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MANAGED BY THE MARKETS How Finance Reshaped America

GERALD f. DAVIS

OXFORD UNIVERSITY PRESS

2009

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Financial Markets and Corporate Governance

As the American economy became increasingly permeated by. finance during the 1990S and 2000S, a series of bubbles, scandals, crashes, and bailouts created a sense of economic vertigo. Dot-corns and telecoms worth billions in February 2000 were worth little or nothing a few months later. In the name of creating synergies, corporate executives built media and financial conglomerates that were later broken up in the name of creating shareholder value. In each case, the strategies seemed to justify eye-popping levels of compensation, often in the form of stock options granted at suspiciously low price levels. The enormous demand by institutional investors for "safe" mortgage-backed securities created a vast industry to make it easy for buyers to get mortgages that stretched their means, and for homeowners to refinance their mortgages to take advantage of the inexorable rise in the value of their house. Mortgage­ backed securities, which pooled thousands of mortgages together into bonds, begat "collateralized debt obligations" (CDOs) which pooled together slices of those bonds. When housing prices reversed course, many of the largest commercial and investment banks went bust or were forced into acquisition. The casualty list from 2008 was a Who's Who of American finance: Bear Stearns, Lehman Brothers, Merrill Lynch, Washington Mutual, National City, and Wachovia, among others. Other financial institutions, such as the two government-sponsored (but shareholder-owned) mortgage companies Fannie Mae and Freddie Mac, were deemed "too big to fail" and were seized by the government in

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September 2008, at a potential cost to taxpayers in the hundreds of billions of dollars. AIG, one of the world's largest insurers, was also effectively seized by the US government a week later. Meanwhile, millions of homeowners discovered that they owed more on their house than it was worth, and many found themselves having to access finance in novel ways-for instance, by selling the payoffs of their insurance policies to entrepreneurs in the "settlements" business, who would then bundle them together and re-sell them as bonds.

This chapter surveys the new world of finance and the institutions that govern it, broadly referred to as corporate governance. "Corporate gov­ ernance" was a phrase rarely heard outside of law and business schools prior to the 1990S, but with the scandals that followed the burst of the market bubble in 2000, the topic gained widespread attention as both a problem and a solution. Corporate governance describes the systems that allocate power and control of resources among participants in organiza­ tions, particularly public corporations. Narrowly, it refers to boards of directors and their connections to shareholders, on the one hand, and top executives, on the other. But more broadly; corporate governance can be seen as the set of devices and institutions that address problems created by systems of financing-how it is possible to get money from households to businesses that need it, and then back again-particularly through financial markets.

In the United States, the main "problem" solved by corporate gover­ nance is the problem of accountability anp control created when own­ ership is widely dispersed. In the decades following the emergence of the large corporation around the turn of the twentieth century, COf­ porations grew concentrated into oligopolies, while their ownership became increasingly dispersed. The largest corporations, such as AT&T Of US Steel, often had hundreds of thousands of shareholders, none owning more than a tiny fraction of the company's shares. In these firms managers, not owners, selected the board that nominally oversaw them, allowing management to become a self-perpetuating, oligarchy accountable to no one but themselves, and using the company's vast resources for whatever purpose they saw fit-a situation that became

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known as "managerialism:' They might use their position of control to line their own pockets and to build corporate empires, or they might be mOre responsive to their employees, customers, and communities than companies run by profit-driven owner/managers. In any case, with ownership separated from control, managers could largely ignore shareholders.

Financial economists and legal scholars in the 1970S argued force­ fully that managerialism could not be the whole story. Investors are not fools-at least not the ones whose assets survive--and sensible investors do not hand their capital to companies whose managers ignore their interests, at least as long as there are alternatives. And companies that do not attract investors are unlikely to survive for long. If their share price drops low enough, then outsiders, such as industry competitors, will find it worthwhile to buy control of the company and manage it more effectively-a sprt of Darwininian selection process favoring shareholder-oriented companies. Scholars in law and economics began to theorize other mechanisms that both responded to and reinforced an orientation towards shareholder value, including Wall Street firms (whose concern with their reputation prevents them from underwrit­ ing stock offerings from unworthy companies), self-regulating stock exchanges (which are similarly attentive to the quality of thejr merchan­ dise), and labor markets for corporate directors (which reward good directors with more directorships and punish those that oversee poorly run companies), among others. Moreover, even self-interested managers cannot force investors to buy their shares, but must attract them with credible shows of their devotion to shareholder interests, by hiring rig­ orous auditors to certify their accounts, listing shares on a stock market with high standards, and incorporating in states with laws favorable to shareholders.

An array of institutions turned out to serve the purpose of orient­ ing corporate managers toward share price, according to this approach. Much as sociobiologists of the time worked backwards from social prac­ tices to the reproductive functions these must serve, theorists in law and economics explained various economic and legal institutions in terms

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of the function these served in creating shareholder value. This was a Copernican revolution in thinking about the corporation: rather than the economy revolving around large corporations, as prior theorists had described things, it revolved around financial markets and the signals they generated. I refer to this approach as the "'functionalist theory of corporate governance:'

The institutions that evolved to address the problems of dispersed ownership may be broadly applicable in a world of expansive finan­ cial markets. Investors are increasingly distant from their investments, whether in emerging market companies or in bundles of asset-backed securities. The functionalist theory of corporate governance could be seen as a basic blueprint for enabling financial markets to work in sit­ uations where owners were distant or dispersed. Thus, aspects of the peculiar matrix of American institutions spread outside their domestic context to new applications.

This chapter describes how financial markets have spread and how corporate governance (at least in theory) deals with the problems of control this raises. It highlights the functionalist theory of corporate governance that has developed and describes how this served as the intellectual and moral bulwark for the shareholder value movement of the 1980s and 1990S. In a sense, finance is to eCQnomics what technology is to science, but the "finance as technology" analogy breaks down in ways that became evident during the recent bubbles and scandals. In subsequent chapters, I analyze in more detail the limitations of using financial markets as the flywheel of the economy.

