On the Optimal Allocation of Power between Shareholders and Managers

Abstract:     
The question of how to allocate power between managers and shareholders, while intensely debated, remains unresolved among scholars and policymakers. This paper contributes to this debate by formally investigating the optimal allocation of power for shareholders recognizing that they may be heterogeneous, and that agency problems exist with managers. In the model, I treat shareholders as economic actors who choose decision rules (or the degree of management insulation) under a veil of ignorance with the goal of maximizing their utility. Managers choose their consumption of private benefits based on the insulation levels chosen by shareholders. I demonstrate that shareholders face a trade-off when choosing the level of managerial power. High insulation is desirable because it prevents other minority shareholders from blocking potentially profitable investments. Low insulation level is desirable because it prevents other shareholders from approving potentially unprofitable investments, as well as reducing agency costs. I discuss how optimal insulation changes if we relax assumptions about shareholder heterogeneity and the presence of agency costs.

Number of Pages in PDF File: 46

Keywords: Shareholders, voting rules, managers, corporate governance

JEL Classification: D72, G34, G38, K22

working papers series