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date: 12 November 2019

Corporate Governance and Enterprise Governance

Summary and Keywords

Corporate governance includes legal, contractual, and market mechanisms that structure decision-making within business corporations. Most attention has focused on corporate governance in large U.S. public corporations with dispersed shareholding. The separation of ownership from control in those corporations creates a unique problem, as shareholders typically have weak individual incentive to monitor managers. Mechanisms that have been developed to address this agency problem include independent directors, fiduciary duty, securities law disclosure, executive compensation, various professional gatekeepers, the market for corporate control, and shareholder activism. In most countries outside the United States, there are few companies with dispersed shareholding. Instead, most companies have a controlling shareholder or group. These companies face a different agency problem, the possibility that controlling shareholders may use their power to gain at the expense of minority shareholders.

Enterprise governance refers to mechanisms aimed at related agency problems that occur in closely held companies without publicly traded equity interests. Here too the agency problem typically encountered is the potential conflict between controllers and minority investors, with the added twist that share illiquidity removes an important protection for the minority. Closely held companies have adopted a variety of contractual mechanisms to address these concerns. Other than the important but special cases of venture capital and private equity fund investments, there is less empirical evidence on governance in closely held companies because information is generally much harder to find.

Keywords: corporate governance, enterprise governance, corporate law, directors, officers, shareholders, stakeholders, agency, fiduciary duty, public corporation

Introduction

Corporate governance includes legal, contractual, and market mechanisms that structure decision-making within business corporations. In particular, it includes mechanisms by which potential agency problems of those with decision-making authority are mitigated. This overview surveys both important legal issues and nonlegal ways in which agency problems are controlled. Under the label of “enterprise governance,” this article goes beyond the traditional focus on governance issues in publicly traded U.S. corporations to also consider governance issues in closely held businesses (many of which are not legally organized as corporations, hence the term “enterprise” rather than “corporate governance”).

This article begins with the type of enterprise for which the term “corporate governance” was developed, U.S. public corporations with dispersed shareholder ownership. It analyzes the nature of the agency problem in such corporations, often referred to as the separation of ownership and control. It outlines various ways in which the officers of such corporations can be encouraged to act more fully in the interests of shareholders and briefly explores the debate over whether the interests of stakeholders other than shareholders should be included in defining the interests of public corporations. The article then considers corporate governance for public corporations in other countries. Although many corporations in a few countries have dispersed shareholding similar to that in the United States, most countries have few such corporations. Instead, most public companies have a controlling shareholder or group of shareholders, often a family. The agency problem differs considerably in such companies, and hence corporate governance solutions also differ. Finally, the article considers enterprise governance in closely held companies. The agency problem in such companies is closer to that of public companies outside the United States than to U.S. public companies. In general, in closely held companies there is a stronger emphasis on private ordering governance mechanisms, although several areas of significant legal regulation do exist.

Corporate Governance in Dispersed Shareholder Public Companies

In a business enterprise, employees, managers, and equity investors must work together to bring input from suppliers and creditors to make goods or services that are then sold to customers. Rather than coordinating all actions with spot markets, decisions within a firm are made by designated decision makers within the company—individual managers or employees or designated groups of managers or employees, as the case may be (Coase, 1937). Business enterprises can be organized within a variety of legal forms of business associations. This article focuses at first on the corporation, which is the leading legal form for large businesses that still dominates the economy in terms of employees and revenues.

When a number of persons must act collectively within an organization, problems arise as to how decisions are made and coordinated and how those who make decisions are motivated to work honestly and effectively in the best interests of the organization as a whole. There are many potential solutions to the resulting problems, and which solutions work best depend upon many features of the relevant organizations. The question of how to motivate and monitor designated decision makers to act honestly and effectively is often called the agency problem, and the agency problem of corporations has come to dominate discussions of corporate governance and corporate law (Fama, 1980; Jensen & Meckling, 1976; Ross, 1973).

A particularly crucial kind of corporation has been the locus of most thought and action concerning what is conventionally called corporate governance: U.S. corporations whose shares are traded on a stock exchange and whose ownership base is large and dispersed, with no controlling shareholder or group that effectively controls the company and can determine who is on its board of directors. Such corporations emerged in the United States to become a critical part of the American economy in the late 19th and early 20th centuries. Berle and Means (1932) engaged in the first major description and analysis of such corporations and identified the separation of ownership and control as a critical feature driving the agency problem in such enterprises.

The Separation of Ownership and Control

If one assumes at first that a corporation is supposed to be run in the financial interest of its shareholders (the dominant assumption in the United States, though that is disputed), a clear problem arises in corporations of the type Berle and Means (1932) described. Who will make sure that those running such a corporation (its directors and officers) will actually act in the best interests of shareholders, as opposed to their own best interests? Shareholders face a severe collective action problem (Olson, 1965). None of them own more than a small fraction of the outstanding shares. Monitoring how well the directors and officers of a corporation are doing their jobs is quite costly as is mounting a challenge when it appears they are doing a bad job. Yet if any shareholder chooses to bear those costs, the benefits from their monitoring will mostly accrue to other shareholders because no single shareholder owns a large fraction of the shares. The benefits of improved performance accrue to all shareholders via higher profits and a higher share price. In general, no shareholder will have incentive to actively monitor corporate managers. Knowing this, the managers of a corporation (its directors and officers) may well be tempted to act in their own interests, since they can greatly enrich themselves with a low chance of being caught and punished (Berle & Means, 1932).

