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Purchase versus pooling accounting

A student in my Mergers and Acquisitions class asked a question that took me back two decades:

I had a question about how pre 2001 consolidation was preferred due to accounting rules allowing pooling rather than purchase. I was taught last year and working this past summer that the form of an M&A deal was heavily influenced by tax considerations. I intuitively assumed purchase was the far superior option; doesn’t purchase accounting create an massive taxation benefit by allowing the surviving corporation deductions for goodwill even though I am ignorant as to the marked up value of assets on other considerations such as basis? I get that there are appearances to consider, but is that the only reason pooling was the preferable method of accounting?

Let's start with basics.

Acme Co., Inc., buys Omega, Inc., with Acme as the surviving entity. If pooling accounting was used, Acme's financial statements would be combined—“pooled”—with those of Omega, so that both companies’ assets and liabilities would be included on Acme’s balance sheet at their existing book value.[1]

If the deal is structured so as to use purchase accounting, however, the transaction is treated for accounting purposes as a purchase by Acme of Omega. In that case, Omega's assets would be marked up or down, as the case might be, to their fair market value on Acme's post-acquisition financial statements.

In addition, in purchase accounting, any control premium—defined for this purpose as the difference between the fair market value of Omega's assets and the price Acme paid to acquire Omega—would be included on Acme’s balance sheet as “goodwill.” In pooling accounting, there is no goodwill, because both companies' items are simply combined—the control premium is ignored.

Goodwill is amortized over time, which during the amortization period generates an annual expense on the company’s income statement. This reduces the company’s earnings and, as such, earnings per share.

Because the amortization period does not depend on the amount of goodwill in question, the more goodwill created in the acquisition, the greater the amount the company will recognize each year as an expense and, hence, the greater the reduction in the company’s annual earnings. Purchase accounting thus typically resulted in lower reported earnings.

Why would a company care? After all, we’re talking about a technical accounting treatment. The company’s actual cash flows are not affected. Yet, because reported earnings get so much attention from analysts and investors, falling accounting earnings are generally disfavored.

In addition, as we’ll see below, the purchase method makes it easier to assess the total purchase price paid to acquire the target, which in turn allows for more meaningful evaluation of the subsequent performance of that investment than is the case with the pooling method. Managers who would prefer that their shareholders not be able to accurately assess their performance might opt for pooling.

Given the option between purchase and pooling, companies thus would often pick pooling because management believed it made their earnings look better.

The SEC and the FASB thus worried that companies would choose between pooling and purchase based purely on how they wanted their accounting earnings to look rather than their actual financial condition.

Did the choice between purchase and pooling actually affect the stock price of the surviving entity? The answer appears to be no. Empirical studies found no statistically significant abnormal returns from one choice versus the other. Analysts and investors appear to have focused on cash earnings rather than accounting earnings. Perhaps as a result, the corporate preference for pooling was marginal. Most years, the split between purchase and pooling leaned only slightly to the latter. Still, there was a perception that companies wasted a lot of money trying to structure deals so that their preferred accounting treatment could be available and that some deals didn’t happen simply because they couldn’t get the preferred treatment.

Turning to the tax consequences, it is true that purchase accounting generates significant tax benefits. The goodwill accrued generates amortization tax deductions. The stepped-up basis means that if the surviving company sells some of the acquired assets, the company will recognize less gain and, accordingly, pay less tax.

In 2001, the FASB ruled that all acquisitions should be taxed as purchases:

The single-method approach … reflects the conclusion that virtually all business combinations are acquisitions and, thus, all business combinations should be accounted for in the same way that other asset acquisitions are accounted for-based on the values exchanged.

The FASB argued that the change would aid investors by ensuring that financial statements would:

Better reflect the investment made in an acquired entity—the purchase method records a business combination based on the values exchanged, thus users are provided information about the total purchase price paid to acquire another entity, which allows for more meaningful evaluation of the subsequent performance of that investment. Similar information is not provided when the pooling method is used.

