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Our latest podcast deep-dives into the recent empirical results in relation to stock ownership dispersion and corporate governance worldwide.

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The original blog article is available on our AYA fintech network platform. https://ayafintech.network/blog/corporate-ownership-governance-theory-and-practice/

This fun podcast is about 10 minutes long (with smart AI podcast generation from Google NotebookLM). https://bit.ly/4gpMkIK

The genesis of modern corporate governance and ownership studies traces back to the seminal work of Berle and Means (1932). The Berle-Means theory serves as the canonical qualitative foundation for the separation of corporate ownership and control. According to this thesis, corporate control over physical assets reacts to a centripetal force and tends to concentrate in the hands of only a few incumbents, whereas, corporate ownership is centrifugal, splits into small units, and passes from person to person. In the Berle-Means image of the modern corporation, executives and directors gain their income primarily from the effort that these incumbents put into business decisions, but not from the return on their stock investment in the enterprise. To the extent that corporate structures evolve in response to competitive pressures in the capital markets, the Berle-Means thesis predicts gradual convergence toward diffuse incumbent stock ownership as the most efficient form.

The Berle-Means theory has influenced the subsequent development of agency theory that highlights a potential conflict of interest between corporate incumbents and shareholders (Jensen and Meckling, 1986; Fama and Jensen, 1983). Subsequent studies question the empirical prevalence of the Berle-Means image of the modern corporation (e.g. Demsetz (1983), Demsetz and Lehn (1985), Shleifer and Vishny (1986), Morck, Shleifer, and Vishny (1988), and Holderness and Sheehan (1988)). The recent strand of law-and-finance literature suggests that the Berle-Means widely held corporation should prevail primarily in rich common-law countries with sound legal protection of minority shareholder rights (La Porta, Lopez-de-Silanes, Shleifer, and Vishny, 1997, 1998). Whether Berle-Means functional convergence toward greater stock ownership dispersion takes place in practice remains an empirical puzzle.

La Porta, Lopez-de-Silanes, and Shleifer (1999) offer an empirical refutation of the Berle-Means thesis. La Porta et al analyze data on ownership structures of large corporations in 27 rich economies to identify the ultimate controlling shareholders of these firms via pyramidal chains and cross-ownership structures. The main evidence suggests that except in economies with robust legal protection of investor rights, few of these firms are widely held with diffuse stock ownership in the Berle-Means sense. Alternatively, these firms are typically family firms or state enterprises. Equity control by financial institutions prevails only in some bank-centric financial systems such as Japan and Germany. The controlling shareholders tend to have power over firms in excess of their cash flow rights primarily through direct managerial influence and the use of pyramidal chains and cross-ownership structures. As a result, the main implication of this empirical work is that the theory of corporate finance for most countries should focus on the incentives of controlling shareholders to both benefit and expropriate minority shareholders.

Claessens, Djankov, and Lang (2000) examine the separation of ownership and control for 2,980 corpora-tions in East Asian countries. In all these countries, voting rights frequently exceed cash-flow rights via pyramidal chains and cross-ownership structures. This separation of ownership and control is most pro-nounced among family firms and small firms. A single shareholder retains the ultimate corporate control in more than 66% of these East Asian corporations. Nevertheless, the concentration of corporate control generally dwindles with the level of a country’s economic development.

Political connections matter a great deal to Chinese CEOs in several major corporate decisions, whereas, these connections have a negative effect on corporate performance in terms of post-IPO earnings growth, sales growth, or profit margin (Fan, Wong, and Zhang, 2007). In East Asia, some large corporations often find it necessary to bribe senior bureaucrats to derive state protection in the form of exclusive trade rights, commercial privileges, and preferential state-enterprise contracts (Claessens, Djankov, and Lang, 2000). From a corporate governance standpoint, the concentration of voting rights is crucial as this concentration allows owners to determine capital investment, M&A, R&D innovation, dividend or repurchase payout, capital structure, managerial personnel, and so forth. To the extent that voting rights often exceed cash-flow rights in many East Asian conglomerates, this control-ownership wedge exacerbates the potential conflict of interest between inside blockholders and minority shareholders. For instance, the Li Ka-Shing conglomerate, which is the largest business group in Hong Kong, comprises 25 companies that are among the largest in Hong Kong in terms of market capitalization. The Li Ka-Shing family holds and controls 35% stock ownership of Cheung Kong Hutchison Group, whose pyramidal chains result in 34% voting control and 2.5% cash-flow ownership of Hong Kong Electric (Claessens, Djankov, and Lang, 2000: 97). This example suggests that a large family conglomerate retains effective control of a subsidiary company with relatively small stock ownership of cash flow rights in this subsidiary company. Both the prevalence and dominance of family firms suggest that significant corporate wealth tends to concentrate in the hands of a few hereditary elites from generation to generation (Piketty, 2014).

