VOLUME 22 | NUMBER 1 | WINTER 2010 APPLIED CORPORATE FINANCE Journal of A MORGAN STANLEY PUBLICATION In This Issue: Honoring Michael Jensen Baylor University Roundtable on The Corporate Mission, CEO Pay, and Improving the Dialogue with Investors 8 Panelists: Michael Jensen, Harvard Business School; Ron Naples, Quaker Chemical Corporation; Trevor Harris, Columbia University; and Don Chew, Morgan Stanley. Moderated by John Martin, Baylor University. Value Maximization, Stakeholder Theory, and the Corporate Objective Function 32 Michael Jensen, Harvard Business School The Modern Industrial Revolution, Exit, and the Failure of Internal Control Systems 43 Michael Jensen, Harvard Business School Just Say No to Wall Street: Putting a Stop to the Earnings Game 59 Joseph Fuller, Monitor Group, and Michael Jensen, Harvard Business School CEO Incentives—It’s Not How Much You Pay, But How 64 Michael Jensen, Harvard Business School, and Kevin Murphy, University of Southern California Active Investors, LBOs, and the Privatization of Bankruptcy 77 Michael Jensen, Harvard Business School Venture Capital in Canada: Lessons for Building (or Restoring) National Wealth 86 Reuven Brenner, McGill University, and Gabrielle A. Brenner, HEC Montreal How to Tie Equity Compensation to Long-Term Results 99 Lucian Bebchuk and Jesse Fried, Harvard Law School Executive Compensation: An Overview of Research on Corporate Practices and Proposed Reforms 107 Michael Faulkender, Dalida Kadyrzhanova, N. Prabhala, and Lemma Senbet, University of Maryland Promotion Incentives and Corporate Performance: Is There a Bright Side to “Overpaying” the CEO? 119 Jayant Kale, Georgia State University, Ebru Reis, Bentley University, and Anand Venkateswaran, Northeastern University Are Incentives the Bricks or the Building? 129 Ron Schmidt, University of Rochester Journal of Applied Corporate Finance • Volume 22 Number 1 A Morgan Stanley Publication • Winter 2010 43 The Modern Industrial Revolution, Exit, and the Failure of Internal Control Systems 1. This is a shortened version of a paper by the same title that was originally pub- lished in the Journal of Finance (July 1993), which was based in turn on my Presidential Address to the American Finance Association in January 1993. It is reprinted here by permission of the American Finance Association. I wish to express my appreciation for the research assistance of Chris Allen, Brian Barry, Susan Brumeld, Karin Monsler, and particularly Donna Feinberg, the support of the Division of Research of the Harvard Busi- ness School, and the comments of and discussions with George Baker, Carliss Baldwin, Joe Bower, Alfred Chandler, Harry and Linda DeAngelo, Ben Esty, Takashi Hikino, Steve Kaplan, Nancy Koehn, Claudio Loderer, George Lodge, John Long, Kevin Murphy, Mal- colm Salter, Rene Stulz, Richard Tedlow, and, especially, Robert Hall, Richard Hackman, and Karen Wruck. 2. Walter W. Price, We Have Recovered Before! (Harper & Brothers: New York, 1933), p. 6. 3. Donald L., McMurray, Coxey’s Army: A Study of the Industrial Army Movement of 1894 (Little, Brown: Boston, 1929), p. 7. BF undamental technological, political, regulatory, and economic forces are radically changing the worldwide competitive environment. We have not seen such a metamorphosis of the economic landscape since the industrial revolution of the 19th century. e scope and pace of the changes over the past two decades qualify this period as a modern industrial revolution, and I predict it will take decades more for these forces to be worked out fully in the worldwide economy. Although the current and 19th-century transformations of the U.S. economy are separated by almost 100 years, there are striking parallels between them—most notably, rapid technological and organizational change leading to declin- ing production costs and increasing average (but decreasing marginal) productivity of labor. During both periods, moreover, these developments resulted in widespread excess capacity, reduced rates of growth in labor income, and, ultimately, downsizing and exit. e capital markets played a major role in eliminating excess capacity both in the late 19th century and in the 1980s. e merger boom of the 1890s brought about a massive consolidation of independent firms and closure of marginal facilities. In the 1980s, the capital markets helped eliminate excess capacity through leveraged acquisitions, stock buybacks, hostile takeovers, leveraged buyouts, and divisional sales. And much as the takeover specialists of the 1980s were disparaged by managers, policymakers, and the press, their 19th-century counterparts were vilified as “robber barons.” In both cases, the popular reaction against “financiers” was followed by public policy changes that restricted the capital markets. e turn of the century saw the passage of antitrust laws that restricted business combinations; the late 1980s gave rise to re-regulation of the credit markets, antitakeover legisla- tion, and court decisions that all but shut down the market for corporate control. Although the vast increases in productivity associated with the 19th-century industrial revolution increased aggre- gate welfare, the resulting obsolescence of human and physical capital caused great hardship, misunderstanding, and bitter- ness. As noted in 1873 by Henry Ward Beecher, a well-known commentator and influential clergyman of the time: e present period will always be memorable in the dark days of commerce in America. We have had commercial darkness at other times. ere have been these depressions, but none so obsti- nate and none so universal…Great Britain has felt it; France has felt it; all Austria and her neighborhood has experienced it. It is cosmopolitan. It is distinguished by its obstinacy from former like periods of commercial depression. Remedies have no effect. Party confidence, all stimulating persuasion, have not lifted the pall, and practical men have waited, feeling that if they could tide over a year they could get along; but they could not tide over the year. If only one or two years could elapse they could save themselves. e years have lapsed, and they were worse off than they were before. What is the matter? What has happened? Why, from the very height of prosperity without any visible warning, without even a cloud the size of a man’s hand visible on the horizon, has the cloud gathered, as it were, from the center first, spreading all over the sky? 2 Almost 20 years later, on July 4, 1892, the Populist Party platform adopted at the party’s first convention in Omaha reflected continuing unrest while pointing to financiers as the cause of the current problems: We meet in the midst of a nation brought to the verge of moral, political, and material ruin…e fruits of the toil of millions are boldly stolen to build up colossal fortunes for the few, unprecedented in the history of mankind; and the possessors of these in turn despise the republic and endanger liberty. From the same prolific womb of government injustice are bred two great classes of tramps and millionaires. 3 Technological and other developments that began in the mid-20th century have culminated in the past two decades by Michael C. Jensen, Harvard Business School 1 44 Journal of Applied Corporate Finance • Volume 22 Number 1 A Morgan Stanley Publication • Winter 2010 4. For a rare study of exit in the nance literature, see the analysis of the retrenchment of the U.S. steel industry in Harry DeAngelo and Linda DeAngelo, “Union Negotiations and Corporate Policy: A Study of Labor Concessions in the Domestic Steel Industry dur- ing the 1980s,” Journal of Financial Economics 30 (1991), 3–43. See also Pankaj Ghemawat and Barry Nalebuff, “Exit,” Rand Journal of Economics 16 (Summer, 1985), 184–194. For a detailed comparison of U.S. and Japanese retrenchment in the 1970s and early 1980s, see Douglas Anderson, “Managing Retreat: Disinvestment Policy,” in Thomas K. McCraw, ed., America Versus Japan (Harvard Business School Press: Bos- ton, 1986), 337–372. Joseph L. Bower analyzes the private and political responses to decline in the petrochemical industry in When Markets Quake (Harvard Business School Press: Boston, 1986). Kathryn Harrigan presents detailed rm and industry studies in two of her books: Managing Maturing Businesses: Restructuring Declining Industries and Revitalizing Troubled Operations (Lexington Books, 1988) and Strategies for De- clining Businesses (Lexington Books, 1980). 