Financial intermediation Financial intermediation describes how money gets from savers (such as households) to those that can put that money to use profitably (partic­ ularly firms) and back again. Financial intermediation can be done in many ways. Informal groups can pool their savings into funds that are lent to members to start businesses. Individuals can put money in bank accounts, and banks can invest the money with entrepreneurs or compa­ nies that meet their standards. People can buy shares of stock directly,

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or invest in mutual funds that buy company shares. Each method of intermediation has characteristic strengths and weaknesses, and each creates its own set of problems to be solved.

Political scientists have categorized advanced industrial economies into two main types based on their primary form of financial inter­ mediation. Bank-based systems allocate capital through the decisions of particular organizations, while market-based systems allocate capital largely through stock and bond markets. In the first case, bankers hold a critical place as intermediaries, determining what kinds of projects and businesses are worthy of funding, while in the second case funding is dis-intermediated once the securities are brought to market. Thus, bank­ based systems are intrinsically more susceptible to personal influences. Moreover, in some bank-based systems, the most important banks are owned or strongly influenced by governments, leaving their decisions open to political influcrnce. Governments can use banks as levers of policy to guide business investment in particular directions. In South Korea, for instance, the state sought to grow the economy by focusing on particular keystone industries (such as steel, shipbuilding, and autos), which it accomplished by guiding bank lending to favored chaebols­ family-run conglomerate groups that established leading firms in critical industries. In the other cases, such as Germany, banks are relatively autonomous actors in their own right, holding substantial ownership stakes in companies and often asserting their influence directly, such as by placing representatives on corporate boards. 1

Market-based systems allocate capital through relatively impersonal processes, at least in theory. While banks are important intermediaries in bank-based systems, market-based systems lack centralized actors, and banks may be relatively unimportant. In the US, for instance, mutual funds own large stakes of the corporate sector, and investment banks act as brokers to bring stocks and bonds public, while commercial banks became relatively peripheral during the 1980s and 1990S, as it became cheaper for companies to rely on markets for both debt and equity.

Each system of intermediation allocates control differently, and each has a characteristic problem to be solved. When banks are gatekeepers

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for capital, bankers have a direct means to exercise influence over the companies they fund and to make course corrections when things go wrong. But bankers may be prone to "cronyism" -favoring the projects of friends and family, or those that are politically connected. Risky projects with merit may not be funded, and banks are prone to valu­ ing tangible collateral (e.g. real estate and factories) over intellectual assets (e.g. the ideas of scientists at a biotech lab). Financial markets, on the other hand, are good at funding riskier ventures because they allow the risk to be priced and spread over many participants. But by spreading risk, they also dilute the capacity for influence. The separation of ownership and control that comes with dispersed shareholdings is the characteristic problem of market-based systems. It is also sometimes called the "agency problem" because agents-the managers who run the company-are detached from the principals that own the firm.

The separation problem was commonplace in the US but relatively rare elsewhere in the world, at least until recently. Most countries did not have stock markets, and in those that did, families, banks, or gov­ ernments typically held controlling stakes in most enterprises. Since 1980, however, the number of countries with stock exchanges has dou­ bled, as formerly Communist states set up markets to allow trading in shares of formerly state-owned businesses ¢at were privatized, and low­ income countries sought access to overseas investors newly interested in "emerging markets." Solutions to the separation problem-how to ensure returns on investments outside one's direct control-became a major growth industry in the 1990S as cross-border equity investment became legitimated and then rampant, and privatization became a pop­ ular mode of raising finance for governments around the world. As financial markets have grown in size and scope, so has the relevance of corporate governance.

Thegrowthoffinancialmarkets While commentators in the 1990S often spoke of the "triumph of mar­ kets;' it was the triumph of financial markets that was most' distinctive. International trade in goods surpassed levels seen on the verge of the

FINANCIAL MARKETS AND CORPORATE GOVERNANCB

First World War, but financial flows reached an unprecedented vol­ ume, with trillions of dollars exchanged across borders daily. More than four dozen nations opened their first local stock exchange after 1980, including current and former Communist countries (China, Vietnam, Russia, Hungary); low-income countries in Latin America (EI Salvador, Honduras) and Africa (Malawi, Swaziland); and nations in the Middle East (Oman, Kuwait) and the Caribbean (Trinidad, Barbados). Portfolio investment by wealthy nations in these "emerging markets" grew from almost nothing in 1980 to hundreds of billions of dollars in the 1990S, led in large part by dozens of new investment funds attracting the capital of institutional investors. Trading in company shares spread to almost every comer ofthe world-including Iceland, which opened its stock exchange

in 1985.2

Investing in foreign shares was made easier by the practice of list­ ing companies on non-domestic markets. Hundreds of companies from around the world Hosted their shares on Nasdaq and the New York Stock Exchange during the 1990s-including more than sixty Israeli high-tech companies and two dozen Chilean firms. By 2005, all but two of the world's twenty-five largest corporations were traded on US stock mar­ kets, regardless of where they called home. Sociologist Anthony Giddens states that "the current world economy has no parallels in earlier times. In the new global electronic economy, fund managers, banks, corpo­ rations, as well as millions of individual investors, can transfer vast amounts of capital from one side of the world to another at the click of a mouse. As they do so, they can destabilize what might have seemed rock-solid economies-as happened in the events in Asia" in the late

1990S.3

The range of things traded on financial markets has also spread well beyond plain-vanilla stocks and bonds. Stocks and bonds are capital assets-that is, ownership of claims on future cash flows. In principle, almost anything that has a cash flow associated with it can be channelled into a tradable capital asset ('<securitized") if the price is right. Some fla­ vors of securitization are widely known-for example, Fannie Mae in the US pioneered the practice of bundling together illiquid home mortgages

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and selling slices of these bundles as bonds (known as mortgage-backed securities). The rationale for doing this is straightforward: while holding anyone mortgage may be risky because the homeowner may default or repay the loan early, large groups of them together are more predictable, and thus suitable for selling as bonds. (Chapter 6 goes into more detail on the market for mortgage-backed securities.) From mortgages, the practice of bundling debts together expanded in the 1980s to include auto loans and credit card receivables. In each case, the ability to make reasonable estimates of future payoffs meant that securities could be created to trade in these assets.

