Controlling family shareholders in developing countries: Anchoring relational exchange

Stanford Law Review

Volumn 60, Issue 2, 2007, Pages 633-655

  Gilson, Ronald J ^a,b,c  

^a STANFORD LAW SCHOOL   (United States)

^b The Earth Institute at Columbia University

^c European Corporate Governance Institute   (Belgium)

Author keywords

[No Author keywords available]

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EID: 38749128425     PISSN: 00389765     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Review

References (87)

1. Ronald J. Gilson, Controlling Shareholders and Corporate Governance: Complicating the Comparative Taxonomy, 119 HARV. L. REV. 1641 (2006), surveys this development.
2. See Luca Enriques & Paolo Volpin, Corporate Governance Reforms in Continental Europe, 21 J. ECON. PERSP. 117 (2007) (describing recent reforms in European controlling shareholder systems).
3. See Stijn Claessens, Simeon Djankov, Joseph P. H. Fan & Larry H.P. Lang, Disentangling the Incentive and Entrenchment Effects of Large Shareholdings, 57 J. FIN. 2741, 2748, 2750 tbl.II (2002);
4. Stijn Claessens, Simeon Djankov & Larry H.P. Lang, The Separation of Ownership and Control in East Asian Corporations, 58 J. FIN. ECON. 81, 92 & tbl.3, 93 (2000).
5. See, e.g., Rafael La Porta, Florencio Lopez-de-Silanes & Andrei Shleifer, Corporate Ownership Around the World, 54 J. FIN. 471 (1999);
6. Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, Law and Finance, 106 J. POL. ECON. 1113 (1998);
7. Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer & Robert Vishny, Investor Protection and Corporate Governance, 58 J. FIN. ECON. 3 (2000);
8. Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer & Robert W. Vishny, Legal Determinants of External Finance, 52 J. FIN. 1131 (1997).
9. See Gilson, supra note 1, at 1649.
10. See Alexander Dyck & Luigi Zingales, Private Benefits of Control: An International Comparison, 59 J. FIN. 537 (2004) (measuring differences by relative prices in control transactions);
11. Tatiana Nenova, The Value of Corporate Voting Rights and Control: A Cross-Country Analysis, 68 J. FIN. ECON. 325 (2003) (measuring relative differences in stock exchange trading prices). The price difference between controlling and non-controlling shares, however measured, is dramatically smaller in countries with good shareholder protection.
12. I should be clear at the outset that my shorthand terms "poor" or "bad" commercial law encompass two different sources of failure: substantively bad law regardless of the quality of enforcement and substantively good law but with poor enforcement. Thus, a wonderful civil code that is not effectively enforced would fall within my terms.
13. See, e.g., STEPHEN A. ROSS, RANDOLPH W. WESTERFIELD & JEFFREY JAFFE, CORPORATE FINANCE 407-09 (7th ed. 2005).
14. Gilson, supra note 1, at 1651-52.
15. John Shuhe Li states, "In catching-up economies, there is generally no rule-based [formal enforcement] governance; hence relation-based governance is the only available mechanism to enforce agreements." John Shuhe Li, Relation-Based Versus Rule-Based Governance: An Explanation of the East Asian Miracle and Asian Crisis, 11 REV. INT'L ECON. 651, 658 (2003).
16. See generally Benjamin Klein & Keith B. Leffler, The Role of Market Forces in Assuring Contractual Performance, 89 J. POL. ECON. 615 (1981);
17. L.G. Telser, A Theory of Self-Enforcing Agreements, 53 J. BUS. 27 (1980).
18. Interesting recent work has sought to link elements of corporate governance other than shareholder distribution to conditions in the product market. See, e.g., K.J. Martijn Cremers, Vinay B. Nair & Urs Peyer, Weak Shareholder Rights: A Product Market Rationale (Yale Int'l Ctr. for Fin., Working Paper No. 06-29, 2006), available at http://ssrn.com/ abstract=890570 (discussing the relation between strength of shareholder rights and character of product market competition);
19. Maria Guadalupe & Francisco Pérez-González, The Impact of Product Market Competition on Private Benefits of Control (Feb. 2006) (unpublished manuscript), available at http://ssrn.com/abstract= 890814 (discussing the impact of product market competition on private benefit extraction).
20. There is a very interesting literature addressing the institutions necessary to support trade that is both formally sophisticated and historically grounded. The work of Avner Greif on the organization of the Maghribi traders and of Avner Greif, Paul Milgrom, and Barry Weingast on medieval European trade are examples of this work. See Avner Greif, Contract Enforceability and Economic Institutions in Early Trade: The Maghribi Traders ' Coalition, 83 AM. ECON. REV. 525 (1993) [hereinafter Greif, Maghribi Traders' Coalition];