Improve the comparability of reported financial information—all business combinations are accounted for using a single method, thus, users are able to compare the financial results of entities that engage in business combinations on an apples-to-apples basis. That is because the assets acquired and liabilities assumed in all business combinations are recognized and measured in the same way regardless of the nature of the consideration exchanged for them.

Provide more complete financial information—the explicit criteria for recognition of intangible assets apart from goodwill and the expanded disclosure requirements of this Statement provide more information about the assets acquired and liabilities assumed in business combinations. That additional information should, among other things, provide users with a better understanding of the resources acquired and improve their ability to assess future profitability and cash flows.

In addition, the FASB argued it would lower transaction costs:

Requiring one method of accounting reduces the costs of accounting for business combinations. For example, it eliminates the costs incurred by entities in positioning themselves to meet the criteria for using the pooling method, such as the monetary and nonmonetary costs of taking actions they might not otherwise have taken or refraining from actions they might otherwise have taken.

In sum, both forms had perceived advantages—but only if you assumed analysts and investors focused solely on headline earnings rather than digging into the income statement and balance sheet.

SOX Section 404 Compliance Costs are Still Rising Twenty Years Later

Sarbanes-Oxley section 404 average compliance costs have not fallen significantly over the last two decades. According to Protiviti, for example, large accelerated filers had average internal § 404 compliance costs of $1,335,000 in 2016 and $1,338,000 in 2018.[1] Firms with more than two years of compliance experience had average internal compliance costs of $1,183,000 in 2016 and $1,105,300 in 2018.[2] Fifty percent of large accelerated filers reported that their external audit fees went up in 2017 relative to 2016.[3] In 2019, Protiviti reported that the hours and effort level committed to SOX compliance had not decreased significantly in the preceding decade.[4]

Protiviti’s 2022 report found that § 404 compliance costs continued to rise, as did the number of personnel hours expended on compliance.[5] It also reported that external auditors were requesting greater amounts of SOX-related information in connection with § 404(b) evaluations.[6] The average cost for companies in their first year of § 404(a) and 404(b) compliance was $1,477,500.[7] Large accelerated filers had average internal compliance costs of $1,450,800 in 2022.[8]  Firms with more than two years of compliance experience had average internal compliance costs of $1,468,300.[9] The percentage of large accelerated filers paying more than $2 million per year rose from 24 to 26 percent, while the percentage paying less than $500,000 fell from 24 to 16 percent.[10] At least some of the increase was due to pandemic-related factors, such as labor shortage and employees working remotely,[11] but it remains striking that 20 years after § 404 was adopted costs continue to rise.

Still more on the requirement that board of director decisions be informed

Mark Twain and the Hale & Norcross Mining Case which is one of the ur-precedents on the requirement that board of director decisions be informed. https://t.co/NoL4pivbqk

— Steve Bainbridge (@PrawfBainbridge) August 23, 2022

Keith Paul Bishop on the origins of the requirement that board decision be informed

He writes:

In  Fox v. Hale & Norcross Silver Mining Co.,  108 Cal. 369, 41 P. 308 (1895), the trial court held directors liable for a diversion of funds by the president of the corporation to himself. The court said: “None of the directors, however, had any substantial interest in the corporation.…Being chosen in this way [i.e., by the president and substantial shareholders] and receiving no compensation for their services, except $5 for each meeting of the board at which they attended, they gave to the affairs of the company the amount of attention that might have been expected. Several of them seemed to have known next to nothing about the operations at the mine. While others took a little more trouble to keep themselves informed in a general way about the mining of ores and the price paid for reduction, they seem one and all to have entrusted the management of the entire business to the president, Levy, and to the superintendent of the mines; and, if these officers, by abuse of their trust, caused the loss and damage to the mining company which the court has found, the evidence warrants the conclusion that the directors were at least guilty of gross negligence.”  Despite this statement, the Supreme Court reversed the judgment against the directors on the technical pleading point that the complaint had alleged only that they were guilty of fraud, and not of negligence.

