corporate governance: some theory and implications

Corporate Governance: Some Theory and ImplicationsAuthor(s): Oliver HartSource: The Economic Journal, Vol. 105, No. 430 (May, 1995), pp. 678-689Published by: Wiley on behalf of the Royal Economic SocietyStable URL: http://www.jstor.org/stable/2235027 .

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The Economic Journal, 105 (May), 678-689. ? Royal Economic Society I995. Published by Blackwell Publishers, Io8 Cowley Road, Oxford OX4 iJF, UK and 238 Main Street, Cambridge, MA 02142, USA.

CORPORATE GOVERNANCE: SOME THEORY AND IMPLICATIONS

Oliver Hart

I. INTRODUCTION

This article attempts to provide a theoretical framework for the corporate governance debate, and to derive some implications which may be useful as a guide to policy. The first part of the article reviews the conditions under which corporate governance issues are relevant. The second applies the analysis to the case of a public company.

II. A FRAMEWORK FOR CORPORATE GOVERNANCE

Corporate governance issues arise in an organisation whenever two conditions are present. First there is an agency problem, or conflict of interest, involving members of the organisation - these might be owners, managers, workers or consumers. Second, transaction costs are such that this agency problem cannot be dealt with through a contract.

A. Why Corporate Governance Does not Matter in the Absence of Agency Problems In the absence of agency problems, all individuals associated with an organisation can be instructed to maximise profit or net market value or to minimise costs. Individuals will be prepared to carry out their instructions since they do not care per se about the outcome of the organisation's activities. Effort and other types of costs can be reimbursed directly and so incentives are not required to motivate people. Also no governance structure is required to resolve disagreements, since there are none.

The above describes the situation assumed to hold in the standard neoclassical theory of the firm. It is no surprise then that it is often said that this theory treats the firm as a 'black box' - that is, the theory predicts how the firm's production plan varies with input and output prices, but says nothing about how this production plan comes about.

B. Agency Problems Alone Do NVot Provide a Rationale for Corporate Governance

Neoclassical theory assumes that effort choices and costs are observable. Principal-agent theory departs from this assumption by supposing that some costs are private information. For example, in a typical principal-agent problem, an owner hires a manager to run his (or her) firm for him. The firm's performance, represented by gross profit, II, depends on the manager's effort e and also a chance variable, e, determined after e is chosen:

= =g(e, e).

[ 678 ]



[MAY 19951 CORPORATE GOVERNANCE 679 It is supposed that the manager's effort choice is observed only by him. Thus a contract which makes the manager's compensation, I, a direct function of e cannot be enforced. Instead the manager's compensation must be geared to realized profit Il: I= I(H).'

This model generates a classic trade-off between incentives and risk sharing. On the one hand, to motivate the manager to work hard, it is necessary to give him 'high-powered' incentives, i.e. to make I very sensitive to Hl. On the other hand, to protect the manager from risk, it is necessary to give him 'low- powered' incentives, i.e. to make I insensitive to H. A large part of the principal-agent literature has been concerned with determining the optimal balance between efficiency and risk-bearing. Also the model has been generalised to allow for multiple agents, multiple principles, many dimensions of action, many periods, etc.2

Principal-agent theory is useful for providing insight into why managers (or workers) might be given some performance-related pay in the form of shares or stock options, say.3 However, the theory does not by itself provide a role for governance structure. The reason is that optimal principal-agent contracts, although second-best, in the sense that I depends on Hl rather than directly on e, are ' comprehensive' in the sense that a contract specifies all parties' obligations in all future states of the world, to the fullest extent possible (i.e. to the extent that these obligations are observable and verifiable). For example, in a multi-period version of the principal-agent model the initial contract would. specify not only the first-period incentive scheme, but also the second- period incentive scheme as a function of what happens in the first period; the third-period incentive scheme as a function of what happens in the first and second periods, and so on. In more general versions of the principal-agent model, the contract would specify conditions under which the manager should be replaced, conditions under which assets should be bought and sold, conditions under which new workers should be taken on or old workers should be fired, and so on.