During the 1990S, securitization became increasingly baroque, thanks in part to advances in information technology and financial theory that allowed the valuation of more kinds of future income streams. In 1997, pop star David Bowie received $55 million from the issuance of lO-year bonds, to be paid from the anticipated royalties generated through future album sales. The entire issue was purchased by Prudential Insurance, and a unit of Nomura Securities subsequently established a division to spe­ cialize in creating such instruments to be backed by future revenues gen­ erated by music, publishing, film, and television products. 4 J. G. Went­ worth, affiliated with Dutch financial conglomerate ING Group, bought the rights to insurance settlements from their beneficiaries-typically injured persons-that were normally paid out over the course of several years. These were then bundled together and re-sold as debt securities­ in some cases, to the insurance companies making the payouts in the first place,S Similar schemes have been used to buy veteran's pensions and lottery winnings, in which the beneficiary receives cash now to sign away their monthly payments (often at very high interest rates), Distressed firms and others can securitize their receivables, based on the creditworthiness of their buyers. Entrepreneurs have sought to securitize property tax liens, lawsuit settlements, and college loans, among other things. Information and communication technology massively increased the ability to gather value-relevant information and therefore to create new species of securities that convert expected future payments into bonds with an agreeable face value. By the end of the decade, the value

FINANCIAL MARKETS AND CORPORATE GOVERNANCE

of securitized assets outside the mortgage market grew into the trillions

of dollars. An essential factor enabling the growth of securities markets is a

technology for evaluating capital assets at low cost. What is the right price for a security? The value of a capital asset (such as a share of stock) should be equal to the value of all the future cash flows that come with its ownership, appropriately discounted to present value (that is, future payoffs are worth less than current ones, and uncertain payoffs are worth less than certain ones). If one summed all the dividends that a company paid out until it was liquidated, and discounted them to the present, that would give a good idea ofwhat a share should be worth. The capital asset pricing model (CAPM) in finance specifies some ofthe details, proviaing a framework for setting prices for securities in markets.

Financial market efficiency A central claim offinancial economics is that the stock market is remark­ ably good at predicting a company's future and reflecting it in the share price-in other words, that the price on the market is quite close to what it should be. According to the efficient market hypothesis (EMH), the prices of traded securities (stocks and bonds) represent the best estimate of their discounted future value stream. When buying shares, you get what you pay for. More formally, the EMH claims that the market price of a security is "informationally efficient" in that it represents an unbiased estimate of its value based on all publicly available information. When new information appears, prices change accordingly. For instance, when a pharmaceutical company receives an important patent or has a new drug approved, its share price is likely to go up quickly, and conversely for rejected drugs. The speed of this reaction is an indication of the informational efficiency of the market.6

Financial markets therefore can be seen as a species of prediction market in the sense that the prices they yield are well-informed pre­ dictions about the future. Research suggests that prediction markets are often highly accurate at estimating quantifiable future events, such as the outcome of elections, or the amount of weekend ticket sales for

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a new Hollywood movie, or the likelihood of a business project being completed by a particular date, or who will win a sports event. Although there is occasional evidence of bias, the track record of several predic­ tion markets (e.g. the Iowa Electronic Market, which predicts electoral outcomes-see http://www.biz.uiowa.edu/ieml) is quite good and gen­ erally beats other prediction sources such as opinion polls. In part this is because prediction markets can take into account all these other sources of information when generating prices.7

Prediction markets are particularly effective at gathering dispersed information-in this sense, markets "know" things that no individual participants in them do, and this is what gets revealed in prices. Sum­ marizing their review of the research, economists Justin Wolfers and Eric Zitzewitz state that "The power of prediction markets derives from the fact that they provide incentives for truthful revelation, they provide incentives for research and information discovery, and the market pro­ vides an algorithm for aggregating opinions. As such, these markets are unlikely to perform well when there is little useful intelligence to aggre­ gate, or when public information is selective, inaccurate, or misleading:'8 In other words, share prices may not be accurate in situations of execu­ tive deception. Notably, it is difficult to assess the accuracy of prediction markets when the truth is never known-the outcomes of elections and Hollywood film openings are observed, but the "true" value of a share, or a bundle of mortgages, arguably is not.

Claims for the efficient market hypothesis have occasionally been extravagant. Financial economist Michael Jensen stated in 1988 that "No proposition in any of the sciences is better documented" than the effi­ cient market hypothesis-a remarkable claim for a hypothesis that had only been named two decades earlier.9 But more importantly, if the EMH were true, then prices on financial markets provide an unbeat­ able augur of future events. The head of Israel's central bank put it thus: "Capital markets are capable of transforming all the future and all the past into the present. When individuals go to the market, they bring all their memories about the past and act on all their expectations about the future:>lO Share prices aggregate all the information available

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to all the significant players about a company's prospects. Unlike the evaluations of a founding family or a banker, the price that prevails on the stock market is stripped of sentimentality and reflects hard fucts (or at least their consensus interpretation). Moreover, the market price adjusts remarkably quickly to new information, providing a minute-by­ minute assessment of a company's performance, and thereby a guide to decisions. Managerial decisions are rewarded or punished within hours after they are announced, and thus mis-steps can be recognized and corrected quickly. If a company's share price declines after it announces an acquisition, then we not only know that it was a bad idea, but how bad it was in dollar terms.

According to enthusiasts, then, price accurately answers two ques­ tions: "What is it worth?" and "What will the future bring?" The effi­ cient market hypothesis thereby solves many problems for managers, law, and public policy. For managers, it provides a relentless report card, letting them know how their performance measures up at any given moment. For judges and lawyers, price can provide a yardstick for measuring damages-indeed, one tax accountant received a 24-year sentence for fraud based on the drop in his employer's share price on the day that news of the fraud was revealed. ll For policymakers, market movements indicate the wisdom of policy changes-Bill Clinton was famously responsive to bond market reactions to his policies, thanks in large part to the influence of Treasury Secretary Robert Rubin. And for outside observers, prices on financial markets provide a barometer to measure how an economy is doing and an informed indication of what the future will bring.

