Corporate ownership and governance
Session 1 : corporate strategy and theory of the firm
Kraakman, R, et al. (2009, 2nd edition) The Anatomy of Corporate Law; A
Functional and Comparative Analysis, Oxford: Oxford University Press
What is a firm ?
• Firms are one of the most important economic institutions of modern capitalism
• Firms mean entities that are separate from the individuals that own and run them
• A corporation is a legal construction : Corporations cannot exist without the law enabling us to
create them
Ex: Publicly listed firms, cooperatives, limited liability partnerships
What is corporate law ?
Business corporations have fundamentally similar sets of legal characteristics (five in total)
1. Legal personality
2. Limited liability
3. Transferable shares
4. Delegated management under board structure
5. Investor ownership by contribution of capital
In market economies, almost all large-scale business firms adopt a legal form that possesses all five
characteristics of the business corporation. However, it might be that these characteristics also generate
tensions and tradeoffs that lead to agency problems.
Legal personality (Needed to start a firm)
As an economic entity, a firm serves as a nexus of contracts. It is a single entity that coordinates the
activities of suppliers and consumers.
Legal personality means you protect the firm against the owners. If you would allow owners to withdraw
their investments at any time, you would jeopardize the going-concern (presumption that the firm will
keep on existing) of the firm, and reduce the value of the firm to the liquidation value which would
disadvantage all the stakeholders à Basis of entry shielding
The core element of legal personality is separate patrimony. This is the ability of the firm to own assets
that are distinct from the property of other persons, such as investors, and that the firm is free to use,
sell and pledge.
Entity shielding involves two relatively distinct rules of law:
1. A priority rule that grants to creditors of the firm, as security for the firm’s debts, a claim on the firm’s
assets that is prior to the claims of the shareholders. Debts to creditors will be paid off first, then
shareholders divide the remaining assets à Protects creditors
,2. A rule of liquidation protection that provides that the individual owners of the corporation (the
shareholders) cannot withdraw their share of firm assets at will, nor can the personal creditors of an
individual owner foreclose on the owner’s share of firm assets. This rule serves to protect the going
concern value of the firm against destruction either by individual shareholders or their creditors
Firms characterized by both rules can be thought of as having a strong form legal personality, in contrast
to partnerships which are characterized only by the priority rule and not liquidation protection.
àProtects the firm against shareholders
Limited liability
Limited liability shields the firm’s owners, the shareholders, from creditors’ claims; this facilitates
diversification.
With unlimited liability, the downside risk borne by shareholders depends on the way the business is
carried on. Limited liability imposes a finite cap on downside losses, making it feasible for shareholders
to diversify their holdings.
Limited liability here refers to limited liability in contract— that is, limited liability to creditors who have
contractual claims on the corporation. It is a special feature of corporate law which protects investors
from decisions they do not make meaning they can’t lose more than what they invested.
Transferable shares
Transferability permits the firm to conduct business uninterruptedly as the identity of its owners
changes, thus avoiding the complications of member withdrawal that are common among, for example,
partnerships, cooperatives, and mutuals. This enhances the liquidity of shareholders’ interests and
makes it easier for shareholders to construct and maintain diversified investment portfolios.
Standard legal forms for enterprise organisation differ in their allocation of control rights, including the
authority to bind the firm to contracts, the authority to exercise the powers granted to the firm by its
contracts, and the authority to direct the uses made of assets owned by the firm.
Example of low transferability :
Insiders are not supposed to benefit from asymmetrical information à Restricted by blackout periods
where they cannot participate in the market
Family firms have shares that cannot be traded to outsiders which constraint them from growing and
that cannot be sold without the authorization of others meaning exiting is difficult
Delegated management
Delegation permits the centralization of management necessary to coordinate productive activities.
Business corporations are distinguished by a governance structure in which all but the most
fundamental decisions are generally delegated to a board of directors that has four basic features:
formal matter seperate from the operational managers, board of a corporation is elected, the board is
formally distant from the firm's shareholders, and the board has multiple members.
