ABSTRACT
The separation of ownership from control The corporate form as we know it today is the product of an evolutionary process that began in England as early as the seventeenth century. In most of the early corporations, ownership claims were held by a handful of individuals, some of whom also participated in management. The initial corporate charters were very specific with regard to the kind of activities the corporation could engage in. If the management of a company founded to make rifles wished to diversify into making pots and pans, or to purchase another company that made pots and pans, it would require the approval of its shareholders. Moreover, decisions like this typically required the unanimous approval of the shareholders. Even one shareholder’s vote could block a merger. This tight control by shareholders characterized corporate structures in the United States as late as the mid-nineteenth century. At that time there were also no organized markets for exchanging ownership
claims. Shares were transferred to relatives or sold to friends. Shares were not widely distributed and most owners actively participated in the control of the firm. Control of corporations was by voice rather than by exit, and rested in the hands of corporate owners. Innovations like the steam engine and the open hearth furnace for making steel
greatly expanded the optimal size of firms in many industries, and created entirely new industries like the railroads with giant firms and giant demands for capital. To satisfy these demands large numbers of shares were issued and shareholder numbers grew. Toward the end of the nineteenth century, organized markets to exchange shares opened in New York and in the capitals of Europe. To attract corporations and the jobs and taxes they bring with them, many state
legislatures rewrote their laws regarding incorporation, allowing corporations to write broad charters and thus granting considerable authority to managements. The unanimity rule was replaced by the simple majority rule and many important decisions likemergers no longer required the approval of the shareholders. As their numbers grew, shareholders increasingly relied on the exit option to express their pleasure or displeasure with “their” managers’ decisions. Control via voice nominally shifted to the boards of directors, but they typically contained and were
dominated by the managers themselves. Thus, over the latter half of the nineteenth and beginning of the twentieth centuries control of corporations shifted into the hands of their managers. In 1932, Adolph Berle and Gardiner Means published a book in which they
recounted the corporation’s evolution, and documented the extent to which effective control had shifted from shareholders to managers. They argued that managers were in effective control of a company whenever its outstanding shares were so widely dispersed that no single person or group held 20 percent or more of the outstanding shares. Forty-four percent of the largest 200 corporations at that time, with 58 percent of their assets, met this criterion. As the twentieth century enfolded and corporations continued to grow, and the
second and third generations of their founding families reduced their shareholdings, the extent of the separation of ownership from control, which Berle and Means first documented, advanced. Using the lower cut-off of a 10 percent concentration of shares in a single group’s hands, Robert Larner (1966) found that by the mid-1960s control of some 75 percent of the 200 largest US corporations had fallen to management. Similar figures have been reported for UK corporations (Florence, 1961; Prais,
1976), so that by the 1960s or 1970s, in the United States and the United Kingdom, it is safe to say that well over half of the largest corporations were effectively controlled by their managers. The same could not be said for other countries in Europe, however, at least if the criterion for management control is that no single person or group owns, or can cast the votes for a large fraction of the companies’ shares. In Continental European countries, family control of even quite large companies is still the general rule. In Germany, the large banks and other financial institutions control many of the largest companies. Large Italian firms rely heavily on bank borrowing for capital, and in this country banks also typically exercise considerable influence on corporate decision-making. Nevertheless, it is also true that in each of these, and most of the other European countries, corporations can be found where ownership and control are separated as in the United States. In the last quarter of the twentieth century, two developments have taken place
that arguably reduced the extent of a separation of ownership from control in the United States. The first was the hostile takeover wave of the late 1980s, when managements were replaced, ostensibly because of their poor performance owing to the discretion provided to them by the separation of ownership from control. Fearful of losing their jobs, corporate managers responded by substituting corporate debt for equity thereby increasing the fraction of outstanding shares that they themselves held. The second development has been the tremendous growth of pension funds, mutual funds, and other institutional holdings that has concentrated share holdings in the hands of the managers of these funds. Shareholdings in the United States today are more concentrated than Larner found in the early 1960s.1 The existence of a separation between ownership and control gives rise to what
has come to be called the principal-agent problem. We turn now to a general analysis of this problem.