Since optimal principal-agent contracts are comprehensive, it is hard to find a role for governance structure (or asset ownership). The reason is that governance structure matters when some actions have to be decided in the future that have not been specified in an initial contract: governance structure provides a way for deciding these actions. However, in a comprehensive contracting world, everything has been specified in advance, i.e. there are no 'residual' decisions.4

C. Governance Structure Does Matter If Agency Problems Are Present and Contracts Are Incomplete The standard principal-agent model supposes that it is costless to write a comprehensive contract. In reality, however, contracting costs may be large.

1 It is assumed that the owner also does not observe e. 2 For surveys, see, e.g. Hart and Holmstrom (I987) and Milgrom and Roberts (I992).

3 Although some have argued that the theory predicts that we should see higher-powered incentive schemes than are actually observed. On performance-related compensation, see Conyon et al. (I995).

4 For a further discussion of this, see Hart (1995).

? Royal Economic Society I995



68o THE ECONOMIC JOURNAL [MAY

The transaction cost literature has identified three costs that are particularly important. First, there is the cost of thinking about all the different eventualities that can occur during the course of the contractual relationship, and planning how to deal with them. Second, there is the cost of negotiating with others about these plans. Third, there is the cost of writing down the plans in such a way that they can be enforced by a third party - such as a judge - in the event of a dispute.5

Given these transaction costs, the parties will not write a comprehensive contract. Instead they will write a contract that is incomplete. That is, the contract will have gaps and missing provisions - future actions will be specified only partly and in some cases not at all. An additional implication of contractual incompleteness is that contracts will be renegotiated as new information arises and there may be legal disputes to the extent that the initial contract is ambiguous.

In a world of incomplete contracts (where agency problems are also present), governance structure does have a role. Governance structure can be seen as a mechanism for making decisions that have not been specified in the initial contract. More precisely, governance structure allocates residual rights of control over thefirm's nonhuman assets; that is, the right to decide how these assets should be used, given that a usage has not been specified in an initial contract.6 For example, one form of governance structure is individual ownership of the firm. If party I owns firm A, then this means that party I has the right to make all unspecified decisions concerning firm A's (nonhuman) assets, e.g. how the assets should be used, who should have access to them, whether they should be sold, etc. A second form of governance structure is joint ownership. If parties I and 2 jointly own firm A, then they must agree on a decision about firm A's assets for it to be implemented.7 A third example would be a partnership: if parties I, 2, and 3 each have one third of an interest in firm A, then decisions about the firm would be made by majority vote.

As the above discussion shows, corporate governance is an issue even in a small (closely-held) firm. However, it is usually thought to be a much more significant issue in large, public companies. To these we now turn.

III. CORPORATE GOVERNANCE IN A LARGE PUBLIC COMPANY

The distinguishing feature of a (US- or UK-style) public company is that it has a large number of small owners. This creates two issues that are not relevant in a small closely-held company. First, the owners, that is, the shareholders, even though they typically have (ultimate) residual control rights in the form of votes, are too small and numerous to exercise this control on a day-to-day

5 For discussions of the importance of transaction costs, see Coase (I 937), Williamson (I985), and Klein, Crawford and Alchian (I978).

6 See Grossman and Hart (I986), Hart and Moore (I990), and Hart (1995). Nonhuman assets include machines, buildings, inventories, client lists, patents, copyrights, etc. Human capital is excluded since, in the absence of slavery, the (ultimate) right to decide how human capital is used always resides with the possessor of the human capital.

7 Presumably there must be a status quo decision on which they can fall back if they disagree.




I995] CORPORATE GOVERNANCE 68i

basis. Given this, they delegate day-to-day control to a board of directors, which in turn delegates it to management. In other words, to use the phrase made famous by Berle and Means (I 933), there is a separation of ownership and control.