Ed Steiner sends along more information about the origins of the requirement that board decisions be informed

He writes:

The citation to the trial court opinion in Youngstown Sheet & Tube prompted this.  As you know I am on a solitary mission to pull Ohio corporation law out of obscurity. I came across a surprising manuscript in which Dodd and Berle were on the same side (nominally) in  arguing against an early 1931 proposed amendment to the appraisal section of the  Ohio corporation code. The amendment was  sponsored by Cyrus Eaton in connection with the Youngstown Sheet & Tube/Bethlehem Steel transaction that was the subject of the trial court opinion.  

That said, the  trial court opinion was reversed on every substantive issue on appeal.  (As to being informed, the Board members were all steel industry players and Y S & T had been in merger discussions on and off since 1927, including with Eaton companies).  As to Berle and Dodd, volume 44 of the Harvard Law Review had some interesting content.  Berle’s powers in trust piece was sandwiched between  Pound’s attack on the legal realists and Llewellyn’s response. Point 10 of Pound’s attack was on the legal realists’ so-called entrepreneur theory of the law,  that business functions were the proper concern of the law and not broader social matters. Llewellyn rebutted that, noting that 7 of the 10 commercial lawyers in his sample (Berle was not in  the sample group) were not guilty of that charge.  Given that Pound was Dodd’s mentor (Pound got Dodd his first real academic job at Nebraska, where Pound had been dean and where he was shaping the faculty in the early 1920s), Harvard colleague  and friend, it seems conceivable that Dodd’s response to powers in trust (coming out of Columbia, the hotbed of legal realism)  was another version of Pound’s point 10.  In his response to Dodd, Berle (like Llewellyn had) rebutted the notion that he didn’t take social concerns seriously.  The piece Berle wrote in the Ohio appraisal statute context could also have been cited by Berle in rebuttal.  More of this later (I still have a day job). Finally, I wonder whether Berle’s reaction to Eaton (who espoused a local control of industry philosophy but who was in fact a fairly cut-throat empire builder) added fuel to Berle’s response to Dodd about industrial princes feeling no obligation and not being accountable.  That too awaits further development.     Thanks for your provocative  blog post. Best.

California greenhouse gas statute stumbles onward

Keith Paul Bishop reports:

SB 260 (Wiener & Stern) is moving forward despite strong opposition from business groups.  As has been previously noted in this space, the bill would require any U.S.-based business with annual revenues in excess of $1 billion and that does business in California to annually report the full range of greenhouse gas (GHG) emissions attributable to the business, including direct emissions, electricity use, and indirect emissions from the business’s supply chain and other sources. 

Keith notes lots of opposition to the bill and various constitutional defects in the legislation.

Mitchell v. Highland-W. Glass Co.: The origin of the requirement that director decisions be informed?

Delaware law provides that the business judgment rule will not protect uninformed decisions by the board of directors. Specifically, the rule will not apply if plaintiff can show that a majority of the board was grossly negligent in failing to avail themselves of all material information reasonably available to them. Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), is usually cited as the origin of that requirement.

I recently got into a discussion on Twitter about whether there were pre-Van Gorkom signals that Delaware would make an informed decision a precondition to application of the business judgment rule.

It was suggested that Aronson v. Lewis was the root of Van Gorkom and its progeny in cases like Unocal and Revlon.

Aronson is relevant today mainly as one of the two "seminal demand futility cases in Delaware" (the other being Rales v. Blasband). Orexigen Therapeutics, Inc. v. Narachi, CV 12412-VCMR, 2018 WL 1100372, at *9 (Del. Ch. Feb. 28, 2018).

