Formal Model Basics. I denote the level of investor protection as X∈[0,1], with higher values indicating more investor protection. To put this more concretely, consider a Xxxxx-Means corporation – that is, a corporation without a single controlling shareholder - that is run by managers, whose income is derived solely from salary, and owned by shareholders, whose income is derived solely from share price and dividends payments. In this example, all of a firm's income must be allocated to either managerial salaries, dividends payments or reinvestment in productive capital. At low levels of corporate governance, shareholders will have little ability to monitor and potentially sanction managers or directors. In this situation, managers can (and if history is any guide, will) set their salaries at an inefficiently high level at the expense of dividend payments and investment in productive capital, effectively claiming for themselves an unproductively large share of corporate wealth. Under higher levels of corporate governance, shareholders have greater oversight over earnings allocation within the firm. Rather than over-pay themselves, managers will be more incentivized to allocate firm resources towards a mix of managerial salaries, productive capital and dividends payments that maximizes shareholder value. The above obviously refers to corporate governance policies, but a similar story could be told with respect to securities laws that decrease (or increase) insiders abilities to profit through xxxxxxx xxxxxxx, accounting fraud, or a variety of other practices, at the long-term and short-term expense of shareholder value. The dynamic in firm with a single controlling shareholder is similar, though managerial salaries is no longer the most obvious source of contention. Instead, imagine a firm that must decide on a contractor to build a new office building. In the absence of a corporate governance regime that empowers minority shareholders, the corporate board is likely to be stacked with directors that are friendly to the interests of the majority shareholder. Indeed, in the absence of cumulative voting or proportional representation or mandates on the number of independent members on the board, it is likely that all of the directors have been explicitly approved by the controlling shareholder. Now imagine that the majority shareholder also owns an over-priced, uncompetitive construction firm. The directors of the firm, whose job security depends on the approval of the majority sh...