Note that a crucial assumption for this argument is that no shareholder owns a large enough percentage of shares to benefit enough from monitoring to make it worth the price. If one shareholder does own a large enough fraction of shares, that assumption may fail, and the nature of the agency problem will change. Even if no single shareholder owns enough shares, if a small enough group of shareholders do, they may be able to act together at a relatively low cost and share the costs of monitoring and responding to bad behavior. This crucial assumption does not hold for more concentrated shareholder patterns, and the governance problem looks quite different. Even in most U.S. public companies, the rise of institutional investors has created the potential for concerted shareholder action, leading to forms of shareholder activism.

A variety of methods to mitigate the agency problems that arise from the separation of ownership and control have arisen over the years. Major mechanisms include monitoring by independent directors, fiduciary duties, disclosure, executive compensation, monitoring by a variety of gatekeepers, the market for corporate control, and shareholder activism. The rest of this section considers these mechanisms.

Monitoring by the Board and Independent Directors

As a matter of law, the board of directors is the core locus of authority within corporations. Within large corporations, boards will typically delegate most decisions to appointed officers, but the board remains responsible for monitoring what is going on within the company. Several influential legal theories of the corporation justify the central legal role of the board in a variety of ways (Bainbridge, 2003; Blair & Stout, 1999). However, a question arises as to whether and why one should expect directors themselves to zealously pursue the best interests of the corporation. After all, directors are agents of the corporation (in the economic sense, although not in the technical legal sense), so quis custodiet ipsos custodies?

Through most of the 20th century, the answer was that in fact most boards of public corporations did very little to effectively monitor the officers they appointed, because most boards were dominated by inside directors (i.e., the officers themselves) along with other professionals such as lawyers who worked closely with the corporation and were dependent on its patronage. However, the last few decades of the 20th century saw the rise of the monitoring board model (American Law Institute, 1994; Eisenberg, 1976). By the 21st century, most directors of public corporations were independent directors with no connections to the company beyond being a director. This occurred both as a matter of evolving norms, stock exchange requirements, and eventually federal securities law rules (Fairfax, 2010; Rodrigues, 2008).

The argument for independent directors is that they must avoid ties that create conflicts in order to avoid temptations and be motivated to zealously monitor what the directors of a corporation are doing. However, it is not clear that removing conflicts alone is enough to motivate directors to perform their duties well. Some other governance mechanisms apply to directors and are intended to help provide stronger incentives. But even if their incentive structure is strong, outside directors face a serious informational problem. Large public corporations are complicated entities, and monitoring how well they are being run is a difficult task. Independent directors are typically high-level officers at other companies, and they do not have much time to devote to their jobs as directors of companies where they do not work. It is thus far from clear whether they know enough to do their jobs well. Moreover, time spent focused on monitoring diverts directors from their more traditional task of providing strategic advice. These considerations have led some to question whether the push for independent directors has been at all effective (Fairfax, 2010; Rodrigues, 2008). Analysis of systematic empirical evidence does not support much positive impact from the presence of independent directors (Bhagat & Black, 2002).

Beyond the independence requirement, development in the early 21st century aimed at improving the effectiveness of directors has focused on proxy access for shareholders. The process of soliciting shareholder votes in corporations with thousands of shareholders is quite expensive and heavily regulated by securities law. The corporation itself, under the control of the board, will circulate a proxy to shareholders with the suggested candidates and positions that the board favors. Proxy access reform seeks to make it easier for shareholders to nominate board candidates using the corporation’s own proxy, so that the costs of solicitation are borne by the corporation. The U.S. Securities and Exchange Commission (SEC) promulgated a regulation that required companies to grant proxy access if the holders of a large enough block of shares requested it, but a court struck down the rule on procedural grounds. The SEC has not repromulgated the rule, but in the 2010s a large number of public corporations enacted their own rules providing proxy access in response to shareholder activist campaigns (Sharfman, 2017).

Fiduciary Duties and Disclosure

As a matter of state law, directors and officers have fiduciary duties to the corporation. The two main duties are those of loyalty and the duty of care. The duty of loyalty prohibits transactions in which directors or officers benefit at the expense of the corporation. The duty of care requires managers to adequately inform themselves before making decisions (Hill & McDonnell, 2012). Shareholders may sue if they believe that directors or officers have violated one of their duties. The business judgment rule protects defendants in duty of care suits and makes liability extremely unlikely (Black, Cheffins, & Klausner, 2006).

Liability is more possible in duty of loyalty cases, but companies that follow recommended procedures will likely avoid it. Where boards adopt antitakeover defenses or sell control of the corporation, Delaware courts have developed special standards of review intended to calibrate the degree of scrutiny that courts apply. Even in the change of control context, however, case law has evolved in a way that limits the legal risks faced by defendant directors (Johnson & Ricca, 2014).

At least as significant as state law duty suits are federal securities law suits. Federal securities law requires mandatory disclosure by companies in many contexts. Such disclosure is intended to provide greater transparency in securities markets so investors can make better-informed decisions in trading and voting their shares. It is hoped that this will improve corporate governance and protect individual investors. Securities law antifraud rules allow shareholders to sue companies and managers that make fraudulent statements under a variety of circumstances. In the late 20th century, the U.S. Congress and courts made a variety of attempts to limit the scope of shareholder litigation out of concern for the existence of abusive suits. However, shareholder litigation under both state and federal law continues to be significant (Thomas & Thompson, 2012).

Executive Compensation

Compensation critically affects the incentives of managers to carry out their duties. In the 1980s and 1990s, compensation in large American corporations began to undergo a significant shift. The percentage of compensation that came from set salaries declined. A larger fraction of compensation began to come from bonuses and particularly from stock-based compensation, especially stock options. Corporate governance advocates played a major role in pushing for this change (Jensen & Murphy, 1990). The argument was that stock-based compensation better aligned with the incentives of managers and shareholders.

