Subordination of American capital

Journal

of Financial

Economics

27 (1990) 89-114.

Subordination Joseph

A. Grundfest

of American

September

capital

*

Stanford Law School, Stanford, CA 94305, Received

North-Holland

1990, final version

USA

received

December

1990

To economists, agency problems present challenges that can be resolved through optimal contracting or incentive mechanisms. To politicians, agency problems represent entitlements to be allocated among favored constituencies. Corporate management constitutes a powerful constituency independent of the interests of workers, local communities, and other corporate stakeholders. The political process has, for politically rational but economically debatable reasons, systematically subordinated investors’ desire to resolve agency problems to managers’ desire to be protected from capital-market discipline. Politically explicit modes of analysis thus complement traditional tools of finance theory and improve our ability to explain capital-market structure and behavior.

1. Introduction

America seems not to trust her capitalists. For more than half a century state and federal governments have limited investors’ influence over the governance of publicly traded corporations.’ Investors’ ability to monitor corporate performance and to control assets that they ultimately own has been subordinated to the interests of other constituencies, most notably *Commissioner, United States Securities & Exchange Commission (1985-1990). Research for this paper was supported by a grant from the Kendyl K. Monroe Research Fund and the John M. Olin Program in Law and Economics at the Stanford Law School. I would like to thank Ronald Gilson, Mark Kelman, Kenneth Scott, William Simon, the editors of this journal, and the participants in the Conference on the Structure and Governance of Enterprise for many useful and perceptive suggestions. These collaborators are, of course, absolved of all responsibility for any errors or shortcomings in this work. ‘Although the legal rules governing investor behavior are the subject of extensive treatises, see Loss and Seligman (1990) and Pitt, Miles, and Ain (1988), the implications of these rules for corporate capital structure and governance have only recently received careful attention. See Roe (1990), Black (1990), and Pound (1990).

0304-405X/90/%03.50

0 1990-Elsevier

Science

Publishers

B.V. (North-Holland)

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J.A. Grundfest, Subordination of American capital

corporate management.’ The persistent theme of this legislative trend is that society cannot trust stockholders and bondholders to promote the ‘public interest’. Society is better served, according to this view, if management is sheltered from the discipline that results from active capital-market oversight.3 This observation is stated as a matter of fact, not as a value judgment. The law books are rife with regulations that constrain the freedom of investors in publicly traded corporations.4 In contrast, the business judgment rule gives corporate management broad latitude to exercise its discretion, both in response to takeover bids and in daily management of the firm.5 Shareholders have attempted to influence management through the market for corporate control, but their efforts have been hobbled by recent legislative and judicial developments that increase management’s ability to defeat unwelcome tender offers. The rapid spread of state antitakeover statutes and the perception that courts are likely to uphold ‘just-say-no’ defensive strategies6 are among the significant developments restricting the market for corporate control. These regulatory constraints effectively restore the balance of corporate power to the status quo ante before the takeover wave of the late 1970s and 1980s. 1.1. Recent statutory and judicial developments

In the wake of restrictions on takeover activity, shareholders must generally resort to proxy contests to oust incumbent management.’ Proxy contests, 2“[T]he traditional model of the nature of the corporation, sees shareholders as ‘owners’.” Stahl us. Apple Bancorp., Inc., Civil Action No. 11510 (Del. Chancery, Aug. 9, 1990) at p. 25. Some commentators, however, reject the proposition that ‘corporate managers must govern on behalf of shareholders by whom they are elected and to whom the fiduciary duties of care and loyalty run’. Lipton (1987, p. 35). See also Lipton and Rosenblum (1990). 3For example, Lipton and Rosenblum (1990, p. 29) contend that ‘the normative model that looks to discipline of corporate managers, conformity to the wishes of stockholders and preservation of hostile takeovers as the goals of corporate governance is not a compelling one’. 4Hazen (19901, Loss and Seligman small fraction of this literature.

(19901, and Pitt,

Miles, and Ain (1988) represent

but a

‘See, Paramount Communications, Inc. u. Time, Inc., 571 A. 2d 1140 (Del., 1990) (upholding Time board decision to continue with a tender offer for Warner Communications despite evidence that Time’s shareholders would have preferred to terminate the transaction SO as to accept a premium tender offer for Time made by Paramount); Sulliunn u. Hammer, Civil Action No. 10823 (Del. Chancery, Aug. 18, 1990) (upholding settlement of class action on grounds that board’s decision to finance construction of a museum to house the corporate chairman’s art collection would likely fall within the bounds of the business judgment rule). 6Grundfest (1990b, note 4) explains how current legal precedent can cause potential bidders to behave as though the ‘just-say-no’ defense is established law, although there is no precedent squarely on point. ‘Gavin (1990) explains that because of the changed regulatory environment ‘the hostile tender offer has been supplanted by the proxy contest as the weapon of choice in seeking corporate change or control’. Wilcox (1990, p, 391) concurs that ‘during 1990 proxy fights were the primary method used for acquisition of control and for influencing corporate policy’.

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however, are far less effective than tender offers in disciplining corporate management.* Even so, at least one state has passed a law that imposes financial penalties on shareholders who mount an electoral challenge to an incumbent board.’ Courts have also interpreted poison-pill provisions in a way that makes it harder for shareholders to mount proxy contests.” In addition, proponents of managerial security have begun lobbying for quinquennial elections and other measures that would further erode the effectiveness of an electoral challenge to an incumbent board.” The trajectory of modern politics is clear: notwithstanding nascent institutional shareholder activism, investors’ influence over the governance of publicly traded corporations will continue to erode. The articulated political logic that underlies this trend is best illustrated by the ‘other constituency’ statutes adopted in at least 23 states.12 These statutes generally allow but do not require managements to consider the interests of nonshareholder constituencies, such as employees, retirees, suppliers, and local communities, when responding to hostile takeover bids. These constituencies generally have no legal standing to challenge corporate decisions ostensibly made in their behalf. Thus, instead of directly protecting such constituencies, as could be done through plant-closing laws or severance-pay provisions,13 or through legally enforceable corporate obligations, the statutes implement a ‘trickle-down’ theory of corporate governance in which managements are relied upon to exercise their discretion in favor of intended beneficiaries of state intervention. sEasterbrook and Fischel (1983, p. 402), for example, explain that ‘collective action problems . . . suggest that voting would rarely have any function except in extremes’, and Black (1990, p. 9) concludes that ‘the assumed weakness of shareholder oversight [through the voting process] underlies the central importance of the takeover market in both public debate and academic commentary’. Gilson (1981) further explores the inefficiency of proxy contests as a means of disciplining management. ‘Rosenbaum and Parker (1990) explain how Pennsylvania’s recently adopted antitakeover law imposes disgorgement penalties on certain shareholders who engage in proxy fights for control of boards of Pennsylvania corporations. “See DiBlasi and Feit (1990) and Stahl u. Apple Bancorp Inc., Civil Action NO. 11510 (Del. Chancery, Aug. 9, 1990) (holding that a poison pill can be triggered by collective shareholder action in connection with a proxy contest). “Lipton and Rosenblum (1990) contend that electing directors on five-year cycles will promote responsible, long-term management. White (1990) and others, however, criticize the quinquennial proposal on grounds that it will inevitably lead to greater management entrenchment and further reduce management incentives to operate efficiently. “American Bar Association (1990), Hanks (1990), and Hart enumerate these ‘other constituency’ statutes.

