By Viral V. Acharya, Stewart C. Myers, and Raghuram G. Rajan

Recent upheavals in the world of finance and business have been eye-popping even to the most battle-hardened observers. With trillions of dollars in capital having evaporated, it is perhaps surprising that even more firms haven’t followed suit. But the corporate structure is surprisingly hardy. One reason may be the effect of what we call internal governance – the checks and balances employed and imposed by a firm’s own employees on its decision-makers. While corporate governance is generally interpreted as the effectiveness of such mechanisms as boards of directors, takeover activity, and shareholder activism, the recent financial crisis has illustrated that the internal governance of firms can be equally important.

To explore this, we developed a model of internal governance where the self-serving actions of top management are limited by the potential reaction of subordinates. Our hypothesis, put simply, was that if top managers are myopic or short-term in their outlook and do not invest in the firm’s long-term future, then subordinates and junior management – who are better aligned with the firm’s long-term future – may restrain their own efforts. Such a reaction can, in turn, hurt top management, because it will affect the firm’s short-term prospects. Thus, by extension, internal governance can function to lengthen the horizon of top management’s decision-making. It works best when both top managers and subordinates play active roles in creating value at the company.

In our model, we allowed also for governance provided by external financiers. We showed that such external governance can complement internal governance by enhancing firm value. Interestingly, this provides a theory of investment and dividend policy over the firm’s lifecycle, where dividends are paid by the top management when growth prospects diminish, with the effect of maintaining a balance between internal and external control.

Finally, we examined how certain aspects of the internal organization of firms – for example, the succession plan – may be structured to enhance the role of internal governance. Working through the variables as we tested our theory, we were able to see why firms with limited external oversight, and firms in countries with poor external governance, can still have substantial value. Conversely, it was obvious why even firms with external oversight can go astray when their internal governance mechanisms break down.


Complex Dynamics

The common view of the public corporation is that of an organization run by top managers, and monitored by a board of directors on behalf of public shareholders. The separation of decision management (the CEO) from decision control (the board) and from risk-bearing constituents (public shareholders) is thought of as a reasonable way to structure firms, and so long as decisions are made in the interests of the shareholders, efficiency is maximized.

Yet the clear evidence that the public corporation is an organizational structure with survival value has to be set against the equally clear evidence, shown by various researchers over the past few decades, that most shareholders have little control over boards, that many boards are poorly informed and have little ability to scrutinize top management’s decisions, and that some CEOs are self-interested rather than working for shareholders. Admittedly, the market for corporate control can offer some discipline, but it is hard to see it as effective in controlling operational decisions. How then do we reconcile the survival, and hence presumed efficiency, of the public corporation with the ineffectiveness of the supposed channels through which it is governed?

In June, Professor Viral Acharya (center), along with his co-authors Raghuram Rajan and Stewart Myers, received the III Jaime Fernández de Araoz Corporate Finance Award for the working paper on which this article is based, “The Internal Governance of Firms.” The award was presented in Madrid by the Prince of Asturias (right), Crown Prince of Spain, and the ceremony was attended by Miguel Sebastian, Spanish Minister of Industry, Tourism and Trade; Ms. Esperanza Aguirre, President of the Community of Madrid; and Mr. Luis de Guindos, Chairman of the Jury of the III Jaime Fernandez de Araoz Corporate Finance Award. This award, the only one of its kind in Spain, recognizes the impact of applied research in economics and corporate finance. It carried a cash prize of 10,000 euros.

We argued that there are important stakeholders in the firm, such as critical employees, who care about its future even if the CEO has short horizons and is self-interested and shareholders are dispersed and powerless. These stakeholders, because of their power to withdraw their contributions to the firm, can force a self-interested, myopic CEO to act in a more public-spirited and far-sighted way. We call this process internal governance.

