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Joumal of Financial Economics 20 (1988) 3-24. Norii-Holland Michael C. JENSEN G.&v@u 4 Rochester, Rochester, NY 14627, USA Hanwui h&ess Mtod Basttq MA 02165 USA Jerold B. WABNEB Univ&q 4 Rtndm, Rocker, NY 14627, USA ‘IhisarticlesurveysthcseverrrCenpapersinthisspccialissueof~Jwunnt~~~~~iu~ f%unomics. and reiated work. The majorlindiqs are: (I) patterns of stock ownershipby insiders and outsiders can influence fnaq@al behavior,corporate performance, and stockwder voting in election contests; (2) corporate leverage, inside stock ownershipby managen, and the control market are interrela~, (3) dqsrtms from one &are/one vote affect firm value and efikiency; (4)talreoverresistancethroughdefeasive~~arpoisonpinptavisioasisassodatedwith declines in share price; and (5) top management turnover is inversely related to share price perpor-. This special issue of the Journal of Financial Economics contains seventeen papers presented at the Conference on the Distribution of Power Among Corporate Managers, Shareholders, and Directors. The conference was joint!y sponsored by the Managerial Economics Research Center and the JOT of Finuncid Economics, and held at the University of Rochester on May 28-30, 1987. This article highlights new insights from these papers and other recent work in the area -.I suggests directions for future research. Understanding the behavior of the corporate organ&a&onrequires deeper knowledge of its governance and the factors that determine the dlytribution of power among corporate managers, shareholders, and directors. The papers in this volume add considerably to the scientific framework for [email protected] issues of corporate governance that have arisen recently in the courts, the regulatory sector, and the deliberations of corporate boards. These issues in&de: (1) the mix and ownership distribution c..f the fhm’s 6nancial claims, (2) the effects of *This research is supported by the Managerial Exmomics Research Center, University of Rochester, the Division of Research, Harvard Business school, a& the John M. Olin Foundation. We are grateful for helpful commcats from James Bric&y, Harry DeAngelo, Linda DeAngelo, Oliver Hz% CXfford Holdemess, John Long, Richard Ruback, G. William Schwert, Clifford Smith, Michael Weisbach,Toni Wolcott,and Karen Wruck. 03@UO5X/88/$3.500 1988, Elwier Science F-ublisbers B.V. (North-Hotlaud)
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Page 1: Michael C. JENSEN Jerold B. WABNEB papers presented at the ...

Joumal of Financial Economics 20 (1988) 3-24. Norii-Holland

Michael C. JENSEN G.&v@u 4 Rochester, Rochester, NY 14627, USA Hanwui h&ess Mtod Basttq MA 02165 USA

Jerold B. WABNEB Univ&q 4 Rtndm, Rocker, NY 14627, USA

‘IhisarticlesurveysthcseverrrCenpapersinthisspccialissueof~Jwunnt~~~~~iu~ f%unomics. and reiated work. The major lindiqs are: (I) patterns of stock ownership by insiders and outsiders can influence fnaq@al behavior, corporate performance, and stockwder voting in election contests; (2) corporate leverage, inside stock ownership by managen, and the control market are interrela~, (3) dqsrtms from one &are/one vote affect firm value and efikiency; (4)talreoverresistancethroughdefeasive~~arpoisonpinptavisioasisassodatedwith declines in share price; and (5) top management turnover is inversely related to share price perpor-.

This special issue of the Journal of Financial Economics contains seventeen papers presented at the Conference on the Distribution of Power Among Corporate Managers, Shareholders, and Directors. The conference was joint!y sponsored by the Managerial Economics Research Center and the JOT of Finuncid Economics, and held at the University of Rochester on May 28-30, 1987. This article highlights new insights from these papers and other recent work in the area -.I suggests directions for future research.

Understanding the behavior of the corporate organ&a&on requires deeper knowledge of its governance and the factors that determine the dlytribution of power among corporate managers, shareholders, and directors. The papers in this volume add considerably to the scientific framework for [email protected] issues of corporate governance that have arisen recently in the courts, the regulatory sector, and the deliberations of corporate boards. These issues in&de: (1) the mix and ownership distribution c..f the fhm’s 6nancial claims, (2) the effects of

*This research is supported by the Managerial Exmomics Research Center, University of Rochester, the Division of Research, Harvard Business school, a& the John M. Olin Foundation. We are grateful for helpful commcats from James Bric&y, Harry DeAngelo, Linda DeAngelo, Oliver Hz% CXfford Holdemess, John Long, Richard Ruback, G. William Schwert, Clifford Smith, Michael Weisbach, Toni Wolcott, and Karen Wruck.

03@UO5X/88/$3.500 1988, Elwier Science F-ublisbers B.V. (North-Hotlaud)

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4 MC. Jensen 4nd.f.B. Wmer, Power andgowmance in corporations

&e capital and takeover markets on f&n behavior and effitiency, (3) the voting fi&ts of ~~OII sham, (4) antitakeover provisions such as poison pills, and (5) top management changes and internal controls. The papers present a mix of theoretical and empirical work and reflect the intense interest among financial economists in the inner workings of corporations. Key points from these papers are:

(11 Share owmmhipcan~an important source of incentives for manage- ment, boards of directors, and outside blockholders. The pattern and amount of stock ownership influence managezial behavior, corporate per- forman= and stockholder voting patterns in election CoILtests. In ad- dit,ion,a fi.&~charactcaisticseaninti~its ownershipstru~ture.The data suggest that for some firms the amount of ownership by inside or outside blockholders is economically signifies. T%e precise effects of stockholdings by managers. outside blockholdeq and institutions are not well understood, however, and the interrelations between. ownership, 6.rm characteristics, and oqorate performance require further investigation.

(2) Manage&l share ownership and control of voting rights inknce a firm’s attractiveness as a tie~ver target, as does the debt/equity ratio. ManageA talcmver resistance takes many form!$ including changes in capital and owwship shucture that decrease the probability of a suazss- fill takeover.