The second, related issue is that dispersed shareholders have little or no incentive to monitor management. The reason is that monitoring is a public good: if one shareholder's monitoring leads to improved company performance, all shareholders benefit. Given that monitoring is costly, each shareholder will free-ride in the hope that other shareholders will do the monitoring. Unfortunately, all shareholders think the same way and the result is that no - or almost no - monitoring will take place.

Because of the separation of ownership and control, and the lack of monitoring, there is a danger that the managers of a public company will pursue their own goals at the expense of those of shareholders (we suppose that the latter are interested only in profit or net market value). Among other things, managers may overpay themselves and give themselves extravagant perks; they may carry out unprofitable, but power-enhancing investments; they may seek to entrench themselves. In addition, managers may have goals that are more benign but that are still inconsistent with value maximisation. They may be reluctant to lay off workers that are no longer productive. Or they may believe that they are the best people to run the company when in fact they are not.

In view of the managers' ability to pursue their own agenda, it is obviously important that there exist checks and balances on managerial behaviour. A major part of corporate governance concerns the design of such checks and balances. We discuss next some of the more important constraints on managers, including monitoring by boards of directors and by large shareholders; the threat of proxy fights and takeovers; and corporate financial structure. Our theme will be that all these mechanisms are useful, but each has limitations. One implication that we will draw is that any attempt by outside parties - for example, the government - to weaken these mechanisms may well be counterproductive.8

IV. MECHANISMS FOR CONTROLLING MANAGEMENT

A. The Board of Directors

One check on management is provided by the board of directors. Shareholders elect the board to act on their behalf, and the board in turn monitors top management and ratifies major decisions. In extreme cases the board may replace the company's chief executive and other members of the management team.

In principle, the board has a very important role to play, but there are some reasons to doubt its effectiveness in practice. The board consists of executive

8 Our discussion of constraints on managers is not exhaustive. Other forces constraining managers are competition in the managerial labour market and competition in the product market. On these, see, e.g. Holstrom (I982) and Hart (I983).




682 THE ECONOMIC JOURNAL [MAY

directors (who are members of the management team); and nonexecutive directors, who are outsiders. On the one hand, it would hardly be reasonable to expect the executive directors to monitor themselves. On the other hand, the nonexecutive directors may not do a very good job of monitoring for several reasons. First, they may not have a significant financial interest in the company, and they may therefore have little to gain personally from improvements in company performance.9 Second, nonexecutive directors are busy people (they may themselves be chief executives and sit on many boards) and probably have little time to think about the company's affairs, or to collect information about the company - over and above that provided by management. Finally, nonexecutive directors may owe their positions to management, who proposed them as directors in the first place. As well as feeling loyal to management, they may want to stay in management's good graces, so that they can be re-elected and continue to collect their fees.'0

The Cadbury Committee has put forward a number of suggestions for changing the structure of the board; among other things the committee has recommended that the chairman of the board should (usually) be independent, that there should be a formal selection procedure for nonexecutive directors, that audit and remuneration committees should consist mainly or entirely of nonexecutive directors. These suggestions might improve the effectiveness of the board, but are unlikely to solve completely the problems described above. We shall have more to say about the Cadbury proposals below."

B. Proxy Fights We have suggested that board members may not do a good job of monitoring managers.'2 Of course, if the performance of board members is sufficiently bad, shareholders can always replace them.'3 The standard way this is done is through a proxy fight: a dissident shareholder puts up a slate of candidates to stand against management's slate, and tries to persuade other shareholders to vote for his (or her) candidates.

Unfortunately, proxy fights may not be a very powerful tool for disciplining directors in a company with dispersed shareholders. There are several reasons for this. First, and most important, there is a significant free-rider problem. The dissident bears the initial cost of figuring out that the company is

' Board members could be given a greater financial interest, e.g. they could be made significant shareholders. Note, however, that (a) this dilutes the ownership interest of other shareholders; (b) unless board members own I00% of the company they will still have an insufficient incentive to monitor management.