5. Joseph A., Schumpeter, Capitalism, Socialism, and Democracy (Harper Torchbook Edition: New York, 1976), p. 83. 6. This section draws extensively on excellent discussions of the period by Alfred Chan- dler, Thomas McCraw, and Naomi Lamoreux. See the following works by Chandler: “The Emergence of Managerial Capitalism,” Harvard Business School #9–384–081, revised by Thomas J. McCraw, July 1, 1992; Scale and Scope, The Dynamics of Industrial Capital- ism (Harvard University Press, 1990); and The Visible Hand: The Managerial Revolution in American Business (Harvard University Press, 1977). See also Naomi R. Lamoreaux, The Great Merger Movement in American Business, 1895–1904 (Cambridge University Press: Cambridge, England, 1985); and Thomas K. McCraw, “Antitrust: The Perceptions and Re- ality in Coping with Big Business,” Harvard Business School #N9–391–292 (1992), and “Rethinking the Trust Question,” in T. McCraw, ed., Regulation in Perspective (Harvard Uni- versity Press, 1981). 7. McCraw (1981), p. 3. 8. McCraw (1981), p. 3. At the close of the paper, I offer suggestions for reforming U.S. internal corporate control mechanisms. In particular, I hold up several features of venture capital and LBO firms such as Kleiner Perkins and KKR for emulation by large, public companies—notably (1) smaller, more active, and better informed boards; and (2) significant equity ownership by board members as well as managers. I also urge boards and managers to encourage larger holdings and greater participa- tion by people I call “active” investors. The Second Industrial Revolution 6 e Industrial Revolution was distinguished by a shift to capi- tal-intensive production, rapid growth in productivity and living standards, the formation of large corporate hierarchies, overcapacity, and, eventually, closure of facilities. Originating in Britain in the late 18th century, the First Industrial Revolution witnessed the application of new energy sources to methods of production. e mid-19th century saw another wave of massive change with the birth of modern transportation and commu- nication facilities, including the railroad, telegraph, steamship, and cable systems. Coupled with the invention of high-speed consumer packaging technology, these innovations gave rise to the mass production and distribution systems of the late 19th and early 20th centuries—the Second Industrial Revolution. e dramatic changes that occurred from the middle to the end of the century clearly warrant the term “revolution.” Inven- tions such as the McCormick reaper in the 1830s, the sewing machine in 1844, and high-volume canning and packaging devices in the 1880s exemplified a worldwide surge in produc- tivity that “substituted machine tools for human craftsmen, interchangeable parts for hand-tooled components, and the energy of coal for that of wood, water, and animals.” 7 New technology in the paper industry allowed wood pulp to replace rags as the primary input material. Continuous rod rolling transformed the wire industry: within a decade, wire nails replaced cut nails as the main source of supply. Worsted textiles resulting from advances in combing technology changed the woolen textile industry. Between 1869 and 1899, the capital invested per American manufacturer grew from about $700 to $2,000; and, in the period 1889–1919, the annual growth of total factor productivity was almost six times higher than that which had occurred for most of the 19th century. 8 in a similar situation: rapidly improving productivity, the creation of overcapacity, and, consequently, the requirement for exit. Although efficient exit has profound import for productivity and social wealth, research on the topic 4 has been relatively sparse since the 1942 publication of Joseph Schumpeter’s famous description of capitalism as a process of “creative destruction.” In Schumpeter’s words, Every piece of business strategy…must be seen in its role in the perennial gale of creative destruction…e usual theorist’s paper and the usual government commission’s report practically never try to see that behavior…as an attempt by those firms to keep on their feet, on ground that is slipping away from under them. In other words, the problem that is usually being visualized is how capitalism administers existing structures, whereas the relevant problem is how it creates and destroys them. 5 Current technological and political changes are bring- ing the question of efficient exit to the forefront, and the adjustments necessary to cope with such changes will receive renewed attention from managers, policymakers, and researchers in the coming decade. In this paper, I begin by reviewing the industrial revolu- tion of the 19th century to shed light on current economic trends. Drawing parallels with the 1800s, I discuss in some detail worldwide changes driving the demand for exit in today’s economy. I also describe the barriers to efficient exit in the U.S. economy, and the role of the market for corporate control—takeovers, LBOs, and other leveraged restructur- ings—in surmounting those barriers during the 1980s. With the shutdown of the capital markets in the 1990s, the challenge of accomplishing efficient exit has been transferred to corporate internal control systems. With few exceptions, however, U.S. managements and boards have failed to bring about timely exit and downsizing without external pressure. Although product market competition will eventually eliminate overcapacity, this solution generates huge unnecessary costs. (e costs of this solution have now become especially appar- ent in Japan, where a virtual breakdown of the internal control systems, coupled with a complete absence of capital market influence, has resulted in enormous overcapacity—a problem that Japanese companies are only beginning to address.) 45Journal of Applied Corporate Finance • Volume 22 Number 1 A Morgan Stanley Publication • Winter 2010 9. For most of the examples of cost reduction cited in this paragraph, see Chandler (1992), pp. 4–6. 10. Lamoreux (1985), p. i. 11. Measured by multifactor productivity, as reported in Table 3 of U.S. Department of Labor, Bureau of Labor Statistics, 1990, Multifactor Productivity Measures, Report #USDL 91–412. Manufacturing labor productivity also grew at an annual rate of 3.8% in 1981–1990, as compared to 2.3% in the period 1950–1981 (U. S. Department of Labor, 1990, Table 3). By contrast, productivity growth in the overall (or “non-farm”) business sector actually fell from 1.9% in the 1950–1981 period to 1.1% in the 1981– 1990 period (U. S. Department of Labor, 1990, Table 2). The reason for the fall appar- ently lies in the relatively large growth in the service sector relative to the manufacturing sector and the low measured productivity growth in services. But there is considerable controversy over the adequacy of the measurement of productivity in the service sector. For example, the U.S. Department of Labor has no productivity measures for services employing nearly 70% of service workers, including, among others, health care, real estate, and securities brokerage. In addition, many believe that service sector productiv- ity growth measures are downward biased. Service sector price measurements, for ex- ample, take no account of the improved productivity and lower prices of discount outlet clubs such as Sam’s Club. As another example, the Commerce Department measures the output of nancial services as the value of labor used to produce it. Because labor pro- ductivity is dened as the value of total output divided by total labor inputs, it is impos- sible for measured productivity to grow. Between 1973 and 1987, however, total equity shares traded daily grew from 5.7 million to 63.8 million, while employment only dou- bled, thus implying considerably more productivity growth than the zero growth reected in the statistics. 12. Nominal and real hourly compensation, Economic Report of the President, Table B42 (1993). 13. U.S. Department of Labor, Bureau of Labor Statistics, 1991, International Com- parisons of Manufacturing Productivity and Unit Labor Cost Trends, Report #USDL 92–752. 