and Degener

(1990) describe

and

13Maine, for example, has adopted a severance-pay provision requiring that terminated employees receive one week’s pay for each year of employment [Maine Revised Statutes Annotated, Title 26, Section 625-B (Supplement, 1986-1987)]. This severance provision, unlike Pennsylvania’s, applies whether or not the termination follows a change of control. Rosenbaum and Parker (1990, pp 41-43). As Grundfest (199Oa) explains, the primary consequence of the Pennsylvania severance-pay provision is to erect a barrier to change-of-control transactions and not to compensate employees of Pennsylvania corporations.

J.F.E.-

D

J.A. Grundfest, Subordination of American capital

92

Much of the same logic underlies the antitakeover statutes adopted by at least 42 states.14 The proliferation of these statutes suggests that ‘for all intents and purposes, there is now a de facto national antitakeover law’.15 These statutes increase managements’ discretion to thwart unwelcome takeover bids and, as with ‘other constituency’ statutes, the greater discretion comes without a commensurate increase in responsibility to any identifiable constituency. The net effect is thus to favor incumbent managers over management teams likely to prevail in contests for corporate control, and to expand incumbents’ discretion in the belief that they are more likely to ‘do the right thing’ if protected from capital-market discipline than.if forced to respond to market pressures.

1.2. Management as an independent constituency Although managements applaud the freedom afforded by state antitakeover statutes, they criticize initiatives that would impose on corporations binding obligations to workers, communities, or other constituencies.t6 Simply put, managements want to retain the traditional legal doctrine that they are responsible only to stockholders while simultaneously constraining stockholders’ ability to oversee management performance, and legislatures seem to agree. Management’s call for greater autonomy, however, supports an alternative explanation for recent legislation stifling the market for corporate control. Rather than serving as champions for constituencies who perceive their interests threatened by hostile takeovers,” management can be viewed as a constituency in its own right. Under this hypothesis, the interests of ‘other constituencies’ provide a convenient rhetorical mask for management’s advocacy of legislative and judicial developments that shelter it from capital-market discipline. Management is a powerful constituency in its own right. It directs political contributions and makes plant-location and other decisions that can reward 14Bureauof “Bureau of compiling

National

Affairs

National Affairs 150 state antitakeover

(1990a). (1990b). statutes.

S ee also

McGurn,

Pamepinto,

and

Spector

(1989)

r6For example, the American Bar Association Committee on Corporate Laws (1990) and Hanks (1990), both strong supporters of antitakeover statutes and of managements’ right to oppose unwelcome bids, also oppose ‘other constituency’ statutes because they can arguably be construed as providing a foundation for legal doctrines whereby managements can be held accountable to nonshareholder constituencies. “The perception of a threat may be quite different from the actuality of a threat because, as documented by Lichtenberg and Siegal (1989), the layoffs associated with takeovers occur primarily at the white-collar level that supportscorporate overhead rather than at the blue-collar level that draws most political support and performs actual manufacturing and service.

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or penalize specific legislators. Management’s own lobbying positions also often suggest a clear self-interest. For example, management groups support job-preservation measures that are tied to antitakeover legislation but oppose prolabor measures that do not also protect incumbent managers.” The notion that management is protected so that it can serve a greater good may thus be a politically expedient rationale more than an accurate explanation of legislative action. The political favoritism displayed toward management is not, however, without irony. Though many managers perform ably and responsibly, others behave foolishly and even maliciously toward society and toward their own stockholders and bondholders. I9 Allegations of criminal management conduct ranging from polluting America’s resources2’ to adulterating baby food21 to overcharging the Pentagon22 are hardly rare. Indeed, diverse constituencies frequently complain of social irresponsibility by corporate managements - not by stockholders or bondholders.23 On the economic front, there is also powerful evidence that managers have wasted billions on strategies that promote their private interests without adding to the efficiency or value of the enterprise. Anecdotally, the RJRNabisco leveraged buyout has highlighted examples of lavish extravagance and wasteful management. In addition to tales of a plush private air force, dozens of country-club memberships,. and questionable celebrity contracts, RJR’s management apparently engaged in more fundamental forms of mismanagement. 24 For examp Ie , a ‘trade-loading’ practice caused cigarette wholesalers to carry more product than they could resell promptly. The purpose was to bolster RJR’s market share measured at the production level and to accelerate the reporting of operating profits. The result, however, was

“Grundfest (1988, 1990a) describes situations in which managements support labor-protection measures that increase the costs of contests for corporate control but oppose measures that protect worker interests without also protecting management interests. “Mokhiber (1988) and Hochstedler corporate conduct.

(1984) catalogue

scores of incidents

of allegedly

criminal

“For example, United States of America us. Exxon Cotp, Case No. A90-015 Criminal (D. Alaska, Oct. 29, 1990) is an order denying Exxon’s motions to dismiss all five counts of the federal criminal indictment arising from the Exxon Valdez oil spill. 210’Brien (1989) describes the trial of two top executies of Beech Nut Nutrition who were found guilty of adulterating apple juice intended for infant consumption: perfect crime, because the victims were babies, who can’t talk.’ at p. 194. 22Geyelin and Garcia (1990) describe criminal conduct connection with fraudulent defense contract billings.

by General

Electric

Corporation ‘It was the

and Northrup

in

23Nader, Green, and Seligman (1970), Stone (1975), Mokhiber (1988) and Hochstedler (1984), among several others, voice a litany of complaints about the actions of corporate managers as distinct from the investors who provide capital to the firm. 24Burrough and Hellyar (1990) describe several executives for their direct and indirect benefit.

