Tension between Shareholder Primacy and (Quasi) Monopoly: A Theoretical Analysis of Controlling Shareholder Economies and China

Abstract

Professor Mark Roe explained that the shareholder wealth maximization norm (“the norm”) is not appropriate for a country with a (quasi) monopoly, because the norm encourages managers to maximize monopoly rents to the detriment of the national economy. This Article provides new findings and counter-intuitive arguments on the tension created by the norm and (quasi) monopoly, by exploring three key corporate governance concepts that Roe did not examine — (1) “controlling minority structure” (CMS), where dominant shareholders hold a fractional ownership in their controlled-corporations, (2) “tunneling” (i.e., the transfer of corporate wealth to controlling shareholders), and (3) Chinese state-owned enterprises (SOEs). First, given (quasi) monopoly, this Article considers the impact of CMS. CMS controllers, due to their fractional economic interests (e.g., 5% ownership), do not have a strong incentive to vigorously follow the norm. When the norm is not actively sought, public shareholders lose the opportunity to gain the maximum monopoly profits. A positive byproduct, however, is that national welfare is improved, since non-maximized monopoly profits do not hurt society and consumers to the fullest extent. Second, given CMS and (quasi) monopoly, this Article analyzes the impact of tunneling. Since tunneling provides more cash flows — including illicit cash flows — to CMS controllers, it strengthens their incentive to maximize shareholder wealth. The direct effect of tunneling to public shareholders is, by definition, negative. Counter-intuitively, however, tunneling is indirectly beneficial — to some extent — to public shareholders, due to CMS controllers’ reinforced incentive to increase profits. Thus, the net effect of tunneling on public shareholders is mixed. In regard to social welfare in (quasi) monopoly CMS, tunneling has a negative effect, since it encourages CMS controllers to pursue monopoly rents in a more aggressive manner. Third, this Article calls into question the effectiveness of the norm in a context of Chinese SOEs that do their business in domestic markets. Formally, the controlling shareholder of Chinese SOEs is the party-state. The party-state is, however, an agent of its citizens, who are the “ultimate shareholders” (and consumers). Given the (quasi) monopoly held by SOEs in China, the norm will encourage SOE managers to set a monopoly-profit maximizing price in domestic markets. Such pricing is beneficial to the citizens of China as the “ultimate shareholders” when the government holds a high percentage of ownership in an SOE. However, the pricing damages the citizens of China as consumers. Under certain circumstances, the combined effect of the norm on the “ultimate shareholders” — i.e., the citizens of China — could be a net loss if a significant amount of welfare in society disappears as dead-weight loss (DWL) in the national economy.