The centrality of smart prices is why financial economists place great emphasis on reducing impediments to market efficiency. If one takes seriously the idea that price provides privileged access to truth, then getting prices right is an important policy goal in itself. Accurate prices can justify market practices that some find unfair. Thus, short selling­ betting that prices of a security will decline-has at times been illegal and is still unavailable to certain classes of investors, yet according to financial economists, it should be actively encouraged, the better to get

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prices right. If one can only bet on prices going up rather than down ("going long" by buying shares outright), then prices will tend to have a positive bias. Similarly, insider trading, although perhaps unfair to non­ insiders, is nonetheless useful as a means to get prices right, because insiders have access to value-relevant information that can, through their trading, make prices more accurate more quickly.

The separation ofownership and control Capital markets provide a means for matching investors with opportu­ nities and yield informative prices as a side benefit. But capital assets are a strange kind of property. When you buy a pair of shoes, you can hold them in your hands and examine their qualities. Capital assets, in con­ trast, are virtual goods, and their elusive qualities lead buyers to require a different kind of quality assurance. A shoe buyer may have little sense of the conditions under which the shoes were made-whether by well-paid union laborers working under comfortable conditions, or by children in poverty. But buyers of capital assets will demand that structures be in place to protect their investment and ensure accountability. This is the domain of corporate governance.

Berle and Means acutely analyzed what the m~agerialist corporation, whose dispersed ownership had left management in command, had wrought for our conception of property ownership. They argued that the corporation had "destroyed the unity that we commonly call property" and dissolved "the old atom of ownership into its component parts, control and beneficial ownership." Beneficial ownership was subsequently defined in the law to have two parts: the ability to buy and sell one's shares, and the ability to vote. 12 But owners of shares on this account lack a large number of rights associated with other kinds of property. The finance company that (briefly) held your mortgage could not move some of its mortgage brokers into your spare bedroom, because what they owned was a claim on your future payments, not access to your house. Similarly, ownership of shares means only that one is a "residual claimant" entitled to whatever is left of the revenues after all the other expenses are paid (or, in the case of mutual fund shareholders, the

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residual of the residual that is left after the fund company deducts its fees for buying, selling, and voting on your behalf).

Shareholders do not have direct control of the organization or its property-they can't show up and demand a ride on the corporate jet, for instance. Moreover, in the US they don't get to vote on who will be CEO, and while they do elect the directors that select and supervise the CEO, it is extremely rare for them to choose which candidates end up on the ballot. In almost all cases, their only options are to vote in favor of a director candidate or withhold their vote, and a director receiving a plurality of votes (which in an uncontested election means at least one) wins.

Buying shares in a company thus entitles an investor to almost no real influence on how the company is run, or by whom. A vast territory of corporate policies is immune from shareholder oversight because most questions of strategy,and operation are considered "ordinary business;' under the sole direction of the board of directors. Even if almost all shareholders voted in favor of a particular policy (e.g. in the case of one restaurant chain, demanding that the company not discriminate against gay employees), the board could legally ignore them, as such shareholder votes are merely advisory ("precatory"). In short, in a company with dispersed ownership, it is difficult for shareholders to speak with one voice, and even if they did speak with one voice, they could often be ignored. Practically speaking, they can have little control without buying up a majority of shares through a takeover. 13

The functionalist theory of corporate governance Described in this way, it is hard to imagine why anyone with sense would buy corporate shares, handing their savings over to companies that offer them no control in return. Yet millions of people agreed to this deal­ when Berle and Means wrote in 1932, about one in eight US adults owned shares, and AT&T alone had over a half-million shareholders. Why?

Financial and legal theorists concluded that Berle and Means must have got it wrong. If dispersed shareholdings left unaccountable man­ agers in charge to run the company as they saw fit, then smart investors would bail out. And even foolish investors are not oblivious to their

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returns. If the stock market is efficient-or even paying attention at all-then the share price of companies run by indifferent managers would reflect this. A relatively low share price makes it costly to raise capital, which benefits competitors who have a higher share price. And if price falls low enough, a competitor or someone else is likely to buy enough shares of the company to take control and rehabilitate it for a quick profit-a takeover. Henry Manne, one of the seminal figures in contemporary law and economics, dubbed this process the "market for corporate control" in a remarkably influentialu-page article published in 1965. The notion ofa market for corporate control implied that control of public corporations was always for sale in principle, and that this fact sets a limit on just how much management could ignore share price. "The lower the stock price, relative to what it could be with more effi­ cient management, the more attractive the take-over becomes to those who believe that they can manage the company more efficiently. And the potential return from the successful takeover and revitalization of a poorly run company can be enormous.»14 Takeovers thus provided a get­ rich-quick scheme for those able to identify undervalued companies­ people later referred to as "raiders."

Manne's paper highlighted tWo ideas that became increasingly impor­ tant in discussions around the corporation. The first is that the stock market is a good judge of managerial quality. Share price is an ongoing report card for management on this account, and management should be held accountable for it. The second is that institutions exist to keep corporate managers attentive to share price even if ownership is widely dispersed. Berle and Means had created an image of the managerial­ ist corporation that had endured for decades. With ownership spread among thousands of powerless shareholders, these firms were allegedly controlled by managers with little financial stake in the company, able to ignore financial markets by relying on retained earnings. Yet from Manne onward, scholars began to re-think this position and to specify the mechanisms that oriented managers and the corporation toward share price, without having to rely on an owner/manager or a major outside stockholder such as a bank.

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One early scholarly contribution set the tone by describing the cor­ poration as a mere "legal fiction which serves as a nexus for contracting relationships."15 The corporation did not have an inside or an outside­ it was a nexus of contracts, a network. The contracting metaphor meant that the relationships were mutual and voluntary, and if dispersed share­ holders had consented to this relationship millions of times over the course of decades, they must have had good reasons. As Berle and Means had argued, the separation of ownership and control introduced "agency costs" because managers' interests as agents were not perfectly aligned with those of their shareholder-principals. But this separation was not a license to steal; agency costs were simply another kind of cost that must be taken into account when considering what kind of organization was best on balance.