(3) How common stock voting rights are specified also intluenm corporate behavior and shareholder wealth. Theoretical analysis indicates that in certain situations dv f’rom one share/one vote can krease km value by enabling shareholders to capture the benefits of control from the winning b-;dder in a control contest. Under such governance rules, how- ever, *the best management team is less likely tu win control, and this reduces 6XOllOIIliG &ciaq. Empirica evidence f&n Crms recently abandoning one share/one vote indicates such changes decrease value. Explanations of the conflicts between the theory and evidence await furtherreSarch.

(4) Evidence on management actions taken to forestall takeovers & iu~n- &tent with the view that management always acts in shareholders’ inter- est. Share prices decline on target-lrrauager announcements of defensive restructurings in response to hostile takeovers and on announcement of poison-pill antitakeover measures.

(5) Top management turnover is negatively related to share-price perfor- mance. Turnover is not highly sensitive to share performance, however, and only performance that is extreme infiuences the likelihood of a management change. Several internal monitoring mechanisms appear to be at *work, and the turnover/performauw relation is stronger if the board is dominated by the outsiders.

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M. C. Jensen and J. B. Warner, Power and gooemmce iti coqwrutions 5

2. chporate owamship stNcture

Badcg~~4 - The idea that general characteristics of a &m’s ownership stnnctwe and financial claims fan a8i’ect its ~~~MIIWNX is reviving increasing attention ia the Glance profession. Mod$iani and Miller’s (1958) &,&c paper demonstrated that the value of a fim with given cash flows is invariant

to its debt/equity ratio in the abscmx of taxes. Extensions of their pA”ogclsi- tions [see Jensen and Smith (1984) for a surveyb incorporating variables SU& as taxes, banlrrarptcy costs, and agency costs, indicate that the mix of financial claims (imAuding debt and equity) affects the value of the firm because changes in the mix change the fim?s total msh flows,

In addition, both the distribution of 6nancial claims and the distribution of votes can affect 6rm perfo~rmance and therefore value. For example, Jensen and kkkling (1976) argue that managers perform better the greater their ownership stake in the fhm. Managerial kentives are also afkcted by debt [Grossman and Hart (1982), Jensen (1986a, b)k so firm vaiue will depend on capital struetme as well as inside stock ownership by managezs. Ownership concentration is also the focus of work by Shleik and Viiy (1986) and Wruck (1988); Demsetz (1983) and Demsetz and Lehn (1985) treat omership concentration zs an equilibrium response to a &u’s operating characteristics. Camey (1987) zmlyzes how the agency mts associated with mordinating the actions of coinvestors are atkcted by the distibution of shareho@ings, capital structure, and contracting devices such as supermajority rules. Voting rights are analyzed by Easterbrook and Fischel (1983), DeAngelo and DeAngel (1985), Lease, McCo~eli, and Mikkelson (1983,19&I), and Bhagat and Brickley (1984). Furthermore, there is extensive empirical evidence already in i31e literature indicating that changes in leverage and ownership concentration are associated with substantial changes in shareholder wealth [see Smith (1986)].

Evidence on share ownemhip - Table 1 summarixes recent evidence on ownership of corporate common stock from a variety of studies. For large [e.g., Fortune 508 or New York Stock Exchange (NYSE)-listed fums], on average the largest shareholder holds 15.4% of the shares. 8~ average, the board of directors holds 10.6% the chairman and president jointly hold.3.7%, the CEO holds 2.48, institutions hold over 19.1% and for 25.7% of firms the largest sharebolder is an institution. Median ownership fines ~;e Ljpicahy lower, however, particularly for insider holdings. For example, Jensen and Murphy (1988) show that while the average CEO holding is 2.4% of his fitm’s stock, the median holding is only 0.2% and 80% of CEOs hold less than 1.4%. Nevertheless, the data suggest that ownership in at least some firms is su&iently concentrated to be important to our understanding of corporate behavior. Moreover, although the benchmark for gauging the importance of firm ownership is not obvious, managers’ ownership stake represents the bulk

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6 hf. C. Jensen and J. B. WmerD Power and gouemance in copwatitxu

Mean

Table I

ad m&&n gercennq owne+$ of !h 5 comman stock by insiders and institutions from studies of various samples in diKerent subperiods in the inten& l98&1985.

Percentage of common stock &Id by: -. Largest shrehcIdera Five largest &areholdersb Board of directors= Board of directors plpls oficersd Chairman and presidente CEO’

1 instituti\Xls Bricklev Lease &nit@ P0lmdi

Investment counsel firmsd Banksd Mutual fmdsd

Mm I$) Median (S)

15.4 NR 24.8 NR 10.6 3.4 10.1

;:: ii? 0.2

32.9 33.9 19.1 NR 6.2 4.7 5.9 4.5 3.4 1.9

Identity of largest shareholdera %offirms

Family represented on board Pe!ISiOS a!Id ptit-b& plans IIlStitUtiOKk

Firm or family holdiq company not represented @!I kwrd

NR-notrepotted.

32.7 19.7 25.7

21.9 --

All references to artisles in this volume are in boldface. “Skif~r and VUny (1986, p_ 462). Sampic. 4 6 Forttme 500 tirms based on the data from

: Fo;rtwe 500, compiled for December 1980. from Corporate Data Exshange Stock (1980). and ForMle 500 (1981).

une 500 firms based on the data from 500, compikd for December 1980.

A3, A.4). Sample: 191 !irms proposing antitakover

6). Sample: 208 New York Stock Exchange ihs in 1980. 988, table 4). Sample: 746 CEOs in 1987 Forbes Compensation Survey.

es options exercisable within 60

3). Sample: 95 firms with proxy contests in the years 1981-1985.

of their wealth, and this afkts their incentives [Lewellen (1971), Benston (1985), and Murphy (198S)J

th ratio, and the takeover ma&l. Seth papers assume that managers who face a

‘&I references to articles in this volume are in boldface.