21. Avner Greif, Paul Milgrom & Barry R. Weingast, Coordination, Commitment, and Enforcement: The Case of the Merchant Guild, 102 J. POL. ECON. 745 (1994).
22. See infra text accompanying note 47.
23. Here I anticipate ongoing work with Curtis Milhaupt. See infra text accompanying note 54.
24. See, e.g., AVINASH K. DIXIT, LAWLESSNESS AND ECONOMICS: ALTERNATIVE MODES OF GOVERNANCE 16-17 (2004).
25. This is the "folk theorem" of non-cooperative game theory. See, e.g., id. at 61; Drew Fudenberg & Eric Maskin, The Folk Theorem in Repeated Games with Discounting or with Incomplete Information, 54 ECONOMETRICA 533 (1986).
26. I develop similar conditions to reputation-based contracting in the venture capital market in Ronald J. Gilson, Engineering a Venture Capital Market: Lessons from the American Experience, 55 STAN. L. REV. 1067, 1086-87 (2003).
27. Douglass North states the conditions in terms of the barriers they present: exchange "is difficult to sustain when the game is not repeated (or there is an end game), when information on the other players is lacking, and when there are large numbers of players." DOUGLASS C. NORTH, INSTITUTIONS, INSTITUTIONAL CHANGE AND ECONOMIC PERFORMANCE 12 (1990). The discussion in the text assumes the condition that MacLeod and Malcomson specify as necessary before the game is worth the candle: "The fundamental requirement for an implicit contract to be self-enforcing is that there exist sufficient economic surplus from continuing it over what the parties can jointly get if it is terminated."
28. W. Bentley MacLeod & James M. Malcomson, Implicit Contracts, Incentive Compatibility, and Involuntary Unemployment, 57 ECONOMETRICA 447, 448 (1989).
29. DIXIT, supra note 14, at 67-71.
30. "Cultural beliefs and behavioral norms coordinate expectations and provide a shared understanding of the meaning of various actions." Avner Greif, Commitment, Coercion, and Markets: The Nature and Dynamics of Institutions Supporting Exchange, in HANDBOOK OF NEW INSTITUTIONAL ECONOMICS 727, 762 (Claude Menard & Mary M. Shirley eds., 2005);
31. see Markus Mobius & Adam Szeidl, Trust and Social Collateral (Nat'l Bureau of Econ. Research, Working Paper No. 13126, 2007) (modeling a decrease in trust among trading partners in a reputation market as the heterogeneity of potential trading partners increases).
32. DIXIT, supra note 14, at 70.
33. This account assumes that misbehavior is punished only by individuals-the injured trading partner and those who learn of the misbehavior-who decline to trade with the misbehaving trader. However, reputation markets can develop institutions that facilitate the market's operation by collectivizing information acquisition and sharing, and expanding the breadth of responsive sanctions. See Greif, supra note 18, at 733-34 (discussing "[o]rganic, multilateral reputation institutions"); Barak D. Richman, Firms, Courts, and Reputation Mechanisms: Towards a Positive Theory of Private Ordering, 104 COLUM. L. REV. 2328, 2338-50 (2004) (contrasting the circumstances that underlie the choice of enforcing a contract through firms, courts, or private organizations). Because of the path dependency of institutional characteristics in particular jurisdictions, an account of their development requires a rich historical context.
34. See, e.g., Greif, Maghribi Traders' Coalition, supra note 11 (reputation-based contract enforcement among early Maghribi traders). My argument does not depend on the simplified presentation in the text; however, its application to a particular country will require developing the context, including the institutional structure of the reputation market.
35. David M. Kreps, Corporate Culture and Economic Theory, in PERSPECTIVES ON POSITIVE POLITICAL ECONOMY 90 (James E. Alt & Kenneth A. Shepsle eds., 1990).
36. A rollback cascade occurs when a potential trading partner knows that the party will not perform in the final round, so it will anticipate that behavior and not perform in the next-to-last round, which will be anticipated by the first party, and so on back to nonperformance in the current round.
37. Kreps, supra note 21, at 111.
38. Id. at 108-10. Other techniques also can be used to bond future reputation, such as making observable investments in assets that will be valuable only if the corporation is successful.
39. See Klein & Leffler, supra note 9.