But there also is no doubt that Aronson was an incredibly important case in the evolution of the business judgment rule. As the late Delaware Supreme Court Justice Randy Holland observed, "the Delaware Supreme Court refined the business judgment rule in what is now a seminal case--Aronson v. Lewis." Randy J. Holland, Delaware Directors' Fiduciary Duties: The Focus on Loyalty, 11 U. Pa. J. Bus. L. 675, 681 (2009). In particular, the Aronson opinion stated that "to invoke the rule's protection directors have a duty to inform themselves, prior to making a business decision, of all material information reasonably available to them. Having become so informed, they must then act with requisite care in the discharge of their duties." Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984). Arguably, however, that statement was dicta, leaving it for Van Gorkom to raise the principle to that of a holding.

Having said that, however, I do not think Aronson is the ur-source of the principle. A decade before Aronson, the Delaware Chancery Court decided Gimbel v. Signal Companies, Inc., 316 A.2d 599 (Del. Ch. 1974), aff'd, 316 A.2d 619 (Del. 1974). In it, the Court stated that invoking the business judgment rule requires "a showing that informed directors did, in fact, make a business judgment authorizing the transaction under review." Id. at 609.

The procedural posture of the case matters. The issue before the court was whether plaintiff shareholder was entitled to a preliminary injunction enjoining Signal from selling off one of its subsidiaries. The court concluded that "The circumstances are such as to raise the question as to whether the Signal Board, when the sale of Signal Oil stock was presented, were able to perform their fiduciary obligation as directors to make an informed judgment of approving the transaction." Id. at 614. The court went on to identify a number of allegations suggesting that the decision to sell was not an informed one. 

It is at this point that the procedural posture becomes critical. Comparing the potential harm to Signal shareholders if the injunction was denied to the potential harms to Signal and the buyer if the deal was blocked--even on a temporary basis--the court stated it would grant the preliminary injunction but only if the plaintiff posted a bond "in the amount of twenty five million dollars, an amount which is, as far as I have been able to determine, without precedent." Id. at 618. 

Plaintiff appealed, arguing that the required security was unreasonable. The Supreme Court rejected that argument. Gimbel v. Signal Companies, Inc., 316 A.2d 619, 619 (Del. 1974).

Plaintiff was unable to post the required security and, as a result, the preliminary injunction did not issue and the case did not proceed to the merits.

But the requirement that the board's decision be informed was on the books ten years before Aronson.

Yet, even Gimbel is not the true ur-source. (One begins to feel like an explorer looking for the source of the Mississippi or the Nile.)

Gimbel itself cited two earlier cases. See Kaplan v. Centex Corp., 284 A.2d 119, 124 (Del. Ch. 1971) ("Application of the [business judgment] rule of necessity depends upon a showing that informed directors did, in fact, make a business judgment authorizing the transaction under review."); Mitchell v. Highland-W. Glass Co. 167 A. 831, 833 (Del. Ch. 1933). ("I can find no justification in the evidence for concluding that the defendant's directors acted so far without information that they can be said to have passed an unitelligent and unadvised judgment.").

I have been unable to find a Delaware decision on point that is older than Mitchell. I did, however, find an earlier decision by an Ohio Court of Common Pleas, which was interpreting an Ohio statute allowing the corporation to sell sell, lease or exchange or otherwise dispose of all ... of its property and assets ... upon such terms and conditions and for such considerations, ... as its board of directors deems expedient ..." Wick v. Youngstown Sheet & Tube Co., 1930 WL 2386, at *2 (Ohio Com. Pl. 1930) (emphasis supplied), rev'd, 188 N.E. 514 (Ohio App. 7th Dist. 1932). The court observed that:

“Deems” means “to judge or to form an opinion; to determine.” To deem expedient thus requires and pre-supposes fully informed judgment on the part of each and every member of the board present to take action, after reasonable opportunity afforded for investigation, weighing and determination at the meeting of all the terms, conditions and considerations entering into the proposal.

