Chapter 10: Corporate Governance 325
By the same token, because none of the three mechanisms are perfect in design or execution,
the market for corporate control, an external governance mechanism, is sometimes needed.
10-4 Market for Corporate Control
The market for corporate control is an external governance mechanism that is active
when a firm’s internal governance mechanisms fail.^99 The market for corporate control is
composed of individuals and firms that buy ownership positions in or purchase all of
potentially undervalued corporations typically for the purpose of forming new divisions
in established companies or merging two previously separate firms. Because the top-level
managers are assumed to be responsible for the undervalued firm’s poor performance,
they are usually replaced. An effective market for corporate control ensures that ineffec-
tive and/or opportunistic top-level managers are disciplined.^100
Commonly, target firm managers and board members are sensitive about takeover
bids emanating from the market for corporate control since being a target suggests that
they have been ineffective in fulfilling their responsibilities. For top-level managers, a
board’s decision to accept an acquiring firm’s offer typically finds them losing their jobs
because the acquirer usually wants different people to lead the firm. At the same time,
rejection of an offer also increases the risk of job loss for top-level managers because the
pressure from the board and shareholders for them to improve the firm’s performance
becomes substantial.^101
A hedge fund is an investment fund that can pursue many different investment strat-
egies, such as taking long and short positions, using arbitrage, and buying and selling
undervalued securities for the purpose of maximizing investors’ returns. Growing rap-
idly, in 2014 hedge fund assets topped $3 trillion and are expected to exceed $5 trillion
by 2018. It is expected that up to 65 percent of their funding comes from institutional
investors.^102 Given investors’ increasing desire to hold underperforming funds and their
managers accountable, hedge funds have become increasingly active in the market for
corporate control.^103 For example, “Some of the most complex deals in the current mar-
ket, including Baker Hughes and Halliburton, Allergan and Actavis, Staples and Office
Depot, and Time Warner Cable and Comcast, count prominent hedge funds as major
stockholders” who are working to close these deals suggesting positive prospects for the
combined firms.^104
The market for corporate
control is an external
governance mechanism that
is active when a firm’s internal
governance mechanisms fail.
In summary, executive compensation is a complex issue
that cannot be simply determined by the overall size of
the package. Although executive compensation has grown
dramatically, there are both legitimate and illegitimate
reasons for such huge pay packages. Each case needs to
be examined closely for possible problems of excess ver-
sus appropriateness. However, there is likely to be social
problems due to the perception that top management
executive compensation relative to the average worker has
added to the inequality in our society. As such, care should
be taken to manage this issue from a policy point-of-view.
Managerial human capital should be rewarded for its capa-
bility and the value it creates, but lower levels workers and
their human capital should also have opportunities to make
progress.
Sources: D. Fitzgerald, 2015, Staples CEO Sargent’s pay grew 15% to $12.4 million
last year; Chief executive earned $2.6 million in non-equity incentive compensa-
tion in 2014, Wall Street Journal, http://www.wsj.com, April 13; K. Hagey, 2015, Discovery
Communications CEO gets 2014 compensation of $1.561 million, Wall Street Journal,
http://www.wsj.com, April 6; J. W. Kim, B. Kogut, & J.-S. Yang, 2015, Executive compensation,
fat cats and best athletes, American Sociological Review, 80: 299–328; E. K. Lim, 2015,
The role of reference point in CEO restricted stock and its impact on R&D intensity in
high-technology firms, Strategic Management Journal, 36: 872–889; P. Rudegear, 2015,
Wall Street’s pay gap slims, Wall Street Journal, April 6, A1, A4; E. M. Fich, L. T. Starks, &
A. S. Yore, 2014, CEO deal-making activities and compensation, Journal of Financial
Economics, 114: 471–492; S. Williams, 2014, BG Group draws more heat over CEO com-
pensations; one of the biggest revolts against executive pay in the U.K. in recent years,
Wall Street Journal, http://www.wsj.com, November 28; R. Wilmers, 2014, Why excessive CEO
pay is bad for the economy, American Banker, http://www.americanbanker.com, March 14.