14. U.S. Department of Labor (1990). Trends in U.S. productivity have been contro- versial issues in academic and policy circles in the last decade. One reason, I believe, is that it takes time for these complicated changes to show up in the aggregate statistics. For example, in their recent book Baumol, Blackman, and Wolff changed their formerly pes- simistic position. In their words: “This book is perhaps most easily summed up as a compendium of evidence demonstrating the error of our previous ways The main change that was forced upon our views by careful examination of the long-run data was abandon- ment of our earlier gloomy assessment of American productivity performance. It has been replaced by the guarded optimism that pervades this book. This does not mean that we believe retention of American leadership will be automatic or easy. Yet the statistical evi- dence did drive us to conclude that the many writers who have suggested that the demise of America’s traditional position has already occurred or was close at hand were, like the author of Mark Twain’s obituary, a bit premature It should, incidentally, be acknowl- edged that a number of distinguished economists have also been driven to a similar evaluation ” William Baumol, Sue Anne Beattey Blackman, and Edward Wolff, Produc- tivity and American Leadership (MIT Press, Boston, 1989), pp. ix–x. To appreciate the challenge facing current control systems in light of this change, we must understand more about these general forces sweeping the world economy, and why they are generating excess capacity and thus the requirement for exit. What has generally been referred to as the “decade of the ’80s” in the United States actually began in the early 1970s, with the 10-fold increase in energy prices from 1973 to 1979, and the emergence of the modern market for corpo- rate control and high-yield, non-investment-grade (“junk”) bonds in the mid-1970s. ese events were associated with the beginnings of the ird Industrial Revolution which—if I were to pick a particular date—would be the time of the oil price increases beginning in 1973. The Decade of the ’80s: Capital Markets Provide an Early Response to the Modern Industrial Revolution e macroeconomic data for the 1980s show major produc- tivity gains. In fact, 1981 was a watershed year. Total factor productivity growth in the manufacturing sector more than doubled after 1981, from 1.4% per year in the period 1950- 1981 (including a period of zero growth from 1973-1980) to 3.3% in the period 1981-1990. 11 Over the same period, nomi- nal unit labor costs stopped their 17-year rise, and real unit labor costs declined by 25%. ese lower labor costs came not from reduced wages or employment, but from increased productivity: nominal and real hourly compensation increased by a total of 4.2% and 0.3% per year, respectively, over the 1981-1989 period. 12 Manufacturing employment reached a low in 1983, but by 1989 had experienced a small cumula- tive increase of 5.5%. 13 Meanwhile, the annual growth in labor productivity increased from 2.3% between 1950-1981 to 3.8% between 1981-1990, while a 30-year decline in capi- tal productivity was reversed when the annual change in the productivity of capital increased from -1.0% between 1950- 1981 to 2.0% between 1981-1990. 14 Reflecting these increases in the productivity of U.S. As productivity climbed steadily, production costs and prices fell dramatically. e 1882 formation of the Standard Oil Trust, which concentrated nearly 25% of the world’s kerosene produc- tion into three refineries, reduced the average cost of a gallon of kerosene by 70% between 1882 and 1885. In tobacco, the invention of the Bonsack machine in the early 1880s reduced the labor costs of cigarette production by 98%. e Bessemer process reduced the cost of steel rails by 88% from the early 1870s to the late 1890s, and the electrolytic refining process invented in the 1880s reduced the price of aluminum by 96% between 1888 and 1895. In chemicals, the mass production of synthetic dyes, alkalis, nitrates, fibers, plastics, and film occurred rapidly after 1880. Production costs of synthetic blue dye, for example, fell by 95% from the 1870s to 1886. 9 Such sharp declines in production costs and prices led to widespread excess capacity—a problem that was exacer- bated by the fall in demand that accompanied the recession and panic of 1893. Although attempts were made to elimi- nate excess capacity through pools, associations, and cartels, the problem was not substantially resolved until the capital markets facilitated exit by means of the 1890s’ wave of mergers and acquisitions. Capacity was reduced through consolidation and the closing of marginal facilities in the merged entities. From 1895 to 1904, over 1,800 firms were bought or combined by merger into 157 firms. 10 The Modern Industrial Revolution e major restructuring of the American business community that began in the 1970s and continues in the 1990s is being driven by a variety of factors, including changes in physi- cal and management technology, global competition, new regulation and taxes, and the conversion of formerly closed, centrally planned socialist and communist economies to capi- talism, along with open participation in international trade. ese changes are significant in scope and effect; indeed, they are bringing about the ird Industrial Revolution. 46 Journal of Applied Corporate Finance • Volume 22 Number 1 A Morgan Stanley Publication • Winter 2010 15. As measured by the Wilshire 5,000 index of all publicly held equities. 16. Bureau of the Census, Housing and Household Economic Statistics Division (1991). 17. Business Week Annual R&D Scoreboard, 1991. 18. “Out of the Ivory Tower,” The Economist, February 3, 1990 19. Mergerstat Review, 1991, Merrill Lynch, Schaumburg, Illinois. 20. Martin Lipton, “Corporate Governance: Major Issues for the 1990’s,” Address to the Third Annual Corporate Finance Forum at the J. Ira Harris Center for the Study of Corporate Finance, University of Michigan School of Business, April 6, 1989, p. 2. 21. For a list of such studies, see the Appendix at the end of this article. 22. Measured in 1992 dollars. On average, selling-rm shareholders in all M&A trans- actions in the period 1976–1990 were paid premiums over market value of 41%. An- nual premiums reported by Mergerstat Review (1991, Fig. 5) were weighted by value of transactions in the year for this estimate. In arriving at my estimate of $750 billion of shareholder gains, I also assumed that all transactions without publicly disclosed prices had a value equal to 20% of the value of the average publicly disclosed transaction in the same year, and that they had average premiums equal to those for publicly disclosed transactions. 23. In cases where buyers overpay, such overpayment does not represent an ef- ciency gain, but rather only a wealth transfer from the buying rm’s claimants to those of the selling rm. My method of calculating total shareholder gains effectively assumes that the losses to buyers are large enough to offset all gains (including those of the “raid- ers” whose allegedly massive “paper prots” became a favorite target of the media). 24. A 1992 study by Healy, Palepu, and Ruback estimates the total gains to buying- and selling-rm shareholders in the 50 largest mergers in the period 1979–1984 at 9.1% of the total equity value of both companies. Because buyers in such cases were typically much larger than sellers, such gains are roughly consistent with 40% acquisi- tion premiums. They also nd a strong positive cross-sectional relation between the value change and the operating cash ow changes resulting from the merger. See Paul Healy, Krishna Palepu, and Richard Ruback, “Does Corporate Performance Improve After Mergers?,” Journal of Financial Economics 31, vol. 2 (1992), 135–175. 