instances

of lavish

expenditure

by RJR

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J.A. Grundfest, Subordination of American capital

expensive peak-loading in the production process and a backlog of stale cigarettes that would eventually reduce RJR’s long-run profits as consumers switched to better-quality brands [Loomis (1989)]. More significantly, RJR’s own executives conceded before the buyout that with better management RJR’s operating income could be increased ‘40 percent in a single year if necessary. Profit margins could be taken to 15 percent from 11. Cash flow . . . could be taken to $1.1 billion a year from $816 million.’ [Burrough and Hellyar (1990, pp. 370-371)]. Mismanagement at RJR apparently extended far beyond the accoutrements of corporate privilege. In light of this experience, the natural question is whether RJR’s management before the buyout was atypical. Unfortunately, there is a substantial reason to believe that it was not alone. Several studies indicate that corporate productivity increases in the wake of management changes that accompany restructuring. 25 If the premiums paid to stockholders in takeover targets are a rough measure of productivity gains that management could have made, then accumulated losses from mismanagement over the decade from 1975 to 1986 exceed $400 billion.26 These premiums overstate efficiency gains insofar as they represent net tax savings or wealth transfers from employees, bondholders, or stockholders of acquiring companies who overpay for acquisitions.27 On the other hand, they understate gains to the extent that takeovers improve efficiency at corporations not engaged in any takeover transactions,28 generate additional tax revenue to the Treasury,29 and yield profits for successful bidders who- earn positive returns as a result of improved performance over and above that paid out in premiums.30 “Lichtenberg and Siegel (1989, 1990a,b), Healy, Palepu, and Ruback (1990), Smith (1990), and Kaplan (1989~) are among the studies that find improved productivity at plants and firms subject to various forms of restructuring, including leveraged buyouts, divestitures, and mergers. 26The $400 billion estimate is based on Jensen (1989a). Black and Grundfest (1988), using more conservative procedures likely to understate premium gains, estimate an increase in shareholder wealth of at least $162 billion, measured in 1987 dollars, as a result of transactions between 1981 and 1986. *‘For example, Shleifer and Summers (1988) discuss the possibility that restructurings transfer wealth from employees to shareholders, Coffee (199Ob) reviews recent studies examining wealth transfers from bondholders to shareholders, Kaplan (1989b) examines the tax incentives for highly leveraged transactions, and Black (1989) explores the possibility that executives of publicly traded firms systematically overpay in acquisitions. 28Rappaport (1990, p. 100) contends that ‘it is impossible to overstate how deeply the market for corporate control has changed the attitudes and practices of U.S. managers.. . . It represents the most effective check on management autonomy ever devised. And it is breathing new life into the public corporation.’ “Jensen, on average $75 billion per year in

Kaplan, and Stiglin (1989) estimate that ‘Treasury revenues from LB0 firms increase by about 61 percent over prebuyout payments’ and that ‘at a total dollar volume of per year, the Treasury gains about $9 billion in the first year and about $16.5 billion present value of future net tax receipts’.

30Kaplan (1989a) estimates that the gains to postbuyout premiums paid to shareholders in those transactions.

investors

are roughly

equivalent

to the

9.5

J.A. Grundfest, Subordination of American capital

2. An academic agenda The political system’s proclivity to shelter management and to exacerbate agency problems in the corporation presents several opportunities to expand the scope of modern finance scholarship. At one level, the challenge is simply to document and analyze the cumulative effect of regulatory measures that limit investors’ ability to monitor management. Without a detailed appreciation of these constraints it is often impossible to explain observed market behavior. At a second level, the challenge is to explain why the political system has embraced these restrictions. Both political and economic systems are subject to incentives and constraints, and both can be analyzed through formal analytic techniques. 31 Capital markets respond to regulatory intrusions by evolving new transactions and organizational forms, to which regulators respond with new restrictions. 32 Capital-market behavior is therefore guided by a jointly determined political and economic equilibrium, and an understanding of the political marketplace is essential to appreciate the role that capital-market mechanisms can, over the long run, play in corporate governance. At a third level, the challenge is to describe the economic and social consequences of regulations that limit capital-market monitoring. The American political process does not want an economy that is ‘efficient’ by traditional economic yardsticks. It goes out of its way to create rents and inefficiencies that promote political objectives. Indeed, ‘[llegislation often favors the interests of a minority and may be quite contrary to the interests of the majority. Thus, public choice theory suggests that republican legislative systems produce socially useless or even harmful laws . . . [and] [t]he victims of takings may not be the minority, as in classical welfare-liberal Takings Clause analysis, but rather the majority who have been legislatively robbed by a well-organized minority.’ [Hovenkamp (1990, p, 8711. A welfare analysis of the political process as it applies to corporate governance issues would consider the full panoply of wealth transfers and inefficiencies generated by these regulations, and not just the premiums gained or foregone as a result of antitakeover restrictions. This agenda is in some respects similar to the one outlined by Moe (1990) in his call for public-choice theorists to focus on political institutions as ‘weapons of coercion and redistribution . . . the structural means by which political winners pursue their own interests, often at the great expense of 31Weingast and Marshall (19881, Weingast (1984), Shepsle examples of the formal analysis of political systems.

(19861, and Ordeshook

(1986) are

32Jensen (1989b) and Roe (1990), for example, describe how the evolution of leveraged-buyout firms constitutes a market response to legal restrictions on activist management by institutional investors.

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of American

capital

political losers’, rather than on their role as institutions that mitigate collective-action problems. Roman0 (1984,1987), Coffee (1990a), and Macey and Miller (1987) provide examples of politically explicit analyses applied to corporate governance issues, but finance and legal scholarship have barely scratched the surface in exploring the subtle, elaborate, and powerful linkages between political systems and capital-market processes. 2.1. Politically explicit analyses of capital-market structures Several papers in this volume make substantial contributions to a politically explicit analysis of corporate capital structures. In particular, Roe (1990) documents a broad array of legislative restrictions that impair the ability of the largest pools of institutional capital in the U.S. effectively to influence decisions made by corporate management. As Roe explains, U.S. banks, insurance companies, pension funds, and mutual funds are prevented from accumulating large debt and equity positions in individual portfolio firms. The U.S. legal regime thus limits large institutional investors’ ability to discipline the managements of companies in which they invest, and forces them to adopt passive strategies that further exacerbate potential agency conflicts between equity- and debtholders. The net result is substantially greater latitude for managements. An associated consequence is a higher cost of capital for U.S. firms, because they have to compensate investors for the financial risks created by a regulatory structure that impairs monitoring and promotes agency costs. No doubt, many of these constraints have their roots in diversification requirements that are motivated, at least in part, by a rational desire to reduce the risk associated with nondiversified portfolios. In addition, there are well-founded concerns over a moral hazard problems that can arise if federally insured institutions lend to borrowers in which they hold a material equity interest. As Roe (1990) explains, however, other constraints on the behavior of institutional investors are less clearly motivated, and indicate a specific intent to limit the exercise of authority over management by large pools of capital. Moreover, if the political system had an interest in promoting active monitoring by large institutional investors, it could craft regulatory structures that would allow monitoring while reducing associated risks. Lack of interest in such reforms suggests that prevention of active monitoring may well be a desired objective of the political process. 2.2. The disciplining effects of bankruptcy The regulatory structure Roe describes does not, however, imply that institutional monitoring is impossible. Under the terms of bank-lending agreements, once a firm defaults or voluntarily restructures its debt, its

