Implicit Contracts and Dominant Shareholders

This paper presents an efficiency argument that contributes to understand why corporate governance structures with a dominant shareholder are so prevalent in so many countries around the world. In an environment where outsiders cannot accurately monitor the performance of transactions made between firms and stakeholders, the existence of a controlling shareholder who is an insider to the firm’s management allows for efficient contracting with stakeholders. Firms controlled by outside shareholders cannot sustain relationships with stakeholders, because managers of such firms have an incentive to falsely claim that transactions with stakeholders have produced an outcome that is unfavorable to the firm, and misappropriate the cash flows associated with the true outcome. To avoid being expropriated, the controlling party will fire the manager and it will refuse to make good on costly obligations toward the stakeholder, in response to the announcement of an unfavorable outcome. However, because outsiders cannot observe the transaction’s true outcome, punitive actions by outside shareholders will occur even when the manager truthfully reports an unfavorable outcome. Since these misguided disciplinary actions reduce the ex-ante value of transactions to stakeholders, stakeholders only accept doing business with firms controlled by outside investors if the frequency of misguided disciplinary actions is not too high. Thus, where outside shareholders cannot target accurately disciplinary actions to opportunistic managers, insider control is required for efficient contracting with stakeholders. This efficiency benefit of insider control should be taken into account if one wants to explain the prevalence of firms featuring dominant shareholders with a hands-on approach to their firms’ management.