However, some critics argue that the shift has a dark underside. The total amount of compensation that directors and officers receive has soared, which may help explain why boards have been happy to follow the new practices. Some argue that new compensation practices are frequently not well-designed to align the incentives of managers and shareholders, and are easily gamed to provide high compensation at relatively low risk (Fried & Bebchuk, 2004). There have been some reforms in response to these critiques. The topic is highly debated, with much empirical dispute over whether compensation is generally well-designed (Murphy, 2002) or highly flawed (Bebchuk & Fried, 2010).

Gatekeepers

Gatekeepers are professionals who collect information about corporations and whose actions may help certify to investors that a company is effectively run. Gatekeepers include auditors and accountants, investment banks, lawyers, credit rating agencies, and research analysts (Coffee, 2006). As with directors, major questions for gatekeepers concern their incentives to honestly disseminate or certify information and whether they can and will access the internal information they need to do their jobs well. The market value of reputation gives many gatekeepers strong incentive to honestly carry out their role. However, agency problems within gatekeeping organizations may create temptations to cheat.

The main legal responses to the last two major financial crises in the United States featured a number of rules focused on several types of gatekeepers. The Sarbanes-Oxley Act of 2002 was the legal response to the dot-com stock crash of 2000. It created a new agency to regulate auditors, the Public Company Accounting Oversight Board. Sarbanes-Oxley also strengthened rules requiring securities lawyers to report securities law violations up the ladder within their clients’ organizational structure (Painter, 2012). Following Sarbanes-Oxley, the SEC promulgated Regulation AC, which governs disclosure by research analysts.

The main statutory response to the financial crisis of 2008 was the Dodd-Frank Act of 2010. A significant set of reforms under Dodd-Frank concerned credit rating agencies, a type of gatekeeper that played a major role in the market for asset-backed securities. The reforms addressed disclosure, internal governance, and compensation of the rating agencies. It remains quite unclear how well the reforms are working (Darbellay & Partnoy, 2012; Hill, 2012).

The Market for Corporate Control

Another potentially important corporate governance mechanism is an active market for corporate control. In particular, the threat of hostile takeovers can discipline directors and officers. If a company is perceived as being poorly run, its share price will tend to decline. This creates an opportunity for an outside investor to bid a price above the current market price to acquire enough shares to control the company and replace the existing underperforming directors and officers. Merely the threat of such a takeover can give a strong incentive to do a good job, and actual takeovers may remove poor managers (Manne, 1965).

By the 1980s, an active market for hostile takeovers had developed in the United States. The directors and officers of companies vulnerable to such takeovers replied by devising a variety of market and legal strategies that made it expensive to engage in a hostile takeover. A number of legal battles ensued over whether those strategies violated the fiduciary duties of the boards that enacted them. The Delaware courts developed special rules for such cases (see the section “Fiduciary Duties and Disclosure”). Much debate remains over both the net social benefits of active takeover markets and the effectiveness of the law’s response to takeovers (Romano, 1987, 1992). The bottom line appears to be that in the United States, the law has been lenient enough to boards defending their companies against takeovers that purely hostile takeovers have become rare, although persistent bidders can put enough pressure on companies to be successful if they make some concessions to the demands of the defendant board. The threat of a hostile bid thus may retain some disciplinary force in the United States, but probably not much. Much debate remains over the effect of takeover defenses and the optimal legal responses to them (Barry, 2016). Hostile takeovers are a more important governance mechanism in the United Kingdom (see the section “Corporate Governance in Public Companies Outside the United States”).

Shareholder Activism

A growing percentage of shares of American public corporations is owned by institutional investors rather than individuals. Major types of institutional investors include mutual funds, hedge funds, pension funds, and insurance companies. The amount of shares owned by the largest of these companies has reached a point where a small number of investors can own a large enough fraction of the shares of most public companies to cause a shift in the cost-benefit calculus of investor activism. If a small enough number of investors own a large enough fraction of shares, those investors may find it economically attractive to engage in sustained monitoring of companies and to take action when they believe a company is not being well-managed.

Formal shareholder activist campaigns take two basic forms. The first is to attempt to elect shareholder nominees to the boards of target companies. If successful, those nominees can gather more information and attempt to persuade their fellow directors to follow the suggestions of the activists. The mere threat of a successful campaign may cause incumbent directors to try to deal with the activists, as directors typically want to avoid the costs and embarrassment of a losing board campaign. For a brief period a rule promulgated by the SEC allowed investors who held enough shares to nominate candidates for the board using the corporate proxy (see the section “Monitoring by the Board and Independent Directors”). That rule was struck down, but activist campaigns have pushed many public corporations to adopt their own rules allowing proxy access.

The second form that formal activist campaigns can take is that of shareholder proposals under SEC Rule 14a-8, which allows shareholders to use the corporate proxy form to make proposals on which shareholders can vote so the company bears the cost of distributing the proxy. Most such shareholder proposals are only advisory even if passed, although if they take the form of shareholder bylaws they are binding on the corporation (McDonnell, 2005). In most circumstances a board will choose to follow an advisory proposal that passes. Shareholders propose hundreds of proposals a year, and the rate of votes in favor of these proposals had become much higher by the 2010s than it had been decades earlier.

Two main types of activist investors engage in shareholder activism. Both are controversial, though in different ways. One type is union and public employee pension funds. Critics charge that these funds pursue proposals that benefit employees and public officials but not shareholders. Defenders respond that they pursue proposals that help shareholders generally, and that they are solving a collective action problem for shareholders while other types of funds remain more passive in part because they must appeal to corporate managers who decide which funds will be part of their corporate employment retirement portfolio (Schwab & Thomas, 1998).