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M. C. Jensen and J. B. Warner, Power and gwernance in cwpcearitm 7

possible takeover bid act in their own interests. ese interests can diverge from those of nonmanagement shareholders beta f the assumed benefits from 623ntrol. St& ex s how, for an all-equi managerial iz~nerstip and control of voting rights tiect 6rm value by i~uencing its attractiveness as a iakeover target. Both the Stulz

shows that the fractim of s y managers fs an

because it influences both the hkelih the oEer premium. in StCz’s model, the higher the fraction of votes controlled by managers, the higher the premium ratio& “u;&Icrs must 0fFer to acquire *. Sh&W, b& AC ,,tiL L&L; i;;,.t_uAJ# L,. _ _rG;;Lab%. L ;t! WiEl &&Sd;r, __ I ,_; a9 -& <-*up

the value of the Grm will reflect the expected premium, Stulz demonstrates firin value initially rises as managerial control of voting ri then falls. Fi value is generay maximizd when management 0~~3 shares anri heuce controls a s&e fraction of voting rights.

- In both the Stulz and the paper, managers acquire voting rights by purchasing shares, but wealth li&ations and restrictions on personal borrowing make control of a large fraction of votes dii%cult in large Erms. For a given dollar investment in sh:ues, managerial control of voting tights is greater the greater is the amount of debt or other nonvoting securi?ies such as preferred stock or warrarns in the firm’s capitsl structure.

&cogn~rksN3 of tL #.rr - =Fatica between capital structure and mana~~tia! car troll of voting rights leads to addiLonal insights along several difter&t sions. First, the MS optimal (i-e * value-max.&G&g) capital structure is affected. Given his result that managerial voting rights a.Gec; firm valluc, and the link between t5nancing and voting rights, Stulz also demonstrates there is a positive debt/equity ratio tiat maximizs the value of the Erm. The basic argument is ihat debt makes it easier for managers with thmited resources to control the optimal fraction of votes. -&cond, as Harris and Raviv em&ashe, leverage is an important device that ent managers can use to defend against takeovers. The basic idea in and Raviv is that incumbent management can strengthen its control of voting rights and its incumb issuing debt md kssinng the proceeds to purchase equity from non

shareholders. Managers can also issue new equity to diW.e the ho

er.

H,tis and Raviv provide a rich set of e s. The predictions concern, for example, how capit& structure

afTec!s the !ikelihood, form, and success of a performance is affected by the various fo takeaver attempts will a&3ct capital struct3re.

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the Stulz and Harris and Raviv papers are yet untested, the theory is consistent with a number of knmn empirical regularities. For example, Stub umes *&at_ the theory is consistent with empirical evidence mdicating that incr~ in the debt/equity ratio reduce the likelihood of takeover [%lepu (1986)] and re&ce the value of the &m when the change leads to large concentrations of voting power by managers 1 also argues that the theory is consistent with empirical convertib ebt decrease the value of the ti [ son (198X)] and are systemati delayed beyond the optimal shares 4th higher vo+&g rights zire w ----z&y held by managers iDeAngelo and

ts of hostile bids whose da&Y3 res%& tUX4W~i iii thr3 J7SkXI 2-X$3 provides strong evidence

@_‘s, h&&d strWhrr* ic -W.-W -W by managers’ cr33re to avoid a agers make changes in capital strWure

that create a consolidated voting block or increase the proportic.~ua~e voting pwer of an existing block. In the remaining cases, managers use acquisitions or divestitures to inhibit a takeover ZWZB$ Although in the ;authors’ sample the conteSt resu3.s are approximately equally divided between cases in which the hostile bidder acquired controi, another bidder acquired control, or the target fum remained independent, hostile bidders rarely prevailed when management’s defensive restructurings were actually implemented.

The resistance of these target managers cannot be qMmzd as in share- holders’ interest. Target shareholders in the Dan and &Angelo sample experience statistically sign&ant average wealth losses at announcement of defensive corporate restructurings. The mean and median abnormal value changes are -- 2.2% (t = 4.0) and - 2.7%, respectively. Although shareholders gain if a take-o~zz ultimately succeeds, loss of the large tender premiums and the substantial declines in share prices that occur when a sole bidder fails more than off&et the gains to successful takeover targets. Dann and DeAngelo’s evidence is also consistent with that of Ruback (1988b), who shows statisti- cally sign&ant losses to target &m shareholders when management defeats a takeover and the Czn rem&m i~dqmdent. [See also Eastcrbrook and JarreM (1984), Jarrell (P985), and Bradley, Desai, and Kim (k983).]

Dam and DeAngelo conclude tiat managers’ Meusiw reactions to hostile takeovers are best explained by b&eir desires to entrench themselves in office. Consistent with Stulz and Harris and Raviv, they also conclude that financial poticy, including both capital structure and ownership structure, is affected by the market for corporate antro’i. Tfre comb&&on of tbeoztical and em- pirid work in these papers provides a gati start in understanding hog mmageria.! interests interact with voting rules, ownership structure, and the market for corporate control to affwt corporate financiai pohcv

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MC. Jensen and J. B. Warner, Power and governance in coptatiom 9

Limited-voting stock distributes voting rights to shareholders in ways that are not proportional tc their cl s on corporate cash of limited-voting csmm~n stock in the wake of relaxation of the prohibition on limited-votmg shares has created a maj regulatory sector.

signiscant negative average price effects of -0 such recapitalizations, with the negative effects cases that have occurred since the NYSE relaxed its

capitaliz;tions ii3 !he peri prior to the NYSE relaxation of listing standards,

stantially larger institutional ownership and insider holdings than thw re- capitalizing before the change in standards. The largest we,?r?th losses occur for those firms with insider holtigs in the 30% to 55% ;ange. This evident is consistent with the hypothesis that recent dual-class r=apitahAons are by firms that are more susceptible to takeover and that they serve to entrench managers.

The negative wealth elects of the recent exchange offers pose a puzzle because the exchanges are approved voluntarily by corporate shareholders. Mthough, as Jarrell and Paulsen point out, the voting power of insiders is important eving shareholder approval, this cannot explaiu ah approvals. R&adc (1 develops a model of the shareholder exchange decision that

explains shareholders’ behavior. He demonstrates how managers can entrench themselves by inducing shareholders to exchange their shares for limited voting right shares carrying higher dividends (as is frequent& observed), even though such shareholders are harmed by the exchange. When individual shareholders cannot act jointly, the oiTer of shares with claim to a higher dividend places each shareholder in the classic prisoner’s dilemma. The rational chaise of ah shareholders to acquire the higher dividend leads to a de&m in their we&h. The wealth decline occtus because such shareholders generally canuot cohude to avoid the reduced probability of receiving a takeover bid caused by their aggregate exchange decisio:t.