Id. at *3. The case is not directly on point, because it was not dealing with the business judgment rule, but it does suggest that the requirement of an informed decision is even older than I suspected.

Is Caremark coming for ESG issues?

Bass Berry has a very good blog post on board oversight of ESG issues. They explain that a number of developments, including "the heightened consideration of institutional investors and proxy advisory firms on ESG board oversight and ESG considerations more generally, as well as various recent proposed rules and initiatives of the Securities and Exchange Commission (SEC) with respect to ESG matters, including the proposed climate rules issued by the SEC earlier this year," have induced many boards of directors to assume direct oversight of ESG issues.

They further explain that:

Most public companies have an oversight structure whereby the full board has sole or dual (along with a board committee) primary oversight responsibilities with respect to at least certain ESG matters. The approach of having the entire board be primarily responsible for the oversight of certain ESG matters may reflect that a particular matter is viewed as a core responsibility of the full board. ...

However, there is a trend toward the increasing delegation of ESG matters to board committees. For example, according to an EY study of Fortune 100 companies in 2021, 85% of the surveyed companies disclosed that a committee of the board oversaw environmental sustainability or corporate responsibility matters, compared to 78% in 2020. While these figures are likely higher among Fortune 100 companies than public companies as a whole, this increase between 2020 and 2021 reflects a trend toward greater board committee oversight of ESG matters occurring more generally among U.S. public companies.

They do not suggest that Caremark concerns are driving board attention to ESG issues. But I worry that that's coming down the pike:

Since the foundational decision in In re Caremark Intern. Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996), Delaware corporate law has required boards of directors to establish reasonable legal compliance programs. Although Caremark has been applied almost exclusively with respect to law and accounting compliance, the original Caremark decision contemplated applying the oversight duty to the corporation’s “business performance.” Accordingly, there is no doctrinal reason that Caremark claims should not lie in cases in which the corporation suffered losses, not due to a failure to comply with applicable laws, but rather due to lax risk management.

The question thus arises as to whether Caremark should be extended to board failures to exercise oversight with respect to environmental, social, and governance (ESG) factors. Obviously, where existing legislation or regulations impose compliance obligations in ESG-related areas, such as human resources, the environment, or worker safety, Caremark already applies. As such, boards must “ensure that compliance and monitoring systems are in place” to oversee corporate compliance with those laws.

Many ESG issues are not yet the subject to legal requirements, however. The question addressed in this Article is whether the board’s Caremark obligations should be extended to encompass oversight of corporate performance with such issues. In other words, should the board face potential liability not just for failing to ensure that the company has adequate reporting and monitoring systems in place to insure compliance with ESG-related legal requirements, but also to monitor ESG risks in areas where corporate compliance would be voluntary or aspirational.

Bainbridge, Stephen Mark, Don’t Compound the Caremark Mistake by Extending it to ESG Oversight (September 2021). Business Lawyer (September 2021), UCLA School of Law, Law-Econ Research Paper No. 21-10, Available at SSRN: https://ssrn.com/abstract=3899528

How does Delaware decide cases so quickly?

Matt's theory is that " It is the expertise within Chancery’s broader ecosystem – both bench and bar – that fuels the court’s performance." Makes sense to me.

— Steve Bainbridge (@PrawfBainbridge) August 14, 2022

Corporate social responsibility can backfire

John List & Fatemeh Momeni, 2017. "When Corporate Social Responsibility Backfires: Theory and Evidence from a Natural Field Experiment," Natural Field Experiments 00618, The Field Experiments Website.

Corporate Social Responsibility (CSR) has become a cornerstone of modern business practice, developing from a "why" in the 1960s to a "must" today. Early empirical evidence on both the demand and supply sides has largely confirmed CSR's efficacy. This paper combines theory with a large-scale natural field experiment to connect CSR to an important but often neglected behavior: employee misconduct and shirking. Through employing more than 3,000 workers, we find that our usage of CSR increases employee misbehavior - 20% more employees act detrimentally toward our firm by shirking on their primary job duty when we introduce CSR. Complementary treatments suggest that "moral licensing" is at work, in that the "doing good" nature of CSR induces workers to misbehave on another dimension that hurts the firm. In this way, our data highlight a potential dark cloud of CSR, and serve to forewarn that such business practices should not be blindly applied.