J.A. Grundfest, American capital subordination

97

lenders can discipline management, either through termination of senior executives or through restrictions on the firm’s activities. Gilson (1989,199O) describes how defaults correlate with significantly greater senior executive turnover at the defaulting firm, as well as among members of the board. In addition, lenders often receive large blocks of voting stock under voluntary restructuring and in Chapter 11 reorganization plans and, in some cases, banks are also able to appoint their representatives to the debtor’s board. A default thus increases monitoring by external creditors and reduces reliance on the debtors’ preexisting management. From management’s perspective, there is a powerful incentive to avoid default, both because it will probably lead to a personal wealth loss for terminated managers, and because it will probably produce a sharp change in internal governance mechanisms. Managers therefore attempt to avoid default by choosing more- conservative debt-equity ratios, favoring less risky projects, diversifying into new lines of business through conglomerate acquisitions, and purchasing insurance and other financial hedges. Within those constraints, managements also have an incentive to operate their firms more efficiently to reduce the probability of default [Gilson (1989,1990)]. The possibility of more active monitoring after default does not, however, suggest that the regulatorily imposed agency constraints identified by Roe are costless or irrelevant. Indeed, if a company simply steers clear of default, it is immune to the monitoring and discipline described by Gilson. This particular incentive to avoid default, which is private to the corporation’s management, establishes yet another agency problem that can lead corporations to adopt excessively conservative operating strategies and waste significant value [Jensen (1989a, b)].

2.3. International comparisons: The Japanese and U.S. systems contrasted The effects of the political constraints Roe describes are difficult to assess rigorously within modern U.S. capital markets alone. Analyses limited to U.S. markets are by design unable to capture variations in the relevant regulatory regime unless they look back to the 1930s. Looking back more than 50 years for guidance on the present-day implications of our regulatory structure is dangerous, because so much has changed since the Depression that inference would be difficult.33 An alternative approach, which has its own hazards related to cross-cultural comparisons, is to compare the operation of U.S. capital markets with the operation of foreign capital markets subject to 33The debate over the effects of the adoption of the securities laws, as reflected in Stigler (1964a,b), Friend and Herman (1964, 1965), Benston (1973, 197.5), and Friend and Westerfield (19751, illustrates the difficulty of research strategies based on such long-horizon longitudinal designs.

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different regulatory regimes. Prowse (1990) and Hoshi, Kashyap, and Scharfstein (1990) provide insightful contributions in precisely this direction. Prowse’s examination of Japanese corporate capital structures complements Roe’s analysis by illuminating a specific consequence of capital-market fragmentation that is common in the U.S. but until recently was foreign to Japan. As Prowse explains, Japanese financial institutions can establish significant debt and equity positions in the same firms. In contrast, U.S. regulations effectively force the separation of stockholders from lenders. As a consequence of the harmony of interests created by joint equity- and debtholding positions, Japanese firms have to compensate lenders less to induce them to bear the risks associated with potential bondholder-stockholder conflict. Thus, all else being equal, Japanese capital structures reduce agency costs and allow investors to monitor managements more effectively than in the U.S. In particular, the amelioration of agency problems allows Japanese firms to invest more in research and development and to maintain more liquid and flexible asset structures than their comparably leveraged American counterparts. From a slightly different perspective, the Japanese regulatory structure allows Japanese firms to operate with lower financing costs and higher debt-equity ratios than comparable U.S. entities. Prowse’s conclusions are confirmed and expanded by Hoshi, Kashyap, and Scharfstein who find that Japanese firms belonging to keiretsu weather financial distress far better than firms that are not keiretsu members. Keiretsu are groups of Japanese firms characterized by intricate equity cross-holdings, a strong lead bank that is both a dominant lender to and an equityholder in members of the group, and close ties to common suppliers and customers. In addition, lead banks within keiretsu frequently place bank executives in top management positions at member firms even when the firms are not financially distressed. As a result of these intricate cross-relationships at the executive, capital, and product market levels, providers of debt and equity capital within keiretsu are typically far better informed about developments in portfolio firms than are U.S. institutional investors. They are also better able to avoid free-rider problems and can more effectively guide managements that stray from the group’s objectives. Hoshi, Kashyap, and Scharfstein’s results confirm Prowse’s finding that agency costs in Japan are lower in firms that have banks with large debt- and equityholdings. Their results extend further, however, because they demonstrate that keiretsu membership has an independent capital-market effect. Keiretsu members who experience financial distress are able to increase investment and revenue as part of their workout process more rapidly than similarly situated firms that are not in keiretsu. The resolution of financial distress appears to be easier within keiretsu because their financial structures reduce informational asymmetries, ameliorate free-rider problems, and restrain opportunistic behavior. Moreover, the group’s links in product markets

