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resemblance to the legal system which continues to surround it. So too, an obsession with the formal legal system surrounding corporations obscures the actual functional relationships involved.

For example, the "separation of ownership and control" is a problem only if one views corporation law as a comprehensive functional description of the corporate system. Viewed in other terms, however, the "separation" is no more than a perfectly sensible division of labor. As Richard Posner has written,

“... The [management] group consists of people who are experienced in the business and involved in it on a full-time, day-to-day basis. In contrast, the typical shareholder is not knowledgeable about the business of the firm, does not derive an important part of his livelihood from it, and neither expects nor has an incentive to participate in the management of the firm. He is a passive investor and, because of the liquidity of his interest, has only a casual, and frequently quite brief, relationship with the firm. His interest, like that of a creditor, is a financial rather than managerial interest.

...

"It is no more anomalous that shareholders do not manage or control "their" corporations than that bondholders do not manage or control the corporations whose bonds they hold, or trust beneficiaries the trustee. All three groups have an investment interest."

Similarly, many have criticized the role played by institutional investors in controlling corporate behavior. For the most part, such investors have not attempted to influence management behavior by invoking their rights on shareholders. Such criticism demonstrates the depths of economic misunderstanding corporate critics are prone to. If a pension fund, for example, were to undertake to exert control over the firms in which it owned stock, it would have to add a sufficient number of managerial personnel to keep informed about the activities of each firm. This would impose enormous additional salary costs upon the fund and would compel it to diminish diversification, since the marginal cost of buying stocks in firms not then in the portfolio would be increased by the need for additional personnel to keep informed about their activities. And for all this, what would be gained? The fund's managerial personnel are unlikely to be better than those in corporations and their additional "control" is unlikely to add much in the way of returns.

The obsession with "control" through the exercise of right has been the cause of neglect of a small but important part of the legal literature. For a decade and a half, Professor Henry Manne has written a series of articles demonstrating that share price and the capital market disciplines the behavior of corporate management and the body of his work has yet to be seriously confronted, much less weakened. And while Manne stands out in the legal literature, economists of varying stripe accept the same propositions as true or at least plausible theories of corporate behavior.

As Professor William Baumol has written:

"Reports of the deliberations of the top levels of management in major American corporations seems to indicate a widespread concern with the performance of the companies' securities. Even in companies which have long refrained from the issue of new stocks and which apparently have no plans for such an issue in the foreseeable future there seems to be a heavy preoccupation with the market's evaluation of the corporation's shares. Whatever the reasons, and I shall discuss these briefly in a moment, this concern is by itself sufficient to empower the market to oversee the behavior of management. If the businessman is motivated to avoid reductions in the price of his firm's securities and if, in fact, he hopes that those prices will rise rather steadily and dependably with the passage of time, he will be driven to adapt his decisions to this purpose. Behavior which depresses security prices will then conflict with company objectives."

A most recent example of this phenomenon involves the Washington Post, which, soon after going public, brought on a confrontation with a major union of its employees and won a brutal labor dispute. Some attributed the Post's change in attitude to the fact that it had become a "hostage to the stock market." Corporate management's attention to the price of the firm's stock is perfectly understandable. The lower the price, the easier it will be for others to take over the corporation and hire new management. Thus, if a firm is mismanaged, robbed or overly attentive to non-profit goals, the price of its shares will drop and others will perceive an opportunity to take-over the corporation and install new and more efficient management to raise the share price. The take-over may

be by way of a proxy fight, purchase of control or merger. Those who take over the corporation will thus profit either by the compensation received as successful managers and/or by capital gains incurred as a result of the increase in share price.

Trading in corporate share therefore, is not only a market in investments but also a market in management control. It is this latter market which, because it is closely related to the behavior of the former, constitutes a constraint on management conduct. The implications of this for the debate over corporate power are profound. Product market competition alone is a pressure on corporate management to profit maximize on behalf of the corporation, for any other goal would quickly be reflected in the company's earnings and in the price of its stock. Management thus has substantial incentive to maximize the profits of the corporation, and this incentive is directly related to investor behavior. Two serious challenges are made to this analysis: (1) the constraints on management may not be very severe if product market competition does not exist; (2) the cost of a take-over is so great that management has unwarranted discretion.

