Under the ideology of the “shareholder capitalism,”77 the purpose of a corporation is to maximize the wealth of shareholders. Consistent with this view, Milton Friedman opined that to increase a corporation’s profit is indeed its “social responsibility.”78 In reality, however, we often encounter cases where corporate insiders put their interest before shareholders’ interest and deviate from the normative standard of profit maximization. In addition, according to the business judgment rule,
79 directors/managers are required to act only reasonably (not perfectly) in the best
interest of shareholders.
The conventional thought on the business economics and corporate governance views empire-building as an important example of corporate insiders’ aberration from the ideal norm of the shareholder capitalism.80 Since empire- building is seen as the reckless expansion of a corporation, it is understood to be the strategy of pursuing size maximization by adopting even negative NPV (net present
77 On the other hand, according to another ideology, i.e., “stakeholder capitalism,” the purpose of a corporation is to balance welfare of all stakeholders in a corporation such as creditors, employees, suppliers, consumers, and even community.
78 Milton Friedman, The Social Responsibility of Business Is to Increase Profits, N.Y. Times Sunday Magazine, September 13, 1970.
79 The business judgment rule is “a presumption that in making a business decision, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.” Aronson v. Lewis, 473 A.2d 805 (Del. 1984).
80 Empire-building of corporations is embodied by diversification through conglomerates or business groups. The prevailing view in the economics, management, and corporate governance is that corporate diversification destructs corporate value. See e.g., Morck et al., supra note 60; Larry H. P. Lang & Rene M. Stulz Tobin’s Q, Corporate Diversification, and Firm Performance, 102 J.POL.
value) projects – hence, the normative standard of the profit maximization is sacrificed. In sum, it is a common sense in advanced economies that unrelated- diversification depresses profitability.81
Managers in the United States in the 1960s were preoccupied with “conglomeration” – this third wave of M&A is thought to cause a significant level of inefficiency in the economy through unrelated-diversification. Subsequently, the fourth wave of M&A in the 1980s was mainly designed to rectify the inefficiency problem by divestiture – since then, in running business, “focus” rather than “diversification” has been established as the business norm in advanced Western countries.82
On the other hand, in most emerging countries, whether it be the grupos in Latin America, the business houses in India or the chaebol in South Korea, business groups still play a prominent role in the economy.83 According to established thought in advanced economies, these business confederations that are based on unrelated- diversification suffer great inefficiency as a result of value destruction. If this evaluation is true, all shareholders including a controller are damaged by a controller’s reckless pursuit of empire-building. Why, then, does a controller keep unrelated-diversification? The answer is related to the disproportional features of a controller’s personal payoff scheme in empire-building.
81 Tarun Khanna & Jan W. Rivkin, Estimating the Performance Effects of Business Groups in
Emerging Markets, 22. Strat. Mgmt. J. 45, 45 (2001).
82 For the general explanation of this Western norm, see e.g., Khanna & Palepu, Why Focused
Strategies May Be Wrong for Emerging Markets, 75 HARV.BUS.REV. 41 (1997); Khanna & Palepu, supra note 29.
Let us note NPB as the equivalently capitalized dollar value of incremental non-pecuniary benefits from empire-building that a controller can enjoy – even if market value for non-pecuniary benefits is not set, a controller has her own reserve value for non-pecuniary benefits. It cannot be overemphasized that a controller is thought to take all NPB no matter how much economic interest she has in a corporation. On the other hand, the dollar value of incremental inefficiency from expanding the empire is defined as INEF. As opposed to NPB, INEF is shared among all shareholders according to their pro-rata economic interest in a corporation. As a result, the amount of dollar value in economic inefficiency that a controlling shareholder has to bear personally in pursuit of empire-building is α INEF, where α is a controller’s economic interest in a corporation (0 ≤ α ≤ 1). In sum, costs arising from empire-building are proportionally borne by all shareholders whereas all benefits accrue to a controller.