The Jarrell and Paulsen and Ruback results suggest that managers use dual=cIass exchange ogers to expropriate wealth frorrr ~4s ~ot&ng zg&st t&s expropnauon does not r dual-~6s organizational forms, but can be aclhiev

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10 hf. C. .&men and .l. B. Warner, Power and govermnce in carporations

the use of coercive exchange otters ot the type analyzed by Rub& The propostxi SEC Rule 19c-4 restrictions on issuance of dud-chas shares will mdx such exchanges more difficult.*

G&on (1987) argues that dual-class reorganizations are substitutes for leveraged buys ES (LBOs) because both transactions transfer cant company to managers. Because the ass reorgSan~~tion allows continuing access to the equity capi markets, he argues at managers of rapidly ‘ng firms would ration he sh~eholde~’ ~~~~~~~~~ choose t ud-class reorganization following Jensen (19 6a,b), that mmagers of lowgrow

and in the shareholders’ interests, choose the LB0 form. ual-class reorganizations and LBOs differ, however. Ageruzy costs are

h@her for dual-class &ms because fcr given voting power, insiders in dual-c!ass aller claims on cash flows than LB0 insiders. Also, the du&ciass receive the control benefits of high leverage [Grossman and Hart

a, b), and St& (1988)]. Consis with these arguments, shareholders in transactions eirn premiums of [&Angelo, DeAngel and Rice (i984) and Kaploan (l988)], whereas those in dual-class recapitahza- ti

and (1 analyze the optimal&y of the one share/one vote rule for deciding corporate control contests. The issues are complex and difiicult to Generally, the papers show that 6rm value is a&c& by voting FJies, t under certain conditions firm value can be increased by moving away from one share/one vote. Grossman and Hart distinguish between the private -benefits of control that a management team receives from running the corporation and the public bcneiits that accrue to security holders. They show that if only one party to a control contest obtains &nScant private benefits of control, one share/one vote maximiz es firrsl value and is socially optimal. However, if more than one party obtains a signif&nt private benefit, shareholders may choose to capture some of these private benefits by deviating from one share/one vote. They argue that the one party case is most likely to describe the usual situation and, there%e, that one share/one vote should be widely observed. Harris and Raviv show that a simpie majority rule system with one share/one vote ensures that the better management team ii; alwars elected and is therefore the ~s~ialiy optimal system. Maximizing the Yralue of the firm, hoNever, requires issubs equity claims with no voting rights and voting rights with P,S cash flow claims. Moving awav from one Ghan,‘.=-- =_ -3 .-, VW tiows shareholders to gain by capturing more benefits from the winner in a control contest. In contrast to one share/one vote, such a dual-cksss system does not ensure that the best management tern ~31 win control., and the result is a reduction in efhciency.

*SEC Releav No. 34-24623 $m 22, I’M), 17 CP;R Part 240.

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MC. Jensen and J.5. Hkner, Bower and governance in corpwz~ions 11

assume that each investor is n

5. lh”

Kew evidence indicates that owners ure and shareholider voting in corporate election contests are related. examines election con- tests in which a dissident faction either (1) attempts to obtain seats &III’S board of directors or (2) opposes a management proposal (or o own proposal) for a change m cqorate structure, such as an anti proposai. He focuses on how the outcome of proxy contests is ownership characteristics. Pound’s cross-sect evidence indicates that the probability of dissidents’ success is higher (I) the lower is the mumber of shareholders and (2~ +&e lower are ownership levels by either institutions (i.e., banks, mutual funds, insurance companies) or bkkholders not afhhated with the contesting factions. He argues that a large number of shareholders makes dissident victory more difkult because it is less costly for management than for the dissidents to identify shareholders. Furthermore, incumbents hnve an advantage because dispersed public stockholders evaluate management perfor- mance by simple measures such as accotmting earnings, whit> are subject SO managc&l manipulation [DeAngelo (1988)]. Pound also argues that hstitu- tional investors and unalW.iated blockholders are likely to side with manage- ment. Although institutionai investors such as pension fund money managers and insurance companies have fiduciary responsibihties to their beneficiaaries, they can be infiu~nced b-1 existing business relationship;; v&h nianagement. A money manager is subject to pressure from corporate managers to vote shares ix controls in the intere et= nf mrJ*DoPvent rather than those of hmd bedkia- UC” “L ,.,,**u~V* 1 c &W ries. Corporate managers can de, nlr rion-agcrat& rmonev maqagers

c;portunity to manage the fkin’s pensiou $an. Direct evidence that institutions c

relations with the firm is presented by examine voting behavior on m~ag~rne~t~~ro~os Their evidence indicates that institutions such as nies (both of which can benefik froin exist management) are significantly more

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12 MC. Jensen and .I. B. Warner, Power and governance in corporatimti

antitakeover amendments than institutions such as college endowments and mutual funds (which seldom have GthS business relations witt management). This evidence supports the reports in the popular press [see Heard and Sherman (1987, pp. 43-44)j ‘&at managers of large corporations influence the votes of managers of pension and other funds where the ability to impose cost thholding their biisimss.

Brickley, Lease, and S also indicate that institutional investors and olders vote more actively on antitakeover amendments than

lders and that opposition by institutions is greater when the proposal appears to harm shareholders. In contrast to Pound’s results, this suggests that blockholders serve a monitoring role. The importance of this role is un&~r, however, because 95% of the proposed amendments pass, and BC&ley, Lease, and Smith argue that there is too little cross-sectional varia- tion in ,&Gr sample outcomes to detect the influence of blockholders on passage. The two papers’ somewhat conflicting results on the role of block- holders could arise itiA sloerai reasons. For example, the events the papers study are differertt. Proxy contests launched by a dissident faction represent a direct threat to management’s continued tenure, whereas management typi- cally does not propose antitakeover amendments unless their passage is likely. The :kentives of institutions and other blockholders could differ iu the two situations. In addition, the mix of institutions and blockholder types can systematically differ for &ms having each type of event, and the Merent results would therefore not be surprising. Attempts to reconcile the apparent differences between the two studies appear to be a fruitful area for future research. At this point, however, the conclusion that stock ownership and voting patterns are related seems safe.