This formal distinction between the board and executives facilitates a separation between initiation and
execution of business decisions & monitoring and hiring of those executives.
,The board is also different from the shareholders ( even tough they are elected by them in a substantial
part). This separation optimizes on the cost of decision making by avoiding the need to inform the firm’s
ultimate owners and obtain their consent.
There are three cases where shareholders are always required for a decision : The incorporation in
another country (jurisdiction), meaning the company becomes subject to another corporate law, a legal
merger, and changing the constitution of the firm
Investor ownership
Providers of financial capital own the firm àthis is called external financing. External finance can be
divided in two types : Debt (have no say) and equity (have a say and have governance rights).
How does an investor make money from these two types ?
• Equity investor will get returns through dividend or increasing share price
• Debt investors get returns through collecting interest payments
In an investor-owned firm, both the right to participate in control, which generally involves voting in the
election of directors and voting to approve major transactions, and the right to receive the firm’s
residual earnings, or profits, are typically proportional to the amount of capital contributed to the firm.
Business corporation statutes generally provide for this allocation of control and earnings as the default
rule.
(Examples of non-investors-owned firms : Sole proprietorships, state-owned firms, universities,
cooperatives)
Santos, F. & Eisenhardt, K., 2005. Organizational Boundaries and Theories of
Organization, Organization Science, 16 (5) (you should be able to explain and
apply alternative theories of (the) firm (boundaries) to existing cases.
There are four distinct conceptions of boundaries: efficiency, power, competence, and identity. Each
deals with a fundamental organizational issue.
Boundaries of efficiency
The boundaries of efficiency focus on minimizing governance costs and asks whether a transaction
should be governed by a market or organization à Outcome = efficiency
Goal = Minimize the sum of governance and transaction costs
Organizations are assumed to have specific decision and property rights to efficiently govern
transactions. Thus, for particular transaction attributes, the costs of governing activities through
markets are different from the costs of governing these activities in organizations.
, The central argument is that boundaries should be set at the point that minimizes the cost of governing
activities. A boundary decision is, therefore, the choice of whether to conduct a particular transaction
inside the organization or outside through a market exchange
There are three streams of thought on the source of governance cost differences:
1. Transaction costs
2. Measurement difficulties
3. Knowledge differences
Transaction costs : In a context of bounded rationality of economic agents and exchange
uncertainty, the terms of transactions are costly to define, monitor, and enforce, leading to
incomplete contracts. Asset specificity and small numbers bargaining in repeated transactions
increase the potential for hold-up by opportunistic agents. In these situations, hierarchical
governance is assumed to have advantages over market governance. These advantages arise
because internal organization enhances managerial oversight, enables managerial fiat, and allows
better-aligned incentives to motivate desired behavior
Measurement costs are caused by information problems. Information problems exist when it is
costly to assign the correct value to product attributes in a market exchange, leading to adverse
selection and moral hazard. Because it is easier to supervise activities, align incentives, and gather
information within organizations, bringing transactions inside the organization is likely to reduce
costs associated with information problems.
Knowledge differences :A strand of the knowledge-based view of the firm suggests that
idiosyncratic knowledge may be sufficient to create coordination costs in market exchanges, even
when partners behave honestly. Individuals bring different knowledge, and so will likely have
different views on how to accomplish the task. These differences can lead to coordination costs,
especially when uncertainty is present. These costs can be reduced within organizations through
authority relations.
Vertical boundaries of efficiency : Every stage of production should undergo assessment of the make-
or-buy choice to minimize governance costs
Horizontal boundaries of efficiency : potential economies of scope should determine horizontal
boundaries, economies of scope can be more efficiently gained through market exchange when
governance costs created by are low. Thus, optimal horizontal boundaries depend upon governance
costs.
Transaction attributes :
• High asset specificity à hierarchical governance
• High environmental uncertainty à Hierarchical governance
• High behavioral uncertainty à Hierarchical governance
• Technological uncertainty à Market governance (Higher behavioral uncertainty favors vertical
integration to avoid transaction costs, while higher technological uncertainty favors outsourcing
to mitigate obsolescence and preserve flexibility)
Session 1 : corporate strategy and theory of the firm
Kraakman, R, et al. (2009, 2nd edition) The Anatomy of Corporate Law; A
Functional and Comparative Analysis, Oxford: Oxford University Press
What is a firm ?