10 Nonexecutive directors may also represent companies that do business with this company (major purchasers or suppliers, the company's lawyers, etc.). This further compromises their independence. For discussions of boards of directors, see Mace (I97I), Vancil (1987), and Weisbach (I988).

" One of the stranger recommendations made by the Cadbury Committee is that nonexecutive directors should not have an ownership stake in the company. The reason given is that an ownership stake would reduce the independence of nonexecutives. See paragraph 4. I3 of the Cadbury Report.

12 The Cadbury Committee suggests that a company's auditors may also have an important role in monitoring management. However, it is difficult to motivate auditors to monitor management for the same reasons that it is difficult to motivate the board.

13 In addition, in extreme cases, if directors are grossly negligent or violate their duty of loyalty to shareholders, shareholders can sue directors for breach of fiduciary duty. On fiduciary duty, see Clark (i 986).

? Royal Economic Society 1995



I995] CORPORATE GOVERNANCE 683 underperforming and also typically incurs the expense of launching the proxy fight - this may include everything from the cost of locating the names and addresses of the shareholders and mailing out the ballots, to the cost of persuading shareholders of the merits of the dissident slate.'4 In contrast, the benefits from improved management accrue to all shareholders in the form of a higher share price. Given this, a small shareholder may quite rationally refuse to undertake a proxy fight that is socially valuable. Second, and related, even if a proxy fight is launched, shareholders may have little incentive to think much about whom to vote for since their vote is unlikely to make a difference. A reasonable rule of thumb for a small shareholder may be to vote for incumbent management on the grounds that 'the devil you know is better than the devil you don't'.'5 Finally, company law often allows management to use company funds to promote management's slate of directors. This further strengthens the hand of the incumbent against the dissident.'6

C. Large Shareholders Given that small shareholders have little incentive to monitor management

or launch a proxy fight, some commentators have suggested that one way to improve corporate governance is to ensure that a company has one or more large shareholders. In the United Kingdom it is often suggested that institutions have an important role to play in this regard.'7

At one level this argument must be right, since if a company has a ioo% shareholder there is no longer a separation between ownership and control. However, such an outcome is presumably undesirable for other reasons, not least that the gains from going public - the risk reduction benefits from portfolio diversification - are lost.

More generally, in the case where a large shareholder owns less than iOO % of the company, agency problems may be reduced, but they are not eliminated. First, a large shareholder will still underperform monitoring and intervention activities since he does not receive i 0% of the gains. Second, a large shareholder may use his (voting) power to improve his own position at the expense of other shareholders. For example, the large shareholder might persuade management to divert profit to himself, e.g. by selling goods to a company the shareholder owns at a low price or by buying goods from a company the shareholder owns at a high price. Another possibility is that the shareholder would agree to leave management alone, in exchange for having his shares repurchased at a premium (this practice is known as greenmail in the United States). Finally, the large shareholder may simply become management, i.e. he may run the company himself.

A further problem with a large shareholder is that, to the extent that the large shareholder is an institution, the shareholders of the institution must hire

14 The dissident may be able to recover some of these costs if he or she is successful. 15I n fact it may be that, because the outcome is stacked in favour of management, 'sensible' dissidents

are deterred, leaving only 'crazy' dissidents to launch proxy fights; this reinforces the shareholders' rule of thumb.

16 For further discussions of proxy fights, see Ikenberry and Lakonishok (I993) and Pound (I988). 17 In Germany and Japan, the role may be played by banks.





a manager to act on their behalf. However, this introduces a new principal-agent problem. In particular, it is far from clear that the manager of the institution will do a good job of monitoring, as opposed to pursuing his own goals - which might involve the extraction of some private benefits from the manager of the company he is meant to monitor, or simply taking it easy.'8

D. Hostile Takeovers On of the major problems with the mechanisms described so far - monitoring by the board or by large shareholders, or proxy fights - is that those who incur the costs of improving management receive only a (relatively) small fraction of the gains. A hostile takeover is in principle a much more powerful mechanism for disciplining management since it allows someone who identifies an underperforming company to obtain a large reward.