David Skeel on The Corporation as Trinity

I am reminded of a line of dialogue from the musical 1776. After Richard Henry Lee returns from Virginia with the proposal for independence, Edward Rutledge states:

"Mr. President, although we of South Carolina have never seriously considered the question of independence, when a gentleman proposes it, attention must be paid."

This came to mind as I read my friend David Skeel's CLS Blue Sky Blog post, The Corporation as Trinity. I have seriously considered the question of corporate personhood. It is a doctrine for which I have very little patience. But when a scholar such as Skeel proposes it, attention must be paid.

Christian theology, as brilliantly explicated in [St. Augustine's] The Trinity, states that God consists of three different persons – the Father, the Son, and the Holy Spirit – but is a single divine being. Drawing on recent work by the theologian Curtis Chang, I argue that corporate personhood has similar qualities and that the analogy is not accidental. According to Christian scripture, the universe is a reflection of God. If this is true, the echoes – in particular, echoes of the Trinity – extend even to human institutions such as corporations. Much as theologically orthodox Christians understand God to be both one and three, I argue that corporations are best seen as having a corporate identity distinct from their managers, shareholders, and other constituents and reflecting the qualities of these constituents. ...

The Trinitarian perspective combines attributes of both the aggregate and the real entity theories of the corporation. The distinction is that the Trinitarian perspective insists that both theories are needed, rather than one or the other.

He elaborates on the argument in a paper posted to SSRN.

I mused on the nature of corporate personhood in my post The corporation is not a real entity and to argue to the contrary is "transcendental nonsense." In it, I confessed that:

I have a very practical mind. Most abstract reasoning strikes me as metaphysical mumbo jumbo. ... Put simply, I just can't wrap my head around the metaphysical abstractions required to think of the corporation as an entity--real or otherwise--rather than as an aggregate. Being unable to perform the mental gymnastics necessary to "thingify" the corporation, I am happy to find such a distinguished precedent for dismissing the effort so blithely. 

The precedent to which I referred to was Felix S. Cohen's wonderful article, Transcendental Nonsense and the Functional Approach, 35 Colum. L. Rev. 809 (1935). In it, he referred to the question of where a corporation is located as "a question identical in metaphysical status with the question which scholastic theologians are supposed to have argued at great length, 'How many angels can stand on the point of a needle?'”

To that confession I must now add that, for me, analogizing the corporation to the Trinity doesn't help much. For while it is the case that I believe in the Trinity (I give it what we Catholics call religious assent), I don't claim to understand it. I take comfort in C.S. Lewis' point that while the Trinity is something that is ultimately beyond our intellectual understanding, we can experience it. Or, as Lewis explained, “We cannot compete, in simplicity, with people who are inventing religions. How could we? We are dealing with Fact. Of course anyone can be simple if he has not facts to bother about.”

If you're more comfortable with metaphysics and philosophy that I am, however, you likely will find Skeel's analysis helpful. Conversely, if you're not, you would still benefit from reading Skeel's article. After all, I'm still trying to understand the Trinity.

In sum, attention must be paid to Skeel's article because it's a wonderful example of intellectual arbitrage. Few other scholars would be so smart, adventurous, and widely read to pull off such a feat.

A Critique of Hart and Zingales "New Corporate Governance"

Oliver Hart and Luigi Zingales are pushing a concept they call the "New Corporate Governance," none of which is exactly new and from which I must dissent.