Much of the existing literature has treated the firm as a monolithic single-employee entity. Our approach was to see it as comprising diverse agents with different horizons, different opportunities for misappropriation and growth, and different interests. Think, for example, of a partnership run by an old CEO who is about to retire and who has a young manager working under him who will be the future CEO. Three ingredients go into producing the firm’s current cash flows. First, there is the firm’s capital stock, which could be the firm’s physical capital (machines), or organizational capital (networks), or relationship capital (client relationships). The second ingredient is the CEO’s ability to manage the firm based on his talent and his knowledge of its specific problems, and third, the young manager’s effort, which allows her to learn to deal with the firm’s specific issues.

In our model, we assumed the CEO could put in place internal audit and accounting mechanisms that would make a predetermined amount of cash flows and assets verifiable and ensure they are left behind as the firm’s capital stock. The CEO could also appropriate the remaining cash flows and assets – more generally, he could consume perks, “tunnel” cash and assets out of the firm through self-dealing, or even not generate cash by shirking his job.

Note that because the CEO has a short horizon, he could simply decide to appropriate all the cash flow and assets. However, in order to generate cash in the first place, he needs the young manager to put in effort. If the manager sees little future in the firm because the CEO leaves nothing behind, the young manager will have little incentive to exert effort. This can reduce cash flows considerably. To forestall this, the CEO will commit to investing some fraction of the cash flows and to preserving past capital stock in order to create a future for his young employee, thereby motivating her. This allows the firm to build substantial amounts of value, despite being led by a sequence of myopic and rapacious CEOs.1

We showed that internal governance is most effective when neither the CEO nor the manager dominates in contributions to the firm’s cash flows. Intuitively, if the CEO dominates, he has no desire to limit his appropriation in order to provide incentives for the manager. If the manager’s contributions dominate, the manager has little incentive to learn because she cannot appropriate value today, and the learning will be of little use when she does become the CEO and can appropriate value. Also, because both contemporaneous and forward-looking elements of the business environment matter for participant incentives, internal governance works best when the business environment is stable and the age profile of employees slopes up the hierarchy.


Outside Influence

We have implicitly assumed so far that the firm’s capital stock is in intangible assets, such as the human capital of employees or client relationships, which cannot be seized or sold. But what if the investment were instead in tangible assets, such as machines or land, which could be seized and sold? This would then offer a role for outside financing (for example, equity), and would allow the firm to be structured as a public corporation. We showed that the combination of crude outside governance, together with internal governance, can improve the efficiency of the firm dramatically.

To see this, we assumed that outside equity has the capacity (through the board of directors) to periodically exercise its fairly crude ownership right of taking over control of the assets. Outside equity thus has no direct effect over the investment or effort decision – it has no operational influence. Even so, it can greatly enhance investment by the CEO and the value of the firm. In our framework, the improvement was not because outside equity monitors the actions of the CEO, but primarily because equity holders are indifferent between being paid in cash or being “paid” via a higher capital stock – and, of course, the control rights inherent therein. For the CEO, the dollar paid out as dividend and the dollar left behind as investment costs the same, but the CEO prefers to pay by investing to increase capital stock because this will have the collateral effect of motivating greater effort by the manager. This could explain the reluctance of firms to pay dividends, even when returns on investment are not great.

Eventually, as the rate of return on capital falls, the CEO could make the manager worse off by investing more capital. This is because investment will increase the capacity of outside equity to extract value by more than it increases the capacity of the manager to generate cash (net of this period’s effort cost) as CEO next period. This is when the current CEO will switch to paying dividends – not because of the pressures exerted by outside equity alone, but because more investment will de-motivate managers. This then gives us a dividend policy in firms run by self-interested CEOs that corresponds to the observed life cycle of a firm, with dividends not being paid when the firm is young and investment profitable but only when the firm is mature.