To understand how a hostile takeover works, consider a company that is worth v under current management, but if managed properly would be worth v +g. Then someone - a raider, say - can buy all of the company's shares for v, install new management and make a capital gain of g on his shares. This way the raider obtains ioo % of the gains from improved management for himself, instead of having to share these gains with other shareholders.

In reality, hostile bids may be less profitable than the above argument would indicate. First, there is a free-rider problem. Small shareholders who believe that their decisions are unlikely to affect the success of the bid have an incentive not to tender to the raider, since they may be able to obtain a pro-rata fraction of the capital gain g by holding on themselves. In fact, if every shareholder is negligible, and corporate law does not permit a successful raider to expropriate minority shareholders who do not tender, then it can be shown that the only successful bids are those in which the raider makes an offer at the post- acquisition value of v +g (see Grossman and Hart, I980). This of course means that the raider makes no profit, and in fact incurs a loss once the ex-ante bidding costs - including the cost of identifying the target - are taken into account.19

Second, the raider may face competition from other bidders as well as from minority shareholders. The raider's bid for the company may alert others to the fact that the company is undervalued. (Management may also invite other bidders - 'white knights' - to make bids and favour these bidders by giving

18 The evidence is consistent with the idea that large shareholders have a mixed role. Morck, Shleifer and Vishny (i 988) find a nonmonotonic relationship between company performance - measured by Tobin's Q - and the fraction of company stock owned by insiders: performance and ownership are positively related in the o to 5 % ownership range; negatively related in the 5 to 25 % ownership range; and (perhaps) positively related beyond 25 % ownership. Barclay and Holderness (I989) investigate the premia at which blocks of large shareholdings are traded. On the basis of these premia, they conclude that large shareholders receive substantial private benefits of control, i.e. the objectives of large shareholders and small shareholders are not (perfectly) aligned.

19 UK takeover law does allow some expropriation of minority shareholders. In particular, a bidder who obtains at least go % of the company's shares in a tender offer has the right to buy the remaining i o % at the tender offer price. This can overcome the free-rider problem in some cases. See Yarrow (i 985). Another way for the raider to make a profit is by earning a capital gain on shares acquired prior to the takeover (although disclosure laws can make a large pre-takeover acquisition difficult). On this, see Shleifer and Vishny (I986).




I995] CORPORATE GOVERNANCE 685

them nonpublic information.) A bidding war may ensue and the company's price may be driven up to close to the full value of v +g. This bidding war reduces the raider's ex-post profit and may cause him to make a loss once the ex-ante bidding costs are taken into account.

Finally, the raider may face competition from incumbent management. By assumption there is slack in the company: the company is not running at maximum efficiency. One strategy is for the manager to take an action to reduce slack after the bid is announced. For example, to the extent that management has built an unprofitable empire, management could sell off some parts of this empire. Or management could take on debt as a way of committing itself not to empire-build in the future (see below). These actions raise the value of the company if the bid fails (to the extent that they cannot easily be reversed), and hence force the raider to pay more to get control. Although shareholders may gain from these actions, the raider's profit is reduced, and, anticipating this, the raider may be deterred from bidding.20

E. Financial Structure The mechanisms discussed so far all involve monitoring or voting by shareholders or their representatives. Another important source of discipline on managers is provided by corporate financial structure - in particular, the company's choice of debt. If a company takes on debt, then this limits how inefficient management can be, at least if management wants to repay its debt. Hencc debt serves as a bonding or commitment device. Debt makes it credible, for example, that management will not expand its empire too much by reinvesting profits unwisely.2' The debt may be put in place by the company's initial owner before the company goes public, or by an active shareholder who intervenes at a later stage, or by management itself in response to the threat of a hostile takeover (see above).