25. A 1989 study by Laura Stiglin, Steven Kaplan, and myself demonstrates that, contrary to popular assertions, LBO transactions resulted in increased tax revenues to the U. S. Treasury—increases that average about 60% per annum on a permanent basis under the 1986 IRS code. (Michael C. Jensen, Steven Kaplan, Laura Stiglin, “Effects of LBOs on Tax Revenues of the U.S. Treasury,” Tax Notes, Vol. 42, No. 6 (February 6, 1989), pp. 727–733.) The data presented by a study of pension fund reversions reveal that only about 1% of the premiums paid in all takeovers can be explained by reversions of pension plans in the target rms (although the authors of the study do not present this calculation them- selves). (Jeffrey Pontiff, Andrei Shleifer, and Michael S. Weisbach, “Reversions of Excess Pension Assets after Takeovers,” Rand Journal of Economics, Vol. 21, No. 4 (Winter 1990), pp. 600–613.) Joshua Rosett, in analyzing over 5,000 union contracts in over 1,000 listed compa- nies in the period 1973 to 1987, shows that less than 2% of the takeover premiums can be explained by reductions in union wages in the rst six years after the change in con- trol. Pushing the estimation period out to 18 years after the change in control increases the percentage to only 5.4% of the premium. For hostile takeovers only, union wages increase by 3% and 6% for the two time intervals. (Joshua G. Rosett, “Do Union Wealth Concessions Explain Takeover Premiums? The Evidence on Contract Wages,” Journal of Financial Economics, Vol. 27, No. 1 (September 1990), pp. 263–282.) as a whole. Based on this research, 21 my estimates indicate that over the 14-year period from 1976 to 1990, the $1.8 trillion volume of corporate control transactions—that is, mergers, tender offers, divestitures, and LBOs—generated over $750 billion in market value “premiums” 22 for selling investors. Given a reasonably efficient market, such premiums (the amounts buyers are willing to pay sellers over current market values) represent, in effect, the minimum increases in value forecast by the buyers. is $750 billion estimate of total shareholder gains thus neither includes the gains (or the losses) 23 to the buyers in such transactions, nor does it account for the value of efficiency improvements by compa- nies pressured by control market activity into reforming without a visible control transaction. Important sources of the expected gains from takeovers and leveraged restructurings include synergies from combin- ing the assets of two or more organizations in the same or related industries (especially those with excess capacity) and the replacement of inefficient managers or governance systems. 24 Another possible source of the premiums, however, are transfers of wealth from other corporate stakeholders such as employees, bondholders, and the IRS. To the extent the value gains are merely wealth transfers, they do not repre- sent efficiency improvements. But little evidence has been found to date to support substantial wealth transfers from any group, 25 and thus most of the reported gains appear to represent increases in efficiency. Part of the attack on M&A and LBO transactions has been directed at the high-yield (or “junk”) bond market. Besides helping to provide capital for corporate newcomers to compete with existing firms in the product markets, junk bonds also eliminated mere size as an effective takeover deter- rent. is opened America’s largest companies to monitoring and discipline from the capital markets. e following state- industry, the real value of public corporations’ equity more than doubled during the 1980s, from $1.4 to $3 trillion. 15 In addition, real median income increased at the rate of 1.8% per year between 1982 and 1989, reversing the 1.0% per year decline that occurred from 1973 to 1982. 16 Contrary to gener- ally held beliefs, real R&D expenditures set record levels every year from 1975 to 1990, growing at an average annual rate of 5.8%. 17 In one of the media’s few accurate portrayals of this period, a 1990 issue of e Economist noted that from 1980 to 1985, “American industry went on an R&D spending spree, with few big successes to show for it.” 18 Regardless of the gains in productivity, efficiency, and welfare, the 1980s are generally portrayed by politicians, the media, and others as a “decade of greed and excess.” e media attack focused with special intensity on M&A trans- actions, 35,000 of which occurred from 1976 to 1990, with a total value of $2.6 trillion (in 1992 dollars). Contrary to common belief, only 364 of these offers were contested, and of those only 172 resulted in successful hostile takeovers. 19 e popular verdict on takeovers was pronounced by promi- nent takeover defense lawyer Martin Lipton, when he said, e takeover activity in the U.S. has imposed short-term profit maximization strategies on American business at the expense of research, development, and capital investment. is is minimizing our ability to compete in world markets and still maintain a growing standard of living at home. 20 But the evidence provided by financial economists, which I summarize briefly below, is starkly inconsistent with this view. e most careful academic research strongly suggests that takeovers—along with leveraged restructurings prompted (in many, if not most cases) by the threat of takeover—have produced large gains for shareholders and for the economy 47Journal of Applied Corporate Finance • Volume 22 Number 1 A Morgan Stanley Publication • Winter 2010 26. J. Richard Munro, “Takeovers: The Myths Behind the Mystique,” May 15, 1989, published in Vital Speeches, p. 472. 27. See the collection of articles on the “credit crunch” in Vol. 4 No. 1 (Spring 1991) of the Journal of Applied Corporate Finance. 28. I make this case in “Corporate Control and the Politics of Finance,” Journal of Applied Corporate Finance (Summer, 1991), 13–33. See also Karen Wruck, “Financial Distress, Reorganization, and Organizational Efciency,” Journal of Financial Economics 27 (1990), 420–444. 29. Its high of $139.50 occurred on 2/19/91 and it closed at $50.38 at the end of 1992. corporate America, and doing it before the companies faced serious trouble in the product markets. ey were providing, in effect, an early warning system that motivated healthy adjustments to the excess capacity that was building in many sectors of the worldwide economy. Causes of Excess Capacity Excess capacity can arise in at least four ways, the most obvi- ous of which occurs when market demand falls below the level required to yield returns that will support the currently installed production capacity. is demand-reduction scenario is most familiarly associated with recession episodes in the business cycle. Excess capacity can also arise from two types of techno- logical change. e first type, capacity-expanding technological change, increases the output of a given capital stock and organization. An example of the capacity-expanding type of change is the Reduced Instruction Set CPU (RISC) proces- sor innovation in the computer workstation market. RISC processors have brought about a ten-fold increase in power, but can be produced by adapting the current production technology. With no increase in the quantity demanded, this change implies that production capacity must fall by 90%. Of course, such price declines increase the quantity demanded in these situations, thereby reducing the extent of the capacity adjustment that would otherwise be required. Nevertheless, the new workstation technology has dramatically increased the effective output of existing production facilities, thereby generating excess capacity. e second type is obsolescence-creating change—change that makes obsolete the current capital stock and organiza- tion. For example, Wal-Mart and the wholesale clubs that are revolutionizing retailing are dominating old-line depart- ment stores, thereby eliminating the need for much current retail capacity. When Wal-Mart enters a new market, total retail capacity expands, and some of the existing high-cost retail operations must go out of business. More intensive use of information and other technologies, direct dealing with manufacturers, and the replacement of high-cost, restrictive work-rule union labor are several sources of the competitive advantage of these new organizations. Finally, excess capacity also results when many competi- tors simultaneously rush to implement new, highly productive technologies without considering whether the aggregate effects of all such investment will be greater capacity than can be supported by demand in the final product market. e Winchester disk drive industry provides an example. Between 1977 and 1984, venture capitalists invested over $400 million ment by Richard Munro, while Chairman and CEO of Time Inc., is representative of top management’s hostile response to junk bonds and takeovers: Notwithstanding television ads to the contrary, junk bonds are designed as the currency of ‘casino economics’…they’ve been used not to create new plants or jobs or products but to do the opposite: to dismantle existing companies so the players can make their profit…is isn’t the Seventh Cavalry coming to the rescue. It’s a scalping party. 