Share ownership by management and the board of directors varies substan- tially across firms. This cross-sectional variation provides the basis for tests of the relation between ownership and G.rm behavior. Moreover, the tests rak .

stions about the nature of the relation. &IO&, SbIelfer, and examine the cross-sectional relation )ZP~CPP~ “~2qrcs of &iu - __ . . 4-u lllV6k-S

performance and the ownership stake of the board of directors. The perfor- mance measures are (1) Tobin’s Q, defined as the ratio of the market value of the firm’s securities to the replacement cost of the km’s plant and inventories, and (2) the 9rti’s accounting profit rate. ~floick, Shleifer, and Vishny report a strong relation between performance measures and ownership stake, but the relation is net monotonic. In particular, as board ov~~rahip increases from 0

Q rises; as ownership increases from 5% to 258, Q falls; as ownership , Q again increases. Although somewhat weaker results are

fit rate as the measure of firm performance, the relation

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M. C. Jemen and J. B. Warner, hoer and got~ernance in corporations 13

between performance ad owners and foF own~ship by outside bo

The tradeoffs between the ali mauagerial entrenc

ests become more

such increases cause

enough to cause fkm vahte to fall. managerial control of the fkm ocfxrs

would be no negative value effects from the additionti concentration power in insider hands.

A caveat to the alignment/entrenchment interpretation of the cross-sec- tional evidence, however, is that it treats ship as exogenow, md does not address the issae of what deteti~es concentration for 3 @ven i%m or why coxeztrztion woub not be chosen to maximize km Managers and stockholders have incentives to avoid inside the range where their iaterestc are not aligned, although constraints and benefits from entrenchment could make such for managers. As Merck, Shleifer, and Vishny discuss, there is an alternative interpretation. Suppose kms with high ~evek of intangible assets, fOF which measured Q is high> require greater management ownership if the Yak of thG Grm is to be maximized. Such considerations could induce a positive carreh- tion between management ownership and Tab causes high oxvnership Father than vice versa. planation, hi)Wever, does not predict the

nt hypothesis; her b in firm value assokted with &mges in owneFShi pr+$apz a&s i:pf q&v yi.dds regression coefhcients Eilorck, %eifeq aud Vishiiy.

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14 M. C. Jemen nrd J. Lt. Warner, Power and gmemnce in cmpmatkms

Nonetheless, the notion that firm characteristics can aifizct ownership is useful. and is also suggested by other recent work. Demsetz and Eehn (1985)

r&ley and Dark (1987) present evidence that variation in ownership structure is partly explained by variation in fi

n. 1-1 addition, using a variety of da no evidence that majoriiy owner&ip b

t to expropriate resources from shareholders. They examin hsted firms in the f978-1984 period in which a sharehohier has at least a stake. They find average majority-shareholder positions of 62%. In over 90 these Grms the majority shareholder is either an officer or employer of an officer or director). Hold majority-shareholder firms sutive over time, but the authors do not fully investigate the characteristics that would make i for a firm to be majority controlled. In sum, the dire&n of tween ownership concentration and firm characteristics is an imptant question raised, but not

rs exploiting cross-sectional variation in owner eates that firm characteristics and inside s

are related, disentangling the causal relation between inside stock ownership and firm value Rqu@s additional investigation.

Time-series evidence on the relation between inside stock ownership changes and firm performance is presented in Kaplan (1988). He examines 76 Grms that were the subject of a management buyout (MBO). Median percentage share holdings of managers increased from 3.5% to 22.6%. He Gnds significant increases in operating income and operating margins in the post-buyout period, consistent with better alignment o,f manager and stockholder interests. Those buyouts that were subsequently sold or l&en public had a mean wealth gain of 109% (median = 56%), with the wealth gain approximately equally divided between the original public shareholders and the management/buyout specialists.

Kaplan’s results are consistent with the analysis of MBOs by Jensen (1986a, b), who argues that the governance of these firms (and the distribution of ownership claims, inside ownership, and capital structure) is so different that they represent a new organizational form. First, in two-thirds cf ME@s, management does not own all the equity aud the board of &rectors is COW~QSW! of buyout specialists who own or control an ,:quity stake avenging 60% [see Kaplan ;1987)]. These speciahsts also act as investment bankers in the transaction. Second, these organizations are &aracterized by strip financ- ing and high leverage (16 to 1 debtjequity ratios are not unusual). In strip financing, all claimants have approximately proportional holdings of each security in the co@icated array of nonequity cl&s (excluding the most se&~r Acbt). Jensen argues that strip financing reduces conflicts of interest

ong chs. 2; Gf ~!aim~~ts and Is-wers expected bankruptcy cw +A, The ciency an 1 sugJ:es .?f s is evident not only by the large wealth gains

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AU. C. Jensen ond.l. B. Warner, Pmer md governance in corporations 15

apla cf pu2&c cqorati

with $1.2 billion in 197

Poison pills are securities issue4 by vste of the board of directors some takeover defenses, do lnst

agents of sh~eho~de~, the corporate charter.

on the circumstances, it can be desirable for a peppy to delegate a wide no event is it ~~s~b~c f*x

- Poison pills aliow the bo

board and management in certain control transactions. These securities take a variety of forms, but ah have the characteristic that they change the right shareholders on the occurrence of a control event such as a tender o acquisition of a large block of s tcck or voting rights, cx adcWion to sash .a. bhxk, by a party not, approved by the board of directors. One cmnmon form

gves *aget shareholders the right to buy stock of the bidder at a large discount from market value, typically SOW, as a conditioln for curl?pUion of the merger. Poison pills received legitimate legal status in November 1985 when the Delaware Supreme Court upheld the right of ousehold Hnteaa- tional to issue such a right to its shareholders. Before this decision, 37 pills of various forms had been adoptt$ md ly t&e MJ -f ~Qw _**~ “1 I/=~ ~-+?e& 3gj mAqora;ioils

had adopted pills4 Critics charge that poison piis entrench managers, and supporters argue

tie pills benefit shareholders by giving management and the b obtain favorable terms in control transactions. The most thorou

s of poison pills are

‘See hna and hsen ~1383a,b).