• Firms are one of the most important economic institutions of modern capitalism
• Firms mean entities that are separate from the individuals that own and run them
• A corporation is a legal construction : Corporations cannot exist without the law enabling us to
create them
Ex: Publicly listed firms, cooperatives, limited liability partnerships
What is corporate law ?
Business corporations have fundamentally similar sets of legal characteristics (five in total)
1. Legal personality
2. Limited liability
3. Transferable shares
4. Delegated management under board structure
5. Investor ownership by contribution of capital
In market economies, almost all large-scale business firms adopt a legal form that possesses all five
characteristics of the business corporation. However, it might be that these characteristics also generate
tensions and tradeoffs that lead to agency problems.
Legal personality (Needed to start a firm)
As an economic entity, a firm serves as a nexus of contracts. It is a single entity that coordinates the
activities of suppliers and consumers.
Legal personality means you protect the firm against the owners. If you would allow owners to withdraw
their investments at any time, you would jeopardize the going-concern (presumption that the firm will
keep on existing) of the firm, and reduce the value of the firm to the liquidation value which would
disadvantage all the stakeholders à Basis of entry shielding
The core element of legal personality is separate patrimony. This is the ability of the firm to own assets
that are distinct from the property of other persons, such as investors, and that the firm is free to use,
sell and pledge.
Entity shielding involves two relatively distinct rules of law:
1. A priority rule that grants to creditors of the firm, as security for the firm’s debts, a claim on the firm’s
assets that is prior to the claims of the shareholders. Debts to creditors will be paid off first, then
shareholders divide the remaining assets à Protects creditors
,2. A rule of liquidation protection that provides that the individual owners of the corporation (the
shareholders) cannot withdraw their share of firm assets at will, nor can the personal creditors of an
individual owner foreclose on the owner’s share of firm assets. This rule serves to protect the going
concern value of the firm against destruction either by individual shareholders or their creditors
Firms characterized by both rules can be thought of as having a strong form legal personality, in contrast
to partnerships which are characterized only by the priority rule and not liquidation protection.
àProtects the firm against shareholders
Limited liability
Limited liability shields the firm’s owners, the shareholders, from creditors’ claims; this facilitates
diversification.
With unlimited liability, the downside risk borne by shareholders depends on the way the business is
carried on. Limited liability imposes a finite cap on downside losses, making it feasible for shareholders
to diversify their holdings.
Limited liability here refers to limited liability in contract— that is, limited liability to creditors who have
contractual claims on the corporation. It is a special feature of corporate law which protects investors
from decisions they do not make meaning they can’t lose more than what they invested.
Transferable shares
Transferability permits the firm to conduct business uninterruptedly as the identity of its owners
changes, thus avoiding the complications of member withdrawal that are common among, for example,
partnerships, cooperatives, and mutuals. This enhances the liquidity of shareholders’ interests and
makes it easier for shareholders to construct and maintain diversified investment portfolios.
Standard legal forms for enterprise organisation differ in their allocation of control rights, including the
authority to bind the firm to contracts, the authority to exercise the powers granted to the firm by its
contracts, and the authority to direct the uses made of assets owned by the firm.
Example of low transferability :
Insiders are not supposed to benefit from asymmetrical information à Restricted by blackout periods
where they cannot participate in the market
Family firms have shares that cannot be traded to outsiders which constraint them from growing and
that cannot be sold without the authorization of others meaning exiting is difficult
Delegated management
Delegation permits the centralization of management necessary to coordinate productive activities.
Business corporations are distinguished by a governance structure in which all but the most
fundamental decisions are generally delegated to a board of directors that has four basic features:
formal matter seperate from the operational managers, board of a corporation is elected, the board is
formally distant from the firm's shareholders, and the board has multiple members.
This formal distinction between the board and executives facilitates a separation between initiation and
execution of business decisions & monitoring and hiring of those executives.