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facilitate the maintenance of supplier and customer relationships that might be severed if the firms had to deal solely at arm’s length in the markets for goods and services. The U.S. regulatory structure effectively prohibits U.S. firms from capturing capital and product market benefits associated with the operation of keiretsu. The suggestion that U.S. conglomerates are effective substitutes for keiretsu misses the mark because, even within conglomerate structures, there is no nondefault opportunity for active monitoring by financial institutions. Investors in conglomerates are, after all, subject to the full panoply of regulations Roe enumerates. The rationale for conglomerate acquisitions is also generally quite different from the rationale for the formation of keiretsu, and the evidence suggests that conglomerate acquisitions are far less successful than keiretsu.34 Indeed, tong lomerate structures can be explained as the result of agency problems that arise from attenuated monitoring, rather than as an attempt to resolve those problems.35 A comparison of corporate capital structures in Japan and the U.S. suggests that the U.S. regulatory regime imposes costs that are not borne by investors in Japanese firms. These differential regulatory costs may explain part of the large cost-of-capital differences recently documented between the U.S. and Japan.36 On the other side of the ledger, however, the U.S. political system may perceive offsetting benefits that result from its regulatory structure. Thus, given a choice, the U.S. could rationally select its regulatory structure over Japan’s. The simple observation that our regulatory system imposes capital-market costs absent in Japan’s marketplace does not, however, explain why our system willingly bears these costs. Nor does it provide insight into the process that led these constraints to be enforced in the U.S., but not in Japan, even though Japan’s immediate post-World War II period saw an effort to replicate America’s regulatory structure.37 To place this debate in a broader context, it is useful to step back and consider the reigning paradigm in the analysis of corporate agency costs. Only by contrasting this paradigm with insights drawn from more politically explicit analyses can we clarify the full domestic and international implications of a politically sensitive analysis of capital markets and agency costs. 34Porter (19871, for example, finds that conglomerate acquisitions by a group of large publicly traded firms have been singularly unsuccessful. 3sAmihud and Lev (19811, for example, find support for the hypothesis that conglomerate acquisitions are motivated by managements’ desire to reduce personal risk in a manner inconsistent with maximization of capital-market value. 36Shoven (1990) and McCauley and Zimmer (1989) document significantly higher capital costs in the U.S. than in Japan. “As explained by Viner (1988, p. 55), Suzuki and Kawamoto (1984, pp. 30-321, and Akashi (19891, Japan’s Securities and Exchange Law, adopted in 1948, was modeled directly on U.S. securities laws.

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3. Beyond Berle and Means

More than two centuries ago, Adam Smith was skeptical of enterprises that separated management from ownership: ‘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 a private copartnery frequently watch over their own.’ [Smith (1776)]. Smith predicted that ‘negligence and profusion . . . must always prevail, more or less, in the management of the affairs of such a company’. He even went so far as to suggest that ‘[i]t is upon this account that joint stock companies for foreign trade have seldom been able to maintain the competition against private adventurers’. Translated into the language of modern economics, Smith predicted that because of agency problems corporations would be unable to compete with organizational forms that allied ownership more closely with controL3* Smith was wrong in predicting that the corporate form would fail, but he was prescient in suggesting that serious agency problems would arise. He thereby presaged an extensive literature analyzing agency problems associated with the corporate form of organization. The seminal works in the modern literature are Berle and Means’ 1932 text, The Modern Corporation and Private Property, and Jensen and Meckling’s 1976 article, ‘The theory of the firm: Managerial behavior, agency costs and ownership structure’. As Berle and Means (1932, p. 6) explain, ‘[tlhe separation of ownership from control produces a condition where the interests of owner and ultimate manager can, and often do, diverge, and where many of the checks that formerly operated to limit the use of [management’s] power disappear’. Jensen and Meckling expand on that insight to motivate an extensive technical literature that dissects the causes of agency problems across a wide range of economic relationships and explores strategies to minimize costs generated by those agency problems.39 The agency problem that motivates the modern literature, and that traces its intellectual roots back at least as far as Adam Smith, would exist even in a pure contractarian state of nature in which corporations are unambiguously defined as a web of private contractual relations free of government regulation. In this state of nature, agency problems arise solely as adverse side effects of otherwise efficient forms of specialization in which groups of executives with a comparative advantage in managing large enterprises un38Jensen (1989b) makes an analogous observation in suggesting that the publicly held corporation has outlived its usefulness in many sectors of the economy and is being eclipsed by the ‘leveraged-buyout association’ and other organizational forms in which investors with substantial equity at risk directly monitor corporate performance. 39Jensen and Smith expanding literature.

(1985) and Smith

(1989) provide

overview

summaries

of this large

and

J.A. Grundfest, Subordination of American capital

dertake to direct the funds invested advantage in contributing capital. 3.1. Agency

problems

as political

by individuals

101

with a comparative

entitlements

The modern corporation does not, however, exist in a contractarian state of nature. As a legal matter, corporations are creatures of the state and their affairs are governed by intricate rules established as the result of a complex political process. 4o Moreover, the political process is not satisfied simply to observe that agency problems exist within the corporate form. Nor is the political process satisfied to observe that market mechanisms can ameliorate many of the costs resulting from separation of management and ownership. Instead, politicians recognize that agency problems can be manipulated for the benefit of distinct and politically valuable constituencies, including workers, local communities, and managements themselves. Governments thus have an incentive to create, exacerbate, or ameliorate agency problems to further political agendas. Accordingly, from a politician’s perspective, agency problems are not an exogenous consequence of otherwise efficient specialization. Instead, they are endogenous variables in a complex political and economic system - variables that can be manipulated for political as well as economic ends - and there is no a priori reasons to conclude that equilibrium in this system minimizes the economic costs the agency problems impose. To a politician, agency problems are better viewed as entitlements to be allocated than costs to be minimized. By making it more expensive for principals to monitor agents, governments can confer valuable benefits on favored constituencies without imposing taxes, without providing direct subsidies, and without engaging in repeated and detailed regulatory intervention. Indeed, by sheltering a favored constituency from market discipline, the political process creates ‘slack’ that the constituency can decide when and how to use. The manipulation of agency costs is thus a particularly valuable policy instrument for politicians subject to budget constraints who want to provide a long-term and flexible benefit to a favored constituency, all without writing a check drawn on the government’s treasury. When viewing corporate governance issues through this lens, it is important to recognize that the political process is itself rife with agency problems that managements can manipulate to their own advantage. Legislators are 40Lipton and Rosenblum (1990, p. 12) argue that ‘the origin of the corporation, even in our private-ownership based economy, was as a state-chartered, quasi-public entity’ and that ‘corporations came into being in England and in the early history of the United States under legislative charters, created to serve specific public as well as private purposes’. From an economic perspective, however, corporations are more readily understood as a nexus of contracts, as in Jensen and Meckling (1976), for example.