26 As critics of leveraged restructuring have suggested, the high leverage incurred in the 1980s did contribute to a sharp increase in the bankruptcy rate of large firms in the early 1990s. Not widely recognized, however, is the major role played by other, external factors in these bankruptcies. First, the recession that helped put many highly leveraged firms into financial distress can be attributed at least in part to new regulatory restrictions on credit markets such as FIRREA— restrictions that were implemented in late 1989 and 1990 to offset the trend toward higher leverage. 27 And when compa- nies did get into financial trouble, revisions in bankruptcy procedures and the tax code made it much more difficult to reorganize outside the courts, thereby encouraging many firms to file Chapter 11 and increasing the “costs of financial distress.” 28 But, even with such interference by public policy and the courts with the normal process of private adjustment to financial distress, the general economic consequences of financial distress in the high-yield markets have been greatly exaggerated. While precise numbers are difficult to come by, I estimate that the total bankruptcy losses to junk bond and bank HLT loans from inception of the market in the mid-1970s through 1990 amounted to less than $50 billion. (In comparison, IBM alone lost $51 billion—almost 65% of the total market value of its equity—from its 1991 high to its 1992 close.) 29 Perhaps the most telling evidence that losses have been exaggerated, however, is the current condition of the high-yield market, which is now financing record levels of new issues. Of course, mistakes were made in the takeover activity of the 1980s. Indeed, given the far-reaching nature of the restructuring, it would have been surprising if there were none. But the popular negative assessment of leveraged restructuring is dramatically inconsistent with both the empirical evidence and the near-universal view of finance scholars who have studied the phenomenon. In fact, takeover activities were addressing an important set of problems in 48 Journal of Applied Corporate Finance • Volume 22 Number 1 A Morgan Stanley Publication • Winter 2010 ing” movement that still continues to accelerate throughout the world.) Since the oil price increases of the 1970s, we have again seen systematic overcapacity problems in many industries similar to those of the 19th century. While the reasons for this overcapacity appear to differ somewhat among industries, there are a few common underlying causes. Macro Policies. Major deregulation of the American economy (including trucking, rail, airlines, telecommunica- tions, banking, and financial services industries) under President Carter contributed to the requirement for exit in these indus- tries, as did important changes in the U.S. tax laws that reduced tax advantages to real estate development, construction, and other activities. e end of the Cold War has had obvious consequences for the defense industry and its suppliers. In addition, I suspect that two generations of managerial focus on growth as a recipe for success has caused many firms to overshoot their optimal capacity, thus setting the stage for cutbacks. In the decade from 1979 to 1989, Fortune 100 firms lost 1.5 million employees, or 14% of their workforce. 33 Technology. Massive changes in technology are clearly part of the cause of the current industrial revolution and its associated excess capacity. Both within and across indus- tries, technological developments have had far-reaching impact. To give some examples, the widespread acceptance of radial tires (which last three to five times longer than the older bias ply technology and provide better gas mileage) caused excess capacity in the tire industry; the personal computer revolution forced contraction of the market for mainframes; the advent of aluminum and plastic alterna- tives reduced demand for steel and glass containers; and fiber optic, satellite, digital (ISDN), and new compression technologies dramatically increased capacity in telecom- munication. Wireless personal communication such as cellular phones and their replacements promise further to extend this dramatic change. e changes in computer technology, including miniatur- ization, have not only revamped the computer industry, but also redefined the capabilities of countless other industries. Some estimates indicate the price of computing capacity fell by a factor of 1,000 over the last decade. is means that computer production lines now produce boxes with 1,000 times the capacity for a given price. Consequently, comput- ers are becoming commonplace—in cars, toasters, cameras, stereos, ovens, and so on. Nevertheless, the increase in quantity demanded has not been sufficient to avoid overca- pacity, and we are therefore witnessing a dramatic shutdown of production lines in the industry—a force that has wracked in 43 different manufacturers of Winchester disk drives; initial public offerings of common stock infused additional capital in excess of $800 million. In mid-1983, the capital markets assigned a value of $5.4 billion to twelve publicly- traded, venture-capital-backed hard disk drive manufacturers. Yet, by the end of 1984, overcapacity had caused the value assigned to those companies to plummet to $1.4 billion. My Harvard colleagues William Sahlman and Howard Stevenson have attributed this overcapacity to an “investment mania” based on implicit assumptions about long-run growth and profitability “ for each individual company [that,] had they been stated explicitly, would not have been acceptable to the rational investor.” 30 Such “overshooting” has by no means been confined to the Winchester disk drive industry. 31 Indeed, the 1980s saw boom-and-bust cycles in the venture capital market gener- ally, and also in commercial real estate and LBO markets. As Sahlman and Stevenson have also suggested, something more than “investment mania” and excessive “animal spirits” was at work here. Stated as simply as possible, my own analysis traces such overshooting to a gross misalign- ment of incentives between the “dealmakers” who promoted the transactions and the lenders, limited partners, and other investors who funded them. 32 During the mid to late ’80s, venture capitalists, LBO promoters, and real estate develop- ers were all effectively being rewarded simply for doing deals rather than for putting together successful deals. Reform- ing the “contracts” between dealmaker and investor—most directly, by reducing front-end-loaded fees and requiring the dealmakers to put up significant equity—would go far toward solving the problem of too many deals. (As I argue later, public corporations in mature industries face an analogous, though potentially far more costly (in terms of shareholder value destroyed and social resources wasted), distortion of investment priorities and incentives when their managers and directors do not have significant stock ownership.) Current Forces Leading to Excess Capacity and Exit e ten-fold increase in crude oil prices between 1973–1979 had ubiquitous effects, forcing contraction in oil, chemicals, steel, aluminum, and international shipping, among other industries. In addition, the sharp crude oil price increases that motivated major changes to economize on energy had other, longer-lasting consequences. e general corporate re-evalu- ation of organizational processes stimulated by the oil shock led to dramatic increases in efficiency above and beyond the original energy-saving projects. (In fact, I view the oil shock as the initial impetus for the corporate “process re-engineer- 30. See William A. Sahlman and Howard H. Stevenson, “Capital Market Myopia,” Journal of Business Venturing 1 (1985), p. 7. 31. Or to the 1980s. There is evidence of such behavior in the 19th century, and in other periods of U.S. history. 