Moreover, just as Adam Smith described an invisible hand that led self-interested parties voluntarily to provide goods and services valued by buyers, so too did an invisible hand lead corporate managers to take actions that limited their own discretion and thus enhanced the value of shares to their buyers. Potential investors will pay more for shares in firms that have safeguards to monitor how the firm is managed and that bond managers to the firm's performance. Managers know this and spontaneously adopt such safeguards to get a better price for their equity. But why would they? Because "If the costs of reducing the dispersion of ownership are lower than the benefits to be obtained from reducing the agency costs, it will pay some individual or group of individuals to buy shares in the market to reduce the dispersion of OWnership"-often lead­ ing to the managers' unemployment. 16 From this basic dynamic arises an entire system of institutions that address (but do not completely "solve") the control and incentive problems created by dispersed ownership.

This system of institutions is what we mean by corporate gover­ nance. As defined by economist Douglass North, "Institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction:m According to gov­ ernance theorists, the function of various institutions around the cor­ poration was to orient company managers to shareholder value. Much

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as sociobiologists at the time interpreted various social institutions (e.g. the division of labor, family structures, altruism, war) in terms of their function in maximizing reproductive fitness, governance theorists interpreted corporate structures and practices, and the legal and other institutions that surrounded them, in terms of their function in maxi­ mizing financial fitness-that is, shareholder value. Following economic convention, these were referred to as "markets;' no matter how un­ marketlike they appeared in practice.

What were these markets? First, a labor market for corporate man­ agers disciplines them in the pursuit of shareholder value. If markets for "human capital" operate like markets for financial capital, then man­ agers know that poor performance now will be reflected in low wages down the road, and thus their expectations of higher future wages will induce them to better performance now. Top managers' performance is reflected in the current share price, and the pay and future prospects of those at lower levels in the organization are shaped by this measure as well, turning them into a Greek chorus that reinforces for top executives the importance of share price. Notably, these lower managers might also hope to get their bosses' jobs or even to leapfrog them to the top, creating healthy competition to be the boss of all bosses-a sort of internal mar­ ket for corporate control that further sharpens attention to share price. 18

Second, the board ofdirectors acts as a referee in these contests, hiring, firing, and compensating top management and ratifying their impor­ tant decisions. Managerialists, following Berle and Means, had argued that because managers controlled the proxy machinery, they effectively selected their own board of directors and often gave themselves a seat at the table. But most boards are composed primarily of outside direc­ tors, whose primary jobs are in other organizations. Their concern for maintaining their reputation in the outside world compels them to be vigilant and avoid the stigma that comes from being the target of an outside takeover driven by low share price. 19

What about the fact that dispersed shareholders have no input into choosing board candidates, and that their votes are effectively mean­ ingless? That simply reflects an efficient division of labor: directors are

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good at directing, shareholders are good at shareholding, and it is ratio­ nal for shareholders to be ignorant of board elections rather than to invest the time and resources to become well-informed. The share price reflects how well the company is being run, and if the board doesn't do its job, the takeover market will protect shareholders from losing their investment.20

Third, a basic premise of Berle and Means's analysis--that dispersed ownership led to lower attention to profit-was false, or at least not obviously true. If concentrated ownership leads to better monitoring, then dispersed ownership can be an effect rather than a cause: if it pays to have a monitor, then in equilibrium the companies that need moni­ toring (through concentrated ownership) will get it. Research suggested that ownership con,centration was higher in firms with more variable profitability (that is, those likely to benefit from monitoring), while­ contrary to Berle and Means--more concentrated ownership did not produce higher profitability.21

The upshot of this analysis was that managerial labor markets, boards of directors, and the takeover market all compelled corporate managers to pay close attention to their company's share price, even when own­ ership was highly dispersed. Moreover, devotion to share price drove the other decisions that they made. Companies signal the quality of their accounting to their investors by relying on auditors with sterling reputations for rigor and honesty, and thus accounting firms have strong incentives to maintain these reputations by providing thorough audits. Companies, in turn, have incentives to use only reputable accountants. Investment banks' reputations depend on thoroughly vetting the quality of the securities they underwrite, and those that hope to do repeat busi­ ness with investors will work with only high-quality clients and partners. Financial analysts working at brokerages are rated by large investors every year in widely read league tables, and thus they have incentives to dig below the management propaganda to uncover and report on the real condition and prospects of the companies they follow. In each case, these intermediaries face reputational markets that induce them to uphold honesty in the pursuit of shareholder value.22

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Functionalist governance theorists discovered other markets as well, all of which were ultimately calibrated by the stock market. In the US, corporations are chartered by the fifty states, rather than by the Federal government, and thus states compete in a "market for corporate char­ ters." But where managerialists saw a "race to the bottom;' in which states offered lax: corporate law in order to attract unaccountable managers, careful analysis showed that this competition was better seen as a "race to the top." Companies get higher valuations when they are incorporated in states with more exacting and well-specified corporate law, and Delaware gets the lion's share of incorporation because of its shareholder-friendly corporate law and its highly responsive judiciary and legislature. Because incorporation revenues account for about one-fifth of the state's budget and support a thriving indigenous population oflawyers, the state's offi­ cials stay in the vanguard of shareholder-oriented corporate law to avoid being out-competed by other states.23 Thus, by 2005 60% of the 1,000 largest US corporations were incorporated in Delaware, the McDonald's of corporate law.