40. However, all strategies require confronting the time preferences of the corporation's short-lived decision makers. Between Corporate Governance and Shareholder Wealth (European Corporate Governance Inst., Finance Working Paper No. 145/2007, 2007), available at http://ssrn.com/abstract=954169 (finding that U.S. firms, on average, have better corporate governance than comparable foreign firms).
41. Compare LUCIAN BEBCHUK & JESSE FRIED, PAY WITHOUT PERFORMANCE: THE UNFULFILLED PROMISE OF EXECUTIVE COMPENSATION (2004) (criticizing the design of U.S. executive compensation),
42. with Bengt Holmstrom, Pay Without Performance and the Managerial Power Hypothesis: A Comment, 30 J. CORP. L. 703 (2005) (assessing criticisms and defenses),
43. and Kevin J. Murphy, Explaining Executive Compensation: Managerial Power Versus the Perceived Cost of Stock Options, 69 U. CHI. L. REV. 847 (2002) (rebutting criticism).
44. Cultural values concerning the importance of family and the trade-off between intrafamily loyalty and individual self interest will differ among countries. See Gilson, supra note 1, at 1673 (noting the cultural value of family control in Asia). Once the commitment to maximizing family wealth, as opposed to that of individual family members, breaks down-whether through cultural change as a result of modernization or because of what I have called the "gravity of generations,"
45. id. at 1668 - then inside conflict over distributional issues will result in decreased commitment to reputation and reduced productivity generally. This, in turn, will undermine the support family ownership provides to reputation-based product market exchanges. Müller and Wärneryd argue that public ownership responds to such internal distributional competition by forcing inside managers to unite against the outside owners' demand for resources. While Müller and Wärneryd do not have family ownership in mind, the intuition seems applicable: dysfunctional family ownership leads to a public offering. Their model, however, assumes that the public's investors have the power through legal rules to assert themselves, a circumstance that is likely not present in developing countries.
46. Holger M. Müller & Karl Wärneryd, Inside Versus Outside Ownership: A Political Theory of the Firm, 32 RAND J. ECON. 527 (2001).
47. For a striking example of the disintegration of intrafamily loyalty within a very successful U.S. family-controlled business, see Suzanna Andrews, Shattered Dynasty, VANITY FAIR, May 2003, at 182 (detailing how internal conflicts within the Pritzker family led to the breakup of the family fortune).
48. Steven Tadelis develops a model of reputation formation that, in contrast to Kreps's focus on moral hazard (one party cheating in a future round), is based on adverse selection (future buyers are uncertain about whether future owners will be talented or trustworthy). Steven Tadelis, What's in a Name? Reputation as a Tradeable Asset, 89 AM. ECON. REV. 548 (1999). Tadelis's model assumes that shifts in ownership of a business are not observable by customers of the business-hence the adverse selection problem that drives the model. Family ownership, by making ownership shifts to nonfamily transparent to future clients, therefore reduces the barriers to the operation of a reputation market in an adverse selection-driven model, just as it does in Kreps's moral hazard approach. To be fair, Tadelis does briefly consider the possibility that family ownership might address the adverse selection problem, but dismisses the fact of family ownership as providing too little information to support a separation between good and bad service providers: "Clearly, businesses that have signs claiming that they have been owned by the same family for 75 years convey little information about the quality of the current owner, let alone of the key employees."
49. Id. at 560. In settings where family ownership powerfully predicts individual family member preferences for business success, Tadelis dismisses the impact of family ownership too quickly. His point might be better understood as a prediction of regression to the mean in talent as control shifts from the business's founder to her heirs. There is some empirical evidence that supports this inference.
50. See Gilson, supra note 1, at 1668-69 (reviewing studies).
51. See, e.g., Tarun Khanna & Krishna Palepu, Is Group Affiliation Profitable in Emerging Markets? An Analysis of Diversified Indian Business Groups, 55 J. FIN. 867 (2000) (explaining the advantages of an internal capital market in emerging market jurisdictions).
52. See, e.g., RONALD J. GILSON & BERNARD S. BLACK, THE LAW AND FINANCE OF CORPORATE ACQUISITIONS 332-57 (2d ed. 1995) (reviewing explanations for conglomerate acquisitions).