The other common type of activist investor involves hedge funds that focus on identifying target companies, organizing to change their corporate strategies in ways that improve perceived underperformance and then selling their shares when the changed strategies lead to higher stock prices. Evidence suggests that such hedge funds are able to achieve above-market rates of return with this activist strategy. Much empirical debate surrounds whether this type of activism actually improves corporate governance. Some argue that the positive shareholder returns reflect real improvements in governance (Bebchuk, Brav, & Jiang, 2015). Others argue that they represent short-term gains that often come at the expense of either longer-term profitability or the interests of other corporate stakeholders (Coffee & Palia, 2016).

A third, newly important type of shareholder is a small group of mutual funds that have become the leading asset managers in the world. BlackRock, Vanguard, and State Street each own near or somewhat more than 5% of the shares of many if not most U.S. public corporations. They do not organize activist shareholder campaigns themselves, but their votes play a major role in the success or failure of such campaigns. Thus, their incentives and behavior in voting their shares is a major and growing topic of significant importance in the corporate governance of public corporations (Bebchuk, Cohen, & Hirst, 2017).

Shareholders Versus Stakeholders

This analysis has considered various ways in which companies and the law try to ensure that corporate managers vigorously pursue the best interests of the corporation. But how does one define the best interests of the corporation? Many different groups have stakes in the performance of a corporation. Shareholders, employees, creditors, customers, suppliers, the local community, the environment and those who rely upon it, all stand to be helped or hurt by the decisions that corporate managers make. Which of these groups should managers be considering and trying to help?

This is a controversial and surprisingly unsettled question in American corporate law (surprising given its apparent centrality). The prevailing opinion is that corporations should be run in the financial interest of their shareholders and managers should aim to maximize profits and share value. That objective is not clearly stated in corporate law statutes and has only been clearly set forth in a few significant cases.1 However, the shareholder primacy objective is set out in a variety of articles by the Chief Justice of the Delaware Supreme Court (Strine, 2015) and a variety of legal academics (Bainbridge, 2003; Easterbrook & Fischel, 1991; Macey, 1991). This scholarship seems to reflect the understanding of most corporate officers.

However, a variety of other academics dispute the shareholder primacy view, and argue that managers should take into account the interests of all of the stakeholder groups listed previously (Blair & Stout, 1999; Johnson & Ricca, 2014; Stout, 2012). A number of states have adopted corporate constituency statutes that explicitly allow managers to take into account the interests of various stakeholder groups, though it does not require them to do so. Delaware, the leading state of incorporation for public corporations, has no constituency statute and has several cases supporting a shareholder primacy norm.

In many circumstances, it may make little or no practical difference whether the shareholder or stakeholder conception of corporate purpose prevails (Smith, 1998a). Even if one adheres to the stakeholder conception, considering the interests of the other stakeholders will often increase long-run profitability. For instance, if a company makes a decision that reduces the durability of its product, that may increase profits in the short run but will reduce profits in the long run by besmirching the company’s reputation. Moreover, in decisions where managers do not have a conflicting interest, the business judgment rule will ensure that courts are quite likely to defer to their stated business reasons, so a decision that seems to help a stakeholder group at shareholder expense can be legally defended by an argument referencing reputation and long-run profits. Nonetheless, in some circumstances the choice between a shareholder and a stakeholder conception may really matter. This is most obvious where the board is selling the corporation to outside bidders. The highest bidder may be best for shareholders, but may not be best for other groups. Beyond such stark choices, acceptance of a strong shareholder primacy norm may affect how managers understand their jobs, even in cases where the rule has little legal bite.

In response to the perceived domination of the shareholder primacy norms in U.S. corporate law, several new legal forms have recently been developed aimed at social enterprises. These businesses conceive of their purpose as both generating profits for their investors and achieving one or more social purposes. The leading new legal form is the benefit corporation. These corporations are governed by standard business corporation law with three important exceptions. First, their purpose must include both creating profit for shareholders and creating other public benefits. Second, their directors and officers have a duty to consider the effect of their decisions on a variety of stakeholder groups. Third, benefit corporations must regularly report what they have done to achieve their public benefits. Thus, in benefit corporations the stakeholder conception of the corporation clearly governs (Alexander, 2018; Reiser & Dean, 2017).

Corporate Governance in Public Companies Outside the United States

So far, the description and analysis in this article has focused on corporate governance in publicly traded corporations in the United States. Although there are many shared legal, normative, and organizational features in publicly traded corporations in other countries, there are also some significant differences. For one, in most other countries a stakeholder rather than a shareholder conception of the corporation tends to prevail. That is, directors and officers perceive a duty to attend to the interests of a variety of stakeholders, not merely shareholders, and the law appears to support that perception (Hopt, 2011; Salacuse, 2003).

Another crucial difference is that the pattern of dispersed share ownership with no controlling shareholder or group is less common in countries other than the United States. In companies with a controlling shareholder, the core agency conflict looks considerably different. On the one hand, the defining agency problem experienced by American corporations is typically much less severe. There is no separation of ownership and control. The controlling shareholders have both the incentive and the means to monitor and discipline the directors and officers of the corporations they control (Salacuse, 2003).