Where product market competition does not exist because the industry is regulated, it is probably the case that the cost of a takeover does allow management considerable discretion not to profit maximize on behalf of the corporation. Additions to the costs of doing business such as lavish community affairs programs, expensive office furnishings, etc., will not incur the penalties imposed by rigorous competition and management may thus exercise some discretion at a cost in the price of the stock.

Where competition is lacking because of an oligopolistic industrial structure— and here I assume arguendo that such structures in fact reduce competitionthe incentive to profit maximize on behalf of the corporation is not, it seems to me, reduced. Oligopolies, or price fixing cartels for that matter, rely heavily on a mutual forebearance among firms induced by the belief that price cutting will go for naught since it will immediately be matched by one's competitors. Thus, it is said that within an oligopolistic structure of four firms holding 35 percent, 25 percent, 25 percent, and 15 percent respectively, a price cut by any will immediately be met and all will retain the same market share but at a lower price. There is no incentive on anyone's part to bring about such a result. Similarly, a cartel of price fixers must reach a compromise price which for each member offers a higher return than a situation where all compete.

In either case, however, the price level reached is based on a relative cost structure which cannot be changed without creating incentives to cut price among some of the firms. And this in turn creates pressure on corporate management, whether in an oligopoly or in a cartel, to profit maximize on behalf of the corporation. For example, if the management of one firm in an oligopoly increases that firm's costs by lavish contributions to Yale, extravagant office suites or just plain robbery, its competitors will no longer view a price cut as a fruitless endeavor since the ability of the first firm to meet it has been impaired and market share can be increased by a price cut. This is so not only because the first firm's costs are higher but also because the resultant decline in share price will have impaired its ability to raise capital either by equity or debt, since a decline in share price will mean an increase in interest rate.

Unlike management in a firm protected by law from competition, therefore, management of oligopolistic firms or firms engaged in private (non-legal) cartels are under considerable pressure to maintain stock prices at the highest level and thus to profit maximize on behalf of the corporation.

The cost of corporate takeovers governs the effectiveness of the market constraints described above. If these costs are invariably large, as some have argued, then even larger rewards must be anticipated by those seeking to oust management, and the constraints imposed on the exercise of management discretion may be relatively weak.

Not every item in the costs of takeovers, however, is relevant to the federal chartering issue. Thus, one cause of high takeover costs is federal regulatory law. The antitrust laws, for example, forbid mergers of all but the tiniest of firms, and the securities laws discourage takeover bids and aid management in proxy fights. If we want to reduce the cost of takeovers, the remedy is less, not more, federal law.

A high takeover cost may also reflect an efficient management. The cost of a takeover will, no matter whether by merger, tender offer or proxy fight, be

closely related to the price of the stock. For the most part, the well-run firm which is an industry "leader" will have the highest takeover cost in that industry. So far as shareholder protection is concerned, that kind of high takeover cost is exactly what is called for, because it diverts competitors in the market for management control (not in the investment market) to the well-run firms. It is not enough, therefore, to say that takeover costs are high. What must be shown is that those costs are high in firms which are not well run or which are impaired competitively because of self-dealing.

The conclusion that federal chartering is necessary because takeover costs are too high to impose effective restraints on management is thus not to be quickly drawn. Costs which are attributable either to federal law or to superior management efficiency must be excluded as either not relevant to the issue or as evidence that shareholders are already well protected by these market constraints. There is every reason to believe that costs attributable to federal law and management efficiency account for a significant portion of observable takeover costs.

My argument is not that corporate management does not have discretion. Of course, it does, and that discretion roughly corresponds to the cost of a takeover. Rather, I am arguing that the relevant discretion (excluding that subsized by federal law) is directly related (but not equal) to management's efficiency in profit maximizing on behalf of the firm. Thus, that management which competes the most effectively will also have the most discretion. But shareholders in that firm also benefit because the value of the firm is high, as are stock prices, and the resultant growth will increase the firm's assets. Management discretion and shareholder benefit, therefore, go together.

Corporate critics have trouble with this analysis for a couple of reasons. One is that some, for all their hue and cry about consumers and stockholders, simply don't like success in the market place. Thus, the Nader work on federal chartering treats "superior production techniques [and] managerial talent" which permit "established firms to maintain an absolute cost advantage" as a barrier to entry with which the antitrust laws ought to be concerned. No matter how long one ponders the point, this is an argument which is wholly anticompetitive in that it penalizes the most efficient producer while protecting the least, all at a cost to consumers.

