Irrelevance of Governance Structure

We developed a model under which the allocation of control rights between shareholders and managers (“governance structure”) is irrelevant to firm value. In our model, governance structures affect managers’ incentive to invest, as strong governance tightens managerial freedom and weak governance loosens it. Given their respective managerial freedom, multiple firms buy resources for their business activities in a competitive market. Managers differ in their integrity, and given their type, can preserve value, create value, or destroy value and consume private benefits. Shareholders deduce from decisions made by managers whether a manager should be retained or fired. The model shows that independent governance choices of individual firms are interrelated through the feedback from resources markets. In a competitive equilibrium, which is socially efficient, the universe of firms splits between strong and weak governance firms, with all of them having the same value. No firm can change its value by changing from weak to strong governance or vice versa; the governance structure is irrelevant. The irrelevance result has important implications for the study of corporate governance. First, it allows us to explore which relaxed assumptions break the irrelevance result. Second, since shareholders with market power violate the irrelevance conditions, the model provides insights into the consequences of common ownership. It shows that, by pushing more public firms toward strong governance, institutional investors with common ownership create a monopsony power, with negative consequences to the labor market, the inputs market, the investment level in the economy, and the number of firms traded on public markets. Third, the model illuminates the need for empirical studies to specify the conditions under which strong governance is assumed to consistently be better than weak governance.