On the other hand, there is a potential conflict between the controlling shareholder and minority shareholders. A controlling shareholder can use its power to get the board and officers to make decisions that benefit it at the expense of minority shareholders. This is the key conflict that the corporate law of most countries must confront. Some of the governance devices considered for public companies with dispersed shareholders (e.g., independent directors and fiduciary duties) may still have value in this different context, but their use will be rather different. However, other devices will not do much good. There is no chance of a hostile takeover in a company with a controlling shareholder. Shareholder activism can also do little good. There is significant variation in corporate law and governance in countries other than the United States. This section considers practices in the United Kingdom, Japan, Germany, and emerging economies.

The United Kingdom

The United Kingdom is one of the few other jurisdictions that also has a relatively large number of corporations with a dispersed shareholder base and no controlling shareholder, although the United Kingdom experienced the move to a market with a large fraction of shares owned by institutional investors earlier than the United States. It thus resembles the United States more closely than most other countries. The shared common law tradition is another similarity. Indeed, some have argued that the common law tradition helps explain the growth of deeper and more developed financial markets (La Porta, Lopez-de-Silanes, & Shleifer, 2008), although that theory has been disputed (Armour, Deakin, Mollica, & Siems, 2009).

One major area in which British and American corporate law differ is in the treatment of hostile takeovers. Delaware courts in the United States have tried to take a balanced approach, but in effect they have allowed defendant boards to block unwanted takeovers. British law has taken a different approach, requiring boards to remain neutral and not take defensive measures when confronted by a hostile takeover. The market for corporate control thus remains more active in the United Kingdom and is an important corporate governance mechanism (Armour & Skeel, 2007).

Japan

Japan also has a number of corporations with dispersed shareholder bases. Corporate governance for most of the post-World War II era was shaped by a pattern of extensive cross-holding of shares in groups called keiretsu (Aoki, 1987), although some have disputed the importance of keiretsu to corporate governance (Miwa & Ramseyer, 2006). In a keiretsu, each company held shares in the other member companies and the group was centered around a major bank that owned shares in, lent to, and otherwise heavily transacted with the companies of that keiretsu. The banks played a central role in the governance of companies with their groups, monitoring management and stepping in where companies were struggling (Aoki, 1987). The importance of banks in Japanese corporate governance has also been disputed (Miwa & Ramseyer, 2007). More recently there has been a move to break up the cross-shareholding groups, thereby weakening the control of the banks (Milhaupt, 2002). In place of the banks’ role in corporate governance, the government has tried to encourage American-style corporate governance (Gilson & Milhaupt, 2005).

Germany

German companies tend to have more concentrated share ownership and control than U.S. companies. Family ownership is widespread, and pyramid ownership structures are used to concentrate control. Banks are also widely thought to have played a central role in Germany corporate governance, not only through widespread ownership of shares but also through voting of share proxies, holding board seats, and lending (Fohlin, 2005).

Two other distinctive features of German corporate governance are dual boards and codetermination. In most countries, corporations have a single board of directors that has formal authority over most decisions, although boards will typically delegate authority to officers who are monitored by the board. German corporations, in contrast, have two boards. Shareholders elect the members of the supervisory board, which monitors management but has little direct control over decisions. The supervisory board in turn chooses the members of the management board, which has most operational authority (Prigge, 1998). Moreover, in large corporations German law requires that a fraction (in some cases one-third, in others one-half) of the supervisory board must represent the employees of the corporation. Thus, Germany represents perhaps the most notable formal rejection of the American shareholder primacy conception of the corporation. There is much debate as to the relative benefits and costs of codetermination in Germany and other countries (Baum & Ulmer, 2004; Hopt, 1994; Pistor, 1999; Prigge, 1998).

Emerging Economies, Including China

Emerging economies, especially China and India, are playing a growing role in the world economy, as are corporations from those countries. The corporate laws in emerging economies typically resemble those in developed countries. However, in many countries judicial and administrative enforcement of corporate and securities law rules is spotty. In emerging economies even the largest corporations have a controlling shareholder, and the tendency is for those controlling shareholders to exploit their positions as a result of both weak legal enforcement and weak market mechanisms (Dyck & Zingales, 2004).

China is the second largest economy in the world, and so its companies are of quite particular interest. China’s economy is a unique mix of markets and state ownership and control. Many of China’s largest corporations are state-owned enterprises (SOEs), with the state as the controlling shareholder, but many have private investors as well. Corporate governance problems are particularly acute in SOEs. Exploitation of minority shareholders is a problem as with any corporation with a controlling shareholder, but management exploitation of shareholders generally, as seen in companies with a dispersed shareholder base, may also be a serious concern where government officials do not perform an effective monitoring role over the state’s interest in an enterprise. In privately owned enterprises, state influence over governance is often strong, given the weak rule of law and the resulting importance of patronage by state officials (Yang, Chi, & Young, 2011).

Diversity and Convergence

Beyond studying individual countries, and sometimes comparing corporate governance in a few countries, some scholarship has tried to make more general comparisons in corporate governance across a wide range of countries. A series of articles by four economists sometimes known by their initials as “LLSV” has been particularly influential in that endeavor (La Porta, Lopez-de-Silanes, Shleifer, & Vishny, 1997, 1998; La Porta et al., 2008). In this law and finance literature (referring to the title of one of the original papers, La Porta et al., 1998), the authors set out to create empirical measures of a variety of important legal and institutional factors, including the strength of shareholder protections, creditors protections, and the rule of law. They then explored potential causal links between these measures and the breadth and strength of financial markets. One pattern they asserted was systematic differences between countries with a common law tradition and different families of countries with a civil law tradition. The empirical measures have been subject to criticism (Armour et al., 2009) and there are questions about the direction of causation, but this remains an area of scholarly exploration.