Interestingly, this combination of internal and external governance can eliminate the rents (rents are the difference between what a factor of production is paid and how much it would need to be paid to remain in its current use) extracted by management, even though equity’s control rights are very crude. Other forms of providing incentives do not always fare so well. We examined whether giving the CEO equity-based compensation could improve matters. It turned out that under a variety of circumstances – it did not, interestingly – the limited control rights possessed by outside equity imply that equity values do not reflect the entirety of cash flows produced by the firm. Indeed, the dictum to maximize equity value may offer little relevant guidance in such firms.


Competing Interests

“Internal governance can function to lengthen the horizon of top management’s decision-making.”

Our point, more generally, was that the traditional description of the firm – an organization run by top managers and monitored by a board of directors on behalf of public shareholders – falls short on three counts. First, control need not be exerted just top down, or from outside, it can also be asserted bottom-up. Put differently, the CEO has to give his subordinates a reason to follow, and this, implicitly, is how they control him. Second, the view that there is one residual claimant in the firm, the shareholder, is probably too narrow. Anyone who shares in the quasi-rents generated by the firm has some residual claims, and thus there is no easy equivalence between maximizing shareholder value and maximizing efficiency. Third, the fact that different parties have claims to different residual rents at different horizons means each one has to pay attention to the others’ residual claims in order to elicit cooperation. The checks that parties inside the firm impose on each other ensure the firm functions well, even if outside control is weak.

Our model is simple, perhaps even overly so. Top management is both myopic and self-interested. Yet, considerable value is preserved in the organization because of the need for top management to motivate younger managers.

Our model suggests why it may be so hard for firms to shrink gracefully, and why it may make sense for a firm (like Philip Morris) in a mature, declining industry like tobacco to diversify into a growing industry like food (by acquiring Kraft). If the firm were to stay in the declining industry, it would either have to over-invest or see a collapse of incentives, and worse, a collapse of the discipline imposed by internal governance. Rather than see the value destruction associated with such a decline, the second best option might be to “morph” into a new business. What might be thought of as empire building by top management may just be a reaction to pressure from below. Indeed, previous research has found that unfavorable expectations of marginal returns to investment in existing businesses are an important spur to diversification, a finding consistent with the implications of our model (but also with others).


Loyalty or Pragmatism?

The breakdown of internal governance may also explain the increasing evidence of agency problems in financial firms in the ongoing crisis. When capital is relatively scarce and allocated based on detailed information available only within a firm, employees of financial firms are relatively immobile. Each cares about the longer-term future of his own firm and has an incentive to monitor the actions of both colleagues and superiors. As capital becomes more widely available, though, employees become more mobile and care less about the long-term future of their firm. The internal pressure to worry about the long term becomes weaker.

Finally, we suggest a rich interaction between the internal structure of firms, the strength of internal governance, and the need for any external governance. Internal governance may be quite effective in growing firms with young staff, where human capital is firm-specific. By contrast, external governance may be much more important in mature firms in declining industries with aging staff, where the required management skills are fairly generic. Countries like Japan that have had a rapid demographic transition may also have suffered as their old system of internal governance becomes less effective in a newer environment. More generally, there is a rich vein of research to be mined in seeing the linkages between the internal organization of firms, internal governance, and external financing and governance. We have just touched the surface.


1 While our CEO is myopic and self-interested, in reduced form, he appears to act as if he cares about his subordinates and the survival of the firm. Indeed, other research that included interviews of top CEOs has suggested that continuity of the firm, rather than maximizing shareholder value, appears to be the primary stated objective of CEOs. Of course, most CEOs are not the caricatures that economic models like ours make them out to be, yet it is reassuring that even though we imbue them with no redeeming qualities, the model still has them doing reasonably good things for the firm.

VIRAL V. ACHARYA (PhD ’01) is professor of finance at NYU Stern. STEWART C. MYERS is Robert C. Merton Professor of Financial Economics at MIT Sloan School of Management. RAGHURAM G. RAJAN is Eric J. Gleacher Distinguished Service Professor of Finance at University of Chicago Booth School of Business.