Note that for debt to be an effective source of discipline it must be backed by an appropriate bankruptcy (or insolvency) procedure, i.e. there must be an appropriate 'penalty' in the event of default. A bankruptcy mechanism that is 'soft' on management - e.g. one that, like Chapter i i, keeps creditors at bay for a long period - may have the undesirable property that it reduces management's incentive to avoid default, thus undermining the bonding or disciplinary role of debt.22

It is also worth noting that debt may be a more powerful instrument than an ' ordinary' incentive scheme in constraining management. A typical incentive scheme encourages management to reduce slack by offering it a

20 In the United States, management can also carry out various defensive measures against hostile bidders, e.g. they can implement poison pills or introduce employee stock ownership plans. These measures act as a further deterrent to a raider.

It is interesting to note that the evidence supports the idea that it is hard for a raider to profit from a raid. Bradley, Desai and Kim (I988) find that most of the gains from a successful takeover accrue to shareholders of the target company rather than to the shareholders of the acquiring company (note that this could be because some raiders are themselves empire-builders rather than profit maximisers). See alsojarrell, Brickley and Netter (I988).

21 On the bonding role of debt, see Grossman and Hart (I982) and Jensen (I986). 22 See Aghion, Hart, and Moore (1992).





financial reward - e.g. a capital gain on shares it owns. However, a very large reward may be required to persuade management to give up its empire or, in an extreme case, to relinquish its position altogether. It may be more effective to

force management to give up control if it cannot make a predetermined repayment to claimholders. But this is how debt works.23

V. STATUTORY RULES AND THE CADBURY REPORT

So far we have described various mechanisms for controlling management. However, we have said little about how these mechanisms come into existence or whether they need to be provided by statute.

There is in fact a strong argument that a market economy can achieve efficient corporate governance without government intervention. The argument is a familiar 'Chicago' one. The company's founders have an incentive to choose an efficient corporate governance structure, that is, one that maximises the aggregate return to all claimholders, at the time the company goes public. In particular, they have an incentive to choose selection procedures for the board of directors, the mix of executive and nonexecutive directors, the structure of audit and remuneration committees, disclosure rules concerning takeovers, etc. The reason is that as long as the founders sell their claims in a competitive market they will receive an amount equal to the (net) present value of the returns on all claims. They therefore have an incentive to choose corporate governance rules that maximise total surplus.

According to the Chicago view, then, there is no need for statutory corporate governance rules. In fact, statutory rules are almost certain to be counterproductive since they will limit the founders' ability to tailor corporate governance to their own individual circumstances. The Chicago view, however, leaves out two important considerations: externalities and unforeseen contin- gencies.

To understand the externality argument for statutory rules, consider the controversial question - not considered by Cadbury - of whether boards of UK companies should have a minimum number of worker representatives (as in Germany). According to the Chicago view, if companies function better when there are worker representatives on the board, then it will be in the interest of the company's founders to put worker representatives on the board - no government intervention is required. However, this argument is correct only if workers receive no surplus or rent from working for the company.

Suppose, for example, that the company pays at above-market rates in order to encourage better quality workers to apply for jobs or to elicit higher effort from workers once they are employed.24 Imagine now that the company suffers an adverse demand shock. Then if the board consists entirely of shareholder representatives, it might lay off workers on the grounds that such an action increases profit. However, from a social welfare point of view - that is, taking into account the workers' surplus from remaining with the company - it might

23 For more on this, see Hart (I995). 24 On this, see Stiglitz and Weiss (I98I) and Weiss (I980).

( Royal Economic Society I995



I995] CORPORATE GOVERNANCE 687

be better to keep the workers on. This outcome is more likely to be achieved if the board consists of some worker representatives, who ensure that some weight is put on worker welfare.