The extent to which different countries’ corporate governance systems differ and the ways in which they differ has been an ongoing source of discussion. Some have argued that at least at a functional level the differences are not all that large (Kraakman et al., 2009). Even if countries have differed historically, those differences may be lessening over time. Corporate law and governance scholars have long debated whether the governance systems of different countries are tending to converge toward each other, whether such convergence would be a good thing, and to which system it would be best to converge. At one point Japan was seen as a promising model, but after the Japanese economy faltered the United States become more popular. The financial crisis of 2008 has rather diminished the luster of the latter. Some see strong signs of legal and functional convergence (Hansmann & Kraakman, 2001; Kraakman et al., 2009). Others are skeptical (Clarke, 2010).

Enterprise Governance in Closely Held Companies

Most scholarly and regulatory attention in corporate governance has focused on large public corporations. That focus is reasonable because such corporations are highly visible and important and a large fraction of the private economy in terms of employment and the value of goods and services produced flows through them. However, closely held companies with few shareholders and whose shares are not widely traded on public exchanges constitute by far the greatest number of companies. Their share of economic output may grow as fewer companies go public, and most net new employment is generated by smaller, closely held businesses.

It therefore makes sense to consider enterprise governance in closely held companies. This article refers to “enterprise governance” as opposed to “corporate governance” because most closely held companies are not legally organized as corporations, at least not in the United States in the 21st century. Instead, they are some form of partnership (typically limited partnerships or limited liability partnerships) or, above all, limited liability companies (LLCs). LLCs are a relatively new innovation in U.S. law, but the advantages they offer in terms of pass-through taxation, limited liability, and great flexibility have made them the legal form of choice for most new businesses (Ribstein, 2010).

The enterprise governance challenges in closely held companies more closely resemble the governance challenges in public corporations with a controlling shareholder than in public corporations with dispersed shareholding. The central conflict is between the controlling shareholder(s) and minority shareholders, rather than between shareholders as a whole and managers. An additional wrinkle in the context of closely held companies is the illiquidity of their shares. Where a public market for a company’s shares exists, exit by selling to a third party is a significant, though far from foolproof, protection for unhappy minority shareholders. Without such a public market, exit by sale to a third party will generally be a less effective protection (Easterbrook & Fischel, 1985; Nagar, Petroni, & Wolfenzon, 2011). The governance challenge is thus enhanced.

Contractual Governance Mechanisms

In deciding to buy shares in a company, persons who will be minority investors can choose to negotiate a variety of contractual provisions that may provide some protection against exploitative behavior by the controlling shareholder. A central feature of LLC and partnership law in the United States, even more so than for corporate law, is the flexibility that statutes grant to private parties to negotiate their preferred organizational and contractual arrangements. Most statutory rules are default, so that contractual provisions to the contrary will supersede statutory provisions (Ribstein, 2010).

One set of provisions that minority investors may negotiate gives them voting rights. One type of voting right concerns the election of directors, or more generally election of the governing body of the company if the company has such a body (Gomtsian, 2015; Norton, 1985; Stevenson, 2001). In general, one would expect minority investors to be able to elect only a minority of the board. If the board follows a majority vote rule and the controlling shareholder is able to appoint a majority of the board, the minority representatives will not have the votes to block board action. However, supermajority requirements for some or all board actions can give the minority veto power, and even if they lack such power, having a representative on the board can give the minority valuable information and the ability to influence decision-making.

Alternatively, minority investors can bargain for direct voting rights over major decisions (Gomtsian, 2015; Norton, 1985; Stevenson, 2001). Here too, supermajority rules can give them the power to block actions of which they disapprove. There is a tradeoff, however. High supermajority requirements provide greater protection against exploitation by the majority, but they may also make it hard to reach agreement on enterprise action, particularly as the number of investors increases.

Another type of protection concerns exit rights. Traditionally in partnership law, partners have a right to exit a partnership at will and receive the value of their interest upon exit. However, corporate law and LLC law in some jurisdictions does not grant this exit right. Investors may bargain for exit rights (Gomtsian, 2015; Stevenson, 2001). These exit rights may grant a put option to sell shares to the company at the investor’s discretion or only when specified conditions occur. For instance, drag-along rights allow investors to sell their shares when other investors are doing so (Gomtsian, 2015; Stevenson, 2001).

Another type of contractual governance mechanism concerns the distribution of profits. One such provision sets a minimum level of required distributions, limiting the ability of controllers to try to squeeze out minority investors by denying them a return on their investment. Another such provision grants controllers higher profit distributions when specified performance levels are achieved (Gomtsian, 2015).

Other types of private ordering but noncontractual protections of minority investors are also available, and common. Most basically, potential investors can research companies in which they are considering investing and try to weed out targets that present a high risk of appropriation (Yung, 2012). The role of reputation is related to this. If a company mistreats its minority investors badly, it risks scaring off future investors. Another strategy is staged investments: an investor can make an initial investment of modest size and wait to decide about making future investments. For a company that will need ongoing investments and is relying upon future contributions from existing investors, this may provide a strong reason not to mistreat those investors (Li, 2012).

Legal Governance Mechanisms

Although a wide degree of contractual freedom is a leading feature of the law of unincorporated business associations, both LLC law and the law of closely held corporations provide some legal protections for minority investors. The most important types of protection are applications of the law of fiduciary duty to the particular problems of closely held companies.

One type of situation occurs when the majority is behaving in a way that oppresses minority shareholders. Many states have provided heightened protection for minority investors in corporations and in LLCs through either judicial decisions or statute. This protection may include a heightened fiduciary duty, either judicial dissolution or buyout at fair value as a remedy, or the ability to sue directly rather than derivatively (Thompson, 2011). Depending on the state and the type of entity, investors may or may not be able to contractually opt out of these protections.