32. Stated more precisely, my argument attributes overshooting to “incentive, infor- mation, and contracting” problems. For more on this, see Jensen (1991), cited in note 27, pp. 26–27. For some supporting evidence, see Steven N. Kaplan and Jeremy Stein, 1993, “The Evolution of Buyout Pricing and Financial Structure in the 1980s, Quarterly Journal of Economics 108, no. 2, 313–358. For a shorter, less technical version of the same article, see Vol. 6 No. 1 (Spring 1993) of the Journal of Applied Corporate Fi- nance. 33. Source: Compustat. 49Journal of Applied Corporate Finance • Volume 22 Number 1 A Morgan Stanley Publication • Winter 2010 of organizations where they have been successfully imple- mented throughout the world. Some experts argue that such new management techniques can reduce defects and spoilage by an order of magnitude. ese changes in managing and organizing principles have contributed significantly to the productivity of the world’s capital stock and economized on the use of labor and raw materials, thus also contributing to excess capacity. Globalization of Trade. Over the last several decades, the entry of Japan and other Pacific Rim countries such as Hong Kong, Taiwan, Singapore, ailand, Korea, Malaysia, and China into worldwide product markets has contributed to the required adjustments in Western economies. And competi- tion from new entrants to the world product markets promises only to intensify. With the globalization of markets, excess capacity tends to occur worldwide. e Japanese economy, for example, is currently suffering from enormous overcapacity caused in large part by what I view as the “breakdown” of its corporate control system. 36 As a consequence, Japan now faces a massive and long overdue restructuring—one that includes the prospect of unprecedented (for Japanese companies) layoffs, a pronounced shift of corporate focus from market share to profitability, and even the adoption of pay-for-performance executive compensation contracts (something heretofore believed to be profoundly “un-Japanese”). Yet even if the requirement for exit were isolated in just Japan and the U.S, the interdependency of today’s world economy would ensure that such overcapacity would have global implica- tions. For example, the rise of efficient high-quality producers of steel and autos in Japan and Korea has contributed to excess capacity in those industries worldwide. Between 1973 and 1990, total capacity in the U.S. steel industry fell by 38% from 157 to 97 million tons, and total employment fell over 50% from 509,000 to 252,000 (and had fallen further to 160,000 by 1993). From 1985 to 1989 multifactor productivity in the industry increased at an annual rate of 5.3%, as compared to 1.3% for the period 1958 to 1989. 37 Revolution in Political Economy. e rapid pace of the development of capitalism, the opening of closed econo- IBM as a high-cost producer. A change of similar magni- tude in auto production technology would have reduced the price of a $20,000 auto in 1980 to under $20 today. Such increases in capacity and productivity in a basic technology have unavoidably massive implications for the organization of work and society. Fiber-optic and other telecommunications technologies such as compression algorithms are bringing about similarly vast increases in worldwide capacity and functionality. A Bell Laboratories study of excess capacity indicates, for example, that, given three years and an additional expenditure of $3.1 billion, three of AT&T’s new competitors (MCI, Sprint, and National Telecommunications Network) would be able to absorb the entire long-distance switched service that was supplied by AT&T in 1990. 34 Organizational Innovation. Overcapacity can be caused not only by changes in physical technology, but also by changes in organizational practices and management technology. The vast improvements in telecommunications, includ- ing computer networks, electronic mail, teleconferencing, and facsimile transmission are changing the workplace in major ways that affect the manner in which people work and interact. It is far less valuable for people to be in the same geographical location to work together effectively, and this is encouraging smaller, more efficient, entrepreneurial organizing units that cooperate through technology. 35 is in turn leads to even more fundamental changes. rough competition, “virtual organizations”—networked or transi- tory organizations in which people come together temporarily to complete a task, then separate to pursue their individual specialties—are changing the structure of the standard large bureaucratic organization and contributing to its shrinkage. Virtual organizations tap talented specialists, avoid many of the regulatory costs imposed on permanent structures, and bypass the inefficient work rules and high wages imposed by unions. In so doing, they increase efficiency and thereby further contribute to excess capacity. In addition, Japanese management techniques such as total quality management, just-in-time production, and flexi- ble manufacturing have significantly increased the efficiency 34. Federal Communications Commission, Competition in the Interstate Interex- change Marketplace, FCC 91–251 (Sept. 16, 1991), p. 1140. 35. The Journal of Financial Economics, which I have been editing with several oth- ers since 1973, is an example. The JFE is now edited by seven faculty members with ofces at three universities in different states, and the main editorial administrative ofce is located in yet another state. The publisher, North Holland, is located in Amsterdam, the printing is done in India, and mailing and billing is executed in Switzerland. This “networked organization” would have been extremely inefcient two decades ago without fax machines, high-speed modems, electronic mail, and overnight delivery services. 36. A collapse I predicted in print as early as 1989. (See Michael C. Jensen, “Eclipse of the Public Corporation,” Harvard Business Review, Vol. 89, No. 5 (September-Octo- ber, 1989), pp. 61–74.) In a 1991 article published in this journal, I wrote the following: “As our system has begun to look more like the Japanese, the Japanese economy is undergoing changes that are reducing the role of large active investors and thus making their system resemble ours. With the progressive development of U.S like capital markets, Japanese managers have been able to loosen the controls once exercised by the banks. So successful have they been in bypassing banks that the top third of Japanese companies are no longer net bank borrowers. As a result of their past success in product market competition, Japa- nese companies are now “ooded” with free cash ow. Their competitive position today reminds me of the position of American companies in the late 1960s. And, like their U.S. counterparts in the 60s, Japanese companies today appear to be in the process of creat- ing conglomerates. My prediction is that, unless unmonitored Japanese managers prove to be much more capable than American executives of managing large, sprawling organizations, the Japa- nese economy is likely to produce large numbers of those conglomerates that U.S. capi- tal markets have spent the last 10 years trying to pull apart. And if I am right, then Japan is likely to experience its own leveraged restructuring movement.” (“Corporate Control and the Politics of Finance,” Journal of Applied Corporate Finance, Vol. 4 No. 2, p. 24, fn. 47.) For some interesting observations attesting to the severity of the Japanese overinvest- ment or “free cash ow” problem, see Carl Kester, “The Hidden Costs of Japanese Suc- cess,” Journal of Applied Corporate Finance (Volume 3 Number 4, Winter 1990). 37. See James D. Burnham, Changes and Challenges: The Transformation of the U.S. Steel Industry, Policy Study No. 115 (Center for the Study of American Business, Wash- ington University: St. Louis, 1993), Table 1 and p. 15. 