They start with two anecdotes: The 2021 approval of a shareholder proposal at Dupont "requiring the company to disclose how much plastic it releases into the environment each year and to assess the effectiveness of DuPont’s pollution policies." Actually, their description of the proposal is inaccurate in an important way. The proposal does not require such a report, it merely requests such a report. This is important because part of their claim is that we are seeing (and should see even more of ) a shift towards a more shareholder-centric model of corporate governance.

The other anecdote is the 2021 approval of a shareholder proposal at ExxonMobil "requiring the company to describe 'if, and how, ExxonMobil’s lobbying activities … align with the goal of limiting average global warming to well below 2 degrees Celsius…'" Once again, they misdescribe the proposal. In fact, as with Dupont, the actual proposal was a request not a mandate.

Based on these anecdotes, they argue that:

It is hard to explain this behavior using the dominant corporate governance paradigm, according to which shareholders have a single objective: shareholder value maximization (SVM). In the above examples, shareholders seem to be pushing companies to do things that might reduce value. Many scholars have criticized the SVM paradigm, arguing that managers should act in the interest of other stakeholders – workers, consumers, the community – or that companies should have a social purpose over and above making money.

It turns out that lawyers are not the only ones who think data is the plural of anecdotes.

When we look at the data it remains the case that the majority shareholder proposals in the ESG space (i.e., environmental, social, and governance) still fail. According to Gibson Dunn's analysis of the 2021 proxy season, in 2021, environmental proposals averaged 42.% support, while social proposals averaged 30%.

Should Shareholders Vote on Corporate Strategy?

Hart and Zingales contend that these anecdotes tells us that the traditional norm of shareholder value maximization (SVM) is neither what shareholders prefer nor socially optimal.

In a classical world of perfect competition, complete markets, and no externalities, SVM will be unanimously favored by shareholders and will lead to a socially efficient outcome. These results still hold in the case of externalities as long as these externalities are perfectly regulated by the government. But what happens if the government has not regulated optimally, a particular concern when an externality is global, as with climate change, and coordination by many governments is required for optimal mitigation? There is then no reason to think that SVM will be unanimously favored by shareholders or be socially efficient. Consider the above DuPont example. Some shareholders may favor a less-polluting technology, even if it is more costly, because plastic waste affects them directly or they care about the effect of the waste on others. Other shareholders may not be personally affected or may care less about the welfare of others and so would like to stick to the current technology.

Hart and Zingales therefore want "to allow shareholders to vote on company strategy."

I could not disagree more.

No serious scholar of corporate law denies that shareholders have heterogenous preferences. In fact, however, it is precisely for that reason that SVM is the preferable decision-making norm and that corporate governance is board- rather than shareholder-centric.

In my book, The New Corporate Governance in Theory and Practice, I explain that claim at considerable length. But a short version of why shareholder heterogeneity leads to board-centric governance is available in an older post here.

As my colleague Iman Anabtawi observed: “On close analysis, shareholder interests look highly fragmented.” Iman Anabtawi, Some Skepticism About Increasing Shareholder Power 4 (unpublished manuscript on file with author). She documents divergences among investors along multiple fault lines: short-term versus long-term, diversified versus undiversified, inside versus outside, social versus economic, and hedged versus unhedged. Shareholder investment time horizons are likely to vary from short-term speculation to long-term buy-and-hold strategies, for example, which in turn is likely to result in disagreements about corporate strategy. Even more prosaically, shareholders in different tax brackets are likely to disagree about such matters as dividend policy, as are shareholders who disagree about the merits of allowing management to invest the firm’s free cash flow in new projects.

Consequently, as I explain in The Case for Limited Shareholder Voting Rights, it is hardly surprising that the modern public corporation’s decision-making structure precisely fits Kenneth Arrow’s model of an authority-based decision-making system. Overcoming the collective action problems that prevent meaningful shareholder involvement would be difficult and costly, of course. Even if one could do so, moreover, shareholders lack both the information and the incentives necessary to make sound decisions on either operational or policy questions.  Under these conditions, it is “cheaper and more efficient to transmit all the pieces of information to a central place” and to have the central office “make the collective choice and transmit it rather than retransmit all the information on which the decision is based.”  Accordingly, shareholders will prefer to irrevocably delegate decision-making authority to some smaller group.

