To Have and to Hold

Nearly seven decades have passed since the publication of Adolf Berle and Gardiner Means' The Modern Corporation and Private Property. Yet the question of firm ownership and control still generates an enormous amount of literature and public debate. In 1932, Berle and Means warned that the separation of ownership and control would destroy the economic foundation on which American capitalism was built. They believed that the increasing separation of ownership and control was inherent in capitalist development. Others express concern that a wide variety of tax incentives, antitrust policies, regulations and political pressures, rather than anything inherent in capitalism, would result in strong managers and weak owners.

Little, if any, systematic evidence, however, has been used to investigate the widely held assumption that managerial ownership has declined over time and that its low level is a feature of the modern corporation. Recent research by Randall S. Kroszner, professor of economics at the University of Chicago Graduate School of Business, shows the converse is true. In conjunction with Clifford Holderness of Boston College and Dennis Sheehan of Pennsylvania State University, Kroszner published a study in the April 1999 Journal of Finance called "Were the Good Old Days that Good? Changes in Managerial Stock Ownership Since the Great Depression."

The authors find that managerial ownership of publicly traded firms is higher now than in 1935. The mean percentage of common stock held by a firm's officers and directors as a group rose to 21 percent in 1995 from 13 percent in 1935. Median holdings doubled to 14 percent from 7 percent. While the very largest firms have similar ownership percentages in both periods, a firm-size weighted average also is higher in 1995. In terms of real 1995 dollars, insiders' holdings today are on average four times higher, rising to $73 million from $18 million, and this increase is true across all firm sizes.

Taking the Long View

Since little is known about how governance structures have changed over time and the forces behind those changes, the authors used a long-term comparison to address a number of important issues. They compare a cross section of roughly 1,500 publicly traded U.S. firms in 1935 with a modern benchmark of more than 4,200 exchange-listed firms in 1995.

First, Kroszner and his colleagues document how the characteristics of firms and managers have changed as the economy, the financial system and regulations have changed. They find ownership data to be similarly reported in 1935 and 1995. Although the real average size of publicly traded firms is much larger today, the average size of the top management team and hence, the number of individuals reporting ownership data, has shown little change. In addition, the increase in ownership is not restricted to specific industries but occurs across all industry categories.

Second, the long-term comparison provides the unique opportunity to examine three alternative hypotheses about how the costs and benefits of managerial ownership have changed. Managerial ownership is only one of many mechanisms that can be used to address the agency problem of aligning management's incentives with those of owners. Therefore, the authors examine an alternate hypothesis that greater managerial ownership has been accompanied by less reliance on other methods of corporate control. They find no evidence that insider ownership is substituting for alternative mechanisms, such as incentive-based pay, monitoring by the board, the market for corporate control or product-market competition. These mechanisms all appear to be used at a similar or greater level of intensity today compared with 60 years ago.

The next hypothesis the authors consider is the link between firm performance and the level of managerial ownership. Based on their study, the relationship between insider ownership levels and performance has not significantly changed over time. Shareholders today have no greater incentive than did their counterparts in the 1930s to induce managers to change the amount of stock they hold based on the idea that increased ownership would result in improved performance.

Finally, the authors examine the effects of firm-specific characteristics, such as firm size and regulations, on the level of insider ownership in 1935 and 1995. In both periods, large firms and regulated firms tend to have low insider ownership. Additionally, for both periods, insider ownership declines with firm age.

Changes in Financial Markets

In contrast to the factors mentioned above, the authors do find that the effect of market volatility on managerial ownership is starkly different in 1935 and 1995. The financial markets 60 years ago were more volatile than they are today, which helps explain the lower level of insider ownership in the 1930s.

Financial innovations also have reduced the costs of hedging for both managers and firms. The ability to diversify risks in both human and financial capital is much greater today than in the 1930s. Modern risk-management techniques also can be used to reduce firm risks outside of management's control. This permits performance to be a more precise signal of managerial competence and may enhance the willingness of managers to hold equity in their own firms, according to the authors.

Granted, these developments, coupled with a general decline in volatility, have lowered the costs to managers of holding large equity stakes in their firms. But the lower costs of holding larger stakes may produce a double-edged sword for management discipline.

As managerial ownership increases, there is more pressure on management to enhance performance. Good managers will reap even greater rewards from their efforts, resulting in increased productivity, lower costs and new innovation. High managerial stock ownership, however, can be used to entrench managers and reduce the probability of a takeover. With a more active corporate control market today than 60 years ago, managers may have an incentive to raise their ownership stakes to achieve the same level of protection they once had. Innovations such as executive stock swaps allow managers to maintain voting rights but hedge against movements in their own stock price. In addition, if the corporate control market provides less discipline for the largest firms, this motivation for insiders to hold large equity stakes is reduced in these firms.

The effects of volatility and financial market development on the costs of insider ownership have largely been overlooked in the debates on financial system and corporate governance reforms. Taking this relationship into account is particularly important in emerging and transition economies, where volatility and financial market development may be closer to that of the United States in the early part of the 19th century than it is today.

While it might be easy to look at these emerging markets and decide that increased managerial ownership may be the right course, this is not always the case. As the recent financial crisis in Asia demonstrated, more insider ownership is not necessarily better. There are costs and benefits that need to be weighed and considered.

In the United States, however, the development of financial theories and markets has allowed for more governance options and richer choices. As the authors of this study have proved, the notion that separation of corporate ownership and control has worsened over time is simply not true. The good old days are here to stay.

Randall S. Kroszner is professor of economics at the University of Chicago Graduate School of Business. "Were the Good Old Days that Good? Changes in Managerial Stock Ownership Since the Great Depression" was awarded the Brattle Prize for the best Corporate Finance paper published by the Journal of Finance in 1999.