The externality argument for worker representatives is not all that persuasive, however. A company creates many types of externalities, and it is far from clear that mandating worker representatives will encourage the company to internalise the right ones. For example, a statutory rule'on worker representatives may discourage a company from setting up in the first place, given that it knows that it may not be able to lay off workers later on in the event of an adverse demand shock. This may convert a situation where workers earn a surplus from the company's operations in the short run into one where they do not earn a surplus at all.

A second argument for a statutory rule concerns the occurrence of 'unforeseen events'. Take the Cadbury recommendation that the roles of the chairman of the board and the chief executive should (usually) be separated. One could imagine that, when many companies were set up, monitoring by the board was less of an issue than it is now, and so no provision in company charters was made for an independent chairman. In the current climate, however, it may be efficient for companies to have an independent chairman. The problem is that in a company with dispersed shareholders, power resides with the board rather than the shareholders and the board may have little incentive to reduce the role of the chief executive - particularly if the board is dominated by executive directors. Thus it is not clear how the transition to a more efficient outcome will occur. In a case like this, it may be p ossible to increase social welfare by passing a law requiring the roles of chairman-and chief executive to be separated.

The trouble with this argument is that it is rarely clear that a particular outcome - in this case, separating the roles of chairman and chief executive - is efficient. Combining the role of the chairman and chief executive may lead to the concentration of power and to bad management in some companies, but, in other companies, such an arrangement may be beneficial. The chief executive may be a talented individual who wields power effectively on behalf of shareholders. Creating a separate chairman's position may increase bureaucracy and also raise corporate expenses since the chairman will receive a (large?) salary. Given that there are costs as well as benefits, a law requiring a separate role for the chairman may reduce social welfare rather than increase it.

Another problem is that it may not be clear that the founders did not foresee changes in the corporate environment. It is almost certainly true that they did not anticipate the exact characteristics of the gos. However, there is plenty of evidence that the founders anticipated that some changes would take place - even if they could not predict exactly what they would be - and put in place mechanisms that would ensure that management, and even corporate governance itself, would respond to these changes. We have discussed how some of these mechanisms work. To give an example, if there are substantial efficiency gains from separating the chief executive and chairman's roles - or ?) Royal Economic Society 1995




for that matter from implementing any of the other Cadbury recommendations - there is an incentive for a (large) shareholder to campaign for a board of directors whose programme would be to implement these changes; or for a raider to take over the company and implement the changes himself. (Faced with this pressure, incumbent managers may choose to carry out the changes of their own accord.)

In view of the above, the case for the government to impose statutory rules on companies on the grounds that 'the world has changed' is not strong. Probably the most the government should do is to follow Cadbury in trying to educate and persuade companies to implement changes, but leave the final decision up to them. In addition it is important that existing corporate governance mechanisms should be allowed to operate freely. From this perspective it is undesirable to interfere with these mechanisms, for example, by making hostile takeovers harder, as is often proposed. Takeovers are potentially one of the most powerful forces for bringing about improvements in corporate governance and management. Any attempt to weaken this mechanism is likely to make corporate governance more rigid, and to worsen company performance in the long run.

VI. CONCLUSIONS

In this article, I have argued that corporate governance issues arise wherever contracts are incomplete and agency problems exist. I went on to describe and evaluate various governance mechanisms in public companies. I also argued that in many cases a market economy can achieve efficient corporate governance by itself.

Two policy implications can be drawn from the analysis. First, the case for statutory rules is weak and so the Cadbury approach of trying to educate and persuade companies to make changes in corporate governance is probably the best one. Second, the Cadbury recommendations should be seen in the context of corporate governance generally. There already exist mechanisms that help to ensure that companies are well managed - such as the takeover mechanism. There is no reason to think that Cadbury is a substitute for these mechanisms. Thus, at the same time that Cadbury is promoted, it is important to ensure that existing mechanisms can operate freely to provide appropriate checks and balances on managerial behaviour.

Harvard University

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