,The board is also different from the shareholders ( even tough they are elected by them in a substantial
part). This separation optimizes on the cost of decision making by avoiding the need to inform the firm’s
ultimate owners and obtain their consent.
There are three cases where shareholders are always required for a decision : The incorporation in
another country (jurisdiction), meaning the company becomes subject to another corporate law, a legal
merger, and changing the constitution of the firm
Investor ownership
Providers of financial capital own the firm àthis is called external financing. External finance can be
divided in two types : Debt (have no say) and equity (have a say and have governance rights).
How does an investor make money from these two types ?
• Equity investor will get returns through dividend or increasing share price
• Debt investors get returns through collecting interest payments
In an investor-owned firm, both the right to participate in control, which generally involves voting in the
election of directors and voting to approve major transactions, and the right to receive the firm’s
residual earnings, or profits, are typically proportional to the amount of capital contributed to the firm.
Business corporation statutes generally provide for this allocation of control and earnings as the default
rule.
(Examples of non-investors-owned firms : Sole proprietorships, state-owned firms, universities,
cooperatives)
Santos, F. & Eisenhardt, K., 2005. Organizational Boundaries and Theories of
Organization, Organization Science, 16 (5) (you should be able to explain and
apply alternative theories of (the) firm (boundaries) to existing cases.
There are four distinct conceptions of boundaries: efficiency, power, competence, and identity. Each
deals with a fundamental organizational issue.
Boundaries of efficiency
The boundaries of efficiency focus on minimizing governance costs and asks whether a transaction
should be governed by a market or organization à Outcome = efficiency
Goal = Minimize the sum of governance and transaction costs
Organizations are assumed to have specific decision and property rights to efficiently govern
transactions. Thus, for particular transaction attributes, the costs of governing activities through
markets are different from the costs of governing these activities in organizations.
, The central argument is that boundaries should be set at the point that minimizes the cost of governing
activities. A boundary decision is, therefore, the choice of whether to conduct a particular transaction
inside the organization or outside through a market exchange
There are three streams of thought on the source of governance cost differences:
1. Transaction costs
2. Measurement difficulties
3. Knowledge differences
Transaction costs : In a context of bounded rationality of economic agents and exchange
uncertainty, the terms of transactions are costly to define, monitor, and enforce, leading to
incomplete contracts. Asset specificity and small numbers bargaining in repeated transactions
increase the potential for hold-up by opportunistic agents. In these situations, hierarchical
governance is assumed to have advantages over market governance. These advantages arise
because internal organization enhances managerial oversight, enables managerial fiat, and allows
better-aligned incentives to motivate desired behavior
Measurement costs are caused by information problems. Information problems exist when it is
costly to assign the correct value to product attributes in a market exchange, leading to adverse
selection and moral hazard. Because it is easier to supervise activities, align incentives, and gather
information within organizations, bringing transactions inside the organization is likely to reduce
costs associated with information problems.
Knowledge differences :A strand of the knowledge-based view of the firm suggests that
idiosyncratic knowledge may be sufficient to create coordination costs in market exchanges, even
when partners behave honestly. Individuals bring different knowledge, and so will likely have
different views on how to accomplish the task. These differences can lead to coordination costs,
especially when uncertainty is present. These costs can be reduced within organizations through
authority relations.
Vertical boundaries of efficiency : Every stage of production should undergo assessment of the make-
or-buy choice to minimize governance costs
Horizontal boundaries of efficiency : potential economies of scope should determine horizontal
boundaries, economies of scope can be more efficiently gained through market exchange when
governance costs created by are low. Thus, optimal horizontal boundaries depend upon governance
costs.
Transaction attributes :
• High asset specificity à hierarchical governance
• High environmental uncertainty à Hierarchical governance
• High behavioral uncertainty à Hierarchical governance
• Technological uncertainty à Market governance (Higher behavioral uncertainty favors vertical
integration to avoid transaction costs, while higher technological uncertainty favors outsourcing
to mitigate obsolescence and preserve flexibility)