Econoiaist of th SEC, 'The konomics of poison

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16 MC. Jensen and 9. B. Warner, Power and governance in corporations

a,lnouncement date. The average abnormal returns are - 2.3% (t = 3.4) for 12 firms subject to takeover bids in the two months prior to adoption of the pill. Malatesta and Walkling also find that when firms abandon plans to adopt a pz th& st,&s pticc increases, and that firms adopting pills are significantly less profitable in the year prior to adoption than a control sample of firm ’

the same industry. Ryngaert, in a study of 380 firms adopting pills in the period 1982-1986,

finds no statistkAy @if&ant effects from the pills on the entire sample. We finds, however, that for those 62 firms perceived as takeover targets, adoption of a pill reduces shareholder wealth on average ty a statistically sign&ant - 1.5% (t = 2.8). He also finds that stock prices fall on average by 2.2% (t = 2.8) when a firm’s pill is upheld by the courts and rise on average by 3.4% (t = 2.2) when it is ruled invalid, that pill defenses double the likelihood of defeating an ;r;;solicited bid, and that such defeats are associated with large prince declines. Although 51% of the firrmas with higher offers than the initial offer, this compares unfavorably wi firms that received increased offers in a sample of 76 control co pills in the Period 1981-1984. If managers use the pills to defeat actual offers where *hey know they can proviele more value to &areholders than the hostile offer price, the v&e lltf the ‘irm should increase at or after defeat of the offer. Ryngaert reports no such evidence. The net-or-marxer returns for 2.1 iirttls in the six months after defeat of “ihe ofl& average - I4.4%; these results are consistent with the findings of Easterbrook and Jarrell <1984), Jarrell (1985), Bradley, Desai, and Kim (1983), and Ruback (1988b). The defeat of an oEer harms,

Discriminatory repurchases are also takeover older ratiflcation. In 1985 the Delaware Suprciz~

Court approved Unocal’s discriminatory tender o&r for its shares, although in 1986 the Securities and Exchange Commission amended its rules to deny the Unocal strategy to future targets. The Delaware decision provides another situation in which information about the qualitative effects of poison pills can be estimated, because discrimin atory repurchases have similar characteristics. Unocal’s offer to repurchase its shares at a substantial premium was available to all shareholuers except Mesa Partners II, Unocal’s largest shareholder, which at the time owned 13% of the firm. Jensen (19$5) examines the effects of the Deiaware decision on the bidder and the target. The threat of expropria- tion Of approximately $2X million through dilution of the value of its Unocal stock holdings caused Mesa Partners to cancel its outstanding tender offer for Unocal and to sign d dstill agreement promising not to make an offer for Unocal in the future. s defeat of the Mesa offer cost Unocal shareholders a

cir (I ) eiitiiate the cKccts of Deiaware’s approval of the discriminatory repurchase takeover defense on firms other than Unocai. If the increase availability of the defense were in sharzl&lers”

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inteicst, the value of other firms subject to control contests should rise. pie of 124 fkms that were t

y significant amouni on the

the decision, as were their were not hostile targets but were subject to 13D filings tal dollar losses to

were $267 million,

the evidence on eir papers inoicates they are

meat rr&cr than shareholders’ benefit.

at c

Both the external takeover market and mechanisms withia the carporation can encourage managers to act in shareholders’ interests. Potentially important internal mechanisms Gnclude boards of directors [Fama (1980}]. competition among the Grm’s managers [Fama and Jen holders of large share blocks [Shleifer and Vi monitoring of fums’ managers is provided by wattq and W Consistent with r Coughlan and 985), both papers inverse relation between a fnm’s share p subsequent change in its top management. This relation is predicted under the joint hypothesis that stock performance reflects information on managerial performance, and the information is ud in evaluating managerial perfor- mace. Further, although it is difhcult to identify management changes that are actually fhings, Warner, Watts, and Wruck indicate that these. results apply more stron&y to management changes likely to have been fmced.

Both Warner, Watts, and Wruck and Weisbach present etidence on the specific monitoring mechanisms that lead to top management changes. Weisbach finds the relation between share performauce and “chinover is stronger for companies whose boards are dominated by outsiders. This sug- gests that outside directors serve a monitoring role and rely more frequently on publicly available performance measures than do inside directors.

The inverse relation between share performance and turnover, however, cannot be attributed solely to the board of chxctors. Warner, Wlruck errmine details of observed management changes. In additi monito&g, they present evidence of involvemerb by !arge 51 competrtion among top managers !ea%ng to forced departures. Furthermore, Gilson (1988) indicates that creditors of firms wit erformance are sometimes involved in removal of t tonng mechanisms appear to be re

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18 M.C. Jensen and J.E. Warner, Power and gwernance in corporations

The issue of the strength of these various internal monitoring mechanisms is raised by Warner, Wattsi and Wruck. They show that unless share perfor mance is extreme, logit specifications of the share performance/turnover

about 11%. These understate the role of internal

rest performing managers. Moreover, these figures do not fully capture ?be ts on turnover of interaction between internal mechanisms and ext= rces such as the

en corporatz control events should also management turnover. If a control event signals

resence of we~-fm~~~io~g int -mal mecha.Gsms im- tak@?ver 1 s p?IIIIs?kcmw-

nt work cn managerial turnover sistent with the prediction that

these events are associated with higher turnover. Martin (1986) exznkzs top zknagement ver following a successful takeover bid; within three years

managers holding the top three titles depart. alsh (1988) indicates that 59 of :a.rg~t fkms have a management change in

the five years follo for a control sample of nonme management changes following a tag&d share repurchase (i.e., greenmail). In the year

e turnover rate is 2 nearly triple their r rate. Klein an senfeld argue that

board monitoring is responsible for their fmdings, and the higher turnover cannot easily be attributed to takeovers following greennkl. DeAngelo and

eAngelo (19g8) study management turnover following proxy contests for generally unsuccessful in capturing a

er (1983)]. Nevertheless, DeAngeio of surviving 6rms that had an unsuccessful proxy

t one top management change within two years of internal and external forces that leads

itself and thus appear linked to temal pressure of the external forces seems

- From the various studies of

Page 17: Michael C. JENSEN Jerold B. WABNEB papers presented at the ...