Similarly, stock markets compete for corporate listings on the same principle of investor friendliness. The New York Stock Exchange (NYSE) made its reputation in the late 1800s by enfotcing rigorous standards for listed companies in order to attract British and other overseas investors. These investors had been scammed in the past by American promoters of railroad securities traded on other markets, and thus NYSE needed to create reassuring quality standards to lure them back. Nasdaq and the New York Stock Exchange compete for listings domestically and internationally, and because listing on them was taken as a sign ofquality, overseas companies typically received an uptick in share price when they listed on these US markets. Stock markets were essentially in the business of manufacturing trust in order to attract outside investors.24

The globalization of stock markets has also led to a market for secu­ rities regulation. Companies listing shares in the US are thereby sub­ ject to American securities regulation, and similarly for London and other markets. In this way, regulators "compete" to attract companies to their jurisdiction, a process that-as with state corporate law-should

FINANCIAL MARKETS AND CORPORATE GOVERNANCE

bring about a race to the top, with the spoils going to the highest­ quality jurisdiction. (US observers were accordingly troubled to find that foreign firms began seeking to de-list from the US market in the wake of Sarbanes-Oxley's strict requirements on corporate governance. Corporate "shoppers" were evidently finding the regulations in London or Hong Kong to be a better value for their shareholders, as the US had gotten too rigorous in its standards.)

Significance ofthe functionalist theory The functionalist theory of corporate governance was a Copernican rev­ olution in thinking about the corporation and its surrounding institu­ tions. From Berle and Means onward, theorists had imagined a society organized around increasingly large and powerful corporations run by relatively autonomous managers. Explaining society, at least in the US, was tantamount to €xplaining the activities of a few hundred corpo­ rations and the people that ran them. But in the functionalist theory, institutions revolved around financial markets and their signals, not corporations. When managerialists looked at corporate boards of direc­ tors, they saw executives staffing the boards with inattentive cronies that would cheerfully overpay them. But functionalists saw competitive labor markets that compensated managers and directors according to the value they created. Sociologists saw state legislators acting under the influence of local business elites to pass corporate laws that favored their agen­ das. In contrast, the new theory portrayed states competing to provide shareholder-friendly laws because that would attract the custom of share price-oriented corporate managers. And while sceptics saw rampant conflicts of interest in accounting firms that provided tax consulting and IT services for their audit clients, investment banks that allocated IPO shares to the executives of client firms, and financial analysts that never issued a "Sell" recommendation, the reputational market provided a forceful counterweight.

This theory of corporate governance is remarkable in two regards. First, it relies quite heavily on deductions following from the efficient market hypothesis, an idea that had little currency until the late 1960s.

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FINANCIAL MARKETS AND CORPORATE GOVERNANCE

We have already discussed the appeal of the EMH as a privileged source of truth. Finding out that financial markets were efficient in this way was like finding out that magnets could be set up to unerringly point to true north. Entire realms of institutions could be linked backwards to this source, a great convenience for theorists. Conversely, if the EMH were false, then proponents of shareholder capitalism had some explaining to do.

Second, in retrospect it is clear that the theory was utterly at odds with the contemporary corporate world of the 1970S and early 1980s. Unwanted takeovers were extremely rare at that time. Managerial tenure was long and firings of CEOs uncommon. Managerial salaries below the very top tier were often set using bureaucratic procedures far removed from the market, and stock-based compensation at the top was a nov­ elty. The 1970S was surely the high water mark of managerialism, when Berle and Means's description of empire-building managers was a virtual blueprint for conglomerateurs. The typical large company operated in several unrelated industries, like an overpriced mutual fund, with little constraint from boards or shareholders and nothing to fear from a legally constrained takeover market.25 It required great theoretical imagination to look out on this situation and deduce that it ';Vas, financially speaking, the best of all possible worlds.

Corporate governance and shareholder capitalism The functionalist theory of corporate governance provided the intellec­ tual foundation for shareholder capitalism, a movement that took shape in the late 1980s and spread widely in the 1990S. Shareholder capitalism took its cues from this theory, as did policymakers. Changes in antitrust enforcement and state-level takeover laws in 1982 enabled a merger wave in which more than one in four Fortune 500 manufacturers faced a takeover bid, thus turning Manne's hypothetical market for corporate control into a reality. Increasingly activist institutional investors took on the cause of corporate governance reform, prompting changes in boardroom practices. Compensation for executives was increasingly tied to share price through devices such as stock option grants. And external

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FINANCIAL MARKETS AND CORPORATE GOVERNANCE

managerial labor markets became more active, as companies increasingly sought outside CEOs rather than promoting from within. By the 1990S, few executives doubted that their companies existed to create share­ holder value.

What kind of a theory was this? As a scientific theory, the functionalist approach to governance suffered from the same limitations of sociobi­ ology, its contemporary cousin. Critics of sociobiology argued that it told "just-so" stories that were difficult to falsify, working backwards from what is to why it must be. Similarly, to look around at the sluggish conglomerates of the 1970S and to see the disciplined products of a Darwinian process played out in the capital markets seemed somewhat wilful. I discuss this in more detail in the next chapter.

As a normative theory, however, it had immediate policy relevance that became evident during the Reagan years. The prescriptions of Manne and other law and, economics scholars came into play, and efforts to restrict takeovers by states, the federal government, or firms themselves, were to be resisted. The Journal of Financial Economics was filled with "event studies" documenting the share price consequences of various managerial policies (adopting a poison pill to defend against takeover, making particular types of acquisitions, recapitalizing to have more debt, being incorporated in a state that passed shareholder-hostile laws, and so on), Such studies provided an evidence-based guide to appropriate corporate strategies. Moreover, once the institutions of cor­ porate governance in the US had been documented, the system became an exportable commodity, potentially useful for promoting economic growth in other countries. In by-passing the tortuous path through which America's capital market institutions had evolved, emerging mar­ kets could quickly install best practices to encourage vibrant economic growth, funded by outside investors.

Finally, the functionalist theory provided a moral rationale for orient­ ing companies to shareholder value rather than toward other "stakehold­ ers:' The case can be stated briefly. Let us suppose, following economist Milton Friedman, that companies maximize social welfare by maximiz­ ing profits over time. Profit is simply the residual that is left after the

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FINANCIAL MARKETS AND CORPORATE GOVERNANCE

revenue voluntarily paid by consumers has been used to payoff all of the other voluntary participants in a venture (suppliers, employees, debtholders); thus, it represents the "excess" value created by the com­ pany, a measure ofthe firm's enhancement of social welfare. According to the efficient market hypothesis, share price provides the best estimate of the future profit stream of the business. Therefore, companies maximize social welfare by maximizing share price, as long as they do not resort to lawbreaking, fraud, or market tricks that undermine their credibil­ ity. From this simple deduction, we have the purported moral ratio­ nale for shareholder capitalism. And from this, the missionary zeal of those seeking to spread shareholder capitalism around the world seems understandable.