Courts, most significantly those in Delaware, have developed a detailed set of duty protections is minority squeezeouts. In these situations, a controller uses its power to buy out the shares of minority investors, often at an unduly low price. When squeezeouts occur through mergers, statutes typically impose appraisal rights, which are intended to provide fair compensation to minority investors. However, there are difficult procedural and valuation issues in appraisal. In addition to appraisal rights, Delaware courts have used fiduciary duty principles to impose a strict fairness standard on the procedures followed and price received in minority squeezeouts (Restrepo & Subramanian, 2016).

Another significant statutory protection is the ability of individual investors to withdraw at will and receive the value of their interest, without a judicial order or showing of wrongdoing. A core difference between traditional partnership and corporate law is that partners have the right to withdraw but shareholders do not. There is a tradeoff here—the right to withdraw helps protect investors against exploitation by a controller, but it makes the business vulnerable to a loss of capital at any time an investor chooses to withdraw. LLC law varies from state to state and has evolved over time, with statutes sometimes resembling partnership law, sometimes resembling corporate law, and often taking an intermediate position by granting some ability to withdraw under more limited position or with consequences other than dissolution or the payment of the fair value of the interest of the withdrawing member.

Venture Capital and Private Equity

In general, there is not a lot of detailed evidence available as to the contractual provisions adopted in closely held companies, with some exceptions (e.g., Gomtsian, 2015). A key reason is that information is much harder to obtain than for public companies, which are subject to securities law disclosure requirements. Two significant exceptions, though, are venture capital and private equity funds. Although information for investments by these kinds of funds is not readily publicly available, they are both widespread and economically important enough that a fair amount of empirical research on contract terms exists (Cumming, 2012a, 2012b).

Venture capital funds specialize in investing in high-tech start-up companies. These are companies that require large early investments before they have an established revenue flow. Their long-term prospects are often highly uncertain—they may quickly flame out, or they may become the next Amazon. The high investment combined with the uncertainty and lack of a track record creates particularly sharp agency and hence contractual problems. All of the contractual mechanisms described previously are common in the agreements that venture capital funds enter into with their portfolio companies (Kaplan & Stromberg, 2003). Venture capitalists hold board seats on the companies in which they invest (Bengtsson, 2012). They have negative covenants that allow them to block specified types of risky actions. Common covenants cover new issuances of debt or equity, asset sales or acquisitions, changes to the business plan, CEO hiring, and compensation (Bengtsson, 2012). Exit rights are also common. They include dragalong rights, tagalong rights, registration rights, and piggyback rights (Bengtsson, 2012). Particularly in later stage start-ups, venture capitalists are typically able to force exit through sales of control or initial public offerings (Smith, 2005).

Although there is much standardization in these various contractual terms, there is also considerable variation in exactly which terms are used. This variation is predictably associated with variations in the nature of the funds and the portfolio companies (Bengtsson, 2012). Venture capital investments typically take the form of preferred stock. The control over portfolio companies typically achieved by venture capitalist combined with the somewhat debt-like financial features of preferred stock may create a conflict between the interests of the preferred and the common shareholders, causing venture capitalists to sometimes behave opportunistically (e.g., by choosing an early exit strategy; Fried & Ganor, 2006). Venture capital reputation helps protect against the risk of this and other forms of opportunism (Smith, 1998b).

The experience of venture capital funds seems to support the general emphasis on contractual freedom in closely held companies. Funds seem to do a good job at actively protecting themselves, using a wide panoply of governance mechanisms, although that self-protection may in turn threaten the common shareholders (Fried & Ganor, 2006). However, one should take care in generalizing from this sector. Venture capital funds are highly sophisticated repeat players with a lot of money at stake. Investors in other kinds of closely held enterprises may not protect themselves as effectively, so the arguments for and against more intrusive legal protections may not generalize from their experience (but then again, they may).

Private equity funds invest in older, more established companies than venture capital funds do. Though the strategies of private equity funds vary widely, many invest in distressed companies with the goal of turning them around and ultimately reselling or having the company go public. Typically, funds finance the acquisition of a portfolio company with a high ratio of debt to equity. Sometimes a fund will be the sole shareholder of the target company at the end of such a transaction, whereas other times it will be a controlling shareholder. A standard argument is that private equity funds can reduce agency costs in portfolio companies, particularly those that were previously publicly traded, because the fund can monitor and discipline management (Kaplan & Stromberg, 2009). Of course, where the fund is not sole shareholder, this substitutes the controlling versus minority shareholder conflict of interest.

Where a fund becomes the sole shareholder, both of the major agency conflicts would seem to disappear, but even here there are concerns from a stakeholder perspective. There is concern that private equity funds create shareholder value by appropriating from other stakeholders, in particular existing creditors or employees. Much empirical debate exists over the central tendencies and variations in the effects on those stakeholders (Tag, 2012).

Open Questions and Topics for Further Research

Ongoing empirical and normative debate continues about all of the topics covered in this article. Some topics have been researched and written about for longer, with a larger literature and better-developed empirical evidence. In general, the later a topic appears in this article, the less well-developed the literature is on that topic.

U.S. public corporations are the most heavily studied subject and object of corporate governance. That does not mean that these heavily studied questions have all been definitively answered. Far from it. The effectiveness of independent directors, fiduciary duty suits, disclosure, executive compensation, various gatekeepers, and hostile takeovers as mechanisms for reducing agency costs are still heavily debated. There is much disagreement about their effects and whether the law should do more or less to actively encourage each of them. Thus, there is still room for more empirical evidence on each of these topics. However, given how much has already been written, even very well done new studies are not likely to move the needle very far.