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agents of the constituencies that elect them, as well as of the constituencies upon whom they rely for political advancement. These groups often have narrowly focused interests. If politicians rationally recognize only those costs that affect constituencies upon which they rely for reelection and advancement, individually rational political decisions can have substantial negative economic consequences for the nation as a whole. [See, generally, Ordeshook (19861.1 Investors, who are geographically dispersed and face substantial coordination and bonding costs, are at a natural political disadvantage to managements. Managements control plants and facilities in specific legislators’ districts, direct substantial political contributions in clearly measurable quantities, and make promises and threats that are far more credible than those that can be made by a large but amorphous groups of investors. In addition, even when collective-investment vehicles attempt to influence the political process, they are less likely to be effective because, as Roe explains, mutual funds, pension funds, banks, and insurance companies are subject to direct political pressures of a sort that cannot be brought to bear against individual investors. Thus, institutional activism, even if it is in the best interests of fund beneficiaries, can trigger a backlash that is contrary to the interests of the managers of collective-investment vehicles. The possibility of such a political backlash creates a potential agency problem in the investor-portfolio manager relationship that can induce portfolio managers to be more passive than investors might otherwise desire. More fundamentally, perhaps, it is critical to observe that despite the assets controlled by banks, pension funds, insurance companies, and mutual funds, those assets don’t vote: people vote, and managements are much more effective at swinging votes in local areas than are collective-investment vehicles. 3.2. The limits

of traditional

analysis

Economic analysis in the tradition of Berle and Means ignores the potential for strategic government manipulation of agency problems because it treats those problems as a side effect of specialization rather than as a direct consequence of regulation. Progress beyond the traditional formulation calls for recognition that the survival characteristics of agency problems are influenced as much by politics as by economics, and that equilibrium solutions must respect political as well as economic constraints. Modes of inquiry traditionally associated with public-choice theory and with the study of political institutions thus have a powerful contribution to make to the analyses of agency problems in the corporate form, as well as in other areas of finance. This approach calls for consideration of the process by which constituencies affected by corporate decision-making coalesce, as well as of the mechanisms by which these constituencies strive to alter market and political outcomes for their benefit. In addition, political analyses can shed

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light on rules and procedures by which corporations govern their internal operations, compensate their employees, and resolve conflicts among competing constituencies. It takes little more than casual observation to conclude that ‘ideal’ economic solutions to internal corporate governance issues are rarely implemented, and that political considerations often militate against the application of ostensibly logical economic principles.41 4. Fragmentation,

isolation,

and pacification

of capital

These political considerations are generally overlooked in the finance literature. As masterfully chronicled by Roe, the United States’ political system has long operated to prevent effective exercise of power by the largest institutional holders of capital. In a nutshell, banks, pension funds, insurance companies, and mutual funds - the largest collective investors in modern American society - are variously prohibited or deterred from accumulating equity positions large enough to make them effective monitors of corporate conduct, from holding combinations of debt and equity that could reduce the conflict between creditors and equityholders, and from taking actions that might directly influence corporate decision-making. Indeed, the problem is even more pervasive than Roe suggests. Through the tax code, Congress limits the influence that foundations and charitable organizations can assert over publicly traded and privately held corporations.42 The tax code can also penalize corporations that sell proportionate packages of debt and equity instruments, even though the sale of these ‘strips’ could reduce agency costs within the firm. 43 In addition, the bankruptcy code is often attacked as favoring debtors over creditors, and corporate managements have, as debtors-in-possession, maintained control of bankrupt enterprises for extended periods against the wishes of corporate creditors.44 The regulatory mechanisms used to subordinate capital generally fall into one of three categories. First, capital is fragmented by diversification require41Scholes and Wolfson (forthcoming) develop this theme in detail in a somewhat different context. They explain how agency problems prevent corporations from adopting straightforward tax-minimization strategies and induce them instead to adopt more intricate strategies that optimize combined tax and agency-cost burdens. 42The tax code restricts private foundations from owning unrelated business. Rose and Chommie (1988, p. 640).

more

than 35% of the equity

of an

43Bittker and Eustice (1986, pp. 4-5) explain that while strip-financing ‘is not fatal per se to debt classification, the fact that debt is owned in proportion to stockholdings tends to poison the atmosphere and to invite special scrutiny by the courts’. 44As explained by Weintraub and Resnick (1986, sect. 8), in a corporate reorganization, preexisting management typically remains in control of the corporation as debtor-in-possession and for 120 days has an exclusive right to file a reorganization plan. This right, which may be extended, combined with bankruptcy’s automatic stay of litigation, and the potentially lengthy course of bankruptcy proceedings, effectively severs capital-market control of the bankrupt entity and places all control in the hands of corporate management, subject to the oversight of the bankruptcy court. Galen (1990) describes investor and creditor frustration with the bankruptcy court’s treatment of Eastern Airlines.

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ments that prevent any one institution from accumulating enough equity to exercise control. Second, capital, once fragmented, is further isolated by regulatory restrictions that increase coordination costs among investors. In particular, the SEC’s proxy system is often criticized as a mechanism that isolates shareholders and insulates management from active institutional oversight.45 Third, in addition to being fragmented and isolated, some institutional investors are further constrained by standards of ‘prudence’. The importance of ‘prudence’ is particularly significant to pension-fund managers subject to the strict fiduciary standards of the Employee Retirement Income Security Act of 1974, which are frequently interpreted as creating substantial legal risks for fund managers actively involved in the affairs of portfolio companies. There is also concern that a seat on a corporate board will expose a pension fund to taxation on income from unrelated activities. To minimize these risks, many portfolio managers follow passive investment strategies and avoid confrontation with corporate management.46 ‘In the U.S. it is unheard of for a pension executive to serve on a corporate board’ [Clark (1990, p. 67)]. In contrast, British pension funds, which operate in a less litigious environment, have long held large, active positions in individual firms. Indeed, the British Coal Pension Funds mounted a successful hostile takeover of a publicly traded investment fund after becoming ‘fed up with its performance’ [Clark (1990, p. 6811. The pacification problem is amplified in corporate pension funds, where fund managers have incentives to curry favor with corporate managements even though their legal duty is to maximize the value of the fund to the fund’s beneficiaries.47 The net result is an environement in which a ‘serious gap exists between what is permitted under traditional legal notions of prudence and what fiduciaries would like to do in the exercise of their best judgment’ [Longstreth (1986, p. 5)]. 4.1. Contrasting the U.S., Japanese, and German systems The fragmentation, isolation, and pacification of institutional holdings in the U.S. create a capital-market structure quite different from that found in Japan and Germany, our two most successful economic competitors. As 45Pound (1990) and Black (1990) present detailed critiques of the isolationist effects of the proxy system. Gilson and Kraakman (1990), however, argue that these effects may be overstated. 46Longstreth (1986) provides a comprehensive overview of the prudent-man rule and many of its illogical implications in the context of pension fund and other fiduciary activities. 47Brickley, Lease, and Smith (1988, p. 284), for example, find ‘significant differences across the various types of institutional investors in voting on antitakeover amendments’ and that the ‘managements of some institutions face conflicts of interest between their fiduciary responsibilities to their stock beneficiaries and other objectives, such as value maximization for the owners of the institution’.