While financial economists are prone to seeing the functionalist the­ ory as a scientific theory, legal scholars typically regard it as a prag­ matic theory for guiding policy. The case for shareholder value relies less on the importance of shareholders as a group than on the privileged epistemological status of share price. If share price reflects the distilled wisdom of crowds, then shareholders are, in effect, just placeholders. As one legal theorist put it, "if the statute did not provide for sharehold­ ers, we would have to invent them."26 ~oreover, the efficient market hypothesis may not be literally true (and there is a large and growing literature critical of the EMH), but it may be on balance the best available alternative: "it does not matter if markets are not perfectly efficient, unless some other social institution does better at evaluating the likely effect of corporate governance devices."27 Delaware's most important jurist for several years, William Allen, stated that the shareholder value approach «is not premised on the conclusion that shareholders do 'own' the corporation in any ultimate sense, only on the view that it can be better for all of us if we act as if they do:' The lawyer's brief for EMH and shareholder capitalism is like Blaise Pascal's case for God: act as if the EMH were true-and the deductions that follow from it-and society will benefit.

During the 1990S, as we shall see in the next chapter, the legal prag­ matism of law and economics became the cynical pragmatism of the

52

----------.--..--------~-=:--===""""""''''''''''-------------

FINANCIAL MARKETS AND CORPORATE GOVERNANCE

shareholder value-oriented managers, as tokens of devotion to share price and ritual use of the right accountan~, investment banks, directors, and alliance partners became rampant.

Finance and governance as technology If market efficiency is the best-documented claim in all of science, then we can see securities and the institutions of corporate governance as technologies for making use of this science. Economist Robert Shiller describes finance in this way, as a technology for managing risk. In his analogy, the science of economics builds on the new information technology as biology built on the microscope and astronomy built on the telescope. As the observational technology is refined, the abil­ ity to track regularities and deduce principles is enhanced. From this perspective, information and communication technologies (ICTs)-in particular, expansive access to data and the ability to process it through computers-have had a revolutionary effect on economics by allowing empirical tests of ideas that had been merely speculative models before. From pen-and-paper to the Internet, the empirical base ofeconomics has expanded drastically. And finance allows practical applications of these ideas.28

Consider trading in company shares. In 1700 in England, new share­ holders of a company were considered "members" and had to register their ownership with a written entry in the company's ledger. To signify their membership in the corporation, they would swear a public oath.29

Today, day traders can buy and sell millions of shares in seconds via their mobile phones. ICTs thus enable unprecedented flows of capi­ tal around the world. Perhaps more importantly, ICTs and expansive access to information (e.g. consumer credit files, housing values, and so on) allow cost-effective credit ratings ~n small units, the creation of exotic synthetic securities, and quick price reactions to new informa­ tion. This is why increasingly incomprehensible financial instruments are brought to market every day, to be bought and sold by highly sophisticated institutional investors seeking to fine-tune their exposure to risk.

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The analogy to prior technologies is a useful device for thinking about financial innovation. Many financial innovations that are now widespread, such as the use of limited liability for company shares, were essentially stumbled into, as Shiller documents. And innovations often follow a peculiar path. Steam engines originated to pump water out of coal mines, and only much later were they seen as useful for powering textile factories, then locomotives, then ships. To find a receptive market, innovations often develop by analogy and family resemblance with what has gone before. In introducing systems of electric lighting powered by centralized generators, for instance, Thomas Edison purposely emulated the style and format of the established gas lighting systems to make electric light seem more familiar to potential consumers.30 Similarly, the basic idea ofcreating asset-backed securities from mortgages was in place for some time before it was applied to auto loans and, later, credit card receivables, insurance payouts, and Bowie bonds.

Once the basic idea is accepted, financial entrepreneurs compete to establish new kinds of instruments for connecting potential buyers and sellers. Thus, if regular insurance payments can be turned into bonds, why not less-predictable payments-say, life insurance benefits for the terminally ill? Such contracts are called "viaticals" and spread during the early 1990S as investors bought the payoffs of insurance policies from AIDS sufferers and, later, the elderly. The practice of exchanging viaticals was initially considered ghoulish and fraught with malign incentives; for instance, by definition the investor's returns are higher the quicker the counterparty dies, while the counterparty has incentives to overstate how ill they are. But relatively quickly it became accepted, regulated, and­ inevitably-securitized. As with mortgages, insurance contracts become more predictable in large numbers, when they are suitable for being re-sold as bonds. Insurance companies once again were often both the buyers and sellers of these instruments. 31

But if innovations in finance are akin to technological innovations for managing risk, there are also important differences. Unlike other technologies, the ability of finance to work depends critically on both laws and perceptions-in short, on institutions. Institutions as we have

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defined them have relatively little importance for whether, say, a steam engine works. It is the laws of nature, not human laws, which matter. But financial markets are like orchids, requiring a very specialized insti­ tutional climate to flourish. Anti-usury laws that prohibit the paying of interest can make any kind of finance considerably more difficult. Laws restricting short-selling can make price changes asymmetric. Anti­ takeover regulations in the US greatly raised the hurdles to changes in control during the 1970s. Moreover, perceptions and norms are essential to finance in ways that they are not for other technologies. Perceptions can hold Boeing shares aloft, but perception alone cannot hold Boeing jets aloft.

