions to the agency problem; and (2) how these mechanisms interact with
each other and with other important characteristics of firms.
For example, Hermalin and Weisbach (2001) point out that we do not yet have formal
models of why the board of directors is an efficient response to the agency problem between
managers and shareholders. They suggest that future research on boards of directors should
include theoretical models of the inner workings of the board, followed by tests of the
implications of these models. Similarly, Core et al. (2001) and Murphy (1999) suggest that we
do not yet understand why stock options have become an increasingly important part of
executive compensation plans. Holderness (in press) suggests that further work is required in
order to understand the general parameters of control. What is the relationship between
control and fractional ownership, whether by insiders or by outside blockholders?
I believe that for many—myself included—there is a general feeling that corporate
governance in the US has improved over the course of the last 25 years and that these
improvements have been good for firms and for the economy. However, the existing evidence
on many of the individual corporate governance mechanisms fails to establish a convincing
link between these mechanisms and firm performance. Certainly, one possibility is that there
is no such link—that firms’ corporate governance systems are not important enough to have
meaningful impacts on their values.
An alternative possibility, however, is that the various corporate governance mechanisms
interact in complicated ways with each other and with other aspects of firms, e.g. the nature of
their investment opportunities. Thus, a mechanism that is valuable for one firm may have no
impact on another, making it difficult to pick up a relation by examining a broad cross-section
of firms. For example, McConnell and Servaes (1995) find that leverage is negatively
correlated with value in high-growth firms and positively correlated with value in low-growth
firms. Further refinement of the samples that we study and the ways in which we study them
may yield important insights in this area.

4.2. Expanding and integrating international corporate governance research

The individual aspects of corporate governance systems in the US, as well as those of
Germany and Japan, have been extensively studied and the systems themselves have evolved
as a result. Shleifer and Vishny (1997) suggest that, while the relative merits of these three
countries’ governance structures have been widely debated, they actually have more in
common than is typically thought. Furthermore, they suggest that to the extent that there are
differences between them, it is difficult to conclusively establish that one of them is the
‘‘best’’ system. More recently, Bradley et al. (2000) suggest that the more contractarian
 D.K. Denis / Review of Financial Economics 10 (2001) 191–212 209

system in the US is more conducive to the need for adaptation to a rapidly changing world
than are the more rigid systems in Germany and Japan. Holmstrom and Kaplan (2001)
suggest that the governance systems in Germany and Japan are moving in the direction of that
of the US.
While the debate about the relative efficacy of the governance systems of the major
economies will go on, it seems clear that the more important evolutions will be those of the
corporate governance systems of the many lesser-developed countries around the world.
Beginning with La Porta, et al. (1998), there has been a proliferation of research on
governance systems in these other countries. This very recent evidence has not been formally
surveyed, and I do not survey it in this paper. It is fair to say, however, that while we now
know a little about corporate governance in a number of different countries, there remains a
great deal to be learned.
While the large body of evidence on governance in the major economies tells us much
about the directions in which lesser-developed economies should move, studies involving
these lesser-developed economies can also provide us with a richer understanding of
governance in the major economies. Shleifer and Vishny (1997) suggest that the most
fundamental determinants of how a firm’s corporate governance system develops are the
extent to which the legal system protects its investors and the extent to which there are large
investors in the firm. There is great variability in legal structure and ownership structure
across the world, much greater than can be found examining only firms in the US or even in
the other major economies. Thus, Shleifer and Vishny (1997) suggest that research into
governance systems around the world may yield interesting insights on a number of issues,
including the nature of legal protection, the costs and benefits of ownership concentration,
financing structure, and the effect of politics on corporate governance.