50 Journal of Applied Corporate Finance • Volume 22 Number 1 A Morgan Stanley Publication • Winter 2010 important role in forcing managers to address this problem. In the absence of capital market pressures, competition in product markets will eventually bring about exit. But when left to the product markets, the adjustment process is greatly protracted and ends up generating enormous additional costs. is is the clear lesson held out by the most recent restructuring of the U.S. auto industry— and it’s one that many sectors of the Japanese economy are now experiencing firsthand. The Difculty of Exit The Asymmetry Between Growth and Decline Exit problems appear to be particularly severe in companies that for long periods enjoyed rapid growth, commanding market positions, and high cash flow and profits. In these situations, the culture of the organization and the mindset of managers seem to make it extremely difficult for adjust- ment to take place until long after the problems have become severe and, in some cases, even unsolvable. In a fundamen- tal sense, there is an “asymmetry” between the growth stage and the contraction stage in the corporate life cycle. Finan- cial economists have spent little time thinking about how to manage the contracting stage efficiently or, more important, how to manage the growth stage to avoid sowing the seeds of decline. In industry after industry with excess capacity, managers fail to recognize that they themselves must downsize; instead they leave the exit to others while they continue to invest. When all managers behave this way, exit is significantly delayed at substantial cost of real resources to society. e tire industry is an example. Widespread consumer acceptance of radial tires meant that worldwide tire capacity had to shrink by two thirds (because radials last 3 to 5 times longer than bias ply tires). Nonetheless, the response by the managers of individual companies was often equivalent to: “is business is going through some rough times. We must invest so that we will have a chair when the music stops.” The Case of Gencorp. William Reynolds, Chairman and CEO of GenCorp, the maker of General Tires, illustrates this reaction in his 1988 testimony before the U.S. House Committee on Energy and Commerce: e tire business was the largest piece of GenCorp, both in terms of annual revenues and its asset base. Yet General Tire was not GenCorp’s strongest performer. Its relatively poor earnings performance was due in part to conditions affecting all of the tire industry… In 1985 worldwide tire manufacturing capacity substantially exceeded demand. At the same time, due to a series of technological improvements in the design of tires and the materi- als used to make them, the product life of tires had lengthened significantly… e economic pressure on our tire business was substantial. Because our unit volume was far below others in the industry, we had less competitive flexibility… We made several moves to improve our competitive position: We increased our invest- mies, and the dismantling of central control in communist and socialist states is occurring in various degrees in Eastern Europe, China, India, Indonesia, other Asian economies, and Africa. In Asia and Africa alone, this development will place a potential labor force of almost a billion people— whose current average income is less than $2 per day—on world markets. e opening of Mexico and other Latin American countries and the transition of some socialist Eastern European economies to open capitalist systems could add almost 200 million more laborers with average incomes of less than $10 per day to the world market. To put these numbers into perspective, the average daily U.S. income per worker is slightly over $90, and the total labor force numbers about 117 million, and the European Economic Community average wage is about $80 per day with a total labor force of about 130 million. e labor forces that have affected world trade extensively in the last several decades (those in Hong Kong, Japan, Korea, Malaysia, Singa- pore, and Taiwan) total about 90 million. While the changes associated with bringing a potential 1.2 billion low-cost laborers onto world markets will significantly increase average living standards throughout the world, they will also bring massive obsolescence of capital (manifested in the form of excess capacity) in Western economies as the adjustments sweep through the system. Such adjustments will include a major redirection of Western labor and capital away from low-skilled, labor-intensive industries and toward activities where they have a comparative advantage. While the opposition to such adjustments will be strong, the forces driving them will prove irresistible in this day of rapid and inexpensive communication, transportation, miniaturization, and migration. One can also confidently forecast that the transition to open capitalist economies will generate great conflict over international trade as special interests in individual countries try to insulate themselves from competition and the required exit. And the U.S., despite its long-professed commitment to “free trade,” will prove no exception. Just as U.S. managers and employees demanded protection from the capital markets in the 1980s, some are now demanding protection from inter- national competition in the product markets, generally under the guise of protecting jobs. e dispute over NAFTA is but one general example of conflicts that are also occurring in the steel, automobile, computer chip, computer screen, and textile industries. It would not even surprise me to see a return to demands for protection from domestic competition. is is currently happening in the deregulated airline industry, an industry faced with significant excess capacity. e bottom line, then, is that with worldwide excess capac- ity and thus greater requirement for exit, the strains put on the internal control mechanisms of Western corporations are likely to worsen for decades to come. e experience of the U.S. in the 1980s demonstrated that the capital markets can play an 51Journal of Applied Corporate Finance • Volume 22 Number 1 A Morgan Stanley Publication • Winter 2010 losing capacity—situations that illustrate vividly what I call the “agency costs of free cash flow.” 40 Contracting Problems Explicit and implicit contracts in the organization can become major obstacles to efficient exit. Unionization, restrictive work rules, and lucrative employee compensation and bene- fits are other ways in which the agency costs of free cash flow can manifest themselves in a growing, cash-rich organiza- tion. Formerly dominant firms became unionized in their heyday (or effectively unionized in organizations like IBM and Kodak) when managers spent some of the organization’s free cash flow to buy labor peace. Faced with technical inno- vation and worldwide competition—often from new, more flexible, and non-union organizations—these dominant firms have not adjusted quickly enough to maintain their market dominance. Part of the problem is managerial and organi- zational defensiveness that inhibits learning and prevents managers from changing their model of the business. Implicit contracts with unions, other employees, suppli- ers, and communities add to formal union barriers to change by reinforcing organizational defensiveness and delaying change long beyond the optimal time—often even beyond the survival point for the organization. While casual breach of implicit contracts will destroy trust in an organization and seriously reduce efficiency, all organizations must retain the flexibility to modify contracts that are no longer optimal. 41 In the current environment, it takes nothing less than a major shock to bring about necessary change. The Role of the Market for Corporate Control The Four Control Forces Operating on the Corporation ere are four basic control forces bearing on the corporation that act to bring about a convergence of managers’ decisions with those that are optimal from society’s standpoint. ey are (1) the capital markets, (2) the legal, political, and regu- latory system, (3) the product and factor markets, and (4) the internal control system headed by the board of directors. e capital markets were relatively constrained by law and regulatory practice from about 1940 until their resurrection through hostile tender offers in the 1970s. Prior to the 1970s, capital market discipline took place primarily through the proxy process. e legal/political/regulatory system is far too blunt an instrument to handle the problems of wasteful managerial ment in research and development. We increased our involvement in the high performance and light truck tire categories, two market segments which offered faster growth opportunities. We developed new tire products for those segments and invested heavily in an aggressive marketing program designed to enhance our presence in both markets. We made the difficult decision to reduce our overall manufacturing capacity by closing one of our older, less modern plants… I believe that the General Tire example illustrates that we were taking a rational, long-term approach to improving GenCorp’s overall performance and shareholder value… Like so many U.S. CEOs, Reynolds then goes on to blame the capital markets for bringing about what he fails to recognize is a solution to the industry’s problem of excess capacity: As a result of the takeover attempt…[and] to meet the principal and interest payments on our vastly increased corpo- rate debt, GenCorp had to quickly sell off valuable assets and abruptly lay off approximately 550 important employees. 