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Prowse (1990) and Hoshi, Kashyap, and Scharfstein (1990) explain, stockholdings and bondholdings in Japan are highly correlated. Keiretsu also creates large blocks held by investors with an active oversight interest in the efficient operation of the firm. Similarly, in Germany, large banks and industrial combines exercise substantial influence over the operation of many companies and are able to effect management and strategic changes when circumstances warrant. Dornberg (1990) documents that the Deutsche Bank, Germany’s largest bank, holds equity stakes of 10% or more in about 70 German industrial and commercial companies, and that Deutsche Bank executives sit on more than 400 corporate boards. Among the bank’s largest holdings are 28.2% of Daimler-Benz, Germany’s largest industrial corporation; 30% of Philipp Holzmann, Germany’s largest construction company; 25% of Karstadt, Germany’s largest department store chain; 10% of Allianz Holding, Europe’s largest insurance company; and 10% of Munich Re, the world’s largest reinsurance company. In addition, the Deutsche Bank holds many equity stakes below lo%, which it is not required to report. Cable (1988, p. 129) further explains that German banks provide industry with substantial long-term finance, have extensive control over shareholders’ voting rights, and are widely represented on company boards. Thus, in both Germany and Japan, corporate investors and intermediaries are able to reach deep into the inner workings of portfolio companies to effect fundamental management change. They do so without the need for a hostile takeover or proxy contest. 48 In the U.S., in contrast, when large institutional investors suggest that they might like to have some influence on management succession at General Motors - a company that has hardly distinguished itself for skillful management - they are met with icy rejection and explicit warnings that presumptuous investors had better learn their place [Parker (1990) and Treece and Dobrzynski (199011. These cross-cultural distinctions provide fertile ground for research. No doubt, direct comparisons between U.S. and foreign experiences are extremely difficult because macroeconomic conditions, tax incentives, and comparative advantages differ cross-sectionally and over time. Moreover, cultural differences can assume particular significance when the analysis draws on asymmetric information models involving regulation, signaling, and related factors. Japanese investors, for example, might interpret an aggressive corporate action quite differently from their American counterparts. Controlling for these differences will be challenging, if not impossible. Nonetheless, as

48‘Fuji Rescue’ (1990) describes the most recent development in this long tradition in which management of Fuji Heavy Industries Ltd., the troubled manufacturer of Subaru automobiles, was effectively handed over to Nissan Motor Co., Japan’s second largest automobile manufacturer. Nissan and Fuji were members of the same keiretsu, as was the Industrial Bank of Japan, which helped coordinate the replacement of Fuji’s management.

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of American

capital

Prowse’s and Hoshi, Kashyap, and Scharfstein’s research suggests, much can be learned by careful examination of economic structures that are both successful and radically different from our own.

5. Regulatory motives and the American

political ethos

Such cross-cultural comparisons will, however, have only limited policy relevance because the American political ethos would certainly rebel against the concentration of economic and social power inherent in the Japanese and German forms of corporate organization. The American political tradition reflects a deep mistrust of accumulations of wealth and power that is rooted in the Jeffersonian notion of an agrarian ideal and expressed even in contemporary Supreme Court opinions. For example, when faced with a challenge to the constitutionality of a state statute prohibiting corporations from using general treasury funds for independent campaign expenditures, the court upheld the restriction partially because of the dangers it perceived from the ‘corrosive and distorting effects of immense aggregations of wealth that are accumulated with help of the corporate form and that have little or no correlation to the public’s support for the corporation’s political ideas’.49 The court’s mistrust of corporate involvement in politics is particularly telling because it relies on a recognition of an agency problem within the corporate form. As the court points out, there is no guarantee that corporate managers will engage in political activity in a manner that reflects anyone’s preferences other than their own. Thus, the court’s decision can be viewed as sympathetic to efforts to resolve corporate agency problems by simply eliminating management’s ability to act in a representative capacity. Severing the agency relationship over a particular decision set is a blunt but sure way of eliminating specific agency problems. A second consideration militating against fundamental reform of the U.S. corporate governance structure is that the regulations that fragment, isolate, and pacify institutional capital are often perceived as serving other, more important purposes. For example, the most frequently stated rationale for a portfolio diversification requirement is that beneficiaries or insurers of institutional portfolios must be protected from the risks of nondiversified investment strategies [Longstreth (198611. This rationale has logic behind it, and it is hard to argue that diversification requirements were adopted solely to fragment institutional capital. On the other hand, the fact that strict diversification requirements directly cause fragmentation hardly detracts from their popularity in many quarters. 4?4ustin v. Michigan Chamber of Commerce, 4371 (March 27, 1990).

110 S. Ct. 1665, 108 L. Ed. 2d 652, 58 U.S. L.W.

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As several commentators have observed, it is often difficult to divine true legislative intent from the formal history of an act’s adoption.” The forces that lead to enactment can also be different from those that support a statue’s long-term survival. Thus, even though the subordination of capital may not have been a stated objective of statutes or regulations that have that effect, that fact hardly makes them less attractive to the political system. Similarly, many regulations that isolate capital, such as the proxy regulations, were initially adopted on the rationale that they are necessary or appropriate to prevent fraud or to inform the market of actions taken by large stockholderssl The rules that pacify institutional capital also have roots unrelated to many of their current consequences. In particular, the fiduciary duty standards that govern fund trustees were initially developed to liberate trustees from the restrictions of state-mandated ‘legal lists’ that limited the set of permissible investments [Pozen (197811. Yet, despite these liberating origins, the prudent-man rule has become so encrusted with legalistic lore urging that the only safe strategies for fiduciaries are passive and conservative that ‘in some respects the rule has become nearly as inflexible as the legal lists it replaced’ [Johnston (1975, pp. 491-492)I. It would be wrong to conclude, however, that the best policy response is to eliminate diversification requirements and allow U.S. pension funds to become the equivalent of mini-Deutsche Banks while money-center banks establish their own keiretsu. Although diversification requirements have costs, they have offsetting benefits. Moreover, U.S. institutional investors and banks do not - at least yet - have the skill and experience of their German and Japanese counterparts in monitoring management. With time, however, these institutions could well gain such expertise, and they can today hire the same investment bankers, consultants, accountants, and lawyers who, as a practical matter, often direct decision-making at many publicly traded firms. The solution to the problems created by the subordination of American capital will therefore have to be found in a uniquely American approach. The political reality is that regulatory mechanisms that subordinate capital are supported by a broad network of political constituencies and are woven through the fabric of a large body of legislation. From the investors’ perspective, the practical challenge is to define an agenda that prevents further erosion of capital’s influence while providing a basis for more aggressive monitoring consistent with a political ethos that distrusts large accumulations of capital.