A responsible line of argument is that while management discretion and shareholder benefit move together, it does not necessarily follow that the discretion cannot be liquidated as a benefit to shareholders without impairing the efficiency of firms.

Recent work on the theory of the firm by Professors Armen Alchian and Harold Demsetz strongly suggests that the wholesale elimination of management discretion would in fact be detrimental to shareholders. While the relationship between marginal productivity and distribution of income is spelled out in economic theory, that theory simply assumes that existence of economic organizations that allocate rewards to resources according to their particular productivity. The theory in short explains how various rewards are allocated to various firms according to output. It does not explain how a similar allocative function is performed within the firm.

The issue discussed by Alchian and Demsetz is how economic organizations (firms) meter input productivity and rewards so that rewards and output correspond. The problem is best illustrated by their example of two men who jointly lift heavy boxes into trucks. The marginal productivity of each individual is very difficult to determine, and their joint product is not the sum of separable outputs by the men. Obtaining information on individual marginal productivity and rewarding accordingly is thus at best very costly. The information problem, however, if not somehow resolved, also creates an incentive to shirk, since the share a party to the effort receives may be relatively unrelated to conscientiousness.

Moving from the two men example to the more complex case of a firm, it can be seen that an essential economic function of the firm is to monitor the various inputs in the team effort so as to meter marginal productivities by arranging or examining the way inputs are used and to take steps to reduce shirking. Performance of the monitoring function requires that some group or individual be given the power within the firm to observe the performance of various input factors, to be the central party to all contracts with inputs, to alter their use in the team effort or to discontinue their use. The "monitor" thus must accumulate information on productivity and act on that information while at the same time policing the inputs so as to reduce shirking.

Because the "monitor" is a team member, a mechanism to meter its productivity and to reduce its incentive to shirk must also be created. Such a mechanism is to allocate to the monitor the residual income left after all other inputs have been paid. This creates an incentive in the monitor to bring about the most efficient use of other inputs and to reduce shirking by them, since the reward to the monitor will vary according to its success in performing those tasks.

Within the corporate framework, management performs the monitoring function. Because of the obsession with the corporate legal structure in which the shareholders are "owners" and of the view that the residual income share is associated with ownership, the discretion over corporate assets held by management has led most commentators to conclude that management receives a share to which other parties are entitled and which is unrelated to management performance.

If, however, management performs the monitoring function, the receipt of a residual share created by efficient performance is not merely understandable but quite essential. The accumulation of capital from many diffuse sources renders it impossible for investors to perform the monitoring function, even if they were interested in performing it. That function is best carried out by a centralized authority whose own reward and security in office will be directly related to its productivity in metering inputs and reducing shirking.

There is, therefore, sound reason for believing that the return to shareholders and the apparent discretion of management over its share are closely related and that the wholesale elimination of management's discretion by legal rule would adversely affect shareholders, since management's residual share is correlated to the cost of takeover, a cost which can be kept high by increasing the yield to shareholders.

The corporation is thus a device which performs both the functions of raising substantial amounts of capital and efficiently using a large, complex and diverse input. This performance, it appears, is largely independent of all but a few basic legal rules and surely does not resemble the apparent legal structure of "ownership" in the shareholders and "unaccountable" discretion in the management."

D. The proper role of law

We may now turn to the question of how the costs and benefits of legal intrusion are to be determined and what the proper legal rules ought to be.

A wholly accurate determinant of these costs and benefits is, of course, impossible and, in the center of a spectrum of alternatives, several may arguably be correct. It is clear, however, that an out of hand rejection of a corporation code because it is less restrictive of management than other codes is wrong. Minimal restriction on management's discretion may maximize the yield to shareholders. It may not also, but that simply demonstrates our ignorance of the impact of law rather than the inherent worthiness of restrictions on management.

The Delaware Code is not open to the facial a priori attack Professor. Cary and others have leveled at it. While it has removed many restrictive provisions of older laws, not all limits on management have been removed. Basic protection of most shareholder expectations is written into the Code and a basic fiduciary duty is imposed on management. Moreover, Delaware procedure is geared to facilitating suits by shareholders since the situs of shares of a Delaware corporation is deemed to be Delaware. A sequestration procedure thus permits stockholder plaintiffs to obtain quasi-in-rem jurisdiction over non-resident directors. Delaware also does not require the posting of security for expenses.