A partial exception is the topic of shareholder activism. This is a relatively new phenomenon in the United States, particularly activism as a profit-making strategy pursued by a set of activist hedge funds. Significant research has been done, but more is left to do. Moreover, the strategies of activist funds continue to evolve, leading to the need to study the effects of new strategies. For instance, though shareholder proxy access has been a hot topic since at least the beginning of the 21st century, it was only in the mid-2010s that a large number of companies started to adopt proxy access procedures. These new procedures have not yet been widely used. If and when that changes, new research will be required to understand the effect of a new generation of proxy battles enabled by the new procedures.

Another relative gap in research on U.S. public corporations concerns the effect of difference governance mechanisms on stakeholders other than shareholders. Most empirical studies of corporate governance use measures of share value to judge the effect of governance rules and practices. That is in keeping with the prevailing shareholder primacy concept of the corporation. However, given growing interest in social responsibility and social enterprise, many observers of and participants in corporate governance are interested in the effect of rules and practices on groups other than shareholders. Some work has been done along these lines, but there is plenty of room for more.

There has been less research done on public corporations in countries other than the United States. Less research certainly does not mean no research, and plenty has been written on corporations in leading European countries such as the United Kingdom and Germany and in Japan. Corporations in emerging economies have received less attention. Those economies have been less important to the world economy and there is generally less information available. However, as emerging economies and their companies become more important, one would expect more attention to be focused on them. Indeed, this is happening already to some extent. Chinese companies in particular have received a significant amount of attention (Clarke, 2003; Yang, Chi, & Young, 2011) and significant work is being done on other countries (Claessens & Yurtoglu, 2013).

Finally, less empirical research has been done on closely held companies than on companies with publicly traded shares. There is much less public information easily available, making empirical research much more costly and time-consuming. Still, closely held companies are an important part of the economy, and as initial public offerings become more scarce, companies without publicly traded shares would appear to be becoming more important. The types of closely held companies that have received significant empirical scrutiny are portfolio companies of venture capital and private equity funds. These are interesting and important, and they have some lessons that generalize to other closely held companies. However, they are also quite different from other kinds of closely held companies in many ways, including the types of investors likely to be involved. The key policy debate in corporate law is about how much protection for investors should be built into the law. Some scholars insist that private ordering will provide adequate protection at lower cost. Others claim that many small investors will not be able to protect themselves well enough in many circumstances. The ways that venture capitalists protect their interests when investing in portfolio companies is certainly interesting and instructive for this debate, but may not be representative of what happens in other kinds of companies. More empirical study of those other kinds of companies would be quite useful in advancing the debate.

Further Reading

Bainbridge, S. M. (2003). Director primacy: The means and ends of corporate governance. Northwestern University Law Review, 97, 547–606.Find this resource:

Bebchuk, L.A., Brav, A., & Jiang, W. (2015). The long-term effects of hedge fund activism. Columbia Law Review, 115, 1085–1155.Find this resource:

Berle, A. A., Jr., & Means, G. C. (1932). The modern corporation and private property. New York: Routledge.Find this resource:

Blair, M. M., & Stout, L. A. (1999). A team production theory of corporate law. Virginia Law Review, 85, 247–328.Find this resource:

Coase, R. H. (1937). The nature of the firm. Economica, 4, 386–405.Find this resource:

Coffee, J. C., Jr., & Palia, D. (2016). The wolf at the door: The impact of hedge fund activism on corporate governance. Journal of Corporation Law, 41, 545–606.Find this resource:

Cumming, D. (2012). The Oxford handbook of private equity. Oxford.: Oxford University Press.Find this resource:

Cumming, D. (2012). The Oxford handbook of venture capital. Oxford: Oxford University Press.Find this resource:

Dyck, A., & Zingales, L. (2004). Private benefits of control: An international comparison. Journal of Finance, 59, 537–600.Find this resource:

Easterbrook, F., & Fischel, D. (1991). The economic structure of corporate law. Cambridge, MA: Harvard University Press.Find this resource:

Fama, E. F. (1980). Agency problems and the theory of the firm. Journal of Political Economy, 88, 288–307.Find this resource:

Fried, J., & Bebchuk, L. (2004). Pay without performance: The unfulfilled promise of executive compensation. Cambridge, MA: Harvard University Press.Find this resource:

Jensen, M. C., & Meckling, M. H. (1976). Theory of the firm: managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3, 305–359.Find this resource:

Kraakman, R., Armour, J., Davies, P., Enriques, L., Hansmann, H. B., Hertig, G., . . . Rock, E. B. (2009). The anatomy of corporate law: A Comparative and functional approach (2nd ed.). Oxford: Oxford University Press.Find this resource:

La Porta, R., Lopez-de-Silanes, F., & Shleifer, A. (2008). The economic consequences of legal origins. Journal of Economic Literature, 46, 285–332.Find this resource:

Murphy, K. J. (2002). Explaining executive compensation: Managerial power versus the perceived cost of stock options. University of Chicago Law Review, 69, 847–869.Find this resource:

Ribstein, L. R. (2010). The rise of the uncorporation. Oxford: Oxford University Press.Find this resource:

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Notes:

(1.) Dodge v. Ford Motor Co., 204 Mich. 459 (Mich. 1919); Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. 506 A.2d 173 (Del. 1986); eBay Domestic Holdings, Inc. v. Newmark, 16 A.3d 1 (Del. Ch. 2010).