38 Without questioning the genuineness of Reynolds’ concerns about his company and employees, it neverthe- less now seems clear that GenCorp’s increased investment was neither going to maximize the value of the firm nor to be a socially optimal response in a declining industry with excess capacity. In 1987, GenCorp ended up selling its General Tire subsidiary to Continental AG of Hannover, thus furthering the process of consolidation necessary to reduce overcapacity. Information Problems Information problems hinder exit because the high-cost capacity in the industry must be eliminated if resources are to be used efficiently. Firms often do not have good information about their own costs, much less the costs of their competi- tors. us, it is sometimes unclear to managers that they are the high-cost firm that should exit the industry. 39 But even when managers do acknowledge the require- ment for exit, it is often difficult for them to accept and initiate the shutdown. For the managers who must imple- ment these decisions, shutting plants or liquidating the firm causes personal pain, creates uncertainty, and interrupts or sidetracks careers. Rather than confronting this pain, manag- ers generally resist such actions as long as they have the cash flow to subsidize the losing operations. Indeed, firms with large positive cash flow will often invest in even more money- 38. A. William Reynolds, in testimony before the Subcommittee on Oversight and Investigations, U.S. House Committee on Energy and Commerce, February 8, 1988. 39. Total quality management programs strongly encourage managers to benchmark their rm’s operations against the most successful worldwide competitors, and good cost systems and competitive benchmarking are becoming more common in well-managed rms. 40. Briey stated, the “agency costs of free cash ow” means the loss in value caused by the tendency of managements of large public companies in slow growth industries to reinvest corporate cash ow in projects with expected returns below the cost of capital. See Michael Jensen, “The Agency Costs of Free Cash Flow: Corporate Finance and Take- overs,” American Economic Review 76, no. 2 (May, 1986), 323–329. 41. Much press coverage and ofcial policy seems to be based on the notion that all implicit contracts should be immutable and rigidly enforced. But while I agree that the security of property rights and the enforceability of contracts are essential to the growth of real output and efciency, it is also clear that, given unexpected and unforeseeable events, not all contracts, whether explicit or implicit, can (or even should) be fullled. (For example, bankruptcy is essentially a state-supervised system for breaking (or, more politely, rewriting) explicit contracts that have become unenforceable. All developed economies devise such a system.) Implicit contracts, besides avoiding the costs incurred in the writing process, provide the opportunity to revise the obligation if circumstances change; presumably, this is a major reason for their existence. [...]... Effective Control Mechanism The problems with corporate internal control systems start with the board of directors The board, at the apex of the internal control system, has the final responsibility for the functioning of the firm Most important, it sets the rules of the game for the CEO The job of the board is to hire, fire, and compensate the CEO, and to provide high-level counsel Few boards in the past... Unfortunately, by the time product and factor market disciplines take effect, large amounts of investor capital and other social resources have been wasted, and it can often be too late to save much of the enterprise Which brings us to the role of corporate internal control systems and the need to reform them As stated earlier, there is a large and growing body of studies documenting the shareholder... the sale of slightly (say, 10%) in -the- money stock options.53 By requiring significant out -of- pocket contributions by managers and directors, and by having the exercise price of the options rise every year at the firm’s cost of capital, Stewart’s plan helps overcome the “free option” aspect (or lack of downside risk) that limits the effectiveness of standard corporate option plans It also removes the. .. component of board failure The great emphasis on politeness and courtesy at the expense of truth and frankness in boardrooms is both a symptom and cause of failure in the control system CEOs have the same insecurities and defense mechanisms as other human beings; few will accept, much less seek, the monitoring and criticism of an active and attentive board The following example illustrates the general problem... should be the CEO; insiders other than the CEO can be regularly invited to attend board meetings in an unofficial capacity Indeed, board members should be given regular opportunities to meet with and observe executives below the CEO—both to expand their knowledge of the company and CEO succession candidates, and to increase other top-level executives’ exposure to the thinking of the board and the board... payout policies, and the control and governance system After the transaction, the company has a different financial policy and control system, but essentially the same managers and the same assets Leverage increases from about 18% of value to 90%, there are large payouts to prior shareholders, and equity becomes concentrated in the hands of managers and the board (who own about 20% and 60%, on average,... in 1988.47 The Failure of Corporate Internal Control Systems With the shutdown of the capital markets as an effective mechanism for motivating change, exit, and renewal, we are left to depend on the internal control system to act to preserve purchase of the Armstrong Tire Company By 1991, Goodyear was the only remaining major American tire manufacturer Yet it too faced challenges in the control market:... the board process The CEO as Chairman of the Board It is common in U.S corporations for the CEO also to hold the position of Chairman of the Board The function of the Chairman is to run board meetings and oversee the process of hiring, firing, evaluating, and compensating the CEO Clearly, the CEO cannot perform this function apart from his or her personal interest Without the direction of an independent... prior to the buyout Thus, the buyout laid the groundwork for the efficient reduction of capacity and resources by one of the major firms in the industry The recent sharp declines in the stock prices of RJR and Philip Morris are signs that there is much more downsizing to come The era of the control market came to an end, however, in late 1989 and 1990 Intense controversy and opposition from corporate... labor, reduced growth rates of labor income, excess capacity, and the requirement for downsizing and exit Events of the last two decades indicate that corporate internal control systems have failed to deal effectively with these changes, especially excess capacity and the requirement for exit The corporate control transactions of the 1980s—mergers and acquisitions, LBOs, and other leveraged recapitalizations—represented . Stakeholder Theory, and the Corporate Objective Function 32 Michael Jensen, Harvard Business School The Modern Industrial Revolution, Exit, and the Failure of Internal Control Systems 43 Michael Jensen, . 1979, and the emergence of the modern market for corpo- rate control and high-yield, non-investment-grade (“junk”) bonds in the mid-1970s. ese events were associated with the beginnings of the. executives below the CEO—both to expand their knowledge of the company and CEO succession candi- dates, and to increase other top-level executives’ exposure to the thinking of the board and the board