Corporate insiders who control firm-specific assets can potentially expropriate outside minority investors by diverting resources for their personal use or by committing funds to unprofitable investment projects that provide private benefits of control to these insiders. This diversion grants incumbents the opportunity to increase their current wealth or perquisite consumption without bearing the full cost of their actions (Shleifer and Vishny, 1997). While some earlier evidence suggests a concave quadratic relation between incumbent stock ownership and firm value (McConnell and Servaes, 1990; Morck, Shleifer, and Vishny, 1988; Holderness, Kroszner, and Sheehan, 1999), some recent studies point to the potential endogeneity issue that all of corporate ownership, investment availability, and firm valuation are jointly determined (Demsetz and Lehn, 1985; Cho, 1998; Himmelberg, Hubbard, and Palia, 1999; Core and Larcker, 2002). Controlling for this endogeneity may yield an unclear nexus between insider ownership and firm value.

Lemmon and Lins (2003) assess whether different corporate ownership structures can explain differences in firm performance during the East Asian financial crisis from July 1997 to August 1998. The crisis can serve as an exogenous shock that helps ameliorate the endogeneity issue around the relationship between corporate ownership and firm valuation. The main hypothesis is that during the crisis firm value should decline the most in firms where incumbents use ownership structures that permit these corporate insiders to effectively control the firm through high control-ownership leverage. With corporate ownership data for 800 East Asian firms, Lemmon and Lins (2003) find substantive stock return evidence in support of this hypothesis. In many East Asian firms, incumbents are able to effectively control the firm even though these corporate insiders hold relatively low cash flow ownership (i.e. the control-ownership leverage is about 2.17 times on average). During the crisis, the average cumulative stock return for firms in the high control-ownership leverage group is –56.2% in comparison to –46.5% for firms in the low leverage group. Ceteris paribus, the 9.7% difference is statistically significant at any conventional confidence level. Thus, firms with high control-ownership leverage exhibit significantly worse stock return performance during the crisis in comparison to firms with low leverage. The ability to control the firm’s assets is a necessary antecedent for the expropriation of minority shareholders.

Lemmon and Lins’s (2003) evidence resonates with a recent line of corporate ownership and governance literature that the widespread use of pyramidal chains and cross-ownership structures in East Asia allows corporate insiders to exercise effective control over the firm although these insiders hold relatively few of its cash flow rights (La Porta, Lopez-de-Silanes, and Shleifer, 1999; Claessens, Djankov, and Lang, 2000; Lins, 2003). In many emerging markets, the absence of robust legal protective rules and institutions or other external governance mechanisms such as takeovers and block-ownership limits further increases the severity of agency problems between inside blockholders and minority shareholders.

High incumbent stock ownership concentration exacerbates the deviation from the social optimum when inside blockholders hold excess voting control rights in comparison to their cash flow rights. For instance, the cost of debt is significantly higher for firms with a wider wedge between the largest ultimate owner’s control rights and cash flow rights due to potential tunneling and self-dealing behaviors and other moral hazard activities by inside blockholders (Lin, Ma, Malatesta, and Xuan, 2011). Also, the shadow price of external finance is significantly higher for firms that experience a wider control-ownership wedge among corporate insiders, thus corporations whose incumbents have large excess control rights tend to face more severe financial constraints (Lin, Ma, and Xuan, 2011). These negative outcomes tend to arise from high incumbent stock ownership concentration. The above equilibrium interplay between inside blockholders and small minority shareholders suggests corporate rent protection in favor of incumbents who hold large blocks of stock in the firm.

Is international divergence from Berle-Means stock ownership dispersion an optimal corporate outcome?

Adolf Berle and Gardiner Means’s (1932) seminal work serves as the canonical qualitative basis for the separation of corporate ownership and control. Their primary thesis has set the mainstream foundation of corporate governance research for legal scholars, practitioners, and economists over 90 years. In line with this Berle-Means thesis, corporate control over physical assets responds to a centripetal force and concentrates in the hands of only a few incumbents, whereas, corporate ownership is centrifugal, splits into small units, and passes from one person to another (Berle and Means, 1932: 9). In the Berle-Means image of the modern corporation, executives and directors gain their income primarily from the effort that these incumbents put into business decisions, but not from the return on their stock investment in the enterprise. To the extent that corporate structures evolve in response to competitive pressures in the capital markets, the Berle-Means thesis predicts gradual convergence toward diffuse equity ownership as the most efficient form.