What is that group? The Delaware code, like the corporate law of virtually every other state, gives us a clear answer: the corporation’s “business and affairs ... shall be managed by or under the direction of the board of directors.”  Hence, as an early New York decision put it, the board’s powers are “original and undelegated.” Manson v. Curtis, 119 N.E. 559, 562 (N.Y. 1918). 

The central argument against shareholder activism thus becomes apparent. Active investor involvement in corporate decision making seems likely to disrupt the very mechanism that makes the public corporation practicable; namely, the centralization of essentially non-reviewable decision-making authority in the board of directors. The chief economic virtue of the public corporation is not that it permits the aggregation of large capital pools, as some have suggested, but rather that it provides a hierarchical decision-making structure well-suited to the problem of operating a large business enterprise with numerous employees, managers, shareholders, creditors, and other inputs. In such a firm, someone must be in charge: “Under conditions of widely dispersed information and the need for speed in decisions, authoritative control at the tactical level is essential for success.”  While some argue that shareholder activism “differs, at least in form, from completely shifting authority from managers to” investors, it is in fact a difference in form only. Shareholder activism necessarily contemplates that institutions will review management decisions, step in when management performance falters, and exercise voting control to effect a change in policy or personnel. For the reasons identified above, giving investors this power of review differs little from giving them the power to make management decisions in the first place. Even though investors probably would not micromanage portfolio corporations, vesting them with the power to review board decisions inevitably shifts some portion of the board’s authority to them. This remains true even if only major decisions of A are reviewed by B. The board directors of General Motors, after all, no more micromanages GM than would a coalition of activist institutional investors, but it is still in charge.

If Government is the Problem, Corporations are not the Solution

Note, by the way, that Hart and Zingales' argument depends on a multinational failure of governments to regulate optimally. This is actually a very old argument. 

Back in the 1930s E. Professor Merrick Dodd’s pro-corporate social responsibility argument rested in large part of the belief that society demanded that business assume social responsibilities.  Forty years later, liberals were still arguing that society was plagued by a host of urgent social ills and that, there being no time to wait for the political process to solve them, business should take the lead. They believed that business could effect social change faster and more effectively than politics.

Setting aside the inconsistency of this argument with democratic principles, does it make sense to draft the corporation to tackle social ills the government can’t or won’t solve?

A core problem thus is that most directors and officers likely lack the skill set necessary to make decisions about ESG issues. If asked to resolve the more complex and difficult questions required by stakeholder capitalism, managers therefore would need to acquire much new information and expertise.  As long as they lack such information and skills, asking managers to focus on such questions will inevitably distract them from ensuring that their company makes money for the shareholders.

Even if managers had the requisite knowledge and skills, they probably have a very weak idea of what shareholders would prefer with respect to social issues.  Of course, some large shareholders can communicate their preferences to management. Larry Fink’s annual letters to the CEOs of BlackRock’s portfolio companies are but the best known example of this phenomenon. Yet, as we’ll see below, those shareholders often act in ways that are inconsistent with the messages they are sending. Should management pay attention to what these investors say or what they do? In addition, it is hardly clear that Larry Fink’s preferences are representative of that of investors as a class, especially that of small retail investors.

Finally, corporate executives lack incentives to solve social ills especially insofar as those ills fall outside their enterprise’s business. Put another way, while business may have incentives to deal with the negative externalities produced by the enterprise’s activities, they lack incentives to generate positive externalities that bestow benefits on society without generating a return for their shareholders.  To the contrary, managers’ incentives are aligned more closely with the shareholders’ interest in value maximization than with ESG concerns.