MC. Jensen and J.B. Warner, POWCT and governance in corpordons 19

standing the forces

creases for their 0

At this point, research on the stock-price effect of management change announcements is inconclusive.

- The work surveyed in this paper ts’ interests from Gnancial m

research on behavior within corporations. Stu governance strurture and the capital markets are natural for

since security prices signal the effects of various Eilcrors on organizational performance. But the current trends in fkncial research extend beyond this link.

The work surveyed here is associated with other research on the interaction between financial c!aims ganizational structure, and firm performance. For example, Akhian and tz (1972) analyze the natural advantage cif residual &&nanrs in mouitoring team producri knsen (1985a,b) demonstrate how alternative erg corporations, partnerships, and nonnkofits r7~e distr by critical diEerences in the detidsr of tkir resld and Warner (1979) analyzes the influence of b choices of investment policy and financial structures, and Brickley an <1987) investigate the advantages of the franchiie substitute for centralized monitoring of Since managers play a key role in

between this volume’s papers and al labor contracts [see Lazear and

‘ir;nrmepman (19(nZ), E:?t a&j ~jo&St urphy (1988)]. This volume’s reflect a general social scie

~~~~~~t~o~~ -

many fields of economics. The work is

Page 18: Michael C. JENSEN Jerold B. WABNEB papers presented at the ...

20 FL.C. Jensst and J.B. Warner, Power and Aovernance in corporations

&ludhg the economics of contracting [I&s (1973) and Nolmstrom and Tirole (‘9P?)], transactions costs [Williamson (1975) and Klein, Crawford, and Alchian (1978)], property rights [hZem-- \ =**v ‘3982,1983)], and corporate fin~acc Grossman and Mart (1982), Easterbrook (1984), Myers and

eA,ngelo and DeAngelo (1985), and Jensen (1986a)]; in labor econotics. the work is progressing unde la3el of compensation and hielarchies i

and Abraham (1980) and sen (198211; h accounting, under information an ante measurement [Healy (1985), Antle and Smith

gelo (1986,1988)]; __ _ 2nd in law, under governance and (1977), Easterbrook aud Fischel (1982), and Camey (1987)].

in these fields is c

ult to predict the future direction of corporations, the studies in this volume signal strong growth in

tical and empirical research. At the same time, the breadth of methods in tie area is increastig considerably. Much remains to be

scope in two general areas. Ownership and vothg m-uctwt+ - In theory, ownership structure and the

allocation of voting tights. ale important determinants of organizational b ior aud hence wi9 be 2 signi&mt focus of future research. Smce characteristics also affect ~ptirnd ownership distribution, d&nta@ing the direction of causality between ownership and 6rm behavior is a diEcult task. Additional evidence on the variation of inside and outside ownership and a taxonomy are required to organize our analysis. The variation in and effects or’

s held by a firm’s insiders, external blockholders, financial institu- sperscd public stockholders also are not well understood. It is

important to understand why and when votes are used passively and v.%e~~ actively - for example, wlij U.S. institutional money managers tend to be passive investors, seldom serving on boards of directors or directly influencing mmagers,’ in contrast to LB0 specialists, family funds (e.g., the Bass brothers and Pritzkers), or takeover specialists (e.g., Icahil ard Picker@. This in turn leads to questions about the effectiveness of voting in monitoring managers and the relation of voting to other mechauisms such as board processes, intepial managerial competition, and hostile bids. Conflicting evidenti pie- sented here on the role of bl&holders and whetner &q scz~ a mo$Eoring function is OIX aspect of these unsettled issues.

Cqitd structure, corporate behavior, and managerial discretion - e h&s k~T~~~s ‘h;sh%z shxk uwllcrship by mscaaqqzmnh, he control market, and the firm’s optimal debt/equity ratio are established in theory, but the empirical

‘See Waldo (1985, table 5.1), who showq that all major shareholders represent only 1.6% C$ Fortune %O directors.

Page 19: Michael C. JENSEN Jerold B. WABNEB papers presented at the ...

Aa. C. Jensen ar8dJ.B. War‘ per, Puwer and governance in corporatims 21

poison pills and other anti cover defensive rn~e~v~~s E

interact with internal 0

~eve~o~me~t of a science of org~tions.

Alchian, Armen A. and Harold Demsek, 1972, Production, information costs, and economic organization, American Economic Review 62,?7?-795.

Ade, Rick and Abbie Smith, 1986, Au empirical investigation of the relative ~rformacce evaluation of axporate exea~tks, Journal of Accounting Research 24,1-39.

Bbagat, Sanjai and James A. BtickL,, m* 1984, Cumulative voting: The value of minority shareholder voting r&bts, Journal of Law and Economics 27,339-365.

Baker, George P., Michael C. Jensen, and Kevin J. Murphy, 1988, Compensation and incentives: practice vs. theory, Joumai ai Finance, forthcoming.

Benston, George J., 1985, The self-serving management hypothesis: Some evidence, Journal of Accounting and Economics 7,613~84.

Bonnier, K.A. and R.F. Bruner, 1986, An a&y& of the stock p&e reaction to management ciiange in &stressed firms, UnpuGisbed manusctipt (Univel*ty of krgin& ‘Z%kttesviie, VA).

Borstadt, L., 1985, Si price reactions to management changes, Unpublished manuscript (University of Utah, salt Lake City, UT).

Bradley, Michael, Anand Des&, and E. Han Kim, 1983, The rationale behind interkm tende offers: Information or ++&s?, Joumal of Financi~ Economics 11.183-206.

Bricklq, James A. and Frederick H. Dark, 1987, The choice of organizational form: The case oh franchising, Journal of Finaucial Economics 18,401~420.