53. A number of explanations have been advanced for why a controlling shareholder would want to establish public minority shareholders, whether in an initial public offering or in a spin-out public sale of a minority interest in a previously wholly owned subsidiary. These include the evaluative information provided by the pricing of an efficient stock market and the availability of publicly traded shares as an incentive compensation vehicle. See Ronald J. Gilson & Jeffrey N. Gordon, Controlling Controlling Shareholders, 152 U. PA. L. REV. 785, 791 (2003) (summarizing benefits to a controlling shareholder from having a publicly traded minority);
54. Katherine Schipper & Abbie Smith, A Comparison of Equity Carve-Outs and Seasoned Equity Offerings: Share Price Effects and Corporate Restructuring, 15 J. FIN. ECON. 153, 182 (1986) (explaining the information effect of a minority carve-out). Such information-based explanations, however, require an efficient stock market, a condition that is not consistent with poor shareholder protection law.
55. Heitor Almeida & Daniel Wolfenzon, Should Business Groups Be Dismantled? The Equilibrium Costs of Efficient Internal Capital Markets, 79 J. FIN. ECON. 99, 116 (2006), provide a good example. In Almeida and Wolfenzon's model, the extent to which the controlling shareholder can divert assets is expressed as a "pledgeability" parameter; the model then yields different results depending on the extent to which returns can be effectively committed to minority investors. However, the institutional structures that allow an effective commitment not to divert more than a particular value of the parameter are not discussed.
56. Andrei Shleifer & Daniel Wolfenzon, Investor Protection and Equity Markets, 66 J. FIN. ECON. 3, 14 (2002), use a similar modeling technique to parametize the level of diversion.
57. See, e.g., RICHARD A. BREALEY, STEWART C. MYERS & FRANKLIN ALLEN, PRINCIPLES OF CORPORATE FINANCE 490-93 (8th ed. 2006);
58. STEPHEN A. ROSS ET AL., supra note 7, at 450-53.
59. Gilson, supra note 1, at 1674-78, addresses possible reforms to improve these adverse selection problems.
60. See Greif, supra note 18, at 732-35 (describing self enforcement among traders);
61. Richman, supra note 20, at 2338-48 (describing private ordering systems).
62. See Dyck & Zingales, supra note 5, at 582-86 (treating newspapers as a corporate governance constraint). Luca Enriques has pointed out that the role of the financial press may be limited to a handful of developed countries where there is a widespread confidence in the newspapers' journalistic integrity. Absent that confidence, they cannot play the contemplated "shaming" role. E-mail from Luca Enriques, Professor of Law, University of Bologna, and Commissioner, Commissione Nazionale per le Societa e la Borsa (CONSOB) (Nov. 24, 2006) (on file with author).
63. I recognize that I am at this point glossing over a serious problem-why is a controlling shareholder's treatment of minority shareholders more observable than the quality of the products or services it provides? Or, setting the bar at a realistically lower level, is the controlling shareholder's treatment of minority shareholders sufficiently observable that it adds something to the customer's assessment of the corporation's reputation based only on the products or services it provides? I will return to this concern after describing the product market explanation for minority shareholders in family-controlled corporations. See infra pp. 651-52.
64. Klein & Leffler, supra note 9.
65. The joke concerns a physicist, a chemist, and an economist stranded on a desert island with a can of food and no obvious way to open it. After the physicist and chemist suggest complex and unrealistic ways to open the can based on their specialties, the economist, expressing disdain for the inelegance of his companions' efforts, offers his solution: assume a can opener.
66. The enforcement of a Japanese main bank's obligation to undertake a rescue of its clients has been said to operate in this informal way. While a main bank had no formal legal obligation to undertake a rescue, the Ministry of Finance had to approve applications to open new bank branches, a decision that was left entirely in the Ministry of Finance's discretion. The failure to discharge the informal rescue obligation would be punished by the denial of branch applications. See Masahiko Aoki, Hugh Patrick & Paul Sheard, The Japanese Main Bank System: An Introductory Overview, in THE JAPANESE MAIN BANK SYSTEM 3, 31-32 (Masahiko Aoki & Hugh Patrick eds., 1994).
67. See DIXIT, supra note 14, at 82;
68. Li, supra note 9, at 651.