Because of this reliance on laws and perceptions, some of the regu­ larities of the function;;uist theory of corporate governance are bound to particular times and places. The philosopher David Hume described the logical limitations of inducing laws of nature from experience. For all we know, the laws of nature might change tomorrow, rendering our inferences based on past experience false. Much the same is true for corporate governance. Why are US corporations taken over? In the 1970S, for the most part, they were not, due to state-level laws limit­ ing takeovers and to constraints on raising sufficient funds. Manne's "market for corporate control" was thwarted. In the 1980s, the answer was, in brief, that firms were taken over when their share price (more specifically, the ratio of their market value to their "book" or accounting value) was low, often because they had over-diversified. Manne's pre­ diction had come true. But most companies adopted takeover defenses and most states adopted new anti-takeover laws later in the decade, and by then almost all conglomerates had been busted up, either vol­ untarily or through outside takeovers. Thus, in the 1990S, takeovers were overwhelmingly "friendly" deals among firms in the same industry. Banking, defense, pharmaceuticals, and many other industries consol­ idated during the 1990S in what was the largest merger wave in US history, but hostile "disciplinary" deals were relatively rare. In short, the "regularities" around the market for corporate control were not particu­ larly regular.32

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Similarly, the methods used to value the mortgages contained in mortgage-backed securities relied on statistical analyses of data from prior years. The likelihood of default, for instance, was inferred from what homeowners in similar situations had done in the past. But in the mid-2000s, the models lost their predictive power-people with good credit ratings started defaulting on their mortgages--which meant that bonds with high ratings were not nearly as safe as the raters (and those that relied on them) believed.33

Moreover, the science and institutions of finance co-evolved to a degree unknown in most other domains, often with the aid of finan­ cial economists themselves. Marx wrote in "Theses on Feuerbach" that "The philosophers have only interpreted the world, in various ways; the point is to change it;' and financial economists and lawyers have taken up this call with a vengeance. Sympathetic economists in the Reagan administration greatly facilitated the creation of the 1980s takeover wave through changed antitrust rules that enabled more significant intra­ industry mergers, through SEC enforcement friendly to takeovers, and through a steadfast refusal to regulate takeovers at the Federal level. 34 Professor Michael Jensen of Harvard Business School, co-author of sev­ eral foundational articles on the finance-based theory ofthe corporation, was a highly vocal advocate for an unrestricted takeover market, which he argued was an essential tool for enabling economy-wide industrial restructuring.35 During the legislative debate over Pennsylvania's restric­ tive anti-takeover law in 1989-1990, which was introduced largely to protect Pennsylvania-based Armstrong World Industries from a takeover bid by the Belzberg brothers, Jensen was a prominent signer of a petition from academics to the Governor and members of the state House urging them to reject the bill. He also served as the Belzbergs' nominee for the board, receiving compensation of 50,000 stock appreciation rights from the would-be raiders-a potential windfall if the takeover were successful. 36 Professor Daniel Fischel, corporate governance authority and former Dean of the University of Chicago Law School, earned millions by leading and, eventually, selling the Lexecon consulting firm, which provided litigation and other support for corporate and

FINANCIAL MARKETS AND CORPORATE GOVERNANCE

legal clients such as Phillip Morris. And countless financial econo­ mists have set up extra-curricular fund management firms (Dimensional Fund Advisors) and hedge funds (Long Term Capital Management), with varying degrees of success (or catastrophic failure, in the case of LTCM).

The economists' commitment to real-world practice suggests a further limitation of the "science and technology" analogy of economics and finance. When William Herschel discovered Uranus in 1781, he named it the Georgian Star to honor King George III, but it is doubtful that his actions had much influence on its orbit around the sun. But when Russia was brought into the orbit of financial markets, first through mass privatization and later through the chartering of mutual funds, the Harvard-based advisors that guided the development of its securities markets undoubtedly did influence its trajectory. In a remarkable expose published in Institutional Investor in 2006, David McClintick documents how Harvard's advisors invested hundreds of thousands of dollars of their own money in companies they were helping to privatize-allegedly in violation oftheir and the university's contracts-and created opportu­ nities for friends and lovers, one ofwhom received the first registration to open a mutual fund from the Russian SEC and lucrative rights to manage some government funds. 37

Shiller notes that all new technologies have bugs at the start of their development-early in the steam age, boiler explosions took many lives, and airplanes crashed almost routinely at the advent of air travel-but that these bugs get worked out and the technology is made more reliable and safer over time. Similarly, financial bubbles and crashes may seem dangerous, but we are still at a relatively early stage in the development of financial technology. Presumably, the bugs will get worked out. Yet the disanalogy between economics and physics is informative. We don't imagine that physicists with money at stake had a hand in designing Boyle's Law (that the volume and pressure of a gas are inversely related), or that petitions from academics substantially influenced the law of gravity. Economics, in short, is still a social science, and finance is a social technology.

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Conclusion Advances in information and communication technologies and in eco­ nomic theory have greatly expanded the domain of financial markets since 1980. The number of countries with stock exchanges has doubled, and the range of traded securities has expanded from traditional stocks and bonds to bundles of insurance contracts on the terminally ill and synthetic instruments that can only be valued using the latest informa­ tion technology. As ICTs get cheaper and more powerful, the range of things that can be securitized-turned into securities tied to future cash flows-expands accordingly. We are in the midst ofa financial revolution on a scale comparable to the Second Industrial Revolution at the end of the nineteenth century. j

Although ICTs are essential for enabling low-cost valuation and trad- J ing of financial instruments, institutions are perhaps even more critical. Corporate governance-in particular, the set of institutions that grew up to orient corporations with dispersed ownership toward share price, without requiring direct intervention by bankers or large shareholders-­ is a sine qua non for market-based economies, and a potential Amer­ ican export. The functionalist theory of .corporate governance was a Copernican revolution in thinking about the American corporation, describing an alternative account for the so-called managerialist cor­ poration and highlighting devices that orient the corporation's elites toward shareholder value. It provided a practical and moral case for «shareholder value capitalism" that was remarkably influential in the 1990S, up through the burst of the market bubble in 2000. As this chapter has emphasized, and the next documents in more detail, the functional­ ist theory was more an "as-if" account than an apt description of the facts on the ground. But regardless of its status as a scientific theory, its influence on thinking about financial markets and their institutional surround is indisputable.