Brick@, James A., Ronald C. Lease, and ClXord W. Smith, Jr., 1988, Qwnership strx(.?~~ ~4 voting oz kzL___. __ _ _. __i_ +*abw=*a* *mn=d=n3t_r, Jo&m2 & Fhmr&d ~II~~ZS 20, this i~ue.

Camey, William J., 1987, The theo~ or the firm: Investor coordination ; ; ,I ?. CC t-d pren~~1’[1s and capital structure, Washington University Law erly 65, l-67.

Cougblan, Axme T. and Ronald M. Schmidt, 198 comps~~.$rr~, ;;idz?~elI “..I P’ ‘7 and firm performank~e: An empirical invest , Journal of Acmmtig zmd tie 7, 43-66.

Dann, Latq Y. and Harry DeAagelo, 1988, Corporate fintici& policy and corporate co~ltd: A study of defensive adjustments in asset and omership structuree, Joun& of Fimmd Fmnomics 20, tbis issue.

Page 20: Michael C. JENSEN Jerold B. WABNEB papers presented at the ...

22 M. C. Jensen and J. B. Warner, Power and governance in corporations

&Angelo, Sarry and Linda DeAngeb, 1985, Managerial ownership of voting rights: A study of public corporations with dual cl&es of common stock, Journal of Financial Economics 14, 33-70.

Qe/A&o, Mamy and Linda DeAngelo, 1987, Management buyouts of publicly traded corpora- tions, Financial Analysts Journal 43,38-49.

Dehgelo, Marry and Lin& DeAngelo, 1988, The role of proxy contests in the governance of publicly-held coqxxations, W.orking paper no. MERC 88-01 (University of Rochester, Roches- ter, NV).

De~nge~o, Harry, Linda DeAngelo, and Edward M. Rice, 1984, Going private: Minority frcezeouts and stockhoIder wealth, JoumaI of Law and Economics 27,367-40i.

DeAngelo, Linda E, 1986, Accounting mmbers as market valuation substitutes: A study of management buyouts of public stockholders, Accounting Review 61,400-420.

IieAngelo, Linda E., 1988, Managerial competition, information ~0~s~ ;;ld corporate governance: The use of atxountiq measures in proxy contests, Journal of Accounting and Economics 10, 3-36.

Demsetx, Hatold, 1982, Economic, legal. and political dimensions of competition (North-HoBand, Amsrerdam).

Demsetz, HaroId, 1983, The structaife of owtit&i~ Ld the theory of the tirm, Journal of Eaw and Economics 26.375-390.

Demsetz, Harold and Kenneth Lehn, 1985, The structure +M’ cqorate ownerslup: Cau ZY! consequences, Journ~ of ?oIitical Economy 93,1155-1177.

Dodd, Peter R. and Jorold B. Warner, 1983, On corporate governance: A study of proxy contests, Journal of Financial Economics 11,401-438.

Easte.rbrook, F,-anL H., 1984, Two agency-cost explanations of dividends, Americaa Economic Review 74,650-659.

Easterbrook, Frank H. and Daniel R. FischeI, 1982, Coruorate control transacticra, Yak Law Journal 92.698-711.

Easterbrook, Frank H. and Datiel R Fischel, 1983, Votiq in corporate law, JournaI of Law and _ - Economics X,395-427.

Eastetirook, Frank H. and Gregg JarrelI, 1984, DC targets gain from defeating tender oilers?, New York University l..aw Review 59.277-299.

Farna, Eugene F., 1980, Agency problems and the theory of the firm, Journal of PoIiticaI Economy 88.288-307.

Fama, Eugene F. and Michael C. Jensen, 1983a, Separation of ownership and control, Journal of Law and Economics 26,301-325.

Fama, Eugene F. and Michael C. Jensen, 1983b, Agency probIem and residual ~mlaims, Journal of Law and Economics 26,327-349.

Furtado, EP., 1986, The wealth effects of manager initir ied manaaement changes, Unpublished manuscript (Kansas State University, Manhattan, KS).

Furtado, EP. and M.S. Rozeff, 1987, The wealth eRects of company initiated management changes, JoumaI of Financial Economics 18, i47-160.

Gilson, Ronald J., 1987, Evaluating dual class common stock: The relevance of substitutes, Virginia Law Review 73,807-844.

Gilson, Stuart C., 1988, Optimal capital structure and management-borne costs of financiaI distress, UqxMkhed manuscript (University of Rochester, Rochester, NY).

Grossman, Sanford I. and Oiiver E Hart. 1982, Corporate financial structure and managerial C. incentives, in: Jobn r. McCall, ecr.. The economics 01 C&P*

of Chicago Przss, Chicago, IL). Aon and uncertainty (University

Grossman, Sanford J. and Oliver D. Hart, 1988, One share/one vote and the market for ccrporate control, Journal of Financisl Economics 20, this issue.

Haris, Milton and Artur Raviv, i988a. Corporate control contests and c~rital structure, Jcg_qJ of Financial Economics 20, t&is issue.

Harris, Milton and Artur Raviv, 1988b, Corpcrate governance: Voting rights and majority rules, Journal cf Financial Economics 20, this issue.

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Healy, Paul M., 1985, e effects of bonus sch.emes on accounting decisions, Journal ol

Accottitinp and Economics 7, 85-107.

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MC. Jensen and J.B. Warner, Power and governance in corporaci~ns 23

Heard, James E. and Howard D. Sherman, 1987, Conflicts of interest in the proxy system (Investor ?. tesponsibility Research Center, W

Holmstrom, Bengt and Jean Tiro!e, 1987, The of the firm, in: R. Schmalensee and R. Wilhg, eds., Handbook of industrial o:ganization (Elsetier Science Pubiishing Co., New York, NY).

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Jngersol?, Jom&In, 1977, An examination of corporate call policies on convertible securiues, Journal of Finance 32.463-478

Jam%, Gregg A., 1985, The wealth effects of litigation by targets: Do interests diverge in a merge?, Journal of Law and Economics 28,151-377.

Jar& Gregg A. and Annette B. Paulsen, i988, Dad-class recapitalizations as antitakeover mechanisms: The recent evidence, Journal of Financial Economics 20, this issue.

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LI’..l.,..I c Jensen, rvAi-a b”, i?85a, Agenq casts of free cash flow, corporate finance, and takeovers, American Economic Review 7a. ??3-329.

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24 M. C. Jensen and J. B. Warner, Power and pwernance i.r corporarims

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