4.3. Corporate governance and the changing nature of the firm

Two recent papers highlight the dramatic changes in the nature of the corporation that
have occurred over the last 25 years and the implications of that change for the study of
corporate governance.
Bradley et al. (2000) detail a number of important areas in which the organization and
environment of the public corporation have changed. They highlight changes in the nature of
the average production process—from one in which land, labor, and capital were the primary
production inputs and employees were valued for their ability to serve those inputs to one in
which employees’ knowledge and intellect are the primary factors of production and
machines exist to serve humans. Individuals are inherently more difficult to monitor and
control than are machines, and their outputs are less easily contracted upon.
Rajan and Zingales (2000) discuss the same general change in the nature of the corporation
from the perspective of the allocation of power within the corporation. Twenty-five years ago,
the average public corporation was more likely to be a large, vertically integrated, and
oligopolistic organization, in which the important assets were physical in nature and owned
by the firms. Management’s control over these physical assets gave it enormous power. In
today’s more knowledge-based economy, human capital has grown in relative importance,
210 D.K. Denis / Review of Financial Economics 10 (2001) 191–212

thereby weakening the top-down command and control structure. The balance of power has
shifted in many organizations; employees’ skills are more important, more in demand, and
less able to be controlled by top management.
While both sets of authors agree on the nature of the changes that have occurred in
corporations, they are in some disagreement regarding the implications of these changes for
governance of these firms. Bradley et al. stress the increased importance of a contractarian
view of the firm, in which the purpose of the corporation should continue to be to maximize
the value of its residual claimants, its shareholders. They characterize the US as having had a
more contractarian governance system over the last two decades than have Germany or Japan,
and suggest that this system provided US firms with the flexibility required to better adapt to
the dramatic changes they experienced. They do recognize, however, that there is much in the
modern corporation that cannot be completely contracted upon, and suggest an ongoing role
for the law in dealing with the adverse effects of this incomplete contracting.
Rajan and Zingales (2000), on the other hand, question the fundamental idea that
shareholder value maximization remains the appropriate goal of a system of corporate
governance. In a world that is increasingly characterized by incomplete contracts and multiple
sources of power, they suggest that most of the parties to a firm will at some time or other be
residual claimants of the firm. They argue that long-term organizational design and employee
motivation should be of more fundamental concern to firms, who should spend less time
worrying about dispersed owners and more time worrying about controlling and retaining
human capital.

5. Conclusion

The efficiency with which capital is invested in order to produce goods and services is a
fundamental determinant of the well-being of an economy. Seventy years after Berle and
Means predicted the demise of the corporate form, it is still going strong—undoubtedly
because it is an efficient way to bring together those who have money and those who know
what to do with it. Human nature being what it is, however, the corporate structure has a
major disadvantage—namely the potential for conflicts of interest between the capital
providers (particularly the shareholders) and the capital users (corporate management.)
Efficiency is further enhanced when this gap is bridged, as long as the cost of bridging it
does not exceed the benefit of doing so.
In this paper, I first review the agency problem between managers and shareholders:
Where does the problem come from, how does it manifest itself, and what are the
mechanisms that can potentially reduce the scope of the problem? I then review the existing
evidence on these various mechanisms. Hundreds of studies of corporate governance
mechanisms have been done in the past 25 years and the collective knowledge that they
have generated has led corporate governance systems in the major economies to evolve
significantly over that time period.
The efficiency gap has been narrowed in the world’s major economies—but there
remain important gaps in what we know. In particular, we lack a sufficient understanding
 D.K. Denis / Review of Financial Economics 10 (2001) 191–212 211

of the complicated ways in which the various corporate governance mechanisms interact
with each other and with other characteristics of firms and economies. In addition, the
nature of the corporation has evolved and will continue to do so, challenging researchers
to evaluate firms and their governance systems in light of the need for flexibility
and adaptability.
While the efficacy of corporate governance systems in the major developed countries of
the world is still being debated, there is little disagreement that in many other countries of the
world, major change is necessary. As we embark on the twenty-first century, emerging
markets around the world look to the more-developed economies for inspiration in their
attempts to improve the efficiency of their own economies, making it ever more important
that we understand the role that corporate governance plays.

Acknowledgments

I would like to thank Dave Denis for helpful discussions and comments.

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