Whether the Delaware or any other code is perfect is unlikely. Cases can be wrongly decided and statutes poorly drafted. A good legal system is always in evolution and absolute certainty as to what is the right rule is never attainable. But in the case of corporate chartering there is a process which over time will reasonably guarantee to shareholders and management alike a proper legal system. That process is the very one reviled by proponents of federal chartering: the competition among the states for corporate charters.

A state which rigs its corporation code so as to reduce the yield to shareholders will merely sponsor corporations which are less attractive as investment opportunities than comparable corporations in other states. The added power which such a law allegedly gives management is not the bargain it seems

Just as shareholder yield and management discretion over its share go up together, so too they descend in tandem. Low yields to shareholders mean low stock prices which mean low costs of takeover which, as explained above, reduces the parameters of management discretion. The chartering decision, therefore, will favor those states which offer the optimal yield to both shareholder and management.

Nor is it in either management's or the shareholders' long run interest to see the ability of a corporation to raise capital impaired. As Professor Baumol has noted, even a relatively small need for capital from stock issues can impose discipline on a firm. Moreover, raising capital through equity or debt are closely related since investors and lenders both are making similar judgments about the long run earning potential of the firm, and management's power to drain off assets obviously affects either judgment. In short, the lower the stock price the higher the interest rate. The availability of internal financing does not change this since the cost of using retained earnings as capital is the highest return available in alternative uses. Thus, if an alternative investment would have returned 20%, the cost of using it within the firm is also 20%.

It is not, therefore, in the long run interests of management to seek out a corporate legal system which fails to protect investors, and the competition between the states for charters is a competition as to which legal system will provide an optimal return to both interests. Indeed, only when that competition exists can we perceive which legal system is preferable for once a single system governs the nation, investors no longer have any choice and we cannot compare their reactions. Indeed, one of the ironies of the claims made on behalf of federal chartering is that it is generally federal law which impedes takeovers and thereby disadvantages all shareholders. Further moves in that direction can only be counterproductive.

This does not mean that our corporation law has achieved a final form or that no federal regulation is appropriate. Rather it means that state competition for charters permits an evolutionary process with many safeguards and that further study should be in the cause of facilitating the economic performance of the corporation and the relative economic functions played by management and shareholders rather than the pursuit of narrowing the "separation of ownership and control."

Attention should be directed to distinguishing between the discretionary use of a residual share related to efficient management and self-dealing which impairs the firm. By and large, that should focus on the identification of specific actions by management involving a "one shot" attempt to increase its "take" without regard to the future value of the firm. For the most part, competition among the states for charters should over time facilitate movement in that direction. One exception exists, however. There may be constitutional as well as practical problems in one state regulating a reincorporation in another state and these reincorporations may involve such a "one shot" effort to take advantage of state laws which hamper takeovers, and impair the long run values of the firm. Federal regulation of reincorporations designed to prevent a takeover may thus be appropriate.

II. Federal chartering as a regulatory remedy

Although some regard federal chartering merely as a means of affording shareholders more protection than is available under state law, other see in it a remedy for every ill of society, some perhaps acne. It has been suggested, for example, that federal chartering might be employed as a remedy for antitrust violation, pollution rules, employment discrimination and so on.

To the extent that the corporate charter merely restates the provisions of the various regulatory statutes, they are superfluous. To the extent that revocation or suspension of the charter proposed as a remedy for violation of such provisions, it seems wholly inappropriate. As a remedy, revocation or suspension is so drastic that its use seems very doubtful. Beyond that, it is a remedy which penalizes employees, supplies and customers as much as the firm itself.

Economic regulation, whether to the end of deconcentration, the reduction of pollution or whatever, is in no sense dependent upon the existence of federal chartering. Indeed, the issues should be kept distinct in the interest of clarity and of a full public discussion of each proposal. Lumping them all together, as some proponents of federal chartering do, can only obscure what issues are at stake and keep the public in the dark. This seems particularly so in the case of dubious proposals such as deconcentration or divestiture.

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