In this paper, we design and develop a model of corporate ownership and control to assess the theoretical plausibility of Berle-Means convergence toward dispersed incumbent stock ownership. To the best of our knowledge, this study is the first mathematical analysis of whether Berle-Means convergence is optimal. Further, this analysis delves into whether Berle-Means convergence is desirable from the social planner’s perspective. A subsequent analysis explores the equilibrium interplay between inside blockholders and minority shareholders.

The core analytical results suggest that Berle-Means convergence occurs when legal institutions for investor protection outweigh in relative importance firm-specific asset protection of investor rights. While legal and firm-specific asset arrangements are complementary sources of investor protection, Berle-Means convergence toward dispersed incumbent stock ownership draws the corporate outcome to the socially optimal quality of corporate governance. High incumbent stock ownership creates perverse incentives for inside blockholders to steer corporate decisions to the detriment of minority shareholders.

In the current study, we extend and generalize Yeh, Lim, and Vos’s (2007) baseline model of Berle-Means convergence with the constant elasticity of substitution (CES) production function in comparison to the Cobb-Douglas special case. While the first proposition remains the same in this more general CES production function, several new analytical results include institutional complementarities, socially optimal incumbent equity ownership stakes, and persistent deviations from Berle-Means stock ownership dispersion in equilibrium. The latter result is an equilibrium subpar outcome in the corporate game with information asymmetries between inside blockholders and minority shareholders. These novel propositions serve as the theoretical basis for subsequent empirical analysis. The appendices provide the complete mathematical derivation.

Our analysis rests on the fundamental concept that corporate insiders can often steer key business decisions at the detriment of minority shareholders. The corporate governance literature is replete with examples of deliberate use of managerial power that leads to a deterioration in firm value. For instance, incumbents may engage in earnings management prior to major corporate events such as initial public offerings (Teoh, Welch, and Wong, 1998a), seasoned equity offerings (Teoh, Welch, and Wong, 1998b), stock-for-stock mergers (Erickson and Wang, 1999; Louis, 2004), and open-market repurchases (Gong, Louis, and Sun, 2008). Also, corporate managers tend to opportunistically time the stock market through equity issuance when the firm’s market value is high relative to its book value or past market values (e.g. Jung, Kim, and Stulz, 1996; Pagano, Panetta, and Zingales, 1998; Baker and Wurgler, 2002; Huang and Ritter, 2009). In addition, abnormal stock returns tend to arise as a result of corporate events that are associated with asset expansion or contraction (e.g. Loughran and Ritter (1995), Ikenberry, Lakonishok, and Vermaelen (1995), Loughran and Vijh (1997), Titman, Wei, and Xie (2004), Anderson and Garcia-Feijoo (2006), Fama and French (2006), and Cooper, Gulen, and Schill (2008)). Incumbent blocks of stock further facilitate this managerial rent-protection mechanism that drives business decisions to benefit inside blockholders (e.g. Bebchuk, 1999; Bebchuk and Roe; 1999; Dyck and Zingales, 2004). In this context, the desire for retaining private benefits of control may induce incumbents to introduce corporate arrangements such as poison pills and board classifications to insulate directors and executives from the influence of outside blockholders (Shleifer and Vishny, 1986; Bebchuk, Coates, and Subramanian, 2002; Bebchuk and Cohen, 2005; Bebchuk and Kamar, 2010; Bebchuk and Jackson, 2012; Bebchuk, 2013; Bebchuk, Brav, and Jiang, 2015). In summary, both managerial power and entrenchment are essential ingredients in our analysis of the equilibrium interplay between inside blockholders and minority shareholders. This interplay can shed light on whether the Berle-Means image of the modern corporation is sustainable near the social optimum.

This study provides a theoretical model of the dynamic evolution of corporate ownership and governance structures over time. This model is general enough to encapsulate both arguments for and against Berle-Means convergence as special cases. In the context of equilibrium interplay between inside blockholders and minority shareholders, the model predicts that the former obtain a positive rent from their large blocks of stock by having both corporate power and influence to steer business decisions while the latter maintain a neutral utility threshold. Insofar as incumbents seek and secure economic rent in the corporate game, this equilibrium interplay persists as a non-trivial deviation from the social optimum. Berle-Means convergence toward diffuse incumbent stock ownership hence may or may not materialize due to the unilateral tilt of both legal and firm-specific asset arrangements for investor protection. In summary, our mathematical analysis sheds skeptical light on high insider stock ownership with managerial entrenchment and rent protection.

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