From a controller’s point of view, when NPB is expected to be larger than α INEF, seeking the expansion of business or unrelated-diversification is personally beneficial even if the strategy of empire-building creates no value for all shareholders. As such, she would choose to enlarge the empire until the private marginal benefit (NPB) is equal to the private marginal cost (α INEF) although it destroys the value of the corporation. Intuitively, a controller may find it more attractive to pursue unrelated-diversification or empire-building when her economic interest (α) in a business group is small – then it is more likely that NPB is larger than α INEF. Accordingly, it is probable that a controller in the deep controlling minority structure
(CMS) has greater willingness to pursue the empire-building strategy than a controller in the deep controlled structure (CS).
Notwithstanding, there are some mechanisms in which a controller in the deep CMS might not pursue empire-building even if minority shareholders absorb the most inefficiency that empire-building creates. First, when huge inefficiency arising from the excessive empire-building would ultimately threaten the survival of the corporation, a controlling shareholder cannot help stopping the expansion of her business – otherwise, she would lose everything, her empire itself, and would not enjoy the private benefits any longer. For example, as a firm pursues inefficient expansion, the firm’s profit gradually decreases. Nonetheless, it could be still a sustainable empire-building for a while. When the profit of a corporate group reaches some point below zero (i.e., when total revenues are less than total costs),84 however, a controller should be concerned about whether she keeps to pursue inefficient unrelated-diversification. If the corporate losses accumulate continuously due to the reckless empire-building, ultimately the corporation would become unviable soon or later. Even if the incremental personal benefit of a controller from the expansion is still larger than the incremental personal cost (i.e., even if NPB is larger than α INEF), she does not have a choice to keep building the costly empire.
Second, given the necessity of continuing finance from the equity market for growth, a controller with a long-term horizon has an incentive to be careful in
84 In this sense, a corporation under a controller in the CMS system can be analyzed by the prism of the bureaucracy model in the public choice theory (e.g., Niskanen model) – rational bureaucrats have an incentive to maximize, rather than optimize, their budgets and/or the size their bureaucracy in order to enhance their power. Similarly, if a controller does not hold a significant economic interest in a corporation, she has an incentive to maximize the corporation’s budget (and/or expand the size of corporation) irrespective of efficiency.
reviewing projects in the first place in order to satisfy the existing and prospective shareholders. If they are not satisfied, existing shareholders would sell their shares, and prospective shareholders would not invest their money when a corporation needs external capital. Accordingly, a chain reaction would occur: the economic interest of a controller in a corporation (α) would increase; in turn, the total amount of the equity capital of the corporation would decrease, resulting in the reduction of debt capital and, ultimately, the size of assets.
If a controller’s time horizon is relatively short, then she would have no reason to voluntarily stop pursuing inefficient empire-building as long as her personal benefit (i.e., NPB) is larger than her personal cost (i.e., α INEF). Since the chain reaction aforementioned will generally take time, a short-sighted controller would not care about the end result of the chain reaction, (i.e., reduction of the size of assets) in the “future” which lies beyond her horizon. However, when a controller deems her time horizon as infinite in consideration of family inheritance, the upshot of the chain reaction is precisely inimical to the interest of a size-maximizing controller. With this fear, a controller may voluntarily stop inefficient expansion of the business at some point even if there is no other constraint in the market. In sum, to a family controller who is “immortal,” growth should be accompanied by profitability since a controller’s desire for empire-building are compromised by potential investors who pursue profits.
Indeed, any decision-maker in a corporation wants to be a captain of a “large ship.” Since a top manager in a widely held corporation in the 1960s (when conglomeration was a business trend in the United States) served for a relatively short
tenure, it is probable that she was not much concerned about how well the ship (i.e., profitability of a corporation) would fare in the future, after she retired. In contrast, since a family controller in a controlled corporation stays onboard the ship eternally, it might be plausible that she would generally have more reasons to care about the future condition of the ship – therefore, a controller has sufficient reasons to abstain from inefficient empire-building or pursue even efficient one.
Then, a more positive story may be possible for a business group in a developing economy that is built on the unrelated-diversification; in pursuing empire- building, it is plausible that family business groups with even deep CMS have reasons to search for profitability as well as growth; accordingly a far-sighted family controller would review more carefully the question of whether the expansionary project creates positive NPV; if a controller succeeds, unrelated-diversification does not incur the inefficiency cost. Thus, it is true that the performance of diversified business entities is not always poor – the experience of the value-destructive conglomeration in the United States might not apply to business groups of other countries with unrelated-diversification.85