“See, for example, Posner (1987) and Farber and Frickey (1988). 51Lo~s (1988, ch. 7D), for example, describes the broad congressional grant of authority to the Securities and Exchange Commission to fashion proxy-solicitation regulations to protect the ‘public interest’.

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6. Agency problems among investors

Difficult as these agency problems are within the corporate form, it is important to recognize that with the emergence of large institutional investors agency problems can now arise among investors as well as between investors and management. If investors are predominantly individuals acting for their own account, agency problems are unlikely. But now that the total assets of institutional investors exceed $4.6 trillion, fund managers’ role as agents is too large to be ignored [Brancato (1989, exhibit 2)]. Where agency relationships exist, agency problems follow. Two forces suggest, however, that agency problems among investors are likely to be less severe than those between management and investors. First, investors can discipline fund managers more readily than corporate managers. An investor unhappy with a fund manager’s performance can often withdraw his investment relatively quickly. Withdrawal of funds directly reduces the asset base under the manager’s control and that in turn diminishes the manager’s compensation. In contrast, when investors grow disenchanted with a corporate management’s performance, the value of the corporation’s shares may fall, but without a hostile takeover or proxy contest management will not suffer a meaningful financial penalty.52 Second, investment managers have less opportunity than corporate managers to exercise faithless discretion. Investment managers are compensated through negotiated fee arrangements, which can be subject to legal limitations, and have no legal discretion to divert a portfolio’s investments for their personal benefit. Indeed, fund managers who invest the fund’s corpus in a way that generates personal benefits are subject to criminal prosecution.53 The span of a corporate manager’s discretion, in contrast, reaches across the entire range of a firm’s activities and provides far greater opportunity for self-dealing. Moreover, if institutional investors invest in efficient markets, they have less opportunity to overpay for acquisitions or to otherwise misdirect cash flow through mispriced investments than do corporate managers who deal in thinner markets, where strategic and self-serving overpricing can be far more prevalent [Black (198911. Institutional fund managers are not, however, the ultimate beneficiaries of the funds they invest. When a fund manager decides to support or oppose a hostile takeover bid, or to cast a vote for or against dissident directors, the decision may well be at odds with the decision favored by at least some of the “Jensen and Murphy (1990) find that changes in executive compensation do not reflect changes in corporate performance and that CEOs only rarely leave their jobs because of poor performance. 531n the case of mutual funds, for example, Hazen (1990, ch. 17) describes legal limitations on fees that can be paid to the fund’s advisors, the strict prohibitions on transactions between the investment company and affiliated entities, and the requirement that no fund act as custodian of its own securities.

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fund’s beneficiaries. As a practical matter, the manager’s decision might draw the support of an overwhelming majority of the fund’s investors, but the simple fact that the decision is derivative creates a political vulnerability that can be exploited by management to fight emerging activism among institutional investors [Cain (1990) and Lochner (1990)]. To illustrate, consider the following scenario. If institutional investors become effective monitors of corporate performance, corporate managers will have a powerful incentive to dilute their influence. One mechanism that could achieve this result, while appealing to democratic notions of equitable suffrage, would be a requirement that fund managers vote in accordance with the ascertainable preferences of the fund’s beneficiaries. Under such a requirement, fund managers would effectively have to poll their investors before exercising proxies or before tendering their shares in a hostile takeover. Such a pass-through voting requirement would diminish institutional influence because fund managers would probably be unable to obtain instructions from a large number of the fund’s beneficiaries.54 Those beneficiaries would, after all, be subject to the same collective-action problems that typically plague small investors. Moreover, the added expense and delay involved in such a polling process could significantly reduce the net benefits of active monitoring. Even more extreme is the possibility that when the institutional investor is a state or municipal pension fund, the governing authority will seek to influence the voting or tendering of the institution’s shares in a way that reflects a political agenda wholly unrelated to sound economic or managerial policy, or to the protection of the fund beneficiaries’ interests.55 The institutionalization of the investment process thus carries the seeds of a strategy that can be exploited by the political system to protect management even more from active capital-market discipline. As difficult as the current climate is from the activist investor’s perspective, the unfortunate reality is thus that the political system could easily make matters even worse. 7. Conclusion

and prognosis

The classic articulation of the corporate agency problem dating back to Berle and Means, and before that to Adam Smith, concentrates on conflicts of interest that arise among stockholders, bondholders, and managers be54The political process already distinguishes between votes cast directly by beneficiaries and votes cast by fund managers without any evidence that the votes reflect underlying beneficiary preferences. For example, Delaware’s antitakeover statute distinguishes between employee stock plans in which a fiduciary votes the plan’s shares and plans in which there is a pass-through mechanism that allows shareholders to determine whether to tender into a hostile bid. Delaware Corporate Code Annotated, Chapter 8, Section 203(a)(2Xii). “Such proposals are discussed Governor’s task force on pension

in Our Money’s fund investment,

Worth, a 1990 report Albany, NY.

of the New York State

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cause specialization creates situations in which corporate decisions that increase the welfare of some groups often reduce the welfare of others [Smith (1990, p. 1011.These agency problems would exist even in a purely contractarian state of nature free of any regulatory intervention. But modem corporations do not exist in contractarian states of nature. Legislators and regulators can generate, exacerbate, and reallocate the costs and benefits associated with agency problems for the benefit of politically favored constituencies. From this perspective, agency problems are entitlements to be allocated through the political process and not the natural byproducts of specialization in the corporate form. Accordingly, there is no reason to believe that corporate agency problems can be resolved in an economically rational manner, or that the corporate governance process will, over time, tend toward greater economic efficiency. Instead, the form, nature, and severity of corporate agency problems will reflect the push and pull of political considerations as much as the flow of economic events. An explicitly political analysis casts the corporate agency problem in a light quite different from the one that prevails in the traditional finance literature. An explicitly political analysis also suggests that progress in our understanding of corporate governance issues depends on the integration of public-choice theory, legal analysis, history, and other disciplines with finance theory and economics. An explicitly political analysis further emphasizes that agency problems within the corporate form are related to agency problems within the political system, as well as to agency problems within the institutional investor community. These politically explicit analyses also hold promise for explaining how and why the interests of stockholders and bondholders in publicly traded corporations have consistently been subordinated to the interests of management and other constituencies. This endeavor will inevitably require exploring agency problems beyond those described by Berle and Means. Indeed, it is only by moving beyond the traditional agency model that economic and financial analysis will come to grips with the full range of forces that typically determine equilibrium structures of corporate governance.

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