69. Both DIXIT, supra note 14, at 80-82,
70. and Li, supra note 9, at 659-60, stress this point. Douglass North has stated that "the inability of societies to develop effective, low-cost enforcement of contracts is the most important source of both historical stagnation and contemporary underdevelopment in the Third World."
71. NORTH, supra note 16, at 54.
72. DIXIT, supra note 14, at 80.
73. For example, in a system with good commercial law, contractual commitments like warranties can provide new entrants a substitute for difficult-to-acquire reputation. When KIA, a Korean automobile manufacturer, entered the U.S. market, it offered a substantially longer warranty than its established competitors. See Micheline Maynard, Things Are Looking up for South Korea's Carmakers, N.Y. TIMES, Dec. 7, 2001, at F1.
74. MANCUR OLSON, THE RISE AND DECLINE OF NATIONS, 167-70 (1982). Almeida and Wolfenzon, supra note 33, make the same point about conglomerates in developing countries. Once conglomerates become a large enough part of the economy, they may impose a negative externality by causing the overall capital market to operate inefficiently because of a kind of crowding phenomenon, even if the conglomerates' internal capital markets operate efficiently. In this setting, government intervention may be necessary to reduce the conglomerates' role.
75. Paul Milgrom & John Roberts, Complementarities and Systems: Understanding Japanese Economic Organization, 9 ESTUDIOS ECONÓMICOS 3, 12 (1994).
76. Id.
77. Li, supra note 9, at 669.
78. Recent scholarship suggests that in some countries causation may run in the opposite direction. Julian Franks, Colin Mayer and Stefano Rossi, Spending Less Time with Family: The Decline of Family Ownership in the UK, in THE HISTORY OF CORPORATE GOVERNANCE AROUND THE WORLD: FAMILY BUSINESS GROUPS TO PROFESSIONAL MANAGERS (Randall Morck ed., 2005), argue that U.K. shareholding patterns arose from informal relations of trust and confidence that encouraged equity investment by investors geographically proximate to the issuer. Here the influence is from product market to capital market. This diversity in actual history among jurisdictions is consistent with Avner Greifs conclusion that the structure of reputation markets in individual countries will be path dependent: "Cultural beliefs and behavioral norms coordinate expectations and provide a shared understanding of the meaning of various actions. Ceteris paribus, initial social structures and cultural features therefore influence which, among the many possible organic [reputation market structures] will emerge . . . ."
79. Greif, supra note 18, at 762.
80. See Gilson, Corporate Governance and Economic Efficiency, supra note 25 at 329-34 (discussing path dependency of corporate governance institutions);
81. Gilson, Globalizing Corporate Governance, supra note 25 (same).
82. See Kenneth W. Dam, Legal Institutions, Legal Origins, and Governance (Chicago Working Paper Series, John M. Olin Law & Econ. Working Paper No. 303, 2006), available at http://ssra.com/abstract= 932694 (surveying literature).
83. Avner Greif and David Laitin provide an analytic road map for developing a dynamic account of system change, noting that a game-theoretic account explains an equilibrium, not what causes a system to shift to a new equilibrium. Avner Greif & David D. Laitin, A Theory of Endogenous Institutional Change, 98 AM. POL. SCI. REV. 633 (2004). A shift resulting from changed external conditions is easy enough to explain-the rules of the game have changed. The harder question is to explain how systems change as a result of internal forces. Given the equilibrium analysis, "[e]ndongenous institutional change appears, then, to be a contradiction in terms."
84. Id. at 633.
85. See Dani Rodrik, Institutions for High-Quality Growth: What They Are and How to Acquire Them, STUD. COMP. INT'L DEV., Sept. 2000, at 3, 16-20 (2000) (finding that, in sample of countries, authoritarian regimes are associated with more volatility in economic growth).
86. Fareed Zakaria makes a related claim that explains the development of democratic government rather than economic development. He argues that the success of democracy is a function of per capita GDP. In his view, the first step toward representative government is economic development, which may require a dictator, but which also then creates the middle class that will bring the dictator down. FAREED ZAKARIA, THE FUTURE OF FREEDOM 69-73 (2003).
87. Played through the model in Greif and Laitin, supra note 52, this would be an example of an equilibrium whose circumstances undermine its stability.